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What’s Your A/E Firm Doing About Bad Debt?
Let’s continue to talk about collecting the fees for work your firm has completed. In Cash or Accrual? Is your A/E Firm Using the Right One? Part 1 and Part 2 we introduced and discussed the issue of collections for A/E consulting firms. In review, the first most important thing for an A/E business is to find the work. The second most important thing is collecting the fees for the work performed. Notice that performing excellent architectural or engineering work was not included in the top two most important things.
The reason performing excellent work is not first or second is because first, if you do not have work to work on, you won’t have the opportunity to do excellent work. Second, if you do not collect on the fees for the work you have performed and receive income, it doesn’t matter if you did excellent work or not because your firm is not getting paid for it. Obviously to be a successful company and grow you need to be great at what you do, but you also need to realize the true importance of selling and then collecting. Great businesses set themselves up to be excellent at all three aspects. This is not a case of the chicken or the egg. In this case the answer is sales comes first, collecting comes second, and excellent service comes third!
When you first start your A/E business it may be hard to fathom that people wouldn’t pay their bills. If you’re like me you pay your home utility bills on time, you pay your mortgage, and hopefully are able to pay off your credit card every month. When you receive a good or service you pay for it. The idea that you would receive a good or service and not pay for it upfront or within the agreed terms is beyond you. The truth that you need to prepare yourself and your business for is that not all of your clients will pay on time, and for that matter, some may not pay at all.
This is where the accounting expense of Bad Debt comes into play. Bad Debt is common among all business types and needs to be accounted for when financially planning. Bad Debt is when a business is owed money (accounts receivable), but the individual or business who owes the debt cannot or will not pay the debt. The business that is owed the money is then forced to write of the debt as a Bad Debt Expense. Typically accounts receivable are written off as Bad Debt when either the company owing the debt goes bankrupt or the cost of resources necessary to collect the debt is greater than the amount to be collected. The second of those two instances is the most common reason for Bad Debt in the A/E industry. At a certain point it may just not be worth your firm’s time to chase down a $500 outstanding payment, for example. Be warned though, if you company gets in the habit of writing off several $500 outstanding debts, the amount of Bad Debt your firm writes off can climb quickly. This can also give clients the idea that they don’t need to pay those smaller bills.
So how do we account for Bad Debt when finically planning for our business’s upcoming year? Bad Debt is an expense, just like any office expense – software licenses, office lease, etc. Those are all examples of expenses that need to be planned for. An anticipated dollar amount needs to be anticipated for Bad Debt expenses when planning for the future. These expenses can then be used to figure out your company’s Overhead Multiplier. Most expenses are estimated based on past company data. Estimating Bad Debt is no different.
The most common way to estimate Bad Debt is to quantify the expense as a percentage of gross sales. In accounting this approach is referred to as an allowance method. Let’s run through a quick example to explain. ABC Architecture wants to determine last year’s Bad Debt expense percentage. Last year ABC Architecture had gross sales totaling $1.2 Million. Of that $1.2 million ABC Architecture wrote off $54,000 in uncollectable debt. That would be $54,000 in Bad Debt expenses. If we consider that expense on an allowance basis, ABC Architecture’s Bad Debt expense for that year would be 4.5% of gross sales (=$54,000/$1,200,000 x 100%). $54,000 in write offs in one year may sound like a lot to you, but 4.5% may not.
The reasons quantifying Bad Debt as a percentage of gross sales is beneficial are twofold. First, if you plan to grow your business and project higher gross sales each year, your Bad Debt expense can be estimated easily based on your average past Bad Debt expense percentage. Second, by accounting for Bad Debt on a percentage basis, you can compare year to year Bad Debt apples to apples, regardless of gross sales for each year. This allows you to track your company’s progress on eliminating Bad Debt expenses, which we all hope to do.
How do we plan for Bad Debt? If your firm has been in business for over an entire year or more, you can estimate future Bad Debt expenses based on past accounting information. The more years of data your firm has available, the better. You can average your Bad Debt expense over several past years or you can choose to average only certain recent years if you feel that only specific past information is applicable. It is possible that in your company’s first year Bad Debt expenses shot through the roof, but your company since has put certain collection processes in place to prevent that outlier of a year from ever happening again.
If you’re just starting your business, you won’t have any past accounting data to estimate from. Bad Debt expenses can be anticipated to be between 2% to 5%, but this can vary depending on the market your business serves, the type of clients you and your business attract, and what invoicing and collection processes your business has in place. When starting out it is always best to reach out to a mentor, a friend, or even someone through social media who runs a similar firm, and ask what to expect. You’ll be surprised how many people are willing to help out and give advice.
Also, keep in mind that it is one thing to plan to invoice and follow up on collections, but it is another thing to stick to that plan. Like the great Mike Tyson once said, “Everyone has a plan ‘till they get punched in the mouth!” If you’re starting your business and it is just you, or you and your partner, you’re going to be wearing a lot of hats. When you get super busy on projects it’s easy to push off invoicing and tracking collections. My advice is to plan for the worst and hope for the best. Invoicing and collections should be a routine for your company that happens consistently the same time of the month, every month. Making sure that happens will be the first step to keeping your Bad Debt expenses low.
If you have effective collection processes in place, but still need to lower your company’s Bad Debt even further, there are additional options available. For ideas on how to collect better check out Five Ways to Collect More Quickly. The last and most important thing to do is assess your clients. In my next article we are going to discuss the 80/20 rule. The 80/20 rule can apply to many things for an A/E business, but you will soon learn that the 80/20 rule absolutely applies to an A/E firm’s client selection process.
Aaron Mitchell, PE, SE
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