That's why it is critical to understand how to manage your cash cycle.
In this series, we will take a close look at the cycle's three components: accounts receivable, inventory and accounts payable. We'll examine common errors in management and we'll review cost-effective strategies that can shorten your cash cycle.
Anyone who has ever run a small-business knows the importance of cash management. Unlike the General Motors and IBMs of the world, the small business person does not have virtually infinite access to the capital and money markets to get through temporary cash shortfalls. And those small businesses that do have credit lines unusually have extremely limited, tightly controlled short-term financing agreements with local bankers that leave little room for error.
This is the first in a series of three articles that will address the most important elements of a cash management system. Each of the articles will focus on a specific portion of the system, and the last in the series will conclude with a discussion of the system as an integrated effort directed toward the single most important objective of the firm: the maximization of the owner's wealth. This article addresses Accounts Receivable management, and starts with a discussion of one of the most common errors small-business managers make: offering early-payment discounts to speed up collections. The article discusses why discounts are generally a strategic error, and then offers three alternative approaches to good receivables management.
Early payment discounts are a routine feature of payment terms in many industries. So routine, in fact, that many managers and business owners rarely question their value for reducing investment in accounts receivable by shortening average collection times. The assumption is that discounts are an effective means of moving payments forward and increasing accounts receivable turnover.
In fact, however, discounts benefit the firm offering them only under a relatively narrow range of circumstances, and they frequently accomplish the wrong objectives. Moreover, early payment discounts can effect changes in standard financial ratios that give the appearance, of having been an effective tool, when they are actually costing the business owner much more than they save. Business owners are often unaware of just how much of a deal they are giving their customers when they offer generous terms.
Opportunities for financial gain by paying attention to discounted terms exist for the small-business owner on both sides of the purchase/sales transaction. As a purchaser of raw materials, products and supplies, the small business owner can frequently negotiate significant savings as a result of seemingly minor adjustments in payment terms. On the other side, she/he can significantly reduce short-term capital costs by a careful review of the terms offered to customers.
Know what your terms are costing you
First, of course, the small-business owner must be able to calculate the real cost of offering early payment discounts. A proper calculation of the cost of a discount recognizes that the real price being charged is not the invoice amount, but the discounted amount due at an earlier date.
Suppose, for instance, that Ajax Company, a manufacturer of quality Ajax widgets, ships one widget to the Bjax Company for an invoiced amount of $100 on terms of 2/10 NET 30. Those terms, of course, mean that Bjax has a choice of paying either $98 within 10 days of invoicing or $100 by the end of the month. The trick to properly calculating the cost to Ajax of offering the discount (or to Bjax of ignoring it) is to see the discount terms as essentially the offer of a loan from Ajax to Bjax of $98 for 20 days (the time from the end of the 10-day "grace period" to when the full invoice amount is due). The real price being charged for the widget is $98. The other $2 due by the end of the month is effectively interest that Bjax will pay Ajax for the use of their money for 20 additional days.
Viewed that way, the calculation of the effective interest rate being paid by Bjax (if they don't pay early) or Ajax (if they do) becomes simple. Divide the interest by the principle to get the rate (2/98 = .0204), then annualize it by multiplying by the number of 20-day periods in a 360-day year (360/20 = 18; 18 x .0204 = .3673 = 36.73 percent). The result is an astounding 36.73 percent! (By the way, it's also easier to calculate the effective interest rate for any particular set of terms if you apply them to an imaginary invoice of $100.00. The amount of the invoice doesn't really matter, of course, but $100 is a nice, round figure to work with).
The above calculation demonstrates just one reason why early payment terms are a very expensive way to effectively manage accounts receivable. Borrowing money from customers in 20 day installments and paying them 37 percent interest is an expensive way to raise working capital. What is more, this author, in managing his own small business, has been offered early payment terms as high as 5/10 NET 30, a discount that translates into an annual interest rate of 94.73 percent [(95/5) x (360/20)]. Needless to say, the terms were accepted and the check happily written 20 days prior to the invoice due date.
High effective interest costs are only one reason why early payment discounts may not be the best approach for managing accounts receivable, however. There are two additional reasons that many small businesses should avoid the practice. First, the incentives for early payment are applied to the wrong customers. Second, the terms themselves are virtually unenforceable.
