Category Archives: Finance

Time to Shorten those Payment Cycles

If you want a sustained recovery, it’s time to start shortening those payment cycles. During the recession, the average payment cycle time in many companies shot up due to “cash flow issues”, and it’s already coming back to bite them in the rear end. As SI has said before, this is not the solution to cash flow and any “cost savings” that the business appears to benefit from (by having more cash in the bank that can potentially earn interest on short 60 or 90 day notes) is more than eaten up by the higher costs the suppliers have to charge to make up for the high interest rates they have to pay to obtain working capital.

It’s important to remember that late payments put extraordinary pressure on suppliers, especially small and medium sized suppliers, which often desperately need cash to purchase equipment, raw materials, and, most importantly, meet their payroll. Furthermore, in addition to cash flow problems caused by late payments, many firms incur significantly extra costs for the time and money spent chasing payments and securing interim financing, usually at exorbitantly high rates – which can often exceed 20% compared to your rate of borrowing, which can be as low as 5%.

All these costs do nothing but drive up the supplier’s cost of operation, and effectively, the price they will need to charge to maintain enough profitability to survive. That’s why many prices for components are rising faster than the raw commodity costs. The lack of prompt payments has cut many suppliers to the bone. Extending payment terms doesn’t help with cash flow or “cost savings”. Extending payment terms only drives up the price in the long term while increasing the risk of a major supply disruption as a supplier could go out of business if all its customers take too long to pay.

So instead of extending Days Payable Outstanding, consider looking at other strategies that can lower your cost of operations – such as improving forecast accuracy, balanced just in time (JIT) production, and low cost financing options that are available to you, as a large company, and not your supplier. Better forecasts lead to less missed opportunities and a reduced need to clear inventory at significant markdowns, balanced just in time (JIT) production reduces inventory costs, which is much better than just shifting them to a third party, and financing your purchase at prime or less will cost everyone less in the long run that forcing a supplier to take out short term financing at 20% to 40% per annum.

Why Finance Needs to Work With Supply Management

A recent survey by KPMG that was highlighted in a Supply & Demand Chain Executive article on how “finance executives [are] at odds with dated, ineffective technology” made it abundantly clear why finance needs to work with Supply Management. The global study found that the number one weakness in finance processes, as reported by almost one-third of respondents, was planning, budgeting, and forecasting.

It’s hard to plan without a budget, and its hard to budget without a forecast. To get a forecast, Finance could work with Marketing, but that’s not meaningful from a Finance perspective. What’s meaningful is how many units are actually bought and used / sold. And how much is actually paid. Who does the buying? Supply Management. And who is most likely to have a price locked in, or at least reasonably estimated? Supply Management. If Finance works with Supply Management, they can get meaningful acquisition/production forecasts (distilled from input from Marketing and Manufacturing), generate meaningful sales forecasts (using historical fill rates), calculate a realistic budget (once target sale prices are factored into account), and then construct an actionable plan. But if Finance doesn’t work with Supply Management, then everything is a crap-shoot estimate based on unrealistic interpolation curves.

Cost Reduction Strategies to Avoid

Cost reduction as a strategy is dangerous. First of all, a company that is too focused on cost might lose sight of value, which is what Supply Management is all about. Secondly, a company that is myopically focussed on immediate cost reduction is likely to make one or more of the following mistakes and actually increase costs in the long term.

Direct cost focus

This sounds like a great idea, since it’s where many organizations in manufacturing and CPG have the bulk of their spend, but the reality is that these are the categories that get analyzed year after year after year, while indirect categories fall by the way side. And the reality is that it’s much better to save 10% on 40 M then it is to save another 2% on a 100 M category. It’s twice the savings.

Landed cost focus

While it’s true that you can (theoretically) “book” a savings if a hardball negotiation gets you the same widget for $1, including transportation, that the organization used to pay $1.10 for, this is not really a savings if the widget is of lower quality and has a higher failure rate. If 15% break-down during the warranty window, when only 5% used to break-down, this has not only increased the average unit cost from 1.16 to 1.18 (in terms of functioning units), but tripled your warranty costs. If replacement costs turn out to be twice the product cost then, instead of paying an average of 1.20 per unit from a TCO perspective, the organization is now paying 1.30 per unit (from a TCO perspective) when the total cost of the lower quality product is calculated.

