It happens every day; a customer pays an invoice but remits less than what was due. In other words they took a deduction or short paid the invoice.
While some industries use the terms short-pay and deductions interchangeably, there are experts who make distinctions. Deductions occur when your customer disputes the value or quality of the services or goods you provided. A short-paid invoice is related to shipping or tax issues. No matter how the terms are defined, deductions are the bane of Accounts Receivable professionals across the country. Deductions can add up to big dollars and some businesses have reported deductions as much as 10 percent of a company’s gross sales.
The deductions your customers take could very likely indicate internal problems within your organization, such as quality control, lack of communication between departments like AR and sales, poor relationships with your trading partners, inadequate order processing methods, incorrect invoicing, shipping irregularities and problems with order fulfillment.
Some companies automatically write off deductions under a predetermined amount. However, savvy customers catch on and deduct amounts slightly below the thresholds. Others take discounts on terms like 2 percent 10 days even when they pay bills monthly.
Large retailers are implementing more stringent compliance standards. For example, Wal-Mart introduced its Must Arrive By Date program in 2010. Suppliers who fail to deliver goods to Wal-Mart within a four day window more than 90 percent of the time during a month will be automatically docked 3 percent of the cost of goods sold. Since Wal-Mart is a leader in the retail world don’t be surprised if more companies don’t start this type of policy.
Deductions can be divided into three categories: intentional; preventable; and unauthorized:
- Intentional deductions are sales-related and include deductions taken for advertising, mark down allowances, and special promotions. These deductions are considered the “cost of doing business” and are almost always legitimate, so opportunities for recovering any money is slim.
- Preventable deductions are most frequently associated with compliance issues, such as shipping too early or too late or using the wrong carrier. These are easy deductions to stop and a quick investigation will help pinpoint the area in your operation that is failing.
- Unauthorized deductions occur when customers short-pay their invoices because of pricing; full and concealed carton shortages; and returns. These are also deductions which can be prevented when proper oversight is in place.
Solutions to reduce deductions
Review current practices and come up with a best practice goal which is shared with all team members involved. For example, start with order fulfillment. Are the quantities, prices, sizes correct? Were the products and cartons inspected before shipping? Have you met your customer’s compliance requirements for shipping, packing and labeling? Next, review your invoices. Does the document contain a purchase order and invoice number? Are payment terms clearly defined? What about pricing? Is the customer entitled to any discounts, allowances or special promotions?
Deductions can be the result of one or many errors in your company’s processes. So it’s important to analyze, categorize and trend deductions by type, frequency, size and customer. Compiling these statistics will allow you to determine where to focus your recovery efforts, route deductions to the appropriate person or department for resolution, conduct root cause analysis, and establish thresholds for automated write-offs.
Metrics – A key metric in deduction management is Days Deductions Outstanding (DDO). It’s a statistic that illustrates how well or how poorly your company is managing deductions. You calculate DDO by dividing the amount of open deductions by the average value of deductions incurred over the last three months. If your company’s open deductions average $1 million each month and deductions total $2.5 million, you would have 2.5 months or 75 days of deductions open. The lower the number the better.
Cost Benefit – Determining the cost of resolving deductions will assist you with deciding where and when to allocate resources to the problem. You can calculate the cost of researching deductions using the following formula:
Average number of staff members (for all involved departments) who contributed to resolving the deduction = S
Average hours each staff member spent =Y
Average hourly cost of their time = X
Other expenses associated with the resolution =Z
Total cost per deduction = $(S*X*Y+Z)
Customer Profitability – Routine customer profitability analysis will help identify if your habitual deduction takers and how much they cost you. For example a customer who owes a vendor $100,000 sends a check for $93,000 or disputes $7,000 of the total amount due. The deduction has eaten 7% of the company’s margin which could be significant.
Automating the AR Department – AR departments which are still pushing a lot of paper (e.g., paper checks, mailing invoices, etc.) will always be behind in managing deductions. The current AR software available can identify, document, track and route deductions to the person responsible for resolution. The faster a deduction is investigated, the faster it becomes resolved.