The true cost of accounts receivable (AR) is rarely known or just ignored. But the fact is the AR costs can turn out to be surprisingly large.
A 2017 survey carried out by the Hackett Group found that effective accounts receivable collection strategies can have a positive impact on the gross margin. Companies which can reduce the cash conversion cycle experience 1.2 percent improvement in gross margin. A decrease in DSO by a week can result in nearly 12 percent growth in profitability.
Here are five hidden AR costs that have a direct bearing on the profitability of the company.
1. Cost of Bad Debts - Bad debts can happen when you issue goods on credit. A certain percentage of customers generally don't pay when there is bad debt. The longer the invoice remains unpaid, the more likely it will become a bad debt. Invoices that are not paid for more than a year often turn into bad debts. These bad debts represent a loss to the company. The amount of uncollectable debt is written off by deducting from the gross profit amount.
2. Labor Costs - The accounts and sales team will both be investing time and effort to manage credit customers. They will send invoices, issue reminders, monitor credit limits, reconcile payments, and report on aging debtors. All of these represent hours and, in some cases, days of a difficult task.As the receivables remain unpaid, the cost of accounts receivable collection increases. The cost of telephone calls, follow-up emails, and recordkeeping will increase as the receivables age and hit the bottom line of the company.
3. Cost of Financing - When customers don't pay on time, a business will experience a cash shortfall. To meet the shortfall, overdraft and loan facility will have to be availed. This will result in an increased financing cost and decreased profitability for the company.
4. Time Value of Money - One cost that is often ignored when considering accounts receivable is the time value of money. The concept involves the fact that the money paid today will have more value as compared to the money paid tomorrow. With account receivable, you will receive money later. The delayed payments represent lost opportunity for earning additional income. The longer the money remains unpaid, the greater will be the opportunity cost of accounts receivable.
5. Bad Debt Costs - Bad debts are inevitable with accounts receivable. Invoices that remain unpaid for more than 12 months are likely to cause bad debts. The unpaid invoice amount eats away at the profitability of the company. The reduced profitability along with a cash shortfall due to outstanding debts worsens the liquidity position of the company.
A company should take every possible measure to prevent the aging of accounts receivable. Consider offering an incentive to customers to pay back the amount due earlier. Also, collecting some money in advance can reduce the damage due to unpaid invoices.
Credit Management Group can help you recover the accounts receivable through an integrated four-stage management/collection process. If you want to know more about our process, you can contact us by dialing 215-845-5040.