Deductions Cause Revenue and Profit Leakage
Surveys show customer deductions comprise 5% up to 20% of gross revenues, depending on the industry, with the highest incidence in consumer products (CPG), which relies on “billback” trade promotion deals. Even if only 10% of these accounts receivable deductions are unauthorized, a $500 million company will be losing millions of dollars of profits. After the expensive resources – often 75% of the A/R department, plus sales department time -required to research, reconcile, and resolve customer deductions, the bottom line takes a double hit. Using best practices in Deduction Management is key to improvement.
A/R deduction management is complicated. It’s easy for customers to make mistakes (it is interesting that errors almost always favor the customer) and easy for them to slip through the supplier’s deduction process. Unfortunately, we also know that more than a few customers take advantage. Regardless of why customer deductions occur, a significant percentage of deductions are too high or outright wrong. Here are a few simple steps to reduce the problem of unauthorized deductions. While most deductions, maybe even 80%, are legitimate our experience is that most debit memos contain errors that, in the aggregate, cost the manufacturers huge profits.
Accounts Receivable Deduction Categories
It’s important to understand the composition of customer deductions. Invalid Deductions include trade promotions not meeting the deal parameters, late discounts, customer returns errors, pricing, shortage, etc. The importance of particular categories varies by industry, but they fall into these general headings.
Trade Promotions, such as bill backs for volume discounts, markdowns, rebates, in-store promotions, coupons, etc. Trade Deals represents the most significant percentage of claims deducted and, like other deductions, has a very high error rate.
Product Returns, which in CPG and pharmaceuticals – health sciences, are huge issues due to product expirations, recalls, etc., and have a typical 10-20% error rate in the customers’ favor.
Preventable Deductions – Process Errors in billing, EDI, and shipping are sometimes systemic and will continue unless the root causes are fixed. Vendor compliance penalties and failure to meet On Time-In Full (OTIF) requirements can cause large profit losses; in some instances, a significant percentage penalty is charged against the entire order.
Unearned Cash Discounts on invoices not paid on time are blatant terms violations that continue unabated because most manufacturers accept and ignore them, creating a self-fulfilling result of more late payments that continue without penalty.
Six Simple Steps to Improve Deduction Management Results
Step 1. Give them Inches; they’ll take miles.
If your company ignores unauthorized deductions, unearned cash discounts, etc., customers will see how far they can push the practices. This includes the small-dollar “threshold” deductions you usually write off because the amounts seem too small to spend time on.
Action: Follow up on even the smaller deductions so customers know that someone is paying attention, plus you will uncover and fix the root causes. Double-check cash discounts and make sure customers have earned the discounts by following credit terms, otherwise prove and collect them and come to an agreement. Otherwise, customer payment habits can worsen, these will become a systemic drip of profits, the late payments will continue uncorrected, and hurt your cash flow.
Step 2. Trade Promotion, Pricing, and ReturnsErrors.
Trade Promotion and product pricing often represent most of the money and require special attention to ensure that trade promotions are correctly interpreted, especially for CPG manufacturers. Because these deals are so significant, the errors also tend to be big. Complexity is the enemy of performance. If discounts, incentives, and timing are hard to understand, you can bet customers will misinterpret them and make payment errors. If your salesmen do not document verbal deals, your deductions – and losses – will skyrocket.
Action: Double-check all prices, terms, and conditions, ensuring that both parties understand the pricing deals. Iron out all differences and get e-mail confirmation or an amended order showing agreement. Second, make sure all deals are in writing and keep all conditions consistent and straightforward to avoid confusion. Third, make certain paperwork goes to the correct person or department.
Action: After Trade Promotions, returns represent the next highest cause of deduction losses in CPG, and in Pharma and other industries, the highest. The challenge is the inability to match and reconcile the variances in large volumes of returns debit memos and credit memos to the granular level of SKU/NDC and price, so you can prove the error and get your money back for the product incorrectly debited. Matching and Reconciliation Automation is the solution to what is often a massive problem and profit loss.
Step 3. Failing To Follow Instructions.
Large retailers have 100+-page billing, packing, and shipping instructions, and they are scrutinizing the orders for every violation and deducting any oversights. Substandard packing and subsequent merchandise damage are other sources of deductions. For many companies, vendor compliance violation deductions amount to 1% of revenues.
Action: Build the customers’ vendor compliance rules into your systems and processes and instruct shipping department employees to follow retailer instructions to the letter, even if you have to modify your practices to meet the demands of your top customers. It could be that a simple change such as label re-positioning could save you big bucks.
Step 4. Deduction Resolution and Collection Proactivity.
If you wait to take action until deductions or payments are 30 or 60 days past due, it only encourages customers to pay late, which will kill the cash flow. Worse, the customers will take unauthorized deductions when they pay late.
Action: Streamline or automate your collection process, reducing delays and unproductive paper shuffling to keep on top of past due accounts. Use automated workflows to manage unauthorized deductions and payment disputes so nothing gets overlooked. A little vigilance goes a long way, and the sooner you resolve problems, the faster you will improve cash flow. If you find your company resources overwhelmed, outsource your collection of unauthorized deductions. Both large and smaller customers keep track of how you follow up and adjust their payables rules accordingly. They behave better with proactive monitoring.
Because they are hard to work, deductions often go stale before they are researched, or documents turn up missing, memories fade, etc., and you will end up with write-offs. Act promptly and consistently, and you will have a significant impact on your company’s results.
Step 5. Measure Performance and Results
If you do not track your performance or have a plan, you probably won’t get far. The standard KPI of Deductions Days Outstanding$ is important, but you might also want to consider tracking the number of deductions (Deductions Days Outstanding#).
Since the most important metric of all (why else are you doing all this work) is the value of invalid deductions identified and collected, we use what we call the Deduction Efficiency Index.
Step 6. Focus on Outcomes, Not Costs.
Big companies have “offshored” deduction processing to exchange higher-priced labor with low-priced labor (often called “labor arbitrage”), but in the process lose even more significant financial “outcomes,” the bottom-line of which is the (i) identification/reconciliation and then the (ii) collection of the invalid deductions. The labor savings of offshoring pale in comparison with the potential profit recovery from excessive deductions.
Deduction outsourcing is worth consideration, and most certainly for backlogs. Studies show that handling unauthorized customer deductions can take 75% of accounts receivable resources, and the fully-loaded cost is hundreds of dollars spent per deduction. And even worse, if you use sales reps to track them down, it eats up 10% to 30% of their time.
A professional accounts receivable deduction management service can clean up backlogs and recover aging deductions that would otherwise be written off, and suggest process improvements to streamline your operations. Even minor improvements can yield impressive results, but a complete audit and recovery program can yield big results and patch holes in your cash flow process.
If you choose the right firm, they will have genuine expertise in the field and include advanced automation with matching, reconciliation, and collaborative workflow systems that streamline the entire accounts receivable, collection, and deduction management process.