How to Calculate Your Costs and Ways to Lower Them
Many building material dealers do not know the true costs of providing in-house credit. They may know the interest rate they charge after 30, 60 and 90 days, but they haven’t allocated all attributable expenses to each customer account, which would reveal the true combined costs of credit extended to a customer. Why the need for such precision? Perhaps in higher-margin business sectors, outside of building material distribution, there is more room for averaging customer costs. But in our sector, where margins are only 4%-5% and the cost of credit over an economic cycle is 2-4%, managing credit well has a meaningful impact on the bottom line. There isn’t room for not knowing true costs at a granular level.
The reason why dealers don’t know the true cost of credit is simple: They often don't know how to calculate it or they may be in denial about exactly how much the cost of in-house credit is dinging their bottom line. Moreover, those costs can change dramatically depending on the economic environment. If you ask a dealer about the true costs of granting in-house credit, he will likely talk about those costs in a good year, when there are actually two additional types of years to consider: 1) bad years and 2) average years. All three must be examined for an accurate picture of your business over time. When you engage in this exercise, you will notice that some costs rise in a recession, even as revenues fall.
What costs could possibly rise? First let’s list a series of typical financial line items, and let’s assume some proportionate baseline numbers for a company whose profile is $10 million in sales, 48 DSO (days sales outstanding), and 0.5% bad debt (see Fig 1). With this in mind, we can compare a good year to a bad one, and see each type of year in the light of an economic cycle average.
First, note the numbers that don’t change, whether it’s a good year, a bad year, or an average year: 1) the costs of billing, bureau, and credit scoring, 2) the cost of labor, and 3) the cost of management.
Now, let’s look at the costs that do change in a recession, and compare it to a good year and an average year. Notice that the line item with the biggest jump is the cost of money. It jumps up because in economic downturns, banks “price in” the higher risk of loaning money. So, the cost of a credit line or a revolving loan rises to $135,616 in a recession. That’s $45,205 more than you paid in a good year, and $52,602 more than you paid in an average year. As revenues drop, you are getting hit with a double whammy: less money to work with and higher borrowing costs.
Bad debt also rises in a recession. In our example, it rises to $75,000, a full $25,000 more than in a good year, and $12,500 more than in an average year. With bad debt, there are also the rising costs of legal fees, more attention paid to collections, and the costs of putting liens on non-payers. Soft costs also rise in a recession. There is the cost of the owner’s time, which increases as more energy must be exerted to manage through the downturn. If the manager is working on remedies to no-pays, slow-pays, and putting out fires, that leaves little room for marketing innovation or efforts to increase market share, something that’s always required in any kind of economic environment.
Other soft costs come through as restricted cash flow, which causes borrowing (cited earlier), and also missed buying opportunities and missed early-pay discounts.
How do you lower your cost exposure on potentially bad in-house accounts? Here are six tips:
- Tighten credit screens. Raise your minimum credit criteria and enforce your A/R terms. You are not a bank.
- Maintain high standards for credit scores. Monitor customers’ credit scores; move the worst to COD.
- Extend your bank line of credit. Credit is hard to obtain in a recession. Get it now.
- Refine your lien processes. Processing liens should be a well-oiled machine, in good times and bad.
- Take the worst case off the table. If there’s one account that would bring your company down, consider credit insurance.
- Offload risk. Bring in a credit management provider like BlueTarp who will assume risk, pay you upfront on all of your B2B sales, and even collect A/R if you choose. The cost of using a credit management provider is typically less than your average cost of granting in-house credit, plus you gain guaranteed cash flow, protection from risk, extended terms and longer lines.
About the Author
Scott is president and CEO of BlueTarp. He has spent the majority of his twenty year career in financial services helping businesses grow more rapidly through the effective use of credit.More Content by Scott Simpson