Managing the Financial Supply Chain

Understanding and managing all aspects of the financial supply chain is an essential ingredient for business success. While that statement has always been true, it takes on a new level of importance in today's world of global sourcing and production outsourcing. The recommendations offered in this article can help supply chain professionals more effectively integrate the physical flow of goods with the financial flow.

By Roland Hartley-Urquhart -- Supply Chain Management Review, 9/1/2006

It is widely accepted that global sourcing and production outsourcing have helped many companies reduce operating costs and adapt to dynamic market conditions. Global sourcing and outsourcing have the added benefit of generating cash for many companies, as investments in plants, equipment, and working capital shift from the brand owners and original equipment manufacturers (OEMs) to their trading partners, who in many cases are overseas. While these benefits can't be denied, business leaders need to assess the unintended consequences of their global sourcing and outsourcing strategies beyond direct cost and capital savings. In particular, they need to recognize that the labor cost advantage of moving these activities offshore masks hidden costs and risks within the financial supply chain.

While global sourcing and outsourcing may reduce the cost of the actual product—the “first cost”—they often decrease the capital efficiency of the value chain. Specifically, plants and equipment are often far more expensive to finance in emerging market countries. In addition, inventory tends to get pushed downstream to suppliers, which often have a higher cost of capital. Furthermore, global operations can add weeks to the value chain, tying up as much as 30 percent of product price in working capital.

Global sourcing and outsourcing also weaken control over the financial supply chain. This reduction in control can affect shareholder value, erode competitiveness, and introduce new business risks. Common challenges include the complexities around Sarbanes-Oxley compliance, complex chargeback management processes, and implicit foreign exchange risks.

This article will identify the risks and challenges in financial supply chain (FSC) management today. It also highlights some of the techniques and practices that can be used to reduce the ecosystem cost of capital in the supply chain, enhance supply chain performance, control hidden operating expenses, and minimize risks within the extended business ecosystem. Finally, we conclude by presenting opportunities for supply chain organizations to work with the chief financial officer to:

• Improve the financial performance of the extended value chain.
• Identify and manage hidden financial and operational risks associated with global outsourcing.
• Leverage existing supply chain visibility and sourcing systems to regain control over the financial supply chain.
• Reduce potential supply chain disruptions resulting from capital constraints within the business ecosystem.

Traditionally, organizations have focused on differentiating themselves and improving operational efficiencies by owning their entire supply chain. Ownership, in fact, was the only way to achieve the seamless flow of information that would allow them to truly optimize operations. Ownership also allowed organizations to take complete control of their businesses—a very appealing prospect to large enterprises in particular.

Although this approach may have been more successful in the past, it has always had several drawbacks. First, ownership is extremely capital-intensive. Organizations had to invest significantly in purchasing, building, and operating various pieces of the supply chain. Second, and perhaps more importantly, this model forced organizations to focus on business functions that were not their core competencies.

The global access provided by advances in information technology and the resulting transparency into a business's extended operations have facilitated a changing view of ownership. The Internet provides a seamless information flow at a relatively low cost. Companies no longer need to own their entire supply chain. Instead they can leverage the core competencies of their partners to create value. The traditional linear value chain exemplified by the vertically organized enterprise is being replaced by hubs of value whose arrangement is more accurately described as a “business ecosystem.” (Exhibit 1 graphically illustrates this development.)

In parallel, information technology and supply chain management practices have allowed organizations to refine the notion of what constitutes core competency. While outsourcing was once limited to such functions as public relations, human resources, and data entry, it now has been extended to a wide range of supply chain activities as well as to direct-material production.

Enterprises today are now enabled to become “core competency centric”—that is, they can focus on those activities that directly affect the customer experience with or relationship to the product or service provided. Global outsourcing, in particular, allows corporations to exist as virtual entities where brand and customer relationship management (CRM) are the central value added. This extended network of business partners—also known as a value chain—includes suppliers, partners, customers, and other entities that have a stake in satisfying the value chain's customers.

