Chargebacks and Deductions in the Retail Supply Chain

Challenges to the retail supply chain have followed closely throughout the year as consumer spending is a key barometer of the broader economy.  The combination of skyrocketing commodity costs and continued bargain hunting by consumers are exerting unusual price and margin pressures on retailers. Currently, everyone is eagerly anticipating the results of August sales as chains hope that back-to-school season and tax-free shopping weekends will boost same-store-sales results.  But one topic that you won’t read much about is the on-going battle over chargebacks and deductions between retailers and their merchandise suppliers.  Billions of dollars of waste and inefficiency exist in the retail supply chain, which impact the bottom lines of both parties.  Why the secrecy?

Primarily due to the fact that manufacturers are reluctant to publicly criticize retailers, which represent their largest customers.  There was one high profile case between Sega and Kmart that was highlighted in the New York Times in 2001.  The dispute arose from Kmart’s refusal to pay for $2.2M worth of merchandise shipped in 1999 because of numerous credits and deductions it had issued.  Sega disputed the deductions and filed a lawsuit.  Tensions flared until June 2000 when Sega halted further shipments to Kmart over the unpaid amount.

One of the organizations which studied the issue of deductions extensively is the Credit Research Foundation (CRF).  In 2009 CRF commissioned a study of 700 companies, which found that for companies selling into retailers, deductions represent 2% of outstanding receivables.  For certain merchandise categories the Days Sales Outstanding (DSOs) are even higher.  For example, the consumer electronics segment struggles with deductions representing 4% of AR.  On the other extreme the toys, games and sporting goods segment only has 1/2 to 1% of AR tied up in deductions.

The Three Types of Deductions

Another leading authority on the retail chargebacks and deductions challenge is the Attain Consulting group.  Attain classifies deductions into three categories – intentional, preventable and unauthorized – which correlate with the manufacturer’s view of the problem.

Intentional deductions are expected and anticipated by manufacturers.  In fact, these deductions are proactively offered to retailers with the goal of increasing the revenues of the manufacturer.  Examples include discounts, rebates, advertising and mark-down allowances, which provide the retailer with an extra incentive to promote their products.  Brand owners might use these incentives to try to catalyze sales of a new product line.  Alternatively, they might offer trade promotions to encourage the retailer to provide favorable placement of their products in high-traffic or high-visibility areas of the store.  The use of these techniques has become so widespread that most manufacturers consider these incentives to be a cost of doing business.  Intentional deductions represent 6% of annual sales on average.

Unauthorized deductions are not anticipated by manufacturers, but also have become a cost of doing business for many.  Shortages, returns and price discrepancies are the most common examples, which in aggregate represent 2% of sales.  For example, shortages might arise from a lack of finished product inventory to ship to a customer.  But with more accurate forecasting and demand-driven supply chain practices, manufacturers can optimize inventory to meet customer needs.  Another root cause of shortages is warehouse errors from the picking and packing process.  Again, suppliers can reduce these errors through automation technology and quality assurance.  However, less controllable by the supplier are incidents of shrinkage in which retailer or distributor employees may deliberately remove product from a shipment.


Not this kind of Shrinkage

Also out of manufacturer’s control are returns.  No matter how tightly managed packaging and quality assurance functions are, there will inevitably be merchandise returns from retailers.  For example, consumers may rip open the packaging while inspecting an item in the store.  The damaged product is then returned to the shelf.  Sales staff in the store may deem the opened item “un-saleable” and return it to the supplier for a credit.

Preventable deductions are the category that manufacturers have the most control over.  Preventable deductions are much smaller percentage of revenue than the intentional category, but still a meaningful 2% of overall sales.  These deductions are the result of a supplier failing to properly comply with a retailer’s rules for order fulfillment, carrier routing, container labeling, shipment documentation or electronic commerce.  For example, a retailer might request that all in-bound shipments labeled with a serialized barcode and preceded by an advanced shipment notice to facilitate cross-docking of merchandise through their distribution center.   Each individual item may need to be folded and ticketed with the manufacturer’s suggested retail price.  Failure to follow any of these procedures would result in a deduction against the supplier’s invoice during the accounts payable cycle.  Suppliers have a much greater degree of control over preventable deductions than unauthorized ones.

Example of a legitimate deduction

Examples of preventable deductions include:

  • Late or early shipments
  • No tickets on floor ready merchandise
  • No advanced shipment notice (ASN) or late ASN
  • No UPC barcode or unscannable barcodes
  • Wrong carrier per routing guide
  • Over-shipment or under-shipment
  • Shipped to the wrong location
  • Unauthorized substitutions
  • No retail price or incorrect price
  • No hangers
  • No packing lists

More on deductions and chargebacks in a future post…