Regardless of how a tech OEM selling through channels recognizes revenue (sell-in or sell-through), they should manage and incent channel players on a sell-through basis. Also, regardless of revenue recognition methodology, they have to continuously recalibrate reserves at the end of each month, for future discounts and possible returns. The only way to do this is by collecting and processing data (POS, inventory, claims) directly from channel partners, since these data are not internally available to the OEM.
Well, this is where things get really interesting. Leaving aside the mechanics of collecting and normalizing data formats, let's explore some other complexities which tend to multiply as the number of product SKUs, distributors, and channel programs grow.
Selling Chain Scenario
Tech OEMs typically ship large quantities of product to stocking distributors over multiple orders. These are often at different prices. This is especially true for markets like semiconductors or consumer electronics. Prices vary due to negotiated upfront discounts, product aging, seasonality or other market conditions.
Let us consider the case of an OEM called Acme Widgets making shipments to a new distributor Rhino Tech at different prices, as shown below:
- Invoice #1: 1000 units @ $120 ea. = $120,000
- Invoice #2: 5000 units @ $115 ea. = $575,000
- Invoice #3: 3000 units @ $122 ea. = $366,000
- Weighted Avg. Price: $118 ea.
- Another data point: Current Price (from Price Book): $121 ea.
Sometime later, OEM Acme Widgets receives a POS report from distributor Rhino Tech, which provides the following information:
- End Customer: Zeb Comp
- Product: SKU #456
- #Units: 2,500
- Resale Unit Price: $150
- Extended Resale: $375,000
- Unit Credit: $10
- Extended Credit: $25,000
They also report that they have 7,000 units of SKU #456 left in stock at the end of the reporting period.
Some key questions:
- Question 1: How should we value the POS transaction? The Resale Price - while interesting - is not the price on which to calculate revenue and incentives.
- Question 2: How do we know the quantities reported in Rhino's POS and Inventory report are correct?
- Question 3: How do we know that the back-end credit being claimed is correct? Once again that has a material impact on revenue and incentives.
- Question 4: What should we pay sales commissions on? Do we dare bring up commission splits?
Let's explore these one at a time.
How do we value POS & inventory?
So what is the value of the 2500 units reported in the POS transaction to Acme? Should it be valued at the current price? Latest ship price? Earliest ship price? Median price? Weighted average price? Getting the valuation right is important, since this is the value Acme will use to pay commissions to sales reps and volume rebates to Rhino. Similarly, the value of the remaining inventory needs to be calculated, since that is what reserves are based on.
Here are the results we would get using the various methods described above:
Current Price: (2500*$121 ea.) = $302,500
Latest Price: (2500*$122 ea.) = $305,000
Earliest Price: (2500*$120 ea.) = $300,000
Weighted Avg. Price (2500*$118 ea.) = $295,000
However, from an accounting perspective, the most correct way to deal with inventory movement is to assume that inventory moves on a First-In-First-Out (FIFO) basis. So the way to value the 2,500 units is to assume that 1,000 units came from Invoice #1 above and the remaining 1,500 is from Invoice #2. So the valuation works out to:
(1000 units * $120 ea.) + (1500 units *$115 ea.) = $292,500
So we can see that not using the correct methodology to value the transaction can lead to significant errors, especially if you multiply this error out across tens (or hundreds) of thousands of POS transactions and hundreds of SKUs per month!
There is a similar issue with valuing inventory remaining in the channel, which also needs to be valued on a FIFO basis. We'll leave that as an exercise to the reader.
Are the distributor reported quantities correct?
