Wednesday, April 30, 2008

Measuring Efficiency; Ineffectively

Borrowing from my entry of two weeks ago on receivables management and reporting, So What, Now What, it never ceases to amaze me that the more people I speak with the more it emphasizes that receivables management is a problem in ever industry in every country. At a recent roundtable discussion at a CFO conference for telecommunication manufacturers, the issues of receivables management came up. Here are companies that deal in the tens of millions of dollars per bill and they have receivables issues! My first thought when I heard abut their issue was, why they aren’t using secured letters of credit? For some, letters of credit was par for the course when dealing with offshore suppliers, however domestically the old mantra of credit checks, billing and waiting for payment was the fare for the day.

With more probing the issue gained considerable depth. No matter who I spoke with they have their own ‘bell weather’ for determining how well they are doing with their management of receivables. Surprisingly enough, there are more variants of core reports in circulation than one can imagine, both in the professional services and in the corporate world. To make it even more surprising, each user swears that their ‘unique’ report is the best indicator.

My first thought after this experience was, I may be missing something in the remedy purported by all of these ‘unique’ reports. With this feeling of void in not knowing what the ‘best’ report is, I undertook my own research to find out what firms are using and what ‘authorities’ are saying about financial reports. As it turns out, today’s professional services firms have an enormous amount of reporting tools. They have reports from their billing systems and reports from their other systems. They buy custom reporting packages, they buy business intelligence packages and they even have custom reports written, all of which they trust as the gold standard. In the market place today, there is no shortage of reporting tools. The first thing the user must remember, the data is fixed it is only the spectacle by which we view the data that changes; the reports.

With the plethora of reporting tools available the user must really know what they want to analyze and why. Although these tools dice and slice the data in a multitude of ways, one should really ask oneself, is what I am analyzing telling me what I need to know? Do I understand the calculation being made? What is the logic behind the calculation? Until you can answer these questions you are stuck in the “So What” mode.

In an internet article I recently read Law Firm Business Model - Realization, the author discussed ways of measuring the various attributes in the firm’s cash cycle. So as we are on the same page, the cash cycle, begins with the entry of time and costs, through prebilling, final billing and ultimately the receipt of cash. The author contends that the only reports the firm really needs to operate are billing and collection realization reports. The contention is that realization provides the user with the measure of ‘efficiency’ by which a process operates, ie billing and collections.

This concept of efficiency continues to intrigue me. In the world of energy and thermodynamics, efficiency is the ratio of output per unit of input. By way of an example, a home air conditioning unit is said to be 67% efficient. In that regard for every kilowatt of energy taken in, 67% of the energy goes toward producing cool air. As an aside note, automobiles are significantly less than 20% efficient.

Back to the article, the author contends that managing the firm with these realization reports and current asset aging reports is essentially the key to firm profitability. In the article the author cites recent LexisNexis research on the average days for law firms to collect. According to the 2007 Law Firm Economic Survey, conducted by LexisNexis, the average North American Law firm will take 169 days to collect on a bill. This is about 30% longer than the findings of the ABA Survey in 2003. So in four years, law firms have showed a 30% increase in time to collect on a bill! However, almost within the same paragraph, the author, by way of example, presented several firms from the survey that had over 95% collections realization.

How could this be? These firms realized 95% of the cash billed, but the average time to collect their bills increased by 30%. The problem here, I feel, is that the true measure of ‘efficiency’ isn’t being taken into consideration. The missing component is – time. If we recall from Finance 101, money has differing values over time. Simply put, a $1 today is worth more than a $1 a month from now. Therefore the calculation of ‘efficiency’ really does need a time component, which in all of the reporting tools I know of – don’t!

Let’s examine the calculation so you can see where we are going. So by way of an example:

Patty Partner produces a bill for $525 and sends it to the client. After 45 days the client is contacted and is disputing a charge on the bill, a courier charge of $30. Patty agrees to write the amount off and within 15 days the firm receives payment of $495.

According to the standard calculation for cash realization, the formula is the ratio of inputs to outputs. Where $525 was the original amount of the bill and $495 was the amount paid. With that said, the realization is given by:

495 x 100% = 94.29%

That is pretty impressive! However it took 60 days to collect! The firm’s policy is payment is due 30 days from date of bill. Let’s alter the calculation to reflect efficiency based on time, which is really the true efficiency!

The firm’s policy is payment is due 30 days from date of invoice, if we add 5 days for processing, the firm should expect payment on or about the 35th day. However, payment came in on the 60th day.

If payment were to arrive on the 35th day, the process would be 100% efficient barring the deduction for the dispute. If payment arrived before the 35th day, the process would be more than 100% efficient, because the client paid early. While beyond the 35th day the process becomes less efficient.

The calculation of time therefore takes on the representation of:

Output 60 days
Input 35 days

However because the output increases, which operates contrary to energy models, we need the following correction.

1/ (output/input) 1/ (60/35)

Apply this to our example of Patty Partner, the calculation becomes:

495 X 1/ (60/35) X 100%= 55%

Therefore Patty’s collection realization for this bill is 55%. The reason for the radical difference from the cash realization report is it took at least 70% longer to collect on the bill than the firm policy dictated and there was a write down! This paints an entirely new picture of Patty Partner.

With this simple example, I hope you can see the need to understand what the calculation means and how it can or should be used to measure activity is vital. This is but a single example of a single calculation. With the number of reports being used, there is no doubt that each day millions of people rely on reports to make decisions, without really understanding what the calculation entails.

As for the article, we have just shown how cash realization can be 95% yet time to collect has increased 30% over the past four years. Realize that each bill for which you are awaiting payment has a time corrected realization that gets worse by the day and so many reports simply aren’t bringing it to your attention! Remember what you think you are measuring may not be in fact what is being measured! Understand the big picture before ‘picking’ a report!

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