By Suresh Dakshina
In 2017, the average business lost 1.9 percent of its revenue from fraud, up from 1.47 percent in 2016, according to LexisNexis. This cost has grown year-over-year for the last five years, becoming a significant burden to merchants. Vesta Corp. reported that when expenses associated with fraud prevention, screening and chargeback management are included, the cost of fraud as a share of revenue rises to 7.5 percent. It's time to update your budget to account for this growing concern.
If, while looking at your year-end profits, you've ever been surprised to find a large number in your "losses" column, you may not be properly accounting for fraud, which is a pervasive problem due to the rapid rise in fraud. So here is a simplified guide for calculating your fraud budget; it explains the common cost contributors and variables and how to account for them.
The first step in calculating your fraud budget is gathering data.
Do a ballpark estimate
Start with a ballpark estimate of what to expect this year. In 2015, Javelin Strategy & Research estimated that combined fraud prevention and chargeback management costs accounted for between 13 and 20 percent of a merchant's total operating budget. Plan for your fraud budget to land somewhere in this range.
Many fraud teams are forced to work with much less. In the 2017 Fraud Benchmark Report, CyberSource found that more than half of businesses surveyed spent less than 1 percent of their ecommerce earnings on fraud prevention. The downside of this almost goes without saying: though these businesses saved money upfront on fraud prevention, their fraud losses were much higher. Prevention can be expensive, but it's not as expensive as being an easy target for fraudsters. So allow up to 20 percent of your operational expenses to go toward fraud management.
Measure your fraud rate
The average revenue lost to fraud is 1.9 percent, but it varies greatly between different industries and even from merchant to merchant. Digital goods merchants, for example, tend to have higher fraud rates than those that sell physical goods, and subscription-based merchants typically have the highest chargeback rates – though there are always exceptions.
Measuring your fraud rate is essential for proper allocation of resources. If your fraud rate is above average for a business like yours, it indicates a need for fraud prevention resources. On the flip side, if your rate is significantly below the going rate, your security measures may actually be too aggressive, creating unnecessary friction for your customers and hurting your conversion.
Analyze your chargebacks
To further refine your resource allocation, crunch your credit card chargeback data. Every chargeback comes with a "reason code"; these codes – properly understood – can reveal how effective your fraud prevention methods are. By identifying the main causes of chargebacks, you can prioritize the biggest problem areas within your budget.
Next, calculate your expenses, including fraud cost, training and development, and third-party services.
Now it's time to calculate some numbers. The first is the actual cost of fraud. You've already identified your fraud rate as a percentage of your revenue, so begin by taking your projected revenue for 2018 and multiplying by that number:
(2018 revenue projection) x (fraud rate) = (base fraud cost)
Now you have your estimated base fraud cost. Unfortunately, your actual fraud cost will be higher – after factoring in banking fees, administrative costs and other related expenses, total fraud costs average about $240 for every $100 lost to fraud. For digital goods retailers, this figure is even higher, averaging $348 per $100.
(base fraud cost) x (2.4–3.48) = (total fraud cost)
Training and development
The other major component of your budget will be training and development. The Javelin study found that hiring and training staff to manage fraud prevention and chargebacks typically accounts for between 36 and 41 percent of a company's fraud budget.
Because, unlike fraud costs, this is a voluntary part of the budget; it's here where many business owners try to cut costs or neglect to scale up as their businesses grow, resulting in many fraud prevention teams working with insufficient resources. But the importance of training and development cannot be overstated – fraudsters are constantly changing their tactics and improving their technologies, so your staff always need to be learning to stay ahead of the curve and keep your business secure.
Once you've calculated projected training and development expenses, do some cost comparisons. Third-party fraud management tools range from simple organizational aids to complete, full-coverage fraud prevention services. Depending on the size and security needs of your business, you may find outsourcing to be more affordable than building an in-house team. Most businesses use some combination of in-house and outsourced fraud prevention. For example, manual transaction reviews require significant man-hours to perform, so you may choose to use a third-party service to review flagged transactions, while performing the rest of fraud management in-house. Transaction volumes will have a significant effect on whether in-house or third-party manual reviews will be more cost-effective.
In theory, fraud costs, training and development, and third-party services should make up your total fraud budget – but there is one complication. Chargeback lag introduces an element of uncertainty. Chargeback loss and management is responsible for nearly 50 percent of total fraud-related costs, and those losses are often invisible until months after the actual sale took place. This is because of the "lag" time between when a transaction is made and when the merchant is notified that it has been reversed. To account for chargeback lag, budget for potential future losses. Remember, for every dollar lost your likely cost will be $2.40. For example, if your profits in January were $100,000, but 1 percent of those transactions by value were charged back, your losses will be:
$100,000 x 1% x 2.4 = $2,400
After chargebacks, your monthly profits in January were only $97,600. But you don't actually know that until April. So it's important to allow for retroactive chargeback losses in your fraud budget to ensure that you don't spend money you don't have.
Taken all together, this should add up to somewhere between 13 and 20 percent of your total operational budget. Remember, cutting corners in your fraud budget may save you a buck right now, but will ultimately result in more money lost to fraud. Finally, fraud loss as a percentage of revenue has grown every year since 2013 – and there's no reason to think it will stop now – so be generous with your fraud budget. The last thing you want at your year-end is a nasty surprise in the losses column.
A pioneer in data analytics and industry-specific risk management, Suresh Dakshina is the President of Chargeback Gurus. He is a certified ecommerce fraud prevention specialist and a Certified Payments Professional who knows firsthand the challenges business owners face, especially when it comes to chargebacks and fraud. Suresh holds a Master's degree from University of Southern California and has consulted Fortune 5000 companies for over a decade on chargeback and fraud minimization. He is a veteran speaker and works closely with card networks such as Visa and American Express on chargeback process optimization and compelling evidence policies.
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