Spend Matters welcomes this guest post from Tom Levene, of The Hackett Group.
Do you pay your suppliers too quickly? New research by The Hackett Group has indicated that 32% of respondents are planning to extend their supplier payment terms. Additionally, our benchmark studies show that many organizations trail industry peers in the key supplier cash flow measure, days payable outstanding (DPO). In these organizations, responsibility for payment terms often spans multiple functions with differing priorities or the value of working capital is not well appreciated. Pursuing a payment term extension program with suppliers can unlock value in your supply chain, but to maximize this value, preparation is key.
1. Know Where you Stand
Knowledge of your position is essential to an effective negotiation. Many organizations may not have full visibility into one or more of the following: how much is spent, with whom, by whom, for what and at what terms. In these cases, the first step is a data cleansing, category mapping and spend analysis exercise.
2. Set a Goal for Each Supplier
To achieve success, you need to establish short and long-term goals. Once you understand your spend, take a data-driven approach to set target payment terms for each supplier. The factors to consider when establishing your targets are:
- The supplier’s days sales outstanding (DSO) — a proxy for your supplier’s receivables collection time — a valuable data point to understand what payment term may be achievable. Note that DSO (and other working capital ratios) are imperfect measures and can be misleading in certain industries (e.g., financial institutions).
- A benchmark of the DSO based on the supplier’s industry — especially valuable for private companies
- The DPO of your peers/competitors
- Your current best available payment terms with the supplier — should act as a floor for term targets; even harmonizing from multiple terms to the best transacted term can be a huge win
- Prominent/benchmark payment terms for your supplier’s industry, if available
Note that naturally some industries require faster payment than others. For example, the DSO for hotels and restaurants is 21 days while professional services are 67 days. Terms vary by geography as well. For example, small companies in Europe are protected by payment terms regulations.
3. Know Your Tradeoff
Flexibility is key to maximizing the value of your trade credit. You can offer to pay suppliers early in exchange for a discount. Employees should be trained to understand the working capital trade-off between days and discounts. If your cost of capital is 7%, a 1% early pay discount has the same value as a 52-day increase in payment terms (equal to 1%÷7%×365 days). The higher your cost of capital, the more valuable discounts are. However, it is important to balance terms extension with increased discounts. Days extension is often less salient than discounts and is less likely to open the door to other points of negotiation that you’d prefer to avoid (e.g., price). An approach we have had success with is to lead with a terms extension then offer a prompt pay discount as an alternative if the supplier balks at receiving later payment.
4. Don’t Negotiate with Everyone
It may seem a counterintuitive negotiations preparation step, but negotiating with every supplier is inefficient or impractical. The overwhelming majority of suppliers can be moved to improved terms without any negotiations. In addition to selecting suppliers to exclude from negotiations based on lower annual spend, be sure to engage stakeholders to identify strategic or operations-critical suppliers for direct negotiations or outright removal from the terms improvement program. While there is tremendous value in optimizing payment terms, the value will erode quickly if operations are disrupted. Once identified, send small-spend and less strategic suppliers a letter or email announcing that company policy is changing and future transactions will be at the new standard terms. Some suppliers will reject the terms (prepare an escalation plan in advance), but clients tend to get a remarkably low response rate (e.g., typically a low single-digit percentage). There is often more reticence from internal parties about supplier pushback than actual pushback.
5. Remember These Tips as you Approach Direct Negotiations
- Ensure your counterpart is authorized to change payment terms or you may have to repeat the exercise with someone who is
- Aim high — you will never get more than you ask for. Your targets are backed by data; do not fear offending suppliers.
- You are not singling any one supplier out; all suppliers are being addressed. Communicating this fact applies social pressure to suppliers and puts the onus on them to justify exceptions.
- Know what you are willing to offer. Terms can often be extended without giving up anything if the data show that the current term is too short, but be prepared to respond to potential counteroffers and alternatives like enrolling the supplier in your p-card payment program.
Congratulations! If you completed the above steps, you have prepared for payment term optimization in a systematic and data driven way. You are ready to negotiate with your suppliers and free up cash for your organization.