A few farsighted finance executives are managing their supply chain as a virtual corporation, finding innovative ways to reduce costs and increase earnings.

Cash-rich Big Buyer places a $1 million order with cash-strapped Small Supplier. Big Buyer usually stretches its payables to 60 days, so when the invoice arrives the assistant treasurer moves $1 million of the company's cash hoard to a 60-day CD earning 1.8 percent. That same day, Small Supplier's treasurer uses the invoice as collateral to borrow $1 million for 60 days at 8.8 percent. Small Supplier has built the cost of its financing into the price of its product, so Big Buyer indirectly pays the 8.8 percent interest rate. The bank makes a 7 percent spread (more than $11,500) on an almost riskless transaction -- value that is lost to the supply chain.

This scenario plays out all the time. In fact, finance teams at companies like Big Buyer often earn nice bonuses because they maintain a glittering balance sheet and a tight cash-conversion cycle. Wouldn't the assistant treasurer who handles investments jump at the chance to earn a whopping 8.8 percent on the company's own risk-free paper? You bet. Does that mean corporate management will shift to a policy of immediate payment of invoices in exchange for a price reduction of, say, $10,000 per order? Probably not.

In the realm of logistics, inventory and transportation, executives have worked to make their supply chains models of efficiency. But finance is another story. For a variety of reasons, the treasury strategy that CFOs have long used within their organization -- centralization of cash management, which minimizes borrowing costs and maximizes investment returns -- is seldom applied across the supply chain.

"It's a great idea, but you don't see it practiced," says treasury consultant James Sagner, managing principal of Sagner/ Marks, a financial consulting firm in White Plains, N.Y. "There's still a lot of concern about maintaining arm's-length relationships and not getting involved in other companies' financing. Attorneys and risk management folks probably discourage it. Japan had a lot of horizontal cartels that helped put its economy in the tank."

"Companies are so used to carrying excess working capital that they shrug it off as a necessary cost of doing business," observes supply chain consultant Jack Barry, CEO and co-founder of Pegasus Global Partners in Fairfield, Conn. "CFOs don't have much fire in their bellies for attacking this problem. They've trimmed excess inventory aggressively, but they don't see the corollary in excess working capital."

Missing Motivation

CFOs aren't confronting financing inefficiencies within their supply chain because they aren't motivated to do so, notes Andrew J. Lauter, president of the PSC Group LLC, a Shaumburg, Ill., business consulting firm. Executives are rewarded for how well they perform their specific job function. They often get paid more if they exploit trading partners than if they look for broader, cooperative solutions, he says. Trading "partners" still focus on trying to eat one another's lunch.

As a result, "not everybody wins," Lauter points out. "Just-in-time inventory means just in time for the largest, most powerful member of the supply chain. Its suppliers are forced to carry more inventory so they can always perform to the big dog's satisfaction." Working capital follows the same pattern: The most powerful player improves cash flow while its partners bear the brunt of long payment cycles.

Some widely praised supply chains -- including those of Wal-Mart and Dell Computer Corp. -- are highly efficient but buyer-centric, says David L. Berkowitz, senior vice president of Stern Stewart & Co., a New York City consulting firm. These big merchants collect payments before they pay suppliers, so they realize a negative cash conversion cycle. This allows them to sell at highly competitive prices and remain profitable on high volumes and thin margins. But Jay Fudemberg, founder and CEO of Pure Markets Corp., an online company based in San Francisco that specializes in equipment financing, suggests that this practice leads to inefficiencies. For example, Dell might be earning money-market rates on its cash surplus while suppliers pay higher borrowing rates as they await Dell payments.

Such financial parochialism is beginning to change, but slowly. "We saw plenty of examples in the 1980s and 1990s where large buyers used payment timing to take capital off their balance sheets by shifting the burden to suppliers, who often had to pay more for it," explains Berkowitz. "That was not a win-win situation. It forced suppliers to operate less economically. Now we're starting to see cooperation to maximize value across the supply chain."

With interest rates low, some big purchasers in the food industry are usingexcess cash to pay early for crops or even finance them, says Bill Michels, CEO of ADR North America, a supply chain consulting firm based in Ann Arbor, Mich. Pushing inventory back up the supply chain is still common, but leading-edge thinkers are treating trading partners like divisions of their own corporation. They are cooperating across various functions to cut costs and share benefits in areas such as financing charges, he reports.

Because the net gains are real, cooperation in financing is coming in a range of industries, Lauter predicts. Long-term trading partners that have learned to trust one another will lead the way.

Leading-Edge Thinking

Companies "at the pinnacle of understanding" are already taking steps in this direction, Barry reports. The automotive supply chain provides good examples of how trading partners can save money by coordinating their financing needs, he says. Ford and General Motors now tell their top-tier suppliers, " 'Because you can't borrow at anywhere near the rates we get, we'll pay you immediately and even let you draw on our bank lines to pay your suppliers, but we'll expect a price discount,' " Barry explains.

Equipment purchases present opportunities for a similar type of savings, says Fudemberg. A large organization such as General Motors could borrow at low rates, buy machinery that its smaller suppliers need and then lease that equipment to the suppliers, saving them money at the same time it makes a profit. Such an arrangement would not require the big company to calculate the cost of the smaller companies' funding options or to request offsetting price discounts. Each supplier could do its own arithmetic, Fudemberg points out.

