Atomic Energy

In the previous article, we laid out the main areas in which the efficiency and effectiveness of operations within a fairly small back-office finance department can impact the bottom-line. In this follow-up article, we will see just how severe the impact can be through a case-study, complete with actual numbers.

The Patient

The patient, firm X, is a $15MM annual revenue firm, so larger than a start-up, but still on the small side. All of the firm’s revenues come from professional services, with an average hourly billing rate is $110, giving 136k hours billed per year. As a professional services firm, its primary costs are labor expenses to the staff who work on billable projects, both salaries to employees and payments to contractors. Using the US Department of Labor standard of 2,000 labor hours per year, the firm uses 68 person-years to deliver its services. The firm has 25 billable employees with a fairly high utilization rate of 80%, or 1,600 hours per year. The rest of their time is spent on training, development, non-billable travel and paperwork. The total billed by employees is 40,000 hours per year, or 29.4% of the firm’s total revenues, with the remaining 96,000 or 70.6%, billed via contractors. The average billing per contractor is 700 hours per year.

The 25 employees cost the firm, on average, $100,000 in salary and benefits per year. Since each employee bills out 1,600 hours per year, for revenue of $176,000, the gross margin per employee is 43%. The average rate the firm pays its contractors is $80/hour, for a gross margin of $30/hour or 27%. Clearly, contractors are much more expensive than employees. However, the firm is subject to two forces that limit the use of employees.

1. Demand fluctuates greatly. Although the firm can reasonably expect to hold to its $15MM in revenues, it wants to keep its fixed costs down, and thus does not wish to be subject to layoffs when business takes a short or medium term downturn.
2. Demand is geographically dispersed. The firm cannot always expense travel costs and times to its customers. Thus, it uses contractors who may only bill 500 hours per year to the firm, but will be much closer to the customer.

Average gross margin for the firm is 27%*70.6%  (contractors) + 43%*29.4% (employees) = 31.7%. With $15MM in revenue and 31.7% average gross margin, the firm has $4.76MM in annual gross profit. Of that $4.76MM, $3MM should pay for various overhead – real estate, accounting, legal, and administrative, including, of course, the finance department. The remaining $1.76MM is operating profit that either goes to the shareholders as dividends or is reinvested in the business.

Back-Office: The Finance Department

The finance department is staffed by 5 people: a CFO and 4 employees. Its average invoice size to customers is $20,000, so it issues 750 invoices and receives an equal number of payments per year. It does no material business via credit cards, and most of its invoices are issued net 45, as is common practice in its industry. The average invoice received for payment to contractors is $2,000, so it pays 3,840 contractor invoices per year, in addition to invoices for basics such as real estate, consumables, bank interest, etc. Employee salaries are paid twice monthly, on the 15th and 30th of each month. Employee expenses are reimbursed at the “next available pay cycle,” which employees understand to mean the second paycheck after approval, or 5 business days plus 2 paychecks. Thus, if an expense is submitted on the 1st, the employee expected to get paid on the 30th, whereas one submitted on the 10th is expected to be paid on the following 15th. Employee expenses consist primarily of travel expenses to customers and training materials, as well as mobile phone bills. Consumables and other incidentals are paid directly by the firm to vendors.

The Issues

Let us examine each of the issues raised, and the cost to the business. 

Payroll

As a small business with 25 employees, some sales people and executive staff, and the 5 people in finance, total regular payroll is 40 people, a fairly small operation. Payroll has been outsourced entirely to SurePayroll. One of the key advantages to SurePayroll is that it sends out reminders to process pay on a regular basis. Thus, X almost never misses payroll and is rarely, if ever, late. Employees like SurePayroll as they can pull their entire pay stub – and its history, as well as end of year tax forms – online. 

Expense Processing

Expense processing is handled by submission to the finance department in a paperwork process. Receipts are attached to paper using Scotch tape, along with printed or handwritten expense reports. The average employee submits $200 per month in expenses. The employee pays the expense out of their own pocket, then awaits reimbursement. The reimbursement is manually entered into the SurePayroll pay stub with the appropriate billing cycle.

Because of the slow paperwork process, the following occurs:

• 25% of expenses are submitted at least two weeks after occurrence, while the remainder are submitted end of the same week. 
• 15% are lost and must be resubmitted. However, without any method of employees tracking the status, it is only once an invoice has failed to be paid do employees know of the lost expense and resubmit.
• Expenses are normally actually reimbursed three pay cycles after submission, rather than two. 

