What a 2% tolerance really costs you over a year

Almost every AP team runs with a price tolerance. Invoices that come in a little above the purchase order pass without anyone looking, because chasing a few cents on every line isn't worth anyone's time. Two percent is a common choice.

But a tolerance is also a standing permission to be overbilled, up to that amount, without anyone noticing. So what does it actually cost, and what does it save? Here's a worked example, then a calculator to run it with your own numbers.

What a tolerance does

A tolerance is the difference between an invoice and its PO that you accept without review. With a 2% price tolerance, a unit price of $51.00 against a PO price of $50.00 passes; $51.01 gets flagged.

That buys you two things and costs you one:

• It saves review time. Small, harmless differences from rounding or currency don't land in anyone's queue.
• It keeps the queue meaningful. The exceptions people do see are the ones worth their attention.
• It lets overbilling through. Anything a supplier bills above the PO, up to the tolerance, is paid without question.

The question is whether the first two are worth more than the third.

The worked example

Take a mid-sized AP team. These figures are illustrative, not benchmarks; the calculator below lets you replace them with your own.

1. Maximum exposure: $40,000

If every invoice came in at the very top of the tolerance, you'd overpay 2% of $2,000,000, which is $40,000 a year. That's the ceiling, and in practice you won't hit it. But it's the number to show anyone who thinks 2% is “nothing”.

2. Money at risk: $3,600

In our example, 15% of invoices come in above the PO, by 1.2% on average. Assuming those invoices are a typical mix of sizes, that's $2,000,000 × 15% × 1.2% = $3,600 a year paid above the agreed price without anyone checking.

Not all of it is recoverable. Some of those differences are legitimate: an agreed price rise nobody updated on the PO, a surcharge in the contract, rounding. But none of it was looked at, so you can't tell which is which.

3. Review time saved: $1,800

Without the tolerance, those 15% of invoices, 270 a year, would each need a review. At 10 minutes each that's 45 hours, and at $40 an hour that's $1,800.

The result

In this example the tolerance lets through $3,600 to save $1,800 of review time. It costs about $1,800 a year more than it saves.

The break-even rule

There's a neat shortcut hiding in that arithmetic. The share of invoices affected appears on both sides, so it cancels out. A tolerance pays for itself only when:

In the example, one review costs about $6.67 (10 minutes at $40 an hour) and the average invoice is about $1,111. That's a break-even variance of 0.6%. The 1.2% actually being waved through is double that, so reviewing would be cheaper.

The rule also shows why one percentage can't fit every supplier. On a $300 invoice the break-even variance is over 2%, so a tolerance clearly helps. On a $20,000 invoice it's about 0.03%: almost any variance is worth ten minutes of someone's time.

Try it with your numbers

The calculator runs the same arithmetic on figures you enter. Its results are scenarios, not measured savings: they are only as good as your estimates of how often invoices drift and by how much.

The formulas and assumptions

So you can check the calculator, or rebuild it in a spreadsheet, here is everything it does:

It assumes:

• invoices billed above the PO are a typical mix of sizes, so their share of spend equals their share of invoices;
• every flagged invoice takes the same time to review;
• everything waved through is money at risk, though some of it will be legitimate, such as an agreed price rise not yet on the PO;
• nothing above the tolerance is counted: those invoices are flagged either way, so they cost a review with or without the tolerance;
• quantity tolerances, early-payment discounts and supplier relationships are left out.

If your largest invoices are the ones that drift, the first assumption understates the money at risk.

Setting a smarter tolerance

1. Pair the percentage with a cash cap. “2% or $50, whichever is lower” keeps the convenience on small invoices without writing a blank cheque on large ones.
2. Set it per supplier. Fixed price lists deserve a tight tolerance. Suppliers with fuel surcharges or commodity pricing may need more room, ideally with the rule written into the contract.
3. Keep quantity tolerance tight. Billing for more units than were received is rarely rounding. With 3-way matching, allow little or nothing above the quantity received.
4. Review what passed, not just what failed. Once a month, look at invoices that passed within tolerance. A supplier that always bills 1.9% over is a pattern, not rounding.
5. Watch the running total. A tolerance applied invoice by invoice can let a PO be overbilled across several partial invoices.

How Tenet handles tolerances

PO matching, and so tolerances, is part of 3-way matching on Tenet's Match plan and above. You set a price tolerance for the workspace on the Matching rules page, and price and quantity tolerances on each supplier's record, as percentages: a fixed price list can be kept tight while a supplier with fuel surcharges gets more room. Lines within tolerance are marked as passed rather than flagged, but the invoice still waits for a person to approve it: nothing is approved or posted to Xero on its own. A separate check compares each invoice with the remaining balance on its PO, so several invoices that each pass on their own can't add up to more than was ordered.