Plastic can turn to gold: how to cost justify a new credit card - a case study.

PLASTIC CAN TURN TO GOLD

How to cost justify a new credit card--a case study.

In 1987, Susee Inc. was informed by a major credit card company (VAM) that its discount rate--the fee charged on sales resulting from the use of its credit card--would be increased immediately unless its credit card sales volume could be doubled. Susee's management was shocked by this unexpected increase to a discount level much higher than those charged by other credit card companies. Top management reacted negatively and decided to discontinue the use of the VAM card.

This article presents a case study of why--and--how the finance department convinced top management to change its decision to drop the VAM card.

BACKGROUND

Susee Inc. is a major retailer with several chains of specialty stores. Although its various chains accepted all major credit cards, only three accepted the VAM card at the time of VAM's proposal.

Susee's customers pay for merchandise and services they buy in the form of cash, personal check or credit card. The credit card method of payment has become very popular in the United States and in many other parts of the world. The primary reason for its popularity are

* For the customer:

1. Generally identification isn't required by the merchant; therefore, there's less hassle compared with checks.

2. It's safe compared with carrying cash.

3. Consumers can pay all bills once a month without interest if paid by a specified due date.

4. The monthly invoice provides a good record of purchases.

* For the merchant:

1. It's safe compared with cash (lessens the danger of robbery).

2. There are no bad debt losses compared with checks, assuming the credit card approval and retrieval procedures mandated by the credit card company are followed.

3. Credit cards generate more sales since the buyer doesn't have to pay immediately.

* For the credit card company:

1. Generally, credit card companies collect money from the cardholder in the form of an annual fee or a minimum bank balance.

2. They collect a discount rate from the merchant (1.3% to 4% of sales).

3. They charge very high interest rates (15% to 18%) on unpaid cardholder balances after the due date.

Susee Inc.'s credit card sales as a percentage of total sales almost doubled in the decade before VAM made its proposal. Credit card sales represented about 20% of sales. In 1987, the VAM card generated about $10 million in annual sales in the three chains using it.

The VAM card is used by millions of consumers, most of whom are affluent compared with other credit card users. Though its discount rate is the highest among all credit cards in the market, it generates higher sales per transaction compared with other cards.

VAM CARD PROPOSAL

In 1987, the VAM card company issued the following ultimatum to Susee Inc.: Install the VAM card in additional chains so the resulting total sales from the VAM card will exceed $20 million annually and the VAM card company will

* Reduce the corporate discount rate from 3.25% to 3%.

* Give an advertisement rebate of .15% of sales if VAM card signs and application forms are displayed in all stores and VAM's logo appears on all advertisements.

* Make faster remittance for all credit card sales.

* Provide free manual imprinters for each store. (Susee Inc. was renting these from another vendor at $2 per month.)

If Susee Inc. failed to double the VAM card's sales, VAM would raise its discount rate to a level substantially higher than that of other credit card issuers.

CONVINCING TOP MANAGEMENT

Top management's initial reaction to VAM's proposal was negative. Nevertheless, Susee's accountants in the finance department prepared a financial justification to convince top management that the top and bottom lines would improve significantly by expanding the VAM card's use.

Step 1. Exhibit 1 on page 61 shows a financial justification form for any new credit card. The form is initiated by the chain management and approved by the chain president, the head of the credit card department, the controller and the treasurer. The chief financial officer gets involved only if there's a disagreement between the chain management and corporate functions.

A new card definitely affects the top line--that is, the company's sales revenues. Its possible acceptance of a new credit card might not increase total sales, but no one has ever complained about total sales going down because of a new credit card. In estimating a new credit card's sales, the finance department should

* Investigate the historical experience with other credit cards introduced recently.

* Analyze other credit card users' experience. (Information generally is available through credit-card-issuing organizations.)

* Ask key sales people to estimate expected sales due to the new credit card.

In forecasting incremental sales, it's important to estimate three variables:

1. Gross sales due to a new credit card.

2. Lost sales from existing credit cards.

3. Lost sales from cash or checks.

Key sales personnel should estimate sales using the guidelines listed above. The net increase in sales resulting from a new credit card or expanded use of a card is gross sales resulting from the new credit card less lost sales from existing credit cards and check or cash sales. What incremental annual sales will be is the most important estimate in justifying the expansion or addition of a credit card.

Step 2. The next step is to estimate the gross margin as a percentage of sales. This figure can be determined from historical data or from the current year's budget. Though it's not difficult to estimate the gross margin for a given chain or division, it's an important variable in determining the overall bottom-line effect.

