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Most Misunderstood Link in Supply Chain Management

Written By: Abe WalkingBear Sanchez
Published On: August 4 2008

Critical to sales, customer service, quality, cash flow, and to a company's very survival, credit and collections is often caught up in a 1950's risk management time warp.

Lots of things have changed since the '50s, besides the color of my hair. One thing that has remained fairly constant though is how most business executives view the credit and collection function.

They Don't Know What They Don't Know

An 18-year-old kid knows everything worth knowing, or so he believes. Most business executives know everything worth knowing about credit and collections, or so they believe.

There are two questions I ask potential clients about their credit and collection operation:

  1. How do you measure performance?
  2. Do you have usable written policies and procedures?

If clients have any kind of trackable numbers with which to measure credit and collection performance, those numbers are usually tied to average turn-time on the accounts receivable (A/R)—the days sales outstanding (DSO) or collection days index (CDI)—and percent of A/R written off as a bad debt loss (money the customer didn't pay). The same as in the '50s. As for usable written policies and procedures, many of these companies have none; only a few have actually documented the why, what, how, and when. The problem with many of these companies is that they have had the same policies and procedures since the 1950s.

"The new guy learns from the old guy, who learned from the dead guy." (Scott Stratman)

The problem with verbal understandings is that everyone gets to be the policy maker and there are as many policies as there are people. Many companies have a loose collection of forms, memos, and letters that they mistakenly call policies and procedures. They can't hand these so-called policies and procedures to someone new and reasonably expect the person to know how things work.

If you think you have usable policies and procedures, pull them out and see if they answer the following questions:

  1. What is the purpose of the credit function?

  2. What is the goal of credit approval, and does that goal complement the purpose?

  3. What is the goal of collections (delinquent A/R management), and does it complement the purpose?

  4. How is credit approval performance measured, and does it complement the goal?

  5. How is collections measured, and does it complement the goal?

People Forget

Eli Goldratt, in his book The Goal, says people in business forget why they're in business, that they get caught up in the process (details) and lose sight of the purpose (vision). I think Goldratt is too kind. I think many people in business never knew the purpose of what they do to begin with. Recently I was visiting with a chief executive officer (CEO) and his vice president (VP) of purchasing, and I asked the VP what the purpose of his function was. He stumbled around and came up with something about customers' needs and balancing that against various other factors.

If the head of a department can't clearly state why that department exists, what are the chances his people know? Or care?

Considering the costs of extending credit to customers—namely, the additional administrative expenses, the cost of time and money that goes with carrying A/R, and the potential for loss (bad debt)—why should any business extend credit? What is the purpose of the credit function?

Why Credit?

Businesses incur the costs of extending credit terms for the following reasons:

  1. It is a customer requirement. These companies are doing business with customers that require that they be given time to ensure they receive what they ordered; they require time to process the bill for payment. If credit terms aren't extended to such customers, the company loses profitable sales.

  2. The customer sells downline. Customers add value to the goods or services they buy and then sell downline to their own customers. Such customers require time (credit terms) to add value, make sales, and perhaps to collect their own A/R before they can pay vendors and suppliers. And if credit terms are not extended, profitable sales are lost.

  3. It is customary. In some industries, credit terms are customary, which means that other vendors and suppliers (competitors) extend credit terms. If credit terms aren't extended, profitable sales are lost.

The only reason to incur the costs that come with extending credit terms is to get profitable sales that would otherwise be lost.

Measurements over Purpose

How performance is monitored and measured means more than any stated purpose. Remember the first question I ask prospective clients: how are you measuring performance? If they are using DSO and bad debt, they are not measuring for how well the function performs in getting profitable sales; they're measuring for risk. The old comeback to credit being a lubricant of commerce, and allowing for the expanded movement of products and services is, "a sale's not a sale until you're paid." Consider this: If the purpose (vision) of credit is "to get profitable sales that would otherwise be lost," then should not the goal of credit approval be "to find ways of accommodating profitable sales while remaining confident of payment"? Who says we can't have our cake and eat it too? Stop painting credit as "the sales avoidance department" by measuring for what you want—profitable sales.

Factors in Credit Approval

There are three main factors companies consider when deciding to extend credit to a customer:

  1. Customer profile and how the customer does business (i.e., process, paperwork, accounts payable [A/P] cycle, etc.).

  2. Customer past performance. If they've never paid anyone in the past, chances are real good you won't be the first they will pay.

  3. Seller's product value (i.e., the margin on the sale, the current demand for the product or service, and lending company's current capacity).

Based on these factors, the goal is to find ways to maximize sales and minimize risks.

Enforcement of Payment

Why do I hate the word collections when used to describe the management of delinquent A/R? Collections has always been defined as "the enforcement of payment." The problem with this definition is that the vast majority of “past dues” aren't trying to stiff creditors; there are very often good reasons why payment isn't made when due.

A recent survey of 1,550 companies found that, on average, 73 percent of the total past due A/Rs are tied to “something going wrong”: sales and service disputes, wrong shipments, overages or shortages, damages, returns, unissued credits, missing backup, lost paperwork, wrong purchase orders (POs), and on and on. A certain percentage of past dues are using vendors or suppliers as a form of short-term financing (the float), but they're not collection agency material. Other past due customers can't pay when due for good reasons, but will be able to pay in the near future.

It is the very smallest percentage of past dues that are trying to avoid making payment. Past due A/R management is "the process of completing the sale." The goals of delinquent A/R management should be to

  1. Keep customers current and buying. Find out what stands between the customer and payment, and resolve the problem so that we get all the repeat business we can (the most profitable sale).

  2. Identify early on the small percentage that represents a potential for loss, and control bad debt by limiting further credit sales and by successfully improving on position (personal guarantees, returns, barter, conversion to a promissory note with additional security).

Summary

Lots of things have changed since the '50s. Customers today have more goods and services to spend their money on than ever before in human history. Unlike the '50s, a business today must be concerned with quality. And unlike the '50s, competition is crawling out of the woodwork and out of cyberspace.

Ask yourself two questions:

  1. How are you measuring the performance of your credit and collection function?

  2. Do you have usable written policies and procedures that support why (the purpose) credit exists?

You may find that you have forgotten a critical link in supply chain management.

The Author

Abe WalkingBear Sanchez is an international speaker, trainer, and consultant on the subjects of cash flow and sales enhancement and of business knowledge organization and use. Founder and president of www.armg-usa.com, Sanchez has authored hundreds of business articles, has worked with numerous companies in a wide range of industries since 1982, and has spoken at many venues, including the Shakespeare Globe Theater in London (England). A hard-hitting and fast-paced speaker, he brings life and energy to a critical business function whose true potential has yet to be realized by most businesses.

 
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