By Kevin Meyer
A few months ago I told you how, in my past life as president of a medical device company, I had two reliable leading indicators of a potential customer relationship. Basically if the customer demanded automatic annual price decreases, or if their payment terms were greater than net-30. Those few customers that offered to pay faster would become strong partners as they knew supplier financial stability is in their best interest. Those that tried to insist on longer terms just considered suppliers a necessary evil. The correlation was nearly perfect.
Luckily my company supplied unique components, so we also had leverage. Upon receipt of a request for long terms I'd fire back a letter saying that in my book the oft-forgotten "respect for people" pillar of lean also applies to suppliers (and customers for that matter), and trying to turn a relatively small supplier into a bank for a Fortune-50 was an affront to a productive relationship. Our terms would remain net-30 or less, or we wouldn't take the order. Occoasionally I received more pushback, including from a very large multinational, coincidentally in the news lately for "discovering" lean (in 2012…) and moving their appliance manufacturing back to the U.S., asking for net-120. Sorry, still net-30 to you, buddy.
So imagine what went through my mind when The Wall Street Journal reported last week how many companies like Procter & Gamble are pushing to lengthen terms even further.
Procter & Gamble is planning to add weeks to the amount of time it takes to pay its suppliers, a shift that could free up as much as $2 billion in cash for the consumer products giant. P&G could use that cash to fund investments in new factories overseas or to help pay for stock buybacks.
Obviously there's another party to that transaction.
That added flexibility, however, will come at the expense of the
companies that supply P&G with materials or services. The suppliers
will have to tie up more of their own cash in receivables or eat the
interest costs charged by banks to bridge the gap until P&G pays its
bills.
Yep, that's partnership. Turn your much smaller suppliers into a bank. And sure, it could "free up" $2B in cash for the large customer, but obviously that reduces by $2B the cash those smaller suppliers have to develop new processes and technologies. So who really loses in the end?
The moves are creating ripple effects. Companies that hold on to cash
longer create deficits at suppliers that have to find financing, raise
prices or squeeze other firms along the supply chain. Smaller companies
with little bargaining power and less access to credit ultimately could
see their costs rise, pinching funds that could otherwise be spent on
hiring or investments.
And speaking of banks…
To help suppliers deal with the changes, P&G is working with banks
that will offer to advance cash to suppliers after 15 days for a fee,
some of the people said.
Wait… so not only are they sucking cash out of suppliers so they can't invest in the innovations that presumably their customers – and end customers – will want later, they are adding to overall supply chain cost by giving banks a piece of the pie. I bet some of these companies even have the gall to call themselves "lean."
I was stewing over this when our friend Bill Conerly wrote a fantastic rebuttal to this nonsense in Forbes. If I was the CFO of P&G I'd feel pretty ashamed, or just plain stupid, after reading it. Not that most CFOs understand the real world anyway.
Procter & Gamble is about to lose money thanks to CFO hubris. It
won’t be the only large corporation, however, to get caught up in false
economy. The Wall Street Journal reported that P&G will
extend its payment terms to suppliers. This sounds like normal corporate
practice, and it is. But normal is not always good.
Bill then digs in…
I understand working capital management, but many of these corporations
don’t understand. P&G has a Aa credit
rating on its bonds. It can probably float 60 day commercial paper for
0.10%. Small companies with bank lines are often borrowing at 3.5% to
4.5% interest. Many small businesses, though, are not eligible for bank
lines. They may use finance companies to factor receivables, or even
the owner’s credit card. So 4.0% is very conservative as an estimate of
borrowing cost for small business.
Let’s say that the small business sells the large corporation $100,000
of materials. Instead of paying in 10 days, the corporation demands 75
day terms. OK, that extra 65 days save the corporation $8. (60/365
times 0.10% times $100,000). What does it cost the small business to
let the payment wait an extra 65 days? $329. (60/365 times 4.0% times
$100,000). So the big fish saves $8, costing the small fish $329.
Yep, that's partnership. Have I said that before? But here's the kicker: the stated reason for this nonsense is to "free up cash." Is sticking it to the suppliers really the best way?
The idea mentioned in the article was to “free up cash,” but cash is
readily available from cheaper sources. Perhaps Wall Street would rather
see “accounts payable” on the balance sheet than “commercial paper
outstanding.” After the recent financial crisis, one can get nervous
about commercial paper becoming unavailable. However, any company
dependent on its suppliers needs to also worry about the suppliers’
credit being jerked away. History is full of examples of small
businesses losing access to credit, to the detriment of their customers.