Incentives
The object of any effort to improve the management of accounts receivable should beto reduce the cash cycle by affecting the worst payers. Suppose, for instance, that a firm offers usual NET 30 credit terms and has an average collection period (ACP) of 45 days. That average collection period is composed of some customers who pay cash, some who pay in 12 days, some who pay in 30, and some who pay in 90 days. Any program we implement should give the greatest incentive to pay early to the worst payers.
But an early payment discount provides exactly the opposite set of incentives. Let's look at the effect of the standard 2/10 NET 30 terms on two customers on opposite ends of our A/R schedule. For the customer who is paying now in 20 days and who has not before had the opportunity to take a discount, the offer of an early payment discount is highly attractive. In fact, since he was already paying early, he was only using our money for 10 days over our discount "grace period" anyway. The effective interest rate we are offering him on the money is [(98/2) x (360/10)] = 73.46 percent. If he takes the discount, we only get the money for an extra ten days, and so are effectively paying 75 percent interest for a short-term loan.
But how about our delinquent customer who routinely pays after 90 days (and many statements, delinquency notices and perhaps phone calls)? That customer, who gets the benefit of our money for 90 days anyway, must give up 80 days' use of our money to take advantage of the discount. The resulting effective interest rate is only [(2/98) x (360/ 80)] = 9.18 percent. Clearly a better deal for us, but not much of an early payment incentive for him. He is better off keeping our money than paying the bill and borrowing from his banker at 14 percent.
The result is that early payment discounts offer the highest incentives to customers who are already our best payers, and the lowest incentives to customers who are our worst payers. Instituting a discount will frequently have a modest effect on average collection periods, but at a very high interest cost to the seller and with very little effect on the worst payers.
The modest effect on average collection periods, in fact, is itself an unfortunate result of the strategy, because it looks like progress is being made when it is not. The average accounts receivable collection period will decline, and receivables turnover ratios will increase, but all at very high cost as the best payers all pay a few days earlier.
Enforcement
Another hidden cost associated with early payment discounts rarely mentioned by finance textbooks but soon discovered by business managers is the near impossibility of enforcing the exact terms of the discount. After all, what can be done when the customer pays in not 10 days, but 25 and takes the discount anyway? If the invoice is for, say, $450, the customer has deducted $9 from the bill. Is it worth collecting the $9? How much will it cost in accounting time, correspondence, telephone calls and goodwill to try to rebill the difference? Early payment discounts invite customer abuse. Unless the business owner is prepared to enforce the terms, the result will almost surely be to provide the discount to many customers who don't actually deserve it.
Summary of the early payment discount approach to cash management
Early payment discounts are not an effective receivables management tool for three reasons:
- The effective cost of the discount is too high relative to the small reduction gained in the Cash Cycle. The business owner is usually better off borrowing from his own banker and waiting for the payment to come in.
- The incentives are misplaced. The largest benefit goes to the best payers and the smallest to the worst. The result is that improvements in the Cash Cycle come from the response of those least in need of improvement.
- Enforcement of the discounted terms is prohibitively expensive. The result is higher administrative costs and discounting to many customers who do not deserve it.
Unfortunately, many small business owners get very poor advice on this subject from their accountants and bankers, who tend to look only at changes in average collection periods as evidence of improved receivables management (see note 1 at end of article). In reality, the "improvement" in such ratios may mean the business owner is merely giving away the store a little bit at a time.
Remember the implications of the Operating Cycle approach to managing cash. The goal is to get the greatest reduction in the cycle for the least cost. Offering early payment discounts to speed collections is a losing strategy, because the reduction in the Cash Cycle is so small for a very large cost.
Three times when early payment discounts can work for you
The clear implication is that early payment discounts are a poor way to reduce the length of the Cash Cycle. There are three circumstances, however, where the small business owner should view early payment discounts with favor. But none of them have the objective of reducing the cash cycle. First, the business owner should see discount terms offered as an opportunity to reduce the effective cost of goods. Second, there may be marketing opportunities that can best be realized by offering discounted sales terms. And third, the creative combination of early-payment discounts and seasonal production and warehousing cost-reduction techniques can yield an effective sales tool.
