How to Keep Credit from Killing You

In the last article we discussed how businesses finance operations by borrowing, and why offering terms can have unforeseen consequences.  In this article we’ll look at an extremely high hidden cost and how to combat it.

Impact of Delinquencies

I apologize.  I'm about to scare you.  It's very likely that after reading this post, you'll never look at debt the same way again.  You'll start operating a cash business going forward.  And you won't personally lend money as freely.  But that's not bad.  The way we typically account for debt shields us from the full impact.

When you grant credit to a customer, you either borrow from your savings or a third party to cover it.  And until they repay you, you lose the use of that money.  If you use your savings, you'll lose the interest you would normally earn.  If you borrow, you pay interest to a bank.  Most of us don't consider the impact of a default because we expect to be repaid.
What happens if they stiff you?

Can't you simply write off a bad debt?  

When you "write off" bad debt, you don't get the money back.  You're only removing profit retroactively. You won't view it on your financial reports and you won't pay tax on the income you never received.  But you still borrowed to lend your client money.  And your cash flow covers the interest on your debt until repaid.  If you're stiffed, that's forever.  

As we touched on in the last column of this series, the highest rate on all your open credit lines is the rate at which you pay interest. Why?  Because you assume that when your client pays you, you'll then pay down your highest rate loan.  If they don't, you continue to carry the debt.  Putting this together we can see that you pay interest on delinquencies forever at your highest rate.

“Okay,” I hear you grumble.  “I know that sometimes I finance my customer's purchases.  And I didn’t consider I was paying interest on delinquencies indefinitely.  And I didn't see until now that I was borrowing at my highest interest rate.  But my customers usually pay within a month or so, and only a few default.  Are a few bad clients costing me so much?”

The answer is a resounding yes!  Over time the amount can cripple your cash flow.  Let's look at an example.

Was Einstein Smart?

The famous physicist Albert Einstein claimed compound interest was the most powerful force in the universe^*.  It’s truly horrifying for a borrower to see compounding turn a small loan into a veritable fortune over time.  Compounding adds interest onto the interest onto the interest… all the way back to the transaction date.
 

Say you borrow $1000 to extend terms to your client and they default.  I'll show the math below, but if you use a business line of credit with an average interest rate you'll lose $180 of net profit your first year.  After five years, $400.  After ten years, $940.  After twenty the profit you lose grows to nearly $5000, five times the amount of the original credit!  And the balance grows even larger and more quickly as the rate increases.

All this expense for extending a single customer who never paid you.  Imagine if you had a lot of bad debts.

One way or another, you're paying ballooning interest on each bad debt every year.  If you use debt, you're carrying more than you need to.  If you're debt-free, you've lost the compound interest on that money.  By granting credit you either decrease assets or increase liabilities.  The net result is the same: a substantial and ever-increasing drain on profit.  All because you extended credit, maybe years ago.  

You can how see even a few delinquencies can become prohibitively costly after several years.  If you are careless in extending credit, you can end up in a huge hole.

Want more proof?  Use the equation below to calculate the amount of money a family business could lose after generations of being stiffed only a small amount at the beginning of its history.  A terrific primer on compound interest is The Skinny On Credit Cards.

The Mathness Behind the Method

Expressed algebraically, the formula for compound interest is C(1 + r)^t where C is the original Cost, r is the interest rate, and t is the number of times the interest compounds.  As the number of years shown by the exponent t, and the interest rate r increases, the result grows very large.

In our example, we used a rate of 18%.  The interest is 18% of the balance of the debt.  So using the formula above the balance of $1000 debt after 5 years is: 1000 * (1.18)⁵ = $2287. In year six you pay interest on $2287.  At 18% cost of capital, that's $411.66.   After ten years, the balance quintuples to $5234 and 18% interest is $942.12.  After twenty years the balance increases to a whopping $27,339, and the interest is $4921.

The Bottom Line

Especially in the beginning of a business you must be miserly about extending credit.  Even better, don't do it at all.   There are times you need to offer credit; for instance, when it's expected or you're trying to compete.  But make credit the exception, not the rule.

