The Total Credit Cost Curve

The trade-off between granting credit and not granting credit isn't hard to identify, but it is difficult to quantify precisely. As a result, we can only describe an optimal credit policy. To begin, the carrying costs associated with granting credit come in three forms:

1. The required return on receivables

2. The losses from bad debts

3. The costs of managing credit and credit collections

We have already discussed the first and second of these. The third cost, the cost of managing credit, consists of the expenses associated with running the credit department. Firms that don't grant credit have no such department and no such expense. These three costs will all increase as credit policy is relaxed.

If a firm has a very restrictive credit policy, then all of the associated costs will be low. In this case, the firm will have a "shortage" of credit, so there will be an opportunity cost. This opportunity cost is the extra potential profit from credit sales that is lost

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VII. Short-Term Financial Planning and Management

21. Credit and Inventory Management

© The McGraw-Hill Companies, 2002

CHAPTER 21 Credit and Inventory Management

Cost ($)

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