Increasingly, companies are discovering that the benefits of global sourcing and outsourcing transcend cost and working-capital savings. Combined with lean manufacturing practices, these approaches can smooth out business cycles. At a broader level they can dampen inflationary pressures in the economy overall. Alan Greenspan was one of the first financial policy makers to acknowledge the dramatic financial impact of supply chain management and related technology. In testimony to Congress, the former Federal Reserve chairman justified a program of aggressive interest-rate cuts this way:

“Extraordinary improvements in business-to-business communication have held unit costs in check, in part by greatly speeding up the flow of information. New technologies for supply chain management and flexible manufacturing imply that businesses can perceive imbalances in inventories at a very early stage—virtually in real time—and can cut production promptly in response to the developing signs of unintended inventory building.”¹

Global sourcing and outsourcing also have served to insulate participants in volatile industries such as high-tech manufacturing. For public companies, the ability to report predictable and consistent earnings despite dynamic market conditions is vital. An adaptive, demand-driven business model can insulate these companies to some extent from rapid market changes, as suppliers bear the burden of fixed overhead or inventory obsolescence during sudden market contractions.

At the same time, advances in supply chain visibility have accelerated opportunities to outsource direct-material production. “They go hand in hand,” according to Gene Tyndall, president of Supply Chain Executive Advisors. Tyndall is an expert in the theory and practice of supply chain management and co-author of Supercharging Supply Chains (as well as three other books on this subject).

Both sourcing and manufacturing have gone global, Tyndall notes, which adds to the importance of the financial supply chain. Adding to the complexity are longer lead times, the involvement of multiple parties, added duties, taxes, longer delays, disruptions, security regulations, and so forth—all of which complicate financial flows and cash management.

Despite the growing importance of the financial supply chain, many companies still don't give it the attention it deserves. “The one area that remains neglected is the financial supply chain,” says Tyndall. “Leveraging global supply chain visibility to control and optimize the financial flows of a business value chain is essential for the long-term viability of companies that have outsourced manufacturing or are sourcing globally. Its importance cuts across all areas that impact shareholder value: demand synchronization, cost, capital deployed, and brand equity.”

Steve Payne, president of Hackett-REL, a firm that helps companies generate cash improvement from working capital, agrees. “Collaborative working capital management between supply chain partners—based on shared goals and visibility—is the North Star of the supply chain management journey,” Payne says.

If the financial supply chain is as important as Tyndall and Payne suggest, why aren't companies focusing more intently on it? In gathering research for the article, we were hard pressed to find leading consulting firms with a dedicated practice capability in this area (with the exception of Hackett-REL, which was acquired recently by Answerthink). Such a practice area would house an integrated knowledge base of the key physical, information, and financial supply chain flows coupled with an expertise in trade finance.

Instead, financial institutions are filling this vacuum with financial supply chain products that improve the overall capital efficiency of the supply chain. This is hardly surprising given the opportunities to profit from the arbitrage of capital-cost imbalances inherent in many supply chains. These products, reviewed later in this article, generate real value in terms of capital optimization. Moreover, they can serve to mitigate some of the financial supply chain risks identified below. However, the starting point for better financial supply chain management should be an analysis of the unique characteristics of the company's business ecosystem. Such a rigorous analysis will inform the steps needed to mitigate risks and to assess financial service products that can optimize the capital structure.

In conducting this analysis, companies need to recognize up front that global sourcing and production outsourcing complicate the value exchange process. In particular, they increase the quantity, velocity, and complexity of interenterprise financial transactions, leading to higher administration costs. As global sourcing and outsourcing continue, the number of financial transactions handled within the four walls of the enterprise decreases. At the same time, the number of transactions handled by outside vendors increases. In cases where subassembly or contracted manufacturing reduces the administration costs of the company doing the outsourcing, these costs are merely pushed downstream. When global sourcing and outsourcing are combined with just-in-time supply chain practices, the velocity of payment transactions is accelerated because the smaller consignments require additional payments or the aggregation of many discrete transactions.

