When a firm’s credit standards are relaxed
A. its costs are expected to increase faster than sales if the standards are not relaxed
B. its profit contribution from sales will be greater than the cost contribution
C. its costs are expected to decrease with a corresponding decrease in sales
D. its sales are expected to decrease with a corresponding increase in costs
The correct answer and explanation is:
The correct answer is: D. Its sales are expected to decrease with a corresponding increase in costs.
When a firm’s credit standards are relaxed, it typically means that the company is willing to extend credit to customers who may have a higher risk of defaulting. This often results in an increase in the number of sales because more customers are eligible to make purchases. However, there are potential downsides.
- Increase in sales: By relaxing credit standards, the firm can attract a broader customer base, which leads to an increase in sales. Customers who previously might not have been approved for credit can now purchase goods or services on credit, thus expanding the company’s market.
- Increase in costs: While the sales may rise, the firm is also assuming more risk. With a larger portion of customers likely to delay or default on payments, the company will face increased bad debt. These uncollected payments represent an increase in costs, as the company might need to increase provisions for doubtful accounts or deal with the administrative costs of pursuing overdue debts. Additionally, more resources may be spent managing the expanded customer base.
- Profitability concerns: While the firm may experience short-term sales growth, it is important to recognize that these increased sales could eventually lead to lower profitability. The additional costs from managing risk, higher administrative overhead, and potential write-offs from unpaid debts may outpace the benefits of the increased sales volume.
In summary, when credit standards are relaxed, a firm could see a rise in sales but with a corresponding increase in costs, particularly due to higher risk and the potential for bad debts. The firm must carefully weigh the benefits of increased sales against the costs associated with this strategy to determine if it will lead to long-term profitability.