Man is predisposed to efficiency…new knowledge enhances efficiency…to be powerful in effect with little waste of effort. In "Lean" thinking there is a line of thought that believes that:
1) All work occurring in an enterprise is interconnected
2) Variation exists in all processes, and
3) Understanding and reducing variation are keys to success/efficiency

I agree with #1 but as to #2 and #3…I'd add some clarification.
To #2 I'd add…variation is an ongoing given and thus new conditions and existing circumstances must drive new processes.
To #3 I'd add…understanding that every enterprise is different and unique is to understand that there is more than one path to the mountain top/efficiency, and it is the identification and elimination of contradicting beliefs, via new goals, that best contributes to new processes and new efficiencies.

A recent email from the CEO of a large regional distribution company reminded me of an article I had written in 2001 based on a call from a STAFDA member.

First the email then the article, then my reply to the email and finally some thoughts about A 21st Century Profit Source…too often still waiting to happen.

The email

"I am the CEO of a member company of the Fluid Power Distributors Association. I have seen Mr. Sanchez speak a couple of times and have always found his information and ideas helpful – sometimes it's good to have a little refresher course on A/R. We do our due diligence up front on credit checks and over the past five years our A/R days averaged 42.

Where there is sizable sales opportunity our sales/inside sales employees are expected to start the qualification process before they ever quote a customer so they don't waste a lot of their time with someone who doesn't/can't pay their bills. We have very little write-off in a normal year and have been caught off guard by few significant bankruptcy filings over the years. We run into problems with new or newer companies who have little history or references. 90% of our business is in the mobile OEM (original equipment manufacturer) markets and as a distributor we are dealing with the small to medium size OEMs. Small start-up companies often offer us the most opportunity to move our products and expertise in the design and spec stages of building a new machine. These same new and newer companies also carry greater risk, as I'm sure you understand.

In his presentations, Abe has stated that, on improving A/R you can be too restrictive with your credit policy and ultimately cost yourself business. We know this to be true.
We recently lost approximately $150,000 worth of business at 30% GM (gross margin) for 2011 and $300,000 for 2012 because of our terms. Based on our credit check, our CFO required 1/3 down, 1/3 at delivery and 1/3 Net 30 Days due to a lack of credit history and information. On the initial order for $26,000 our competitor matched our pricing and took the business on Net 30 Day terms. I have a very unhappy salesman.

My question is whether you can offer any thoughts or helpful means for evaluating credit risk and any other options or alternatives we might have offered this customer when they balked at our terms. It is a difficult position with pros and cons coming from both sides – are we missing any tools or resources we could be using to help us achieve profitable growth with these small and new companies? Thank you for your interest, I look forward to your reply."

The article

Most Profitable Sale Waiting To Happen

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?" "First let me ask you a couple of questions", I said.
"Do you have any unused capacity? Could you take on more business without having to hire any new people or take on any additional fixed expenses?" The answer was "yes", they had unused capacity to do business and could take on new customers without incurring any additional fixed expenses.

Next I asked, "Are you currently turning down any credit sales? Are you rejecting riskier credit customers?" Again, the answer was "yes". They had a long established "risk" model based on TIB (time in business) and a new customer's past payment history that they used in their credit qualification process and based on this standard criteria they would pass judgment on new customers and make a decision whether or not to grant credit terms. This pass/fail , black/white mindset about credit approval feeds on the use of DSO (days sales outstanding) and bad debt performance measurements and leads to the failure to fully factor in the seller's product value at the time of sale.

I then asked the CEO to draw a bar graph representing his total current sales and to keep things simple, to make the amount $100. Starting from the bottom the first 5% or $5 was the pretax profit, the next 45% or $45 was variable expenses such as cost of goods and sales commission. The remaining 50% or $50 was the fixed expenses that do not fluctuate with changes in production activity level or sales such as rent, insurance, dues , equipment costs, repayment of loans, depreciation, fixed salaries, and advertising.

I then asked him to draw another bar graph representing a 10% increase in total sales via new and perhaps "riskier" approval of new customers who did not fit the long established "risk" model. Of the new sales we would budget a whopping 10% for situations where the customers would fail to pay and the new sale would be a bad debt loss. Of the new sales $1 would be lost and there would still be 45% or $4.50 in variable expenses but because of the existing unused capacity to take on more business, there would be no additional fixed expenses. The pretax profit on the riskier credit sales would then leap from 5% to 45%, a 900% improvement because of the effect of "seller's product value at the time of sale. 

