Extending credit to customers is risky and it can be costly; but it is also a part of doing business in today’s world. Just because is it common though, does not mean you should take it at fave value, it is extremely important to fully understand the cost of extending credit and the consequences of doing so. From there, take the necessary steps to reduce the overall expense of extending credit and work to better manage the entire process, therefore reducing the risk and cost while developing long-term, positive relationships with customers. So, when you extend credit to customers, keep the following in mind.
Cost of Credit Totals Let’s take a look at the total cost of credit for a business, considering two invoices: one for $100 and another for $1,000. You can adjust these assumptions for your own situation but what’s your margin on that invoice? Keep in mind that these are estimated credit costs for a single invoice.
This is admittedly an aggressive cost model but if you exclude the bad debt allowance the cost of credit is still significant as a percentage of the invoice value, particularly for smaller transactions. So the real question becomes, when extending credit to customers, “How can you potentially reduce your cost of credit?”
- Cash. Require customer to pay by cash or check, either in advance, upon delivery, or require a substantial deposit before work begins or products are delivered. Advances or progress payments are common is some industries. Holding up delivery of a product until payment in received gives you significant leverage. While a cash payment strategy will reduce costs and risk it may also reduce revenue if customers are unwilling to go along with it. Consider your industry and competitive position – how much leverage do you have?
- Accept Credit Cards. Credit card payments improve cash flow and reduce risk – at a cost. Many small businesses do not accept credit cards because merchant fees can run 2-3% (or more) of the transaction amount, with the potential for additional “hidden” fees. If you have many small transactions this approach is probably cost justified; a few big ones, not so much. However, having the ability to accept credit card information over the phone is an important tool in the collections process and that alone may justify accepting credit cards.
- Minimum invoice amount. Consider establishing a policy that purchases under a certain amount must be paid for by cash, check or credit card and only invoice purchases above that amount. You may want to grant large customers a waiver if their overall purchase volume warrants an exception to your standard policy or could even give product to them for free if the cost of invoicing exceeds the value of the product. I once had a customer that purchased pallet loads of silicone sealant. One day they stopped by because they needed one tube to finish a job. I gave it to them for free (for the above reason), saving money and scoring big customer satisfaction points.
- Charge late fees. You may recover some of the financing cost and provide an incentive for prompt payment but billing late charges adds administrative expense. Frankly, most business customers ignore late fees when they are making a payment, even if it’s 60 days late. Insisting on payment for late fees can cause customer relationship issues. Late fees are of questionable legality unless clearly started on the invoice, credit application, or other document pertaining to the sale. If you expect to take an account to collection and want to add on these fees you will need to have your right to assess them established.
Reduce the cost of extending credit by better managing the entire process- from invoice to collection. Accounts receivable management automation helps businesses improve management over their credit collections and business processes, so that when you do extend credit, you reduce the likliehood of taking on bad-debt because of it. Most businesses can realize significant improvements by using credit management software; some of these are reduced transaction costs, improved cash flow and cash forecasting, optimized staff productivity, and reductions in bad debt and write-offs. According to Industry Analysts, Paystream Advisors, companies who automate collections and nothing more are realizing:
• 10 to 20 percent reductions in daily sales outstanding (DSO)
• 25 percent reductions in past due receivables
• 15 to 25 percent reductions in bad debt reserves
• Return On Investment (ROI) in as little as 2 months