With 25 employees submitting one expense sheet per week, 100 are processed per month. Each expense submission requires 15 minutes of employee time, and 15 minutes of finance staff time, for a total of 3,000 minutes, or 50 hours. At the fully loaded cost of $100,000 per employee shown earlier, direct basic expense processing costs are $2,500 per month or $30,000 per year.

Lost invoices require one hour of employee time and one hour of finance employee time, or two hours total. With 15% lost and requiring resubmission, that is 15 per month, or 30 hours per month, 360 hours per year. At the fully loaded cost of $100,000 per employee, reprocessing of lost expenses is $18,000 per year.

Slowness of paying means that each employee is out, on average, $400 awaiting reimbursement at any given moment. At consumer unsecured debt rates of 15%, each employee is paying $60 per year to finance the business. From the employee’s perspective, however, all that they see is $400 in cash they need to carry for the business. As word has gotten around as to the slowness of paying of expenses, each new employee has insisted on a salary at least $400 per month higher than they would otherwise accept. This is an additional $5,000 per year per employee cost. With 25 billable employees, the cost to the business is $125,000. 

Total expense processing cost is $171,000 per year. Total cost due to late and missed payments is $141,000 per year. Average labor cost per basic processing is $25; this should be between $10 and $15. Cost due to inefficient process is $10-15,000 per year. 

None of these costs takes into account employee turnover and the cost of retaining new employees, which will not be calculated here.

Summary:$156,000 per year in direct waste.

Invoice Processing & Accounts Payable

X spends approximately $3.0MM each year in overhead. $500,000 of that overhead is the finance department, including benefits. Although slow accounts payable affects many vendors, we will focus on one area alone: consultant invoices. As described above, contractors bill the firm 96,000 hours per year. The average rate for contractors is $80 hour, for total billing of $7.68MM. These invoices are all due net 30. However, X loses approximately 15% of the invoices, a rate identical to the lost expense rate. Each lost invoice requires tracking down to ensure that it is truly lost, and then resubmission.

As stated above, 3,840 invoices by contractors are submitted per year, with each contractor performing, on average, 700 hours per year. The time to process invoices is similar to the time to process expenses, 15 minutes of finance department time and 15 minutes of contractor time. Due to the standard terms and conditions with contractors, the 15 minutes of contractor time is not billable. With 3,840 invoices and 15 minutes per invoice, basic invoice processing takes 960 hours per year, or $48,000 in costs. 

Lost invoices take one hour to process, including resubmission, if necessary. At 3,840 invoices per year and a loss rate of 15%, 576 invoices must be reprocessed at an hour of labor each, for a total cost of 576 hours or $29,000. 

The single largest element, however, is the increase in rates. Because the firm is known as one that pays late and frequently loses invoices  - and all contractors who do not know initially, find out very quickly – X is paying above-market rates for each contractors. The rate for this type of contractor is between $70 and $75 per hour. The $5 to $10 increment in rates is demanded by contractors to cover lost hours in following up on invoices as well as late payments. Since contractors bill 96,000 hours per year, the firm is paying, at minimum, $480,000 in excess fees, directly reducing its gross margin.

Summary: $509,000 per year in direct waste.

Invoice Issuance & Accounts Receivable

As stated above, X receives $15MM in revenue, spread over 750 invoices, each with an average amount of $20,000. Like X, most of X’s customers have a “must invoice by y days after service” policy to be paid. On average, the policies provide for full payment if invoices are received within 30 days of service, 10% penalty for invoices received within 60 days, and option to refuse to pay for invoices received after 60 days. X does not have a structured invoice issuance and follow-up process. Almost all of X’s invoices are issued net 45. The distribution for invoice issuance is as follows:

• 60% of invoices are issued within 30 days
• 30% of invoices are issued within 60 days
• 10%  of invoices are issued after 60 days, of which 3/4 are accepted with 15% penalty and the rest are rejected

Additionally, 25% of invoices are not paid within 45 days, but rather once finance personnel follow up, leading to payment within 75 days. Each invoice follow-up takes one hour of finance staff time. With 750 invoices per year, and 25% paid late, 187 invoices are late, costing 187 hours of employee time or $9,375.

