Maintaining receivables bears a cost. It includes the cost of investment in receivables, bad debt losses, collection expenses, and cash discount. Costs related to receivables and their calculation are as follows:
(1) Cost of Financing Receivables
When goods and services are provided on credit then concern’s capital is allowed to be used by the customers. The receivables are financed from the funds supplied by shareholders for long term financing and through retained earnings. The concern incurs some cost for collecting funds which finance receivables.
(2) Cost Of Investment In Receivables
This is the opportunity cost of funds being tied up in receivables, which would otherwise have not been incurred if all sales were in cash. The cost of investment in receivable is calculated as:
Cost of receivables = Investment in receivables X Opportunity costs
Investment in receivables = (FC+ VC)/Days in year) X DSO
Where, FC = Fixed Cost, VC = Variable Cost and DSO = Days sales outstanding.
(3) Bad Debt Losses
This is the loss due to default customers. Extension of credit to low quality-rate customers results into increase in bad debt losses. Bad debt losses are calculated as a percentage on sales as shown in the equation below:
Bad debt losses = Annual credit sales X Percentage default customer
(4) Collection Expenses
This is the cost incurred for operating and managing the collection and credit department of a firm. This includes the administrative cost of credit department, salary and commission paid to collection staff, a cost paid for telephone and communication and so on.
(5) Cash Discount
It is the cost incurred to induce the customer for early payments of their accounts. A firm can offer a cash discount to its customers to reduce the average collection period, bad debt losses, and the cost of investment in receivables. The discount cost is calculated as cash discount percentage multiplied by sales to discount customers as given below:
Discount Cost = Annual credit sales X Percentage discount customer X Percentage cash discount
(6) Cost of Collection
A proper collection of receivables is essential for receivables management. The customers who do not pay the money during a stipulated credit period are sent reminders for early payments. Some persons may have to be sent for collection these amounts. All these costs are known as collection costs which a concern is generally required to incur.