Archive for January, 2010

Reducing Mark Downs, Charge Backs, and Deductions through ERP

January 21, 2010

When you hear the term deduction, you may think of the HR Dept. which administers medical deductions or 401(k) contributions that are deducted from an employee’s paycheck, and remitted to third party administrators. But this article focuses on Accounts Receivable (AR) deductions, sometimes known as charge backs, and mark downs, for various B2B transactions, which can be a major drag on profitability.

These types of financial deductions are common among Manufacturers, Supplier/Distributors, and Consumer Packaged Goods (CPG) companies which develop, manufacture and supply products to retailers, who in turn sell to the end-user consumer. A deduction occurs when the retailer, for whatever reason, decides to short-pay the invoice from the supplier.

Generally, there are three types of deductions. Authorized deductions, often in the form of trade promotions from the supplier, can occur if the retailer meets certain incentives, such as ordering so many products by a certain date. The supplier then provides discounts in the form of authorized deductions. They’re authorized, welcomed, agreed to by both parties, and foster business partnership.

Penalty deductions occur when mistakes are made, and the supplier is penalized by the retailer for not correctly fulfilling the order, or meeting certain requirements. Some examples might include damaged goods, shipping the wrong Stock Keeping Unit (SKU), the wrong amount, or missing the deadline. As a penalty for non-compliance, the retailer extracts a deduction as a form of compensation for the mistake.

The third type is an unauthorized deduction. Often misrepresented as a supplier mistake, some retailers attempt to coerce better deals through trumped up charges, or exaggerations, faulting their suppliers for dubious mistakes. The supplier, thus, did not authorize the short pay, but their options may be limited unless their ERP system is up to the task.

Deductions dilute receivables but are generally a preventable leak, even as retailers regularly rely on them to bolster their own bottom lines. Particularly as more retail power is aggregated among big players like Walmart, Best Buy, and Home Depot, they are more apt to win bigger concessions from their suppliers, who dare not risk losing an important customer. In an economic downturn, retailers may use deductions aggressively. But in an upturn, the supplier may be more apt to ignore deductions because they need not jeopardize a relationship when times are good.

Trade promotions are often vulnerable to deductions because they can become too complex to administer or interpret. The sales rep may promise a deal to the customer, but fail to communicate it accurately to their finance department. The finance department may not have an easy way to track the promised promotion, which leads to errors, and more deductions. Without tight integration between marketing, sales and back-end accounting, and without clearly defined, easy to understand promotions, deductions will result.

Additionally, without an integrated system to create, administer and track promotions, it can be very challenging to research and contest deductions. The resolution process is often manual and paper-based, therefore time-consuming and prone to errors.

Suppliers and Manufactures will often automatically write-off deductions that are under a certain threshold, because the time and effort required to research the claim, and negotiate a settlement, can outweigh that effort. The sophisticated customer may also attempt to determine that threshold, so automatic write-offs occur, as another way to capitalize on potential cost savings.

To address this increasingly vulnerable profit leak, a company must align its people and processes, from better promotional planning, to order-to-cash execution. Sales & Marketing must align their promotions with finance, so discounts, delayed discounts, and accruals can be tracked and administered correctly. Demand forecasts must be communicated back to the supply chain, so they can deliver on promised timeframes. Information on customer pick, pack and shipping procedures must be captured in the ordering process to ensure error-free order fulfillment.

If and when a deduction does occur, despite these steps, Finance needs the flexibility to assign ownership for research and resolution to the most appropriate department, whether it’s sales, customer service, credit or collections. Finance, Sales and Marketing also need to be able to determine customer profitability, not only including deductions in that calculation, but the costs associated with resolving them as well, so they can better align their promotional efforts back toward their truly, most valuable clients.

Other important considerations would include a single, common, customer database shared among all the departments, with flexible workflow, and an integrated order to cash, and order fulfillment process. Flexible reporting, and profitability analytics, such as capturing important metrics like Days Sales Outstanding (DSO), preferably delivered in a real-time dashboard, are equally important, and critical to identifying deduction trends in order to ward off future dilutions. Deduction management is a critical step to elevating the profitability and competitiveness of the enterprise.

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Warren Buffett and the Business of Life – Summarized

January 13, 2010

I just finished The Snowball, Warren Buffett and Business of Life, by Alice Schroeder. It’s a fascinating study, and a pretty fast read despite the 700+ pages, of the life and development of probably the greatest investor of our time who in 2008 became the richest man on earth when Berkshire Hathaway stock reached $140K/share. Here’s a brief summary of his business life, and investor evolution, sans his odd marital arrangement, social life, kids, friends and extended family, that become the bedrock of his persona, and minus his interesting life experiences transcending the bigotry common to those times. You will have to read the full story for those details.