The cost of adding a new credit card or expanding the use of one is easy to calculate once the sales estimates are available. The cost is calculated in three steps:

1. Incremental sales times the discount rate for the new card.

2. Lost sales from checks or cash times the discount rate for the new card.

3. Lost sales from existing credit cards times the discount rate for the new credit card less the discount rate for other credit cards.

Finally, it's necessary to determine if the new credit card company will remit funds faster or slower than the existing credit card companies. This could affect the company's cash float. In this case study, the VAM card company remitted funds in three days while existing card companies took only one day. As a result, Susee Inc. would lose the use of funds for two days compared with other credit cards. This cost could be estimated by this equation: (number of days' float lost divided by 365) times (marginal cost of short-term debt) times (lost sales from other credit cards).

Incremental pretax income resulting from a new credit card equals gross margin less discount fee less cost (income) of the cash float. A company can establish a target pretax income as a percentage of sales. If a new credit card doesn't meet the target pretax profit margin, the card should not be accepted on a financial basis. In this decision making, one can use a return on investment (ROI) approach to evaluate the profitability of the proposed credit card. However, Susee Inc. could not use the ROI approach since there was no incremental investment required for using the VAM card in equipment or software.

Step 3: There are other benefits offered by credit card companies that should be considered in justifying a new credit card or expanding the use of one. As indicated above, the VAM card company offered additional benefits to Susee Inc. if the card's use was expanded to other chains, including a volume discount for the chains currently using the VAM card, an advertising rebate and automated clearing house (ACH) fund remittance.

To summarize the justification analysis, the following benefits would be available to Susee Inc. by accepting the proposal from the VAM card company: Pretax income from

VAM card (see exhibit 1) $1,059,300

Advertising rebate

@. 15% of VAM card sales 48,000

Reduced rate for chains

currently accepting VAM card

(3.25% - 3% X $17,500,000) 43,750

Reduced float (VAM card

  will switch from check to ACH)   31,550
Total annual pretax income     $1,182,600

Considering the proposal required no investment and has no penalty if the VAM card fails to generate new sales, Susee's chief executive officer approved the proposal based on the above estimates.

INSTALLING VAM

Once the proposal was approved by top management, the installation of the card in all stores was implemented as follows:

* Operating management was informed of the decision to accept the VAM card within 60 days. The stores were provided with the ad display material and all necessary supplies.

* Information systems management changed the software used by the point of sale registers at each retail store so credit authorization went directly to the VAM card company instead of the independent authorization network. The MIS staff also added the merchant and terminal identification numbers to the stores' software.

* Treasury management worked out the payment method, the ACH system, with the VAM card company to reduce the collection float for Susee Inc.

The entire implementation process to install the VAM card in all stores took less than 60 days. Representatives of the card company visited all stores to ensure that proper ad displays were in place and the necessary supplies were present.

POSTIMPLEMENTATION AUDIT

A postimplementation audit was conducted one year after installation, and the following observations were shared with top management:

* VAM card sales increased by 10% in excess of the original estimate for the chains that installed the card in late 1987.

* Cash, check and other credit card sales did not decline as projected.

* The discount rate for VAM card sales was 2.85% net of the ad rebate as projected.

* Gross margin was higher than projected, resulting in higher pretax income.

* Money collected from the VAM card company was faster by four days using the new payments system.

Overall, the decision to accept the VAM card proved to be a great one for Susee Inc. Actual savings resulting from the card surpassed the projection, and the float related to the card improved.

WAS IT REALLY A COSTLY PROPOSAL?

To get top management's approval, a company's finance department must use analytical techniques to evaluate a proposal and quantify all benefits and costs.

Costly proposals may not be as costly as they appear on the surface. For example, the VAM card was expensive compared with other credit cards, but it generated more sales per customer. Expansion of the VAM card to other chains wasn't a popular idea, but it deserved serious consideration since it had the potential of contributing to profitability without any downside risk.

To reassure top management of the reasonableness of its decision, the finance department should conduct a postimplementation audit to ascertain whether the original estimates were optimistic, pessimistic or realistic. [Exhibit 1 Omitted]

SURENDRA SINGHVI, CPA, CMA, PhD, is vice-president and treasurer at Edison Brothers Stores, Inc, St. Louis, Missouri. He is an adjunct professor of finance at Miami University, Oxford, Ohio.