Corporate TreasuryFinancial Supply ChainBank RelationshipsEnhancing Financial Performance in Trade

Enhancing Financial Performance in Trade

Discussion at the Trade Exchange1 in May 2005 highlighted two interrelated concerns that impact performance in trade. First, overall product cost (i.e., cost of goods sold/COGS), which affects profit margins; and second, inventory levels, which effect balance-sheet-efficiency ratios. Cost-related challenges and efforts can be grouped as follows:

  • Deriving and managing total cost
  • Determining the most advantageous incoterms
  • Choosing the most advantageous payment terms
  • Minimizing the cost of payment and vendor financing
  • Consolidating vendors

Deriving and Managing Total Cost

Trade Exchange members use different approaches for deriving total cost. For example, one attendee runs a monthly billing report of customs charges. A staff member reconciles purchase-order versus actual pricing and then reviews costs by department and division to understand the variance between actual and estimated costs. According to another participant, an import representative tracks every purchase order falling under a category (e.g. shoes) and ‘marries together costs until the transaction is done’.

The overarching concern across cost-related discussion topics was the impact of discreet processes and decisions along the physical and financial supply chains on overall product cost as a key driver of margin and other aspects of financial performance. Given the fragmentation of processes, participants are challenged to get a timely picture of total cost and to strategically manage cost reduction.

Discussion focused on those aspects of cost over which participants have a level of direct control or influence – international commerce terms (incoterms), payment terms, payment methods, vendor financing, and vendor management. A key goal is to reduce the total cost of supply-chain activities to enhance competitiveness. Participants recognize that a lower cost to suppliers also benefits importers, since suppliers are likely topass back higher costs as a component of pricing anyway. The question is how to manage cost components to optimal effect for both parties and how to measure the impact of fluctuations in suppliers’ costs on COGS.

A presentation on FX posed risk sharing agreements as a way to address the potential impact of foreign-currency fluctuations on price. Attendees say they are not seeing any upward pressure on pricing for purchases in US dollars despite the significant decline in the dollar over the past 18 months. A few participants noted that when currencies move against them, vendors do come back and ask for a price adjustment. One Trade Exchange member asked how other participants measure the extent to which suppliers are passing back other costs in the form of higher prices. A second attendee said that where vendor relationships are good, vendors are willing to provide a breakdown of costs.

Determining the Most Advantageous Incoterms

Trade Exchange participants discussed the varying considerations around cost and inventory control in choosing incoterms. One participant prefers free on board (FOB terms) because it puts the company in charge of its freight and its freight bill. The company gets better pricing by using its own freight forwarder, and the attendee says that the company’s relationship with its forwarders, including a level of automation, makes the process easier. Another participant predominantly uses FOB, although it also has a delivered duty paid (DDP) program. This attendee agrees that with FOB, “we’re in control,” whereas with DDP “we don’t see [goods] come into the (inventory) pipeline the same way”. Delays from back-and-forth communication around customs clearing illustrate the difficulty. The attendee summarizes this: “We want to use our consolidator and forwarder so that it’s cleaner”. Where the company uses DDP terms it has abandoned forcing the seller to use its consolidator, since it does not have the right to do so. But some vendors are willing to use its forwarder and bill the company. The attendee says this arrangement is in place for a limited number of suppliers, which makes the program easy to control.

A third meeting participant prefers DDP terms, in which he names the company’s distribution center as the point of ownership transfer. The letter of credit (LC) specifies the freight forwarder so that the participant knows the cost. The participant does not pay any unexpected costs. By specifying the freight forwarder he also saves money on liability insurance. The attendee has also started using delivered duty unpaid (DDU) terms, whereby the company handles customs clearing and duty payment. The company was concerned about the legal risk associated with the potential for smuggling and decided to clear (the freight) and take care of things themself.

A fourth Trade Exchange member company is taking the opposite approach for its products. Unlike some of the others, this company is driving for complete control of the supply chain. The attendee cited the company’s effort to warehouse in China as an example of how the company is strengthening supply-chain security and improving its freight costs. The company takes possession of goods at the factory (i.e. ex works) and uses import warehouses to pool its safety stock at a distribution point. A fifth attendee said her company is using this approach for its basics.

Another attendee emphasized the goal of linking supply chains and finance and noted that taking ownership later in the pipeline affects inventory terms (e.g. turnover ratio). She says it comes down to a cost/benefit analysis of what’s best for the company. She contends that even if the buyer does not take ownership until the point of entry, the buyer pays for the cost in some way. But the impact on cost is difficult to quantify.

