The most important thing for suppliers used to be getting the right price. Now they are looking for large stable customers with early payment terms – so payment has become a critical activity for suppliers who are managing tight cash flows. The days when they could fund their working capital from the bank are pretty much over.
These are challenging times for supply chains. Globalisation and the sourcing of low-cost manufactured goods from distant locations such as China and India have added great complexity to the way most supply chains operate. By extending the chain the risks have increased and as a result inventory has accumulated to compensate. But with growing tension around credit availability and weakening demand, money tied up in stock is the very last thing a financially squeezed enterprise needs.
Chief finance officers are looking closely at their supply chains for ways of trimming costs and reducing inventories. For those in charge of purchasing that means closer analysis of spend, bringing more areas under management and employing greater levels of automation to achieve savings. On the operational side of the supply chain, management will be called upon to deliver innovative means of reducing costs.
However, there are hidden dangers in the chain that are likely to strike as the downturn continues. A growing number of suppliers are facing the prospect of financial collapse, which introduces supply vulnerability into the equation. Companies are going to have to monitor suppliers carefully and plan a response should the need arise. There are similar dangers for suppliers. Customers are also succumbing to the credit squeeze and many suppliers are finding it more difficult to secure credit insurance for deals with vulnerable companies.
According to Colin Maund, chief executive of Achilles Group, a company that manages supplier information, “companies are becoming very nervous about the health of their supply chains, particularly the health of sub-contractors who may normally play an invisible but key role”. THe drew on the example of BT which has set up a group within the company to go through every supply chain and look in detail for vulnerable suppliers.
“At the moment, there is a lot of fear and alarm,” says Maund. “Whereas back in the late 80s and early 90s a key skill for buyers was to analyse balance sheets – it was regarded as part of your essential tool kit to protect yourself against suppliers suddenly going bankrupt – buyers have now lost the skills necessary to really analyse suppliers.” The relative calm trading conditions experienced over the past 15 years has lulled buyers into a false sense of security, suppliers rarely just disappeared, but now buyers are going to have to sharpen their skills with regards to financial analysis of their supplier base.
Maund points to a significant change in priorities for suppliers. “The most important thing for suppliers used to be getting the right price. Now they are looking for large stable customers with early payment terms – so payment has become a critical activity for suppliers who are managing tight cash flows. The days when they could fund their working capital from the bank are pretty much over,” says Maund.
“If you’re a big buyer with deep pockets,” he says, “you should be selling that to your suppliers”.
He sees risks ahead for buyers. “As the suppliers with weaker balance sheets disappear or are bought up by the larger and more powerful suppliers with deeper pockets, consolidation and hence, the reduced level of competition, will ultimately redress the balance and suppliers will be able to put up costs.”
For some buyers protecting a critical supplier is imperative. In particular, the automotive sector is vulnerable to this as a key component may cause the production line to stop, with costly consequences. According to Maund: “Some of the major car manufacturers are actually paying suppliers not to provide parts to keep the supplier in business.” He says many OEMs are “very worried because they have rationalised down to just a couple of suppliers making key components”.
Big projects are also likely to be affected by the credit crunch. “There is expected to be a significant change in the way suppliers are used to fund projects,” says Maund. “So public/private partnerships, design build operate and finance (DBOF) type contracts, that are quite key in some areas like transport, are starting to be very difficult to get bank loans against.” He sees this as a significant change of direction, “in recent years there has been an increasing desire by government to buy and pay on an operational lease type process. But of course that is going to be very difficult to justify if suppliers aren’t able to borrow the money.” The banks were usually the ones who strung the whole deal together, but in Maund’s opinion, “that is just going to disappear”.
Buffeting
Along with the impact of the credit drought, further pressures are buffeting the chain. Wild swings in commodity prices and currency market movements are making it difficult for planners and strategists to determine the best course of action. Hedging is common practice, with Kraft Foods hedging about half its exposure to commodities.
Richard Stuart, manufacturing industries practice at PA Consulting, highlighted some key issues relating to hedging in a recent white paper. Kraft expected that commodity costs would rise by 12 per cent in 2008. It uses commodity forward contracts as cash flow hedges, primarily for coffee and cocoa, milk, wheat, corn, sugar and soybean oil. But Stuart points out that not all commodities are hedgeable. Problem food commodities include liquid milk, meat and some oils.
However, according to Stuart, hedging brings costs and risks as well. The medium to long-term use of options and swaps to maintain stable and predictable inputs can be expected to result in overall costs a few percentage points above the free market average. This can be regarded as insurance but it can also be tough to justify in terms of the value of revenue predictability. The use of forward contracts and futures can also result in stability at the wrong price, should the market fall, says Stuart. Wrong decisions can have a drastic impact on the cash reserves of a company and affect its liquidity. Stuart believes responsible chief purchasing officers must first take stock of the portfolio of risks for which they are accountable.
Second, to address the immediate financial risks, CPOs should be asking the following questions: Is there a defined policy agreed at board level for hedging key commodities? Is this policy reflected in a strategy by commodity that is documented and adhered to across the company – both by business line and geography? Do these strategies reflect the different exposure to level of expertise in and liquidity of different supply markets? Are these commodity hedging strategies integrated with the currency hedging strategies and are they being managed by the chief financial officer? Are the costs and potential downsides of the strategies known?
Third, CPOs should create a framework to ensure the long-term protection of the business. This should include establishment of a forum to review and act upon new and changing supply risks as they arise.
Expectations
The commodity that has the greatest impact on global supply chain movements is oil. Having reached a high of $147 a barrel in the summer – with some predicting a price of $200 before the end of 2008 – oil has slipped back to just $50 a barrel on expectations of a fall in use from the US and China.
Earlier in 2008 the rising cost of oil and its predicted onward march, sparked the possibility of a structural supply chain network redesign at Procter & Gamble (P&G). The consumer goods manufacturer’s current model of large, single-category regional production sites with long supply chains was based on cheap oil, but the way things were going the cost of transport was starting to change that perception, raising the possibility of building new capacity. How this is considered now, in the light of a $50 barrel of oil, is an interesting question. But P&G has other strategic plans underway that change the perspective from which it views the supply chain.
Thies-Asmus Erdmann, supply and initiatives expert at P&G, recently outlined the prototype demand-driven model, which has been deployed across a number of P&G’s business segments. The initiative, called the Consumer-Driven Supply Network (CDSN), aims to improve the company’s responsiveness to consumer demand by taking a shelf-orientated perspective rather than the more traditional plant-centric approach. Erdmann sees that the new model “integrates business practices, process capabilities, information and analytics that sense and respond to real-time channel data across a network of suppliers, customers and trading partners, so enabling the supply chain to better meet consumer and customer needs.”
According to AMR Research, better demand forecasting in consumer products companies yields 24 per cent less raw material inventory, 22 per cent less finished goods inventory, 21 per cent shorter cash-to-cash cycle times and 22 per cent better plant utilisation.