Along with increasing the velocity and quantity of payments, global sourcing and outsourcing also lead to low or no visibility into the timing of payments. Retailers and brand owners with direct import operations have aggressively moved payment terms from letters of credit (in which the trade finance bank makes the payment decision) to open account (where the payment decision is made by the buyer). One reason is to create a time buffer between visibility into the payment obligation and the actual funding of the obligation. Even though trade finance banks make available online tools to expedite the global payment process, corporations are moving these cross-border payments to standardized domestic payable processes so as to give their treasury better visibility into cash requirements. Assume, for example, that the accounts payable vouchering process takes as long as 30 days. If the company pays in 45 days, it gains over two weeks visibility into the cash requirement. Under a letter of credit, in contrast, the company is usually required to fund its account no later than the next business day.

The problem with moving cross-border payments to open account is that the accounts payable vouchering process becomes far more complex. The paper-based cross-border trade documents—export licenses, bills of lading, and so forth—that were once given to the experts in a bank's letter-of-credit department for review and payment, must now be handled by an accounts payable clerk. In many cases, these individuals may have little experience in cross-border payment. Companies have mitigated this value exchange risk — that is, assuring what's ordered and delivered is what's paid for—by introducing additional checks and balances into their supply chain organization. Some companies such as Wal-Mart are able to leverage their extensive network of buying offices globally to undertake this process. Other companies without a global footprint must rely on a patchwork of agents, faxes, and couriers to accomplish the same task.

In addition to complicating financial transactions, global sourcing and production outsourcing introduce a higher degree of risk into the supply chain. To cite one prominent example: Saks Inc.'s lack of centralized controls and visibility into its sourcing operations' procure-to-pay process contributed to the company's alleged illegal collection of excess vendor markdowns. In addition to facing numerous legal and regulatory battles and distractions, Saks saw its total market capitalization drop by 20 percent immediately following the announcement of the scandal in 2005.

It is often difficult to standardize and monitor payment practices when the supply chain gets complicated and the supply base is in constant flux. Even with a stable base of supply chain partners, the procure-to-pay process is challenging. By using supply chain strategies like postponement, merge-in-transit, and vendor-managed inventory (VMI), companies only add to the complexity of the value exchange process. The reason: Under these practices, information from many different sources needs to be integrated with the purchase-order system in order to provide the necessary visibility to make payment.

Industries and companies have responded to the increased financial supply chain complexity in different ways and to different degrees of success. Many branded apparel companies, for example, have expanded their sourcing from cut, make, and trim (CMT) to full package purchases. In a full package transaction the contract factory is responsible for purchasing raw materials directly from textile mills (usually specified by the brand owner) and selling finished product to the brand owner on a free-on-board (FOB) origin basis. This greatly simplifies the work of the brands. They no longer have to track and maintain raw-material inventory consigned to various factories all over the world like they did under the conventional CMT approach.

While this approach minimizes complexity for the brand owner, moving responsibility for inventory ownership adds cost and complexity to the entire supply chain. What results is a supply chain resembling a barbell, with two large organizations at either end (mill and brand owner) connected by smaller contract manufacturers (CMs) in the middle. The weak middle, unsupported by a collaborative supply chain, is vulnerable to unforeseen problems affecting both top-line and bottom-line growth. “Factories must absorb these higher inventory-carrying costs in their margin or just go out of business,” explains Hackett-REL Senior Business Advisor Mark Tennant.

The textile mills face similar problems. Where once they negotiated and sold products directly to the brand owner, they now may deal with as many as 200 potential suppliers for the same level of orders. This complexity greatly complicates credit management for the mills, which often only ship “cash on delivery” (COD) or against prepayment. And this, in turn, further stresses factories' working capital, often leading to smaller, less economical, and frequently expedited shipments.

From the brand owner's perspective, it's hard to see this complexity as a problem. Yet a lack of collaboration can affect their top-line growth. For instance, textile mills that don't have visibility into the brand owner's order flow to the factories will often slow down or hold up shipments. This can lead to a shortage of sufficient raw-material inventory for production. In fashion, where rapidly changing trends are the norm, a lack of raw material combined with long lead times, can keep hot items from reaching the shelves in time. The message here is that for any financial supply chain strategy to succeed, the needs of all the supply chain partners need to be taken into consideration.

