by Jim Marasco , CPA,CIA, CFE Director, Corporate Services StoneBridge Business Partners

Whether you’re manufacturing cell phones, baby formula or healthcare products, product diversion within your distribution channel is a big problem today. While there is no authoritative source to accurately assess the financial exposure to affected companies, estimates are in the billions of dollars annually. Products intended for distribution overseas are ending up in the U.S. These products may have been priced or manufactured specifically for a foreign market, causing disruption among end-users. In other cases, product intended for a specific class of users may become diverted and sold into a different class within the U.S. This business has created an entire industry coined the grey market. The Department of Homeland Security has traced this activity directly to funding terrorist operations.

Who is Susceptible?

Manufacturers that offer monetary consideration (rebates, charge-backs, co-op credits, etc.) as a form of pricing through their distribution channel are most vulnerable to diversion activity. Typically healthcare products such as medical x-ray film, which carries up to a 60% rebate off list price, contain rich incentives which attract grey market players. In absence of rebates, other manufacturers price their products in accordance with its intended distribution. For instance, diabetic supply manufacturers will offer varied product pricing to Medicare/Medicaid, hospital, managed care and retail markets. The same product is used with different pricing and packaging depending on its intended distribution. Other companies sell their products cheaper abroad. In either situation, the rebates or discounted pricing involved offer diverters an opportunity to profit.

Building a Program to Thwart Diversion

Implementing an audit program is a major step one can take toward controlling diversion. However, putting a business partner on notice that it will be subject to an audit is a difficult step for manufacturers in any industry. Some manufacturers see it as contrary to building and developing a cooperative business relationship. Most manufacturers are trying to add and/or retain customers, not scrutinize the ones they already have. An audit initiative that is properly planned, communicated and executed can dispel these apprehensions. While it can be viewed as a mild annoyance, it has been our experience that the honest and compliant business partners will support such an initiative, because they too understand the threat posed by persistent product diversion. The non-compliant distributors are a threat to the entire distribution system as they are costing manufacturers millions in unwarranted and unearned discounts and rebates and could increase their exposure to product liability lawsuits. Imagine a diabetic using a glucose monitor calibrated to U.S. standards, using a testing strip calibrated to international standards. The results are potentially fatal and costly as it can be argued that the manufacturer is liable for not keeping this product out of the U.S. consumers’ hands. It is in everyone’s interest that no one be allowed to cheat the system. Compliant distributors will get direct benefits from an audit as the auditors can pass along information that can assist the distributor in improving its operations, including issues such as internal theft, weak internal controls, and proper inventory management. Additionally, distributors can use the audit as an opportunity to voice their opinions and/or concerns regarding their relationship with the manufacturer.

Developing the Audit Program

As with most initiatives, a well-designed plan and approach are a necessity for any audit program to be successful. There are three distinct steps in the typical audit program:

1. creation of a detailed outline of the procedures that will be followed, from candidate selection to the physical site-visit of the selected distributors
2. performance of the examination
3. documenting the audit and enforcing its findings

Under most discount/rebate agreements, sales reporting and market share substantiations are primary the responsibility of the distributors. Manufacturers can and do establish controls to govern these obligations, but in the end there is always a heavy dependence on a good faith understanding that the distributor will comply with its agreement to accurately report their sales tracing activity. However, in certain circumstances, a manufacturer needs to be able to ensure that the parties’ good faith understanding is being met. Most rebate/distribution agreements give the manufacturer the right to audit compliance of the agreement. A well-conceived audit process can foster compliance without creating any unnecessary animosity or tension. An audit program should be created in a methodical step-by-step process to ensure consistency in application. The program should also be tailored to address the unique needs and characteristics of the agreement. Most audit programs are designed to evaluate and verify reported sales and to validate purchase volumes and market share calculations. The only method of doing this is by obtaining detailed sales data directly from the distributor – very few, if any, rebate/discount agreements will allow for a detailed review of financial statements, tax returns or payroll records. With the sales data, an auditor can prepare an inventory reconciliation, corroborate quantities reported to the manufacturer via market share or utilization reports, and take a sample of transactions and review the supporting invoice documentation. Additionally, advanced auditing-based software allows for sophisticated data mining and integrity checks, and can uncover irregularities within the sales data. Audit programs do not have to be limited to verifying and validating the sales data. By conducting the audit at the distributor’s location, the auditor(s) can physically observe and count the distributor’s inventory. If possible, the auditor can record lot or tracking numbers which, if utilized correctly, can help determine whether the product on the distributor’s shelves has been obtained through the proper channels. The level of detail that is built into an audit program must take into account a cost/benefit analysis of the consequences of distributor non-compliance. Developing an audit program will involve some expense and the manufacturer needs to ensure that the benefits will outweigh the costs, and the program needs to be tailored to ensure that. The scope and duration of the review must be established. For instance, most rebate/discount agreements stipulate that three years of records be retained and made available upon request, but reviewing three years of data can be time-consuming and expensive, depending on the volume of purchases. Alternatively, a shortened period within this three-year span can be considered. Likewise, if a distributor has multiple distribution centers, consideration should be given to reviewing only certain locations in detail. In applying any limited scope procedures, if instances of abuse are discovered, the review can then be expanded to cover more years or all locations. Concerning the cost/benefit, many agreements have clauses which provide that, in cases of an overpayment of rebates or unwarranted receipt of discounts, the distributor reimburse the manufacturer for the infraction and the cost of the audit. Additionally, manufacturers can realize a huge savings by identifying those distributors that are not meeting purchase or market share commitments and in turn cease or modify the discounts or rebates they offered.