It starts out revealing the strength of Buffet’s inner resolve, or his inner scorecard as he describes it. Back in 1999, most value investors had given in and bought technology stocks, seduced by their increasing run-up in price, and the frothy Internet-hyped environment. Buffet describes himself as always having been an “inner scorecard guy.” As a result, he was able to resist the temptation to participate in the internet bubble despite much criticism at that time. He was more concerned with his own personal values, based on his true investment principles, rather than trying to appeal to broad opinion. An outer scorecard guy, on the other hand, is always more concerned with how the outside world perceives him.

Warren learned from an early age the power of compounding, and was forever struck by a meeting with Sidney Weinberg, CEO of Goldman Sachs back in 1940, when at the age of ten, Warren accompanies his father, Howard, then a banker/broker at the Omaha National Bank, on a trip to Manhattan. Warren admired the lifestyles of these Wall Street brokers, and how one of its most powerful men treated this wide-eyed boy with such reverence. Not long after this encounter, Warren reads 1000 ways to make $1000, which emphasized starting now, and the power of compounding. Warren wanted to be rich, and live like the men on Wall Street, but he had to start earning and saving now, so that the power of compounding money could have the greatest effect.

Buffet began to think of time in a different way because compounding linked the present to the future. A dollar today could be worth ten dollars tomorrow if managed properly. At the tender age of 12, Warren had scrounged and saved $120, to the great amusement of his family, and decided to invest it all in 3 shares of Cities Service Preferred for himself and his sister Doris, simply because it was a favorite stock of their father. At first, the stock dropped from $38 to $27 before eventually rebounding to $40, where Warren quickly sold it. But eventually, Cities soared to $200 per share. Buffett said he learned 3 important lessons from this experience, which he still recalls as one of the most important episodes of his life. First, don’t dwell on the price you pay for a stock. Two, don’t rush to grab a profit. And three, if he made a mistake investing someone else’s money, they might get mad at you as his sister did when the stock first dropped. So, don’t invest someone else’s money unless you’re sure you can succeed.

As a high school teenager, Warren is blessed with analytical capabilities, and a love of all things statistical and math. He was also an avid reader of successful business men such as Jay Rockefeller and Andrew Carnegie. As an enterprising young teenager, he makes money delivering newspapers, collecting lost golf balls at the golf course for re-sale, and even wading into the golf ponds after hours to find more of them. He repairs and refurbishes broken pinball machines and entices local barbershops to install them by offering to split the proceeds with them 50/50.

Warren was socially awkward, somewhat introverted, and a year younger that most of the students in his class, having skipped half a grade. He spent more time reading the The Daily Racing Form, and following horse races, studying the probabilities of each horse winning the race, than he did chasing women, who made him very nervous. Warren eventually realized he needed to be more social, and remembers one of the most influential findings of his entire life, discovering Dale Carnegie’s book on How to Win Friends and Influence People. Warren desperately wanted to be loved and popular, and he relished practical systems that he could practice and follow. Now he had his human relations bible to live by. Rule one, don’t criticize, condemn or complain.

Warren graduates from high school 16th out of a class of 350 students, writing future stockbroker under his yearbook picture, and goes on to enroll at the University of Pennsylvania. After breezing through UPenn, Warren returns to Omaha and applies to graduate school at Harvard, only to be rejected based mostly on his interview. Harvard wasn’t interested in stock-pickers, but having recently read Benjamin Graham’s “The Intelligent Investor,” he enthusiastically applies and is accepted to Columbia Business School, where his emerging idol, Benjamin Graham, is now a professor.

Graham preached that a stock’s intrinsic value was the price per share if you sold off all the assets, minus the liabilities, which left you with the company’s equity or net worth. Eventually, Graham felt a stock’s price would reach its intrinsic value. From Graham’s class, Warren learned 3 important principles:
• A stock is the right to own a little piece of a business, and a stock is worth a fraction of what you would be willing to pay for that business.
• Use a margin of safety. Investments are built on estimates and uncertainty. A wide margin of safety ensures that the effects of good decisions are not wiped out by errors
• Mr. Market is your servant, not your master. Mr. Market’s moods should not influence your view of the price. However, from time to time, Mr. Market does offer the chance to buy low and sell high.

After Columbia, Warren returns to Omaha to work at his father’s brokerage firm, and begins selling GEICO stock to friends and family, one of his favorite bets at that time, the early 1950s. But Warren immediately grows uncomfortable with the conflict of interest of selling stocks based on commission, which could compromise his buy & hold preferences.

Buffett’s prayers are answered when his college idol, Benjamin Graham, reverses his earlier decision, and allows Warren to join his investment firm based in NYC called Graham Newman. Warren begins to develop his own investment strategy which diverges somewhat from that of Graham in regard to diversification. Benjamin’s approach, in an attempt to maximize the margin of safety, invests small portions in many stocks that meet his investment criteria. He calls these companies Cigar Butts because they sold at a big discount to net assets and were good for about one puff before unloading them. He spent less time on the quality of the investment itself, and more time aggregating many stocks that met his criteria, and taking small positions in each one of them. Graham’s ideas of diversification were extreme, and Warren preferred to take much larger positions in fewer stocks. He had complete confidence in his own abilities to determine a worthwhile investment, as exemplified by his early success in GEICO.

