The Administration of Customer Deductions

CRF thanks Darrell Dockery, CCE, for his assistance with this section.

In many cases, a sizable portion of the buildup in trade receivables can be attributed to the growth of unresolved customer deductions and invoice disputes; and these claims are taking too long to investigate, process and collect. If your company sells its products to mass merchants, grocery stores, the government, drug stores, department stores -or just about any type of retailer- you have deduction problems. Various industry studies have revealed that 5% to 15% of all invoices were affected by deductions, amounting to 4% to 10% of all open items on accounts receivable. This is a major problem, and it continues to grow. As the retail environment continues to consolidate into fewer and larger “power” retailers, these customers are becoming more and more aggressive with their deductions. The retailers are taking deductions for any “infraction” of their terms and conditions or routing guides that are included on their purchase orders, an activity that is now termed vendor compliance. This has lead to the establishment of customer profit centers by the name “vendor compliance”. These departments have assumed a great significance in the buyer/seller relationship. Notably, it is impossible for any vendor to abide by the variety of all customer’s terms and conditions. However, the onerous task of identifying, validating, and controlling the problem has been shouldered too often by areas within the organization that generally have neither the resources (information) nor accountability (authority to make changes) to manage this troublesome problem.

A deduction is the hardest type of open item in accounts receivable to resolve because most departments in your company are involved in various degrees. The customer takes the deduction based on their policy and procedures and it is up to you to prove they are wrong or right.

Responsibility for handling deductions

Ironically, the responsibility for the investigation of customer deductions often rests with the credit department. Since many organizations do not approach deductions analytically, and often react out of confusion, deductions are treated as a distraction to their business rather than viewing them as a warning sign that something within the operation is wrong–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.

While the credit department is often charged with the responsibility of deduction resolution, it is not within its control to cure the underlying problems causing them. Other areas such as sales, distribution, traffic, customer service, production, quality, etc., must become accountable for their misjudgments and mistakes.

The overall objective of the entire organization in dealing with deductions is to:

  • eliminate internal mistakes and poor decision making;
  • promptly supply customers with facts and documents which will enable them to make adjustments within a reasonable amount of time;
  • obtain prompt payment for erroneously taken deductions;
  • promptly write-off justified customer claims

How to identify and quantify your deduction problem

  • Identify the problem–If you use a manual system you must compile the deductions by check, by customer and by type of deduction. If you use an automated system you should run programs or queries to identify the deductions in the same categories. See below “Tracking deductions to identify trends” on the importance of identifying deductions by type.
  • Quantify the problem–After you have accumulated the deductions, you should quantify the deductions by type, by customer and by dollar amount.
  • Analyze the problem–After you have quantified the problem and narrowed the focus to deductions by customer (in dollars and number) and by type (in dollars and number), separate the deductions by year and month. Analyze the deductions versus percent of sales for the entire company, versus percent of sales per customer, and against the previous year to identify trends and prioritize by customer or priority types of deductions.
  • Benchmark–Benchmark your deductions against your industry. This can be accomplished by comparing your company’s volume of deductions against your industry. These statistics are frequently a topic of industry discussion groups. Also, CRF periodically updates a survey, Customer Deductions: Impact on Receivables which illustrates by industry a variety of statistics on deductions. Benchmarking will help you quickly identify your largest problems and provide you with a list of priorities.

After you have quantified and benchmarked your deduction problem against the industry the next steps are to find ways to reduce or eliminate certain types of deductions. You will never be able to eliminate all deductions as this has become a way for retailers to reduce staff by putting the burden of proof for deductions on the vendor.

According to the Foundation’s report, 85% of deductions are valid in whole or in part. However, deductions take a large proportion of your resources to investigate because many departments are involved with the root causes of deductions. Sales, marketing, traffic, returns, shipping, receiving, advertising, order entry, customer service and manufacturing are all involved with the causes of deductions. The largest causes of deductions are (in order), pricing, returns & refusals, advertising & promotions, lost and damaged goods, and concealed shortages. This will vary from industry to industry but these are based on the national average.

