Accounts Receivable Deductions: Still A Plague On Profits

Over the past two decades, the consumer goods industry order-to-cash process has seen tens of millions spent on consultants and software to streamline customer transaction processing.

However, the bottom line results show that customer deduction losses have not been reduced and the process has gotten even more complex.

Accounts Receivable Deduction Management remains an intractable problem causing significant revenue and profit dilution for manufacturers, costing even mid-market companies millions of dollars of expense every year – up to 5-15% of revenue, depending on the industry.

To understand the profit impact of customer deductions, consider a $1 billion retail-channel supplier with a net operating margin of 10%, experiencing a typical 9.7%  customer deduction rate. That’s approximately $97 million in customer deductions. Questionable deductions may total a third of that, which is about a third of the net margin, leaving a significant profit improvement opportunity.

Equally as significant, many chain retailers have invested in technology that small suppliers find difficult to comply with, creating an even greater challenge with purchase order requirements.

Deductions result from a panoply of business problems and misunderstandings making deduction management labor intensive and complex. Ideally, customer deduction reason codes should convert to standard supplier codes in the cash application function, however this process often fails making it difficult to match the deductions against credit memos.

Deductions are rarely an exact match, so the variances must be reconciled manually (unless you have the newest technology). When a deduction has no matching credit memo, deductions need to be researched, involving participation of sales, distribution, finance, transportation, marketing, pricing, etc. It’s a labor-intensive process with expensive overhead.

Few companies track the cost of customer deductions since the expense is distributed among many product and departmental budgets. However, those who look at it closely will be surprised at its magnitude.

There is the potential for a significant payoff from managing deductions, but it requires expertly configured accounts receivable deduction software plus a team with industry expertise. The fixes include identifying and correcting the root causes of systemic problems, customer disconnects, and, more directly, recapturing the deduction profit leakage by reconciling and recovering excessive deductions.

Deduction Management Categories

Broad deduction classifications include industry Trade Practices, Preventable (under the supplier’s control), and Customer Errors.

1. Trade Practices, where deductions are the chosen settlement and reimbursement vehicle, such as trade promotions, co-op advertising, markdowns, coupons, etc. This (except for the customer errors) is the “cost of doing business” deduction category.
2. Preventable Deductions include poorly communicated price data, slow credit memo issuance, misinterpreted trade deals, purchasing compliance violations, EDI mistakes, conflict in terms and conditions, or errors in order entry, shipping, billing, etc.
3. Customer Errors include unauthorized or excessive deductions, such as unearned discounts, misinterpretation of pricing, duplicate deductions, post-audit claims, customer process errors, and (occasionally) intentional abuse.

Customer Deductions Causes and Financial Impact

The financial impact of CPG customer deductions varies by industry, however businesses with heavy trade promotions or complex supply chains have the highest incidence of deduction losses. “High-dilution” industries plan to incur more than 15% of revenues deductions because of heavy trade promotion billbacks or the markdown and/or return of unsold seasonal or excess products.

Deduction causes vary by industry. For example, compliance violations run rampant in the apparel industry, slotting fees in the grocery industry, and price protection and rebates elsewhere.

Here are a few of the industry issues:

• In the consumer goods industry, billback deductions are the standardized process for paying trade promotion dollars. This practice allows the customer to settle (deduct) claims immediately. However, being on the receiving end puts the burden of proof squarely on the supplier to document, research, validate, and resolve the deduction.
• Electronic vs. paper processes have streamlined but complicated the process, creating repetitive systemic errors and non-compliance opportunities.
• The need for fast delivery often conflicts with careful order editing and timely shipping notifications (ASNs).
• Complex promotional and pricing matrices, poorly communicated to customers.
• Communication of price or policy changes needs to be tightened up. For example, a pharmaceutical company recently discovered that price change notices were not reaching the correct department at a large customer. As a result, the manufacturer was hit with more than $500,000 in hard-to-solve pricing deductions with a turnaround of 60 days.

Suppliers must carefully investigate all deductions to sort the valid from the invalid to keep their marketing budgets and customer profits on target. Invalid or excessive claims need to be carefully handled and collected. Otherwise, the supplier will relinquish significant gains.