According to Berkowitz, this model is already a reality in the auto industry. Both DaimlerChrysler and Ford offer their suppliers equipment financing options. Berkowitz says, "Sometimes they decide who should own a big piece of capital equipment based on who has the lowest cost of capital."

Barry insists that rumored legal obstacles are pure fantasy. "If you actually read the federal Robinson-Patman Act, it supports negotiations to gain efficiencies. It only says you can't offer trade discounts to selected customers arbitrarily. Nothing stands in the way of working with trading partners to reduce financing costs and then share those savings," he says.

Screwed Up Metrics

Despite the potential savings, flaws in performance measurement tools keep supply chains from achieving maximum financing efficiency, according to Rick Stephenson, treasurer of Covisint LLC, an e-business exchange for the automotive industry in Southfield, Mich. Wall Street and corporate boards often judge executives' performance by their organization's return on net assets (RONA). A company that reduces payables -- a liability -- by quickly paying suppliers increases the net asset figure in its RONA calculation. When the same level of returns is divided by larger assets, RONA falls -- and so do executive bonuses.

The automakers' executives "understand that paying suppliers quicker would lower the total financing cost for the supply chain, but they're reluctant to do it because of the numbers," Stephenson reports. So they do it indirectly. They use their payables (the suppliers' receivables) to securitize asset-backed commercial paper issued by a third party at a low rate. Then they make those cheap funds available to suppliers in return for a negotiated discount on the price of goods. Settlement occurs later, reflecting industry terms of about 45 days.

This roundabout financing method is not the most efficient solution. Plus, its off-balance-sheet tactics might invite close scrutiny in the post-Enron era. Stephenson predicts that the industry will move to direct cost-of-capital reductions, but only after executives' compensation is no longer based on return on net assets.

Using accounting metrics to gauge corporate performance undercuts efforts to maximize economic value across supply chains, Berkowitz concedes. "You should go for the best return on net assets for the supply chain and trade off costs between income statements and balance sheets to see that everybody shares in that gain," he says.

See More, Cut More

More efficient operations can sometimes bring quicker payment to suppliers, Stephenson notes. Covisint's role is to integrate information across the supply chain, in much the same way that enterprise resource planning (ERP) systems consolidated disparate data within individual corporations, he says. "Everyone will be able to see exactly what is shipped and when it is shipped and received. We're having discussions with Citibank and others about using that visibility to reduce suppliers' cost of borrowing by essentially collateralizing them," Stephenson reports.

Net financing activity across supply chains disintermediates banks, just as centralized treasury management did. But banks are looking for a role to play in the streamlining of the supply chain, especially when they have relationships with both buyer and seller, reports Bruce Proctor, head of global trade product management at JPMorgan Treasury Services in New York City.

Morgan is working with several large Spanish businesses on an arrangement that would let their small suppliers access the large companies' lines of credit in exchange for price discounts, Proctor reports. The small companies would get economical borrowing rates, and neither organization's balance sheet would have to change. The large companies would bear the credit risk, he points out.

Stephen Payne, president of consulting firm REL Consultancy Group Americas in Purchase, N.Y., says that one of his clients, a U.S. yacht manufacturer that sells to independent distributors, does something similar. It requires payment within five days but lets its distributors borrow from its bank line at its rates. The credit risk is mitigated by collateral, because the manufacturer can always take back its boats if a distributor goes under, Payne explains. Meanwhile, the boat maker's books sparkle. Credit drawdowns go on the distributors' books, and receivables are cleared quickly.

What will it take to optimize supply-chain financing? Fudemberg takes a macroeconomic view. Over the past century, businesses have moved away from vertical organization, he observes; Ford no longer owns rubber plantations and coal mines. Supply chains evolved as businesses began to specialize in one facet of a process and perform that focused function more efficiently. "Allocating credit to the most efficient borrowers is consistent with this trend," he observes. "We're just reaching that point now."

"We've seen the decapitalization of individual corporations. Now we're starting to see the decapitalization of whole supply chains," Berkowitz observes.

Payne's prescription: "You have to manage the supply chain as a virtual corporation with its own balance sheet and income statement. Then you have to look for ways to reduce net cost and increase net earnings. Then you have to figure out a way to share those gains. That brings the true win-win solutions."

Reality Trumps Logic The grim reality of a tough market still trumps financial logic. NetCom Solutions International Inc., a network services company in Chantilly, Va., was created to hold inventories of IT and telecommunications equipment for its customers. NetCom finances this inventory through asset-based borrowing facilities that are not cheap, explains the company's CFO, Bob Waldron, who is also a partner with Tatum CFO Partners. "It's still a world where each player tries to collect early and pay late," he observes. Actual payment timing reflects clout, not cost of funds. So Waldron and his staff constantly negotiate with NetCom customers about how much inventory they will hold at what price, keeping in mind the substantial financing costs. "In theory, you should sit down and carve out win-win situations," Waldron reflects. "We work with people who understand that logic. We try to build our cost of capital into our price. But telecommunications equipment is such a buyer's market now that buyers push hard for bargains. You can quote a rational price, but they'll pull out a lower bid from a competitor and demand that you match it. In reality, competition dictates what you charge, not cost-based pricing." NetCom's experience suggests that progress toward efficient supply chain financing is likely to emerge first in strong, stable markets. "We make the pitch that if you pay us sooner you can get a better price. Eighteen months ago, when the industry was robust, we could work out deals like that. Now cash is king, and the last thing a buyer will give up is when they let go of their cash," Waldron says.

Originally printed in the June 2002 issue of Business Finance