15 Oct 2012 Financial supply chain management and the fallacy of the one-off hit

Ask a CFO why he shouldn’t pay suppliers early in return for lower prices and he or she is quite likely to say “It’s fine occasionally but generally it just gives a one-off hit”.

I had this exact conversation with a a CFO of a large international organization recently and, not being an accountant, I chose to hold back, go away and lick my wounds and contemplate why his position was both expert and intuitively wrong.

I had the same conversation with Ian Burdon from Elcom, the purchase to pay guru who brings a level of intellectualism to Purchasing Insight that I can’t, and again, I hesitated to disagree. But still my intuition says this doesn’t make sense.

I can see that a wholesale change in payment terms to suppliers, receiving a discount in return for a reduction from let’s say 90 days to 30 days, would be a bit like selling the family silver – cashing in on a valuable asset. You can only do it once. From a cash flow point of view it would make a sudden and painful impact. To suppliers it would be a welcome financial fillip like a sudden cash injection.

But it’s not  a one-off hit is it? To permanently ease payment terms between buyers and suppliers reduces the cost of working capital to suppliers, which in turn allows them to supplier goods cheaper and offer discounts. Done properly and importantly, measured properly, it creates a long term, sustainable win-win.

So why is it that my intuition varies so fundamentally from the “expert” view?

Financial supply chain management – lowering the cost of doing business

Credit terms are an important component of working capital management. Delaying payment fees cash to be used for other purposes and it reduces the overdraft costs. I absolutely get this and I absolutely understand why there are finance professionals who focus exclusively on managing DPO. But there’s a very simple calculation to estimate the value of an early payment discounts compared to the  value of delayed payment.

Compare the interest rate you could get on say $100,000 for a period of 60 days. Let’s say you could get 2% APR. You could earn just over $300. That’s the value of paying in 90 days rather than 30. How does that look from a suppliers perspective? Let’s say the supplier needs early payment and factors invoices by paying what is a fairly competitive market rate of 2% of the face value of the invoice to be paid in 30 days rather than 90. To the supplier, in APR terms, that’s a cost of over 12%. The supplier would be much better off to give customers a discount of 1.5% for 30 day terms. How much is that worth to the buyer? About 9%. Do the math! Is it better to pay the supplier in 90 days rather than 30 or is it better to pay in 30 and get 1.5% discount? Or, in other words, is 9% return on cash better than 2%?

You don’t need to be a mathematical genius to see that these numbers work and it also becomes clear why early payment does not create a one off hit for the supplier. For the supplier, a reduction in payment terms, bringing forward payment by 60 days, could pay off an overdraft that could permanently reduce their working capital costs. For a buyer that moves from managing DPO alone to taking a wider view that captures the reduction in the cost of goods associated with early payment, it lowers the cost of doing business.

Taking a purely cash flow point of view, of course discounts and early payment offer a one-off hit – but that’s not the whole story and CFOs should take a wide view to assess the merits of financial supply chain management.

Pete Loughlin can be found on twitter @peteloughlin