BY SCOTT SMITH, PE
When I was a young lad, my parents owned a delicatessen. We sold many things, but our most significant product was the construction of sandwiches (or hoagies, as we called them in southern New Jersey). This business had relatively simple cash flow. When we constructed a hoagie for a customer, they would bring it to the cash register from the hoagie counter and pay us, before eating it. We really didn't have accounts receivable (AR).
It's a good thing my father didn't come from the building construction business. If he did, that cash register transaction would have gone much differently.
"Thank you for your business. At the end of this month, we'll figure out how much that hoagie cost us to construct and send you an invoice accordingly. You'll then have 30 days to pay, which of course we'll let stretch to 60 or 90 days. And, if you don't like the format of the invoice, we'll reissue it, and the clock will reset."
Of course, this is almost a ridiculous comparison. But the truth is, the time between delivery of HVAC construction or maintenance services and receipt of payment has grown too long. What's the true cost of this payment method to our businesses, and what can we do to help reduce this time period?
There's an accounting term — don't worry; we'll keep it light — called Days Sales Outstanding (DSO). While there are subtle differences in the way DSO can be calculated, it's a good measure of the average number of calendar days that an invoice takes to get paid. If your payment terms are 30 days, then, theoretically, your DSO should be 30 or less. In reality, it's often much longer.
Let's look at an example. Suppose there's an HVAC business that's producing $12 million in annual revenue with a 5% bottom line, leading to $600,000 per year in earnings, before interest. This hypothetical company has a DSO of 90 days. In rough terms, this means that this company's average AR balance is approximately $3 million ( average revenue is $1 million per month, 90 days is three months).
By adjusting its practices and payment terms, let's suppose this company could reduce its DSO to 45 days. This would reduce its average AR balance to about $1.5 million. At a borrowing rate of 7%, this would lead to an interest expense reduction of $105,000 per year — not at all insignificant to the bottom line.
Alternatively, if the company were self-financed, this same reduction in DSO would " freeup" $1.5 million in capital. This kind of money could be strategically invested in the business to facilitate growth, or invested in outside financial instruments to create additional income. Either way, it seems appropriate to do what we can to keep our AR balances and DSO as low as possible. Here's how.
Change Your Billing Procedure
We have made two definitive changes in our business, both resulting in drastic reductions in our DSO (by drastic, I mean more significant than in the hypothetical example). First, we have shifted our project invoicing from progressive billings to milestone billings with a down payment (whenever possible). Second, we have carefully picked the people involved in our collection process, and armed them with a well thought-out written procedure.
Progressive billings are similar to my earlier example; projects are invoiced at the end of each month, for work completed during the month. However, the invoice is usually based on an estimate of the percent of work completed during the month, which can be ambiguous, leaving room for delayed payments.
In the milestone payment system, you define several, significant events in the project and assign a dollar value (or percent of total contract value) to the occurrence of each event. Payments are then issued upon the completion of the milestone. An example for a $250,000 Design/Build HVAC installation might look like this:
This system eliminates ambiguity, and if the milestones are established correctly, it allows a project of a given size to be executed with less cash. We have had good success with this system, and, generally speaking, end-user clients tend to be willing and appreciative. However, this system won't work in all cases, and it's difficult to get approved when you are a subcontractor to a general contractor or construction manager.
Once you've established a good milestone system for your project work, you'll still need to be diligent about ensuring payment of your invoices. Whether these invoices are for milestones, service contracts, or T&M repairs, without diligent follow-up, many of them will be slowly paid. It's simply the nature of the business environment in which we exist. To combat this, your collections procedure should include the following:
- Make initial phone calls immediately after issuance of your invoice, to ensure that it was receivedby the right party, and is acceptable. This makes it difficult to complain about the invoice later.
- If the invoice isn't paid by day 30, call or email on day 31. Don't wait 45 or 50 days later to start calling.
- Strategically use the project managers and/or sales people within your company to assist in collecting difficult invoices. These folks generally have good relationships with the clients . . . relationships that can be useful to the collections process. They do need to be careful, however, because you don't want them to injure that relationship with the clients.
- Be cautious about strong-arm tactics, such as work stoppages and attorney letters. While these tactics can be effective, they are difficult to deploy without hurting your relationship with the client. We typically reserve these actions for extremely difficult payment matters, and recognize that we may not do much future business with the particular client.
Select the Right Person
It's incredibly important that the person you select to manage your collection process is artful and talented. If the person is too overbearing, it can be threatening and unpleasant to your clients, causing them to consider other providers. If this person isn't assertive, he or she will typically not achieve the appropriate target for DSO.
The right person will be assertive, but reasonable. He or she will be methodical about documenting any conversation, and politely remind clients of previous commitments that were made. I like to describe the right person as "pleasantly persistent."
Establishing milestone billings for your project work, developing a consistent collections procedure, and designating an employee with great follow-through skills to execute it is an excellent way to free-up significant cash and/or reduce your interest expense. Carefully measure your DSO, establish improvement goals, and you'll be pleasantly surprised.
|Completion of Engineering Documents||20%||$50,000|
|Arrival of Air Conditioning Equipment||40%||$100,000|
Scott Smith is vice president-general manager at EMCOR Services, Trimech Corporation, of Pompton Plains, NJ. He has responsibility for the company's wide array of Design/Build projects. Scott can be reached at firstname.lastname@example.org
This article is based on the presentation, Getting Paid Upon Delivery . . . A New Concept?, which Scott Smith will give at the upcoming 2006 Commercial Contractor Roundtable in Atlanta, Oct. 25-26.
The Commerical Contracting Roundtable, which also incorporates the Design/Build Seminar, is co-sponsored by the Air Conditioning Contractors of America (ACCA) and Contracting Business magazine. This year's Roundtable will feature 15 business management and technical sessions specifically tailored for commercial HVAC and Design/Build contractors. For more information about the 2006 Commerical Contracting Roundtable, contact Richard Ware at ACCA, 703/824-8843, or visit www.contracting roundtable.com