Your Product Value During Tough Times
By Abe WalkingBear Sanchez, August 1, 2008
Note: This is a vendor-submitted article and is presented as a resource for our Members and friends. Credit Today does not endorse the vendor or the views herein. Traditional risk mitigation thinking can adversely effect your current profit and future business.
Abe WalkingBear Sanchez
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The world's largest economy is in a serious downturn if not a full blown recession. Consumer spending is up but its most probably due to inflation, to everything costing more than to the expanded movement of products and services.Old traditional business wisdom dictates that during economic hard times a business should tighten up on the extension of credit to its customers. The logic behind this risk mitigation, risk avoidance thinking being that all bad debt is bad and that it takes a bunch of good sales to make up for one credit sale that goes bad. For example if a company is earning a 5% profit and it writes off $1000 to bad debt it would take $20,000 in good sales just to break even. However, this logic is flawed because it does not factor in Product Value at Time of Sale.
There are times and situations when bad debt and profit can both go up..at the same time.
Credit Approval...Maximize Sales and Minimize Risks
The only reason why any business should incur the additional costs of selling on the basis of payment at a later date;
a) additional administrative expenses b) the time value of money involved with carrying A/R (short term money due from the sale of a product or service)
c) bad debt write offs...from customers failing to pay, is in order to gain profitable sales that would otherwise be lost. Credit is primarily a sale support function.
There are four parts to credit approval, 1) information gathering 2) investigation 3) evaluation 4) terms and conditions of sale.
Information gathering is learning about the prospective customer, their profile, and this breaks down to "Who" the customer is, i.e. type of business, time in business, business status and just as important "How" the customer does business, i.e. A/P cycle, A/P protocol, paperwork or backup requirements, shipping costs, etc. Both the Sales area and the Credit area need to know this information and being that the Sales area normally has the initial contact with the customer it should be Sales that gathers it.
Failure of the Sales area to capture/gather the customer profile leads to a lessen ability on the Sales area's part to fully service the customer and creates a redundantly for both seller and customer due to the Credit area having to re-contact the customer for the information. Redundancies drive up everyone's cost of doing business and smart customers don't buy on price alone but on the Total Cost of Doing Business.
Once the customer information is gathered a decision must be made whether to continue on or not. If the customer's requirements are such that its impossible to meet them at a profit or if they are in a type of business that is incompatible with the seller's business model there is no reason to waste further time or effort. But if it's determined that the "customer profile" is compatible the next part of credit approval is the investigation of the customer's past performance.
If in checking on a potential customer's past performance it's learned that they have failed to ever pay anyone who's extended them credit..you are looking at a COD,,certified funds only sale. But if they have a history of paying creditors whether slow or not you want to continue to part three of credit approval, the evaluation and this is where Product Value at Time of Sale comes into play.
A seller's Product Value at Time of Sale will vary from time to time and must be weighted along with the Customer Profile and Past Performance in finding a way to say yes to a profitable sale, in determining the terms and conditions of sale.
Product Value?
To understand the concept of Product Value at Time of Sale consider margin, demand, and unused capacity, i. e. the fixed expenses.
Margin..shortly after I entered the consulting field in 1982 I had a client who sold ski hat pins and sunglasses to ski shops throughout the U.S. . The only information gathered was the customer's name and address . There was no investigation or evaluation of the customer, if the address was a P.O.Bx the order was thrown away. This client company had a bad debt write off of 20%. Wanting to contribute to my client's success I said to the CEO that we needed to work on the high bad debt number by gathering more information on the customer (customer profile) and then investigating the customer's past performance.
The CEO of this ski hat pin and sunglass company simply said to me, "You see these ski hat pins, I pay 3 cents for each and I sell them for a dollar. End of story." The man had a markup of 3333.33% . They could write off 50% of credit sales and still have a 1600% plus margin. On the sunglasses they only had a 1000% markup.
Bankers and magazine publisher's have a similar product, paper and ink. The major difference between the banker' product and the publisher's is that the banker's product has pictures of dead presidents on it including my favorite president Ben Franklin..he should have been president, and the publisher's product is advertising. The Product Value of the banker's product is 100%. The Product Value of the publisher's product? 45 to 55%.Because of the difference between a banker's Product Value and that of a publisher the publisher can have a much larger bad debt write-off and still be profitable.
A service company with customers lined up outside the office door with money in hand looking to do business has a high Product Value at Time of Sale and
should grab the cash and not incur the costs of extending credit terms. But if there are no customers outside the door or on the phone then things change, the Product Value at Time of Sale is low.
Product Value may vary from season to season. During times of great demand the Product Value is high, during slow times its low.
A truck hauling a load from Denver to Omaha but returning empty has a low and even a negative Product Value on the return trip. Why a negative? There's a reason why Denver is called the Mile High City and Omaha is not, in addition to the gas, insurance and maintenance costs there's the driver's paycheck and his dental plan to be paid.
Inventory with a slow turnover rate has a lower Product Value than inventory that turns around quickly and has a higher Product Value.
