Why Operationally Excellent Companies Manage Their Channels on a Sell-Through Basis

Technology OEMs and other product companies that go to market via distributors, VARs, and resellers often recognize revenue and manage their business based on what's known as a “sell-in” basis. This means they book revenue as soon as product is shipped to the distributor's warehouse. They may take a small reserve to account for returns or back-end discounts. While this is acceptable and consistent with Generally Accepted Accounting Principles (GAAP), it can expose a company to many channel challenges and issues — including but not limited to inability to track real margins, having too much or too little inventory in the channel, rebate overpayments, commission overpayments, and the reality of little or no partner pipeline visibility.

For these reasons, companies that emphasize operational excellence increasingly are managing their channel on a “sell-through” basis, even if they continue to use sell-in for accounting purposes.

Sell-through vs. sell-in

Generally, manufacturers recognize revenue either when products are delivered to distributors (sell-in) or when distributors resell products to end-users (sell-through). It is becoming more common – but not necessary — for channel-centric companies to recognize revenue on a sell-through basis. Revenue is not considered earned as long as the distributor retains the right to return the goods, or the sale price is not “fixed and determinable” – which happens more often than not in the channel. This is the case in many high tech product markets, where the ultimate final price can vary due to manufacturer rebates, discounts, price protection, and other partner programs.

Sell-in is easier, but can mask problems

OEMs have access to sell-in data in their ERP systems. Manufacturers ship product to a channel partner and book the quantity and price as revenue and take a reserve. They also pay volume incentives and sales commission on this revenue. If you stop here, you can get into trouble.

The first question that usually comes up is how to know that the correct reserves have been taken. Is too much or too little reserved? The company also then needs a way to relieve the reserves based on sell-through.

The second issue is that by paying commissions on shipment to distributors, you may be creating an incentive for channel stuffing.

A third question is if I pay volume rebates on sell-in, how do I account for returns and any further discounts that I might give the distributor? A similar question arises for the value of revenue that the organization has paid sales commissions on. Essentially, that translates to paying on revenues the organization did not get!

So what's the answer?

The answer, of course, is paying attention to sell-through. OEMs generally don't know what happens in the channel. In order to gain some understanding, they require their distributors and resellers to periodically (typically weekly or monthly) provide POS (point-of-sale) and inventory reports. POS reports include the products that were sold by the partner during the period, including the price. Inventory reports are snapshots of inventory position for a specific point in time. Distributors also submit claims for any back-end discounts (e.g., ship & debit, SPA, and price exceptions) that need to be paid.

All this information is then collected and collated and used to determine what the sell-through rates, return rates, and inventory positions are. It can also be used to validate back-end discount claims. Volume discounts and sales commissions are then paid net of the back-end discounts. This information can then be fed into various business analytics and business intelligence engines to get a complete picture of the channel.

This information is also used to re-calibrate reserves at the end of each reporting period, usually monthly.

Sounds good, right?  Well maybe …

Stay tuned for the second article in this series for some potential problems and how to avoid them.

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