DPO - Significantly optimising cash flow by changing the focus - mini-series (Part 2)
Thank you for being interested in the second part of the three-part mini-series on the perennial subject of cash flow optimisation, focusing on the manufacturing and Fast-Moving Consumer Goods (FMCG) industries. The series argues that while finance must report on cash flow, operations should own the metric. For practitioners along a company's value chain, the three posts can also act as a knowledge refresher…
Part 2 - Why focus on supplier payments (included in DPO = Days Payable Outstanding) to optimise cash flow & working capital?
Luckily enough, I learned cash flow management in the supply chain from the ground up early in my career. I will always be grateful for the folks at Ford who taught me. We often joked, that the company was an accounting firm with a large car park…
The story behind this joke was that Henry Ford II, hired World War veterans like Robert McNamara and a group of other Army Air Force officers to work for him in the late 1940s. These "Whiz Kids" (some of them later became Ford Presidents, and some, like Robert, even got into politics) helped reform the firm with modern planning, organisation, and financial control systems, that are still in effect today. Many say that this was one of the reasons Ford did not have to be bailed out during the sub-prime financial crisis in 2008.
In the 1940s of the last century, these accounting and planning processes were ‘swell’ and new. One would assume that this knowledge, a standard curriculum in most business schools, has permeated to every last corner of most companies in the last 70 years.
But, what happened in these decades is that the lessons only sunk in on the finance side. What got lost in translation was that the Whiz Kids transformed Ford’s operations, not just how the books were done. In each function, business, and region, you felt that you were part of a big machine and that your work mattered to keep the company afloat financially.
We argue in this mini-series on cash flow management that a change away from the myopic finance focus offers hard cash benefits for anyone willing to try it. After we looked at inventory in the last post, today we take on payments to suppliers (which wind up as a finance metric called Days Payables Outstanding, or DPO).
External materials & services purchased are the largest cost block in most product-based companies. Hence, the cash flow improvement leverage is significant. Different from cash trapped in inventory, DPO management needs ‘two to tango’. What does it take, that companies start ‘dancing’ again?
As we should be interested in optimising our payment terms (driving DPO), suppliers want to improve their DSO (Days Sales Outstanding). For many firms, this seems to be a zero-sum game in which the party with the biggest buyer or supplier power wins. This is, however, just a small part of supply chain reality. More often than not, cash is burned unnecessarily since
negotiated payment terms are 'lost in translation' between purchasing and accounts payables,
payment standards are missing or not followed through,
local or even global payment benchmarks and trends are not known or tracked,
buyers and accountants are not trained and incentivised along the full procure-to-pay process
contracts and escalation paths are not standardised,
Global Terms & Conditions (GTCs), which make contractual life so much easier for everyone involved, are just missing
supplier and/or market financing schemes are not used
Accounts Payable has no electronic data interchange with the supply base, since Procurement has not put it into the contracts as an order qualifier
payment term complexity/creativity (the most terms I counted in one company was 467) - even the best buyer or accountant had no chance to manage this.
suppliers request shorter payment terms with you, since they do not trust you. Reason: They are seldom paid on time due to complex invoice routing and approval processes
We dig deeper into this with examples and solutions in “The Supply Chain Dialogues” podcast linked to this blog post. For now, I am sure that most supply chain readers will recognise one or other (or all) points in their own company
As always in the “Close the Gap” blog posts, we look at gaps as opportunities. So, here are a few simple questions to establish whether or not you have an opportunity around free cash flow (focus on DPO). Note that you will recognise some repeats in other parts of the series since overlaps can be handled with the same solutions)
How many of the below questions/statements can you answer with a resounding, fact-based "yes" ?
Do you have any Cash Conversion Cycle (CCC) metrics linked to the compensation of business management?
Did your payment terms policy change in the last 5 years, considering the massive change in interest rates and inflation in most global markets?
Do you have minimum thresholds for procurement contracts wrt payment terms (and are those tracked)?
