Determining the Carrying Costs of Accounts Receivable

There are five major costs associated with accounts receivable. They are: bad debts, interest cost, opportunity costs, administrative costs, and miscellaneous costs. Each cost category is described below:

Bad Debts:

Every sale on open account terms carries a risk of nonpayment. Nonpayment may be the result of a legitimate dispute. Nonpayment of larger dollar amounts is often the result of a customer filing for bankruptcy protection.

Interest:

What does it cost to carry past-due accounts? If a 5% net profit is realized on sales, for every $100 accepted in credit, $95 is paid for product, expenses, taxes, and so on. Interest alone can erase the $5 profit in a short period of time:

Interest Costs at 12% Per Year:
First month: 12% x $100 = $12.00 (divided by 12 months = $1.00)

Opportunity Costs (e.g., Alternate Use of Capital):

Consider an example using a yearly sales figure of $12,000,000 meaning $33,000 per day. If the accounts receivable investment improved and the number of DSO decreased, the following amounts could be released or added to cash flow: by three days - $100,000; by six days - $200,000; by thirty days - $1,000,000. The funds could be used for a variety of things including expansion or new product development, or internal improvements such as salary and overhead increases.

Miscellaneous Costs:

Losing the ability to discount (a crucial cost, especially in a high-interest period); paying penalty/late charges (in addition to the possibility of restricted credit); increased risk factors (the older the debt, the harder to collect); maintaining administrative, bookkeeping functions; letters of credit fees.

Administrative Costs:

Administrative costs would include the cost of operating a credit and collection function. It would include the salaries of the employees of the credit department along with all of the ancillary costs of managing the credit function such as the annual cost of credit reports.