The cost of late invoices is as composed of two components: reduced or lost revenues, and cost of carry. For simplicity sake, we will ignore cost of carry.

• 60% issued on time: no costs.
• 30% issued within 60 days: 10% * 30% * $15MM = $450,000
• 7.5% issued within 90 days but paid with 10% penalty: 7.5% * 10% * $15MM = $112,500
• 2.5% issued within 90 days and rejected: 2.5% * $15MM = $375,000

Summary: $937,500 in annual costs. 

Reporting

Cash management and reporting will not be calculated at this stage.

Summary

Total avoidable annual losses from suboptimal finance department management are as follows:

• Expense Processing: $156,000
• Invoice Processing and Accounts Payable: $509,000
• Invoice Issuance and Accounts Receivable: $937,500

Firm X is losing $1.6MM in direct profit each year due to the poor performance of a small back-office department. Recall that the total annual profit of the firm was $1.76MM. Of this $1.76MM, $937,500 is revenue recognized but never received in cash, leaving $662,500 in actual cash profits for the owners or reinvestment each year. This paper profit of $1.76MM but actual cash availability of only $662,500 induces owners to seek out assistance. An additional $665,000 would be available as profit but cannot be claimed.

Conclusion

Efficient and effective back-office operations can have a significant impact on a firm’s profitability. This is especially true with back-office operations that sit at the nexus of the firm’s business, whether finance, IT for information-intensive industries such as finance, supply-chain for manufacturing, and other critical departments. Firm X needed an operations expert to analyze the operations, isolate the costs and recommend improvements, at a reasonable cost to the business.

Before continuing back-office operations, we will take a short detour into a case study of how not to transition to new media.

As we all know, media properties have been suffering greatly, especially broadcast media. Advertising revenue is down, and enormous numbers of viewers have moved to what is termed new or interactive media, i.e. the Internet. Most media firms have been trying, with varying degrees of success, to find ways to make money on the Internet. Some studios have banded together, with hulu.com providing online streaming video for NBC, FOX and a few others. Other networks provide their content on their own Website, such as cwtv.com and abc.com. Still others provide their shows via iTunes or in partnership with existing video sites like YouTube. Finally, several have simply put their heads in the sand and said, “we don’t believe the Internet exists.” Every one of the properties that has gone online has come to some form of agreement with their local affiliates, who rely on the networks for content, advertisers for revenue, and worry that the availability of the shows online would further cannibalize from their viewers. The networks with better foresight used a mixture of muscle and diplomacy to come to an agreement with their local partners. 

Among the most lucrative broadcast franchises over the years have been the sports leagues: NHL, NFL, MLB, MBA. The strong fan loyalty and excitement of a game are good draws, and, unlike scripted shows or “reality” TV, one really never does know the outcome of the “show” until it is over. Combined, these are a great combination for viewer draws. However, the sports franchises suffer from several fragmentation issues:

1. Geographic fragmentation: Fans are mobile. A New York Rangers hockey fan might live in New York, but travel on a regular basis on business to Chicago, Los Angeles or Singapore, and yet want to see his games. Similarly, a Montreal Canadiens fan might actually live in New York, or Beijing, whether for a short period as an expat or diplomat, or permanently.
2. Broadcast fragmentation: Even without fans moving around, games for the same team are often broadcast on different networks. One day it will be local broadcast; they next day on a regular channel on Cablevision; the next day on a regular DirectTV channel; the next day on NHL Network, a special paid add-on channel on many cable/satellite systems; the next day it is not broadcast at all. Fans who do not bother with cable – cost, boredom, religious objections, or any reason at all – are huge untapped market.
3. Fan fragmentation: Many fans actually support different teams, sometimes in the same sport, sometimes in different sports. In theory, someone who already pays $60 per month for cable might pay an additional $160 per season for NFL or NHL. Almost no one will pay for both of those, plus NHL Network, plus another package, plus… all to view fewer games than they want to.

