Unless you are a best-in-class purchasing organization (and that is not the case for 92% of you), then you need to save. Budgets are shrinking. Costs are rising. Growth and consumer spend is flatlining. And if you don’t get your costs under control, you will be out of a job one way or the other.
But there’s a right way to save, and a wrong way to save.
The right way to save is to apply advanced analytics and optimization across your strategic and high spend categories which has proven time and time again to save an average of 10% across the board year after year when properly applied.
The right way to save is to influence and control demand. The only time demand should increase year over year is when it is for products or components that are for sale, or go into for sale products, and sales for those products are increasing. Demand should not increase more than x% for office supplies or MRO where x% is the increase in workforce, and, in fact, in many categories, should be decreasing year over year. For example, paper spend should decrease (since so much can be distributed online). MRO should decrease, as better inventory management and higher quality parts should decrease the number of products required. Etc.
The right way to save is to increase the value of the product sourced without increasing the price, so that even if costs stay constant, value increases and allow for an increased revenue stream.
So what’s the wrong way to save? Capital manipulation. In particular, earlier customer payment and later supplier payment.
The majority of analysts, accountants, and consultants, especially the unenlightened ones, will dazzle you with calculations that show how if you decrease accounts receivable from 30 days to 15 days and extend accounts payable from 30 days to 60 days, the extra 45 days of working capital you have will save you a fortune as you’ll either have to borrow less or can invest more and generate a huge savings on every Million that stays in your coffers an extra 30 to 60 days.
For example, if you have an annual cost of capital of 6% and you typically have to borrow 50% of required working capital to pay your suppliers on a timely basis, you will be paying:
06% ACC | 12% ACC | |||
Borrowed Amount | 30 days | 60 days | 30 days | 60 days |
1 M | 5,000 | 10,000 | 10,000 | 20,000 |
10 M | 50,000 | 100,000 | 100,000 | 200,000 |
50 M | 250,000 | 500,000 | 500,000 | 1,000,000 |
And as soon as a CFO at a mid-size company believes that if he can squeak out an extra 60 days across 50 Million of expenditure at 6%, he can save £500,000, a blind mandate to delay payment terms and expedite payment collection goes out across the board. And then CFO pats himself on the back and goes on a well deserved corporate retreat to the next conference he can find at a mountain resort.
But what actually happens?
If you do the proper calculation, which is:
You see that very little is actually saved because the savings is on the cost of capital for the payment days of the amount, NOT cost of capital for the payment amount. Which is a much smaller number. If you do this calculation, the real numbers are:
06% ACC | 12% ACC | |||
Borrowed Amount | 30 days | 60 days | 30 days | 60 days |
1 M | 500 | 1,000 | 1,000 | 2,000 |
10 M | 5000 | 10,000 | 10,000 | 20,000 |
50 M | 25,000 | 50,000 | 50,000 | 100,000 |
Remember, in the long run, the payments still have to be made and, most importantly, still have to be made on a monthly basis. So while you might see a savings the first month, there will be no further savings because all you have done is shifted all payments ahead by x days. A payment delayed is not a payment negated.
Moreover, all you’ve really accomplished is p!ss!ng off the supplier. And any chance of being a customer of choice has been thrown under the bus, where you effectively threw the supplier, who now has to borrow more capital to stay in operation, often at a rate double yours. In other words, the whopping £5K you saved likely cost the supplier £10K and, at the end of the contract, the first thing they are going to do is increase their costs substantially to cover their loss. So, at the end of the day, your short term savings of £5K is likely going to cost you £15K or more (especially when you consider the value associated with being a customer of choice). But hey, the CFO is always right, right? Wrong!
Don’t believe the doctor? Check out this great piece over on the public defender‘s blog that goes through this calculation in even more detail.