And then there are fixed expenses that directly influence the Product Value at Time of Sale. During an economic slowdown the unused capacity to do business grows but fixed expenses still remain and must be covered by fewer customers and lower sales. Companies with little or no capacity to take on additional customers have a higher Product Value than companies with excess capacity and the ability to take on more customers without having to incur additional fixed expenses.
If fixed expenses make up 50% of the total costs of doing business and variable expenses, including cost of goods, commissions and bad debt a make up 45% of the total cost of doing business there is a 5% profit. During an economic downturn the percentage of variable expenses drops along with sales and profit, but all to often the fixed expenses don't decline at the same rate. Low capacity to take on more business equals high Product Value, high or unused capacity equals lower Product Value at Time of Sale.
Terms and Conditions of Sale
Once you evaluated a customer's profile for type of business, time in business and how they do business you must factor in their past performance and your Product Value at Time of sale to come up with terms of sale.
For example you are looking at doing business with a customer in a currently high risk type of business, let's say General Contracting, they been in business for a reasonable length of time , let's say six years, how they do business is fairly standard with them not having a lot of costly requirements and their past performance isn't real great..now you have to factor in your Product Value to come up with terms and conditions of sale.
Let's say that the customer wants to buy slow turning inventory, your Product Value is low, fast turning inventory has a high Product Value. In this case you may want to ask for a down payment, or shorter terms or joint payment agreement. Your risk factor is lower because your Product Value is lower and if the customer fails to pay your loss in lower.
Or you have a high level of unused capacity to do business and your fixed expenses have to be borne by your current customers, by factoring in your low Product Value you can approve sales to higher risk customers and even after having more bad debt your profit will go up because you are taking advantage of your unused capacity/fixed expenses.
Base Business
% to Sales
Incremental Business
% to Sales
Total Business
% to Sales
Sales
$30,000,000
100.00 %
$3,000,000
100.00%
$33,000,000
Fixed Expense @ 50%
$15,000,000
50.00%
$0
0.00%
$15,000.00
45.45%
Variable Expense @ 45%
$13,500,000
45.00%
$1,350,000
45.00%
$14,850,000
45.00%
Incremental Risk Bad Debt @ 10%
$0
0.00%
$300,000
10.00%
$300,000
0.91%
Net Pre-tax Profit
$1,500,000
5.00%
$1,350,000
45.00%
$2,850,000
8.64%
: The normal credit risk is part of the fixed costs of the company.
If credit risks are increased to stimulate additional business, they are reflected on the Incremental Risk Bad Debt line. This equation will work if you can leverage additional business over your fixed costs (i.e. plant, equipment, rent, etc.) Once full capacity is met and additional investment must be made in the company infrastructure, the equation must be recalculated. The company described above was able to increase sales by 10% utilizing the existing capacity of the company. They increased their sales by extending credit to customers who represented marginal credit risks over their existing customers. Although their credit loss increased, their profits increased substantially! Summary
Give in to the old way of thinking about limiting credit sales during tough times and not only will your current profit suffer but you may well antagonize future customers who will remember that you turned them away or limited what they could buy when they needed you.
Remember that you must weight your Product Value on repeat sales as well as new credit sales.
Fail to take into consideration Product Value at Time of Sale and you may well be passing up some of your most profitable sales.
============================ Side Bar
A slow economic time can have a positive, a silver lining of sorts...time for improvement.
Consider a Friday Afternoon Improvement Meeting.Estimates on the % of the total cost of doing business that results from errors, mistakes, misunderstandings and general inefficiencies is 25% and many a CEO wishes it was only 25%. Tell your managers that each Friday afternoon you are requiring them to participate in an Improvement Meeting. The idea being to take time that is often used talking about the up coming weekend, and use that time to identify areas of opportunity for improvement. If over time you can reduce your inefficenties by just 1% your cost of doing business, and that of your customers drops and your profit will go up. Reduce inefficenties by 5% and you may well double your profit while also driving down your customers' cost of doing business.
Wrap up your improvement meeting with your managers making up a priority list of things they need to do on Monday...rather than starting the week by talking about what was done over the weekend.
Driving down the costs of doing business by constant improvement is like getting compound interest, for you and your customers alike.
A business manager not focused on improvement becomes an administrator at best and a bureaucrat at worst ======================
The Author Abe WalkingBear is an International Speaker / Trainer / Consultant on the subject of cash flow / sales enhancement and business knowledge organization and use. Founder and President of www.armg-usa.com , WalkingBear 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. 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. ICM / Mexico, Irish Institute of Credit Management, Evergreen Marketing Group,Vistage, CU, CSU, Texas A&M, N A C M - Kansas City, HTDA, BCFM, Skinner Nurseries, Deardens, Rain Bird, STAFDA, IBM, PEI, Atradius are but a few of the groups, schools, companies and associations for whom WalkingBear has conducted programs. WalkingBear can be reached through:
A/R Management Group, Inc.
P.O. Box 457
Canon City, CO 81215
(719) 276-0595
email: abe@armg-usa.com
www.armg-usa.com Copyright 1982 - 2008 A/R Management Group, Inc. www.armg-usa.com All Rights Reserved.
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