A serious control problem arises when there is no formal definition of how to calculate a credit limit, what information is required of customers in order to determine the credit limit, the standard terms of sale, and the collections methodology to be followed. The typical result is widely varying credit levels being granted, inconsistent billing terms, and a poorly managed collection strategy. All of these problems are mitigated through the formulation and consistent application of a credit policy.
In this post, I am going to provide example of credit policy you may adopt. In addition, I also add it up with “Order Entry and Shipment Policies” at the end of this post which is closely related to credit policy. Enjoy!
Credit Policy Example
The credit department shall offer credit to all customers except those for whom the risk of loss is probable.
The department goals are to operate with no more than one collections person per 1,000 customers, while attaining a bad debt percentage no higher than 2 percent of sales and annual days sales outstanding of no higher than 42 days.
The credit manager has final authority over the granting of credit and the assignment of credit hold status.
All customers shall be granted a minimum credit level of $500 without any formal credit review. Any customers applying for a credit limit over this amount must submit financial statements and credit references, which shall be used with the company’s credit scoring system to arrive at a credit line.
The standard collection methodology shall be an e-mail message including a PDF file containing the invoice image, which shall be sent five days after the invoice due date. The second step is a fax containing the same information, which shall be issued seven days after the invoice due date. The third step is a phone call to the customer, to be sent nine days after the invoice due date. If an invoice larger than $1,000 is unpaid once it is 15 days past the invoice due date, all customer credit shall be halted. All invoices not yet paid shall be turned over to a collection agency once they are 60 days past due.
Terms of sale
The company’s standard terms of sale are 2/10 net 30. All other terms of sale must be approved in advance by the credit manager.
A number of policies are related to the credit, they are order entry and shipment areas may assist in the enforcement of controls.
Order Entry and Shipment Policies
The next list itemizes four order entry policies that are intended to avoid fraudulent orders, ensure proper pricing, and avoid the acceptance of special customer terms. There are also three policies related to credit management, the most important of which is the overall corporate credit policy.
The intent of having such a policy is to provide some structure to what can be a chaotic process. Finally, there is a policy restricting the company from shipping any order that has not been released by the credit department.
The policies follow:
1. Customer existence must be verified for all orders exceeding $___ from new customers. This policy is intended to root out any customers who have been fraudulently set up as shell companies with the intent of taking delivery of goods from the company with no intention of paying. The order threshold is built into the policy in order to avoid spending more money to investigate customer existence than the company will earn as profit from the transaction.
2. All prices on manually received customer orders shall be reconciled prior to order processing. This policy is designed to spot discrepancies between the prices at which customers order goods and the official company price. Customers must give their approval to revised prices (if any) before the company will process the order; otherwise, there is a significant risk of a dispute with customers that will likely delay payment.
3. Extended rights of return shall not be allowed. This policy limits the ability of the sales staff to engage in “channel stuffing,” since it cannot offer special rights of return to customers in exchange for early sales. The policy keeps a company from gyrating between large swings in sales caused by channel stuffing.
4. Special sale discounts shall not be allowed without senior management approval. This policy prevents large bursts in sales caused by special price discounts that can stuff a company’s distribution channels, causing rapid sales declines in subsequent periods.
5. All customer orders exceeding the credit limit must be held until approved by the credit manager. This policy is designed to keep the sales staff from ramming through large orders without the knowledge of the credit staff, thereby giving the credit department time to weigh the incremental increase in risk associated with making the shipment.
6. The credit manager must approve all increases in customer credit limits. This policy provides some control over the credit granting process, so there is reduced risk that lower-level staff will issue significant credit increases without the knowledge of management.
7. No shipments are allowed without prior approval by the credit department. This policy is targeted at one of the key control failures in many companies—shipping goods to customers without credit. Rigid enforcement of this policy is key to driving down credit losses.
The policies just described work best if adopted as a group. For example, the shipping policy requiring credit approval prior to shipment is the key driver behind the enforcement of the other credit policies, since anyone wanting a shipment to be released must first comply with the credit policies.