Next time I'll discuss a way to prevent bad debt while keeping your customers happy.  In one of the next columns I’ll examine another hidden cost that can be extremely expensive and how to avoid it.  And later we’ll discuss how to flip around this equation so that you start making money on financing cost, not losing it.  It’s all next week so keep your eyes glued.  Until then,

profitable business All!

Add More Profit to Every Sale

In an earlier post I said your prices were too low.  But did you realize that every company loses potential profit on every sale?  It’s true.  You could be earning much more income than you are now.  The key is to reduce your price flexibility.


Perceived Value vs Price
A customer who chooses to buy attaches a value to the purchase.  He assumes that buying will benefit him in a manner that offsets the price and justifies the expense.

All rational customers perceive a value exceeding the price or they won't buy.  Whenever the amount a customer would pay is greater than the listed Price, the merchant is forfeiting potential profit.  Each client perceives a different value of a purchase depending on their needs.  And the greater the perceived Value compared to the lesser Price, the more readily a client will choose to buy.

This means a customer is usually willing to pay more for your offering than you charge.  Although it’s illegal to charge different prices to different people for the same thing, there is a way to maximize the profit for each sale. By allowing your customers to self-select additional value during a transaction, they will increase the price until the total is closer to their perceived value.  A savvy marketing department can test price flexibility over several dimensions to build value and profit into every sale.

A transaction has many dimensions of value.  Focusing on the dimension time within a transaction is an excellent way to add unrealized value.  A customer usually anticipates the benefit of a purchase immediately.  Satisfying the time dimension costs the merchant nothing.  But the client perceives it as valuable so the company may credibly assess a surcharge to provide it.

Case Study
One of our clients was an information aggregator that provided specialized data tables to engineers based on a requested set of parameters.  The customer ordered the tables one day and usually received them the next.

When brought in, we surmised our client company was pricing its data services too low.  A little research revealed their competitors typically fulfilled data orders within four to six weeks.  So to determine the perceived value to their clients we recommended this company inject time into the transaction as a self-selectable dimension of value.

We suggested the company immediately announce they were increasing routine turnaround to four weeks.  Even after this increase they would still fulfill orders more quickly than their competitors.  We further directed them to let clients know that they could upgrade to expedited delivery on any order by paying an appropriate rush surcharge.

Introducing this policy served several functions: it reminded the customer of the previously ignored time component of the transaction; it induced clients to upgrade in a way that cost the merchant nothing to provide; and it added profit as clients self-selected additional components of value to pay a price closer to their perceived value.  A client who believed the service to be worth much more than they were paying unhesitatingly upgraded to expedited delivery.  And by evaluating the percentage of clients who upgraded, the company discovered where prices fell compared to their perceived value.

In this case, almost all its clients chose to pay for expedited delivery which indicated the company’s prices were much too low.  Faced with this data, they began the process of raising them to more closely align with their customers' perceived value.

Approach and Results
How did they accomplish this?  By using the Grandfather Discount Method to increase prices for both standard and expedited services.  They then alternated between periodic increases and inserting and valuing additional dimensions of value to continue to stretch price flexibility.  This boosted the value and the correlating price for the tables self-selected by the client.  After several rounds of this, prices were realigned with expected value and most of the excess slack was removed from price flexibility.  This technique boosted their revenue fifty percent immediately and tripled the bottom line by the end of the first quarter.  Their income soared.

Yours can too.  By strategically raising prices through self-selectable upgrades, the additional profit you'll earn costs nothing.  The extra income drops straight to the bottom line dramatically increasing your margin.  Try it!

Later this week we’ll continue fleshing out our marketing plan.  And next week I’ll talk about how you can train your customers painlessly to increase loyalty and satisfaction.  Until then,

profitable business All!

P.S. To read more about Creating Value, refer to Value-Added Selling

Power Negotiation for Superstars

In the last two posts I explained how you're leaving money on the table by refusing to raise prices and how to raise them without incurring dissent.  In future posts I discuss how and when to raise prices to achieve maximum profit by improving your brand while keeping your clients happy.

For now, let's explore another way many proprietors leave money on the table: by reacting to pricing pressure by indulging haggling.

