Forcing in more products through a distribution channel than it is capable of selling
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When a company forces in more products through a distribution channel than the channel is capable of selling, its sales figures become inflated. The practice is known as Channel Stuffing or Trade Loading. The practice of channel stuffing is very deceptive. Retailers are deliberately loaded with more products than they are capable of selling in the market, and hence, the distribution channels become clogged or stuffed.
Channel stuffing is often carried out to meet year-end sales targets. Sales targets are calculated on shipment and, thus, the practice helps to realize short-term sales targets. In the long run, however, it becomes detrimental because it can adversely affect the reputation of the business. Goods are often returned and lower sales are reported in subsequent months because the commodity was oversold previously. The receivables in the accounts show an increase for a short period of time, as sales are higher than normal.
Example of Channel Stuffing
Suppose a batch of medicines, produced a year ago is nearing its expiry in another few months. In such a situation, the company pushes the medicine through its distribution channel to retailers. The retailer must either sell off all of it to customers months before the expiry date or return the medicines to the company. This is an example of channel stuffing where more of the products were pushed to the retailer to be sold in the market than the actual requirement for the product in the market.
Effects of Channel Stuffing
Distributors often need to return the unsold goods to the company. They incur a transportation cost or carrying cost.
A backlog of product inventory is created in case of channel stuffing.
The large discounts offered due to channel stuffing can affect the long-term viability of the company.
Ultimately, the value of the distributor’s sales will be deflated because stores with excess inventory are more likely to send back the surplus to the distributor and less likely to send cash payments.
Returned goods will affect the accounts and profits of the company. That can create a bad image of the company in the market and, in worst cases, can even lead to a shutdown of the factory.
It can also be the case that the retailers may not place orders with the company for the next period, owing to the stuffing in the previous period. As a result of this, there can be a shortage in the coming period. Customers faced with such periods of shortage followed by an excess of the same good over a period of time may switch to substitutes during periods of shortages, thereby destroying the loyalty of the consumer to a particular product.
GAAP and Channel Stuffing
According to Generally Accepted Accounting Principles (GAAP), only when revenue has been earned shall it be recognized. But in the case of channel stuffing, the retailer or the distributor in the first case did not place orders with the company for the extra units that were sent to it through the distribution channel. Hence, such a sale of excess inventories is not recognized and the distributor can return the excess inventory to the company. This is recognized as a type of fraud, especially in large companies where channel stuffing is carried out to increase the sales and receivables for a short period of time. In fact, this practice leads to a kind of imbalance in the accounts of the company, as it borrows or steals from the sales of the next period and shows it in the sales of the current period to meet sales targets.
Steps to Avoid Channel Stuffing
Companies should avoid setting unrealistic targets. Sales targets should be set in correlation with the demand for the product in the market.
The auditor of the company needs to be vigilant. He/She must maintain the accounts and ensure that the sales department is not inflating the figures and manipulating the accounts to meet their targets.
The company’s policies need continuous revision and re-evaluation, as markets are constantly changing. The company should not go overboard with its sales expectations and should revise sales incentives schemes, performance expectations, length of sales cycles, true costs of sale, terms and conditions of trading, the policy of returns, etc.
Year-end performance bonuses should not be the prime target. Instead, the right balance should be struck between revenue targets and incentivizing people to discourage channel stuffing.
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