                                                                                      $10 Riskier Sales 
 $100 Current Sales                                                                                                
                                                                                      10% or $1.00 
;                                                           Bad Debt
50% or $50                                                                 45% or $4.50 
 Fixed Expenses                                                        Variable Expenses
45% or $45
Variable Expenses                                                    45% or $4.50
(cost of goods / sales commissions)                   Pretax Profit
5% or $5
Pre Tax Profit

When approving credit sales to new customers 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, but all too often they are failing to take into consideration their product value at the time of the sale which will vary based on the conditions and existing circumstances …at that time.


#1 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, any new customers with a Post Office address were rejected out of hand. 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% and they had a minimum sale policy. You can still go to jail for selling most products with this kind of markup, depending on the product.

Their product value at the time of the sale was very, very low compared to the selling price. Just the opposite is true of products/services with a high cost and low markup, they have a high product value at the time of the sale for example a banker's product…cash.

#2 A trucking company had a truck going from Denver to Omaha and on the return leg it was coming back without a paying load. What is the "product value" of a truck coming back empty from Omaha to Denver? Keep in mind that there's a reason why Denver is called The Mile High City and Omaha is not…it's uphill from Omaha to Denver. The "product value? Zero? It is less than zero! The "product value" is a negative, a minus. Minus the driver's pay, gas, insurance, and maintenance. Knowing that there was a negative product value involved a customer who had a slow payment history and who had been placed on credit hold by other trucking companies was contacted. By getting 25% down and by extending 60 day terms on the balance a load was found. And so what if this customer failed to pay the balance? Is all bad debt bad? NO, 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 such as cut flowers. Before the airlines reduced the number flights and of aircraft in service there were empty seats that once the door of the craft was closed had a negative product value and that's why two people sitting next to each other could pay very different fares.. new conditions and existing circumstances have changed the product value and what we pay to fly.

Businesses with customers standing outside their door with money in hand and wanting to buy have high demand and have a high "product value". The same companies with little or no new traffic have low demand have low "product value".

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 (STAFDA)next annual meeting and we grabbed some lunch. His credit sales and A/R were up, as were his turntime on the A/R and bad debt losses (but no where close 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".


Base Business

% to  Sales

Incremental Business

% to Sales

Total Business

% to Sales



100.00 %





Fixed Expense @ 50%







Variable Expense @ 45%







Incremental Risk Bad Debt @ 10%







Net Pre-tax Profit








1) 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.
2) 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.
3) This 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!

Chart Courtesy of: Ron Fleisher, Creative Bottomline Solutions, Inc.

My reply to the email

"Besides the loss of $450,000 worth of business in 2011 and 2012…there are all the years that come after that. Once rejected for open credit terms, and that's all too often how customers take restristicive terms (1/3, 1/3,1/3) as rejection, a potential customer's future business may be lost for a generation or more.

Then there's the risk that a customer turned away (rejected) may talk with other of your potential customers in their circle and influence who they choose to buy from….the negative word of mouth thing comes into play. It takes a lot of positive marketing and sales effort to overcome a negative reputation, whether it's justified or not.

The first thing in your email that caught my attention was your statement " We do our due diligence up front on credit checks and over the past five years our A/R days ave
raged 42."
You are tracking DSO..Measuring the performance of your Credit Sales Function based on DSO and bad debt without also factoring in the product value will adversely affect both short and long term profitability. Do you have unused capacity to do more business? Are you currently tracking for the Total Credit Dollars Applied for and Approved?

If your Marketing/Sales/Credit functions are integrated and not working on different beliefs that contradict each other the total dollars approved should exceed the total dollars applied for. The "silo effect" also called "silo thinking", "silo vision" and "silo mentality" where different business functions operate in isolation results in the absence of operational reciprocity which in turn leads to a higher total cost of doing business…for seller and customers alike.

Are you using a preprinted "Credit Application" with standard terms and conditions of sale vs. "A New Customer Information Form" that is completed by the Sales people and without any set terms and conditions?

Do you have written P&P for your Credit Sales and A/R Function? While margins needs to be considered in coming up with Terms and Conditions of Sale you also need to weigh your unused capacity to do business and the demand for the product/service i.e. "Product Value at Time of Sale". Are you factoring your product value at the time of the sale into your credit approval decision? Is your Credit Function part of Accounting?"

I'm waiting for the CEO to answer my questions …and these are the same questions you should be asking yourself .