Regardless of industry, deduction resolution takes concerted effort and intensive labor by several departments, including customer service, sales, finance, accounting, logistics, and IT. As a result, it represents a significant part of a company’s SG&A expense.

Blame The Customer?

It’s easy to blame the retailer or distributor for using deductions as a budgeted profit item. After all, customer errors can be significant and increase if not consistently counteracted. Still, most deductions go back to supplier inattention to purchasing rules, internal failures, and long-standing industry practices.

Large retailers have a valid argument. Non-compliant supplier shipments cost the retail industry billions of dollars in extra processing and rework. As a result, they charge the supplier for mistakes and track their performance using “Supplier Scorecards,” which measure order fulfillment percentages, EDI compliance, on-time delivery, packaging, labeling, etc.

More deductions mean a lower supplier scorecard rating, ultimately affecting the relationship.

Offshoring

While there may be individual success stories, offshoring customer deduction management has been a failed attempt to “eat your cake and have it too.”

Large corporates that see accounts receivable and customer deduction management only as a low-value transaction process were convinced that cheap offshore labor was the solution to high personnel costs.

It’s commonly called ‘labor arbitrage” – trading high-priced for low-priced labor. However, a more comprehensive examination may show a different picture.

• The quality of offshore customer service (we all have personal experience with this) and lack of subject matter and industry know-how is a recipe for poor results and customer dissatisfaction.
• Many offshore outsourcers use client legacy systems (even spreadsheets) instead of advanced automation for cash application, invoice collection, and A/R deduction management.
• Combining the above with the need to negotiate deduction and chargeback business dispute outcomes is a recipe for poor results.

KPIs, Metrics

Before you start a corporate initiative to control deductions, it is helpful to establish tracking metrics so that you can benchmark progress. Unfortunately, industry benchmark data is not particularly useful as company processes and policies differ.

The best way to track your progress is to set internal baselines (where you are today) and track how you improve.

Deduction Days Outstanding (DDO) By Dollars

• Track deductions using Deduction Days Outstanding (DDO) separately from Days Sales Outstanding (DSO), the total A/R, and invoice collection benchmark.
• To calculate DDO, sum up the deductions received for 90 days, and calculate the average per day. Then, divide the total A/R deductions open on the books by the average per day to calculate DDO.
• For example, if deductions at the end of a month total $1,000,000 and you receive an average of $25,000 per day, the DDO = 40 days.

DDO by the Number of Deductions (DDO-N)

Another way to think about DDO is to use the number of unresolved deduction items since the usual DDO by dollar metric can look better than it is because of the focus on resolving large dollar items first. Using this method, if unresolved deductions at month-end total 6,000 items and you receive an average of 100 deductions daily, the DDO-N = 60 days.

Deduction Effectiveness Index (DEI)

Accounts Receivables departments spend up to 75% of personnel time researching and managing deductions. By employing the DEI as a critical KPI metric, A/R teams can track bottom-line results of recapturing the losses in customer deduction errors.

To determine the DEI every month, compare the total deductions vs. those found to be incorrect vs. the collected deductions. Do this by category (returns, shortages, discounts, trade promotions, etc.) and track your company’s progress.

You Can’t Just Write The Stuff Off

Years ago, it was common to arbitrarily write off masses of deductions against available credits, an ultimately counter-productive idea for many reasons. As a result, auditors largely stopped this practice; customer deductions must properly be handled individually today.

Further, sellers discriminating against providing trade promotion allowances — compensation for advertising and other services — may violate the Robinson-Patman Act.

In compliance with Sarbanes-Oxley (SOX) requirements for operational transparency and financial reporting, your auditors will require documentation to support trade allowances and deductions.

See our post on Sarbanes-Oxley and Trade Promotion Management Best Practices.

Transparency and accountability are the watchwords for corporate management, and CFOs are demanding compliance.

A Simple Deduction Action Plan

While certain types of A/R deduction categories, like legitimate trade promotion billbacks, are, in fact, “a cost of doing business,” there remains significant profit leakage in the types that are “a cost of doing business poorly.” These other deduction categories include vendor compliance and product delivery errors, OTIF chargebacks, shipment shortages, pricing deductions, rebates, returns, debit-credit reconciliations, etc.