Year-over-year price reductions in multi-year contracts

This is my favourite example of cost reduction ridiculousness. Sometimes, anxious to meet the ridiculous mandate of 5% year-over-year cost reductions for the next three years, Supply Management organizations will try to negotiate three year contracts with year-over-year price reductions of 5% built in. And often they’ll exceed, and cost the organization approximately 15% more then if they just negotiated the best deal they could. Why? The supplier is going to have to make a profit each year it is in business. Since it’s likely not going to change the production methodology, the raw materials, or the labor that goes into making the product for the lifetime of the contract, the supplier knows that the price in year 3 has to be enough to be profitable. So the price it quotes in year 2 will be 5% more and the price in year 1 will be 5% more again in an attempt to insure it is still profitable in year 3. As a result, the organization ends up paying significantly more in the first two years than they could have paid by just negotiating the best, flat, deal possible. The right way to get year-over-year savings is to tackle different categories each year, not try to negotiate silly year-over-year savings in a single category.

What Competing Agendas?

The following was recently spoken at a leading sourcing conference:

The dynamics and sometimes competing agendas between finance and procurement are widely known.

Huh? What competing agendas? I am on planet Earth, right?

But more seriously, the fact that this myth is continually perpetuated is a serious problem. The reality is that, in a properly run organization, Finance and Procurement have the same fundamental agenda: Reduce Cost. Increase Efficiency. Drive Innovation. The only difference is that, for the most part, Finance is internally focussed while, for the most part, Supply Management is externally focussed. Just like the real goal of corporate finance is to insure that the company has more than enough money to achieve its goals and generate a return for the shareholders, the real goal of Procurement is to insure that the company has more than enough money to obtain the goods and services it needs and generate value for the customers, which, in turn, generates value for the shareholders.

The ultimate goal of any organization is to derive value for the stakeholders — employees, customers, and shareholders alike. Value is more than profit, it’s also sustainability and brand image. For example, if all a company does is produce cheap products that wear out quickly, either it’s going to go broke in warranty costs, or, if the product is not under warranty, it’s going to have a lot of upset customers who are not going to buy again, putting the long term financial viability of the company on the line.

As a result, Finance is about more than cutting costs and hitting budgets, it’s about analyzing the value of an internal spend and determining if the value is there to help meet the company’s goals. If hiring the best people increases that option, then Finance should determine that a higher payroll is the right decision and cost should be cut from somewhere else or, if there are no less critical areas, debt should be secured to obtain additional value, and profit, down the road.

Similarly, Procurement is about more than cutting costs to hit a savings target. It’s about finding the optimal balance of cost and value-add to maximize the overall return to the company. If buying from a supplier that costs 10% more will have a huge impact in brand perception, because either the component manufacturer is well respected and using their name will increase consumer interest or because the defect rate is significantly lower, then the slightly higher cost supplier is chosen. But if it’s a simple office supplies spend, then cost is cut to the low end of market pricing.

And both organizations are trying to find the right balance between cost cutting and value generation to meet the company’s goals and increase shareholder return. Just because Procurement is always spending while Finance is always trying to cut spend doesn’t mean that the departments are in opposition. Finance knows better than any other department that companies have to spend money to make money, it just wants to insure that the money is being spent wisely. And a good Procurement organization has better spending as its ultimate goal. There is no competing agenda between the Finance and Procurement Group, and any organization that thinks there is has a serious problem as they are not aligned, and alignment is become a key to success in today’s economy now that the Old Normal has returned.

Three Things Supply Management Should Know About Real Estate

A recent article over on Chief Executive that outlined six questions a CEO needs to ask the Director of Real Estate is a must read for Supply Management. In many companies, real estate flies below the radar, but often accounts for a significant portion of spend, especially when lease terms are factored in. In particular, Supply Management needs to know:

  • What are our aggregate lease obligations?
    In some companies, only payroll, debt, and cost of goods sold obligations will be greater than lease oligations. For some industries, lease costs will be very significant. Consider the example of how a restaurant chain saved 3.38 Million simply by reducing lease costs at only seven locations.
  • What is our key metric for evaluating occupancy costs?
    In some industries, market rate is irrelevant. What is relevant is whether or not the occupancy costs of the location make economic sense for the location based on actual performance. In the retail and restaurant industry, it’s typically the occupancy costs as a percentage of sales that matter — and these should be below a given threshold. For example, when occupancy costs exceed 10% of sales, there is a greater than 50% chance that the location will lose money. However, if occupancy costs are less than 8% of sales, there is less than a 20% chance that the location is losing money.
  • If our rent is too high, what are we doing about it?
    A signed lease should not deter action. In most instances, a landlord has a strong interest in retaining a tenant and the associated rent cheque. A tenant who goes out of business automatically vacates the premises and voids the rent cheque. Even though it can be difficult to engage a landlord in a lease negotiation, there are strategies, and risk averse landlords will often prefer a smaller rent cheque than no rent cheque for an extened period of time.