It may seem like a contradiction, but there are times when more bad debt can mean an improvement to the bottom line.

The call was from the CEO of a $30M a year distribution company in Portland; he had a question. "Last year we wrote off $5000 to bad debt, do you think we're too tight on credit approval?"

"Let me ask you a couple of questions", I said.

"First, do you have any unused capacity? Could you take on more business without having to hire any new people or take on any more fixed expenses?" The answer was "yes", they could take on more business. Next I asked, "Are you currently turning down credit sales? Are you rejecting riskier credit customers?" Again, the answer was "yes".

I then asked the CEO to draw a bar graph representing his current sales and to keep things simple, to make the amount $100. The first 5% or $5 is the pretax profit, the next 45% or $45 is variable expenses including cost of goods and sales commission. The remaining 50% or $50 is the fixed expenses. I then asked him to draw another bar graph representing a 10% increase via riskier credit sales. Of the new sales a whopping 10% would fail to pay, and would be written off as a bad debt loss. Of the new sales $1 would be lost, there would still be 45% or $4.50 in variable expenses but there are no additional fixed expenses. The pretax profit on the riskier credit sales would leap from 5% to 45%, a 900% improvement because of the effect of "product value" in the form of unused capacity.
 

Product Value At Time of Sale
When approving credit most companies do a pretty good job of weighing a customer's profile; time in business, etc. They do a fair job of checking past credit history (has the customer ever paid anyone in the past?), where they fail is in taking into consideration their product value at the time of the sale.

Examples: A distributor of ski hat pins and sunglasses was writing off 20% of all credit sales. The only requirement for credit terms was that the customer provide a name and street address for shipping . . . that was it. Most companies couldn't survive for long with such high bad debt write offs, but this company was only paying 3 cents for a hat pin and selling them for $1, a markup of 3333%. You can go to jail for selling most products with this kind of markup. The "product value" was very, very low compared to the selling price. Just the opposite is true of products with a high cost and low markup, they have a high "product value".

A trucking company had a truck going from Denver to Omaha, coming back it was empty. What was the "product value" of a truck coming back empty from Omaha to Denver? Keep in mind that it's uphill from Omaha to Denver. Zero? Less than zero! The "product value" was a minus. Minus the driver's pay, gas, insurance, and maintenance.  Knowing there was a negative product value involved, a customer who'd paid slow in the past was contacted.  By getting 25% down and by extending 60 day terms on the balance, a load was found.  And so what if this flaky customer failed to pay the balance.   Is all bad debt bad? It depends on the "product value at the time of the sale."

Slow turning Inventory has a low "product value" as do products with a short shelf life. An airplane seat empty when the door of the craft is closed has a low "product value"; that's why two people sitting next to each other can pay very different fares.

Services businesses with high demand have high "product value". The same companies with low demand have low "product value".

In Closing

Fail to take into consideration "product value" at the time of sale and you may well be passing up some of your most profitable sales. The CEO doing $30M a year?.. I ran into him at his association's annual meeting and we grabbed some lunch.  His sales and A/R were up, as were his turntime on the A/R and bad debt losses (but no where colse to 10%).  His biggest obstacle in factoring in "product value" was his credit  manager who had always been told "that all bad debt is bad".
 

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The Author

Abe WalkingBear Sanchez is an International Speaker / Trainer on the subject of cash flow / sales enhancement and business knowledge organization and use. Founder and President of www.armg-usa.com , Abe also sits on the board of www.BestBizways.com Inc.

TEC (The Executive Committee), "Inc." Magazine Annual Business Conference, CU (Denver), CSU (Ft. Collins), IBM, NASFT, PEI, BCFM, RAB, STAFDA, WIMA, ISD, Pet Industry Distributors Assn., Rain Bird, Winroc, Johnstone Supply, Able Distributing, Evergreen Marketing Group, Southern Wholesalers Assn., Touchstone/2000 Software are but a few of the groups, schools, companies and associations for whom Abe has conducted programs.

Abe can be reached through:
A/R Management Group, Inc.
P.O. Box 457, Canon City, CO 81215

Ron Fleisher specializes in Crisis Management, Negotiations and Compensation.  President of  Creative Bottomline Solutions, Inc.,  and a highly rated speaker, Ron has worked with many clients in a wide range of industries.  (770) 978-9046    cblsinc@avana.net