Payment Terms: A Leading Indicator of Partnership

By Kevin Meyer

Anyone that has been in business, especially running a business, for two or three decades has noticed patterns that aid their decisions.  Nothing earth-shattering there - it's called experience.  And if we're smart it's why we hire people with a couple decades of experience to run companies - or countries for that matter.

Two such patterns have become ingrained in my psyche when I come across new customers.  The predictive pattern has a nearly 100% correlation.  What are they?

1. The partnership aspect of a relationship will be inversely proportional to the payment terms.
2. The maintenance level of a relationship will be inversely proportional to the requested automatic annual price reductions - targets or fixed.

Net 30 terms are fairly reasonable and I use that as the "zero" point.  It does take some time for a typical customer to receive incoming components, inspect them (yes, traditional, not optimal), and release payment.  Waiting 30 days has minimal impact on my cash position and can be easily planned for and accommodated.

If a customer offers to pay at less than 30 days I know I have a customer that sees value in our relationship, and believes our financial stability is important.  I should qualify that - I don't mean less than 30 days terms with a discount.  In those cases they're just trying to sneak in a price reduction.  If receiving cash fifteen days early is worth 2 or 3%, then I've got other issues.

Unfortunately companies that offer to pay full value at less than 30 days are a rarity.  In most cases traditional supply chain and financial management promotes the concept that terms should be stretched.  Far more often I receive requests for Net 45 or Net 60.  Last week I even received one from a Fortune 10 company for Net 120.  That company, previously known as a six sigma powerhouse, has recently been lauded for leveraging lean to move a bunch of appliance manufacturing back to the United States.  Apparently the respect for people side of lean, which in my book includes suppliers, doesn't run deep in that company.

Those requests for longer terms come in spurts, which I roughly correlate to when there are purchasing-related conferences.  Luckily my company is in a strong position from competitive and technology perspectives, so I have some leverage of my own.

Upon receipt of such a request for greater than Net 30 terms we send a letter from me indicating that we use our cash to improve processes, we look for partnerships and our real partners are actually shortening terms, and we feel it isn't in the spirit of partnership for a much larger company to effectively ask a small company for a loan.  Terms will be Net 30, or else the order will not be accepted.  That usually does the trick.

In some cases, such as the Net 120 situation above, the larger company still tries the abusive approach.  If they continue to push the issue I have a second letter that asks them if their desire for longer terms is an indicator of financial problems on their end, and perhaps we should be concerned enough about that to request cash in advance.  I used to have a statement in the letter asking if the purchasing agent would accept a paycheck 60 or 90 (or 120?) days after the work period, but I know payment terms are generally directed to the poor purchasing agents from way on high.

The kicker with those extended terms is that the customer is setting themselves up for ongoing financial tension.  Just like paying your January mortgate payment in December will help taxes - it helps one time.  If you don't do that for each of the following years, you reverse.  Dell is discovering that with it's well-known inverse cash flow cycle - receiving cash from consumers prior to having to pay for parts for the products.  A great cash generator during growth - but it reverses direction during contraction.  In effect, a suckers bet.

It can be a fun game, although I obviously do have to be careful to not get too comfortable with my competitive advantage.  We're not, and we work on increasing our value to our customers every day.  But the bottom line is that I can predict how a relationship will be developed by the terms that are requested and ultimately agreed to.

If the customer offers to pay at less than 30 days with no discounts, it is going to be very valuable.  If the company demands 45, 60, or even 120 day terms, it is going to be an increasingly difficult and adversarial relatiionship.

Just because a potential customer is big doesn't mean it's a valuable customer.  Just ask all the poor folks that salivated over selling to Walmart and learn a painful lesson.  Volume does not automatically equate to success.

A similar situation exists with the automatic price decreases that many customers demand.  Usually they start off with around 5% per year, with no qualification or adjustment for uncontrollable changes in raw material prices, specification changes, and the like.  Believe it or not, most suppliers swallow and accept such nonsense, again out of lust for the big company customer.  Some will first negotiate to try to even the playing ground a bit - the ability to roll through raw material increases at least at cost, triggers to review pricing if specifications change, and the like.  That helps a lot.

