Extended Payment Terms

By Paul D. Ericksen
Senior Supply Chain Advisor to CAPS Research

Recent CAPS Research benchmarks of payment terms revealed the following variations of how long after an Original Equipment Manufacturer (OEM) waits to pay for purchased materials and services, as follows:

Across the manufacturing and service sectors the largest percentage of companies, 38%, use 45-day payment terms. Meanwhile 36% use 30-day terms, 1% use 75-day terms and 11% use 90-day terms.

A quick review of history will show that there was a logical rationale for 30-day payment terms --- and extended payment terms were a discretionary element of negotiation between buyer and seller.

Back In the Day

Step back, for a moment, to the late 1980s. At that time there was no internet or email. Purchasing professionals had three main options for communicating with a supplier.

1. Travel to the supplier’s location.
2. Call on the telephone - using a land line and voice messaging systems were rare.
3. Send a letter via US Postal “snail-mail” (it was not called that back then) and then wait to receive the supplier’s response, again via postal mail.

It was rare to travel to a supplier just to discuss routine matters --- which includes monthly payments to suppliers --- since it was time-consuming and expensive to do so.

Typically, business was conducted with a supplier via telephone. But this was not always possible, especially when working on something that required formal documentation such as engineering drawings, contractual change orders, or hardcopy invoices to match with payments.

Express and overnight delivery options, such as Federal Express, DHL and UPS were just emerging or not yet available – and these services were relatively expensive. Therefore, companies relied on US Postal to send and deliver hardcopy documents. Today’s younger supply chain professionals probably cringe a bit when considering this infrastructure and the limitations it imposed.

These limitations were the basis of 30-day supplier payment terms. Specifically, it was the only practical way to transact with a supplier, as follows.

• Supplier receives confirmation of delivery from carrier - 2 days.
• Supplier billing department processes request for payment - 4 days.
• Supplier mails hardcopy invoice to customer – 7 days.
• Customer OEM accounts payable receives and processes invoice – 4 days.
• Customer sends paper bank check to supplier – 7 days.

This totals 24 days. Taking into account weekends when billing and account payable departments are likely not working, 30 days was a logical and realistic time for the completion of the payment transaction. While suppliers don’t necessarily like any delay in getting paid, they understood the reason for the 30-day cycle time and took it into account when quoting prices to customers.

Fast Forward – Today

Today’s reality is far different.  Carrier delivery notification, billing, and payment for delivered goods can take place electronically, usually in days or hours --- instead of weeks. Based on this vastly improved flow of information, you might expect that normal payment terms would be reduced to say, 5 or 10 days. But just the opposite has happened. The CAPS survey data reveals that 30-day terms have been stretched to 45, 60 and even longer payment cycles by many customers.

Suppliers understand the reasons for this. Most commonly, customers negotiate longer terms to leverage suppliers as a “zero percent interest bank.” This is frustrating to a supplier, and it can adversely affect the negotiated pricing of goods and services when the supplier has knowledge of longer payment terms as a part of the total scope of contract negotiations. Nothing comes for free.

From a supplier’s standpoint, a far worse scenario is getting surprised with a mandatory lengthening of payment terms after a contract has been agreed. In some cases, suppliers are given no notice and no recourse, leaving the supplier with a negative margin impact. In other cases, finance teams quietly delay payments with no notification to suppliers, simply making suppliers wait beyond the agreed terms.

Supply chain financing is another change that is impacting payment terms and supplier margins. Some OEMs are now outsourcing the payment process to banking partners who arbitrage the payment cycle against the cost of money for the benefit of both OEM and the 3rd party. One actual example involved my consulting business. I had negotiated a price with an OEM for services and was told I would receive a payment contract. Shortly afterward, I received a phone call from their 3rd party accounts payable partner. In my case the terms offered were 100% of the contracted price at 120 days: 90% of the contracted price at 60 days, and: 80% of the contracted price at 30 days.

I responded to the 3rd party stating that this was not the deal I had made with the OEM, and I would contact them to let them know I would not do business under the 3rd party’s payment terms. He was a bit surprised over this, saying I would be giving up significant revenue. I contacted the OEM with my message anyway since it was my paycheck!

There was a bit of angst on the part of the OEM, but a day later they agreed to pay electronically and directly to my bank account within 2 days upon receipt of my invoice.

Current global supply chains are filled with risks and discontinuities. Strong supplier relationships are paramount to navigating through these challenges and it requires a high degree of trust between supplier and customer to identify and mitigate the risks that can impede a business. I strongly encourage reasonable payment terms and timely payments as one key pillar in building and maintaining supplier trust.

 

CAPS is a B2B nonprofit research center serving supply management leaders at Fortune 1000 companies. CAPS Research inspires leaders with profound discovery and executable strategies to shape the future of supply management. Research reveals the destination, benchmarking charts the course, and networking creates the path to transformation. All CAPS offerings are sales-free, bias-free, and practitioner-driven. CAPS was established in 1986 at the W. P. Carey School of Business at Arizona State University in partnership with the Institute for Supply Management. Learn more at www.CAPSResearch.org.