Financing your customer's manufacturing? Credit lessons on the mountain
April 6, 2004
Editor's Note: This is the fourth episode in a mountaintop dialog that Gerald has been having with a "wise business guru." They have been talking about customers and the time line of money.
"In the ideal time line of money, my best customer would prepay. In that situation, the shop's throughput would not matter because the customer's cash would be doing all of the work," I proclaimed.
My little guru opened one eye to peer at me. With an arched eyebrow he looked at me as though I was an alien from another planet. He closed his eye and shook his head slowly. "The good force, the energy of money, eludes you still," he muttered.
"What do you mean by that?" I pouted. "A slight possibility exists that prepaid accounts would help your cash flow for a brief time, but you have a propensity to misspend your income. I wouldn't be surprised if you spent all of the money upfront on raw material, and then were strapped for cash to cover payroll later," he noted dryly. "You do not even know why you offer payment terms to your customers!" he accused.
I blinked. Payment terms seem like an automatic part of doing business. "I think I would lose customers if I didn't give them time to pay their bills," I replied.
"That is true, but probably not for the reasons you expect. To start with, you would not lose them all—at least not right away. The ones that truly value your service will stay with you, but the flaky ones that depend on you to fund their manufacturing will be the first to drift away."
"You think that I am funding my customers' manufacturing?" I was amazed by his claim.
He held his fingers to his skull as though he were doing a mind meld with the force. "Extending credit simply is a form of financing. You are gifting that service to your customers without much thought."
"That is not true! We check credit references and monitor each customer's balance to make sure he stays current and within the credit limits we set," I replied.
"When you borrow money from the bank, you expect to make personal guarantees, possibly offer collateral, and you know you will pay for the use of the money. You should emulate your banker," he insisted.
"Ah, but there are usury laws that prohibit me from charging interest," I bemoaned.
"I am not suggesting that you violate any law or regulation. What I want you to realize is the expense that you incur when you give customers one, two, or more months to pay their bills. Once you have that expense firmly calculated, you will undoubtedly adjust your quoted price."
"We do! Our debt expense is included in our calculation of the burden rate. That burden is included in our price quote to all of our customers," I insisted.
"Average thinking! Your best customers who pay promptly pay more than they should, while your slow-paying customers pay too little. You could change your pricing formula to include your cost of credit terms that you are offering as part of the contract," he suggested. "That would be an incentive to attract better customers and discourage the others! A 10-day payment costs you much less than a 45-day payment," he observed.
"We already give an incentive for customers to pay within 10 days by offering a discount. Doesn't that take care of what you are advising?" I asked.
"It could, if the amount of the discount that you allow were correct. How do you calculate the amount of discount that you will allow?" he asked.
I struggled for an answer. "We adopted an industry standard," I said, hoping to sound prudent.
"Your discount is flawed because it assumes that your customers will pay either in 10 days or 30 days. You have no way of assigning proper costs to customers that typically pay more slowly than 30 days," he advised. "Remember, you want liquidity so you can put the cash to work for you. Your prospering business wants the shortest possible time line of money."
"That is clear to me," I replied. "But I do not understand how to shorten the time line!"
"The shorter the collection period, the lower your cost," he pointed out.
"That, too, is clear to me. But why are you separating this capital expense from general overhead?" I wondered.
"Because you still have the naive attitude that loaning money to your customers is a general expense," he replied. "It is an expense that is specific to the customer."
"But the cost is not that great. My personal credit card is the most expensive money I can borrow, and it is something like only 1 percent per month. The difference between a fast-paying and a slow-paying customer is usually about a month—so we are talking about a difference of only less than 1 percent!" I estimated.
He smiled and asked, "What were your gross sales last year?"
"A couple million dollars," I mumbled.
He offered me a calculator and asked, "What is 2 percent of your monthly gross sales?"
"Three or four thousand dollars," I replied.
"So, Mr. Big Money! Three thousand dollars is to sneeze at? Up here on the mountain, a guru can be a happy camper with pocket change like that!" he exclaimed.
"Well, I do not pay 1 percent a month for money, so you are just tossing around imaginary numbers," I complained. "I can borrow money at the bank at less than 8 percent per annum—about 0.6 percent per month."
"Your cost is more than 1 percent per month for the money you have loaned to your customer," he stated. "If your company were a nonprofit organization dedicated to just breaking even, then I would have to agree with you that your cost is simply the value that you pay to the bank for the loan. I had the impression, however, that you are trying to earn a profit," he goaded.
"Of course I'm trying to make a profit!"
"The money that you loan to your customer is not available to you to invest, so you lose 1.5 percent and you pay at least 0.6 percent per month—a cost of over 2 percent per month," he reasoned.
I still felt defensive about his accusation that I was funding our customers' manufacturing. "The main reason we allow a time period before payment is to allow the goods to transit from our dock to theirs, for the receiving inspection, and for their internal systems to route the paperwork and generate the payment," I said.
"Let me think about this," he said as he hooked up an overhead projector to his laptop. I marveled that he had so much cool equipment up here on top of a mountain. A quarry provided a marble-faced cliff for a wonderful theater screen for the projector.
He fired up a spreadsheet and started adding up the days that it would take for shipping, inspection, routing a receiver, writing a check, and mailing payment. "Looks like 10 days should be enough time," he summarized as he gazed at the results. "Your customers who are paying in six, eight, or 10 weeks really are taking advantage of your low-cost funding," he said.
It dawned on me that if that were not the case, then my customer would borrow money from somewhere else in order to pay me more promptly ...
The saga continues in next month's issue.