But you know what really changes the game?  Offering to target even greater cost reduction, if (and it's a hugely important "if") a defined project matrix is created that defines the projects and the very specific contributions by both parties.  An attempt to create partnership.

As soon as you document what the customer also has to bring to the price and cost reduction project, such as analysis of changes and performance from improved processes, the responsibility shifts.  And we all know how frustrating it is to get customers to play a role in projects - and how they still demand the results that are impossible without their role.  Document it, and define in supply agreements that price changes must be tied to specific projects, and those specific projects will define the roles of each party.

If the customer demands x% price reductions per year, period, it's going to be adversarial.  If the customer agrees to terms that specify projects and contributions, it can work out well.  If the customer doesn't even talk price but instead talks quality and final customer value... jump on and hang on.

So if you are a supplier, or a customer, think about the predictive value of payment terms and automatic price decreases.  What is that saying about your relationship?  Is it what you want?

Comments

[Bob Emiliani]

As a former purchasing/supply chain manager at a major OEM, I agree completely. The "Respect for People" principle is usually absent when companies deal with their suppliers (e.g. reverse auctions, etc.).

The paycheck and January payment examples you cite are ones that I use with my students in my graduate supply chain strategy course. And I focus enormous attention on the importance of bi-lateral engagement in process improvement, cost reduction, and joint growth opportunities.

Is net 30 days reasonable? It certainly is tradition. But we can improve upon that! Net 15 should be the "zero" point. I would like to see business transition to cash on delivery (which is what I do) - starting with small businesses (and later, mid-size businesses, etc.) - and eliminate the system-wide expenses associated with debt service. Doing so will also give a much clearer picture of a company's actual financial condition.

[Kathleen]

If I wanted to get into the business of financing, I'd start a finance company or work at a bank.

My business is a bit different, call it tooling for manufacturing, all custom jobs with customer specified parameters. Most of my peers get 50% down to start the job. I'm very selective of who I take on so I don't ask that but I do get paid before I ship. For projects with longer timelines, I submit invoices weekly.

I've had customers request price reductions but it only happens once. I don't have a letter to send out but I do explain citing number, chapter and verse, how what the customer has done (or not done, poor planning, misplaced priorities) running counter to my advice, has contributed to the project's cost. They get one shot at this. If they make the same mistakes going into their next project, they need to find someone else because I'm not going to do the work.

There is a perception in my industry that given jobs should cost X amount. If a customer makes it known that X provider charged them an order of magnitude more, the provider is considered suspect. Of course the customer doesn't mention all they did that increased the cost of the project but if such pattern emerges that cost overages are routine for a given service provider, the latter is reviled. Which is why people who waste inordinate sums through bad planning and bad priorities find it difficult to get continuity of service. Service providers drop them so they're always having to find someone else even though the job pays "more", lack of continuity further increasing their costs.

As such, there is the expectation that providers offer guidance and advice to customers which if not followed often means cessation of providing services to the customer. No legitimate provider is going to compound matters by financing poor planning with price reductions and so, enable and encourage the customer to continue to make poor spending priorities.

[Jeff Hajek]

I am not terribly opposed to a company asking for generous terms. It is just a different form of negotiating price. Whether they ask for a 2% price reduction or a 120 day float, the bottom line is the bottom line.
What I do have a problem with, though, is when a big company enters into an agreement, and then intentionally pays late because they know they can get away with it. Most small companies are not going to press the issue when they are selling to a giant that accounts for a big share of their sales.

[John Buzolic]

Touching a few nerves with me lately Kevin. I pay all my suppliers cash before shipment. I don't ask for accounts or terms. I constantly have to insist on being treated as well as an account customer. My standard line is "so if I payed you in 90 days you would reward me with a discounted price?" I am constantly being treated as "cash customer - not to be trusted"

[Kevin Meyer]

Jeff - you're right that negotiating payment terms is pretty much negotiating price. The problem is that the most important financial aspect to many small companies is not profit, but cash flow. A small company may be able to play with price and terms to create an appropriate representation of value, but if they've paid for the raw material and labor weeks or even months before being paid, they could simply run into a cash problem - even if there is a lot of profit built into the price. I do completely agree with your comment on abusive tactics like not paying per commitment

John - sorry to cause you pain. But I also agree with you - paying cash does have a negative stigma in the traditional financial world, as ridiculous as that is in reality. Somehow requesting terms is equated with the ability to operate in a credit mode which equate financial success. Crazy. That's a tough one to change. However I would love to have you as a customer and can guarantee that you would be at the tops of list.

