Supply Chain Visibility and the Capital Economy

In a previous article in 2010 I discussed how the hollowing of enterprises, and introduction of external firms into the supply chain’s value stream, created an emerging information economy within the supply chain. The term “information economy” simply means that information had a differing value to the supply chain members, and so could be bought or sold for a net gain in total value.

In the following article also from 2010, I look at the concurrent rise of the supply chain’s capital economy. What we mean by “capital economy” is the differing value of cash or cash flow to the supply chain participants, which enables value to be created by buying or selling capital. The article looks at the mechanisms for exchanging capital, along with some examples and areas worth further discussion.

Supply chains are small subsets of businesses tied together in a common enterprise, and sharing in that enterprise’s success of failure. Because they share similar exposures to the enterprise’s fate, and because they interact continuously, and finally because they are conducting business exchanges (buying & selling), it is natural for a capital economy to emerge within the supply chain.

Capital economy, in this context, refers to the fact that capital (usually working capital) has differing value to the supply chain members and also they have differing levels of access to it. A cash-rich conglomerate may see cash-flow as minimally important and mark its value down quite low. The conglomerate’s partner may be a small upstart company, and their position may require that all efforts are made to ensure cash on hand. Given these differences, true value can be created by the conglomerate selling working capital to the upstart partner. The value is not simply transferred, but it is instead created via the new level of cooperation. By “created”, I mean to say that the combined value to both firms is increased because the smaller company is either able to conduct business it couldn’t have before, or is securing capital at better rates than it would have otherwise. And the conglomerate is generating better returns on its assets by realizing a fee for the capital extended. This, in summary, is a win-win situation.

The situation above may sound too theoretical. After all, do companies really act as loan sharks to each other? Is a small retailer going to Proctor & Gamble to get working capital loans? The answer is, of course, that companies do not always do this. But, the capital economy within a supply chain still exists. Buying terms, in particular, are the principle means of shifting working capital among the supply chain participants in order to leverage the least productive capital and move it to the most in-demand points. It is through the payment terms on transactions that the supply chain is moving capital, often large amounts of it and across multiple tiers, in an effort to create additional value.

INCO Terms Primer:

Buying terms are the legal agreements that surround a transaction. For example, when you buy a refrigerator you might be able to get it delivered and also to have until then end of the month to pay the retailer. The two most salient points of the buying-selling arrangement are the place of ownership exchange and the payment terms. The ownership is being exchanged at your home, during the delivery. If the refrigerator is involved in an accident en route, it is not your problem. The seller is responsible for the cost of the accident and for providing another refrigerator to you without delay. The payment terms are separate from the ownership question. They dictate when and how you will move capital from the buyer to the seller.  The payment date is clear in the example above, but payment method may also be needed, such as cash only, etc.

INCO terms are mostly when used to conduct international trade. They specify the exact point of ownership exchange, and the payment terms, in ways which are re-usable across organizations and iterations.

Follow the Money:

Let’s take a real example I’ve seen in 2010. The situation was a very large durable goods company operating in the tier 4 and tier 5 markets in China. In these markets, there is very poor infrastructure behind retail and even wholesale distribution. That translates into less choice for the consumer, and limited competition for their capital. Buying terms for a durable good item would almost always favor the supplier. In the example I saw, the consumer is putting down their cash about 21 days before the transfer of ownership. For the graphic below, I’m using the arrow’s direction to show the flow of capital, the color to show if it takes place before or after the exchange of ownership, and the number to show how many days before or after the exchange of goods.

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Okay, so we can see that the consumer is moving capital to the retailer 21 days before the transfer of ownership. All else being equal, the retailer can wipe-out 21 days of the cost of carrying from their budget. Another way to express this is to say that the retailer can hold average stock for 21 days without any need for paying inventory carrying costs.

