How Top Performers Manage Accounts Receivable

How do top performers manage receivables? Different industries offer different payment terms to customers -- for instance, a retailer whose customers pay at checkout will have a DSO approaching zero, whereas a manufacturer may carry lease receivables on its balance sheet and have a DSO in the hundreds of days. Even within industries, payment terms vary significantly.

The best managers of receivables tend to be distribution companies, which focus on buying and reselling. Because they can't afford to carry a significant amount of inventory or to finance the purchases of their clients, these companies tend to keep a tighter rein on receivables.

At the same time, high-tech companies, whether they are in IT or medical products, often have the highest profit margins and may be overlooking areas where they can identify and fix hidden costs. They have the most to gain by sharpening their focus on receivables.

Manufacturers fall somewhere in the middle. They develop, design, produce and sell a product and typically manage receivables well. Manufacturers are generally more interested in maximizing production than improving their processes at the other end of the revenue cycle. Their constraints are not only in cost but often the management bandwidth needed to improve receivables processes.

To identify best performers in any industry, the single best measure is to compare actual DSO to the best possible DSO -- the DSO that would result if every penny of every invoice were paid on its due date. In order for a company to do this for itself, it should calculate the proportion of sales generated under every set of payment terms it offers.

What are the characteristics of top performers in managing accounts receivable, regardless of industry? Here are the seven traits that separate world-class companies from laggards:

1. A strategic approach to managing receivables that supports the company's goals. The strategy must be clearly defined and communicated to the organization, eliminating conflicting views and the risk of customers receiving a mixed message. Moreover, a company may approach receivables as a way to provide financing. If it charges and collects interest while managing credit risk and enforcing payment due dates, it will generate a return.

2. Communication and enforcement of a shared vision that the company expects to be paid according to its terms. Practically, that commitment means collection is professional and proactive, and a few customer complaints do not allow the commitment to be abandoned or compromised. It also means that there is a process and organization in place to execute the strategy. A company that sells mostly to large firms needs a collections staff with relationship, account-maintenance and dispute-resolution skills, whereas a company selling primarily to small, thinly capitalized customers requires high-volume collection and credit-risk control skills.

The biggest barrier to excellence for companies in any industry is the belief that effectiveness in receivables management can be achieved only by alienating customers. This is frequently not the case. In fact, customer service is often improved when the company makes a commitment to excellence in this area.

3. The use of key metrics to track results. There are many metrics to evaluate: actual DSO vs. best possible DSO; receivables aging; the risk profile of the receivables asset; the number of collection contacts; and promises to pay secured, or dispute resolution performance, among others. These metrics measure levels of activity as well as results for asset turnover, risk and asset quality. Ideally, metrics are limited, pertain to key activities and results, and are compiled automatically. And while putting the metrics in place may mean an initial time investment, actual reporting should only consume about four hours per month of the credit manager's time.

Often companies use metrics that channel effort to the wrong activities. For example, a common mistake is to measure a credit department on the percent of receivables over 90 days past due. In most firms, receivables over 90 days past due constitute less than 10 percent of the total asset, so this metric directs 80 percent of the effort to 10 percent of the asset.

4. Incentives that reward cash collection on a quarterly basis. Accounts receivable is one of the easiest activities to measure and tie to compensation, aside from sales. For example, bonuses might be provided for achieving actual collections versus a target set to improve or maintain DSO for the quarter, with payouts starting at 90 percent achievement and increasing for those who meet their objectives.

5. A robust process that resolves issues quickly so that disputed amounts are cleared and profit concessions minimized. A dispute is any reason (other than cash constraints) a customer delays or takes a deduction from an invoice. Disputes generally arise from invoicing the wrong price or quantity, omitting purchase order numbers, or quality issues with products or services.

No matter what the source, top performing companies promptly identify, categorize and track the dispute from inception to clearing. The right departments address the dispute -- for instance, the person who maintains contract and pricing files can answer a pricing question faster than a collector. Workflow and responsibilities are clearly defined and standard resolution timeframes are set. In addition, data from the disputes contain important information that can inform ongoing improvement.

Rather than implementing a formal dispute management process, many companies leave it to the collections staff to research and resolve customer disputes even though it involves functions in which others are more knowledgeable (such as pricing, product performance or order fulfillment). This approach assigns a less qualified employee to serve customers and diverts collection time from generating cash.

With the majority of receivables greater than 30 days past due disputed, the speed with which disputes are researched and resolved can directly decrease the number of past due receivables, increase cash flow by releasing payments delayed due to a pending dispute, and reduce disputed amounts often conceded to the customer for no reason other than extreme age.

Remember, customers dispute invoices when they think there is an error. Since their assumptions are often wrong, the full amount of a disputed invoice can frequently be collected if the "error" is addressed promptly.

6. A continuous improvement process focusing on order fulfillment and invoicing accuracy. Data that pinpoints the high-frequency errors -- for example, pricing, sales tax -- directs process improvement efforts to fix the root causes of these errors. Reduction in error rates in filling and billing orders will improve productivity, increase cash flow and enhance customer satisfaction.

7. The use of technology to automate repetitive functions and prioritize activity. Successful users of new technology are industry-leading performers in receivables management. Employing technology consistent with the receivables strategy can improve efficiency, save staff time and minimize mistakes. Many functions can be automated, including prioritizing customer accounts to be contacted based on defined parameters such as size of amount owed, length of nonpayment or risk rating. Scheduling follow-up actions, applying cash and sending collection correspondence can also be automated.