When discounts are offered
On the buying side, one cannot avoid the conclusion that early payment discounts should virtually never be passed up as a purchaser. The small business owner should periodically review his or her relationships with vendors to negotiate such discounts whenever possible. Since many vendors are not familiar with the proper calculation of effective interest rates for terms, the buyer who knows how to use a calculator can negotiate discounts, grace periods and payment requirements to great benefit. Likewise, the value of taking advantage of discounted terms should be weighed against the cost of borrowing money. Bankers' rates for short-term borrowing begin to sound much better when compared to the cost of foregoing discounts. With the discounted terms carrying effective rates as high as 30 to 70 percent (and the more prompt your historical paying habits, the higher the rate for you as a purchaser), it is foolish indeed to pass up any cash discount that could be taken advantage of by maintaining a line of credit with your banker for 14 or 15 percent.
Cash on Delivery (COD) terms, by the way, carry a triple disadvantage to the purchaser. Many small business owners may prefer purchasing on COD terms because it is easier on the accounting system (no payables to keep track of) and because they don't want to bother with the procedure of establishing trade credit (forms, references, etc.) But the cost is high indeed. First the purchaser must of course pay the COD charges for each delivery (especially high if any of your suppliers routinely backorder portions of shipments). Second, you lose any grace period associated with the payment. Even if early payment term are not offered, normal NET 30 terms afford significant source of working capital financing at zero percent interest. But finally, for some strange reason (that this author has never bee able to figure out), suppliers will offer discounts for early payments, but will not for either advance payment or COD. Considering that many businesses operate on 5 to 7 percent Net Profit Margins, the effect of passing up a to 3 percent discount on all purchases has a very major impact on profits. If average cost goods is 50 percent, then consistent 2 percent discounts add 1 percent to the Net Profit Margin. If your Net Profit Margin is normally 5 percent of sales, then you have just brought about a 20 percent increase in profits by negotiating discounts!
Discounts as marketing tools
The fact that discounted terms are not an effective receivables management tool does not mean that they should never be offered. In many industries, discounts are a necessary marketing tool for the sales staff who must compete with other companies for customers' business. Under those circumstances, the business owner should view such discounts (and expense them on the operating statement) as marketing costs. This way the true nature of the expense can realized and it can be weighed against alternative forms of marketing that may be more cost-effective. Remember, however, that the objective of discounts in this instance is not a reduction in the Cash Cycle. The objective here is to increase sales. The effectiveness of the strategy must be measured against the objective it is supporting. There may well be more cost-effective strategies to increase sales. Is the dollar of marketing budget better spent offering payment discounts, offering straightforward price reductions, increasing advertising, or moving sales force commissions up a notch?
Discounts as an inventory and production control technique
The third effective use for discounted terms is as an inventory management technique. Highly seasonal manufacturing companies with high warehousing costs and a year-round sales force can smooth production cycles and advance sales by offering "dating" terms. Suppose, for instance, that a firm produces air conditioning equipment and distributes through an independent dealer network. Suppose also that the company's warehousing costs average 10 percent of sales on an annual basis. (This figure would be calculated by converting operating costs for warehousing as a percentage of sales into an annualized figure by multiplying by the inventory turnover rate). If the cost of short-term working capital funds is 14 percent, those two figures can be combined to determine how much of a discount can be offered to the customer who is willing to purchase and receive the equipment in January instead of July. That puts the sale on the books and avoids six months' warehousing costs for the manufacturer. (The strategy does assume that the warehousing saved can be realized in a reduction in real warehousing expenses).
Using the combined warehousing savings and cost of working capital, 24 percent is the effective annual opportunity cost of not making the sale in January. The manufacturer can then calculate the discount available for 10 day payment on 180 day dating. Divide 24 percent by the number of 170 day periods in a 360 day year (170 days is the period of time for which the "loan" is made: 180 days minus the 10 day grace period). The result is 24/(360/170) = 11.33 percent. The manufacturer could offer up to 11/10 NET 180 terms, a very attractive offer from a sales perspective, and still be dollars ahead.
