Driving Value (and Money) Out of "Deductions"

Attention Finance Leaders – particularly in the CPG industry: Some Non-Core metrics usually not considered in Disputes/Deductions management performance are surprisingly important – because deductions can range from 5-15% of revenue for CPGs, due to the large trade promotion campaigns required to attract consumers. The What: Based on industry averages, customer deductions could range from 5-15% of revenue for the CPG industry, mainly due to the large trade promotion campaigns required to attract consumers. The Why: It’s about time that organizations start to focus on some of these non-metric but critical aspects of the business, which influence the value chain. In addition, managing deduction also has an impact on the corporate wallet by way of large back office expenses. The How: While measuring core performance metrics reflects the health of deduction processing and profit leakage thereof, it does not really help reveal the driver(s) for these metrics. A look into some behind the scene factors (termed non-core metrics) helps understand these drivers. One non-core metric is the way enterprises define their corporate policies around shortage notification, returns, write off, etc. Others include Cross Functional collaboration, Contract Compliance, Trading Partner relationships, Team Organization, etc. The article talks about the impact of each of these non-core metrics on business performance and process efficiency in the form of an example by comparing Company A to Company B. The Impact: Streamlining internal policies, procedures and leveraging industry practices could potentially improve cash flow from end customers as well as reduce the expense of policing deductions where the customer is correct 90% of the time. Deduction Management: Looking Beyond Core Metrics Over two decades in the industry, Order-to-Cash has been a key function and candidate considered for shared services & outsourcing. This is primarily due to the transactional nature of activities in this business function. While there are multiple case studies available on how the performance of end-to-end metrics can be or has been improved over the years, not much attention has been given to aspects beyond the obvious metrics for which the shared services or outsourcer is accountable; in other words: metrics and their variants do paint a picture that is useful to a wide variety of stakeholders but they are far from the only dimensions of enterprise performance that are valuable to the C-Suite. Reviewing certain non-core elements like corporate policies & practices, team structures, end customer scorecards, accountability of other corporate functions, etc, could perhaps fill this gap. This article will discuss the relevance of these elements for one such OTC sub-process: Dispute/Deduction Management. As we know, customer deductions remain an intractable problem causing revenue and profit dilution, and it’s about time organizations start to focus on some of these non-metric but critical aspects of the business which influence the value chain. Managing deductions also has an impact on the corporate wallet by way of large back office expenses. According to industry averages, customer deductions could range from 5-15% of revenue in the CPG industry. This is a common problem for the consumer goods industry as it is driven by large Trade Promotion deductions. Based on CRF's study, if a company's revenue was $100 million, it would have $10 million (10% is midpoint of range) in deductions. Again, using CRF statistics, 85% or $8.5 million would be allowed and $1.5 million would be unauthorized. Significant staff time is required to investigate the claims and bill back the differences to customers. The probability of collecting this amount is increased if you actually bill back (invoice) the customer for the differences rather than just sending letters, which do not demand as much attention. The fact is your company may be its own worst enemy by actually creating deduction problems. To get a quick understanding, deductions can be classified under the following categories: Business Practice - Trade promotions, allowances, coupons, discounts, markdowns etc. Avoidable Internal Errors - Shipping delays, billing, order entry, EDI, Pricing errors, fines for compliance violations (i.e., mis-labeling of packages), shortages etc. Unauthorized Customer Abuse - unearned prompt payment discounts, post audit claims, duplicate deductions, price mismatch, etc. Root Cause The root cause of deduction problems can be traced back to many departments inside a company. Consider the following demand generation’s Impact on the order to cash cycle. Imagine it as a chain, and each daily operation within the chain as a link. A deduction means that one such link has broken, and when that happens it impacts the whole cycle: Improving communication and cooperation between sales, operations, and finance would yield good benefits for companies in the long run. To resolve deductions, a concerted effort is required between these functions to nail down what is valid or invalid. None of the above deduction types are initiated by the credit collections department. Ironically, the responsibility or the investigation of customer deductions often rests with the Accounts Receivable department. Since many organizations do not approach deductions analytically, and often react out of confusion, deductions are treated as a distraction to the business rather than viewing them as a warning sign that something within the operation is wrong – and then taking the opportunity to fix it. If deductions are viewed as a collection matter only, the company is being neglectful of its customer relationship and responsibility. It is a customer satisfaction issue first, and an accounts receivable issue second. Core & Non-Core Metrics Benchmarking Tracking and benchmarking both core and non-core metrics helps unravel the underlying strengths and weaknesses