Every business owner knows what it is like when you first start up in business…
Any sale is a good sale. It is also known as the breath-test. Is the person breathing? Yes!! Great!! A potential customer!!
Credit checks can come later. Personality tests, well so what if they are a toxic personality – we can be kind to anyone.
Listen, I get it. I remember how hungry we were when I opened my first business, and I just wanted more clients – any client (see breath test above).
There is a huge cost to not securing good paying clients though.
And this cost is almost always overlooked when thinking about a bad debt.
The Story of a $5,000 Bad Debt
Imagine you have a $5,000 bad debt to write-off. You just lost $5,000, right?
Sadly, it is much worse. You see, it didn’t just cost you $5,000 which is bad enough.
That $5,000 is now part of your Fixed Costs for the year.
It means the sales volume you now need to generate has just gone up!
Watch how this works with some sample numbers.
Imagine you have sales per month of $50,000. Your cost of goods sold is $35,000. Your Gross Profit (Sales minus Cost of Goods Sold) is $15,000, or 30% when expressed as a percentage ($15,000 Gross Profit divided by $50,000 in sales).
And, in addition, you have fixed costs of $9,000 for rent, wages, office supplies, and telephone.
So, your Net Profit is $6,000 for the month ($15,000 in Gross Profit less $9,000 in Fixed Costs)
Now for The True Cost of This $5,000 Bad Debt
So, now we will add the $5,000 bad debt to the above Fixed Costs, and our Fixed Costs are now $14,000 ($9,000 plus the $5,000 bad debt) and our Net Profit is now just $1,000 ($6,000 as above less the Bad Debt of $5,000).
Ok, you can see that we just lost $5,000, right? Wrong.
You lost $16,667.
How does the $5,000 get to $16,667, you ask?
I will show you…
Additional sales of $16,667 must be generated just to be in the same place of $6,000 Net Profit in the month when you write-off that $5,000 bad debt.
Remember that your Fixed Costs are now $14,000. Your planned monthly profit is $6,000, as above, (all else being equal).
So, when you add $6,000 Net profit to $14,000 in Fixed Costs you get $20,000. Now, divide that by your 30% Gross Margin percentage and you need $66,667 in sales, not $50,000.
A Recap of The Numbers
Sales – $66,667
Cost of Goods Sold (70%) 46,667
Gross Margin (30%) $20,000
Less – Normal Fixed Costs ( 9,000)
Bad Debt ( 5,000)
Net Profit $6,000
For that one bad debt you need to generate a 33% increase in sales in the future to make up for it! Wow! That is no small potatoes. These sales are just to get you back to where you were before accepting that bad-paying customer.
That is the real cost of this bad debt…
What to Do About It
Here are a few things you can do about it:
- Tighten your credit terms. Only give credit to well established reputable customers
- Do better credit checks upfront
- Setup ACH payment terms (money will go into your bank account directly)
- Accept credit card payments
- Make sure you get paid faster. In other words, stay on top of your accounts receivable. This is crucial, as the longer a bad debt stays uncollected the likelihood of collection goes down dramatically
- Do a customer/client profile listing the qualities you want/expect from your customers, and don’t deviate from it
Here is a sample of our own client profile checklist at ControllershipPLUS for our Controllership Division:
- The owner(s) has a positive, pleasing personality;
- They are open-minded to receive coaching (at least to listen to our advice);
- The business is doing between $1 million and $20 million in annual sales;
- They have been in business for at least 3 years;
- They have some record of profitability and are not chronically under-capitalized;
- They have had a Controller, or outgrown their bookkeeper(s) and need a Controller;
- They are open to technology solutions using cloud-based software for better security and real-time reporting.
And, lastly, every time we have deviated from this, we look back at this profile and kick ourselves because we (1) know better – we have a profile for goodness sake 😊, and (2) we compromised on 1 or 2 of them.
By the way, all our clients are amazing in the number (1) category – positive, pleasing personality – and that is why we love our clients, and as a result the Team at ControllershipPLUS is happy and always ready to go that extra mile!
Thanks for reading…