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Why terms extensions without financing innovation will be damaging your competitive position
Matthew Stammers on supply chain innovation versus push DPO. I was in a great conversation the other day where we were talking through Porter’s Value Chain Analysis model in the context of the financial supply chain. For those who don’t know it the model (Fig 1.) proposes that companies build value by taking in raw materials and components, and then through a manufacturing process, convert these into finished goods and services. The marketing and sales functions then add further value by taking these products into the marketplace and selling them for more than the cost of production and raw materials – hence the concept of value creation.
Fig 1: Porter’s Value Chain Analysis (adapted)
In this model, support functions like Finance and Procurement are really seen as an overhead as they are a ‘necessary cost’ to manage the admin ensuring that the company is sufficiently funded, goods and services are procured well, that sales revenues are collected and suppliers are paid.
When looked at through a more modern lens the manufacturing process is akin to the physical supply chain while the finance function, under the CFO, oversees the financial supply chain.
However, my argument is that it’s time to step away from the concept that it is the physical supply chain that creates value and that it’s the financial supply chain that is an overhead cost. Why is this? Well companies (if they ever did) no longer act in isolation. Companies are not islands. Instead, the reality today as shown in Figure 2 is that companies group together to form highly complex supply chains where each member of the supply chain adds value to the production process until the finished goods are completed. This was recognised by Porter when instead of a single value chain he started to group sets of value chains together. What he missed though, was to map how money or finance moves through these chains is equally important to the flow of physical goods.
Fig 2: Modern supply chains are complex webs
To what extent is this important? Well, one procurement expert who I know, who works for a global automotive parts manufacturer, reckons that 60% of their business is their supply chain. These are activities which were once done in-house and seen as part of the company’s core value chain and now are carried out by suppliers. Companies deeply understand that the efficiency, innovation and agility in their physical supply chain dictates how competitive they will be on the global stage – think Just in Time, Lean Manufacturing etc. More recently, this is epitomised by the concept of Industry 4.0, a term coming out of Germany where manufacturing is key to their economic health. Industry 4.0 encapsulates the drivers of the next industrial revolution – highly interlinked, automated supply chains where information is shared in real time between partner companies and enhanced through artificial intelligence and robotics. Companies will be able to create individually tailored products on an industrial scale with industrial scale efficiencies. However, whilst huge strides are being made on the physical supply chain the linkages and strengths are understood far less well for the financial supply chain.
‘Protectionism’ a viable long term business strategy?
The shock of the 2008 financial crisis resulted in companies taking a protectionist approach to their finances, shortening their receivables period and lengthening payment terms. Key health metrics now include Days Payable Outstanding – the longer, the better and the Cash Conversion Cycle – the shorter, the better. In isolation this makes perfect sense, as no sensible CFO would want to be caught short of cash post 2008. Building the cash position is a highly prudent step to take and working capital metrics are closely analysed by the financial markets. But, considered in the lens of the financial supply chain it starts to look less sound. When the world’s largest buying organisations with the best credit ratings are effectively pushing the liquidity loading to smaller, less well rated suppliers they are adding cost to the system. Figures 3 and 4 illustrate this point really nicely in terms of the more poorly rated suppliers taking the load of financing the supply chain. It can be seen that as the large, well rated buyer pushes extended terms to suppliers, shortening their own cash conversion cycle, suppliers are funding their lengthening cash conversion cycle at a higher rate of finance and hence more cost is added into the overall supply chain.
Fig 3: Standard cost of financing a supply chain between a buyer, tier 1 and tier 2 suppliers
Fig 4: Increased financing cost of supply chain when buyer lengthens payment terms
Just like buyers, suppliers have to fund their operations and to do so they will need to borrow capital to purchase the goods and services that go into their production, pay wages etc. Since they are doing this with poorer credit ratings and hence a higher cost of capital there are only two possible outcomes. Either, the supplier adds the additional cost of capital into the pricing and therefore the cost of the overall supply chain goes up; or they take the hit and it affects their margins. They then have less cash and therefore cease to innovate or even go out of business – neither result is great for the supply chain.
So what’s the solution? In the short term the financial markets are unlikely to take a positive view of public large buying organisations reducing their cash positions to fund their supply chains by shortening payment terms. At present it’s more seen as every business for itself. And suppliers are not going to be able to get alternative cheap funding from the market easily at the scale they need due to a number of factors including the likes of BASEL III.
The solution therefore is that large buying organisations need to take control of funding their supply chain.
They will need to identify how they are going to ensure the right level of funding is available to their supply chain to ensure that it has the liquidity it needs to thrive, innovate and compete. This means the introduction of new, agile supply chain financing solutions, with the technology underpinning them to make their implementations successful and scalable. Doing this in a smart way, either creating self or third party funded programmes at a lower cost of capital, will enable large buying organisations to reduce the overall cost of their supply chain by reducing the financing costs for suppliers. Hence the CFO office moves away from being a cost centre and instead becomes a true value-add to the company’s production process encompassing its supply chain.
So this brings me round full circle. The job of CFOs is no longer to focus on ensuring that their company has the right cash in the right place at the right time in order to compete effectively. It’s about ensuring that your supply chain has the right cash in the right place at the right time in order that it can compete on the global stage. And to do this the CFO needs to identify, evaluate and implement solutions that enable them to execute on this new strategy. After all, as my procurement friend says, 60% of your business is your supply chain. Surely it’s time to fund and manage it properly.