In pure negotiation, neither party knows the other's expectation.  The first person to name a figure loses because the other person now knows their boundaries.  The counter-party can then move their own figure closer or further away from the figure as it benefits them.

Information has value, and the one who possesses more of it is better positioned.  When neither parties know the other's limits, the seasoned negotiator strives to get the other party to name a starting price.  When as in retail sales, the seller publishes the price, buyers are forearmed with the seller's expectation but the seller is not similarly equipped.  Thus a retail seller who demonstrates flexibility on price puts herself at a disadvantage because her buyer starts with more information.

Sometimes a prospect pushes for a discount.  What is their underlying motive?  Do they truly demand a reduction to buy?  Contrary to popular myth, a customer will almost never engage you in the buying process without being able to afford the product.  Price objections from customers arise when they're probing your confidence level.  If they sense you wavering, they may interpret it as a lack of confidence in your product or service.

Believe it or not, your clients hope you’ll stand firm.

To bear this out, imagine you're looking at a vehicle on a dealer’s lot.  It sports a ten thousand dollar sticker but you really want it.  The salesperson sidles up and you low ball him.  "I like this car but I didn't want to spend more than eight thousand dollars."  You expect your utterance will preface a lengthy negotiation.  But instead of negotiation the rep replies "$8000?  Sold!"

How do you feel now?  Confident?  No, you’re seriously reevaluating your decision, anxious you may have just made a huge mistake.
 
To contrast, imagine the same scenario but instead of giving in the rep smiles assuredly at your inquiry and begins outlining the value of the vehicle.  He stays firm on the price, explaining the value of the car.

As a consumer, which experience would you rather have?

In this same way, your customers expect you to demonstrate confidence in your offering.  If you exhibit conviction in the value you provide, your client will feel the validity.  When a qualified client reconsiders a purchase at the last minute or brings up price, the culprit is usually uneasiness.  Often this is because they sense a lack of confidence in the salesperson.  Your savvier consumers (often salespeople themselves) may opt to push for a discount if they feel you're unconfident.

If a customer starts to haggle or seems to question the value, realize that it is probably because you have opened the door by failing to demonstrate your conviction.  To recapture lost momentum, express confidence in the value.  Whatever you do, don't let their inquiry make you defensive.  Build trust.  Reiterate the value and assuage your client's anxiety.  Confidence is the secret to POWER negotiation!

Have you ever printed a huge run of printed material only to discover a typo after the fact?  I'll show a way to avoid that in the next article.  Look for it in the next couple of days.  And please keep your comments coming!  

Until then,
profitable business All!

P.S. For further reading on negotiation, I enthusiastically recommend Getting to Yes.

Raise Prices Without Losing Customers

In the last post, I shared why your prices were probably too low and how you're leaving money on the table.  If you've ever worked at a business when it raised its prices, you probably endured grumbles from customers.  Justifying the increase becomes so exhausting that many merchants take the path of least resistance and swallow the increased expenses.  But what if you could raise prices and avoid the grumbles?

One way to increase prices without risking upsetting or losing clients I call the Grandfather Discount.  It works like this:

1. Raise prices immediately.  
2. Tell the customers you want to keep that you're grandfathering them under the old rate for six months.  
3. Discount the new price back to the old.

Here's why this works:

• When your client receives the bill, your new price will stare at them from the top line with the discounted price displaying at the bottom.  Your customers won't be angry about the increase because you aren't asking them to pay it yet.  Those who do complain will be polite and you can receive it as feedback.
• Each repurchase during this time your bill subtly reminds them of the imminent price change.  The grandfather gives them  time to get used to the new price.  And they'll subconsciously revise the value they are receiving upward to reflect this higher price.
• After six months, eliminate the discount as agreed.  By removing a discount instead of adding an increase, the customer feels (and you can remind them) the benefit they received for six months.  This is in contrast to feeling penalized going forward.  
• Because you raise prices immediately all new customers will pay your new price.  This adds extra profit to every new sale starting immediately.  

You may find some clients stock up to buy before the price discount expires.  From day one you'll start booking additional sales.

This simple re-framing technique improved the bottom line of many corporate clients, even some big ones.  Try it!  Do you think this will work for your business?
 
