Introducing the DSO Efficiency Gap: Controlling the Controllables in the Credit & Collections Process

Credit & Financial Management Review, First Quarter 2004 by Verma, Deepak

Abstract

Credit and collections managers work to reduce DSOs, but external factors make it difficult to measure the results of their efforts. To help these managers measure the degree of impact that they can have on DSOs, we have developed a metric called "The DSO Efficiency Gap". This article will outline three methodologies for calculating your efficiency gap - as well as several best practices for closing it.

Introduction

Credit and collections managers do their best to minimize bad debt and DSOs, but they lack the ability to measure their progress against a reasonable goal. Although credit quality and collections efficiency both have a direct impact on DSOs, so do various types of disputes and delays that are beyond these managers' control. When DSOs do improve, it's tough for managers to receive the credit that they deserve for their hard work and accomplishments.

Lack of Visibility

Managers and CFOs that are committed to continuous improvement strive to benchmark the performance of each business function. Performance metrics are key to any benchmarking effort, but often companies don't track the most relevant ones. Although most companies calculate average DSOs, there are other metrics that yield much better insight into the effectiveness of credit and collections teams - including average days delinquent and best possible DSO.

Unfortunately, many departments don't find that these metrics yield sufficient insight to merit the time required to track them. According to the CRF only 52% of companies monitor average days delinquent and only 71% track best possible DSOs compared to the overwhelming 97% that track average DSOs.

The situation is not likely to improve, given that increasingly lean credit and collections departments have even less time to collect additional information. According to the CRF, 90% of credit managers say that "do(ing) more with existing staff resources" is a "very" or "significant" challenge.

Introducing the DSO Efficiency Gap

Clearly, credit & collections managers need a new metric, one that provides even more visibility into the specific impact that credit and collections managers have on the receivables management process without requiring too much additional effort. To address this need, we have developed the "DSO Efficiency Gap" performance metric, which we have defined as (see Figure 1):

A metric that tracks the number of days by which average DSO's could be reduced if the credit & collections processes were optimally efficient.

The DSO Efficiency Gap addresses many of the key challenges associated with tracking average DSOs. This metric:

* Backs the impact of disputes out of average DSOs. Disputes have a significant impact on DSOs, but they are more directly linked to flaws in the manufacturing process, administrative errors, and misunderstandings than to inefficiencies in the receivables process. Given this, it's critical to exclude the impact of disputes that are not related to the credit and collections departments.

* Factors out external delays. Credit and collections have no control over the U.S. Post Office, lockbox configurations, or invoicing processes. Consequently, the DSO Efficiency Gap is reported net of all days associated with mail and billing delays.

* Mutes the impact of the revenue biases, where applicable. Firms that use the classic average DSO equation (gross receivables / annual net sales * 365) rather than backing out sales month-by-month find that rapid revenue growth can distort DSOs.1 However, the methodologies described below are geared to help correct for this bias.2

Benchmarking Your Performance

The DSO Efficiency Gap will take more time to calculate than the average DSOs metric, but the effort will be worth the time investment. We've developed several calculation methodologies, which are listed in Figure 2 and ordered from simplest to most complicated. The approach that makes the most sense for your organization will depend on the type of information that is most easily accessible to you as well as the consistency of your payment terms.

1. "Average days delinquent" methodology. This methodology is the most basic one. Companies that track average days delinquent need only exclude all sources of delinquency that aren't directly attributable to the credit and collections department.

The first step is to calculate the adjusted days delinquent by backing out the impact of all problem accounts for which the issue cannot be linked to the credit and collections department. This includes:

* accounts in which payments are delayed due to disputes with other areas of the organization, as well as

* accounts that were initially classified as high-risk by the credit department and then approved via an exception process.

Once this is accomplished, the DSO Efficiency Gap can be easily calculated by subtracting the impact of delays related to time spent "in the mail" or any other issues not controllable by the credit or collections department (e.g., billing system time lags related to a mismatch in the date of sales v. invoice).3