The cost associated with receivables management for small and medium-sized businesses is a difficult task.
Receivables are the amounts of money owed to a company as a result of sales of goods and services that occur in the regular course of business. It is also known as debtors or trade credit, and a part of current assets.
Important among these are the total number of credit sales made and the particular periods between the sale and collection of the money owed.
Account receivables are funds that will be due at a later time for the credit sale of current goods and services. Presently, credits are used in most economic transactions.
The majority of companies use credit sales as an important instrument for sales promotion when they are faced with competition.
Credit sales increase a company’s sales revenue as a sales promotion tool, which eventually increases profitability. However, the real cash collection may take months after the credit sale has been made.
These delayed payments could quite reduce a company’s profit margin as they accumulate over time. The manager must be able to measure both costs and advantages of credit extensions to verify the final impact of credit sales.
This article will explain more about the cost associated with receivables management.
Significance And Purpose Of Receivable Management
Determining an efficient credit policy that boosts the effectiveness of the firm’s credit and collection department and contributes to the maximum of the firm’s worth is the fundamental goal of receivable management.
The following are the various goals of receivable management:
- To assess a customer’s creditworthiness before extending or giving credit.
- Reduce the expense of investing in receivables.
- To reduce potential losses due to bad debt.
- To structure the credit conditions so that they maximize sales income while yet requiring minimum investment in receivables.
- To keep the credit and collection department’s operating expenses to a minimum.
Cost Associated With Receivables Management
The cost of maintaining receivables must be determined. It considered things like the cost of investment in receivables, losses from bad debt, collection charges, and cash discounts.
The following is an analysis of the costs associated with receivables management:
1. Cost Of Financing Receivables
When a company extends credit to its customers for the purchase of products and services, those customers are permitted to spend the available capital.
The financing for the receivables comes from the cash provided by the shareholders for long-term financing as well as the retained earnings of the company.
There is a cost associated with the collection of money that is used to finance receivables by the company.
2. Cost Of Investment In Receivables
The amount of money that is being restrained in receivables, is the cost that would not have been incurred if all sales were made in cash instead of being tied up in receivables.
The following equations are used to determine the cost of investment in receivables:
The cost of receivables is calculated by multiplying the amount invested in receivables by the opportunity costs.
The investment in receivables is calculated as follows: DSO multiplied by (FC+VC)/days in the year.
Whereas DSO stands for days sales outstanding, FC stands for fixed costs, and VC stands for variable costs.
3. Bad Debt Losses
This is the loss that occurred as a result of consumers going into default. When credit is extended to consumers with a low-quality rate, this results in a rise in the number of bad debt losses.
The following equation can be used to determine how bad debt losses should be calculated as a proportion of sales:
Bad debt losses = Annual credit sales × Percentage default customer
4. Collection Expenses
This is the expense incurred by a company as a result of the operation and management of its credit and collection departments.
This covers the cost of the administrative work done by the credit department, the salary and commission provided to the collection team, the cost of the telephone and other forms of contact, and so on.
5. Cash Discount
It is the expenditure that must be incurred to attract customers to make early payments on their invoices.
A firm can lower the average collection period, the amount of money lost to bad debt, and the cost of investment in receivables by providing a cash discount to the customers.
The cost of the discount is computed by multiplying the cash discount % by the sales to discount customers, as shown below:
Discount Cost = Annual credit sales × Percentage cash discount × Percentage discount customer.
6. Cost Of Collection
To effectively manage receivables, it is necessary to collect them properly. Customers who do not pay their bills within the allotted credit term are sent reminders to make early payment arrangements.
Certain people may have to be sent to collect these amounts. All these expenses, are often referred to as collection costs and are typically expected to be held by a firm.
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How To Reduce The Cost Associated With Receivables Management
- Develop clear strategies and screening procedures to identify unstable customers.
- Instead of billing monthly, you should issue invoices whenever products or services are provided.
- Customers need to be informed of the terms and conditions around payments.
- Include payment options that are quick and easy to use, such as electronic fund transfers, options to pay with credit cards and debit cards, opportunities to pay with checks, etc.
- When you automate the process of accounts receivable, you may send automatic reminders to customers, which will save time and money while also speeding up the payment process.
The cost associated with receivables management must be considered as listed above, such as the cost of financing receivables, cost of investment in receivables, bad debt losses, collection expenses, and cost of collection.