Are you tired of shelling out money for unreimbursed costs?  In a future post I'll explain how to deal with merchant card fees and other surcharges.  I'll show you how to eliminate these cash drains and turn them into profit centers.  Stay tuned!   Until then,

profitable business All!

Your Prices Are Too Low!

Would you rather earn $100 each on ten customers or $10 each on one hundred?

If you answered ten customers, you’re an efficient businessperson.  Why expend extra effort dealing with ninety more people for no extra income?  You are in business to make a profit, right?

In the same way, you might be leaving money on the table, charging less to sell more volume but earning a lower net profit if your prices aren't high enough.  Ultimately, you want to charge as high a price as your most price-sensitive customers will pay.  So if everyone can easily afford to buy your product, your prices are too low.  Your most price-sensitive customers should feel the pinch.  If you never encounter any price resistance, you’re leaving money on the table.

If it’s your job to set prices, I understand you don’t want to deal with customers endlessly grumbling over increases.  But there’s an equilibrium between too high and too low, and it’s the manager’s job to determine where that point lies.  Learn to justify your value.

If the last time you raised prices was during the Bush administration – especially the first one – it’s time to do it again.  In the next post I’ll explain how to increase prices painlessly using a technique I named the Grandfather Technique.

You should raise prices each time your supplier does, and every time your market improves.  In the next post, I’ll discuss exactly how to do this.  Learn how to earn optimum profit without irritating or losing customers.  In the next few weeks I'll share how you can design advertisements that work; avoid high printing charges; learn how to calculate your clients' value to your business, and much more.

Until then,
profitable business All!

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An Ingenious Method to Add Profit

Have you ever had a client ask for a discount? What a pickle. Do you: 1) give in and feel taken advantage of; or 2) refuse and risk losing the client.

The other day I was at the service station D & S Auto where I took my car in for a $40 oil change. I asked Denny, the owner: "Can I get a discount?" He looked down at the floor, shuffled his feet, and caved. He grudgingly agreed to knock $5 off the bill.

I asked him how he felt about acquiescing. He confessed he disliked it but was afraid declining would upset me. "Besides," he added "$5 won't break me."

The Impact of this paltry $5 Discount

Would you believe me if I said that Denny was about to give away most of his profit? I detail this below but let me share a way to offer a discount that saves your blood pressure while offering the customer a supposed concession. All while adding profit to your bottom line.

The Discounted Upsell

We've all experienced the upsell. This is when the drive-in asks you "Do you want fries with that burger?" You give a discounted upsell by offering a discount off an additional purchase. But it can also be used effectively when a client asks for a concession.

Instead of shaving profit off an already booked sale, offer an additional purchase at a discount. In the case of my oil change, Denny could have asked to rotate my tires and offered to reduce the normal price by $5.

Choose a service with an ultra-high margin and the firm books additional profit for additional work it wouldn't normally perform. The customer leaves satisfied because they feel you gave them a concession. And you can feel satisfied too.

The Mathness Behind the Method

• Denny employs a skilled mechanic at roughly $50/hour. We'll ignore payroll taxes and benefits that increase costs. Let's assume that a half hour oil change is $25 in labor costs.

• My vehicle is occupying one of his bays on the floor. Denny sells this time slot only once. So we must apportion overhead. The company pays rent, utilities, office supplies, telephone, advertising, and other expenses. We'll allocate $5 for overhead. So far his costs are $30.

• Other costs: interest on bank loans and credit cards, bad debt, equipment, and any other unexpected or unusual costs eat up profits. These easily make up 5% of gross sales. That costs $2 leaving $8. A 20% margin isn't terrible. However, after taxes Denny's left with net profit of $5.

By Denny discounting $5, he relinquished all his profit. Scary, huh?

In a future post I'll explain how you can use a variation of this technique to placate an irate customer. With this simple gimmick, they'll usually settle down immediately. And there are additional ways to use this tip to dramatically boost net profitability. But more on that in the next and future postings.

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These tidbits are from my time at the consulting firm. I'll post at least weekly.

I appreciate all your comments. Let me know if there are any particular business issues you've experienced and I'll write about them and credit you. Until then,

profitable business All!