The hidden costs of accounts receivable

Healthcare Financial Management, Nov, 1993 by Edmund J. McCormick, Jr.

ACCOUNTING

To maintain and expand their missions, hospitals must make the best use of their assets. Knowing the true cost of accounts receivable is important for efficient operations. Knowing how to reduce this cost is critical for liquidity. This article offers a guide to ensuring these assets are used most productively.

Accounts receivable add only one thing to hospital operations--cost. How much cost is often a misunderstood and controversial issue. This article will explore the nature of the true carrying costs of accounts receivable and offer suggestions to reduce them.

The carrying cost of receivables is often equated with the time cost of money, calculated using the discounted cash flow method. But the time cost calculation of a receivable actually is only one of seven elements of cost. To understand the real cost of carrying accounts receivable, the influence of the other six cost elements must be considered. These include administrative, opportunity, predictability, financing, and bad debt costs as well as a more subtle but nevertheless real cost--morale cost.

Time cost. The cost most often associated with receivables--time cost--is the present value of money to be paid at a specified point in the future. In other words, how much money would have to be invested today, at a given interest rate, to generate a principal-plus-interest amount equal to what will be paid or collected in the future? The calculation is the reverse of compounding interest, and in this case the interest rate is called the discount or capitalization rate.

Administrative cost. Administrative cost is a function of a receivable's age. Assume a normal collection cycle to be cost neutral. (Obviously there is a cost, but for this comparison, assume it to be zero.) As the receivable ages beyond the normal cycle, the collection process becomes more cost intensive. Follow-up letters, telephone calls, and additional record keeping are costs directly related to the age of the receivable. These expenses grow proportionally larger as the receivable ages. If unpaid, eventually the receivable will need to be turned over to a collection agency, creating additional administrative cost.

Opportunity cost. This cost is the difference between the value of a resource used in a particular way (in this case, the resource is cash and its use is carrying receivables), and the value of the same resource if used in the most profitable manner (invested in a revenue-generating alternative with a return greater than simple bank interest, as calculated in time cost). Opportunity cost is often more narrowly defined as the rate of return one would experience by investing in a particular project. The more rapidly cash is generated, the more opportunities the cash can be applied to, thus optimizing profits.

Opportunity cost is similar to time cost, but completely unrelated. It is a separate discrete cost.

Opportunity cost is difficult to predict unless project opportunities can be identified and their costs calculated. The rate of return required before an opportunity is considered for investment is known as the hurdle rate. Most organizations establish a range of desired return (hurdle rate) of 15 percent to 20 percent.

Examples of opportunities that may provide the greatest returns include changing a hospital's mix of beds, implementing efficiency improvement programs for staff, and adding new equipment.

In an organization constantly chasing cash, opportunity cost is frequently ignored (often with the rationalization that no cash is available for investment). However, regularly calculating this cost as part of the management information reporting system provides a truer picture of the real cost of carrying a receivable. This provides further incentive for finding solutions to speed collections.

Predictability cost. Predictability cost is the expense resulting from imprecise forecasting of cash receipts. The ability to accurately forecast cash receipts is in itself a cost-decreasing activity. Knowing when cash is expected provides financial managers with the ability to achieve budgets, meet deadlines, achieve goals, and fulfill vendor payment promises. The costs of inaccurate forecasting can be of significant consequence to an organization with little "head room" in cash resources.

A poorly predicted income stream generates costs in several ways. Plans cannot be followed and budgets cannot be met; the need to recast budgets adds to administrative expenses. Vendor payment dates are missed, compelling vendors to tighten payment terms and jeopardizing "vendor financing" (use of goods and services before payment is made). Crisis borrowing at above-market rates often results.

Predictability cost--the cost of inaccurate cash flow forecasts--is often misunderstood and ignored altogether in a receivables analysis. Failure to anticipate the expense of inaccurate forecasts can affect an entire organization.

Financing cost. Financing cost is the cost associated with credit lines or other regular funding sources used to smooth erratic cash flow in collection cycles. Some organizations have cash peaks and valleys that require some type of accounts receivable financing. In addition, many healthcare providers are unable to utilize commercial bank financing sources due to generally perceived instabilities within the healthcare industry. As a result, alternative sources of financing, most often more costly, must be utilized.