This technique is a perfect example of the Cash Cycle concept in action. The portion ofthe discount offered that derives from the cost of working capital results from the reduction in the Cash Cycle as a result of a shorter ACP if the dealer pays early. The portion of the discount offered that derives from the saved warehousing expense results from the reduction in the Cash Cycle as a result of a smaller AAI. The combination of the two savings are expressed in a single discount that is attractive to the customer. In fact, if the sales force concentrates on offering these attractive terms to dealers with excess warehousing space in the off season, a win-win transaction has been created. From the dealer's point of view, taking the inventory early is no real cash cost but the early-payment terms offer a real reduction in cost of goods. The net effect is that the dealer has purchased goods less expensively, and the manufacturer has gotten the benefit of the dealer's excess warehouse space. The combination of the cost of warehousing and the cost of capital invested in receivables both derive from the effect on the cash cycle.
Thinking of the transaction in terms of the Cash Cycle helps clarify why this strategy is a benefit to the manufacturer. If the dealer pays early, the manufacturer's total cash cycle remains unchanged relative to not having sold the air conditioner at all. Had the manufacturer not sold the air conditioner, AAI would have been 180 days longer but ACP would have been 180 days shorter. But if the dealer does purchase early and takes delivery now, ACP goes up by 180 days and AAI goes down by 180 days. The cash cycle remains unaffected by the transaction. But what if the dealer takes advantage of the discount? If the dealer buys, then warehousing costs for the manufacturer have been reduced and production cycles have been smoothed. And if the dealer takes advantage of the discount (as he should), the manufacturer has paid the same warehousing cost as before and has paid the same cost of capital as his bank charges, but has put a sale on the books, kept his sales force productive (freeing the sales rep to make an additional sales call in July), and smoothed production cycles throughout the year.
Three ways to reduce average collection periods
Let's return now to our discussion of managing receivables. We've established that offering early payment discounts to speed collections is a losing strategy. There are a host of other, more cost effective mechanisms for better managing receivables and we will take a look at three of those now.
Let's first remember that the ultimate objective is to reduce the length of the Operating Cycle. Acting on the Average Collection Period may not be where the quick and easy gains come from. We may be better off making our first cash management moves by working with either inventory or payables, and those strategies will be discussed in later articles in this series. Working with the accounts receivables, while sometimes emotionally satisfying (it just feels good to be doing something to get people to pay sooner), is actually one of the more difficult places to have a real effect on the Operating Cycle of the firm. Both inventory and payables are under your control. Affecting receivables means getting someone else to change their behavior. That is always more difficult, and usually more expensive.
If you remember, however, that there may be more cost-effective places to influence the Operating Cycle, here are three strategies that can be employed to speed up collections in a cost effective manner:
Personalize collections
Standard "collections" lore is to identify late-paying accounts early and initiate a series of increasingly-frequent, increasingly-stern letters first requesting, then suggesting, then demanding payment. The final series of letters threatens legal action, and the process culminates in handing the client over to a collection agency or attorney.
What is right about that process is the part about starting the process early. The sooner the late account is contacted, the sooner the bill will be paid. And the older the bill, the less the obligation felt by the customer ("Well, it's so old now, a little longer won't matter."). What is wrong about the standard process is that it is expensive and ineffectual.
In the collection process, guilt and pity are your friends; anger and indifference are your enemies. Collection letters, whether form letters or computer-personalized (everyone knows about computer-personalized letters these days), cannot evoke the desired response because they don't connect you as a person with some other person. If your customer isn't paying bills on time, then decisions are being made about which bills to pay with the limited funds available. Some person makes that decision, and that is the person with whom you must speak.
The telephone is the best collection tool, not the letter. Even long-distance calling is not expensive compared to the cost of bad debts, the surprisingly high cost of multiple statements and a series of collection letters, and the opportunity cost of capital for a bill paid late. Remember the calculations about the cost of money over time. If the company is borrowing from the bank on a line of credit at, say, a 14 percent annual rate, then a $1,500 bill paid one month late has cost (.14 x 1,500)/12 = $17.50. After all, if the company had received the $1,500 payment on time, borrowings could have been reduced by that amount. Seventeen dollars will pay for a lot of phone time for one account.
The decision to pay which bills is often made at a surprisingly low level, though it may not be. In any case, your job is to develop a systematically personalized collections process. Here is how to do that:
Target marginal accounts for personal attention
Develop a list of all of your marginal accounts. Check payment records over the past two years and include anyone who has paid a bill late. Even if they are now current, they will be among the first to be in trouble in the next economic downturn. Automatically include new accounts in the system until they prove themselves by their payment history. But don't let the system grow out of control. Allow customers who pay well to graduate from the system and concentrate on marginal payers.