As markets increasingly go global and more value is added offshore, greater foreign exchange risk becomes embedded in value chains. This risk extends to products purchased from overseas vendors or sold to distributors on U.S. dollar terms. Supply chain managers need to be cognizant of these embedded foreign exchange risks, even when all prices are expressed in dollars. At the most basic level, the local content value costs have added a direct foreign exchange component. These costs can include the cost of labor, plant, and equipment (if purchased locally); depreciation; and local currency financing costs. Supplier profits are affected too, as these costs are typically accounted for in local currency and paid from sales revenue collected in dollars. If the dollar strengthens relative to the local currency and the product price does not change, the supplier's margin increases.

Although trade in physical products and services is largely free of regulation, emerging market countries often manage the dollar exchange rate for political purposes such as preventing social unrest, maintaining price stability, or protecting and fostering favored industries. When the exchange rate is managed, unforeseen changes in the underlying global economy can create shifts in foreign exchange markets. These foreign exchange movements can be sudden, unexpected, and sometimes of even seismic proportions, acting much like the force of an earthquake unleashed by the gradual underlying movement of tectonic plates.

An example of the worst-case scenario occurred during the Asian currency crisis of 1997-1998. At that time, several Asian currencies were artificially pegged to the dollar by government fiat. Yet market pressures overwhelmed these governments' ability to maintain the fixed-exchange-rate pegs, and the Asian currencies went into a free fall. While falling local currency prices would seem to present a great opportunity to obtain lower product prices, the scale of the devaluations effectively shut down all dollar lending activity. This meant that local producers were unable to buy raw materials to keep their factories in production, and many quickly went bankrupt. Supply chain managers were forced to find new sources of supply or assist their vendors financially to survive.

Most economists agree that China maintains an artificially low exchange rate vis-à-vis the dollar today. China may have sufficient policy tools in place for maintaining control. However, it is not unthinkable that the government would either modify its policy or loosen control over the yuan. The probabilities and potential impact of such events occurring are speculative. Still, supply chain managers must be alert to the impact that a revaluation (an increase in the value of the yuan) would have on prices of Chinese-manufactured goods as well as on the global price of underlying commodities used to manufacture their products. At a minimum, the cost of local value-added content in China would become more expensive in dollar terms. Additionally, a more valuable yuan could add inflationary pressure on dollar-denominated commodity prices globally.

The experience of artificially fixed exchange rates in Asia in the late 1990s provides a valuable lesson that should not be ignored. In early 1997, many (but by no means all) economists agreed that the fixed exchange rates were unstable over the long run and that devaluations would be required. Yet while most companies were aware of these warnings, few had actually developed contingency plans to cope with the fallout. Today, we don't know exactly what the risks are of a Chinese revaluation, but supply chain managers and CFOs should come together to think through the potential impacts.

While business managers can do little about exchange rates, they can exert some measure of control over the capitalization of the business ecosystem. It is not uncommon for businesses to offer favorable terms for sales financing. However, companies are just beginning to consider the impact that supplier financing costs can have on supply chain cost and performance. A well-thought-out strategy can help reduce product costs, enhance supply chain performance, and insulate businesses from risks such as unexpected exchange rate movements.

As with the focus on core competencies, the emphasis on shareholder value has been a major driver of global sourcing and outsourcing. Shareholder value, which is a way of measuring profit after allocating the cost of capital, favors asset-light business models. Global sourcing and outsourcing generally have the twin benefits of lower unit cost and a reduction in the fixed assets and working capital associated with production.

Outsourced suppliers such as contract manufacturers, however, often have a higher cost of capital than their larger buying partners. As seen in Exhibit 2, most leading CMs have noninvestment-grade credit ratings, whereas many brand owner have investment-grade ratings. The higher cost of financing the CM is added to the supply chain. Initially, the operational savings associated with outsourcing manufacturing operations offset these higher capital costs. However, pressure to reduce costs does not stop with the initial outsourcing—and the companies doing the outsourcing are striving to reduce costs continually.

