What is a deduction in accounts receivable?

What is a deduction in accounts receivable?

A deduction is the most difficult type of an open item in accounts receivable to resolve or deal with because most of the departments of an organization are involved in various degrees. The customer takes the deduction according to their policy and procedure and now it is up to the organization to prove whether they are right or wrong.

It happens almost every day; a customer makes payment of an invoice but remits less than what was due. In other words, we can say that the customer took a deduction or short paid the invoice.

The word short paid invoice and deductions are used interchangeably. However, there is a thin line of difference between the two. Deductions occur when the customer argues about the quality or price of the goods or services delivered by the organization. A short-paid invoice is generally related to shipping or tax issues. Deductions are the burden of accounts receivable.

The deductions your customers take could possibly be the outcome of internal problems within the organization, such as communication gap between various departments like accounts receivable and sales, quality control, pricing strategy, poor relationship between trading partners, error in an invoice, irregularities in shipping, inadequate order in processing methods, inadequacy in order fulfillment.

There are some companies which automatically write off deductions under a predetermined amount. However, some customers are smart enough and they deduct amounts slightly below the predetermined amount of the deduction estimated by the organization.

Deductions are broadly divided into three categories: intentional deductions, preventable deductions, and unauthorized deductions:

Intentional deductions

Intentional deductions are related to sales and include deductions taken for special promotions, markdown allowances, and advertising. These deductions are generally considered as ?cost of doing business? and so the chance of recovering any money is less.

Preventable deductions

Preventable deductions are normally associated with compliance issues, such as wrong timing of shipping like too early or too late, using the wrong carrier. It is comparatively easy to stop these deductions and a thorough investigation will help to find flaws the operations of the organizations.

Unauthorized deductions

Unauthorized deductions occur when your customers short-pay their invoices because of quality, pricing, wrong packaging, shortage of full and concealed carton, and return policies. It is possible to prevent these deductions with proper oversight of the situation.

How to reduce deductions?

It is not hidden that deductions put a negative impact on accounts receivable and therefore it becomes largely important to reduce deductions. By reviewing current practices with proper analysis and investigation and come up with a best-practice goal which is shared with all departments and team members involved. For example, first of all, start with the fulfilment of the order. Properly check the quantity, price, size, manufacturing and expiring date of the product. Properly inspect the product and carton before shipping. It is utmost important to comply with the requirements of the customer regarding shipping, packaging and labelling. Next, review the invoice of the product whether all the details regarding the product are correct like purchase order, invoice number, price, quantity, size, quality, etc. Mode of payment should be clearly defined. Is the customer is entitled to any discounts, allowances or special promotions?

Deductions can be the result of one or many problems in the organization?s processes. So it is important to analyze, categorize deductions by its type, size, frequency, and customer. All these details will help the organization to put its efforts in the right direction. Root cause analysis should be carried out to find out the errors and corrective actions should be taken to recover.

Deductions preventive tools

Metrics ? An important metric in deduction management is Days Deduction Outstanding (DDO). DDO is a statistical tool that tells whether the company is managing deductions properly or not. DDO is calculated by dividing the number of open deductions by the average value of deductions incurred over the period of last three months.

Customer Profitability ? Daily customer profitability analysis will help the organization to identify habitual deduction takers and how they cost the organization.

Automation of Accounts Receivable Department ? Accounts Receivable department still involves a lot of paperwork which will always keep the AR department behind in managing deductions. The current Accounts receivable software can be used to identify, record, track and route deductions to the person who is responsible for resolving this issue. The faster a deduction is investigated, the faster it can be resolved.

Cost-Benefit ? By determining the cost which will incur in resolving deductions will assist in deciding when and where to properly allocate the resources to solve the problem.

Responsibility for handling deductions

The responsibility of investigating customer deductions rests with the credit department. Deductions are treated as bane and distraction to the business rather than viewing it (deductions) as a warning bell that something is wrong within the organization and it is the time to fix it. If deductions are seen only as a collection matter of money, the organization here is being neglectful towards its customer relationship and responsibility.

Credit department is responsible for resolving deduction. But the credit department is not responsible for controlling and resolving the underlying problem that is causing deductions. Other departments or areas such as sales, traffic, distribution, customer relation, quality, production, etc., must be held accountable for their mistakes causing underlying problems.

The objective of dealing with deductions in accounts receivable

  • Promptly write-off justified claims of customers.
  • Obtain payment for deductions taken erroneously by your customers.
  • Promptly supply customers with correct facts, figures, and documents to make corrective adjustments in a reasonable amount of time.
  • Eliminate the mistakes done within the organization and poor decision making.

How to detect deduction problem

Identify ? It is important to identify the problem either by using a manual system or automated system, depending on whichever system the organization is using.

Quantify ? It is important to quantify the problem after having accumulated the deduction. Quantify the deductions by its type, by amount, by customer.

Analyze ? After having quantified the problem, now analyze the problem. Analyze the deductions and compare it with the per cent of sales that took place for the entire company, and also compare with per cent of sales per customer, and against the previous year to understand the trend prioritize by customer or important or priority types of deductions.

Benchmark ? Now benchmark your deductions against your company. And this can be done by comparing your company?s volume of deductions against your company.

Deductions are obvious to happen but then it depends on the company how they use preventive tools to reduce deductions and thereby complying with customer requirements.