Assign collections to the right person
Not everyone has the ability to make a good collections call. It takes a combination of the right voice, manner, and temperament. The caller must balance on a precarious emotional fence: forming friendly relationships with key people in the customer's office while being gently insistent and unyielding. The boss may not be the right person for this job.
Make a friend
Find an excuse to call customers and get to know the people in their payables office. Start to build a data file on the customer. The main object of the initial call is to establish a relationship with the person in the accounts payable office who handles the account. That may be the president of a very small mom-and-pop company, or it may be the payables clerk who codes accounts that start with "L." When you get the right person on the line, take some time to chat. Ask about the weather. And accept whatever explanation for the late payment you receive. Your goal is to make contact with a potential bad account, not make a collection.
Contact with marginal accounts ...
that are not currently past due should take place at least every three or four months (three to four times a year, in other words). Payables clerks change and the personal relationship must be maintained. Invest in five minutes on the phone discussing mundane matters every few months (another invoice check, is the address correct, etc.). It will pay off 50 times over when you have to make a real collections call.
When an actual collection process starts ...
the phone calls should observe the following rules:
- If they are currently running late every month, make the first collections call within 10 days of the due date. If they are marginal for other reasons or a new account, call to make sure that the invoice arrived because you had some "computer problems" and some didn't go out properly (or some other story to keep the conversation light).
- Never, never, never get angry. Anger on your part dissolves guilt on the customer's part. They in turn get angry at you, and you become a bad person in their eyes. Bad people don't deserve to get paid (goes the unspoken rationalization) and your bill will go to the bottom of the stack.
- Always speak to your friend who makes the decisions. Never leave messages and never communicate frustration to anyone else in their organization.
- Commiserate with their problems and suggest that your company is hit hard by the bad times too. Share sympathy for each other's plight. You will appreciate any help she/he can give you. Your own suppliers have been hounding you as well. Misery loves company, and guilt will be increased if the person on the other end can sympathize with your need to get paid. Along those same lines, always let them know that you are a small company. Decision-makers at all levels have more sympathy for small firms and are much more likely to pay your bill first if they know you are not General Motors. (This may be the only time a small firm actually has a financial advantage over a large one.)
- Always end every conversation with some commitment. Gently refuse to accept vague promises. Listen to the excuses and don't question them, but ask for some payment on the bill on some definite schedule. If it doesn't arrive, your phone call the next day increases the guilt. Guilt is your friend.
- Never threaten. Threats produce anger and anger dissolves guilt. If you need a threat, use your banker as the fall guy. Invent a bank receivables audit that is coming up next week. If the specter of a collection agency or legal action is necessary, explain that your banker's audit procedures require legal action on overdue accounts, but you can argue them out of it if you can show something paid on the account in good faith. The banker is the bad guy.
You will be amazed how much more effective personal contact is than a series of statements stamped "Past Due" or angry and threatening letters. Of course, statements are still necessary. But overdue accounts already know they are overdue. What they need is the motivation to pay your bill before someone else's.In addition, letters are surprisingly expensive. With basic postage rates now up to 34 cents and adding the cost of paper, envelopes, and personnel time to prepare and mail them, a single series of collections letters (standard would be a series of five to seven letters before handing over for collection) can cost as much as 25 to 30 dollars. And time is lost as well. Letters take time to prepare, time to be delivered, and time to wait and see if the customer responds. If collection letters are mailed out once a month, some letters go out when the account is barely past due and others when the account is too far gone to help.
The key to this entire approach is to recognize that effective collections systems are not confrontational. They are negotiative. See the customer as the enemy and you'll never see your money. Treat the customer like a friend and you can not only negotiate a solution that gets the bill paid, you will have kept a customer who will often be extremely loyal when economic times get better. Not all late accounts are bad accounts.
Integrating sales and collections
It's too bad, but the sales department and the accounting department don't usually talk with each other enough. If they did, the accounting office would realize that the company's sales force can be the best collection agency around. If you're in a wholesale or manufacturing business and have a sales force calling on customers regularly, they need to be armed with up-to-date collections information to put the bite on their own customers. And, most importantly, the sales incentive system must reward the identification and maintenance of good accounts. Sales reps respond to incentives.