Choosing the Most Advantageous Payment Terms

One participant cited payment terms as another disconnect between physical and financial supply chains. For example, buyers (i.e. merchants) at the participant’s company give vendors extended terms, since they are measured (among other things) against their leverage rate. But are vendors borrowing at higher rates than the importer and then building that cost into their pricing? The participant’s company is debating whether this approach to payment terms makes sense.

Participants debated the use of LCs versus open account. One Trade Exchange member contends that today her company’s LC cost is included in the cost of FOB terms and that LCs give leverage. For example, the attendee accepts discrepancies but constantly forces deductions and charges one per cent of the invoice value for every day the goods are late. When there’s a quality issue she can get a refund for duty from the government. She notes, “There have been times that if the presentation is clean and it’s the last time with a supplier, I’ve had banks work with me”. The participant questioned, “What’s in it for us to go to open account?” Aanother attendee asserted that from the buyer’s perspective, open account gives more leverage than an LC. This Trade Exchange member structures terms to allow enough time to clear the product through customs. A third participant said her company builds in payment terms of at least 90 days so that often it pays for inventory after it’s sold. And despite the fact that another participant company’s current LC process is automated and its open-account transactions are manual, the attendee said it’s more beneficial to move to open account for many reasons. Another Trade Exchange member pointed out that no matter what the payment method, there are terms behind it.

Minimizing the Cost of Payment and Vendor Financing

A number of Trade Exchange participants continue to move towards open account and alternative payment programs. According to one attendee, bank LCs and private label LCs (PLLC) respectively comprise 30 per cent and 60 per cent of the company’s trade business, with other payment methods including TradeCard, open account (bank handles documentation), and small payments (locally printed checks). A second participant has drastically reduced its bank LC volume in the past three years. Before the participant’s company was using 100 per cent bank LC but now has shifted volume to PLLC and third-party open account (bank handles documentation). She says that large vendors approached the company and said that bank LCs were expensive, cumbersome and unnecessary. The company started by moving large vendors to open account, and now “it’s any vendor that asks for it or any vendor that we ask”. Another participant said that her company is moving towards open account as a requirement for all new vendors.

Participants generally continue to provide bank LCs to those vendors that require it for financing, putting the onus of cost on the suppliers. One attendee noted, “We push a lot of fees to our suppliers,” especially for bank LCs with multiple drawings. Another said, “A few hundred dollars per transaction adds up in a competitive space.” A third participant charges suppliers 2 per cent of the value of negotiation for bank LC usage (which it credits back to COGS) but no fee for PLLCs. But some Trade Exchange members voiced concern that supplier pricing likely reflects the cost associated with bank LC fees.

It is likely that suppliers pass along higher financing costs in their pricing to importers too. Several participants are interested in seeing a study of the cost of vendor financing obtained from overseas banks. As to the question of whether it is cheaper for the importer or the importer’s bank to provide funding, several participants questioned the value of allowing vendors to leverage the company’s balance sheet versus obtain other sources of financing, albeit at higher rates. One attendee noted that she has not seen interest from vendors in her company providing open-account financing and says it is not worth the effort for a small percentage of clients.

Another attendee said, “It would be great to get out of the LC business and have banks check documents and do vendor financing.” A third Trade Exchange member said that while bank LCs are expensive, she doesn’t want to take on document checking. Ideally banks would work with vendors on open-account financing, but web-based banking solutions that provide finance based on the purchase order only work when the buyer is willing to guarantee a large portion of the purchase order. But another participant pointed out that vendors pay so much for bank LCs that even if his company paid all of the fees for an outsourcing solution, the company’s COGS would decrease.

Consolidating Vendors

A number of Trade Exchange members are working to rationalize supplier relationships and establish preferred vendors. One participant approached its top 50 vendors about forming strategic partnerships. Another Trade Exchange member is also moving towards a smaller number of preferred vendors. A third participant’s company has reduced its supplier base from 200 to 30 or 40 and is looking to further shrink this number to 30. The participant says that costs go down and controls are easier. Especially in Asia, the company wants to consolidate production with those suppliers it views as partners in lowering production cost. The attendee noted that it is easier to achieve given the company’s buying focus on classic trousers, sweaters, leather, and accessories. But another Trade Exchange member had a different perspective: “It’s not all about basics. We have specialty items that require some smaller vendors”.

Domestically, one company uses new sources all of the time when it finds “opportunistic buys.” Another attendee has succeeded in reducing the company’s vendors in some areas, but the vendor base is growing in other areas (e.g., new products). Another Trade Exchange participant says a number of supply-chain-related factors – a vendor’s stability, financing needs, global presence, and partnership with other mills, to name a few – drive her company’s choice of strategic vendors. She has found that the company’s top vendors are the lowest maintenance. Another attendee added that since larger vendors tend to have working capital, they don’t need financing.