in a company’s potential to optimize deductions resolution. If benchmarking indicates competitive limitations, then amending these would be a step in the right direction and a catalyst for change. Oftentimes, benchmarking helps convince a reluctant audience that refuses to accept a point, especially when it comes to changing policy and practices. A recent CFO research report highlights that companies that benchmark are more likely to standardize their order-to-cash processes in the next two years, compared with companies that make limited use of benchmarks. The survey also points out that many companies are willing to devote substantial resources to order-to-cash process improvement. Out of those covered in the survey, about 71% have an automated means of tracking customer satisfaction, which is the most well tracked order-to-cash measure. By comparison, invoicing/billing errors, unearned cash discounts, and preventable deductions are the least well-tracked order-to-cash-related measures. This further confirms the need to benchmark deduction-related elements, as tracking measures is just one part of the story. Companies need to understand where they are in comparison to their peer group. A deduction is the hardest type of open item in accounts receivable to resolve, because most departments are involved in various degrees. Customers take the deduction based on their policy and procedures and it is up to the vendor to prove them right or wrong. The core metrics used to reflect the performance of deductions are as follows: Deduction Days Outstanding Cycle time to process deductions (APQC) Percentage of annual deductions written off to revenue Deductions as a percentage of Accounts Receivable (CRF) Number of FTEs managing deductions "per $1billion revenue" (APQC) or cost of deduction function as a % of revenue. The above metrics indicate the end result reflecting the health of deduction processing but they do not reveal what’s driving these metrics. A deeper dive into some behind-the-scene factors (non-core metrics) helps us understand what drives these metrics. Let’s look at how some of these non-core policy and procedural elements impact the performance, efficiency and eventually the core deduction metrics. Industry- CPG S.No Non-Core Metric Company A Company B 1 Auto Write off Threshold $400 $200 2 Shortage Notification Policy 3 Days 5 Days 3 Returns Policy 1 Year 2 Year 4 Post Audits Non Existent 2 Year limit 5 Bad Debt Reserves 50% 100% 6 Write Off Practice 100% after 365 Days No standard practice 7 Team Organization By Customer By Deduction Type 8 Cross Function Collaboration Routine Ad-hoc 9 Policy Enforcement Stringent Lax 10 Time To Submit Chargebacks Claims 12 Months Max No fixed limit 11 Customer Relationship Routine Limited 12 Contract Compliance Collaborate Regularly Limited 13 Treatment of unresolved customer claims Chargeback to business or department Impact to corporate P&L Now, let’s understand the details of the elements mentioned above. Based on the table above, Company A seems to be inefficient when compared to Company B and there is opportunity for Company A to adopt industry practices for the criteria mentioned and move towards similar performance as Company B. The interesting point to note is that there is no relation to Advertising or Trade Payments – key deduction types used to drive business growth. That, in the true sense, is the cost of doing business, as you need to attract customers to buy your product. Advertising has not been considered in the comparison above. Let’s understand the reasons for this, below: 1. Write Off Thresholds – If there is a higher minimum threshold for writing off deductions, the AR analyst would have fewer transactions to review compared to a lower threshold. A higher number of transactions will get adjusted automatically, either through the system or manually with minimal effort. This becomes critical when the volume of transactions is high which is true for the CPG industry. However, it’s important to know the end customer’s behavior to safeguard against the practice of abusing the threshold limit by deducting the threshold amount from every invoice. 2. Shortage Notification Policy – Many companies have a shortage policy whereby they direct customers to notify them of a shortage within a specific number of days (e.g. 3 days) post, which they refuse to honor the deduction and it is considered invalid. Such a policy drives customer behavior and pushes accountability to ensure they are active in resolving their claims. In the case above, company A is stricter than company B and hence drives the right behavior for end customers. This metric is relevant when the manufacturer is responsible for delivery of products vs. the customer carrier. In the case of customer pick up, it becomes important to pinpoint when the ownership is taken and who is responsible for the shortage – e.g. Concealed Shortages. 3. Returns – Usually, there is a duration threshold for raising claims and disputes. This could range from 6 months to 1 year, after which no claims are entertained by the vendor. Some companies also provide adjustable rate allowances for unsellable products to push the sale of slow moving products; this also helps in reducing claims from customers. In the example above, Company A would be able to manage deductions more effectively than Company B, as their returns policy has a shorter duration. As a result, it becomes an obligation for customers to manage their internal processes quickly if they want a credit for returns. 4. Post Audits – Having a clearly defined post audit policy restricts customers from making disallowed claims. If there is no policy, as is the case with Company A, customers will make one on their own. End customers should be reminded of the post-audit policy on a regular basis. This can be mentioned on invoices, in EDI agreements, customer statements etc. There is a greater chance to collect on post-audits if a policy exists that clearly articulates the cut off timeline, and documentation required to allow the claims. 