A significant source of erroneous deductions is the common misinterpretation of trade deals caused by easy-to-fix, confusing trade deal sheets and invoicing formats.

Use best practice systems and processes to manage deductions without losing monetary recovery value. Examine the revenue cycle from order entry to cash collection to find the delays, error-prone areas, extra hand-offs, and paper shuffling you can eliminate. This will free up both cash flow and resources.

1. “What is measured gets done.” Start by auditing and benchmarking your company’s operations. Issues will often be found not just where you expect but also where you inspect.
2. Get all the root-cause departments involved.
3. Analyze deductions by type, key customer, amount, etc., to identify trends and problems. Report and fix the root causes of systemic issues that cause deductions.
4. System. Compare your accounts receivable, collection, and deduction management software against the newer intelligent SaaS systems such as Carixa that are super-efficient because of robotic process automation, machine learning, and user-configurable strategies.
5. Formats. Customize the system formats for your collection reconciliations, statements, or documents for the biggest customers.
6. Understand and embed your customers’ operating needs into your processes, from trade planning to billing to fulfillment.
7. Review purchasing agreements and resolve conflicts with your policies and terms. Send product, pricing, and promotion information to the right people, not just generic email addresses.
8. Design easy-to-understand invoices, as Accounts Payable only have a minute to check invoices and use easy-to-interpret trade promotion deal sheets.
9. Do an in-depth audit of the top 10 customers, including (a) policy and process disconnects and (b) deduction experience, abuse, and profits lost.
10. Prepare a detailed customer P&L for your top 10 customers, starting with gross profit and deducting deduction losses. You may not know you are losing money on some of your most significant accounts because of deductions.

A/R Management Software Can Transform Deduction Management

When transaction volumes are high, great technology is the key to performance. You set the strategies, and the system can drive the entire process from cash application through deduction and collection management, eliminating redundant overhead.

For example, consider a system with a flexible rule-based workflow down to deduction type (i.e., return deductions follow a different process than discounts) and configured by the customer (“Wal-Mart” type customers requires a different approach than “mom-and-pop” type customers).

• Cash application will be automated (“auto-cash”) and can match 90% or more of the incoming payments, reconcile the debits and credits, then set up and workflow for exceptions.
• Robotic process automation (RPA) bots will eliminate repetitive interaction with customer portals and transportation carriers.
• Automatic escalation rules are based on the customer, type, amount, or age of the dispute or deduction.
• Automatically reconcile large numbers of credits and debits using custom algorithms to match partial and varied reference numbers.
• Automated validation of trade deal allowance deductions against accruals and deal parameters.
• Fully automated contact controls ensure follow-ups, including autonomous collection emails and letters, are not overlooked.
• The ability to reclassify deductions and problems after research to ensure easy automatic reconciliation.
• Ability to forecast cash collection results and then manage collection activities against that.
• Drill-down reporting for the CFO, Credit, and A/R Management.

Look at state-of-the-art trade promotion and deduction management software, which includes automatic matching and validation of deductions against trade promotion deals. This will give your staff time to handle the most complicated customer issues.

Summary: Have We Made Any Progress?

For all the talk, very little progress has been made over the past two decades. A recent survey by the Credit Research Foundation indicates that deductions continue at up to 10% of sales revenue, about the same as twenty years ago. Some industries exceed 20%.

In addition, the median deduction cycle from receipt to the resolution of deductions is 105 days (45 days to investigate and 60 days to pursue collection if charged back), about the same as in 1995.

A $1 Billion consumer goods company may incur $100-150 Millions of deductions annually and have $20-50 Million tied up in deductions at any one time.

No company can afford to let profits leak away in today’s business environment. Yet some companies lose one-third or more of their profits due to customer chargebacks and accounts receivable deductions (often without realizing the magnitude of the losses). Advanced accounts receivable automation software, once configured to your rules and policies, will guide operations and serve as the guardrails for your A/R deduction initiatives.

Making material headway in eliminating deduction root causes and recapturing excessive deductions will take top management commitment, focus, and ensuring deduction management expertise.

Ready to get started? Schedule your consultation today.