By Tom Green
Companies must make the best use of their assets if they are to maintain and expand their missions.
Knowing the true cost of your accounts receivable and how to reduce it are critical for liquidity and efficiency.
However, determining how much cost accounts receivable actually add is often a misunderstood and controversial issue. So, it’s imperative that a company explore the nature of the true carrying costs of accounts receivable.
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.
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, eventually the receivable will need to be turned over to a collection agency, creating 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. Should debt go beyond 120 days, the chances for collection become remote.
Though very real, morale 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 more 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
- Time 0.82 1.63 2.44 3.22
- Administrative 0.00 0.50 1.50 2.00
- Opportunity 0.00 2.50 7.50 12.50
- Predictability 0.00 1.00 1.00 1.00
- Financing 0.00 0.66 1.30 1.99
- Bad debt 1.00 4.00 6.00 10.00
Total cost 1.82% 10.29% 19.74% 30.71%
*Harvard Business Review, August 2009 edition
If you were to have a $500.00 account that is 60 days old it is costing you $51.45 to carry. At 90 days the cost jumps to $98.70 and at 120 days your cost has gone to $153.55.
Predictability costs will differ for each company, depending on the consistency of collections. 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 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 if you do not have a chief financial officer, controller or an accounting department the job falls to you—the business owner—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.
Numerous administrative changes and collection routines can improve the collection of your accounts receivable. For example, you can:
* Offer incentives to customers to pay on time. Point programs work but they are expensive.
* Institute an incentive program to recognize outstanding performance of your collection staff. Incentives increase morale but reduce your net profit.
It’s important to remember that while all of the above options can help, they can be costly to implement and control, and could impede growth.
Though the costs of carrying accounts receivable are sometimes incorporated in planning at an intuitive level; in many cases they are simply ignored. When fully calculated, however, these costs can be surprisingly large. It is essential that an early intervention program be put in place, preferably before 60 days but no later than 75 days, to reduce your costs and improve the collectability of the accounts.
By Tom Green, Southeast Region Manager with AmerAssist A/R Solutions, Inc. a Columbus, Ohio-based collection organization that serves credit grantors in a broad range of industries. You can reach Green at (904) 825-1563 or email him at firstname.lastname@example.org.