What exactly do companies mean when they refer to their high financing costs on sales? To answer this question, think of the company’s financing costs to support its inventory and its financing costs of supporting its receivables. The longer it takes to sell inventory, the higher the costs. The longer it takes a customer to pay their invoice, the higher the costs. These aren’t soft costs by any means, but real, identifiable and quantifiable costs that directly impact a product’s gross profit and the company’s bottom line. So what are the critical steps to determining your financing costs on sales?
When thinking of inventory think of how your company uses bank loans and business credit lines to finance your purchase or materials and finished goods. These same financing options are used to finance your receivables up to the point where your customers pay their bills. You borrow money to purchase inventory and won’t be able to recoup any of it until your customer closes their invoice. Measuring your inventory and receivables financing costs is essential to defining your costs on sales.
Steps to Determining Your Inventory Financing Costs
First, take your company’s yearly interest rate on money and divide it by the 365 days in a year. This will give you your company’s daily interest rate. Second, take this daily interest rate and multiply it by your product’s COGS (Cost of Goods Sold). Third, take the number of days you held inventory before you made the sale. Multiply these days by your daily cost of money. This will give you your company’s financing costs on sales.
Steps to Determining Your Receivable Financing Costs
Now take the same daily cost of money and multiply it by the number of days it took your customer to pay their invoice. This answer will give you your financing costs on the receivable. Combining this cost and your financing cost on inventory, will provide you with your total financing cost on sales.
When looking to reduce these costs, focus on initiatives that speed up inventory turnover rates and spur customers to pay their invoices sooner. Granted, this is obviously much easier said than done and most companies must spend an inordinate amount of time reducing these costs. However, start by using reduced pricing, discounts and reward programs to liquidate slow moving inventory. Use contractual agreements on supply to justify inventory levels. For your receivables, use discounts and rewards for paying sooner. Take the time to investigate 1% net-10 day term reductions on invoice totals.
Don’t be concerned about giving your customer a 1% discount. The intention is to speed up the time it takes to get paid. This minimizes your company’s risk and reduces your financing costs. Finally, redefine how your company values your customer base. Which customers contribute to a high inventory turnover rate and pay on time versus those who purchase low turnover product and take longer to pay?
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