What are the main reasons for selling on credit? Most suppliers allow their credit-worthy customers to defer payment for their purchase. Deferred payment terms exist to allow buyers to store, process, and sell the purchased items before having to pay off the amount due. Without them, most companies would be unable to operate without relying on expensive, constant lines of credit.
But is selling on credit the right solution for your company? Selling on credit is essentially a marketing technique: providing a service to customers to entice more customers to buy. However; in some industries, especially capital-intensive ones, credit is almost always expected.
Companies sell on credit to the extent that the increase in sales justifies the associated bookkeeping, bad debt, and carrying costs. As an example, almost all of Airbus’ sales are credit sales. On the other hand, almost all of Burger King’s sales are cash sales.
But why does Airbus sell on credit, and why doesn’t Burger King sell on credit?
Let’s now analyze the three costs of selling on credit.
1. Bad Debts
Once a Whooper is eaten Burger King’s leverage in the collection process is substantially diminished. They can’t get the inventory back. And the cost to collect, going around to people’s homes to collect would exceed the cost of the meal. In contrast to Airbus, the thought that an airline may fail to pay its bill is tempered by the knowledge that Airbus can recover the airplane and sell it to someone else.
If your company trades goods and/or services on credit, you might often find yourself chasing unpaid invoices. While you might be successful in getting your money back a few times, sometimes you’ll have to ask a professional for help and hire a debt collection agency. Here are 6 fundamental tips you need to follow before hiring a debt collection agency.
2. Bookkeeping costs.
We all know that Burger King has served billions and billions of people. Imagine the number of monthly statements that would have to be mailed if it were to sell on credit. The postage cost alone would be huge.
Besides, Burger King would have to maintain a large computer database to track each of the millions of credit customers. Also if Burger King were to sell on credit, a credit check would need to be run on each potential credit customer to keep the amounts of bad debts at a reasonable level. Because the transaction amounts are so small, this process would be prohibitively expensive. Finally, each Burger King location would have to hire several new staff-people who would do nothing but manage the bookkeeping associated with credit sales.
It is entirely possible that the bookkeeping costs associated with a single credit sale would exceed the cost of the meal.
By contrast, for a company like Airbus, where each credit transaction totals tens of millions of dollars, the associated bookkeeping cost is not large enough to worry about.
3. Carrying Costs.
With cash tied up in receivables, Burger King would have to pay its operating expenses and finance its expansions through increased borrowing, increasing its annual interest expense. Presumably, the managers of Airbus have done an analysis and have concluded that the benefit of selling on credit, in terms of attracting more customers, exceeds this increased borrowing cost.
In Conclusion
In summary, credit sales make the most sense for companies like Airbus, where the number of individual accounts is small, the value of each transaction is large, and the recoverability of the inventory reduces the expected costs of bad debts.
For all of these same reasons a business like Burger King, with lots of customer transactions with small-dollar values, and where the inventory is not recoverable, is not a good candidate for credit sales.