Extended payment terms is like heroin in the supply chain

By Kevin O'Marah | May 07, 2015 | 0 Comments

Supply ChainBeyond Supply Chain

Payment terms of 150 days may sound like madness, but that’s exactly what Coty is now expecting of its advertising and promotional suppliers. Many companies are suddenly extending payment terms to as much as four months, especially for indirect spend categories like plant equipment, packaging and services.

It all seems to have started with AB InBev during the depths of the recession in 2009, when suppliers were told that payment would no longer be made in 30 days, but instead 120. The push didn’t come from procurement, however, but from the new private equity ownership group that bought Anheuser-Busch. Just like opiates to the down-and-out, extended payment terms during a recession feel great initially. The problem is it’s very unhealthy in the long run.

Working capital should work

Cash-to-cash cycle time is a vital measure of a supply chain’s ability to convert capital into profit: by capturing days sales outstanding as a measure of customer satisfaction, days payable outstanding as a measure of supplier cooperation and inventory as a measure of physical efficiency, it is among the best supply-chain metrics available. For supply chain practitioners it’s a great way to diagnose and fix problems in fulfilment, supplier quality, and conversion cycle time.

From a purely financial perspective, however, the easiest buck you can make is bumping up days payable. Nothing actually works any better, butcash flow goes up, return on working capital looks good and someone’s spreadsheet justifies a higher valuation for the business. The only obvious loser is the supplier who pays interest you should have paid.

For financial investors, especially short-term investors, this is a no-brainer at the company level, but at the value chain level it is destructive. As a case in point, consider the now well-known story of General Motors, which made high art of beating up suppliers in the 1980s and 90s. By grinding the tier-one base on cost and terms, GM nearly destroyed the automotive ecosystem in North America. Detailed analysis by John Henke at Oakland University clearly shows how this adversarial approach to suppliers ruined profitability at the big three for a long time.

Like an addiction, it felt good at the beginning, but over time it sapped the strength of an entire sector.

Competitive advantage

Michael Porter of Harvard Business School has written eloquently about work having to be done where it is most effectively done. This applies at the level of the global economy and at the level of companies and their supply chains. The biggest problem with extended payment terms is that manufacturers and service providers being forced to do the work of banks donít know how to manage financial instruments and don’t have the liquidity to handle this job cost effectively.

Making matters worse is that this goes against a clear trend toward strategic supplier engagement, instead of simple purchasing. Companies across industries are cutting the number of suppliers they work with, while deepening co-development relationships, joint market expansion efforts and collaborative planning. Data on strategic supplier-engagement benefits shows how important collaboration is to business. Do we really want to stress and insult these partners by holding back payment for work already done?

 

Diagram illustrating how strategic supplier engagement boosts competitive advantage.

Break the addiction

Traditionally, extended payment terms served as a lever pulled in times of distress to bridge temporary cash shortfalls. As such, it provided a buffer against earnings volatility. Recently, under the rising regime of private equity, this buffer has been drained.

Some suppliers, including one of AB InBev’s that was featured in a New York Timesstory on the subject, are choosing to quit rather than comply. Most, however, fall in line, especially as the plague spreads among big companies in the same industry. In CPG, for example, a perfect storm of waning consumer demand, desperate retail customers, and absentee financial vultures is forcing the hand of even the most enlightened sourcing teams.

Short term, these companies may get a nice little buzz in their balance sheets, but over time the value chain as a whole can count on weakening supplier innovation and less flexibility in order fulfilment.

Plus, when supply gets tight, who really wants to be a junkie in need of a fix?

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