AR’s Role in Profitability

Customer profitability is critical to sales decisions particularly with large customers who are in a position to demand razor thin profit margins. These large volume deals are typically negotiated by the sales side of the business and, based on my experience, often neglect to account for the customer’s AR behavior. While the sales folks aren’t always excited to hear about this, your CFO should be keenly interested. Depending on the situation, a customer’s AR record can substantially erode an already anemic level of profitability.

Major AR factors

Let’s look at the list of some examples of major AR factors that affect a customer’s profitability:

• Cash discounts
• Tolerance write-offs
• Disputes
• Damages write-offs
• Trade promotions
• Compliance deductions
• Concealed shortages
• Mark-down allowances
• Co-op advertising
• Average days to pay
• Finance charges and finance charge write-offs
• Cost of payment methods (eg. credit cards)

Some of these factors may not apply to your industry and others may be incorporated into your agreements with customers and so be already accounted for in terms of profitability. However, based on my experience, I know very few organizations that track profitability to this degree of detail at the customer level and most miss at least one or two factors that have significant impact.

Gross profitability by customer

The credit department is where these hidden costs reveal themselves. If your AR system doesn’t readily allow you to summarize these factors at the customer level, you can start out with your top tier of customers and run your own calculations. Most modern systems have the ability to display gross profitability as supplied from your ERP by customer to aid in credit decisions. But even if you don’t have access to this information, you do know sales by customer and can, therefore, calculate the per cent profitability impact of any factor.

If you must resort to manual methods, focus on the most important customers and factors that have the most impact. If you can show that the “known” profit margin of customer X is really 3% lower due to cash discount, trade promo and dispute abuse, you can help your company make truly informed decisions and reinforce the importance of taking the credit side of the equation into account.