Given the twin challenges of declining viewership and increasing fragmentation, the Internet would appear to provide a beautiful solution. A league – or a conglomeration of leagues, like the hulu.com model – could sell packages online. If you remove the overhead of base cable or satellite, many fans would be happy to pay a monthly fee of $15-30 to receive all of the games in their league. Indeed, this is the price point that many leagues have come across, from NHL (a latecomer) to MLB. The key challenges are:

• Technology: Online video is not easy to implement if you have no experience in this space.
• Partners: Leagues sell rights to various broadcast and cable or satellite networks to broadcast live games. These partners will be unhappy if online availability moves viewers away from their advertising or subscription supported channels. This is exactly the same problem that networks have vis-a-vis their local affiliates.

So how has the NHL managed this transition with their NHL GameCenter Live? In a word: disastrously.

Technology

There are two ways to solve the technology problem. Either build (or buy) the expertise in-house, or get a partner. The NHL has partnered with NeuLion of Plainview, NY, to provide online streaming. About a year ago, I met an executive and founder of NeuLion. The video broadcasts themselves are sometimes great, sometimes choppy, sometimes terrible. To be fair, this cannot totally be the fault of NeuLion, as it is dependent on the bandwidth and latency of each customer, something they cannot entirely control.

Partners

Many leagues, including the NHL, solve the problem problem by creating blackouts. If you live in an area where the game is already broadcast, you cannot watch it online. This pleases all its partners: we won’t let anyone see it, unless it cannot take away from your viewers. NHL, however, has done this far worse than anyone could have predicted.

1. The blackout lists are enormous. Anytime a viewer could possibly view it in their area – it is broadcast on-air, it is on any cable or satellite channel anywhere that might reach the area – it is blacked out. In other terms, the chances are greater than 50%, and sometimes as high as 80-90%, that the game a fan wants to see will be blacked out. This may make the partners happy, but it infuriates the fans who, in the end, are the real source of league revenues. Most other leagues have a far more limited blackout regimen.
2. The blackout lists are secret. The entire league season schedule, and most of its broadcasting, is known well in advance. It would be quite simple for the NHL to post the blackout list prior to viewers signing up. The fact that it declines to – indeed, it hides the blackout terms quite well – speaks volumes about the respect the league has for its viewers… which is the real root cause of the league’s decline in the last several years.

Customer Service

Here, indeed, the NHL has exceeded everyone’s expectations for abysmal customer service. In a day of wireless carriers and their legendary poor customer services, this is pretty impressive. 

1.  Blackout: As listed above, the NHL seems to realizes, perhaps only subconsciously, that posting an extensive blackout list will only turn off potential customers. Thus, it actually hides the list. It simply cannot be found online prior to (or after) purchase. Every business tries to paint itself in the best light. However, a business that hides a material negative of a sale from a customer is asking for trouble. 
2. Subscription: Somewhere hidden in the terms and conditions of the signup is an automatic renewal. If someone buys the 2008-09 season for $160, they will receive a nice charge for another $160 in October 2009, unless they explicitly follow up and cancel. Automatic renewal does make sense with month-over-month sales, or sometimes even annual sales with explicit warnings and pre-approval. The NHL – and its partner, NeuLion, who actually does this billing, and thus takes equal share of the blame for these disgraceful business practices –  simply renews without agreement and without warning. Again, it appears that the NHL and NeuLion are afraid that if they gave customers the option, they would opt out. Generally, if your customers wouldn’t otherwise buy it, the problem is you, not your customers.
3. Cancellation: Cancellation is equally egregious. NHL.com offers two subscription models: pay once $160, or pay $20 per month over the season. Many people choose $20, despite the overall greater cost, for two reasons. First, it is easier on the cash flow. Second, it makes cancellation easier. If you do not like the broadcast quality, or the games, or anything at all, you can always cancel for next month. Theoretically, if you pay $160 for a season’s subscription and do not get the quality that you paid for, you should be able to get a full or, at least, a pro-rated refund, but it is always easier to just stop next month’s subscription. And here is the rub. Buried in its terms and conditions, NHL redefines the $20 monthly plan as actually just a payment plan for the entire $160 season. If you sign up, you are committing to the entire $160, just spreading out the payment terms. Additionally, they give viewers five days, yes, just five days, to cancel, after which no cancellation is possible. Five days is not enough to try out a bicycle, let alone a season-long online subscription. If on day 6 you discover that 80% of your games are blacked out, and the other 20% are choppy or poor quality, NHL will try to make you pay the rest. A short warranty period, which is what this is, is always a strong sign that a seller knows its product is garbage. 
4. Civility: Unsurprising when coming from a company that views its customers this way, its customer service reps are abysmal. They are rude and condescending to the viewers who call their customer support number. This point has been reinforced by legions of frustrated viewers across the Internet. At this point, it is unclear if the representatives are NHL staff, NeuLion staff, or a third-party provider. Either way, the NHL will suffer from the poor reputation.

