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.