You should know at the start that your sales reps will initially resist the idea. So, for that matter, will the sales manager and every marketing director with whom you speak. Their concerns have merit, but they are misplaced. They, after all, are gung-ho to write more business and want nothing to stand in the way of the next sale (and their next commission or bonus check).
The primary objection to what follows will be that it damages the "sales relationship" with the customer and may reduce the effectiveness of the sales force. Nothing could be further from the truth in a well designed sales/ collections system. The system, however, needs to be structured to encourage such cooperation by rewarding the sales force financially for acting in a manner that is in the long-range best interests of the firm. There are several practical techniques to do so.
If the company's sales commission and bonus system has not already been structured to reverse commissions on bad debts, it should be changed to do so. Paying full or even partial commissions on bad debts sends the wrong message to the sales force and provides no encouragement to seek out and maintain a high-quality customer base.
Likewise, annual sales bonuses should be structured to provide an incremental factor based on the ACP of a sales rep's accounts. The calculation is a simple one (exactly the same as for the ACP of the firm as a whole, simply isolated for those accounts handled by the individual sales rep).
This concept need cost nothing at all. Suppose, for instance, that last year total annual sales bonuses amounted to 2 percent of credit sales (probably based on achieving certain sales quotas), and total credit sales were $40,000,000. Total annual sales bonuses therefore were .02 x $40,000,000 = $800,000. Now redesign the bonus system with a portion of the bonus reserved for rewarding low ACPs. You could, for instance, take one-quarter point off the sales quota bonus plan (.0025 x 40,000,000 = $100,000) and reserve it for collections bonuses.
The bonuses could be structured with the highest percentage bonus going to ACPs below the credit-term period (ACP < 30 for terms of NET 30). Or a portion of the bonus money could be reserved for the largest single annual reduction in ACP, aiming the incentives at the sales reps whose accounts are most in need of improvement.
Use some imagination and target the incentives to achieve appropriate objectives. The total paid in bonuses is the same, but the incentive system now rewards those sales reps who not only sell their quotas, but sell them to customers who pay their bills on time. What is more, the sales force is now motivated to keep collections up to date on their customers and to assist with the collections process. This author, implementing a similar system, has seen sales reps who once couldn't be forced into accepting information about their customers' payment history calling into the office long distance to get the latest receivables balances.
And contrary to what the sales manager says, there need be no concern here about overdoing the collection efforts and driving away good customers or about damaging the "sales relationship." In fact, you may find that your sales force accomplishes the job with much less damage to customer relations than your accounting office is capable of. What better part of your organization to strike the correct balance than those whose livelihoods depend on future sales to that customer? There is a natural brake against overzealous efforts at work here that is an advantage, not a detriment.
Use systematic follow-up procedures
It sounds so simple, doesn't it? Of course there is in place a systematic method of following up on past due accounts, right? Someone in the accounting office must be handling it. It's just a matter of remembering to send the next letter or make the next phone call, after all.
But of course it isn't really that simple. In fact, it's incredibly complex with even the mostly straightforward procedure, and especially complex with the attempt to follow up each marginal account personally. So Kristie's Boutique and Used Motorcycle Shop in East Harley, Wisconsin promised to send a check for $150 on her past due account by the end of next week. Who's going to remember to check the receivables record next Friday to see if the check came in? And then who's going to call her on Friday afternoon to express polite concern and remind her because surely she just forgot? And if the check does come in, how is the information going to get from the receivables entry clerk to the collections caller before waiting for the next posting cycle so the phone call that is made can thank her for the check and ask for the next installment instead of setting her up for righteous indignation ("But I did send the check! Something's wrong with your whole system! Call me back if you don't get it by the end of next week!" There goes all your carefully-cultivated guilt).
A good receivables follow-up system is worth even a major investment. Remember, the calculation above showed what a reduction in the Cash Cycle can save in short-term financing expenses each year. Four years ago, this author (while CEO of a mid-sized wholesaling company doing business in 26 states with about 3,600 accounts) invested in the development of an automated customer tracing and follow-up system that integrated all elements of the company's operations to concentrate on customer service and account maintenance. That system turned out to be a top-of-the-line approach to receivables (and customer service) management and beyond some very small firms' capital budgets. But the systems elements it employed are a model for simpler, even pen-and-paper clerical approaches to managing the collections process.