Fostering Collaboration

Discussion analysis revealed the following key challenges, which exacerbate supply-chain fragmentation and the ability to optimize financial performance:

  • Influencing merchant behavior
  • Overcoming internal silos

Influencing Merchant Behaviour

Several participants noted that organization-wide data synchronization (i.e. standardizing identifiers such as style numbers to foster integration) is not a foundational issue at their companies. One said the problem is not “the communication of data” but rather “the mentality of different departments”. A number of Trade Exchange members cited merchandising as a key department making maverick financial decisions that impact cost. At one participant company – which ramped up its LC process one year ago – the merchants have “gone wild, giving into the vendors’ every whim,” which includes removing LC clauses.

Several participants agreed that merchants should not be unilaterally negotiating financial terms beyond the purchase order. According to one, part of the problem is that merchants don’t see the full cost picture. She says, “A lot of people in production are looking at a purchase order, your landed cost may be much more.” But payment timing lags behind the ordering process, which means that the financial staff is working with historical data. This limits the ability to preempt merchant actions.

Overcoming Internal Silos

The timing issue resurfaced when participants discussed the extent to which organizational structure impacts their ability to see the total cost picture. For example, at one company, the logistics department pays duty and freight, inputting these costs directly into the accounting system. But the department reports through a different channel than finance, and duty and freight charges hit the books at a different time than other costs. Another participant said that while “logistics is the only thing outside of our umbrella”, the staff member who handles duty costs is part of her department.

One Trade Exchange member company struggles with how to best organize its international team. As to the question of whether an optimal structure for global sourcing might combine both the physical and financial supply chains, the attendee responds that an integrated structure becomes harder the bigger the organization grows.

Best Practices and Proposed Solutions

Trade Exchange participants shared current practices that have succeeded in changing merchant behavior and overcoming internal silos. A few voiced the need for education and training. One attendee uses policy guidelines (i.e. a common set of instructions) and a proforma spreadsheet (i.e. a standard format for data entry) as effective training tools, rejecting transactions that don’t comply.

Another company has successfully used incentives to influence merchant behavior. The attendee asserts that buyers must understand the bottom line financial impact of their decisions on margins and must meet certain returns. Several participants also discussed limiting the merchant’s level of authority to curtail unilateral decision-making. At one company, planners, who serve in a part financial, part merchandising role, “hold the checkbook”. They must sign off on merchant purchases.

To foster closer working relationships, one Trade Exchange member has formed a cross-functional team that meets monthly to share information. The team includes sourcing, logistics, customs, and compliance, among others. Several attendees say that the sponsoring group often drives the cross-functional team in their companies.

Improving Efficiency

Discussion focused on moving towards a paperless environment. Currently one attending company has a completely paper-based environment. The Trade Exchange participant says that with multiple purchase orders per invoice, three to four months after a transaction “we’re figuring out why we’re short, or where’s this invoice”. A second participant said that the LC process at her company is automated while open account is manual. Global sourcing at another company has doubled from $300m in 2004 to $600m in 2005 and projected to grow to $1.3bn in 2006. One staff member inputs 50 LCs per week, but LCs are in a standard format.

A fourth attendee noted that documents must be in a standard format whether they are paperless or electronic. “We have service providers who have standard formats, and that’s what our suppliers use”. The company’s sales contracts are the basis for its LC template. The company includes any documentation – including country-specific requirements – when it creates a contract in its treasury system and then sends a SWIFT file to its banks. The merchandiser keys the payment method into the purchase order. Two staff members process all trade transactions.

A few participants cited the inability of suppliers to send EDI formats as a roadblock to automation. One Trade Exchange member-company does 100 per cent of its business in an automated fashion, including for bank LCs, with the support of its consolidator and software system. The participant says the consolidator handles its 810 matching (i.e. standard trade EDI format). The consolidator performs data entry, provides an “electronic file used for billing, makes payment, conducts three-way matching, and everything”, including working out discrepancies between invoices and purchase orders. The attendee asserted, “I never see a paper invoice ever. If I do, I throw it in the trash. It’s taken me four or five years to get to this”. One drawback is that the system cannot handle charge backs, but all duties, commissions, etc. are electronic. The company has reduced headcount by 15 people (from 20 down to five) between the cash management and the logistics departments.

A few participants voiced interest in the concept of a communications portal. One company is using a portal to give vendors access to their purchase orders. The solution is a web-based, homegrown secure application, whereby a supplier can use its purchase order to create an invoice.

1 Trade Exchange was launched by Bank of America in 2004. It is an annual person meeting with topic-based teleconference calls.

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