Summary

In order to claim that it is getting “into the Internet,” the NHL has done so in a manner that gave the maximum number of its business partners the most short-term satisfaction (i.e. avoiding conflict), at the direct expense of its viewers, while doing its best to seduce them into buying something they would not spend a penny on if they had known what was really inside the box, then locking them into it under onerous terms and renewing them surreptitiously and without approval. If I am not mistaken (and I am not an attorney), I believe the phrase is “fraud.” Most people call it “bait and switch.” Either way, the NHL smacks of desperation. The real pity of it is that it could do so much better, gaining revenue, fans (for the game and the league as a business), and consumer protection kudos. How it could do that is something I will not explain here; any business strategist with a real understanding of the Internet could do that (but apparently not NHL).

Perhaps the NHL’s new tagline should be: “watch us drive our Zamboni… right over the cliff.”

As an expert in operations efficiency and effectiveness, I am often asked how much of a difference back-office operations can make to a firm’s profitability? After all, sales are what drive any business, and so the front-office should be the primary focus. While I agree wholeheartedly that sales drive a business – one of the best stories I have heard in this regard is of a startup where everyone had a little box on their desk that went “cha-ching” with each sale, reminding everyone that the company lives or dies by sales – sales are only the tip of the iceberg. If the company cannot deliver on its promises, or if it fails to collect its payments in a timely manner, a profitable sale can quickly turn into a loss. Too many losses and the business is history.

There are a lot of areas to focus on when it comes to operations. For the purposes of this article, we will focus on that historical bastion of efficiency, the finance department.

In addition to strategic issues relating to issuance of debt and equity, as well as currency and commodity hedging, a finance department has several operational functions. These include:

• Payroll: making sure all employees gets paid on time and the appropriate amount
• Expense processing: making sure employee expenses get reimbursed on time and the appropriate amount
• Accounts payable: paying vendors more or less as agreed, whether upon receipt, net 30, 45, 60, 90, etc.
• Invoice processing: closely related to accounts payable, ensuring that invoices get entered and tracked as rapidly as possible
• Accounts receivable: making sure the firm gets paid for its products and services on time, more or less as agreed, or preferably faster
• Invoice issuance: closely related to accounts receivable, making sure invoices get issued to the firm’s customers, that the invoices reflect all the information needed to process the invoice, and that the information is correct.
• Reporting: the department is responsible for managing all of the above so that management can understand the current and future cash position of the firm.

Suboptimal operations in any of these areas can significantly impact a firm’s profitability. Since these are all processed by one department, they normally move together. Worse, these are all considered fixed costs, and thus come after the gross margins. In this section, we will examine each of the functions in turn. In part 2, we will look at a hypothetical firm and the impact on its business.

Payroll

Payroll must be paid on time and accurately. What happens if payroll is late?

1. Angry employees: Very few employees, if any, are willing to work for a firm that does not pay them as agreed. The rare exception is employees of a startup that has no cash, and thus have agreed to be paid in equity. Other than that, however, your employees expect to be paid. If they are regularly paid incorrectly or late, turnover increases and lawsuits are sure to come your way. What is the cost of turnover? The general rule of thumb is somewhere from 50-200% of the employee’s annual compensation, depending on the level of an employee. Put in other terms, an $8/hour employee will cost you from $8,000 upwards in loss and replacement costs. Higher-wage salaried employees cost much more. Additionally, if word gets out that people left because of payroll issues, replacement may be near impossible, until the issue is fixed and significant funds are spent marketing the improvements. 
2. Lawsuits: It is hard to travel a subway or through an airport nowadays without an ad for some law firm that is only too happy to sue anyone who wronged you, however accidentally. For payroll negligence, you can expect to be sued. The costs of these potential suits is difficult to estimate, but one can expect to spend at least $20,000 in legal costs alone defending a single lawsuit, even if filed the suit is dismissed. If there are multiple employees, large amounts of pay, or you have to settle out of court or, worst of all, lose the costs can be orders of magnitude greater.
3. Penalties: Some states assess penalties for late payroll. However, the IRS and almost all states assess significant penalties if you do not pay withholding and payroll taxes on time. 