But, things get more interesting when we look further. The retailer, in turn, has payment terms negotiated with a wholesaler. They will pay the wholesaler an average of 17 days before they take ownership of goods. Graphically, it would appear like this…

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Because this supply chain has very little safety stock, because most of their goods are manufactured-to-order, and because capital is liquid, the diagram is effectively saying that the consumer is funding 17 days of stocking at the wholesaler and a further 4 days at the retailer. Analytically, we would assume that the consumer has the lowest “next best offer” on return for their capital. In other words, if they didn’t give the money to the retailer, it would be under a mattress earning no interest, etc. Likewise, the retailer has less productive uses for the capital than the wholesaler. If the retailer had the capital it may be better used than with the consumer, but not as best used as with the wholesaler.

The wholesaler, of course, has their own buying terms. They differ according to the manufacturer, but we can pick one as an example. In this situation, the wholesaler is paying the manufacturer AFTER the exchange of ownership. In other words, the wholesaler takes a delivery of goods and then, one day later, sends payment to the manufacturer. The color red in the line indicates the payment takes place after exchange of ownership.

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Analytically, we can say that the manufacturer is paying for one day of inventory carrying at the wholesaler, and so the wholesaler must have a better return on capital than the manufacturer. Combined with the capital from the consumer’s side, the wholesaler is being financed by its supply chain partners to hold up to 18 days of inventory.

The final step is to add the payment terms from supplier to manufacturer. In this case, the supplier is being paid 7 days after the exchange of ownership. In effect, the supplier is financing the manufacturer for six days and the wholesaler for one day.

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A simplified analysis suggests that the wholesaler, retailer, and manufacturer are net capital buyers, and the consumer & supplier are net capital sellers. The days of financing are shown in the graphic below, with buyers in blue and sellers in orange… Depending on the level of transactions, the operational exchange of capital could reach very high levels.

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Complicating Factors:

There are a few reasons to be wary of the simplified picture above. I’m listing below the factors that affect the true degree of capital exchange. While these factors don’t destroy the analysis, they would be needed to really understand the usefulness of the flow of capital.

  1. The relative cost of capital for each participant, if they borrowed elsewhere
  2. The daily average invoice value
  3. The volatility of the invoice value, such as seasonality
  4. The terms of ownership exchange, as in “where” the exchange occurs
  5. The timeline between ownership exchanges, since they are not simultaneous

Capital and Supply Chain Visibility:

Clearly, invoicing and invoice payment are part of the remit for supply chain visibility. I would argue that INCO or other buying and payment terms should also be visible, at least to the anchor organization. Beyond just “having them”, the visibility practice should be enabling critical review of the capital flow or capital economy in the supply chain. For example, some very interesting business alignments can take place for seasonal or event products via buying terms. A classic situation might be the short selling season for high-end ski-wear. In effect, the supply chain can extend capital to manufacturers so they can operate efficiently year-round, in preparation for the 2-3 weeks of sales when the whole supply chain makes money. This kind of alignment should be identifiable through supply chain visibility into capital flows and payment terms.

But does anyone do this in practice? Yes, certainly. The company Tradecard, now merged with GT Nexus, offered supply chain visibility and finance software specifically to support this kind of solution. In others situations, its occurring ad-hoc via procurement and sales negotiations. By that I mean to say that companies tend to seek out better capital resources and lock them in via payment terms on transactional business. Even if no analyst is conducting the process with an end-to-end view, the supply chain achieves stable, beneficial, capital economies among its members.  But this kind of piece-meal optimization has limits, and it has loopholes. A determined and equipped team of analysts with a good visibility solution could find arbitrage opportunities, and would otherwise certainly be able to make improvements. Here’s a quick example:

Annual Sales Annual Purchases Net Payment Terms Internal Cost of Capital Value of Terms
Consumer None 1 million USD -21 2% -$1,151
Retailer 1 million USD 1 million USD 4 4% $438
Wholesaler 1 million USD 1 million USD 18 7% $3,452
Manufacturer 1 million USD 1 million USD 6 6% $986
Supplier 1 million USD None -7 3% -$575
Total SC Value $3,151

 

The table above could be used to summarize the net payment terms in the supply chain. By “net”, we mean how many days an individual firm has its purchases financed by another firm’s capital. A negative figure indicates a net seller of capital. A positive figure indicates a net buyer, or recipient, of capital. The table also shows the cost of the next-best source of capital for each firm. In the table above we see that the consumer really has quite low usefulness for available capital. The last column to the right shows the value of the payment terms, meaning what the company gains or loses based on its payment terms. The whole table addresses a year-long period, but could be used for smaller time frames. In the bottom of the table we sum the value of the financing for each company and find that, in total, the supply chain creates value by exchanging capital. This occurs because the companies that have lower internal return on capital are selling capital to firms with greater internal return. By altering two of the internal return rates, we can see that a misalignment of payment terms to internal rate of return erodes the value realized.