The centerpiece of the computerized system was a "Customer Profile" screen tied to networked accounting and order entry software. The entire programming effort (completed by a local software company in Omaha, Nebraska) took just under one year and cost a little over $20,000. More on its cost effectiveness later. Here were the major elements of the system:
First, a "Customer Profile" record was created for every company account. The Customer Profile record contained:
- Real-time accounts receivable data (with invoice numbers, amounts, dates, payments received, dates of receipt, finance charges and average payment time history);
- Address, phone number, contact name for sales, contact name for receivables, date of last sale, amount of last sale, date of account initiation, average amount of sale, total sales to date this year, total sales previous year, and sales rep name.
- Current orders in house by dollar volume, date of last shipment, dollar volume of backorders currently held.
- A record of every single customer contact by anyone in the entire organization (see below).
- A "Personal Data" section with information about the important people in the company, including the company president, buyers, payables clerks, receptionists and others. The section was a place to note personal information (children, spouses, health problems, birthdays, vacation experiences and favorite recreations) that was noted during casual conversation.
We had an absolutely ironclad rule: no one made any contact with a customer without making an entry in the Customer Profile record. Every sales call was followed by a sales report, submitted at the end of the week and entered into the Customer Profile. Every warehouse call to check on an order, issue a return authorization, respond to a shipping or quality complaint was followed by an entry in the Customer Profile. Every contact from our Telemarketing office (setting the sales reps' appointments throughout their territories) was followed by a Profile entry. Every accounting office call to correct an invoice, ask or answer a question, or request payment resulted in a Profile entry. The result was that when the collections clerk called to chat with the customer's payables clerk, she knew immediately that their receiving department had been on the phone yesterday with our warehouse and already negotiated a credit on the shortage in the last shipment (no excuse to not pay there). And the follow-up phone call on a collection request always remembered exactly what was promised and when it was promised.
The program also had a powerful sorting feature that could identify accounts by sales reps, state, ZIP code, telephone area code, county (important for telemarketing), total sales last year, total sales this year, most recent ship date, "no sales since ..." date, sales rate "fall off" from the previous year, and past-due dates and amounts. In addition, each member of our staff had a personal "call-back" file. When finishing with a customer call, a "callback" date was entered in the Customer Profile. Every morning the computer provided an on-screen list of all the accounts targeted for follow-up that day, and brought their Profile screens up for review and action one at a time.
The system also provides information to the sales force and encourages them to participate in collections and customer service efforts. Every week a complete list of Customer Profile records was printed out for our sales force by territory. The sales force had up-to-date information on every contact their customers had with the home office, every complaint and how it was handled, every collection call and A/R detail.
The benefits of a system of this sophistication should be self-evident for customer service in general and a collections system in particular. One of the unintended side benefits discovered was the ability to identify "problem accounts." Some accounts, it turned out, were so much trouble that they weren't worth selling to at all. Before the customer profile system, no one had tracked just how much customer service time different elements of the organization were spending on a particular (often marginal) account.
Was the system worth the $20,000 investment? The company did about $15 million in annual credit sales, and before the implementation of the Profile system had an ACP of 57 days (in an industry with an industry average ACP of 53 days). By the end of the first year on the system, and utilizing the personalized follow-up methods described above, the ACP had fallen to 46 days. There were additional reductions in later years as use of the system improved, but the first year reduction itself was sufficient to justify the investment. Not even mentioning the tremendous benefits in internal efficiency, customer service and satisfaction, and sales productivity, the system yielded a positive return from the impact on the Cash Cycle and short-term financing costs alone.