5. Bad Debt Reserves – The amount of reserves a company keeps on a quarterly basis is a function of how effectively their AR department is able to resolve invalid deductions. If the trend shows collection of 50% of invalid deductions, quarter on quarter, the company may decide to reserve for only 50% of the outstanding deductions balance. As a result, there is more liquidity available for other business needs. Company A has a lower reserve % compared to company B, and hence is able to better manage business needs. 6. Deductions Write off Practice – If deductions remains uncollectable after a period of time, it is written off against the provisioned reserves. The usual practice amongst CPG companies is to write off deductions over 365 days, as it is unlikely that a customer would be interested in talking about a deduction after a year. As a result, it’s important for the deduction analyst to complete proper due diligence within in the first year. The efforts by the deduction analyst to collect a deduction >1 year may not be a good use of their time; and perhaps this time could be more effectively spent on managing current deductions. History tells us that most customers generally pay as agreed. When there are deductions against payment, customers are right more often than they are wrong. A standard write off practice ensures appropriate reflection of the AR sub-ledger, and drives focus on activities that could be influenced. As we can see in the example above, the effort and time spent by the deductions analyst for company B would be higher as they continue to chase deductions regardless of their age. This could potentially lead to frustration amongst the AR group. 7. Team Organization – The deductions team is usually organized in a couple of ways and each way has its pros and cons. Some companies organize this function by way of top retailers and distributors, while others arrange by the type of deduction to build experts. Creating an organization structure by customers would give the team an opportunity to learn all types of deduction and act as the single point of contact for the end customer. In the other case, a deductions analyst becomes an expert (for shortage, advertising, chargeback, etc.) over time, with different customers, and understands the nuances to resolve a particular dispute type. However, this could lead to customer satisfaction issues, where one customer is contacted by multiple people for different types of deductions. 8. Cross-Department Collaboration – A closely-knit approach amongst various functions is what makes resolution of deductions effective. Regular meeting cadence and routine collaboration goes towards ensuring all stakeholders are aware of their respective roles and responsibilities to close disputes. 9. Policy Enforcement – Effective administration of corporate policies is another element that cannot be ignored. It is important for organizations to drive the right behavior to ensure policy and procedures are adhered to by end-customers, as well as internal teams. Lack of governance on this front could result in customers getting away with invalid claims. In addition, organizations should frequently review the market dynamics and adjust their corporate policies to be aligned with the industry. 10. Chargeback Claim Notification – Many companies impose a time limit beyond which a chargeback claim would not be honored. A policy like this could potentially detract end customers who are not serious about sending their claims. In turn, this also helps the customer, as their Accounts Receivable ledger would look clean. Usually this time limit is 12 months. This is similar to the Post Audit policy described in point #4 above. 11. Customer Relationship – The frequency of personal interaction with end customers is critical to reducing invalid deductions and improves the cycle time for resolution. Some companies routinely visit their end customers to discuss and collaborate on effective ways of working. This is also a good opportunity to deep dive into complex unresolved claims that have not been resolved in the past. 12. Contract Compliance – Similar to point # 10 above, it is important to negotiate contracts in advance by understanding specific customer requirements. This would help limit updating the contract after a deduction is claimed. In addition, there should be routine collaboration between the manufacturer and end customer to understand additional aspects that may change during the life of the contract. 12. Unresolved Claims – How a company handles unresolved customer claims is key to inculcating the right culture within the business. Some organizations charge back unresolved claims to the sales function vs. letting it impact the corporate profit & loss account. This brings in accountability from the sales function, which sometime needs to have tough conversations with end customers to recover on invalid deductions. Conclusion The economy of the 21st century requires organizations to understand that economic changes in the market affect the business landscape and can possibly change the customer base. Policy and procedures should be reviewed at regular intervals to align with organizational goals. The strategic challenge companies face is, "how much expense do I want to incur to police deductions where the customer is correct 95+% of the time?" A deductions team should collect (recover) at least the amount of their cost and hopefully more, so they pay for themselves. One important potential source of added value to note is that the deductions team could also be instrumental in identifying gaps in upstream processes that result in deductions and eventually reduce the overall volume. [eventpdf] References:- CRF Deduction Survey, April 2012 CFO Research Made to Measure Report, 2012

Driving Value (and Money) Out of "Deductions"

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