The Cost of Extending Credit

written on April 21, 2011 by John Doucette

Rate this Article

  • 1
  • 2
  • 3
  • 4
  • 5

Many small businesses extend credit to their customers as a matter of course, without evaluating the cost and consequences of doing so. In most cases you will want to continue selling to your customers on credit but you should understand what it costs you, take reasonable steps to reduce this expense and consider some alternatives.

The costs of extending credit fall into three broad categories:

  • Administrative
  • Financing
  • Risk

Administrative costs include labor and direct expenses (such as paper and postage) associated with billing your customers, collecting past due invoices and processing payments. A Fidesic Corporation study found cost of paper billing and processing checks received in payment was $8.44 per invoice for smaller companies and that about 90% of this cost was labor. If you issue a lot of small invoices this cost could significantly erode your margin.

You can potentially reduce administrative costs through technology. First and foremost, you should use some software product to create invoices – don’t generate them manually.  You may have an industry-specific application that can produce invoices and every small business accounting software package (QuickBooks, Peachtree, etc.) has this capability.  Another way technology can help is by sending invoices and accepting payment electronically.  This could be as simple as emailing your invoice as a PDF file, saving on printing and postage, or as elaborate as using a web application to present invoices and accept payments the way many utility companies do.

Financing costs are driven by the size of your Accounts Receivable balance.  There are interest costs if you have to borrow to get the operating cash represented by these receivables. If you have a bank line of credit this could be at a rate of 6% APR -- or more.  If you have available cash there is the opportunity cost associated with the funds tied up in receivables – how could you have invested that capital to grow the business? 

You can reduce financing costs by being more effective in collecting your outstanding invoices.  Reduce Days Sales Outstanding (DSO) and your financing cost comes down. When applicable, collection automation software can reduce administrative effort and reduce outstanding receivables by 10-20%, producing additional savings. Also, don’t forget to bill promptly and accurately.  Companies that issue invoices monthly can be extending their DSO by 10-15 days since the clock doesn’t start on payment until a customer has received their invoice.

Also consider the cost of credit by customer. A customer that typically pays in 30 days costs you less than one that pays in 90 days. Take this into account when evaluating pricing discounts and planning collection activity.

Risk cost is potential that an invoice will never be paid and must be written off. According to CreditPulse, the average Bad Debt Allowance is about 4% of credit sales but it varies greatly depending on industry, ranging from about 1% for oil & gas to over 8% for service businesses. I would also include unauthorized deductions as part of this cost element – that freight charge your customer deducted but you had to pay goes straight to your bottom line.

You can reduce risk by doing a better review of applications for credit from new customers and monitoring customer payment trends and other developments over time for existing ones.  I addressed that topic in another article here.  Further, you need to evaluate whether deductions are warranted and, if not, bill them back.  Finally, engage outside collection agencies sooner. You will give up a substantial percentage of the value of an invoice – if it’s collected -- but 50% of something is better than 100% of nothing.

Adding it all up . Let’s take a look at the total cost of credit for a business, considering two invoices: one for $100 and one for $1,000.


 Cost Element  $100 Invoice  $1,000 Invoice
 Processing cost  $8.44  $8.44
 Financing cost (45 days @ 6% APR)  $0.74  $7.40
 Bad Debt Allowance (4% of sale)  $4.00  $40.00
 Total Cost of Credit  $13.18  $55.84
 Cost as percentage of invoice  13.18%  5.58%

You can adjust these assumptions for your own situation but what’s your margin on that invoice?

Alternatives?   Admittedly, this is an aggressive cost model but if you exclude the Bad Debt Allowance the cost of credit is still significant as a percentage of the invoice value, particularly for smaller transactions. What alternatives are available?

  • Cash . Require customer to pay by cash or check, either in advance or upon delivery, or require a substantial deposit before work begins. Advances or progress payments are common is some industries. Holding up delivery of a product until payment in received gives you significant leverage. While a cash payment strategy will reduce costs and risk it may also reduce revenue if customers are unwilling to go along with it. Consider your industry and competitive position – how much leverage do you have? 
  • Accept Credit Cards.   Credit card payments improve cash flow and reduce risk – at a cost. Many small businesses do not accept credit cards because merchant fees can run 2-3% (or more) of the transaction amount, with the potential for additional “hidden” fees. If you have many small transactions this approach is probably cost justified; a few big ones, not so much. However, having ability to accept credit card information over the phone is an important tool in the collections process and that alone may justify accepting credit cards.
  • Minimum invoice amount .  Consider establishing a policy that purchases under a certain amount must be paid for by cash, check or credit card; only invoice purchases above that amount. You may want to grant large customers a waiver if their overall purchase volume warrants or even give product to them for free if the cost of invoicing exceeds the value of the product. I once had a customer that purchased pallet loads of silicone sealant.  One day they stopped by because they needed one tube to finish a job. I gave it to them for free (for the above reason), saving money and scoring big customer satisfaction points.
  • Charge late fees . You may recover some of the financing cost and provide an incentive for prompt payment but billing late charges adds administrative expense. Frankly, most business customers ignore late fees when they are making a payment, even if it’s 60 days late, and insisting on payment of these fees can be a customer relationship issue.  Late fees are of questionable legality unless clearly started on the invoice, credit application or other document pertaining to the sale. If you expect to take an account to collection and want to add on these fees you will need to have your right to assess them established.
  • Factoring .  Like accepting credit cards, selling your receivables to a factoring company gets you immediate cash and is appropriate for large commercial invoices. The cost is comparable to credit cards for accounts that pay close to on time but it could be more for slow payers – as much as 10% of the invoice amount. Further, you usually still bear the risk of write-off (recourse) for uncollectable accounts. Factoring may make sense if you need dependable cash flow to provide working capital for operations (to pay employees and suppliers) and do not qualify for conventional bank financing. You can find out more about factoring here.

John Doucette
Anytime Collect Product Specialist
e2b software
(440) 352-4700 x249