Thursday, June 02, 2011

The Trap of Extending Credit

The crux of the issue on this past Great Recession was credit.  We all overextended ourselves by borrowing too much and we all over extended ourselves by lending too much.  Both sides the debtor and the financier were at fault here.

So what are the lessons learned for a small business?  My business FMW Fasteners  is a small regional distributor of fasteners serving the construction and commercial applications industry - an industry hardest hit by the recession.  Like everyone else we had many customers "On Account" where they picked up fasteners and then we billed them / invoiced them on a standard Net 30 terms.

Like always, necessity is a mother of all inventions (or reinventions)!  At FMW we took a close look at our customer base, average transactions, and the type of customers we had.  For the most part a large majority of customers with the highest transaction costs were small customers that bought $20-$300 worth of Fasteners "On Account". 

The issue with these customers was the entire transaction and cash flow was not profitable at all!  How many of our small businesses have these type of customers?  Those that walk in, buy about $30 worth and then walk away with a signature putting this small order on account?  Then what happens?  Well, you have an administrator that "bills" this invoice or your system "invoices" this customer.  This invoice is then sent to the small business owner via email, fax or mail.  

Then 30 days go by and guess what.....the customer has not paid the $30 invoice....ever have that happen?  I am sure this is a common issue all of us have faced?  So now you start chasing a $30 invoice.  You try calling them, emailing them, faxing them...taking up time and money.  Let's assume you had 50% gross margin on the invoice.  That means you made a gross profit of $15.  Take out transaction cost of picking the item, packing it, giving to the customer, admin costs, etc.  You may be down to a measly $5 to $6 profit.  Now you have to wait for 30 days for this profit?  If you end up making any follow up calls, emailing, or any other follow up work you will start losing money.

So now the question comes, what can you do differently.  At FMW have made a conscience choice to convert our customers to debit card, credit card, checks or cash.  Would you be willing to pay 3% to a credit card company so that they can take up the burden of lending that $30 customer the money to pay you immediately?  3% on $30 is $0.90!  far less than the cost of making a single follow up call or the cost of two stamps for mailing the invoice and a statement?

The answer for us was a resounding yes!  Have a policy that if a customer does not do more than $5000 per year with us you, do not even contemplate giving them credit.  Further, those that you extend credit to have to either be a public traded company or have a good DUNS credit report.  If they do not have a DUNS number then we absolutely require personal guarantees on the credit application.

The rest who do not meet the above criteria, here is how my conversation goes:

CUSTOMER:  Can I put this order on account.

FMW:  Sir, I am sorry but effective this month, we are no longer extending credit terms to any of our customers.  However, for your convenience we accept all other forms of payment.

CUSTOMER:  Why is that?  I have always had an account?
FMW:  Yes I understand and we continue to appreciate your business.  But in order for us to reduce our transaction costs and to allow us to offer you the most competitive prices and service, we are no longer extending credit to any of our customers.  We can accept Debit cards, credit cards, checks or cash and our system can easily have that securely on file so that the next time you buy from us it will automatically charge to that system, if you like.  

CUSTOMER:  That does not make sense....why not
FMW:  Well sir, FMW is a small business and we simply are not well equipped to continuously evaluate credit for our customers plus we are able to extend to you more favorable prices if we you buy with credit card, cash or check. 

Normally, this resolves about 80% of the objections. The customer whips out their CC and pays for it.  Most of these customers are small business owners themselves and they can certainly appreciate what you are doing.

Yes there will be the 20% who will argue or will say I do not have a credit card, etc. etc.  To those I start wondering....that if a customer does not have a way to pay for a $30 transaction using a credit card, cash or check, OR if the credit card company does not deem them worthy to give them a credit or debit card then do you want to extend them credit?   In these 20% cases, you can always evaluate on an individual basis and then decide.

At FMW we have implemented this cash basis transaction and it has dramatically reduced admin workload, improved cash flow and vastly reduced dead beats!  Would you rather do a $100 in sales and make $50 or would you rather do a $200 on account and get only $30 after 30 days? 

Evaluate your customers, use technology to monitor your cash flow and understand your transaction and collection cost.  You will quickly realize that this simple technique may save you a lot of headaches and save you time and money and make you more profit!

1 comment:

Charlie Accetta said...

Good post, Taja. Most of the established distributors started cleaning fiscal house back in the early Nineties. It all started when Craig Cohn at ITW Shakeproof instituted his 80/20 program and eliminated most of the low-volume authorized distributors in network. After considering the philosophy, they tried it themselves. What ended up happening was they opened the door for low overhead and on-line competitors. To counteract that (too late), they revised policy again with the credit card requirement.

It makes sense for everyone; even higher volume accounts benefit on the payable side with the tracking data provided by the credit card companies. An invoice, for any number of reasons, may not match up to a purchase order, which means there's no sure way to tell who placed the order or if it were placed at all. The credit card implies an identity attached to the transaction, making for improved traceability. Thanks for spreading the word on this important customer service element.