Spend Matters welcomes a guest post from Kurt Cavano, Vice Chairman and Chief Strategy Officer at GT Nexus.
Rising labor costs continue to affect trade and force companies to look to less developed regions. One of the causes behind accelerating demand for higher wages is technology. Factory workers in countries such as Vietnam and Bangladesh who have worked for minimal hourly compensation know what’s happening at other factories around the world. And as a result, they are demanding more.
For industries such as apparel where labor makes up a major component of production, there’s a trend of production shifting further down into even more remote regions, like sub-Saharan Africa. In places like these wages are lower and the potential for savings can be huge, but there are many pitfalls. The obvious challenge in these remote regions is the lack of infrastructure such as roads, ports, etc. The most overlooked infrastructure component is banking and the access to affordable capital. The high cost of capital can dramatically affect the final cost of finished goods manufactured in these infrastructure-starved locations.
The Troubling Cost of Capital in Emerging Markets
The US Federal Reserve today stands at a 0.25% interest rate and the Bank of England is at 0.5%. But look beyond that into developing regions: China has a much higher interest rate at 6%, India at 8%, Turkey at 10%, and Brazil at 10.75%. Move further into the frontier markets, such as sub-Saharan Africa or Argentina, and they’re even higher. Why is this a dangerous factor that must be considered upon entering new regions? For one, there is the risk of delays. Lack of capital among suppliers in emerging regions is one of the biggest causes of shipment delays. Depending on the industry, raw materials and goods being produced, high capital costs can become a vice grip on the flow of supply.
Suppliers who struggle to obtain capital to start an order are a major risk. Consider this: suppliers have to finance materials, equipment, plant, payrolls, and account receivables. Unfortunately, the supply chain partner with the highest cost of capital gets squeezed, especially if customers start extending payment terms. Manufacturers who don’t tread carefully end up with higher cost of goods or suppliers that go out of business.
The second danger factor is the built-in cost. Capital costs are essentially built into the final cost of goods. Whether a business is producing smartphones or sneakers in a low cost locale, an interest rate hike from 6% up to 10% is going to drive up costs. Depending on the industry and brand, that manufacturer may not be able to pass along those excess costs to the end customer. That means margins must take a hit.
Taking Advantage of Interest Rates to Reduce Cost
Low labor costs versus high capital costs. Considering the lack of infrastructure, existing social and political risks, and overall uncertainty of some emerging markets, it’s not always worthwhile to move into the lowest cost region. But there are ways to hedge your bets. One way is by taking advantage of the 0.25% interest rate available to the US-based manufacturer and enabling factories in Argentina or Bangladesh to access capital based on those competitive rates. The financial strength of the original buyer eliminates capital-related costs from the supply chain.
For example, a British retailer with a 2% annual cost of short-term capital working with a Turkish supplier with a 10% cost of short-term capital has the potential to transfer the lower cost of capital to the supplier, thereby reducing its costs. Assuming in this example that 20% of the supplier’s cost was capital- related, the supplier’s cost would be reduced by 16%. For the retailer, that 16% savings now avoids the supplier’s mark-up and import duties. Assuming both were 15%, the aggregate supply chain saves approximately 22-23%.
The Solution: Connected Sourcing Networks
This works when all parties – including financial institutions – are plugged into the same network and direct visibility is provided to the finance provider to know the parties, transaction history, documents, and key events. This is easier said than done. But business-to-business networks that deliver this level of connectivity and visibility already exist in the cloud.
When all supply chain parties are connected on one network the world becomes a smaller place – with capabilities and opportunities that cannot be obtained elsewhere. Visibility and control of transactions becomes easier. Transactions become more strategic. Risk is removed for financial institutions – enabling capital to flow more easily and at less cost. And all parties involved benefit.