Accounts Receivable Deductions: Still A Plague On Profits
February 9, 2023
February 9, 2023
Over the past two decades, corporate order-to-cash processes have received investments of billions spent on consultants and software, with the aim of streamlining transaction processing with customers.
The results, however, are that at the bottom line, customer deduction losses have not been reduced, and the process has gotten even gotten 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, depending on the industry, up to 5-15% of revenues.
To understand the profit impact of customer deductions, consider a $1 billion retail-channel supplier with a net operating margin of 10% and experiencing a typical 9.7% ($97 Million) customer deduction rate. Of the 9.7%, questionable deductions may total a third, which is also about a third of the net margin, which leaves a significant profit improvement opportunity.
Chain retailers, especially, have invested in technology that has created an even more significant problem for many smaller suppliers since few can comply perfectly with their major customers’ technology and purchase order requirements.
Deduction processing is labor intensive and complex since deductions result from a panoply of business problems and misunderstandings. It starts in the cash application function, which should convert the customer deduction reason codes to standard supplier codes, failing which it is 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, which often requires the participation of other departments. These departments may include sales, distribution, finance, transportation, marketing, pricing, etc. It’s a labor-intensive process.
Few companies track the true cost of customer deductions since the expense is distributed among so many departmental budgets. Those who look at it closely will be surprised at its magnitude.
There is the potential for a significant payoff from managing deductions, but achieving it requires expertly configured accounts receivable deduction software automation plus staff with industry know-how. The fixes include identifying and correcting the root causes of systemic problems and customer disconnects and, more directly, recapturing the deduction profit leakage through the reconciliation of excessive deductions, which can more than outweigh the costs of the entire process.
The broad customer deduction classifications are Trade Practices, which are largely unavoidable, Preventable under the supplier’s control, and Customer Error.
The financial impact of deductions varies by industry, with businesses having the most trade promotions or complex supply chains having the highest incidence of deductions. There are “high-dilution” industries that plan to incur deductions of more than 15% of revenues because of heavy trade promotion bill-backs or the markdown 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:
The supplier must carefully investigate all deductions to sort the valid from the invalid so they can 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 profits.
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.
It’s easy to blame the retailer or distributor for using deductions as a budgeted profit item.
Still, the root of most deductions goes back to supplier inattention to purchasing rules or internal failures of one sort or another, as well as long-standing industry practices. Customer errors can also be significant and tend to increase if not consistently counteracted.
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.
While there may be individual success stories, offshoring customer deductions 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.
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.
Track deductions using Deduction Days Outstanding (DDO) separately from Days Sales Outstanding (DSO), which is 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.
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 per day, the DDO-N = 60 days.
The A/R department spends up to 75% of the A/R personnel researching and managing deductions. We employ the DEI as a critical KPI metric to track bottom-line results of recapturing the losses in customer deduction errors.
To determine the DEI every month, compare the total deductions vs. the deductions found to be incorrect vs. the collected deductions. Do this by category (returns, shortages, discounts, trade promotions, etc.) and track your company’s progress.
Years ago, it was common to arbitrarily write off masses of deductions against available credits, an ultimately counter-productive and bad idea for many reasons. Auditors largely stopped this practice; customer deductions must properly be handled individually today.
Further, sellers discriminating in the provision of trade promotion allowances — compensation for advertising and other services — may be violating 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.
Transparency and accountability are the watchwords for corporate management, and CFOs are demanding compliance.
While certain types of A/R deduction categories like legitimate trade promotion chargebacks are, in fact, “a cost of doing business,” there remains plenty of profit leakage in the categories 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 so that no monetary recovery value is lost. 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.
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 Software as a Service (‘SaaS”) system with flexible rule-based workflow down to deduction type (i.e., return deductions follow a different process than do discounts) and customized by the customer (a Wal-Mart requires a different approach than mom-and-pops).
Look at our 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.
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.
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.
In today’s business environment, no company can afford to let profits leak away. 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 both guide operations and serve as the guardrails for your A/R deduction initiatives.
However, to make material headway in eliminating deduction root causes and recapturing excessive deductions, it will take top management commitment, focus, and ensuring deduction management expertise.