Exhibit 3 presents a specific example. We have used the 90-day corporate bond spread as a proxy for U.S. corporate working-capital financing costs. In this example, we compared the spread between Wal-Mart's cost of funds and a group of its largest suppliers with public debt ratings, recently identified by The Wall Street Journal.² For companies with investment-grade credit ratings,³ the cost differential was as low as five basis points (5/100th of 1 percent) for AA-/Aa3 rated consumer goods giant Procter & Gamble. At the high end the differential was 23 basis points for BBB-/Baa3 rated toymaker Hasbro. However, the average cost of capital differential between Wal-Mart and its large noninvestment-grade suppliers in this analysis rises over 4.5 times that of the investment-grade group, to over 64 basis points.

We use this example because of the relative ease of obtaining both objective credit-rating data and reliable sales percentages. In many cases where the suppliers are offshore companies, the cost of capital differential may be significantly higher.

A very simple model can be used to estimate the cost of capital differences between two companies.⁴ Exhibit 4 shows recent corporate bond spreads over U.S. Treasury securities for investment-grade and noninvestment-grade bonds respectively. To estimate the approximate cost-of-capital differential between two companies based upon known or estimated credit ratings, subtract the bond spread of the higher-rated company from the lower-rated company—for example, the contract manufacturer Flextronics (Ba3/BB-), which manufactures desktop personal computers and servers for Dell (A2/A). To estimate the difference in capital costs between these two companies, subtract Dell's bond spread (40 basis points) from Flextronics (320 basis points) for a difference of 280 basis points, or 2.8 percent.

CMs have proven adept at accessing the capital markets for reasonably priced debt. During market downturns, however, CMs appear vulnerable. Working-capital requirements of outsourcers are subject to a high degree of volatility and therefore higher cost. Rapidly rising demand requires increased raw-material inventory and days sales outstanding, while falling demand often leaves CMs holding high levels of finished goods. These costs over time must be absorbed by the CM's margin or added to their unit costs.

Various solutions­—some old, some new—are available to help companies manage their financial supply chain. Some of the more useful options are discussed below.

Early-Payment Programs

The cost-of-capital differences between brand owners and CMs created a market for supply chain financing (SCF). Beginning in the late 1990s, several financial institutions began offering early-payment financing to vendors of large multinational companies. Set up as a form of reverse factoring, these arrangements enable suppliers to accept early payment of receivables in exchange for a discount. The funding was provided by financial institutions. SCF products generally originate with the buyer or importer of goods as distinct from traditional receivable financing, which typically originate with the seller (exporter) of goods.

These SCF programs are based on the operational requirements of the supply chain. They usually permit higher advance rates to vendors than traditional receivable factoring or financing and can be used to mitigate a large portion of the capital cost differentials between vendors and OEMs. Moreover, many early adopters of supply chain financing programs have improved their financial supply chain processes to allow suppliers to discount receivables earlier. Earlier discounts translate to higher returns delivered by these programs. Companies have found that the same financial supply chain process improvements that enable earlier capture of discounts help mitigate the risks and better manage the complexities of the procure-to-pay process.

These financial products fell out of favor when the two largest players, GE Capital and Credit Suisse, exited the business largely because of deteriorating credit quality within their portfolios. Yet despite subsequent concerns raised by the Security and Exchange Commission's Office of the Chief Accountant concerning how buyers were treating the accounting of these programs, bank-funded early-payment programs appear on the rise. Today, most major global banks offer early-payment solutions for large buyers. In addition, many companies now find that they are well-positioned to manage and self-fund early-payment programs thanks to the available technology and process improvements. These self-funded programs are a profit center for buyers and provide working-capital assistance to vendors.

Inventory-Ownership Solutions

In addition to early-payment programs, several specialized providers are offering another way to help optimize capital costs within the supply chain ecosystem. Inventory ownership has emerged as a new tool for financing suppliers. This solution provides financing at rates less than what a supplier may have to pay for working capital. This service can be an effective means of mitigating large capital-cost differentials between sellers and buyers. Further, it provides a new source of capital to suppliers at a time when they are facing greater requirements to hold inventory in transit or at vendor-managed-inventory facilities for their customers.

GE Trade Distribution Services, for example, was recently established to equalize inventory-ownership costs in a supply chain. GE will buy goods from the seller, hold title to the goods while they are in transit or in warehouses, and then sell the inventory to the buyer when it's needed. GE uses an information management system integrated with in-transit data to manage the program. The agreements are carefully constructed so that GE does not end up with unsold inventory.

