Extra Credit Newsletter - Bad Debts: More than just principal is lost

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Bad Debts: More than just principal is lost
It's official. The customer/client is insolvent or bankrupt with no hope of recovery. Either way (depending upon your specific credit policy and procedure) the next step would suggest that the account balance be written off to bad debts and life goes on. Unfortunately, removing the principal amount owing from the ledger does not always represent the true cost of the bad debt when one considers the impact on other aspects of the business.

With the advent of just in time delivery, many suppliers perform an essential customer service by ordering or manufacturing, in advance, products specifically required by the customer. If these products are customer specific, they will ultimately have to be written down as obsolete or sold at considerably less than market value. This is often accounted for differently and never really tagged as part of the bad debt, although it arguably could be.

Annual budgets look ahead and sales forecasts cascade down to individual customers. Product sales and margins are predicated on the retention and growth of these identified customers. A bad debt removes this opportunity from the mix and the void must be filled from among the existing accounts or a concerted prospecting effort must be undertaken to find a volume/margin replacement. If neither is found, these lost sales become very measurable.

If the bad debt is significant, it might induce a sales territory realignment to balance out the lost revenue among all of the sales representatives. This would make sense if the bad debt were a disproportionate contributor to one's individual sales budget. Matching customers with new sales representatives could be disruptive to some relationships and actually inhibit sales growth in the budget year. Again, there is potentially a bottom-line impact stemming from this business failure.

Bad debts are financed out of a bank line. The reduction of bank availability because of this loss would mean funding for specific projects, like new product development. Programs may have to be curtailed. Companies need to continue to advance and remain competitive. The impact of not having access to these resources will have a much longer term effect on the overall business.

Depending upon whether it's the size of the bad debt or just the number of bad debts incurred during the course of a fiscal year, there will likely be a philosophical adjustment internally that could also affect business. If the credit department reacts by "tightening up" on credit granting, sales growth opportunities could be missed for all the wrong reasons. If a similar attitude is applied to collections, customer goodwill could become an issue with many simply moving their business elsewhere. Again the notion of losing existing or anticipated sales becomes a significant one with a negative effect on profitability.

All of these considerations and the impact on current business are often not linked to the actual bad debt "principal" loss. Conventional accounting provides no basis for doing so and therefore any tabulation of these costs, real or otherwise, would likely have to be booked informally.

While bad debts typically fall within the domain of the credit department, the true cost of losing a customer has both short and long-term consequences for the company. Therefore, recording the principal loss is in reality an understatement, if these others factors are not recognized in some form or another.

Gary Larson, BUSINESS CREDIT, March 2000