In addition, the customer pays the vendor credit insurance; that is, he makes a contribution to help pay for the goods, with interest on their purchase value, purchased from the vendor by some other customer who will fail to pay wholly or in part. In other words, when a dealer sells on credit, he takes a chance of losing a certain part of the amount due him. As he cannot tell which customer will be unable to pay and hence cannot avoid losses of this kind, he must charge so much more to each customer to pay for the cost of the goods sold to him, allow for the vendor's customary profit and create an excess which will be equivalent to his loss on the amounts uncollected.
7. A practical illustration.—As an illustration of this point, suppose a wholesale merchant has a certain lot of goods on which he could make his customary profit if they were sold for $120,000 cash, but, sup pose also that he intends to sell the goods on 60 days' time. Three new elements enter here, viz.: (1) the risk of non-collection of a part or of all the funds promised; (2) the tying up of capital for 60 days without considering the risk of non-collection; (3) the maintenance of a credit department with its expense for stationery, postage, preparing statements, col lector's commissions and so on.
Let us consider the second point first. Assuming that the collection is absolutely certain and that the credit system entails no added expense could the mer chant afford to sell these goods for $120,000 if he al lowed his customers 60 days in which to remit? Ob viously, he could not. Assuming that he could ob tain 5 per cent upon his money without involving any chance of loss, he could invest $120,000 and earn $1,000 in 60 days. Or, viewing the situation from another angle—the merchant sells on 60 days' time and, therefore, he must either have a larger capital with which to carry on the same volume of business or, he must borrow from the bank and pay interest in order to maintain his stock of goods. If he does not borrow from the bank he must purchase on credit and pay a correspondingly higher price for the ma terial because of the discount allowance for cash set tlements which he would lose.
In any event, if_the merchant had a larger capital, he would secure a smaller rate of return on it for the same amount of business, or he would pay the bank or his creditors for the privilege of using their money. No matter how he plans, if he is to make his cus tomary profit, the merchant must have at least $1,000 more for his goods if sold on 60 days' time, even with out risk, than if he sold for cash. Therefore, his
goods must now be sold for at least $121,000 as a time price which will contain an allowance for inter est on the investment during the credit period.
8. Valuing the risk us now intro duce the risk element. Suppose these same goods were to be sold to a thousand different customers who, with regard to capital invested, volume of business, managerial ability and amount and character of past patronage, are so situated that the merchant will be unable to collect one per cent of the total amount due him. If he knew in advance which ten of these thou sand customers would wholly fail to pay or what part of any account would remain unpaid, he would not sell to any person, in excess of his ability to pay, and he would not sell at all to those who would be unable to pay, even in part.
But, not knowing these facts in advance and know ing only that enough failures will occur to prevent him from collecting one per cent of the total, the mer chant, nevertheless, considers it good business policy to sell to each of the thousand customers providing that the price is right. Leaving out of consideration for the present, the expense of a credit and collection department, we must charge enough so that the 99 per cent which we shall collect amounts to $121,000. That is, we must charge $122,222.22, to be exact, or, we must charge each one of the thousand customers $122.22 for goods which we could sell him on 60 days' time for $121 if there were no risk of loss, and for $120 if the sale were for cash. The first added dollar is for interest on the $120 and $1.22 is a contribution to pay for the goods sold on credit to the defaulters made up by those who pay in full.
If the credit system necessitates a credit depart ment with collection machinery and if the cost of maintaining a credit system amounts to 2 per cent of the value of the goods sold, then, in order to cover this added expense the merchant's price must be sub jected to a further increase. By paying out the 2 per cent and sustaining a 1 per cent loss from non collection, the 97 per cent left for the merchant will still amount to $121,000; that is, he must ask $124, 742.27 for his goods or, $124.74 from each one of the thousand customers.