## Approaches to Evaluation of Credit Policies

There are two methods of evaluating which credit policy a company should adopt:

1. Total Approach

2. Incremental Approach

Both lead to the same decision; they differ only in presentation. Choose the policy with the highest net benefit.

### A. Total Approach — Format

Particulars	Present Policy	Policy I	Policy II	Policy III
A. Expected Profit
a. Credit Sales
b. Total Cost other than Bad Debts
i. Variable Costs
ii. Fixed Costs
c. Bad Debts
d. Cash Discount
e. Expected Net Profit before Tax (a − b − c − d)
f. Less: Tax
g. Expected Profit after Tax
B. Opportunity Cost of investment in receivables locked up in collection period
Net Benefits (A − B)

Advise: Adopt the policy with the highest net benefit (A − B).

### B. Incremental Approach — Format

Particulars	Present	Policy I	Policy II	Policy III
A. Incremental Expected Profit
a. Incremental Credit Sales
b. Less: Incremental Costs (Variable + Fixed)
c. Incremental Bad Debt Losses
d. Incremental Cash Discount
e. Incremental Expected Profit (a − b − c − d)
f. Less: Tax
g. Incremental Expected Profit after Tax
B. Required Return on Incremental Investment
a. Cost of Credit Sales
b. Collection Period (days)
c. Investment in Receivable = a × b ÷ (365 or 360)
d. Incremental Investment in Receivables
e. Required Rate of Return (%)
f. Required Return on Incremental Investment (d × e)
Incremental Net Benefits (A − B)

Advise: Adopt the policy with the highest incremental net benefit.

### Key Supporting Formulae

Total Fixed Cost:

$$\text{Total Fixed Cost} = (\text{Average Cost per unit} - \text{Variable Cost per unit}) \times \text{No. of units sold on credit under Present Policy}$$

Opportunity Cost of Receivables:

$$\text{Opportunity Cost} = \text{Total Cost of Credit Sales} \times \frac{\text{Collection Period (Days)}}{365 \text{ (or } 360)} \times \frac{\text{Required Rate of Return}}{100}$$

Worked example

### Example 1

Deriving Total Fixed Cost from average cost data:

Suppose average cost per unit = ₹9, variable cost per unit = ₹6, and 1,00,000 units are sold on credit under the present policy.

Total Fixed Cost = (9 − 6) × 1,00,000 = ₹3,00,000.

This fixed cost stays constant across all proposed policies (it does not change with sales volume), which is exactly why the Incremental Approach can ignore it when capacity is unchanged.

### Example 2

Opportunity cost of funds locked in receivables:

Total cost of credit sales = ₹8,00,000, collection period = 60 days, required rate of return = 20%, year = 365 days.

Opportunity Cost = 8,00,000 × (60 ÷ 365) × (20 ÷ 100) = ₹26,301 (approx).

⚠️ Common exam mistakes

Computing opportunity cost on sales value instead of on the total cost of credit sales (investment in receivables is valued at cost, not at selling price).
Recalculating fixed costs for each proposed policy — fixed cost is constant; only variable cost changes with volume. Treat the same total fixed cost figure across policies.
Mixing the day-count base (using 365 in one line and 360 in another) — be consistent throughout the problem.
In the Incremental Approach, comparing incremental profit against total investment instead of incremental investment in receivables.
Forgetting to deduct tax before comparing net benefits when the problem gives a tax rate.

Reference:

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Evaluation of Credit Policies — Total Approach vs Incremental Approach

Worked example

⚠️ Common exam mistakes