Companies facing technological deficiencies can overcome them in one of two ways: by expending the time and effort to maximize the use of an ERP system, or by buying a best-of-breed receivables management application. Many companies use adequate ERP applications for their receivables management but fail to utilize them to their full potential. Nevertheless, most world-class organizations use function-specific applications rather than an ERP system. Installing one of the many commercially available best-of-breed credit and collection applications can cost hundreds of thousands of dollars initially, but these tools often generate an attractive payback from increased productivity and improved performance.

Although returns vary, investing in skills improvement and process redesign has generated paybacks from three to 10 times the initial investment. At the same time, for many organizations, the true investment is the time spent training employees and ensuring that they use the system fully rather than reverting to familiar but less efficient habits.

Success in Receivables Management

What can companies do to move from being good managers of receivables to great ones?

Get a strong commitment from senior management to do what it will take to improve. Without it, a company is simply enforcing the status quo.

Strive to improve accuracy in order and service fulfillment and invoicing. The receivables asset reflects the quality of the entire revenue cycle operation. If all orders are fulfilled and billed accurately, many disputes are prevented. Improving accuracy in fulfillment and invoicing also improves productivity.

There are several ways to implement this improvement: First, appoint a senior executive to champion the benefits of increased accuracy, enhanced customer service and satisfaction, improved market perception, increased efficiency from less error correction and rework, and improved cash flow. Second, analyze error data, which can be in the form of recently issued credit memos, reports from a dispute resolution system, or other quality tracking. Identify the three or four most frequent types of errors. Third, identify the root cause of the errors. A pricing error may emerge from an expired contract, uncommunicated price increase or sales tax error. Fourth, develop process changes to prevent the errors, such as faster updating of price schedules or securing customer acknowledgement on price changes. Finally, measure the improvement in the error rate (both the total number of errors and their cause).

Formulate a portfolio strategy for receivables. Just as different customer segments require customized marketing approaches, different collection approaches are needed for distinct categories of customers. A properly formulated portfolio strategy, executed with the right processes, resources and organizational structure for each segment, will keep cash flowing and minimize bad debt exposure.

To develop a portfolio strategy, first classify similar customers into groups: government vs. private sector, export vs. domestic, national vs. small accounts. Then determine if the groups merit different collection approaches. For example, large national accounts typically require less collection contact but closer monitoring for skipped invoices. Small, thinly capitalized customers usually require very active collection contact. Design the approach for each group, then ensure that the staff members with the right skills are assigned to that group. In this way, the portfolio strategy can support a company's overall strategy for the receivables asset.

Accounts receivable can be a financing tool for customers to be used as a competitive advantage in the marketplace; a source of cash flow to fund the business; or a way to generate high-margin, incremental revenue by selling to high-risk customers. Most companies have not specifically articulated how receivables fit into their corporate strategies, but instead view them as a necessary cost of doing business. This approach, by default, seeks to minimize the investment and cost of the asset and the impact on sales.

For companies that are up to the challenge of taking a hard look at their accounts receivables, the payback -- in cash, efficiency and market perception -- is worth the investment.

Case Study: The A/R Management Payoff A $1.5 billion heavy manufacturer delivered big cash and profit benefits by improving its management of accounts receivable. The company had numerous divisions making heavy-duty construction materials and engineered products. Its client base was broad and varied, including contractors (which are often undercapitalized and slow to pay), government agencies and Fortune 100 companies. The company's DSO was in the mid-40s-to-50 range -- decent, but not at the level where management wanted it to be. In addition, each division was decentralized, with its own receivables management, metrics and practices. In many divisions, management didn't see an urgent reason to change and was invested in maintaining the status quo. How did the company manage the change? First, it conducted an assessment, which found that collection processes in the divisions were inconsistent and credit controls were lenient -- sometimes so lenient that a client company would go bankrupt before it had paid long-overdue bills. Dispute resolution, where it existed, was ad hoc. Metrics often measured the wrong data. After reviewing the assessment, the company implemented the following initiatives: A redesigned, rigorous collection process with increased customer contact to enforce agreed payment terms. Before, clients were given 30 days to pay but not contacted until day 45 of non-payment. With the new process, clients were contacted on day 35. As well, all clients -- not just a few problem ones -- received follow-up calls. A formal, documented, dispute-management process to replace the ad hoc process. Processes were tailored to each division, and everyone understood their responsibilities within each process. Redesigned reports to enable management to monitor progress of receivables management and identify serious risks. Rather than receiving an itemized breakdown of every outstanding bill, management received a regular report of the exceptions -- the biggest problems -- and focused on cash collection. An incentive plan for collection staff to spur performance. While targets varied among divisions, the result was the same: Employees were spurred to collection by the promise of a quarterly payout. Technological enhancements to automate the collection and dispute-management processes. Instead of tapping the potential of the ERP system they already had, employees were still using Excel spreadsheets. Once they were trained on the system, they began to use it consistently. The results? In one group of about a dozen divisions, the following results were obtained: Cash released from receivables totaled $45 million. Valued at a 10 percent cost of capital, this reduced funding costs by $4.5 million per year. DSO decreased from 47 days to 36 days over the course of 14 months. Bad debt expense was reduced by $1 million. Total profit improvement in the first year totaled $5.5 million.