What is Collection Effectiveness Index and How is it Calculated?

What is Collection Effectiveness Index and How is it Calculated?

May 4, 2021

Businesses use the right key performance indices or KPIs to make informed and data-driven decisions. One such KPI is the Collection Effective Index or the CEI. The CEI specifically allows a company to understand how effective their collection practices are, and it is particularly important for construction companies or material suppliers that extend trade credit to their clients.

What is Collection Effectiveness Index or CEI?

As the name implies, the Collection Effectiveness Index is a KPI that measures how effective your efforts are in retrieving accounts receivables from your clients over a given period of time.

The CEI is a percentage value, and it is calculated by comparing the amount of payment that you are able to collect during a chosen period against the amount of receivables that are available for collection during that period. The resulting percentage gives you a measure of how well and effective your payment collection policies are.

Companies understandably look at net revenue and ROI as the key barometers for how well their business is doing. The CEI, however, allows you to take a closer look at your payment collection practices, which also affect your company’s earnings.

By ensuring that your payment collection efforts are effective, you place yourself in a better position to protect and grow your earnings and to maintain a healthy cash flow.

Collection Effectiveness Index Formula

The formula for the collection effectiveness index can be summarized as follows:

Collection Effectiveness Index Formula

The CEI formula may be broken down into the following detailed calculation:

Collection Effectiveness Index Formula Detailed Calculation

How to calculate Collection Effectiveness Index?

  1. Determine the assessment period

    Before you calculate your collection effectiveness index, you must first set the assessment period or the period of time over which you are calculating your CEI. You may choose to calculate your CEI over a year, a quarter, or a month.

    There is no specific requirement, and every company will have its own policies for how often to measure their CEI.

  2. Gather the required information

    Once the assessment period has been decided, the next step is to collect the required information for calculating the CEI based on the formula shown above:

    • Beginning receivables

      Beginning receivables are the total amount of open accounts receivables at the start of the assessment period. Open accounts receivables are receivables that have not been retrieved yet, while the assessment period is up to you. It typically spans a year, but you may choose to measure your CEI in smaller segments, such as every month or every quarter.

    • Credit sales

      Credit sales are the total amount of money that you made by extending credit to your clients during the assessment period. If, for instance, you extended $50,000 worth of trade credit in a given month, your credit sales for that month would be equal to $50,000.

    • Ending total receivables

      Ending total receivables are the total amount of open accounts receivables that you have at the end of the assessment period. The ending total receivables must include both current and overdue receivables.

      Current receivables are open receivables that are still owed to you by your clients, while overdue receivables are also receivables that are still owed to you but have already gone past the payment deadline.

    • Ending current receivables

      Ending current receivables is the total amount of open accounts receivables at the end of the assessment period. This amount refers to only current receivables, so it must not include overdue receivables.

  3. Use the CEI formula

    Once you have all the required information mentioned above, all that is needed to do is plug the values into the CEI formula:Collection Effectiveness Index Formula Detailed Calculation

    The result will give you a percentage value that shows how effectively you collect payment from your clients.

How to get your Collection Effectiveness Index: An Example

To understand how to calculate the Collection Effectiveness Index, consider the following example:

Collection Effectiveness Index Sample Data

The table above shows Company A’s monthly data. They have beginning receivables of $500,000 at the start of the assessment period, and they made $600,000 during that month. They also accrued a total of $1,000,000 total receivables by the end of the month, with $800,000 are their current, non-overdue open accounts receivables.

Plugging the values into the CEI formula, we get the following:

CEI = [(500,000 + 600,000 – 1,000,000) / ( 500,000 + 600,000 – 800,000)] x 100

CEI = 50%

Company A, therefore, has 50% CEI during that month.

What is a good Collection Effectiveness Index?

The higher your CEI is, the better. A good CEI is generally above 80%, which means that your payment collection practices are 80% effective. Anything below 80% means that there may be gaps in your payment collection processes that must be addressed to ensure that you are able to collect money from your clients effectively.

Companies who choose to measure their CEI monthly may observe a trend in their payment collection efforts. For instance, if your CEI begins at 90% at the beginning of the year but has consistently declined since, it is best to investigate what has been causing the decline.

There are also companies that may choose to prioritize collecting payments from clients with the highest credit. This way, they will yield a higher CEI. In any case, the CEI allows you to quantify the effectiveness of your payment collection policies and helps you make better business decisions.

Why measure your Collection Effectiveness Index?

  • To quantify how well your payment collections team is doing

    There are many ways to quantitatively determine if your payment collections team is doing well or not. Measuring the collection effectiveness index is one of the most straightforward methods as it is a direct comparison between the amount that the team has collected versus the amount that was available for collection.

    While you can simply look at your revenue or ROI metrics to see how well your business is doing, understanding your payment collection practices is just as important. It becomes even more imperative if your company makes money by extending credit and ensuring that those credits get paid.

  • To identify points for improvement in your business practices

    If your CEI does not go above 50%, it implies that your payment collection efforts are only 50% effective. In a given assessment period, you are only able to collect 50% of your open accounts receivables, which proves that there are loopholes in your current collection practices that must be improved.

    Maybe your accepted payment methods are too limited, in which case you need to allow your clients some flexibility in sending over their payments. Maybe your payment collection staff are not properly trained in conducting payment collection calls, in which case you need to provide them the right training. Whatever the case is, you need to address these roadblocks to ensure that you are able to collect payment from your clients effectively.

