Redraw the map to reduce suppliers’ finance costs

Supply chains are complex beasts. Suppliers and customers create a web of trading relationships that are difficult to map – not least because, depending on the industry, the products and the service, suppliers can also be customers. A company’s supplier could also sell to other suppliers (see chart 1, below). Products can be physically shipped from highly-rated suppliers to less-highly rated suppliers for additional value to be added, then shipped again to a highly-rated business to be sold on to an end-consumer.

Traditionally, however, the supply chain finance business has tended to think of SCF purely in terms of how corporate customers can get cash into the hands of first-tier suppliers. But if we look at the flow of product it’s immediately apparent that there are myriad suppliers in this web with which a large corporate buyer will have no contractual relationship. In the simplified map of the supply chain, these second tier suppliers, third tier, and so on may not be able to turn to their own immediate customers as a source of supplier finance – and may have to resort to considerably more expensive financing options.

The lack of a contractual relationship is a defining characteristic because it means that the large corporate buyer cannot provide conventional invoice-based supply chain finance such as reverse factoring or dynamic discounting. But that ought not to impinge on the ability – or, indeed, willingness – of a corporate to use its balance sheet strength or its buying power to provide financial help to suppliers that are tiers away.

It’s not about being generous – it’s about taking cost out of the supply chain. Typically, the further upstream you go in the supply chain, the more expensive funding becomes for suppliers. Farmers, for example, can easily pay 15%, 20%, 25% interest rates while multinational branded food manufacturers pay just 30-40 basis points. By the time agricultural produce makes its way to the inbound factory gate, 6%-8% of the purchase price could well be aggregated financing costs borne by tiers of suppliers – possibly very much more than that figure. If a buying organisation can take that cost out, then it can reduce its cost of goods sold (COGS).

In the SCF research project SCF 2.0 we looked at the supply chain of barley and malt. In the agriculture supply chain what you see is the multiple working capital and funding needs arise from the inventory that has to be maintained throughout the year after the harvest. So the question is, who pays for the funding costs to have that inventory?

There are four basic business models that allow buyers to reduce financing costs. For the purposes of this exercise, assume that tier 1 suppliers have an average cost of finance of 5% while tier 2 suppliers have an average cost of finance of 12%. The four-quadrant grid (chart 2, below) arises out of the financing permutations depending on whether particular suppliers are above or below those averages.

Quadrant 1: Soft tolling Here, both the tier 1 and tier 2 suppliers have below-average cost of finance. Therefore, there isn’t a lot to be gained by trying to restructure the working capital requirements across the supply chain to squeeze out financing costs. So the soft tolling model isn’t a financing model as such, but rather a model in which the buyer intervenes in the suppliers’ by setting conditions or negotiating the prices that the tier 1 pays tier 2, for example.

Quadrant 2: Hard tolling In this quadrant, the first tier supplier has a relatively high cost of finance so in a hard tolling structure the large buyer purchases and takes ownership of the necessary materials from the second tier supplier and pays a tolling fee to the first tier supplier to perform whatever work is required on those materials. This eliminates the inventory financing cost of the first tier supplier who then becomes a contract manufacturer.

Quadrant 3: Buy-Sell The buy-sell model works in situations where the second-tier supplier has a higher than average financing cost but the first-tier supplier doesn’t. To reduce financing costs across the overall supply chain, the large buyer buys the goods from the second tier supplier and immediately resells them to the first tier supplier, for whom financing costs are less of an issue. It’s a bit like becoming a trader in your own supply chain. This allows the buyer to have a contractual relationship with what was the second tier supplier, enabling the buying organisation to give that supplier access to reverse factoring or dynamic discounting programmes.

Quadrant 4: Contract farming In this model, where finance costs are high across the supply chain, the large buyer purchases the seeds, fertiliser and all the other things needed by a farmer who then becomes a contract manufacturer. The buyer keeps ownership of the produce throughout the supply chain. This is a model often seen in developing countries, for example, where much of the supply chain is financially weak. These farmer/suppliers’ margins may be smaller under this model than they otherwise would be, and the profit upside is more limited as farmers have less opportunity to deal with other buyers; they are more tied in to just the one supply chain. But they benefit from having a more certain income stream, relieving them of the downside risk.

Some of these models require the ultimate buyer to take on board a certain level of performance risk. These aren’t pure financial plays: if you intervene further up the supply chain you take on converting risks or availability risks that you have to manage yourself. But a large buyer will be in a far better position to manage and insure or hedge these risks than an individual farmer ever could.

It can also be possible to get surety of supply by intervening earlier in the supply chain and in certain industries that can be much more important than cutting costs. And using the buyer’s ability to buy in bigger bulk than any player in its supply chain can yield volume discounts that the buyer could not previously have accessed.

These are not just theoretical models, by the way. They have been tried and tested. We implemented a model with Phillips in which it bought components from tier 2 suppliers and sold them to tier 1 suppliers, enabling a number of second tier suppliers to get access to cheaper financing by taking advantage of Phillips’ credit rating. Heineken and Unilever have implemented hard tolling and contract farming models.

While we’ve talk about intervening in the relationship between tiers 1 and 2, there is no reason why the same couldn’t be done between tiers 2 and 3, say, or to go even further up the supply chain. The starting point for any large buying organisation is to better understand the detailed purchase costs: how much of the cost is suppliers’ finance costs? It could easily be as much as 20% in some supply chains. What about energy costs? Or transport? Or raw materials? Good buying organisations will be able to at least estimate these cost components, disaggregate their cost structures and get the insight they need to determine how much could be saved by reorganising their supply chains a little bit differently.

The lesson is, get the transparency you need and then look at your options. The opportunity is there to redraw the supply chain map, removing much of the supply chain’s cost of finance and lowering buying costs significantly.