AUG 17, 2001 Manufacturers Fight Retailers' Discounts for Faulty Shipping By CONSTANCE L. HAYS arlier this year, Sega (news/quote) of America Dreamcast, which makes computer games and the machines to play them, went to court, suing one of its biggest customers over a $2.2 million unpaid bill.

Sega contended that although it had delivered some $25 million worth of Dreamcast consoles and other items ordered by Kmart buyers to its stores around the country, the Kmart front office had refused to pay for $2.2 million of them because of "numerous credits and deductions which were not authorized" and were disputed by Sega. Kmart declined to comment on the dispute because of the pending legal matter.

The deliveries were made in 1999 and last year, according to the lawsuit, and by June 2000 Sega had halted further shipments to Kmart over the unpaid amount.

Sega's lawsuit was a rare public eruption of what those in the retail business say is a broadening undercurrent in their industry: stores charging their suppliers for all kinds of supposed infractions on the receiving end, ranging from late-arriving trucks to wrongly placed bar-code labels to incorrectly dangling tags on clothing and boxes that are unloaded out of order. By some estimates, retailers charge back as much as 10 to 15 percent of certain types of purchases, which can make a huge difference in the bottom line of suppliers affected by the practice.

Manufacturers are reluctant to discuss specific charges because they usually are still doing business with the retailers in question. But now, with most businesses suffering from the slowing economy, manufacturers large and small say they are being squeezed harder than ever. And new charge-back permutations have emerged, like the reopening of old accounts to claim fresh deductions.

"Doing business with the department stores has gotten worse over time, and I think it's in correlation to their balance sheets," one clothing manufacturer said. "It is a major, major thing. From the hangers to how it's hung to the placement of the tags, it just goes on and on and on, and there are penalties if you don't do it right."

At first glance, consumers would seem to benefit from the practice because it keeps retailers' costs down, giving them flexibility to keep prices low. The stores, for their part, say the charges, which are perfectly legal, are an attempt to improve the efficiency of their operations, starting at the mammoth warehouses where all kinds of goods are delivered.

But when retailers are charging back as much as they are today, manufacturers say they sometimes end up raising prices to offset their losses. Some may even stop dealing with particularly troublesome retailers, as Sega did, reducing the choices available to shoppers.

"Sometimes retailers find themselves being penny-wise and pound- foolish, by nitpicking with a vendor and then finding themselves without product," said Darrell Rigby, a retail specialist at Bain & Company.

The practice, generally referred to as charge backs and deductions, dates to the 1970's in the apparel business, where it started small. But in the last few years, industry experts say, chain stores and department stores have spread the practice to packaged food, cosmetics, toys and other products. Consolidation among the stores has left fewer players, and they have more power over their suppliers than in the past. Many stores have information technology that is superior to that of the manufacturers, giving them another edge in the disputes over money owed.

"It's more aggressive lately because business is tough," said Walter Levy, a consultant with Kurt Salmon Associates in Manhattan, which advises retailers all over the country. "It is capitalism run amok."

The problems begin after products ordered by a store have been delivered. A store might claim that cartons arrived with less than the promised amount of, say, compact discs, rubber sandals, blenders, cashmere sweaters and the like. Or they might have held too much. Or the cartons were not delivered the way the store prescribed, perhaps landing on the loading dock in the wrong order or arriving on a truck that was too late or too early.

Increasingly, stores want products packaged in ways that cut the amount of time required to set them up on shelves or racks. And they will deduct a certain amount for each aspect of product delivery that does not fit specifications, which can quickly add up to thousands of dollars.

The stores serve notice that they expect things to be done a certain way, issuing thick binders of "vendor compliance" regulations. But manufacturers say that the demands have become increasingly onerous, and differ from store to store.

One store even introduces its policy with the following: "When dealing with a major retailer, things will go wrong. So, be prepared, and the journey through charge back and deduction land will be as painless as possible."

For many of the manufacturers, painless is not the word that springs to mind. "You might have an invoice due for $1 million, but then you get paid $100,000, because $900,000 is in charge backs," the credit manager for a California company said. "You then have to identify what the charge back is for, and that could take anywhere from one week to three months. If you think about the cost of capital, you see that they finance their operations on chargebacks."

For the manufacturer, "it affects cash flow," he added. "If you are expecting a million dollars and you get just $100,000, then you have to go out and borrow that missing $900,000."