Annual Sales Annual Purchases Net Payment Terms Internal Cost of Capital Value of Terms
Customer 0 1 million USD -21 2% -$1,151
Retailer 1 million USD 1 million USD 4 7% $767
Wholesaler 1 million USD 1 million USD 18 4% $1,973
Manufacturer 1 million USD 1 million USD 6 6% $986
Supplier 1 million USD 0 -7 3% -$575
Total SC Value $2,000

 

If an analyst was working in real life in this supply chain, they would hopefully identify the mis-alignment and seek to negotiate new payment terms which bring about greater net value. If such an analysis ever occurs, I believe supply chain visibility is the proper place for it to begin. The data shown in the table above, if not the creation of the table and structuring of alerts or other business interruptions, are supply chain visibility tasks.

If we tried to optimize the table, using a mathematical algorithm, we would find that the wholesaler ought to be financed by every other company, and for an unbounded number of days. In reality, a countervailing force would dampen capital exchanges as they get more and more focused on one party or longer in repayment time. That countervailing force is Counter-Party Risk, and is addressed below.

Counter-Party Risk: The Moderating Force

The one area I have seen systematic exploration of this capital economy is in the domain of counterparty risk. Finance teams understand that payment terms are in effect micro-loans riding along with transactions, and they are offsetting or inflating working capital needs. If everyone is healthy and prompt in fulfillment and payment, life is good. But as relationships stop, or in the face of bankruptcy, the healthy little exchange of working capital becomes a dangerous addition to the already serious exposure that supply chain partners have from the interrupted flow of materials. If your supplier goes bankrupt you then face a loss of materials and a concurrent loss of working capital (or a place to productively place spare capital, depending on the payment terms). For this reason, I have seen finance professionals use supply chain visibility to seriously monitor counterparty risk.

If an analyst was looking to optimize the capital usage in a supply chain, the first stage would be to maximize capital lending from the least productive capital pools to the most productive. But, the next step would be to carefully consider counter-party risk. As capital exchanges grow larger and with longer time for payment, the counterparty risk becomes significant. A good alignment created by 30 days of financing could be reduced significantly when risk exposure is considered. Together, counterparty risk and global cost-of-capital sourcing should result in moderate capital exchanges.

The Monday morning wrap-up:

As in most of my articles, I’d like to end with wrap up of how the insights discussed above can be applied in your daily supply chain life.

    • Organizations have differing uses, and accessibility, to working capital. Some firms are cash-rich and have trouble finding a good place to invest. Others are holding debt and have to carefully balance their cash flow.
    • Based on the differing value of capital (accessibility and internal return), firms have the opportunity to sell capital to each other for a net gain.
    • In practice, very few companies want to become pure capital lenders. Instead, they attach payment terms to their supply chain transactions as a means of deriving additional value from their own or their partner’s capital.
    • These payment terms, along with relevant data, should be included in supply chain visibility practices. Their inclusion allows analysts to better coordinate the supply chain’s capital economy.
    • There are probably many ways to visualize the capital flow, and experimentation is needed given the relative lack of current application.
    • Using a table similar to what was shown in the article; analysts can find misalignments of the capital economy and quantify the value of alternate arrangements.
    • Part of planning a re-alignment in the capital economy is to consider counterparty risk, which tends to countervail against the potential value of deep and long-term capital exchanges.
    • Finally, this description of a capital economy aligns well with other articles and frameworks describing a supply chain as the flow of capital, information, and materials. It also aligns with the framework of supply chain visibility effectiveness. Expanded with the points from today’s article, they offer more value and potential for initiatives.

 

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