Warren dabbles successfully in arbitrage at Graham Newman on Cocoa Bean futures, following Jay Pritzker’s investment in Rockwood, a chocolate maker based in Brooklyn. But he eventually found it more profitable to simply follow Jay Pritzker’s lead, and invest directly in shares in Rockwood, just as Pritzker was doing, an investment strategy Warren coins as coatailing, or unabashedly following investment ideas learned from other investors like Jay and Ben.

By 1956, at the age of 62, Benjamin Graham was tiring of investing, and wanted to move out to California to pursue his true loves of art, music, women and leisure. With the firm Graham Newman winding down, Warren decides it’s time to branch out on his own, and moves back to Omaha to start his own partnership based on the Graham Newman model called Buffet Associates, started with seven partners on May 1, 1956. He devises a formula to reward his upside gains based on investment results, not commission, and similarly penalize himself personally for any downsides as well.

A major turning point in Warren’s growth as an investment manager came in 1958 in the form of an under-valued company called Sanborn Map. Sanborn published detailed maps of power lines, water mains, building engineering, and emergency stairwells for all the cities in the US. Its customer base was shrinking as insurance companies merged, but its stock price was cheap at $45/share even though its investment portfolio was worth $65/share. To get a hold of that investment portfolio, Warren needed to raise more capital not only from his partnership, but from individuals outside the partnership as well.

Warren wanted the Sanborn board to distribute the investment portfolio to the shareholders but they refused, and Warren decided he needed to wrest away control of the board by accumulating the stock himself, or attracting more investors in the stock who were more amenable to his way of thinking. Eventually, the board capitulated, forced by Warren’s hand, and this ushers in a new investment strategy in Buffet’s evolution, enabling him to exert a more active role in how a company is managed.

Dan Cowin, another Graham disciple in Buffet’s network, brought him a textile maker in New Bedford, MA called Berkshire Hathaway, because it was selling at a discount to the value of its assets. Buffet wanted to buy it, and liquidate it, or tender the shares he acquired back for a profit. Through an apparent slight by the owners, Buffet decides to build an equity stake with the intention of acquiring a majority position, which he completes in 1965. The original investment in the textile maker itself becomes a dog as local textile mills migrate to cheaper labor and lower productions costs elsewhere in the country. But eventually, Berkshire morphs into the mutual fund like behemoth that is today, representing the pooled investments in all of Warren Buffet’s holdings.

Berkshire Hathaway invests in many companies along the way, from Coca Cola, to Clayton Homes, a mobile home manufacturer, to General Re and Swiss Re, reinsurance companies, and to PetroChina in 2008. Johnson & Johnson, Proctor & Gamble, Travelers, JP Morgan, Goldman Sachs, NetJets and ConocoPhillips are just a sampling of the many prominent names in his portfolio.

In 2004, Warren correctly predicts the downfall of the dollar because he felt Americans were over-consuming vast amounts of foreign manufactured products on borrowed money. US debt and government spending were all increasing, a harbinger of bad things to come. Buffet complained they were spending over two percent of US income just to pay interest on our national debt. Warren wisely puts his money where his mouth was by purchasing $12B of foreign currency to hedge Berkshire’s dollar risks.

In 2008, Buffet begins referring to the derivative market as “financial weapons of mass destruction.” As the financial crises unfold, Berkshire Hathaway with their enviable financial strength and AAA rating is poised to rescue many businesses at advantageous rates. He gives $150M to Sealed Air at 12%; $300M to Harley Davidson at a 15% interest rate; $300M of ten-percent contingent convertible senior notes from USG; $250M of Tiffany bonds at 10%, and a $2.7B, 12% convertible stake in Swiss Re. These aggressive investments at the height of the financial crises, coupled with his statesmanlike appearances on CNBC, proclaiming his confidence in the US economy, helped stabilize the markets and positioned Berkshire Hathaway as one of the great benefactors of any turnaround in the economy.

For me, as an avid stock investor, the most interesting part of this story is Buffett’s evolution as an investor, from his early years as a value hunter, seeking under-valued asset plays, to his modern day transformation which included big contrarian bets, often presciently before the heights and depths of the markets. Additionally, Buffet had a great appreciation for enduring American brands such as Coca Cola, Proctor & Gamble and Johnson & Johnson. From the evolution of Warren’s investment philosophy, to his adoption of the Dale Carnegie edicts, to his extreme discomfort and avoidance of confrontation, and to the types of friendships and qualities he valued, as he fostered long-term business relationships based on honesty, integrity, unequivocal trust, and dedication, this story reveals a fascinating portrait of how this vulnerable, humble, self-deprecating, and didactic man not only became the richest person on the planet, but ultimately reached the decision to give away the bulk of his fortune.