By Joe Sandor and Dave Nelson
The recent recession prompted many large buying firms to extend their payables, often times unilaterally. This rush to lengthen payables has been heralded as major savings. Billions of dollars of cash has been freed up. It’s what Thrasymachus claimed in his debate with Socrates – Might makes Right. Do whatever you can get away with regardless if it’s legal or ethical. One can imagine buyers going deeper into their supplier’s pockets with ever increasing payment terms. The tendency for buyers will be to continue to one up each other until the day we see payment terms that read, “payment will follow in the year following the year that both the Detroit Lions win the Super Bowl and the Chicago Cubs win the World Series.” Let’s not debate the legality or ethics of arbitrary payment delays but ask is it the right thing to do from the standpoint of effectiveness. Does extending payables as far as possible add value to either the buying firm or the supply network? Does delaying payments actually save money when total cost is fully understood? Clearly, paying later liberates cash but is this additional “free cash flow” really free? And of course, the suppliers “free cash” is reduced accordingly. What effects does this have on overall supply network performance?
As companies take longer and longer to pay, more and more stress is put on their suppliers. When things get really desperate you can always count on a banker or lawyer coming to the rescue. A new financial instrument is now available to help these desperate, cash-starved suppliers. It’s called Supply Chain Finance. Essentially, a supplier can go to a bank (usually prearranged by the buyer’s attorney) to sell its receivables. Naturally, the bank buys these invoices at a discount and also charges a fee. The collateral for the banks to give out money in this arrangement is the buying firms purchase order to the supplier and the buying firms approved receiving documentation supporting the supplier’s invoice. Risk is transferred from the probably less credit worthy supplier to the more credit worthy buyer. In this case, the seller gets the benefit of the buyer’s superior credit status. Furthermore, the bank’s risk is low since the monies it gives the supplier are based on invoices the buyer has approved. It’s a slick deal provided the bank fees and the discounted amounts of payment aren’t too steep. Supply Chain Finance may be helpful to some suppliers but is still a suboptimal way to approach supplier payment or supply network financing. Supply Chain Finance imposes a needless additional cost to a supply network and all costs must ultimately be paid for by the end consumer.
To answer the question as to whether extending payables is effective or adds value to the buying firm, we first need to go back to basics. Payment terms are essentially a trade-off decision. The decision to take a cash discount with an early payment or pay later can be easily calculated based on a firm’s cost of capital. If the discount is greater than the cost of capital for the days of delayed payment at a higher price, then pay early. If not, pay the undiscounted amount later. Only simple math is needed and a payment table can easily be created based on various costs of capital the buying firm may have. Indeed, the rationale for early payment discounts is based on the simple fact of any firms borrowing costs. Borrowing costs, like all costs, are imbedded into the price. Accordingly, a supplier with high borrowing costs would be inclined to offer significant early payment discounts. The idea that price doesn’t vary based on payment terms is strange. If asked what a supplier would charge for X if payment were made in 10, 40, 70 or 100 days, the suppliers quote for X would look something like $97 in 10 days, $98 in 40 days, $99 in 70 days and $100 in 100 days. Unilaterally extending terms an additional 30 or 60 days costs, in the example given, an additional $1 or $2. The idea that a buyer can just extend payables without effecting cost and price is simply idiotic. But, these extended payable schemes have seemingly worked – the price remains the same but the supplier is paid later. It’s like owning a money machine. And, the more money that gets printed the more the CFO and CPO prance about in their chest pumping celebrations.
Now let’s look at some more basics. Many supply networks resemble a barbell – large players at either end with small companies in between. The large companies at the ends tend to have the lowest cost of capital. But, payment terms are more related to power than need. Typically, the bigger players near the end consumer impose arbitrarily long payment terms upon their suppliers while the large companies nearest mother earth demand quick payment. Accordingly, the actual financing costs are increased and these costs are ultimately borne by the final consumer. And, things are getting worse.
Now let’s look at even more basics. Only two things can happen to costs. First, the amount can remain the same or change, up or down. Second, the cost can move between supply network participants. Clearly, extending payables just moves costs. And, given the barbell shape of most supply networks, these financing costs are not just moved they often are increased since weaker sisters between the gorillas at either end have a higher cost of capital. Further, accounts payable reconciliation is like wine. The older it is, the more it costs. Reconciling invoice discrepancies becomes more costly with the addition of time. Also, the process of extending payables can create unneeded supply base turn. Buyers must be prepared to replace suppliers unwilling to accept their lengthened payment terms. If no suppliers are replaced, the sellers may think the buyer is bluffing. So, several public hangings send the clear message that suppliers must accept the new terms or lose a customer.
In many ways, firms are coming to realize that companies within a network don’t compete, supply networks do. Supply networks compete against each other for the end consumer’s purchase. The network of sources from mother earth to end consumer that can consistently win the customer’s purchase will be the network that provides the most value to that end consumer. Adversarial actions by large buyers to extend payables merely adds costs to the overall network that the end customer doesn’t value and won’t pay for. Many firms seem to forget this important concept when it comes to paying their suppliers.
Here are the consequences for suppliers confronting longer payment cycles. If the supplier is big enough or important enough it can resist the buyer’s demands for extended payment. If not, here are the likely results from the opportunistic and adversarial buyer demanded payables extensions:
• The additional financing costs are imputed into new prices plus a hedge for more buyer opportunistic behavior
• Supplier’s margins are reduced and they are less likely to make investments to support buyer requirements
• Supplier quality and delivery reliability suffer
• Suppliers reduce technical support, service and innovation
• Suppliers strike back when conditions change
• Suppliers find more attractive customers
• Suppliers will serve others first during periods of shortage
• Suppliers bring breakthrough technology to others first
• Suppliers go out of business
Proactive buyers will make sure these bullets above don’t happen to them and will in the process earn preferential treatment from their suppliers that delivers actual value, not financial smoke and mirrors. To sum up, extending payables (arbitrarily or otherwise) is almost always bad business since it:
• Reduces supplier performance along multiple dimensions
• Likely will increase the actual cost to finance the supply network
• Increases the cost to reconcile invoice discrepancies
• Creates needless supply base turn and switching costs
• And, perhaps most important, misses the opportunity to develop effective collaboration that can add real value