Fortunately, most firms outsource their payroll nowadays, from small business providers like PayCycle and SurePayroll to the giants like ADP, which reduces the likelihood of problems. Nonetheless, all of these payroll providers depend on timely input from their customers’ management to ensure that the payroll information is correct and approved, and that the appropriate cash is in the bank.

Expense Processing

Even the best-run firms regularly have difficulties with expense processing. I have rarely seen a firm that handles it expeditiously. Even when the approval requirements are onerous, most employees will get the appropriate approval within a few days… after which it languishes in the expense processing area of the finance department.  This is partially because it is an “unimportant” back-office function, and partially because some firms view their employees as a bank. Because of this, expectations for expense processing are so low that as long as the rest runs well, most employees have greater tolerance for expense processing. Conversely, a place that reimburses in a timely manner will gain a large amount of employee goodwill. What happens if expense processing is late or incorrect?

1. Angry employees: Employees are more willing to work for a firm that is late in reimbursing expenses than one that is late in paying salaries. Nonetheless, resentment does build.
2. Reduced investment by employees: Assume you are working for a firm that asks you top travel to San Francisco for 5 days on business. You whip out your AmEx, and buy a JetBlue plane ticket for $400, 4 nights in a hotel at $800 including taxes, another $300 in food and $200 in cabs here and there, a grand total of $1700. The trip is a grand success and you close two new accounts. Now your employer takes 7 weeks to reimburse you, in which time you need to pay off the AmEx bill with your own funds, money you may or may not have lying around. You never intended to become your employer’s bank, and are quite stressed during the lag. The next time an opportunity comes for you to fly to Miami to close a big account, how likely are you to go?

Accounts Payable

Assuming you know what invoices you have received and what you have to pay by when, you have an obligation to pay these invoices on time, or reasonably close to on time. Some businesses explicitly rely on paying invoices late as a way to generate cash; I have worked with and for several firms like this. What happens when firms do not pay invoices on time?

1. Loss of vendors: Some vendors refuse to do business with the firm. No one wants to spend time chasing down accounts receivable. Most vendors are in business to sell a product or service, get paid for it, then do it again. If chasing down payment becomes too burdensome, thus reducing the profitability of a client, eventually some vendors will simply refuse to do any more business with the firm. The cost of switching vendors as well as the increase in prices due to less competition both have direct costs to the firm.
2. Higher prices: Other vendors raise their prices or impose penalties. In many businesses, when dealing with firms of questionable payment practices, vendors have imposed percentage penalties per day late. When compounding comes in, that can get very expensive. Effectively, even if you can get services, their prices increase.
3. Worse payment terms: Other vendors insist on upfront payment. This can make managing cash flow particularly difficult. The difference between net 30 and upfront payment on a $10,000 sale at 12% cost of capital is $100 more than it was the last time you did it. 
4. Bad business reputation: This makes it even harder to close deals with vendors at reasonable prices, or get decent payment terms. It may also affect your credit rating and banking relationships. A firm with annual revenues of $10MM and debt of $1MM that sees a difference in rates of 2% can pay an extra $20,000 a year in interest.
5. Bad owner reputation: Unlike poor service or products, if the firm does not pay its bills responsibly and on time, the stigma attaches to the people. Quite simply, people expect business owners and managers to be responsible and pay their bills. If they do not, the person himself or herself is viewed as contemptible.
6. Higher processing costs: Every time a vendor does not get paid, they call you, they harass you, they harass your staff. Besides the lowered morale and turnover among the staff, you are paying for the staff’s time. 

Invoice Processing

Before bills can possibly be paid on time, invoices received from vendors must be processed and managed. What happens when invoices are not properly entered?

1. Delayed payments to vendors: Accounts payable are delayed, with all of the negative impacts discussed above.
2. Higher processing costs: Since each payment is now a scramble to find, enter and process an invoice, your costs increase.
3. Impossible cash-flow planning: Without an understanding of what invoices are due in the next period of time, management cannot do short-term cash management. It then will find itself either keeping too much cash on hand, depriving it of investment income or returns on investment in growth of the business, or too little, leaving it to scramble at the last minute for more expensive, usually high-interest debt, cash to pay its bills.