Do you have standard payment terms across all businesses, considering local differences (i.e. Italy vs Germany vs US vs India)?
Do you measure the difference between contractual payment terms & actual payments performed by your accounts payable department?
Do you have standard guidance on your company supplier webpage for payment terms (do you even have a supplier webpage, and can it be found easily)?
To further professionalise the hedging process, do you provide at least monthly automated reports to the Treasury Department about the outstanding payments by currency and month/quarter?
Are your buyers trained in dealing with payment terms and understand it as a normal part of supplier contract negotiation (assuming you have contracts with suppliers…but this is a different kettle of fish altogether)
Do your procurement and accounts payable teams align the input of the respective ERP payment term fields (in ERPs, there are 8-10 fields containing payment terms for suppliers, and to make it more fun…they differ across functions)
Bonus question: Do you have a Supplier Financing Scheme in place?
If you answered „yes“ to most questions, great: you have your DPO under control. Congratulations! Do not read any further; better to focus on other topics.
Size of the Prize
If you do not know or answered several questions with a "no", you can make your company more stable and cash rich. To understand the „size of the prize“, please use these simple steps to establish the gap and a target:
Divide your total external annual spend (normally between 40-80% of your revenue depending on producing industry) by 220 (=workdays). Now you have your daily DPO cash flow.
Now set your payment terms average target (Tip: depending on your supply footprint your average should be 70-95 days).
Now subtract your current payment terms status from your target status and multiply by the daily DPO cash flow…voila !
For a company with $10b of spend, $ 50-100m of cash improvement is very likely in the first step. Note: If you are a CPA or financially inclined, you know that DPO has a few more input factors. Still, the above is good enough to engage the procurement department and make a real contribution to the DPO. The full GAAP DPO definition (incl. Full Account Payable, COGS, inventory etc.) I leave up to Finance colleagues to calculate for the books.
How to set up the Cash Flow improvement project (here: DPO)
Time plan: 6-12 months
Board Sponsor: COO (instead of the CFO)
Lead: Head of Procurement & Head of Accounting (joint target)
Project set-up: weekly task force with clear objectives, monthly reporting on board level by CFO with clear output KPI's (=DPO trend, # of suppliers negotiated, total spend/countries covered (%))
Sustain success: Establish training courses for procurement & accounting; develop procedures on working level; update General Terms / Conditions, and, and, and…
Digitalization/Automation opportunity: HIGH. With a bit of effort, no contractual payment term should be missed in accounts payable. No late payment by suppliers should go un-notices, average payment terms by order should match average invoice terms, no contract should be signed outside of the payment terms parameters set, etc. Software solutions such as Power-BI, Tableau, Looker, Sisense, Qlik Sense, and SAP Analytics Cloud can be used to control, while process mining can help the detection of loopholes in the Procure-to-Pay process.
Risk: Low - while there will be always a few disgruntled suppliers that are used to your leniency in the past, most will appreciate clear guidance as well for their cash flow planning
Cost: Minimal - the licences and training on the software mentioned above are dwarfed by the lever you get with improved cash flow guidance. And, who knows, maybe the processes and systems learned here are as well used for topics such as customer payment behaviour, revenue patterns, and product portfolio margin analysis…
Watch out’s
Pushback: Both from purchasing and accounting. A detailed analysis often reveals that purchasing leverages payment terms vs cost reduction - which should be the exception, not the rule. On the other hand, accounting operational metrics are often linked to their "Payment on Time" assessment. Often these do not align with the actual contractual terms.
Mitigation: Do not look back - and no killer questions like: How could that happen? Whether you like it or not: It did happen (and does so in most companies). So rather help the departments to improve and then celebrate the success together!
Thank you for reading through part two of the mini-series on cash flow optimization in the value chain. The next post is on customer payment optimization (Days Sales Outstanding: DSO), which will conclude the series.
Stay safe. Be bold.
Daniel
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