The only way for Acme Widgets to make this determination is to do an independent reconciliation by using information that can be trusted. This is typically known as Inventory Rollforward or SISO (Sales-In-Sales-Out) Reconciliation. The trusted pieces of information are Beginning Inventory and Sales In (invoice data) and the ending inventory from the previous period. We compare this to what the partner reports:
- Beginning Inventory: 0 (because we assumed this was a new distributor)
- Sales In: [1000+5000+3000] = 9000 units
- Sales Out: 2500 units
- Reported Ending Inventory: 7000 units
Here's what the reconciliation would look like:
- Calculated Ending Inventory: [Beginning Inventory] + [Sales In – Sales Out] = [0+(9000-2500)] = 6500 units
- · Ending Inventory Variance = [Distributor Reported Inventory] – [Calculated Inventory] = [7000-6500] = 500 units
As can be seen from the example above, Rhino's reporting is not consistent. Distributor Rhino Tech is overstating either sales or ending inventory. The 500 units are worth about $60K at current prices ($121 each). Depending on how material $60K is to Acme's business, Acme would have to make a decision on whether to raise this with Rhino or accept the reported numbers.
Before Acme decides to ignore this variance, they might also consider the possibility that Rhino purchased the extra quantities from another distributor. If this is the case, it is very likely that this other distributor would report the sales out in their proof of sale (POS) and additionally claim some back-end credits. In that event, Acme might end up double-counting sales out, double paying back-end credits and double-paying commissions. Just something to think about!
Are we overpaying back-end credits?
OEMs often provide incentives and discounts to help partners move inventory out to end customers. This often takes the form of ship & debit or special pricing credits, which are paid out when the distributor provides proof of the sale (POS). A distributor then submits a claim to the OEM to receive the credits.
Using our earlier example, the claim is actually embedded in the POS. Rhino is requesting $25,000 in credits. Once the quantities and valuation have been established, using methodologies above, Acme could choose to take the distributor's word for it and pay out the claim, or they could choose to further validate the claim (our recommended approach). Typical attributes that would be validated on a claim such as this, against the original Special Pricing or Ship&Debit Agreement (aka SPA), are:
- End Customer (Is Zeb Comp, same as Zebra Computers from the SPA?)
- SKU (Is this SKU covered by the SPA?)
- Unit Credit (including step/tiered credits)
- Minimum or Maximum Quantities (Have appropriate thresholds been hit or crossed?)
- Transaction Date Ranges (Was this transaction within the allowable dates?)
There is at least 10 to 15% overpayment of channel incentives in the high tech, according to Accenture. So it really behooves Acme to perform these additional validations before paying out the credits.
Did we mention that doing the validations and valuations described above is the only way to calculate your Effective Gross Margin? Effective gross margin represents the true margin by including the cost of goods sold and related selling and promotional costs.
What about commissions & splits?
As you might imagine, best practice is to pay commissions on actual realized revenue and not on phantom ("hoped-for") revenue. So it goes without saying that commissions should only be paid on the value of the transactions after they have been SISO-reconciled, FIFO-valued and net of any back-end credits. Anything short of that would be phantom revenue.
Wait! What about commission splits among several sales people and distributors who contributed to a sale? We'll leave that whole discussion for another day.
This is way too complicated... Let's put our heads back in the sand
The complex nature of tracking and validating product as it moves from the OEM, through channel partners, all the way to end customers may make some folks throw up their hands and opt to just go back to tracking sell-in data. But there's too much at stake for such an approach.
That's why best-in-class companies have opted to deal with these issues head on. They have had their large and sophisticated IT departments build custom applications to automate the processes described above. Alternatively, they've chosen a more efficient route by partnering with a SaaS solution provider.
Either way, even though corporate finance may report on sell-in basis, sales leadership and business unit managers rely on sell-through to truly understand the effective gross margin on products, orders and distributors. They trust but verify. They have automated validation workflows to prevent revenue leakage and gross margin erosion.
And they make better decisions.
Driving a better top & bottom line
By taking a sell-through approach, we've seen companies add three to five percent to their top line without selling one additional unit! For a $500M revenue company, that's an additional $15M a year, straight to the bottom line. Others have seen an even larger ROI. These levels are consistent with a study published by Accenture last year.
But the biggest benefit is the culture and process – a true understanding of channel performance at all levels, and where to focus to get the biggest bang for the buck.