Payment deductions, also known as chargebacks or short pays, happen when the customer pays less than the full invoice amount. They occur because a customer does not receive your product or service as ordered, or feels the invoice is incorrect. Should you confirm that the customer is indeed correct, the deduction is removed from the Accounts Receivable (AR) ledger via a credit memo. If not approved, there should be an attempt to collect the disputed amount to avoid diluting profits, and if not collected, the deduction should be cleared by a bad debt write-off.
This all seems fairly straightforward, doesn’t it? Well, it’s not.
Many firms incur a substantial volume of deductions. A large number of deductions involve relatively small dollar amounts that can “fly under the radar.” Large or small, many deductions also require significant time to research. Adding to the pain, 80 to 95 percent of the time, the internal investigation will determine that the deduction is valid. The major challenge with deduction handling is that at best a lot of work will only generates marginal benefits.
Please feel free to share this newsletter with your small business customers . . . it just might help them pay you sooner!
Halt Profit Dilution
Here’s an example of the benefits of effective deduction management. A $350 Million Medical Products Distributor had no formal Deductions Resolution Process. Deductions were not addressed but left to age to 180 days, then written off. To improve the situation, this firm instituted a formal deduction resolution process. As a result their focus moved from items that were over 90 days old to processing all deductions in under 30 days. They also improved the tracking and reporting of open disputes by responsible party. The results:
Recovery of over $500K of invalid deductions (pure profit)
Over 90 day receivables reduced by 70 percent
DSO reduction of 16 percent
This case study also illustrates the cumulative effect deductions can have on profits and cash flow. Quite simply, unresolved deductions create a mushrooming problem that can sabstantially dilute profits.
There’s another danger with not addressing deductions promptly and letting them accumulate. Once a customer takes a deduction they consider the issue closed. Contesting the validity of the deduction several months after the fact is annoying to customers, often dismissed, and usually unsuccessful.
The Impact of Deductions
There is nothing good we can say about deductions. Here’s a summary of the problems they cause:
Up to a 2 to 3 percent gross margin erosion
Huge productivity penalties to Cash Application, Collections, Customer Service, Sales, and Logistics resulting in higher costs and/or reduced performance
Elevated AR — total and past due
Serious degradation of the Customer Experience
Employee frustration and even burnout
Potential over-statement of financial results (net sales, profit, assets,) and large one-time hits to earnings to clear backlog of aged deductions and disputes.
Not a subscriber … why don’t you take advantage of a free YVCM subscription?
9 Hacks for Handling Deductions
Why not just assign adequate resources to this problem, utilize a best practice process, measure the improvement, and so forth? Again, it’s not that simple.
As illustrated, deduction resolution can consume an inordinate amount of resources. Here are some ways to reduce the volume of deductions while conserving your resources:
The key to deduction management involves identifying and eliminating their root causes. As previously noted, the vast majority of deductions are valid. That means they are being caused by system weaknesses or other problems in the supplier’s order fulfillment process. This means your deduction resolution activities, must involve identifying recurring deduction types, so the root causes can be isolated and corrected. For example, recurring deductions of the same amount implies a price discrepancy that can be easily fixed pre-billing. Over time, such an approach will reduce the volume of deductions. One company that took a Six Sigma approach to eliminating deductions realized a 15 percent improvement to DSO.
Save time and effort by establishing a dollar threshold below which you will automatically write-off the deduction without performing any research: The higher the threshold, the greater the reduction in volume to be researched. Be aggressive: researching individual deductions can consume $50 to $100 of labor costs because many of the issues will require responses from key managers and your sales team. Another client reduced the number of deductions to be researched by 40 percent by raising the small balance write-off threshold. They realized a huge labor savings well in excess of the marginal 2 percent of deduction value that may have been recovered. In large organizations with high deduction volumes, the optimal write-off threshold can be several hundred dollars.
Negotiate with Customer to move deductions off invioce. If damage and shortage deductions comprised 1.1 percent of all sales to a customer, try granting them a 1.1 percent discount off your price in return for their not taking any shortage or damage deductions. The principal behind this involves taking deductions “off invoice” — in other words settle the issue apart from the payment process. Trade promotions are often taken as deductions, but are better managed as separate transactions.