Steven Parks, director of deductions management at Dun & Bradstreet (news/quote) Receivable Management Services, told of seeing a check representing the net payment to a manufacturer from a $1.5 million invoice. "With all the deductions, the net effect for the manufacturer was 94 cents," he said.

Charge backs have become so pervasive this year that trade groups like the Fashion Association in New York started holding seminars to discuss the problem. On the Internet, various companies advertise their recovery services, intended for both retailers and manufacturers. Agencies have sprung up, like the Vendor Compliance Federation, also based in New York, which tries to bring the two sides together.

"There's no doubt in my mind that there's abuse," said Kim Zablocky, secretary to the federation, which has 150 large companies as members. "It's all subjective. Some manufacturers won't have any issues at all. Others are getting their brains handed to them."

He says that 85 percent of all the charges are the fault of the manufacturers, and most of those stem from shipping problems.

Stores of all sizes and types are using charge backs. At Sears, Roebuck & Company, executives say they are not interested in collecting money, but in improving the logistics of their business. Still, suppliers are fined for not fulfilling orders and other problems.

Each of Sears' 3,000 suppliers also gets a monthly report card — with grades of A through F — on how well they perform. "It's just like being back in school," said Charles Izzo, the company's director of vendor performance management. Filling orders counts for the most, followed by operational compliance, or how the orders are delivered to Sears. Poor grades usually generate a call from someone at the manufacturer, asking how it can improve, Mr. Izzo added. "You are changing their behavior," he said.

If a company fails to ship a product on time, it is fined 5 percent of the cost of each product that was supposed to be in the shipment and did not arrive promptly, Mr. Izzo said.

Some stores have begun charging for what are called unidentified deductions, in which retailers deduct part of their payments for problems they do not specify. Others even forecast deductions as a certain percentage of an order, based on past experience. Post-audit deductions, in which closed accounts are reopened and challenged by the retailers, are another recent development. In effect, an increasing number of deals are just never done. Instead, they are subject to endless negotiation.

"A lot of them will try to get away with just about anything," said Judy Palilla, vice president for business development for Internal Audit Bureau Inc., which recovers unpaid bills for manufacturers from its headquarters in Clarks Summit, Pa. "They throw it up to see what will stick."

Much of what is charged as noncompliance can be difficult, if not impossible, to prove, Mr. Garuba of Dun & Bradstreet said. "The box arrives on the loading dock, and someone at the store signs for it," he said. "But when they open it up, there's only three-quarters of the order inside. So they take a one-quarter deduction for the missing part of the order." Some manufacturers have begun photographing their cartons as they leave the factory, in order to escape certain kinds of chargebacks.

Once a claim is made, many manufacturers do not have time to research it or otherwise defend themselves, Ms. Palilla said. She estimated that the retailers are wrong at least 25 percent of the time, and as much as 50 percent.

"I had one situation where a retailer deducted $200,000 from my account for perfume," said Andy Kahn, president of the children's wear division of the American Apparel and Footwear Association. Mr. Kahn's company made clothing, not perfume. Even so, it took him a year to get his money.

The effect is also felt by companies that lend money to the manufacturers, since the payments become more difficult for manufacturers to make. "We never know if we're going to get a dollar bill for a dollar bill," said Jerry Sandak, a principal with Rosenthal & Rosenthal, a Manhattan company that finances manufacturers, "or 67 cents for a dollar bill because the store didn't get it at the right time with the right label."

Wayne Hood, a retail analyst with Prudential Securities in Atlanta, said Wal-Mart (news/quote) was the first discount store to begin charging its manufacturers for noncompliance about five years ago. Wal-Mart declined to comment.

Mr. Hood said that better collaboration between the stores and the manufacturers will ultimately cut down on charge backs. More stores are working with their suppliers to plan what will be on the shelves and when, a development that has improved the sales of many products, he added.

But for now, the penalties are escalating.

"You used to be charged a dollar, or five dollars," said Mr. Zablocky of the Vendor Compliance Federation. "Nowadays, the penalty could be as high as $25,000. If you want to get your goods sold, it's the cost of doing business. The customer is always right."

http://www.nytimes.com/2001/08/17/business/17CHAR.html?ex=998712000&en=301619341cf275f6&ei=5040&partner=MOREOVER

-- Doris (nocents@bellsouth.net), August 17, 2001