There is a lot of confusion at our organization about whether to classify a market development fund (MDF) payment as contra revenue (Contra) or operational expense (Opex). Financial departments have their preferences, but the assignment of one or the other is not that simple. What do you suggest?
The distinction between one or the other was established after the ENRON collapse. However, for the purposes of classifying MDF, and more broadly, channel incentive programs, contra revenue (Contra) is typically where all incentive programs are assigned. Conversely, operational expenses (Opex) is the typical assignment for all marketing related functions. As far as financial accounting is concerned, there are advantages and disadvantages to having MDF as one versus the other. That is beyond the scope of this document, as that preference is usually defined by the financial department.
What is pertinent to this document is the following:
- As a program, expenses related to MDF programs can ALWAYS be classified as Contra, if the financial decision-makers so desire.
- Expenses related to MDF reimbursements only CONDITIONALLY qualifies as Opex, to comply with the full requirements.
This document focuses on these conditions for MDF expenses to qualify as an operational expense. In summary, FASB (Financial Accounting Standards Board) states that in order to qualify as a marketing expense, the payment must meet four criteria:
- The payment covers a service by the partner that is a clear benefit to you.
- The benefit is clearly separate from the sale of a product.
- The benefit could be purchased by you from a source other than the partner.
- You obtained proof of performance to reasonable estimate true cost.
As all four of these criteria must be met, it limits the type of activities that will qualify for Opex, and as a result are usually limited to things like traditional media or lead generation because you or the partner can buy things from a media outlet at pretty much the same price. They're equally accessible. The expense is not treated as an incentive to the partner and you're not paying a premium price to the partner to produce it. A table that may be representative of the activity classifications is provided below.
Trade Show Space
To further complicate matters, the activities listed in the Opex column on the left don’t automatically qualify.
To truly qualify an MDF expense as Opex, one must audit the program against the actual costs of the media and only reimburse for third-party expenses—no reimbursement for internal expenditures. In many cases partners tend to include the price of ad development or creative development that was done internally not through a third party.
To legally classify an MDF expense as Opex:
- Only reimburse for third-party costs.
- Only reimburse up to the cost of that third-party, nothing in excess.
- Don’t reimburse for internal costs.
- Always attach an invoice as a way to prove that all the marketing expense conditions were met in case of an audit.
Therefore, to qualify as Opex, the activities are subject to an extra layer of scrutiny in the auditing process. Additionally, those activities may require more substantive proof-of-performance, adding an administrative burden to the partner to substantiate their reimbursement
Conversely, many channel partners will conduct the activities listed in the left column of the above table, but then mark up the actual expense. At that point, the resulting total cost no longer qualifies for Opex classification. Here’s an example: Consider a vendor that partners with a retailer such as Best Buy. The vendor might want placement in the retailer’s holiday flyer and the retailer charges the vendor X dollars for the privilege of being in the flyer. If the cost of the placement is more than the actual cost of a six-inch ad in a flyer, a lot of people don’t classify that as a marketing expense even though it is basically an ad in a flyer.
Essentially, the vendor is paying a premium price and the only way they can get in the retailer’s flyer is to pay the retailer. Some people consider this Contra rather than a marketing expense even though a flyer, catalog, or direct mail is accessible to all.
Our clients typically use one of two methods to classify expenses as either Contra and Opex.
Some of our clients classify everything as Contra revenue because there is less required documentation, the context doesn’t meet all the mandatory conditions, and there is less risk of getting called out about Contra revenue.
Another reason is that the difference between how much money is actually spent on a marketing incentive versus Contra isn't worth the bother because a lot of the money goes into sales incentives, events, and training anyway—in many cases as much as 80% of the money. So why not just put everything in Contra to make it easy, right?
Assign only the Activities that Qualify to Opex
The second approach is to define the activities that will qualify as marketing expense. Those activities could be:
- Advertising (print/web)
- Broadcast (radio/tv)
- Direct mail email
- Seminars & Webinars
Next the organization will break out spending against the approved activities (marketing expense) versus non-approved activities (Contra).
If that is the route you choose, I strongly suggest that the guidelines align with the government expectation for what qualifies as a marketing expense, which are basically those four points mentioned at the beginning of this article.
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