Accounts Receivable

Accounts receivable is directly responsible for turning sales made into the cash the business needs to survive. What happens when accounts receivable is poorly run?

1. Lost payments: Cash due to the firm is never received. This might be because the invoice was not known about or never issued, the customer is intentionally or accidentally slow, the check was never received, or any of a myriad of other reasons. Either way, this is worse than a lost sale. If a $10,000 sale was never made, it was never made. But a $10,000 sale that has a gross margin of 20% has already cost the firm $8,000 in direct cost of sales or cost of goods sold. 
2. Late payments: Cash due to the firm is received late. Every time you do a sale on receivable, you are lending your customer money. If a $10,000 payment is received 30 days late, you just lent your customer $10,000 for 30 days. You never wanted to be a banker, and you certainly don’t want to be one if it means lending money for zero interest.
3. Higher processing costs: Since inevitably management realizes it is missing cash, a “fire drill” occurs in which everyone in accounts receivable scrambles to find and recover the missing payments. This processing time is expensive.

Invoice Issuance

Before payment can be received, an invoice must be issued. What happens if invoice issuance is not running smoothly?

1. Wasted multiple processing runs: Since invoices are not entered and managed properly, many invoices will need to be submitted multiple times. This eats up time from: finance staff, who must issue the invoice; management, who need to understand and give special approval to an unusual invoice; and sales staff, who need to follow up and explain the sale and its terms. These sales staff do not want to spend time on administration, let alone doing so twice, and cost far too much to do so. Not only is their time expensive, but could have been spent making sales rather than processing invoices.
2. Late payments: Even if the customer is responsible and timely, they are only responsible to pay an invoice based on the days from issue. If the terms of our $10,000 sale specify net 30, and the invoice is issued 30 days late because of invoice sloth, you just lent them $10,000 for another 30 days at zero percent interest.
3. Rejected payments: Many businesses have a “maximum invoice by” policy. Quite simply, you must invoice within a certain time period of service rendered or product sold, or the invoice will be rejected. This is understandable. If you issue them an invoice months late, it is difficult for them to manage their cash reliably.
4. Impossible cash-flow planning: Just like outgoing invoice management allows you to predict cash outflow, incoming invoice management allows you to predict cash inflow. Both are critical to cash management.

Reporting

The finance department has a critical role to play in providing historical, current and future information on the financial state of the business to management. It is expected to have accurate and timely information. What happens when this information is incorrect, slow or out-of-date?

1. Impossible short-term cash-flow management: The business will not know what bills are due nor what payments can be expected in the near future. As a result, the business will either have too much cash on hand, leading to lost investment opportunities – how many businesses do you know that don’t wish they could have had an extra little bit of cash to invest in an opportunity – or too little cash on hand, leading to a scramble for cash when the bills are actually due. This additional cash will have to come either from suddenly cancelled investments, which lead to lost future revenue and demoralized staff, or high-interest lending facilities, which increase unnecessary interest costs.
2. Impossible customer profitability management: The business will not know with any level of reliability what percentage of its receivables comes late or not at all. This makes: provisions for lower profit impossible; provisions for bad debt difficult or inaccurate, a significant problem in public companies that must report accurately; management of customers for maximum profitability impossible. Put in other terms, management cannot know which sales are truly profitable and which ones look profitable but are actually low-margin or losers, and thus a drag on profitability. 
3. Weakened negotiations: Since management does not know what the historical payment record of its customers and suppliers has been, it is in a weak negotiating position for its next negotiating round, either with a new customer/vendor or renewal of a contract.
4. Difficult long-term planning: As the business does not have accurate and timely information on its revenue and expenses, it will have a severely delayed view of its future position. Without this information, it is difficult, at best, for the firm to plan hiring, capital investment, growth or other initiatives. Significant growth opportunities will be missed, while downturns that could have been better managed will be dealt with in crisis mode.

Summary

Efficiently and effectively running operations are important to any organization. Looking at the finance department, we can see how just one poorly run department, one that is not even sales or front-office, can significantly impact the profitability of an organization and its owners and managers.

In a follow-up post, we will look at a case study using real numbers and see the impact of these operations on the profits of an organization.