[Liz Guthridge]

Thank you for writing about this important issue. As a small consulting firm that primarily serves Fortune 1000 companies, I'm getting tired of the biggest companies wanting to extend payment terms.

The Net 120 payment, which I also encountered, is insulting and I turned down the business. Another well-known company charges its suppliers for electronic invoices for the privilege of billing them online and then waiting 90 days for payment. Having completed all my projects, which included winning a prestigous award for one of them, I've now decided that the imbalanced power arrangement isn't worth it. I've stopped pursuing new projects with them and once my printer and PC start to falter, I'll ditch the equipment and stop being a customer too. Life is too short too spend time in bad partnerships.

[Karen Martin]

Great post, Kevin. I echo Liz's thoughts. I always ask for 14 days but often get refused. I won't accept more than 30-day terms any more. I don't care who the client is. It's just not right. And it's certainly not in keeping with any organization who wants to begin or accelerate their journey to becoming a Lean enterprise. It's indeed insulting as Liz puts it.

I've had good success lately with 14 and 21 days but I often have to coach my key contact on how to negotiate with their purchasing folks. In my experience purchasing does more to harm relationships than any other department.

[Robert Drescher]

Hi All

I agree with Kevin for the most part companies that are constantly ask for terms are bad business partners and they are not if fact getting the best price or level of service for it.

My family has long been in business dealing with large and small compoanies in several different fields. My late uncle was a mechanical contractor working for large companies. He purchased huge volumes of materials for his jobs at the time since most large comopanies delayed payments the suppliers often offerred terms to everyone and they were 2/10 net 30, he always paid in less than 10 days. Overtime all his suppliers started giving him better discounts knowing they would get paid immediately. Soon he was capable of underbidding most competitors simply because he had lower input costs than they did. My own families business did the same paying for everything when we were invoiced, and like my uncle we had automatic discounts from most of our suppliers that ensured we had the lowest possible price, we also never had to worry about being the one short shipped or given inferior quality, simply because our suppliers respected us and look after us because we looked after them.

Even today I know dozens of businesses that do very well that simple avoid customers that want extended payment terms, they aren't worth it. If a large company has such poor cerdit it cannot pay ontime what makes you think they will. In our area we have had a huge number of small suppliers to GM and Chrysler that are now out of business because they ran out of cash extending credit to these monster companies, and do you know that these monster companies prefer you going out of business because they can deal with the banks that endup with the receivables and pay them a fraction of what is truly owed. One company was outrightly told why should we pay you we can pay your bank 10%.

One of North Americas and the world's largest industries is food production, in it the raw materiakl buyers in most countries either pay on delivery or have to provide proof they can pay within a short time frame under legal requirement. Hell even China requires payment to be made upon shipment, wonder why their economy is growing.

All these extended terms do nothing but add cost to any product or service while adding zero value to anyone in reality. It is nothing but a game created to help the financial services industry make money.

[John Hunter]

120 days is just ridicules in my opinion. I would likely just say it seems like you all must be in perilous financial position so we will require cash up front. This might be why I am not in sales.

I don't mind people negotiating a bit, but making crazy requests because they think their big market power means everyone should bend to their will doesn't make me want to be in business with them.

[Beth Plutchak]

The more uneven the power relationship (your size vs size of company you are doing business with, for instance) the more likely the larger power player is going to demand more and more unreasonable terms to keep the relationship going. I have had clients who have turned down business that seemed to have a big payoff initially, because of potential long-term effects of the unequal relationship.

[Jeff Hajek]

One thing I haven't seem mentioned much here is that the push for 120 day terms is part of the voice of the customer speaking. They are not wrong for wanting something. If the customer wants extended terms, they are going to find a supplier who is willing to meet those needs. It is no less reasonable than an auto manufacturer requesting that its suppliers build production facilities within spitting distance of the car assembly lines. In both cases there is an unmet need. The solution isn't to fight it. It is to either figure out how to meet it profitably, provide a more desirable alternative, or walk away from the business.