Thoughts on 21st Century Profit Source…still waiting to happen

"In every age and time there comes a turning point, a new way of seeing and asserting the coherence of reality." J. Bronowski

Prior to the invention of money each party in a transaction had to need or desire what the other party had to trade. Business transactions were severely limited by the " barter system". Money created a medium of exchange with an established value that was accepted in return for goods and services and business transactions expanded.

Some form of credit on a person to person basis most probably existed even before the invention of money, but modern Trade Credit , also known as Commercial or B2B Credit, really came into full being in the 20th Century and with it came an expanded movement of products and services.

However, use of B2B Credit for most of the 20th Century was mainly a local affair and the emphasis was on the "risk factor" to be found in the selling a product or service based on payment at a later date. 20th Century Credit was about risk and loss avoidance which was justified by the conditions that existed for most of that century, such as limited communication and information technology, the legal system, the lack of much competition. During this time Credit was rightly thought of a "privilege", as a favor to select customers, and the performance of the Credit Function was correctly measured by DSO (days sales outstanding) and by the % of Credit Sales that failed to pay altogether.
And all bad debt was bad.

This "risk avoidance" mentally was reinforced in the 1950s following WW II when the United States was the only major industrial society left unscathed by the destruction of the war. Not only had American production capacity been left untouched by the war it had in fact greatly expanded during the war and had been focused on the production of war goods/services and not consumer goods/services. Following the war a great number of Americans had savings in banks or "war bonds" because of the full employment that came with the war and of course due to the lack of products/services to spend their money on.

With the end of WW II the birth rate exploded, today between 8,000 and 10,000 American turn 65 EVERY DAY. The "baby boom" created a growing demand for goods/services. Many American women who had left their traditional roles as homemakers to work outside the home during the war didn't return to those traditional roles after the war; this also added to growing demand. The devastated industries and cities of Europe and Japan had to be rebuilt following the war and this also created growing demand for goods and services. And because of the devastation caused by the war, except for America, there was little in the way of competition.

Conditions in the 3rd Quarter of the 20th Century (1950 to 1975)
Pent up demand
Growing demand
Limited Competition

…and then things, as they have a way of doing, changed.

A New Paradigm but still Old Thinking.
Once their industrial capacity was rebuilt with new and more efficient infrastructure the European, Asian and other economies sprang to life.

In the last quarter of the 20th Century production caught up with demand, and then surpassed it. Quality in products, processes and services became the new norm. Competition became worldwide, big box stores and cyber stores competed with the old traditional outlets for goods/services…the world changed EXCEPT for how most companies managed their Credit Function.

In 2008 the world entered a global recession, the first global economic downturn since 1946. During and following the 2008 recession many Commercial Lenders restricted lending to businesses. Banks cut back on business credit including lines of credit on business credit cards.

In 2010 the world economy started to rebound. China (+10.1%), Taiwan (+8.3%), India (+8.3%), Brazil (+7.5%), and South Korea (+6.1%) recorded the biggest GDP gains. China also became the world's largest exporter and its GDP surpassed that of Japan making it the second largest economy in the world. Continuing uncertainties in the mortgage and financial markets combined with an overabundance of goods/services and an ageing population resulted in slower growth in Japan (+3.0%), the US (+2.8%), and the European Union (+1.7%).

Conditions in the last Quarter of the 20th Century and into the 21st
An abundance of gods/services
Decrease in demand
Reduced Commercial Lending
Worldwide, cyber and big box store competition

Although the business environment has dramatically changed from the 3rd Quarter of the 20th Century many most business managers still view their Credit Sales and A/R Function in the same way as their fathers or grandfathers did in 1955.

When asked how the Credit Function of their business can best contribute to profitability most business owners, CEOs and senior business managers still say it is all about avoiding bad debt and cash flow, they still focus on the "risk" factor first and foremost and they still measure performance by DSO and bad debt.

Clearly being able to control bad debt resulting from credit customers failing to pay and keeping credit customers paying is very important, but that is just a small part of how the Credit Function can best contribute to a company's profitability. Risk Management Is But The Tip Of The Credit Profit Iceberg.

A 21st Century Source of Profit…

"It must be considered that there is nothing more difficult to carry out, nor more doubtful of success, nor more dangerous to handle, than to initiate a new order of things. For the reformer has enemies in all those who profit by the old order, and only lukewarm defenders in all those who would profit by the new order, this lukewarmness arising partly from fear of their adversaries and partly from the incredulity of mankind, who do not truly believe in anything new until they have had actual experience of it. Thus it arises that on every opportunity for at
tacking the reformer, his opponents do so with the zeal of partisans, the others only defend him half-heartedly, so that between them he runs great danger."