Most deductions involve a perceived violation in a commitment from the vendor to the customer, either implied, oral or written. If the commitment (usually a P.O., order acknowledgment or sales contract) is not in writing and very detailed, a lot can be lost in translation — thus causing deductions. Based on CRF’s study, if your company’s revenue was $100 million, you 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.

Tracking deductions to identify trends

There are many ways to track deductions, the most successful manner is to segregate deductions by type. If you have a manual system, it means keeping the deductions of the same type in a separate folder. If you have an automated system, it means using different transaction codes or numbers for different types of deductions. Some examples would be ADV for advertising deductions, RTN for returns, DIF for destroyed in field, PRC for pricing, etc. Another way is to identify by number i.e., 01 for returns, 02 for pricing, 03 for advertising, etc. Either way, you can generate reports or queries by customer or by transaction code/type to determine who the worst offenders are for each type of deduction. This is invaluable information when you are negotiating with the customers on claims. If a particular type of claim is out of line with a large number of customers it would seem there is an operational problem that needs addressing.

Your cash applicators must be consistent in assigning transaction codes/types. On the remittance advice sent with the checks, most customers will tell you what they are deducting. Customers use codes to identify their deductions which is how they track your company’s “vendor compliance” with their orders. For example, code 06 would be advertising, 01 would be an invoice, 02 would be a return, etc. If you get your remittances via electronic funds transfer (EFT) the codes would be a part of the transmission. Get a listing from each major customer or make a notebook of the transaction codes/types used to help cash your appliers identify deductions.

Tracking deduction notes

Deduction notes can be used to track deduction resolution progress and to distribute valuable data to affected departments. These notes could be mailed to the customer asking for backup, for repayment or they could be investigated by the departments for validity. If valid, a credit or journal entry could utilize the note as backup for a credit memo to clear the deduction. Some companies do not create paper notes, they are charged back to the customer and a reference number is assigned for follow-up. There are several companies that provide software for managing deductions on a mainframe, a personal computer or network.

By tracking notes it becomes apparent that you have problems with certain customers. By identifying these customers and types of deductions, you are able to calculate the cost of deductions to this customer by using days sales outstanding, and/or reports indicating dollars that are tied up in deductions (see Appendix 1).

Using these procedures will allow you to concentrate your resources on the types of deductions that are tying up the highest percentage of your accounts receivable, allowing you to prioritize your deductions by value and quantity.


Once you have identified and prioritized your deductions, you need to identify the cause of the deductions. Most pricing deductions are caused by differences in price between the customer’s purchase order and your invoice. Why is the price different? Does the customer have correct pricing in their system? You should ask for the customer’s Vendor Profile. This profile will list your prices, your package size, your weights, your method of shipping, your terms of sale, your remit to address, and your vendor number. If any of these are wrong, your pricing is going to be wrong or your payments will be delayed. It is best to review the vendor profile with the customer during a visit to insure the changes are made. However, you might have to work through your sales force to accomplish this task, and affirm that the pricing error is not due to the sales persons miscommunication. If this is a chronic problem, it should be brought to the attention of sales management. If the sales person is commissioned based on dollars billed, an adjustment must be made to the commission on the original invoice.

The best way to approach the myriad of deductions, is to form a team within your company to visit customers and negotiate agreements to waive or change requirements of the customer’s terms and conditions of sale, or their Routing Guide. The team should include representatives from credit, customer service, EDI, shipping, returns, sales and advertising. The customer’s routing guide details how everything should be shipped, in what size boxes, at what time of the month, by what carrier, how to label, how to pack, etc. Any deviation from this routing guide will produce a deduction for Vendor Compliance Violations. All customers have different requirements, so there is no way your company can accommodate all vendor requirements. The main purpose of the team is to identify the requirements that cannot be met and to offer an alternative or get a waiver from the requirement. The wavier agreement must be in writing and be part of the vendor agreement. It is the most important part of the prevention process.

After you have established policies and procedures the results should start to show quickly. Evaluate the hours of work and costs that are related to enforcing the policies and do a cost analysis to find the amount of deductions that is acceptable for your company. You will never get rid of deductions entirely, but you should reach an acceptable and cost effective level.


