Ninety-five percent or more of all Commercial or B2B Sales involve Credit Terms, payment due at a later date. The resulting A/R (short term money due from customers) is one of the largest assets of a business.
The A/R is not only the greatest source of working capital for a business, but it’s management is also directly tied to the most profitable sales yet to happen, to the lowest of the low hanging fruit...additional sales to existing customers.
And yet, in many if not most companies, those engaged in Sales and those engaged in Credit and A/R Management are at odds with each other.
The Credit Function is often referred to as “the place where sales go to die”, “the Sales Avoidance Department” and as one company CEO put it, “the ugly step-child of Accounting”.
In this piece, I cover the history of the old “risk avoidance at the expense of profit” mindset that still prevails and that drives the conflict between Sales and Credit. This old thinking in turn leads to the use of Credit performance measurements that are counterproductive, contribute to shortsighted "silo" thinking and that have an adverse effect on Sales, customer retention and on profitability.
I then address a new Profit Driven understanding of the Credit Function’s role based on the Profit Imperative. Why the investment is made and costs incurred.
In Part Two - Once a new purpose for the Credit Function is established, new Sales and profit friendly goals, and new Credit performance measurements follow. Lastly, there will be a short Quick Quiz to establish your company’s current understanding of the Credit and A/R Function and a few suggestions for improvement.
The 1950s...The 1950's were very much defined by WW II which preceded the 50s. During WW II the entire economy was focused on war production and not on goods and services for consumers. It was a time of all people being called on to do their duty for the war effort. Women left their traditional roles as homemakers to take on non-traditional jobs in industry, commerce and the military. http://www4.gsb.columbia.edu/filemgr?&file_id=7222926. Everyone had a job even if that job consisted of picking up scrap metal. But here was little to buy with the money earned.
Following the war, industry and the economy transitioned back to providing goods and services for the consumer.
The 50s was a time of pent up demand and of growing demand as many women stayed in their new non-traditional jobs and as the population boomed. http://en.wikipedia.org/wiki/Post%E2%80%93World_War_II_baby_boom
The 50s was a time of Americans having money in the bank or in war bonds and a time of limited competition as many countries rebuilt following the destruction of the war. It was a time of a seller’s market with people standing in line, cash in hand, looking to buy things.In the 50s, Credit was seen as a privilege, as a favor to some and not others. In such a business environment the focus was rightly placed on avoiding the risk of customers failing to pay, of incurring bad debt losses. DSO, average turntime on the A/R, and % bad debt are appropriate performance measurements... when the goal is risk avoidance .
The shortages of the 50s are long gone.
In today's world of rapid change, of mergers, of international companies competing for the same customers, of an increasing number of new business startups, of big box stores, of cyber competition and of quality/efficiency...
The old risk avoidance Credit paradigm of the 50s is a handicap.
In order to compete modern companies must have quality in their products and services and quality in the way they carry out business functions. A lack of quality will lead to increased cost of doing business for everyone involved in supply or production chain.
And yet, many if not most businesses engaged in B2B commerce still cling to the old risk avoidance mindset of the 50s at the expense of more sales, higher customer retention and enhanced profitability . They still use DSO (days sales outstanding) and % bad debt to measure the performance of the business function (Credit & A/R Management) involved in 95% or more of Sales and with direct ties to the most profitable sales yet to happen... additional sales to existing customers.
The Profit Imperative... In a competitive business environment every business manager and every business function has a responsibility, an obligation to ensure that the investment made and the work they do results in a positive return... a profit.
Any business manager not focused on the profit imperative becomes an administrator at best and a bureaucrat at worst.
Sadly all too often, the Credit Function is focused on the risk cost at the expense of profit .
The time value money, of carrying A/R and the cost of bad debt write offs are just variable costs of doing business and like all variable costs need to be factored in to the sales proposition...however, they should not define the role of the Credit and A/R Function.
While there are different ways of turning a profit , such as the Enron Model of books cooking, or of a company not paying it’s taxes or failing to fund the employees’ retirement plan... The best way of earning a profit, and the basis for what follows, is to meet or exceed expectations ...at a profit.
What is the investment made in the Credit and A/R Function and why is it made?
Why incur the costs/make the investment in extending credit terms to customers?
