Thursday, October 10, 2013

Responsibility to notify a supplier of a defect.

In linkedIN an individual asked the question whether language that waived responsibility for buyer to provide notice of a defect was common. In my opinion it isn’t and whether you would want to agree to that as a supplier would depend on a number of things. I personally wouldn’t recommend it for suppliers.

The first key issue in notification of a defect is at what point does a defect in the product change from being covered by the right to return the material for a full credit as being defective versus needing to process it as a warranty claim. For suppliers in U.S. that issue is important. The U.S. Securities and Exchange Commission (SEC) has revenue accounting rules to the effect that a company cannot claim a sale as revenue if the buyer has the right to return the product for credit. I think those accounting rules may have been put in place as a result of companies doing what I call phantom shipments at the end of a fiscal quarter to make their revenue look good only to get the materials returned in the next quarter for credit.

If you don’t have a notice period or leave the period open via including an exclusion from providing notice, my belief is the selling company couldn't claim that sale as revenue as the buyer could return it as defective at any time. As a result of the SEC’s revenue accounting rules most U.S, suppliers want to establish a specific time limit a buyer has to return the product for being defective so they can claim it as revenue. If you agree to that your sole recourse after that period has expired is under the product warranty provision.

As a buyer you want that time limit to notify the supplier of the product being defective to be long enough so it may be able to be put in use to discover the defect. That is because many companies no longer do incoming inspection on materials because of the added cost. As a buyer I always want the period to be at least as long as the payment period. That way if I discover that it’s defective I can stop payment rather than pay them and have to chase them for a refund. I also want the warranty obligation to provide me with repair, replacement or full refund in the event the supplier can't repair or replace it. Since my primary right is to get repair or replacement, the supplier can still classify it as a sale and classify it as take revenue. If they need to provide a refund because they couldn’t repair or replace it, that does not impact their claiming it as a sale from a revenue accounting perspective, it just becomes a later adjustment to their sales.

Another simple reason suppliers want to be notified of defects is so they can understand there are problems allowing them to identify the root cause of the defect. That way they can reduce or eliminate it the defect in the future reducing both their qualify and warranty costs. They also don’t want buyers to be collecting a stockpile of defective products for return at sometime in the future. They do that for a number of reasons. Some products have limited shelf lives where even if they could repair the defect no one would buy it because of the shelf life. Another reason is many products simply have a product life. If you were a supplier would you want to receive a large quantity of defective product where the buyer wants their money back because they are defective. Think about the financial impact it would have if they were returned at a point in time where even if they could be repaired there is no longer a demand for them, making them worthless.

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