Costs Associated with Receivables Management

Efficient receivables management isn't just about maximizing collections; it's also about minimizing the costs associated with extending credit and maintaining accounts receivable. Balancing these costs is crucial for maximizing overall profitability.

Core Idea: Balancing Sales and Cost

The key to successful receivables management is striking a balance between:

• Generating sales through credit
• Minimizing the costs associated with managing that credit.

1. Collection Cost

• Definition: Expenses incurred in recovering outstanding payments from customers.
• Examples:
  • Salaries of collection staff (employees responsible for follow-ups)
  • Cost of sending reminders (emails, letters, phone calls)
  • Legal expenses (if legal action is required for overdue accounts)
  • Third-party collection agency fees (if external agencies are hired)
• Impact: Higher collection costs can reduce profitability.

2. Capital Cost

• Definition: The opportunity cost of funds tied up in receivables. It's the return a company could have earned if the money wasn't locked in accounts receivable.
• Explanation:
  • When a company sells on credit, it doesn't receive cash immediately. This delay means the company loses the opportunity to invest those funds elsewhere.
  • The capital cost represents the lost earnings from not being able to use those funds.
• Formula:

  Capital Cost = Receivables * Cost of Capital
  

  Example: If a company has $100,000 in receivables and its cost of capital is 12% per annum:

  Capital Cost = $100,000 * 0.12 = $12,000
  

• Impact:
  • A higher credit period (longer time for customers to pay) increases the capital cost.
  • Companies must balance the potential for increased sales through credit with the cost of tying up capital.

3. Default Cost (Bad Debt Cost)

• Definition: The loss incurred when customers fail to pay their dues (bad debts).
• Causes:
  • Customers go bankrupt or refuse to pay.
  • Poor credit assessment leads to extending credit to high-risk customers.
  • A weak collection policy fails to recover overdue payments.
• Impact:
  • Direct loss in cash flow and profitability.
  • Increased risk and uncertainty in financial planning.
• Mitigation:
  • Perform thorough creditworthiness checks before granting credit.
  • Set strict credit policies to reduce extending credit to high-risk customers.
  • Maintain a proactive collection policy.

4. Delinquency Cost

• Definition: Costs incurred when payments are not received on time, even if customers eventually pay after a delay.
• Components:
  • Interest on late payments (opportunity cost of delayed funds)
  • Administrative costs (sending reminders, tracking late payments)
  • Loss of goodwill (strained customer relationships due to delayed payments)
• Example: A payment of $50,000 is due in 30 days but received after 60 days, the company incurs interest losses and additional tracking costs.
• Impact:
  • Reduces liquidity, affecting day-to-day operations.
  • May lead to financial distress if large payments are significantly delayed.
• Mitigation:
  • Implement late payment penalties.
  • Encourage early payments with cash discounts.

Conclusion

Managing receivables effectively requires a careful balancing act: boosting credit sales while minimizing costs. Companies must actively work to minimize collection, capital, default, and delinquency costs to ensure financial stability and profitability.