Published: October 01, 2014
At first glance, the mechanical interpretation of accounts receivables appears to be simple: provide a product or service to a customer and receive payment for it. Unfortunately, the reality cannot be further from this – a number of factors impact the effectiveness of this process. These factors can delay the time in which payments are received and therefore increase days sales outstanding (DSO) and negatively affect working capital.
According to The Hackett Group’s 2013 Working Capital Survey of the largest public companies in each region, there is significant opportunity for improvement in working capital overall, with $1,061bn in the US and $980bn in Europe (Figure 1). This opportunity could be seized by process improvement to release the amount of cash tied up in working capital.
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Accounts receivable is shown to be the greater area of opportunity for both regions. The US survey identified a total of $459bn in opportunity for accounts receivable; for Europe the opportunity is $350bn. This opportunity relates to billed receivables and does not consider the amount of unbilled receivables that may exist. More often than not, when looking into improving accounts receivable performance, the value of unbilled receivables is not considered.
Unbilled receivables are receivables for which the product or service has been delivered but the invoice has not been generated. No charges have been sent to the customer, and therefore the receivable is not collectable. Unbilled is also referred to as accruals, accrued billing and revenue shipped not billed, but the accounting term is accrued receivables. It is important to note that accruals may not account for all unbilled receivables. Typically, a company will accrue for known unbilled receivables, but it is possible that unidentified unbilled receivables also exist. Accruals have to be reported on the balance sheet as receivables. It is not always possible to invoice accruals due to contractual agreement or lack thereof; for example, if the customer demands month-end or milestone invoicing.
Expected unbilled receivables are particularly prevalent in those sectors that provide complex project-type based services, such as IT, engineering, construction, advertising and telecommunications. In these industry sectors, milestone billing is typically used. Sending the invoice to a customer does not guarantee that it will be paid on time or in full. Although many factors cannot be internally controlled, ensuring that the invoice is generated and delivered in a timely manner is within the organisation’s control and can be achieved by having a defined order-to-bill process and proper internal controls in place.
Even though unbilled receivables are quite often a necessary side effect of conducting business in certain industries, the value of unbilled is also often due to inefficiencies within the billing process. Some of the reasons leading to unnecessary levels of unbilled receivables are:
The lack of an automated billing trigger upon product shipment or delivery (whatever the point of revenue recognition may be)
It is best to ensure the billing system is equipped to automatically generate the invoice upon the point of revenue recognition, or at a minimum to flag invoices to be generated. Implementation of this type of automated invoice trigger may require some ERP modifications.[[[PAGE]]]
Invoicing delays when back-up documentation must be provided with the invoice
Typically these conditions are driven by customer requirements. Often the invoicing delays occur because the back-up is highly complex or a standard format is not in place. Therefore, it is critical to carefully consider and manage customer requirements according to the level of effort to satisfy and the anticipated delays associated with satisfying these requirements.
Cost-plus contracts or milestone billings
The invoices can be created only under the percent completion method or after specific portions of the work, such as milestones, are achieved. It is important to have controls in place to recognise milestone achievements and invoice timely when the appropriate work is completed. Starting work on a project without a signed contract or change order can also result in unbilled receivables. The contract approval process, if not properly defined, can be lengthy and may result in further invoicing delays.
Delays can also exist due to the invoicing schedule in use, for instance, generating invoices only on a monthly basis. Other than for milestone billing, invoices should be generated daily or at least on a weekly or biweekly basis.
The first step to managing unbilled receivables is to define a process to identify and manage unbilled receivables and assign clear resolution roles and responsibilities. In addition, some system and contractual elements need to be looked at in order to have a complete picture of the causes of unbilled receivables. Some considerations when defining a successful process to manage unbilled receivables follow.
First, define a clear process for managing unbilled items receivables. This process is similar to managing disputes, which includes prompt logging and communicating of unbilled items to the person responsible for resolving. Categorising unbilled items facilitates measuring and monitoring. Expected resolution time frames and targets must be set to promote timely resolution of unbilled items.
Establish an escalation process if resolution does not occur within the established time and escalate items to management with the objective of facilitating resolution. It is important not to overlook the method and frequency of communication of unbilled across the organisation, especially to the areas responsible for resolution. The use of some form of workflow may facilitate this process.
Second, have controls in place to trigger the generation of the invoices upon product shipment or at the completion of the services or work. This is one of the most effective ways to prevent unnecessary unbilled receivables.
Because unbilled receivables are particularly prevalent in sectors providing complex project-based services, review and approve project charges weekly in order to eliminate any period-end bottlenecks. For project-based billing, generate invoices at least on a weekly or biweekly basis. However, for products, invoices should be generated daily.
Where possible, change the contract types from milestone basis to a time-and-materials basis. When milestone contracts are used, evaluate the cash flow and financial impact of a project based on financial and time exposure. This analysis should identify the adequate billing triggers to maintain optimal cash flow position. Also consider requesting higher prepayments for milestone contracts, such as 30% or higher.
As part of the process, clearly define billing frequency and prepayments requirements necessary to minimise risk and level of exposure. Avoid allowing wide time intervals for invoicing. This is extremely important when using cost-plus contracts or milestone billing. Consensus with the commercial organisation is required to achieve this. Finally, ensure that the impacts of customer requirements to timely billing are identified and minimised.
Third, develop and distribute metrics for unbilled performance. In the same way as measuring DSO, measure days unbilled outstanding (DUO). DUO represent a cycle time corresponding to the number of billing days tied with unbilled. In accordance to best practices, the target time frame for DUO should be between one and two days. It is necessary to measure performance against the established unbilled targets to drive and sustain improvements (Figure 2).
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To calculate DUO, use the total number of days in the time frame examined.
Total Unbilled Receivables
DUO= ——————— x Number of Days
Total Credit Sales
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Unbilled aging reports are useful to prioritise resolution actions (Figure 3).
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Calculation of true DSO is shown in Figure 4.
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Add a valuable dimension to the existing key performance indicators used to measure working capital by including unbilled metrics. Support this by establishing and monitoring targets to more effectively measure unbilled performance. Make individuals accountable for improving or maintaining the desired levels of unbilled receivables by including targets in performance evaluations and provide encouragement by offering improvement incentives.
Managing unbilled receivables cannot be ignored. It can have a significant impact on working capital and cash flow that is often not captured in conventional metrics such as DSO. To minimise unbilled receivables, it is important to keep revenue recognition in line with billing milestones and to ensure that all triggers between order completion and invoice submittal are managed effectively. Clearly defined processes for managing contracts, orders and invoices should be included within an overall credit policy to ensure effective management of unbilled receivables and to minimise billing delays.
It is up to the organisation to determine the level of sophistication required for an unbilled receivables management process, but simple solutions can achieve significant improvements. The important point is to keep sight of this issue, which is often overlooked and not effectively managed.
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