What are the Objectives of Credit Policy?


What is Credit Policy?

The credit policy of a firm is a marketing tool or it can be used as a marketing tool to expand the business. A firm that has a good credit policy in place is advantageous among its peers in the industry. Buyers would prefer a seller that offers its goods or services through a credit policy that is not too stringent. Credit policy helps firms retain old customers and create new ones. It is therefore essential for firms to have a good credit policy to grow in business.

Before we consider the objectives of credit policy, it is worthwhile to look at the two types of credit policy, namely −

  • Lenient Credit Policy
  • Stringent Credit Policy

The lenient credit policy is liberal to the maximum. In the case of a lenient credit policy, the firm offers maximum credit and/or credit to almost all buyers without judging their financial capabilities.

On the other hand, a stringent credit policy is a very selective one. It offers credit to only a select group of buyers whose credit history is known to the seller.

Now, the question that is most common is - why should a company build a credit policy, or what are the objectives of creating a credit policy?

Credit Policy as A Marketing Tool

The credit policy of a firm is a marketing tool or it can be used as a marketing tool to expand the business. A firm that has a good credit policy in place is advantageous among its peers in the industry. Buyers would prefer a seller that offers its goods or services through a credit policy that is not too stringent. Credit policy helps firms retain old customers and create new ones. It is therefore essential for firms to have a good credit policy to grow in business.

Objectives of Credit Policy

A credit policy requires a great idea about customers and firms that have worked in a market segment for a long can create better credit policies depending on their past experiences. So, the objective of the credit policy is to add incremental profit by working as a marketing tool for a firm.

Firms do not engage in credit just for sales maximization. If it were so, the firm would have a very lenient credit policy where it would offer credit to all firms without any strict standards. In practice, no company offers credit in so lenient terms. In practice, there is a cost of credit that increases with increasing sales.

Additional sales affect the firm’s operating profit, but there are three types of costs involved in the case of additional sales. They are as follows:

Production and Selling Costs

Variable production and sales costs increase with the increase in credit with expansion in sales. If sales expand within the existing production capacity, then variable costs will increase. If expansion is made for an increase in sales, then incremental production and sales costs would increase. A tight credit policy excludes some of the companies which lead to loss of opportunity or the creation of lost opportunity cost. If subsequently, the credit policy is loosened, some of the lost opportunities can be regained. The opportunity cost, therefore, decreases with the loosening of credit policy.

Administrative Costs

There are two types of administrative costs involved with the loosening of credit policy.

First, the credit investigation and supervision cost increases with the expansion and loosening of credit policy.

Second, collection costs increase when the firm applies more effort to collect the accounts receivable. Therefore, the firm will have to bear incremental costs for getting incremental profits despite the loosening of credit policy.

Bad Debt Losses

Bad debt losses usually increase with incremental loosening of the credit policy. As the company sells to a large number of buyers without considering the financial soundness of the buyer, some customers may fail to make the payments. In such cases, the seller may feel the brunt of losses due to the loosening of credit policy and may have to resort to tightening the credit policy in the future.

Conclusion

Having a good credit policy that can result in incremental profit is the utmost objective of all business firms. Credit policy is used as a great marketing tool and it is a good objective of the firms to use credit policies as marketing tools. However, as is obvious, there are no hard and fast rules to build the credit policy and it may depend on many factors to create an ideal credit policy for firms in their own industries.

Updated on: 30-Jun-2022

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