Pacific Asset Funding (PAF), the trade finance subsidiary of mutual life insurance company Pacific Life, has been in the inventory-ownership business for several years now. In addition to owning inventory, PAF acts like a trading company, arranging for transportation, warehousing, and customs clearance. Unlike the GE program, which typically requires an investment-grade buyer, PAF is willing to work selectively with unrated buyers on a global basis, wherever PAF can legally take title to goods. The finance company also works with U.S. asset-based lenders and factors that for regulatory or credit reasons cannot underwrite exporters from certain countries such as China. PAF will stand in as the exporter of record on these transactions, thereby enabling its client to finance the import.

“Often the supply chain executives get excited by what we have to offer,” says Robert Denhert, managing director of Pacific Asset Funding in Newport Beach, Calif. “But once their treasurer or CFO takes a look at the program, they'll often realize that if we are only talking about finance, the company can do it cheaper by funding it through their pre-existing bank lines of credit.”

However, as owners of inventory, PAF does more than just provide financing. It also offers a variety of related logistics services. That combination appears to be the sweet spot for early-payment and inventory-financing solutions. “When the procurement and logistics staffs come together to analyze the true cost of their operations, more often than not it is eye-opening for all parties,” says Denhart. “This leads to a further analysis of the services—in addition to funding—that we can offer to the company's suppliers. The result is often that buyers realize the need to assist their suppliers with outsourced financing and logistics management to help grow the business.”

Virtual Consignment Financing With Assignment of Proceeds

Another way to reduce financing costs is through consignment financing by buyers. This involves having the brand owner buy raw materials and consign or sell them to the contract manufacturer. Consignment financing creates an opportunity to consolidate and reduce unit-cost spend across commodity or component classes. It also provides another tool for strategically financing the supply chain.

In recent years, consignment financing has fallen out of favor largely because of the complexity of global supply chains and the aversion on the part of large buyers to hold stocks of raw-material inventories for long periods of time. However, the growing availability of more robust supply chain data combined with the deployment of vendor portals may spark renewed interest in this traditional financing approach.

Supply chains with a barbell credit profile could leverage supplier portals to share purchase-order data with key raw-material suppliers. This would ensure that the suppliers would sell inputs to selected CMs at prices agreed upon with the buyer. As long as these fixed prices and quantities were accurately reflected in the CM's invoice, the contractor could assign the proceeds of the buyer's payment to the raw-material producer in exchange for a larger credit limit or more extended terms. In this way, the raw-material producer, not the buyer, helps optimize the financial ecosystem.

Better control of accurate supply chain information facilitates supply chain financing. Thanks to the global access provided by the Internet and the use of common Internet standards, this information is readily available. The task is one of extraction, integration, and responding to the events that occur in the chain. Accuracy and timeliness of supply chain information are the critical success factors in this regard.

Understanding and managing all aspects of the financial supply chain are essential for companies today. High-priority areas that require a broad, strategic understanding include the procure-to-pay process, ecosystem capital costs, and foreign-exchange implications. Below are several recommended ways that a cross-functional finance and supply chain management team can enhance their organization's financial supply chain management capabilities:

1. Adopt a formal supplier-risk-assessment process. Use this process to understand the capital costs and foreign exchange risks embedded in first cost—even if all purchases are denominated in dollars.
2. Evaluate payment policies and systems (including chargebacks and warehouse receiving data) to mitigate Sarbanes-Oxley risks and assure that what you're paying for is what you've ordered.
3. Develop collaborative financing solutions. Earlier visibility can be leveraged to create flexibility around early-payment options for suppliers. Supplier portals can be leveraged to consolidate raw-material spend. In combination, these techniques can help you manage assignment of proceeds to reduce credit and transportation costs embedded in your first cost.
4. Ensure that inventory-reduction programs eliminate inventory across the total supply chain.

Integrating information about the physical flow of goods with the financial flow is the key to optimizing the financial supply chain. In the end, it's all about finding the right strategy and mix of trade-offs in terms of costs and assets.