The Hidden Cost of Managing Your Accounts Receivable
To maintain and expand their missions, companies must make the best use of their assets. Knowing the true cost of accounts receivable is important for an efficient operations. Therefore, knowing how to reduce this cost is critical for liquidity. With that in mind my goal is to point out what is the cost of managing your accounts receivable.
Accounts receivable add only one thing to company operations–cost. How much cost are often a misunderstood and a controversial issue. It’s imperative that a printer today explore the nature of the true carrying costs of accounts receivable and look for ways to reduce them.
The carrying cost of receivables is often equated with the time cost of money, calculated using the discounted cash flow method. But the time cost calculation of a receivable actually is only one of seven elements of cost. To understand the real cost of carrying accounts receivable, the influence of the other six cost elements must be considered. These include administrative, opportunity, predictability, financing, and bad debt costs as well as a more subtle but nevertheless real cost–morale cost.
Time cost. The cost most often associated with receivables–time cost–is the present value of money to be paid at a specified point in the future. In other words, how much money would have to be invested today, at a given interest rate, to generate a principal-plus-interest amount equal to what will be paid or collected in the future? The calculation is the reverse of compounding interest, and in this case the interest rate is called the discount or capitalization rate.
Administrative cost is a function of a receivable’s age. Assume a normal collection cycle to be cost neutral. (Obviously there is a cost, but for this comparison, assume it to be zero.) As the receivable ages beyond the normal cycle, the collection process becomes more cost intensive. Follow-up letters, telephone calls, and additional record keeping are costs directly related to the age of the receivable. These expenses grow proportionally larger as the receivable ages. If unpaid, in most cases, the receivable will need to be turned over to a collection agency which creates additional administrative cost.
The cost of bad debt is directly related to the age of the receivable. The older the debt, the more unlikely the full amount will be collected. With the complexities of the payment collection, 90-day-old receivables may not seem unreasonable, but such age should not be tolerated.
If a company’s receivables are averaging 60 days with 4 percent annual bad debt write-off, it is logical to assume that 30 days will create a lower bad debt write-off, while 90-day receivables will create a higher rate. And should debt go beyond 120 days because the chances for full recovery becomes remote and very costly.
Morale cost. Though very real, this cost has not been included in the cost matrix shown in Exhibit 1 because it is difficult to quantify. If the other six costs of accounts receivable combine to threaten cash flow, an organization often will shift resources from income-generating projects to tasks designed to minimize losses. Committing these resources to non-value-added efforts further adds to the cash shortage spiral.
Nothing is so debilitating to morale as working in an organization that does not have the resources to grow, or even to maintain the status quo. The result is higher personnel turnover, managerial stress, and a pervasive pessimism that in turn stifles the very motivation needed to solve the problem.
Exhibit 1: Cost elements of accounts receivable*
Percentage carrying cost to receivable dollar
Cost element 30 days 60 days 90 days 120 days
1. Time 0.82 1.63 2.44 3.22
2. Administrative 0.00 0.50 1.50 2.00
3. Opportunity 0.00 2.50 7.50 12.50
4. Predictability 0.00 1.00 1.00 1.00
5. Financing 0.00 0.66 1.30 1.99
6. Bad debt 1.00 3.00 4.00 6.00
Total cost 1.82% 9.29% 17.74% 26.71%
*Harvard Business Review, August 2009 edition
If you were to have a $500.00 account that is 60 days old it is costing you $5-0.44 to carry. At 90 days the cost jumps to $88.70 and at 120 days your cost has gone to $133.55.
Predictability costs will differ for each company, depending on how consistent collections are. For this example, a nominal accuracy of forecasting was assumed, keeping costs constant for each period. Financing cost was based on the line of credit cost. The bad debt costs column used printing industry norms.
Many of the costs of carrying accounts receivable over varying time periods can easily be calculated if you would sit down and take the time but for those printing firms that do not have a CFO, Controller or an accounting department the job fails to the businesses’ principle to figure it out. Those that take the time find there is a powerful incentive to keep accounts receivable to a minimum. The question is – how.
There are a number of administrative improvements and collection routines that can be implemented at little or no expense to help improve the collection of your accounts receivable. You can:
- Offer incentives to customers to pay on time such as point programs but they are expensive.
- Institute an incentive program to recognize outstanding performance of your collection staff. Offer your people incentives are a great way to increase morale but it reduces your net profit which is the downside.
- Only accept cash credit cards or cash but that limits the size of customers you able to attract…larger customers expect terms.
It’s important to remember, all of the above options can help but the can be helpful but are very costly to implement, control and could impede growth.
The true cost of carrying accounts receivable is rarely calculated and seldom known. In some cases these costs are incorporated in planning at an intuitive level; in many cases they are simply ignored. When fully calculated, however, these costs can be surprisingly large. To get the cost down it is essential that an early intervention program be put in place preferably before 60 days but no later than 75 to reduce your costs and improve the collectability of the accounts.
This can be done with the program that NAPL has negotiated for their members through AmerAssist A/R/ Solution’s, Binary Program – AmerAssist provides NAPL members with its Binary Collection Program, which consists of two phases. (A) “Primary Phase” for a fixed fee per account, followed by a (B) “Secondary Phase,” when necessary, and at the NAPL’s member’s discretion, for a contingent fee on harder core accounts.
– Primary Phase – All Primary Phase collection services will be provided for a fixed fee of typically less than 10% per account. Typical fees range between $10.00and $30.00 and are determined based upon average of account balances size and accounts to be submitted.*
– Secondary Phase – AmerAssist’s contingent collection fees for payments made during this optional Secondary Phase, for harder core accounts, will be Thirty Five Percent (35%).
– Litigation – In the event that litigation is authorized by the NAPL member, they agree that AmerAssist contingent fee will be increased to Fifty Percent (50%).
* AmerAssist reserves the right to adjust the rate based on account size, number of transmitters purchased and complexity of work required to effect collection. All rates and terms will be outlined in a signed agreement between the specific NAPL member and AmerAssist before any work begins.
This article was written by Tom Green, Southeast Region Manager for AmerAssist A/R Solutions, Inc. whose headquarters are in Columbus, OH. And one of the most experienced collection organizations in the nation, serving credit grantors in a broad range of industries. The Binary Collection Program Concept is endorsed by over 150 national trade and professional associations. Last year, their people collected over a billion dollars maintaining the cash flow necessary for the profits and growth of over 50,000 clients. They are licensed and bonded services and provide their service nationwide. AmerAssist also maintains a $1,000,000 excess liability policy for each client’s protection. You can reach Tom at (904) 825-15763 or firstname.lastname@example.org. He will introduce you to the AmerAssist agent in your area.