Identify customers taking a disproportionate number of unauthorized deductions: Deal with them directly about their practices. If you have offered the customer trade promotion credits and they regularly abuse the terms of the promotion, stop offering them the promotions you offer other customers. You have to be tough with abusers.
Prioritize deductions to be researched: Deductions should be grouped by customer and deduction type. They can then be prioritized by value and probability of recovery. Here a few insights to help with prioritization:
If a customer takes one of your credit memos twice, it is easy to document this and secure reimbursement. Those types of deductions are relatively easy to resolve.
If the customer claims they received only 47 cartons in a pallet instead of 48, it is almost impossible to prove them wrong. In this case write it off and move onto a deduction you have a reasonable chance of recovering.
When there are recurring deductions of the same amount, something’s wrong — find out what it is and fix it
Compliance Issues are self-inflicted deductions that result in penalties or fines because the supplier did not adhere to the buyer’s delivery requirements — everything from labeling issues to how many boxes can be stacked on a pallet to delivery windows.
Ensure you have the right people researching and resolving deductions: The first qualification is liking deductions research and an attention to detail. The second is knowledge of your Order-to-Cash process.
Implement a best practice process flow: This should cover the creation of the deduction in the cash application process through to its clearing from the AR Ledger. Key attributes are:
Tracking of deductions from creation to clearing
Routing deductions to “resolvers” who are positioned to research deductions quickly and efficiently (e.g., sales tax deductions should be routed to your Sales & Use Tax expert, not Logistics, while pricing issues should be routed to sales administration, etc.)
Set Time limits to clear deductions and Escalation protocols: If a deduction is not resolved within parameters it should be routed to the next higher authority for action
Measure the operation and results. Key metrics are: deduction volume incurred and volume cleared in a month, backlog (volume and age) at month-end, number and value of those deemed invalid, number and value of invalid deductions collected.
Deduction Management Workflow Software: If your deduction volumes are substantial (this is a likely situation if you are selling consumer products to retail chains), you should consider investing in deduction processing automation. The major ERP systems have useful applications for identifying deductions. There are, however, several excellent Best-of-Breed applications on the market that will automate and accelerate most of the deduction resolution process, delivering enormous productivity gains as well as increased recovery of invalid deductions. These applications employ Robotic Process Automation (RPA) and Artificial Intelligence (AI) to automate most operations previously performed by humans. They also have advanced analytics capabilities which accelerate improvement in Order Fulfillment and reduce the number of deductions incurred.
Outsourcing: There are also a number of firms that will perform deduction research and resolution for you. This requires them to connect with your ERP and/or AR systems to download transaction data as well as possibly place their employees on your site. Setting up an outsourcing partnership may require a significant one-time investment of your time as well as continued monitoring and modification. It can be an excellent long term solution in the right situation as well as a short term fix to get a deduction backlog under control. Remember, you outsource the activity, not the accountability.
Your Virtual Credit Manager stands ready to recommend deduction management software or outsourcing vendors that will fit your needs. We can also assist you in overcoming specific deduction processing challenges impacting your organization.
Some Things to Consider…
If your customers take a significant number of deductions, it is a problem that cannot be ignored. Even at lower volumes, the impact of deductions over time will involve a significant reduction of your profit. It’s something like death from a thousand cuts.
As with any business operation, deduction handling will benefit from good policy, process and people. Given its high volume/low return nature, deduction handling effectiveness can be substantially enhanced by technology driven solutions at all but the lowest volume levels.
The Key Metric of Deductions Resolution Success is the value of invalid deductions collected vs the cost of your deduction resolution efforts. When estimating the cost of deduction resolution, in addition to the cost of direct deduction resolution staff, add the portion of the cost of Sales, Customer Service, Logistics, Collections, etc. staff who also contribute to deduction resolution and recovery. The income should always exceed the cost.
If it doesn’t, and attempts to increase recovery are not successful enough, then reduce the amount of effort and cost in the resolution. One common, quick way to do this is the raise the value threshold of deductions that are automatically written off, enabling effort to be focused on the larger value deductions that will provide a larger payback.
With interest rates rising, we expect suppliers to see an increase in deductions, especially those that are price related, even more so after a price increase. The best defense is concise contracts and pricing schedules. Where deductions are concerned, ambiguity breeds abuse.