Manufacturing

The Questionable Practice of Extending Original Equipment Manufacturer Payment Terms

Paul Ericksen / May 7, 2018

Push It! The Problem with Extending Supplier Payment Terms

For several years I was a regular contributor to the IndustryWeek website, writing a column called Next Generation Supply Management.  Over 73 articles, I covered a lot of ground.  At times, my articles for MakeTime will touch on some of those same topics, and, when they do, my intent is to expand on — not simply repeat — what was written in that earlier article by including discussion that was previously not covered.  In 2016 I wrote the Industry Week article, “'Extending Payment Terms' Is Just Another Term for Pilfering,”which discusses OEM Payments Terms and the justified frustration of manufacturing suppliers.

The issue of payment terms is not a new one, since most people deal with them in their daily lives.  When a consumer buys a product at a store they either pay for it immediately or work out a payment plan with the seller.  These plans usually involve the payment of interest. This is because sellers usually can’t put off paying the people who provided them with the product in the first place, and the interest increases seller revenue/cash flow enough to allow them to offer payment plans.  OEM’s, on the other hand, have traditionally paid Net 30 without paying interest to their suppliers. Suppliers have accommodated to this in their business plans and no one really questions the practice today.

When is Extending Supplier Payment Terms OK...

Over the last thirty years or so, OEM’s have shifted payment terms upward, sometimes significantly.  There can be a good reason for this.  For instance, extending payment terms may help an OEM get through a period of low cash flow.  When something like this is needed, however, progressive OEMs will usually offer their suppliers a “carrot” for their support in the form of something like a contract extension.  Though I’m sure in many cases this strategy passes without a hitch, my issue comes when there is no pressing need — other than a desire to increase profitability — to extend supplier payment terms.

...And When is Extending Payment Terms Not OK?

If you’ve read my bio you’ll see that I served a stint as Chief Procurement Officer at a large corporation.  The job came about through a consulting engagement in which I put together a purchasing business plan meant to transition the company from a sole focus on piece-price to one of total-cost/total-revenue.  In offering me the position, the CEO told me that he and his staff liked the plan I had laid out and felt there was no one better positioned than I to carry out the changes it described.

I refer to my tenure above as a stint because I could see early on that the gig wasn’t likely to work out.  In my first one-on-one meeting with the Chief Financial Officer, he described my business plan as a nice “academic” paper, but reminded me that the primary measure of purchasing department effectiveness would continue to be Material Variance, i.e., year-to-year pricing.  Long-time readers will know that I believe an emphasis on this performance metric effectively narrows purchasing’s ability to have business impact.  Regardless, I understood I was working in a manufacturing organization where the purchasing function did not have a seat at the table and it would take a lot of heavy lifting to establish one.

As I started laying the groundwork for the changes outlined in my business plan, I immediately encountered not only push-back (similar to what I had received from the CFO)  but also pressure to initiate new actions that —while they might deliver short-term benefits to the corporation — would likely result in longer term negative outcome. One of these related to Payment Terms.

Short Term Benefits, Long Term Consequences

At the time we paid for our purchases Net 30. Our primary competitor paid after about double that time.  As you might expect, there was significant overlap between our supply base and that of this competitor. Most of our common suppliers indicated to me that they gave my employer favorable pricing over that competitor because of this disparity.  They did this, not because they necessarily liked working with us, but because having to wait an extra month from our competitor for payment cost them money. Unfortunately, I was not able to quantify in concrete terms the magnitude of this pricing advantage.

At a CEO staff meeting the Chief Financial Officer reported that he had heard of other companies extending their payment terms to three to four months and suggested we extend ours to Net 100. Our annual buy at this time was about $4 Billion and the CFO had translated what the extra 70 days of holding that cash would do for company financials.  I knew that I wouldn’t get by without agreeing to extend the terms at least somewhat since it was obvious to me that the CFO had really been telling — not asking — me to make the change. So, I gathered the competitive information I had collected from those common suppliers and convinced the CEO and CFO that we match our competitor’s terms instead of extending our payment terms to the full Net 100.

Predictably, the supplier response to this move was very negative and quite a few major suppliers wanted to renegotiate their contracts after  receiving my “Dear Valued Supplier” letter.

The Real Cost of Squeezing Suppliers? Trust.

But what is the lesson from this example?  There are several, but namely:

Financial people — such as the CFO I alluded to — tend to focus primarily on short-term metrics.  Who is to blame them? After all, Wall Street focuses on these same metrics, which are the ones financial people are tasked with managing.  You can’t tell me, though, that these same people don’t understand that sometimes greater/more sustainable financial improvements won’t result without a comparable focus on metrics other than these shorter term ones.  In the case above, for example, where did the suppliers end-up? After extending their payment terms, the OEM did realize a short-term positive financial impact... until the suppliers could adjust their practices. But, eventually their suppliers  amended their business plans in reaction to the change. Many felt they had been leveraged, and as a response, started working with this OEM in a more commercial — rather than partnership — way.

Besides the arguable ethics of squeezing your suppliers, aggressively leveraging your suppliers is a problem for OEMs for several reasons, including — as I discussed in the IndustryWeek article — the fact that ultimately suppliers have much more leverage than OEMs, or they themselves, give credit for. Of equal importance is the crucial understanding that in the long run it always pays more, both literally and figuratively, for OEMs to keep a healthy and respectful partnership with their suppliers. That, more than profit, makes good business sense.

As previously mentioned, my next article will continue this discussion on this topic using an experience I had as a supplier.

Learn more about Paul Ericksen and his over 40-years in the manufacturing industry here.