Management and Administration of Accounts Receivable Part 2
This is the 2nd article in a series about Management and Administration of Accounts Receivable. This material is adapted from The Automated Accounting Systems and Procedures Handbook (John Wiley, New York 1991) Chapter 5.
Measuring Accounts Receivable Departmental Efficiency:
Bad Debt Ratio. Another key indicator of credit performance is the bad debt ratio, the ratio of write-offs to sales. This measures the effectiveness of credit and collections policies in relation to sales volume. The Credit Research Foundation measures the bad debt ratio based on a full year’s credit sales:
| Bad Debt Ratio | = | Current year write-offs | - | Recoveries against current or prior year write- offs |
| | Current year credit sales | | |
The final result is most often represented as a percent. Sometimes net income is used in lieu of credit sales.
The accounts receivable system can compute this using a rolling 12-month time horizon, adding a new month each period and dropping the oldest. This will help smooth out aberrations. For example, many businesses have a mad rush to collect funds just before their year end when they also write off a disproportionate amount of bad debts. Using a rolling 12 months for this calculation ensures the denominator always contains exactly one year end’s write-offs.
Both the credit and collections processes can affect the bad debt ratio. The effectiveness of the collections department is measured in the bad debt ratio since their ability to extract payment from marginal accounts will impact the amount of write-offs for a given sales volume. Likewise, the ratio measures the effectiveness of credit approval and credit management. Poor credit screening and approval will push this number up by allowing more sales that will have to be written off.
Generally speaking, a lower debt ratio indicates a healthier credit function. But as with most key indicators, this single interpretation cannot be taken carte blanche. A low debt ratio (in comparison to an industry average, for example) can also mean that credit policies are too restrictive. Perhaps too many customers are being given cash or COD terms and a large number of them have gone to other suppliers to obtain better credit terms.
Percent of Current Accounts. The percentage of current accounts is the ratio of all amounts past due to the total accounts receivable balance. This indicator is primarily a measure of collections efficiency and is easily derived from the accounts receivable aging.
Recall that the system can prepare the aged trial balance by aging invoices according to their due date. Only those invoices that are past due are reported in the aging columns (1–30, 31–60, etc.) Current invoices can either be not reported or shown in the “Current” column. The footings at the bottom of this aging report show both the current accounts and the total accounts receivable —the amounts required to compute this ratio.
Figure 5-5 Credit Department Costs Analysis.
| Cost Category | Total Annual Cost | Cost per $1MM Sale |
| Department manager salary and benefits | $75,000 | $500.00 |
| Salaries and benefits for credit, collections and cash receipts entry | 120,000 | 800.00 |
| Credit research reports | 10,500 | 70.00 |
| Telephone | 3,500 | 23.33 |
| Supplies | 4,800 | 32.00 |
| Collections services | 6,000 | 40.00 |
| Allocated computer costsa | 18,000 | 120.00 |
| Bank lockbox charges | 43,200 | 288.00 |
| Total cost of accounts receivable processing | $281,000 | $1,873.33 |
a $60,000 in software development costs prorated over five years, plus $6,000/year in operating costs.
Unit Cost for Credit Management. Tracking the credit costs per unit of trade credit gives a true picture of trade credit cost. This identifies credit costs irrespective of business volumes, representing the credit department costs required to manage a “unit” of receivables. This unit cost analysis is helpful for comparing credit department performance against published industry standards compiled from surveys of accounts receivable and credit departments.
Computing the unit cost for credit management can also be useful for measuring progress toward cost reductions and improvements in internal credit processing efficiency. By graphically tracking this indicator over time, financial management can get a clear picture of credit department trended performance.
Measuring the unit cost for credit management requires first computing credit department costs by cost classification. Figure 5-5 shows a breakdown of the costs for credit management in a $150MM enterprise. Note that bad debt write-offs are not a cost of running the department; they are a result of how well it is run. Also note that personnel costs are by far the highest cost component in credit management. Because of this the quality of the people is a significant determinant of departmental efficiency.
Next Month's topic: Cash Flow Improvements
| About this article and the author: |
Doug Potter is the owner of The Newport Consulting Group a professional management consulting organization that provides clients with information systems planning, selection, and implementation services. He can be reached at dpotter@newportconsulting.com or through his Web site, http://www.newportconsulting.com.
Note: The contents of this article were excerpted from Mr. Potters book "Automated Accounting Systems and Procedures Handbook" Copyright 1991 by Douglas A. Potter, published by John Wiley & Sons, Inc. New York
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