  • To take action on issues before they get worse

    Say, for instance, that your company consistently hits a 95% CEI every month. It means your company is doing great in ensuring that your payment collection efforts effectively turn your invoices into cash. But what if all of a sudden you yield an 80% CEI? Even though 80% is still a good collection effectiveness index, the sudden dip in your CEI may tell you a different story.

    There are many possible reasons that may have caused the decline. You may have updated your invoice management processes, or you have taken on a new big client that turned out to be delinquent. By measuring your CEI, you can investigate and take actionable steps to mitigate potential issues from turning into bigger problems.

What is the difference between CEI and DSO?

Another popular KPI for understanding your payment collection practices is the DSO or day sales outstanding. Some companies use only DSO, some use only CEI, while others use both. Both are powerful KPIs, but they also have key differences, which are summarized in the table below.

Difference Between CEI and DSO

  • CEI measures quality while DSO measures time 

    The main difference between CEI versus DSO is the value that they measure. The CEI measures quality or how “good” something is, while the DSO measures time or how long it takes to complete a certain task. Both are valid KPIs depending on what exactly you want to understand about your payment collection practices.

  • CEI measures the effectiveness of your collections practices, while DSO measures the time it takes you to collect payment 

    CEI specifically measures the quality of your payment collection practices. The higher your CEI is, the better the quality is your payment collection efforts. DSO, meanwhile, measures the time it takes your payment collection team to retrieve payment from your clients. A lower DSO is better because it implies that it does not take you long to collect payment and turn an invoice into cash.

  • CEI is an internal measurement, while DSO is a potential benchmark for comparing your practices against other companies’ 

    Both CEI and DSO can help you gauge the quality of your internal business practices, but between CEI and DSO, it is DSO that you can use as a benchmark to compare how well your company is doing against other businesses. If other organizations report a DSO of 60 days and your DSO is 90 days, you may be running behind industry standards and may need to improve your collection practices.

Why is the Collection Effectiveness Index an important KPI?

  1. It gives you a fuller picture of your payment collection practices compared to other KPIs 

    Other KPIs such as the DSO may not give you a complete picture, especially if you want to gain a deeper insight into how effectively you collect payment from your clients. The CEI is the KPI that gives you a value that quantifies the robustness of your payment collection system.

  2. It helps you gauge the quality of your collection policies over a long period of time 

    The CEI is a good and tangible key performance index if you want to understand the effectiveness of your collection efforts. You may apply the CEI formula over a monthly assessment period, but you can also use the CEI to understand the quality of your collection efforts over long periods of time, such as a quarter or even a year.

  3. It allows you to be proactive in mitigating potential issues 

    You can measure the CEI monthly, quarterly, or annually, and if you regularly calculate your CEI, you can observe the trends and identify any issues, if applicable. Using the CEI as a key performance index will allow you to address and mitigate problems about your payment collection processes, invoice management, and other business aspects.

How to improve your Collection Effectiveness Index?

The CEI is a tangible measure of your payment collectors’ performance. Since it is a quantitative measure, it is possible that the numbers may not necessarily agree with the efforts that the payment collection team is showing. To improve your CEI, you can consider implementing or looking into the following:

  1. Implement a robust payment collection policy

    Even if you have a dedicated team that sends out invoices and reminds clients to collect a payment, your collection practices may still be ineffective if you have no standardized policies to address overdue payments. This is why you are highly encouraged to draft, develop, and implement a robust payment collection policy.

    A robust collection policy streamlines the steps needed to be taken to retrieve missed payments. When should you reach out to the client? How should you reach out to them? Are there any late payment fees? You need to answer these questions, among other queries, to ensure that you provide clear guidance to your payment collection staff.

  2. Conduct effective payment collection calls

    An effective payment collections team knows how to conduct payment collection calls. Just like with late payments and overdue accounts, it is also just as important to have a standard set of guidelines when performing collection calls.

    When making collection calls, the staff making the call must be prepared with facts about the client and the amount owed. They must be trained on how to address questions, how to be firm, and even how to offer alternative payment terms, if necessary. A payment collection team that is properly trained in making effective collection calls is more likely to result in higher CEI.

  3. Identify problematic and delinquent clients

    The root cause of a low collection effectiveness index may not be related to your current business practices and policies – it may just be because of one or multiple difficult clients. You should therefore investigate deeper and identify which of your clients are being delinquent. You can then decrease their credit limit or encourage them to pay on time by offering incentives.

    You may also evaluate your trade credit policies and see if you are being lenient in accepting high-risk clients. If you do not have a credit policy in place, you are advised to develop one so you can implement a set of procedures in assessing your clients before you sign them on.

  4. Optimize your invoice management practices

    One potential reason for having a low CEI is managing your invoices poorly. Payment delays are more likely to happen if you serve your invoices late or if you consistently make errors in the invoices that you issue. If invoice management is an issue, you may want to take advantage of technology and consider investing in invoice management software.

    If there are any disputes regarding the invoices that you send out, you must be able to address them in a timely manner. Be ready to justify why you are charging a specific amount and to show the paperwork to back up your costs. Keep in mind that responding to disputes late will only delay the payments further, which can impact your CEI.

  5. Protect your lien rights at all times

    In every project, you must make sure that your lien rights are protected. Protecting your lien rights can mean differently in every state. Some states require that you file a Notice of Commencement, while others require that you serve a preliminary notice or a notice of intent to lien. You must familiarize yourself with the applicable lien requirements to ensure that you can file a mechanics lien.

    Note that recording a mechanics lien is the most effective method in recovering payments from clients. You significantly raise your leverage in payment negotiations once you file a mechanics lien and put a legal claim against a property.

Further reading