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Opportunity Cost and Cashflow

Kim Radok25 February 2012

OPPORTUNITY COST AND CASHFLOW

Opportunity cost is a well known accounting and investment term. Your accountant, consultant and finance partners will talk about opportunity costs when weighing up one business strategy or investment verses another.

Unfortunately, we rarely see the same approach applied when reviewing the credit and accounts receivable process in protecting the business's cashflow. In fact, we normally see managers and consultants run for miles when we bring up the subject of lost opportunities because of an inefficient credit or accounts receivable system.

Before proceeding, let us review one definition of opportunity cost.

Opportunity cost can be explained as being the cost of an alternative action or benefit that must be forgone in order to pursue another strategy or action.

The simplest explanation of an opportunity cost is explained in the following example. $10,000 is available to improve a sales process or your credit or accounts receivable process. The normal reaction is to spend the $10,000 on a sales process because it is believed, there will be increased sales. Improving cashflow recovery from sales is deemed less important, based on the theory, that increased sales must equal increased cashflow.

Is this theory always correct? Here are two options to consider.

OPTION ONE

The money is spent on the sales process and sales increase by 20%. So far so good.

A review of this decision later reveals cashflow does not increase by the same 20%, and in fact only increased by 15% with bad debts increasing by 10%. In addition, the 90, 120 and 150 days figures had blown out by another 15% in the Debtors Ledger.

Furthermore, the cashflow needs of the business have now increased due to additional sales expenses, which are required to maintain the extra sales.

OPTION TWO

The $10,000 was spent on improving the credit and accounts receivable process.

A review later found there was no decrease in sales,  cashflow had increased 25% and bad debts reduced 5%.

Which is the best option for the business?

The answer should always depend on evaluating the following factors; the current economic cycle, the growth stage of the business, whether a competitive advantage can be achieved, whether additional sales expenses have been factored in to assist with the increased sales, the on-going cash requirements of the firm etc.

On the other hand, if the Debtors Ledger is increasing and the new cashflow requirements are affecting company liquidity, then ideally - the $10,000 should have been spent on the credit and accounts receivable processes.

When the credit and accounts receivable processes are not sufficient to maintain the cashflow/liquidity status of the business, then that is the time to spend money on these processes. Whenever there is any investment in credit and accounts receivable processes, inevitably experience shows cashflow will increase and operating expenses are reduced.

Furthermore, my experience says that sales will also increase. Why is this so?

Firstly, your customers that advocate efficiencies will buy more. They buy more because they are not wasting their time and money correcting your sales mistakes.

Secondly, your sales people are visiting the better paying customers, wasting less time dealing with mistakes (credit claims and customer enquiries) and with additional time for researching and approaching new customers.

In every business strategy and investment decision, opportunity costs must be calculated properly to maximise the worth of the money invested. Failing to properly calculate and acknowledge these costs is wasteful and affects future business operations.

Over the years and through my consulting work, I have seen the cost of a lack of investment in the credit and accounts receivable process. Therefore I am always advocating the need for ongoing investment in these processes, proportionally to the needs of the business. 

However, I am also realistic enough to know, ongoing investing in sales is also a necessary process. After all, without sales, you do get the cash required to grow your business.

At the end of the day, opportunity costs apply whichever process receives the investment - sales or credit and accounts receivable. Adequately measuring the opportunity costs is one way of ensuring the investment is made in the best cashflow interests of the business.

May you be paid today rather than tomorrow.

Kim Rado

kim@creditmatters.com.au

www.creditmatters.com.au

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