Co-operation between trading partners is essential in reducing uncertainty in the physical supply chain. Uncertainty is reduced incrementally and requires investment from both trading partners. Rather than apportioning the benefits to each company, the investment continues as long as they both expect to receive a net benefit. The benefits of adopting a co-operative financial process would be realised by the functions that are already co-operating with the trading partners. The financial supply chain ceases to be a separate process and merges into the overall supply chain.
Physical Supply Chain – Co-operative Relationship
In the early development of integrated supply chains, powerful companies dictated their requirements. An example is the integration required for a Just-in-Time system. The timely delivery of components reduced the working capital requirements of the powerful customer. To achieve a benefit the supplier had to make significant investments to adapt their processes. An example is the introduction of flexible manufacturing to increase the speed to respond to the customer’s requirements.
In the longer term, a process of iterative improvements requires close co-operation. Rather than apportioning savings for every investment, the focus is moved to a broader form of reciprocation. As long as both organisations continue to expect to receive a net benefit, it makes sense to continue to co-operate. The focus on the trading relationship moves away from competition between trading partner and towards co-operation within the supply chain and adversarial competition between supply chains. The success of BMW’s component manufacturers depends primarily on BMW and not via direct competition with other component manufacturers.
The Financial Supply Chain
Integration across the functions of a company can be achieved using ERP systems. It has proved difficult to implement a certain process for the input of invoices and generation of payment orders. The process is uncertain for a supplier because they don’t know when the payment will be received. Often, international suppliers paid in a foreign currency don’t know how much money they will receive. Powerful customers are reluctant to make the investment to provide a certain process because the suppliers will receive the benefits.
Rather than co-operating to remove costs from the supply chain, the customer’s finance functions can take an opportunistic approach. Payments can be delayed due to operational processes or to match cash flows. The foreign exchange risk is passed to the supplier when the customer invoices in their own currency.
Introducing Costs to the Supply Chain
The smaller supplier faces two main costs from an uncertain process:
- Foreign exchange risk: The smaller company may not have access to services to hedge the risk, which is a particular problem in the US, or they lack the infrastructure to manage the process.
- Uncertain date of payment: Larger balances need to be held.
The smaller supplier also incurs higher transaction charges for cash management services and foreign exchange. The costs introduced to the supply chain can be greater than the bank’s transaction charges. A recent example was where a smaller company added 5% to the price of a dollar transaction rather than face the hassle of arranging a forward.
The uncertain process can have a more significant impact on the broader trading relationship. Sales may be turned down where the financial risk is perceived to be too high. They can also be reluctant to make investments that are specific to the customer.
Cost of Implementing a Co-operative Supply Chain
The customer must make an investment to implement a co-operative financial process. However, there is a small incremental cost to operate the process. They can still pay late as long as the customer knows when they are going to get the money. Hedging currency transactions are relatively trivial for European and Asian based companies. The transaction cost for hedging and exchanging foreign currency for a large company with a treasury function is a small fraction of the transactional cost to a small supplier. The potential is for the larger company to remove the uncertainty from their supplier by pricing in the supplier’s currencies and paying on a certain date. Changing the process would reduce the net costs within the supply chain.
Delivering the Benefits
Automating the financial process has been simplified with the introduction of ERP systems. Time is still required to enter, match and authorise invoices, but there is sufficient time to pay the suppliers on a certain date. The working capital requirements of the supply chain and the administrative effort can be reduced without an adverse impact on the customer’s working capital. The customer could still pay consistently late.
Foreign exchange risk can be recognised, in real time, by ERP systems from the point where a purchase order is issued and received. There is a range of processes to manage hedging foreign exchange risk from periodic netting systems to the real-time trading of the foreign risk.
Large companies can access highly competitive rates for hedging and converting foreign exchange, and typically have dedicated, skilled staff that can manage the process. An exception may be US-based companies that invoice and order in dollars.
Barriers to Implementation
Powerful customers initially captured the benefits from the integration of the physical supply chain. In contrast, investment to produce a certain financial process is made by the customer while the supplier receives the benefits. The achievable benefit is dependent on whether the customer approaches the problem from a transactional or co-operative point of view. To justify the investment required to improve the process, the customer needs to determine that:
- There is an adequate benefit to the supply chain.
- The customer can achieve an adequate benefit.
- The improvement in the process can be delivered.
Where the customer has a transactional relationship with their suppliers, the focus will be to obtain a direct benefit from each transaction. The disadvantages of the process are due to the additional complexity introduced to the supply chain and the fact that only a limited number of the suppliers would adopt the process. An example of a transactional finance process would be supply chain finance. With a co-operative finance process, the focus is on the overall benefit to the supply chain and the likelihood of the customer receiving an adequate financial return.
- What is the order of the benefit to the supply chain?
- What proportion of the suppliers will recognise they have received a benefit?
- Where could an indirect benefit be received?
Moving to a Co-operative Financial Process
There are issues related to the technical development of a solution, which will not be covered in this article. Compared with the complexity of the systems developed to manage the physical supply chain, they are relatively trivial.
The company making the investment will first need to recognise that there is a sufficient benefit to the supply chain. Developing an understanding of the impact of the uncertainty on its suppliers would be a start. The supplier’s perception of the benefit is key. The investment is more likely to have a positive impact on the trading relationship if the supplier believes they have received a significant benefit.
The benefit will not be directly captured by the finance function in the form of a discount. The benefit will be achieved on a basis consistent with co-operation within the physical supply chain. Indirect reciprocation will provide a benefit to the functions that are already co-operating with the suppliers. The reciprocation does not need to be equivalent to the total benefit produced but enough to provide an adequate return for the investment. The benefit that is not reciprocated still adds value, as it is captured, within the supply chain.
To capture the indirect benefit, the customer’s finance function will have to work closely work with the functions that already have a co-operative relationship with the suppliers.
Conclusion
An adversarial finance process of powerful customers can introduce unnecessary costs to the supply chain. The technology is available to remove most of the costs but it can still be difficult to justify the investment. The investment cost is borne by the powerful customer while the suppliers receive the benefits.
Where the powerful customer has a co-operative relationship with the suppliers focused on the efficiency of the supply chain, it is possible to obtain a sufficient benefit. The benefit is received, indirectly, by the functions that are already working on a co-operative basis with the supplier. The outcome of the approach is to move away from the financial supply chain as a separate entity and move to an integral process within the supply chain. The powerful customer becomes the central point for the purchase of international banking services within the supply chain.
Longer term there will be a significant impact on the banking market and major increase in customers’ expectations for the capability of transactional banking services. There will be a move towards smaller and more frequent transactions. Certainty will be a key requirement, so the bank will need to provide a certain date for the supplier to receive the funds. The powerful customer will need to minimise the time they hold a foreign exchange exposure and its value. There is a significant opportunity for leading commercial banks to increase their market share by serving the company that leads a supply chain.