Thursday, February 14, 2013

Financial accrual calculations 101

This is the latest post from The Revitas Exchange

Financial accrual calculations:
challenges and solutions
Most companies, whether in life sciences, manufacturing , technology, oil and gas, or food service, to name a few, pay rebates to their distributors and customers in order to help facilitate the flow of their product through the supply chain. While the types of rebates and conditions for earning them vary by industry, every organization using rebates has to reckon with financial accrual calculations, which can present challenges to both their operational efficiency and their bottom line if not managed properly.

This post will dig into financial accrual calculations -- what they are, how they work, the problems with the process today, and what companies can do to shore up their bottom line.

What are financial accrual calculations?

The financial accrual process is a component of the gross-to-net process that companies use to see what components drive their gross sales down to net sales. Financial accrual rates are often calculated by the finance department to forecast the rebates and incentives that the company is expecting to pay as a result of selling its products.

Financial accruals help account for future rebates at the time of the sale so that a company can smooth its bottom line reporting. For example, let’s say a manufacturer sells its product to a customer for $1,000. The full amount isn’t counted as direct revenue because the manufacturer has to factor in deductions -- for example, $450 for chargebacks/ship and debits/billbacks (the term depends on your industry), and an additional $300 in direct and indirect rebates. It doesn’t know when the chargeback/ship and debit will be submitted, but it knows that, based on history, the wholesaler will likely submit them. In addition, the direct or indirect rebate might not be due until the quarter after the sale incurred -- or longer. As a result, finance teams record an expected $750 in chargebacks and rebates that will eventually be paid as a result of the sale, so they only show $250 in revenue for the period when the $1,000 sale was made.

Issues with financial accrual calculations

Finance teams run into issues when they sell through distributors since they don’t know where the product is going to end up. Instead, they need to project what they will need to pay in rebates and chargebacks based on historical information as well as forecasted sales activity. In some cases, the finance team might over-accrue for the rebates and sometimes they will under-accrue. While under-accruing for rebates creates more financial exposure than companies expect, over-accruing for rebates is almost as bad, as it results in lumpy earnings reports.

The process today

Today, most finance teams export data from various sources, including their rebating system, into intricate Excel spreadsheets. From there, they manually manipulate the data to forecast the rebate percentage that each sale will generate. In my conversations with several manufacturers across different industries, these finance teams spend several weeks each month calculating the percentage that they need to accrue, and then they manually enter the rates into their ERP system to actually record the accrual.

Once everything is entered, they spend the rest of their available time monitoring the accruals and the actual payments to make sure the difference between the two isn't too far off. The process is like the Wild West and reminds me of the early days of rebate calculation in life sciences, when calculations where performed in Excel. Any small mistake can be deadly.

The alternative

While some software providers are starting to emerge to help manufacturers with their accrual process, many solutions lack the integration needed to transform the way organizations see and perform their accruals. The best solutions integrate with ERP systems to eliminate manual entry and automatically calculate financial accrual rates based on historical data.

We will be hosting a product council on financial accruals to share our thoughts and vision for this exciting and underappreciated area. While not confirmed, the tentative date is set for March 27th and we are currently looking for companies to participate and share their current processes. Check back here or subscribe to the blog for the official announcement!

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