An increasing number of negative economic forecasts have caused me to reflect on the impact a down economy has on dilution, the percentage of your receivables that is not collected. Not in terms of bad debt but rather percentages lost in deductions for pricing, promotion, shortages, penalty charges, etc. Depending upon your industry, dilution can range from 2 percent to 30 percent. These dilution percentages reflect real profit leakage from your company's bottom line.
There are many credit executives with substantial experience (5-8 years) that have only managed receivables in an expanding economy. It is critical to recognize that different strategies need to be adopted to manage dilution issues in a contracting economy.
Dilution/deduction problems become more critical in a slumping economy because many faults can be hidden when there is top and bottom line growth. Situations, which may have gone unquestioned by senior management, will likely come under intense scrutiny. A well-prepared credit executive will take proactive steps to address potential problems.
One of the first issues to be considered is the actual level of dilution in your company. While this might seem a basic, simple information-gathering exercise, it is probably more complex than you would initially believe. One of the reasons for the complexity is that when companies operate in an environment where sales and profits increase for a number of years, the diligence applied to tracking dilution issues tends to diminish. As a result, there are dollars written-off at the time of cash application, and through the receivable cycle, additional dollars are either written-- off or debited against various internal accounts, such as promotional funds.
It is crucial to accurately determine the dilution factors on a micro and macro basis. That is, you need to analyze the situation on a specific customer basis, on a deduction category basis and on a total deduction basis.
On a micro basis, insofar as specific customers are concerned (the 80-20 rule is certainly in effect), you won't need to review each customer, as the top 20 percent of your customers will generate 80 percent of your deductions. By carefully examining the deduction patterns of those large accounts, you will be able to isolate customers that statistically stand out from other major customers. They may be outliers in a positive or negative sense, deducting significantly less or more than the average. The more serious offenders may utilize deduction categories, such as penalty charges, that other customers don't deduct for at all.
This analysis helps you in two ways. First, it identifies customers that, relatively speaking, are more profitable and isolates customers who may, in fact, not be profitable at all. Secondly, it establishes a baseline for customers that enable you to track trends, and quickly spot an increasing deduction pattern. That information, always important, has even greater significance in a down economy. Most of your company's customers are astute and recognize that the fastest way to attract a high profile from their vendors is to stop paying invoices on time. Conversely, increasing the number and dollars of deductions will likely generate much less attention. Accordingly, as a purchaser of goods and services that is experiencing cash flow shortfalls, I can maintain vendor relations more effectively using an aggressive deduction approach as opposed to paying invoices slower. Most vendors view deductions as a normal part of the sales process, and a high percentage of vendors do not even count open deductions against a customer's credit line.
Now as a credit executive that has proactively determined a baseline deduction profile for specific customers, you have distinct advantages over your less analytically inclined peers. Not only do you have an early warning system in place to spot the deteriorating trend, but you also have the data necessary to address the situation with your customer. …