The only reason for any business to extend credit to customers is in order to secure profitable sales that would otherwise be lost.
A profitable Credit Sale means taking into consideration the variable risk costs of carrying A/R and of bad debt as well as the seller’s Product Value at Time of Sale.
Credit is a lubricant of commerce that allows for the expanded movement of products and services.
Credit is a Sales Support Function and Not an Accounting Function.
Profit goals/Measurements
There’s a front door and back door to the Credit Sales Function. The front door is Credit Approval and the back door is A/R Management.
The front door... Given that the reason why credit terms are extended is to gain profitable sales that would otherwise be lost, the goal of Credit Approval is the find a way, via terms and conditions, to make a profitable sale happen.
Remember that to determine a profitable sale both the risk cost and the seller’s Product Value at Time of Sale must be considered and factored into the terms.
There’s always a way to say yes to a profitable sale such as down payment requirements, shorter terms , PGs, Joint Pay Agreements, 3rd party guarantees , first born child.
Part Two
The goal of Credit Approval is to maximize profitable sales, and that being the case we want to measure for the Percent of Applied for Dollars Approved.
A profit focused Credit Function should be saying yes to more than 100% of the applied for dollars. You should never think of setting credit limits that place limits on profitable sales, but rather establish expanding Credit Lines. Remember there’s always a way to say yes; to expand on the Credit Line and sell more.
The back door... If any kind of due diligence was followed during Credit Approval the vast majority of past due customers are not out to avoid payment...there are valid reasons why payment is not made by the date.
PDCM (past due customer management) is not “Collections”.
Collections is the enforcement of payment and is a relationship between a creditor and a debtor with the debtor being the beholding party. This is the old risk mindset at the expense of profit at work.
PDCM is the Completion of the Sale - it’s the process of listening to customers to determine why payment was not made by the due date and then resolving the issues or issuing a credit, if called for, and having the payment made and the customer reordering.
PDCM is a relationship between seller and customer and it is the seller who is the beholding party.
It is the very smallest % of past dues that represent a potential for loss , those who are uncooperative , lie, break arrangements and who given time will skip out ...the Completion of The Sale includes the early identification and control of this small % of customers.
The goals of PDCM...The Completion of the Sale, is to keep customers paying and buying and the early identification of the very smallest % of past dues that are at risk of failing to pay and controlling losses.
Based on the goals for PDCM (past due customer management) we want to measure for the A/R percentage under 60 days and for how soon a potential loss was identified and controlled.
Remember that the A/R is the greatest source of Working Capital - and that it’s management is directly tied to the most profitable sales yet to happen...additional sales to existing customers.
What is watched gets done.
DSO and bad debt performance measurements are still used by many if not most companies and in so doing they adversely effect their profitability.
Why are they still used DSO and Bad Debt ? Because they always have.
“The path of least resistance is the path of the loser.” HG Wells
Just as with Sales, Credit Sales is not a black and white accounting function, so when looking at the result of performance measurements the question to keep in mind is WHY?.
The Promised Quick Quiz...Answer these questions based on how you currently do things and if you don’t know you may want to find out.
1) What % of your sales involve credit terms?
2) Your Accounts Receivable (short term money due from customers) makes up what % of your total assets?
3) In your company who does the Credit Function report to?
4) How is the performance of your Credit Function measured?
Promised Suggestions...
1) based on your new understanding of the Credit Sales Approval and PDCM (the completion of the Sale) function consider if the right people are involved.
First and foremost these people must be able to establish and maintain relationships ...they must be communicators.
2) replace traditional Applications for Credit with a New Customer Information Form ...to be completed by Sales .
3) have the A/R Aging printed/sorted by largest dollar account balance and work the largest past due dollar accounts first.. the 80/20 rule.
In closing... I remember the 50s and many things have changed, but two things that have remained consistent are...
1) you can’t go wrong by meeting or exceeding expectations... at a profit
2) the thinking that Credit Management is about risk avoidance and that it’s a cost center, a necessary evil and the ugly step child of accounting.
One of the above still works the other doesn't.
Copyrighted 2014 by A/R Management Group, Inc. All Rights Reserved
Sept. 2014 Canon City Colorado, USA