Bill then reaches a conclusion that the truly lean company will understand:
The focus of both parties to each supply agreement should be how to
provide better products at lower cost. When one party gets too focused
on getting the better side of the bargain, then the joint effort is less
likely to succeed. If one of the parties in a transaction has to borrow, it should be the party with the cheaper debt cost.
Amen. So next time a customer asks you for long payment terms, perhaps you should just ask them why their financial situation is so difficult that they want to use a much smaller supplier as a bank, risking your financial solvency let alone investment in new and improved processes, instead of tapping a much cheaper line of credit. Fools.
Daniel says
The other tactic big firms try to pull on us small suppliers is the runaround. Oh you sent that Invoice to this address? No it should go to this address. Oh you sent it there, it also was labeled for the wrong Department, It’s not Accounts Payables, it’s Dept. AP13499DD. Please resend for the 3rd time. Oh, you also forgot to put to the attention of the AP Dept. Head. Please resend for the 4th time. Meanwhile that has all taken an additional 60 days.
Sharon Simmons says
Kevin – thanks for this. I think I’ll just send your post to my customers that ask for longer terms! Fools!
Jeff says
Excellent post. I’m the CFO of a mid sized company that is caught in the middle of the squeeze. Our fortune 500 customers delay payments to us, and we have difficulty paying our smaller vendors and subcontractors. Much time is wasted and relationships are strained by the collections and delays that happen to all in the chain.
Jeff Hajek says
Kevin,
I might be one of the few people who disagree with you on this.
I think net terms are just one of many bargaining poingts of a negotiation that includes pack size, minimum order, transaction costs, return policy, customer service, and more. Each decision adds costs and benefits that might not be shared evenly. If a company values long payment terms, something else has to give, or the vendor won’t make any money. If a customer gets too aggressive, they will lose the supplier.
As for the term ‘partnership’, again, I may be in the minority, but it is greatly overused when talking about suppliers and vendors. It is not a partnership, it is a relationship. Keeping the relationship on good terms is important, but partnership implies a shared investment and shared risk.
As for the financial costs, there is no obligation to pass the savings on, just as a Lean company with a great cost structure is not obligated to pass the savings on. The vendor just has to add that into the overall cost-benefit analysis and see if the deal still makes sense. If not, the buyer will need to look elsewhere. That said, the better terms could be a great negotiating tool. Perhaps it could be turned into a Net-0 with a 2% discount where both sides come out ahead.
I do agree, though, that when both sides keep the needs of the other in mind, they both walk away with a better outcome.
Final thought. Unfortunately, the push for longer terms smacks of a misguided metric. Someone probably is measured by how AP/AR relate and they got the idea that paying later will help with the metric. Local optima at the expense of global performance.
Kevin Meyer says
Jeff,
Thanks for the comments. I agree with a lot of what you said, with a couple caveats. Yes, payment terms should be part of the negotiation process, but in my experience they usually aren’t. Instead they are set by policy, which usually takes an act of God to change. I’ve been in many negotiations, large and small, where all the factors you mention are discussed, but payment terms are off the table – until we say we won’t accept the order at greater than N30. Then the faces of the customer reps turn white knowing that they’ll have to change that policy. It’s that hard policy that I have a problem with, not that it could be a negotiable point.
Your comment on partnership vs relationship is interesting, and made me think a bit. Perhaps it’s different in different situations and industries. In the technology and medical device industries I was involved with, I’d still characterize it as more of a partnership – at least with the better customers. We were mutually working to push the envelope on processing technologies to co-develop components to support end designs that pushed the envelope. As a contract manufacturer, we had no off-the-shelf or standard components. Needless to say, we put a lot more of our own skin into that investment with customers that recognized our value – and less with those that just pounded on us for price.
Thanks for the thoughtful comments. Kevin
Karen Schultz says
This is a great conversation. When a company goes to Chapter 11 to reorganize, the court looks at terms and the shortest terms get paid first. Correct me if I am wrong. When the Auto industry was in trouble for poor management, how many companies went out of business or was never able to recoup the money owed due to terms. Bosch learned the hard way, as I recall, financially. I think if a business is lean and healthy, there is no problem with 30 days terms. The games played remind me of government’s lack of best managment practices and speaks loudly about the leadership’s ability to manage an organization in a lean fashion. Lean or the minute manager approach, is about handling something once. Receive in mail, pay and never have to handle it again is the only process that can claim lean.