Is it worth it to invest in collecting bills just a little sooner? Once again, remember that there may be better places to affect the Operating Cycle. Later articles in this series will discuss some of those. But here's how to figure out what a receivables management system is worth to you:
- Project the expected reduction in Average Collection Periods (ACP)
Results may depend on how tightly the company is managing receivables now. Your estimate will be necessarily subjective, so err on the side of conservatism (estimate a smaller reduction). Example: In the case of our business, an 11 day reduction was effected in the first year. That experience is probably not typical; the company's receivables had been poorly managed before the new system. - Calculate average daily credit sales
Alberghi PortugalDivide annual credit sales by 360. Example: 100 percent of our sales were on credit terms. Total annual sales were $15 million. $15,000,000/ 360= $41,666. - Determine average A/R reductions
Multiply the average daily credit sales by the number of days' reduction in the ACP. Example: Average daily credit sales = $41,666 and the reduction in the Average Collection Period was 11 days. The reduction in average accounts receivables was 11 x 41,666 = $458,326. - Calculate the expected annual savings
The reduction in Accounts Receivables represents a one-time cash inflow to the company. In our case, the benefits were so huge that the decision to invest $20,000 in programming costs to realize almost a half-million dollar reduction in investment in new working capital was obvious. Example: But what if the expected reduction in ACP had been just two days for a company doing one-quarter our business? $3,750,000 in annual sales/360 days = $10,416/day sales x 2 day = $20,832 reduction in average A/R balance. That represents a permanent reduction in investment in working capital that offsets the permanent investment of $20,000 in the system.
If the decision is a close one, such as in the above example ($20,000 to program the system versus $21,800 reduction in working capital investment), there are several factors to consider. The costs are certain, the benefits uncertain, so err on the side of conservative investing. On the other hand, there may be many by-products associated with a comprehensive accounts data management system such as the one described. By-products in terms of customer service and satisfaction and efficient management of your company's data base are hard to quantify and you will have to make a subjective judgment of their probable worth.
There may also be many subtle costs associated with system management. In our case, we wound up investing considerably more in personnel time to maintain the data in the system and provide frequent, personal contact with our customer's offices. But our decision wasn't a close one.
A proper financial analysis of the investment should take into account the time value of the cash flows that will result from the investment. In this case, the present value of the future cash flows is adequately represented by the reduction in the investment in working capital. Thus an effective approximation of Net Present Value is being used when a comparison is made between the cost of the system and the reduction in working capital investment.
Keep in mind, though, that if the investment in the system is a depreciable item, the cash outflow will not be expensed on your operating statement until future periods. That is, the benefit of the tax shield will be deferred to match the increased tax payments associated with reduction in interest expense for the working capital not borrowed. But if the initial investment in the system is all in the form of training costs for employees and supplies for paper-based office systems, then it is fully expansible in the year paid for and the tax benefits are immediate. Those who have had some finance training will recognize a slight time value for the current year's tax shield relative to the future years' tax obligations.
One more closing thought about the benefit of a systematic approach to A/R collections management. What has just been described is a Cadillac system tied to a sophisticated computer network. You can get a lot of the benefits of that system just by maintaining good paper customer files containing the same type of information, cross referencing the files by sales rep (color code the tabs), and setting up a "tickler file" for call-backs. Computers are just big, dumb file cabinets that happen to be very good at storing and quickly retrieving a lot of file folders filled with information. The computer between your ears coupled with the file cabinet in the corner can do a lot of the same things for a lot less money.
Summary
Early payment discounts are a poor way to manage accounts receivable for three primary reasons: they cost too much relative to the minor gains they produce, the incentives are misplaced by focusing on the best payers rather than the worst payers, and the specifics of the terms offered are impossible to economically enforce.
If we remember that there may be better places than receivables management to influence the overall Operating Cycle of the firm, then three better receivables management techniques can be considered:
- Personalizing collections
Assign the collections responsibility to an individual in the company with the appropriate skills. Then build a personal relationship with the people in the customer's office that make the actual payment decisions. Collections should be seen as a cooperative, not an adversarial, process. Negotiation, not confrontation, gets the bill paid. - Use the sales force as a collection agency
Sales bonuses based on annual quotas should be partially redirected to encourage and reward sales reps who maintain low Average Collection Periods for their accounts. No one knows the customers better than the sales reps, and there is no better team to intuitively recognize the proper balance between aggressive collections and customer service. - Implement a comprehensive receivables management system
The system may not be automated and computerized, but it should include the maintenance of central files on marginal customers, notes on all customer contacts by key elements of the organization regarding any customer contact, and a tickler file to assure timely follow-up on collections and other contacts.
The next two articles in this series will take the same close look at Inventory Management and Payables Management and how they fit into the Cash Cycle management puzzle. Each article will discuss a common error in management, and will review three strategies that can be used to cost-effectively reduce impact on the Operating Cycle of the company.