There are still those who resist the idea that Trade Credit Management is about far more than just "risk management" or mitigation . They cling to DSO and bad debt for KPIs and Performance Measurements.

When making changes/improvements expect resistance,old orders cling to their ways until there is no choice but to change…for example Egypt, but changes/improvements will have their way for efficiency is an inborn human quality. The drive to be powerful in effect with little waste of effort, to do more/better with the same or less effort.

Bear in mind that 80 to 90 % or More of all B2B Sales involve credit terms and as commercial lenders have cut back on business lending the use of Trade Credit has grown. In the U.S., as of Sept. 09, the spread between business to business trade credit and commercial lending had grown by nearly $100 billion since the end of 2008 and will continue to do so.

Consider that Accounts receivable (A/R) is one of if not the largest asset of a company selling on credit terms. On average the A/R represents 40% of total assets and as more trade credit is extended it can only increase in size. The A/R is also one of the most liquid assets that of a business, being but one step removed from money in the bank.

Remember that while on average 25% or more of A/R are past due at any given time (1 day + beyond terms) on average less than 1% is ever lost to bad debt. Understand that there's a cost factor of 8 to 14 times as much involved with selling to a new customer than there is in selling to an existing customer, that the repeat sale is most often the most profitable sale with each repeat being more profitable than the last.

When a business sells its products/services on credit terms, based on payment at a later date, additional administrative costs are incurred in the gathering of customer information , the evaluation and verification of customer information , the customer past performance investigation, the consideration of seller's product value at time of sale, the establishment of terms and conditions of sale, account establishment, billing, posting payments, and past due management (not collections). Then there's the time value of money cost from carrying A/R, and of course there's the cost of customers failing to pay.

The reasons why any business should create the costs that go with selling on credit are;

1) Customers require time to ensure they received what they ordered before they pay and they require time to process the billing.
2) Customers need time to add value to the products/services purchased, to make sales to their own downline customers and to receive payment on those sales before they can pay.
3) Credit terms are customary in the seller's industry and competitors extent credit to customers. Part of the "competitive advantage" thing.

The reason why any business creates/incurs the costs of selling on the basis of payment at a later date in in order to get profitable sales that would other wise be lost.

The Credit Function is primarily a sales support function and if a company wishes to avoid risk, cash flow delays and bad debt altogether it should get out of credit and get out of selling. Cash flow is a two way street…Money In and Money Out….Sales is the Source of Money In and without Sales Cash Flow stops cold. And again, this is not to say that risk management is not important, but it has to be kept in the proper perspective and not be the tail trying to wag the dog.

In the course of approving credit sales and then working with the issues involving past due payments , the credit function interfaces with just about every facet of a business and has insights that if understood and used can help direct marketing and sales efforts toward specific types of customers or markets.

The cost or loss resulting from a key supplier failing can also adversely effect its customers. The credit function can provide an initial and then on-going investigation and review of key suppliers.

The credit function can also support the Operations function by identifying and reporting "areas of opportunity for improvement" throughout the entire business chain thus bringing about new efficiencies that result in lower costs of doing business for everyone, including customers and suppliers. Again it's that "competitive advantage" thing, inefficiencies erode Competitive Advantage by driving up the Total Cost of Doing Business…for everyone.

In Closing

"Two men look through prison bars one sees the mud the other the stars." F. Langbridge
Credit exists primarily to capture Profitable Sales that would otherwise be lost, the Credit Sales and A/R management function should report directly to the CEO in smaller companies or to the Operations/Sales area in larger companies . The accounting/finance function has a responsibility to safeguard assets and it must have oversight regarding the credit function, as it does with all business functions.

Credit Managers can directly contribute to new efficiencies throughout the entire business chain of suppliers,sellers and customers, if but asked.

The credit function can and should support more and larger new and repeat sales, customer service and retention levels, marketing, sales, purchasing and operations efforts… all while maintaining good cash flow and controlling bad debt.

Credit is a lubricant of commerce that allows for the expanded movement of products / services and can contribute to a company's profitability in many different ways with risk management and good cash flow being but the icing on the cake.

Trade Credit is a 21st Century Source of Profit….waiting to happen.