Game theory studies the decision-making and possible outcomes in games. For decades, it has been widely used in social and economic behavior analysis (but not only these areas).
In our company, we’ve been employing game theory to accounts receivable (AR), aiming to maintain higher collecting rates and increase customer lifetime value. Here are some tips both on the utility and limitations of game theory that we’ve learned from this exercise:
Sequential Move Game
In accounts receivable, a buyer and a supplier know about each other’s steps before taking their own. The supplier has the first move by sending an invoice and reminders to a buyer. The advantage here is the knowledge of the buyer’s next decision, which will help you with further strategy.
Tips:
• Send reminders before overdue invoices. This will help you promptly uncover errors in communication with your buyer, like missing essential data or wrong contact details in an invoice.
• Gain as much information as possible from the buyer’s moves to facilitate further decisions. For example, keeping track of their credit score changes or credit alerts can help you identify problematic customers.
Asymmetric Information Game
In my experience, most late payments happen because of the simple asymmetry of information each player has. This can be the case when, say, the invoice was received by the wrong person, wasn’t received at all or had missing data, such as the tax or purchase order number.
Tips:
• Be proactive. A minor problem overlooked at the start might snowball into a disaster later. As a rule of thumb, be sure to import all of the necessary data, from order to invoice, accurately, and always get your hands on the contact details of your buyer, as this information changes frequently.
• Track the delivery of postal invoice confirmations, return email delivery, bounces and open rates. They’ll signal what’s going on with your buyer. For example, if an email has never been opened, it might mean that the recipient changed their email or they’re ready to leave you.
• Provide invoices with supporting documents that hold critical information, such as the proposal or schedule. The more the buyer knows, the fewer excuses they'll have to delay the payment.
Manipulative Game
To get an edge over opponents, players use so-called strategic moves -- commitments, promises, threats and other actions that change the game. It’s important to ensure that your strategic moves aren’t just observable, but also irreversible. There are two ways of achieving this:
First, restrain yourself from changing your mind. Create a system rule so you cannot go around contract terms even if you want to. Automation can help you with that. For example, if an invoice goes 20 days past due, the algorithm could shut down the service you provide to the buyer.
Second, deter yourself from changing your commitments. You can, for example, form an agreement with a debt collection agency, giving them the right to buy receivables that are 120 days overdue for a considerably lower price.
Your clients, in turn, might dodge your strategic moves with theirs. For instance, they can use salami tactics and pay their invoices just a few days late. This is not a big deal at first glance, but it will eventually affect your collection KPI.
Tips:
• Commit to your own rules, and keep yourself and your buyers from parlaying a payment delay.
• Be transparent with your clients about the rules of your cooperation from the start. Smart buyers attempt to “test” suppliers' tolerance to delays. Try not to give them reasons to do so.
• Study your customers’ behavior. Pool the players who violate the agreement even in the slightest way. Try to figure out if it was a strategic move or if they had a legitimate reason to do so, like damaged goods or internal pricing errors.
Repeated Game
In accounts receivable, every billing cycle or new invoice is a separate subgame. In such games, players adopt so-called trigger strategies where every action depends on the previous step of another player. So, if your buyer doesn’t pay on time, takes deductions or makes a short pay, you may change your trigger strategy accordingly. Two popular strategies include the grim strategy and tit-for-tat.
In the grim strategy, you cooperate with your client until they don’t, and then switch to defection until the end of the game. For instance, decrease the credit limit after the first significant payment delay. In tit-for-tat, you choose every move based on the action of your client. They play nice, and you play nice; they defect, and so do you, and so on.
Tips:
• Be flexible, and make strategic moves based on your buyer’s actions. Tit-for-tat is one way of responding to the buyer’s payment behavior and maximizing your customer’s lifetime value.
Limitations Of Utility
Game theory has its limitations. First, it assumes that players are rational, which is not always the case. Second, the theory displays the relations between two players, while AR is often a multi-agent game that requires complex solutions. Finally, the order-to-cash process differs by nuanced “love stories” between you and each buyer, so there will be a scale at which it’s impossible to make decisions based merely on theoretical principles.
This is the point where artificial intelligence and machine learning algorithms can play better than humans. Cutting out the busywork is not the only field where automation shows its superiority. AI can track countless trends and actions, giving you forecasts with accuracy a human could never achieve. You can benefit from using AI/ML solutions to analyze the behavior of clients, choose optimal customer terms or suggest the best possible email text.
Using intelligent solutions is like being able to see the hands of all the players at the table. Combining them with game theory principles gives you the opportunity to play a perfect game that will not only improve your revenue, but also increase customer satisfaction.