Whom to Audit

Any manufacturer can probably point to a few business partners who would be good candidates for an audit. Unfortunately, without proper planning and documented procedures, simply selecting the “problem” distributors for audit can have serious consequences, especially if it proves unwarranted.

1. a method for choosing audit candidates should be created that selects a fair cross-section of distributors. That way, the selection process can withstand scrutiny for fairness.
2. notification should be made to the distributors in a formal manner: the selected distributors and their representatives should be contacted officially by certified mail. Individual agreements may dictate the amount of lead time that must be given before an audit commences. If the audit clause does not set forth a time period, we recommend no more than two or four weeks advanced notice.
3. the same types of records should be requested from all audit candidates, by means of the notification letter or in a follow-up correspondence.
4. all audit procedures and notices should follow the standards established in the audit clause of the agreement.

Conducting the Audit

After the audit program has been designed, the candidates selected, and the notices sent, a distributor should be given a limited amount of time to gather the records for the audit. While the distributor is collecting its documentation, the auditors should be in contact with the distributor to discuss any questions or concerns regarding the scope of the review, when and where the review will take place, and the records that will need to be available. From the time a distributor is notified of an intended audit to the actual performance of the review by the audit team, much can be learned. In our experiences, the distributor’s initial reaction will typically determine the cooperation that will be received and the level of concern the auditors will carry with them. Be prepared for destroyed/altered records, difficulty in scheduling, challenges to your right-to-audit, challenges to the records you are seeking to review and a host of other objections or concerns. Once the logistics are determined, the auditor should arrive and communicate the scope and objective at the initial introduction meeting. At this point, the auditor should commence a directed yet cordial interview with the representatives of the distributor. This is an extremely underrated tool in the audit process. Many people will unknowingly provide insight to their operations that they otherwise would be hesitant to provide. A seemingly benign contradiction in answering an auditor’s questions may be the key to an effective audit. Any questions or concerns can again be addressed, but at this point, the audit process should commence. The records of the distributor can be reviewed on-site or (if permitted) taken off-site. Audit teams usually number one to four individuals (depending on the size of the project) and audits will typically last one day to a week, depending on the audit scope and volume of the distributor records under review. Different auditors have different approaches. The most successful method to conduct an audit is to obtain the necessary records (with as little disruption to the distributor as possible) and then efficiently and accurately apply the procedures to validate compliance or accurately substantiate levels of noncompliance.

After the Audit

The audit team should ensure that, prior to departing, all necessary information is obtained. In most cases, it may be difficult to obtain the timely assistance from a distributor after you have departed. After the audit is completed and the results analyzed, any suspected instances of noncompliance with the rebate/discount agreement should be dealt with promptly and decisively. To support enforcement, adequate documentation must be maintained regarding all aspects of the audit. If a dispute arises (like a termination proceeding or a collection action), the documentation will likely be subject to intense scrutiny. Weak or unsubstantiated allegations by the manufacturer could prove embarrassing and costly. A uniform and detailed report should be prepared and distributed to the applicable parties within a reasonable time period after performance of the audit. Any serious noncompliance should be quantified and then a demand for compliance and cure should be made of the distributor. In the absence of a cure by the distributor, other appropriate action should be taken against them, including litigation or termination. Naturally, actions taken against distributors should be consistent and uniformly applied. Exceptions that are granted to some may be challenged by others in similar situations seeking similar treatment. A tough, zero tolerance attitude evidenced by your actions will do more to spark added compliance by your system than any other program or procedure you could implement. Today, more then ever, manufacturers are being challenged. They are being challenged to grow their market share, add new product offerings, and monitor their business partners. Distributors have been entrusted to represent and deliver the product to the public and are rewarded for this, in the form of rebates and discounts. However, this has put manufacturers at risk – many people have seen this as an opportunity to profit, albeit unjustly. Greed and ambition have created an atmosphere where people will go to great lengths to further their own financial well-being. The financial strength and well-being of the manufacturer depends on compliance and integrity. Manufacturers owe it to themselves, their investors and their distribution network to ensure full compliance. Periodic on-site audits can be a valuable tool in achieving that goal.

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