EDI (Electronic Data Interchange) and EFT (Electronic Funds Transfer) are tools that will reduce deductions if they are used correctly. Electronic order transmission from customers allows your company to audit prices and terms at the point of entry into your system. You could install a policy that rejects wrong prices or terms. You could then advise the customer to reenter the orders correctly. EFT allows you to audit payments as they are received from the customer to identify problems that are noted on the checks as deductions. The transmissions usually classify deductions by type and amount. Many types of AR software can apply the deductions and cash automatically by using this electronic data.


If it is not cost effective for your company to pursue the investigation and collection of deductions, there are companies that provide a service that will audit and collect your deductions. They usually charge a percentage of their collections but you might negotiate a flat rate to handle all deductions. Some of these companies are:

IAB Solutions

Reasons for outsourcing

  • assistance in evaluating the current deduction situation and help with establishing a plan to organize and control the work
  • reduction in staff — the current staff level cannot adequately handle the research and/or collection required to maintain satisfactory result
  • a significant acquisition that will strain your current resources
  • a new product launch that will increase workload
  • a significant backlog that will require temporary help
  • a temporary “spike” in deductions due to creative marketing programs
  • to reduce fixed expenses (personnel and benefits)

Value Added

Deductions are a way of life for the retail industry. However, your success in controlling them is often aligned with your significance as a vendor. Whenever possible, use customer visitations on a regular basis to discuss ongoing deduction issues. Also, review the forms and documents sent to customers such as order acknowledgments, invoices, chargeback notices and system generated letters to be sure they are clear and easy to read. Be sure your sales force understands your company policies and procedures. They are the “front” person who can prevent many deductions by properly communicating your company’s policies and procedures to your customers. As the person responsible for deduction control, you may have to lead the charge to determine the true profitability of an uncontrollable customer.

Appendix 1 is a model of a Sales Performance Analysis. This type of analysis, done at a customer level, will help you determine the profitability of the customer. At a salesperson or sales division level, you may find policy abuses, or profit drains that can be rectified by management.

Reporting to management

As a rule, most organizations chargeback unauthorized or unidentified deductions at cash entry (either automated or manually) to balance a customer’s remittance to their account. Some companies automatically approve an adjustment or write-off at the time of cash entry if the amount deducted is within an established tolerance. This tolerance may be adjusted for such factors as gross margin or cost/benefit analysis; but, must be reevaluated yearly. Like other matters that may reflect on price breaks, the tolerance level must be applied uniformly to all customers.

An important aspect in the management of deductions is knowing where you are, and how you are doing. As previously mentioned, reports at each month end that break out chargebacks by type (returns, pricing/billing, transportation, advertising, etc.) with an aging by type are often helpful in seeing how serious a problem the company has. When possible, these reports should be done on a consolidated basis and broken out by sales division to show possible product problems, selling irregularities (untrained sales personnel), or operational problems within a business unit or sales division.

Appendix 2 is a model of a report that summarizes total open chargebacks (the billed back deductions) and illustrates by month, their relationship to the total amount past due. This relationship of chargebacks to total past due is significant because chargebacks generally have no dating or grace period and therefore are past due the day after they are created. Some companies might find it more useful to substitute the total past due column for the total A/R or use a rolling twelve months sales (assuming most chargebacks are within a year old). The method an organization decides on to conduct its analysis becomes an individual preference; but the important point is that such an analysis be done routinely and in a consistent manner.

In the model presented, it would appear that the company has made some progress in controlling the deduction problem since the dollars of open chargebacks have declined. However, a more thorough analysis reveals that the average dollar amount per chargeback has increased over 25 percent from the previous year. This could be an aberration caused by one, or a few, very significant deductions driving the average amount up, or it could be an overall increase in the amounts deducted, indicating some sweeping problem in the business. Deductions are sometimes viewed as a customer’s report card of your operation. Any perceived inequities or injustices by the buyer, manifests itself in a deduction penalty.

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