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Managing the Financial Supply Chain – Part 2

In Managing the Financial Supply Chain – Part 1, I reviewed the first part of Supply Chain Management Review recent article titled – Managing the Financial Supply Chain by Roland Hartley-Urquhart in a recent edition of their online magazine.
In this post, I want to go deeper into Roland’s article about Managing the Financial Supply Chain because of its critical importance in how the efficacy and direction of progress of supply chains are decided under the headings of New Processes & New Competencies, Forex Risks and Capital Cost Inefficiencies
So a firm has decided to go the route of outsourcing or offshoring some of their non-core competencies, what is the immediate effect of such a strategic decision on the financial processes within the firm.

New Processes & New Competencies
As Roland notes,

In conducting this analysis, companies need to recognize up front that global sourcing and production outsourcing complicate the value exchange process. In particular, they increase the quantity, velocity, and complexity of interenterprise financial transactions, leading to higher administration costs. As global sourcing and outsourcing continue, the number of financial transactions handled within the four walls of the enterprise decreases. At the same time, the number of transactions handled by outside vendors increases.

What’s more, in the case of applying JIT to an outsourced supply chain, the following could be expected to occur:

When global sourcing and outsourcing are combined with just-in-time supply chain practices, the velocity of payment transactions is accelerated because the smaller consignments require additional payments or the aggregation of many discrete transactions.

Roland notes a shift from the traditional payment terms such as using Letters of Credit (LC) to open account i.e. making payments the purview of the buyer rather than international banks that have always been the traditional intermediaries of such transactions. However, moving away from using the traditional intermediaries implies that the work performed by these intermediaries have to be brought inside the firm’s four walls i.e. the creation of new competencies within the firm in order to handle the outsourcing/offshoring of non-core competencies. Moreover, along with the creation of a new competency within the organization, this change also introduces the vagaries of international finance.

In addition to complicating financial transactions, global sourcing and production outsourcing introduce a higher degree of risk into the supply chain. To cite one prominent example: Saks Inc.’s lack of centralized controls and visibility into its sourcing operations’ procure-to-pay process contributed to the company’s alleged illegal collection of excess vendor markdowns. In addition to facing numerous legal and regulatory battles and distractions, Saks saw its total market capitalization drop by 20 percent immediately following the announcement of the scandal in 2005.

Different industries follow different outsourcing or offshoring practices and therefore the changes in the supply chain, the distribution of risks, inventory handling and even total cost of acquired goods is different according to the extent of outsourcing and resultant supply chain design.

Many branded apparel companies, for example, have expanded their sourcing from cut, make, and trim (CMT) to full package purchases. In a full package transaction the contract factory is responsible for purchasing raw materials directly from textile mills (usually specified by the brand owner) and selling finished product to the brand owner on a free-on-board (FOB) origin basis. This greatly simplifies the work of the brands. They no longer have to track and maintain raw-material inventory consigned to various factories all over the world like they did under the conventional CMT approach.

That is fine and well – it is a strategic decision but note the following implications:

While this approach minimizes complexity for the brand owner, moving responsibility for inventory ownership adds cost and complexity to the entire supply chain. What results is a supply chain resembling a barbell, with two large organizations at either end (mill and brand owner) connected by smaller contract manufacturers (CMs) in the middle. The weak middle, unsupported by a collaborative supply chain, is vulnerable to unforeseen problems affecting both top-line and bottom-line growth. “Factories must absorb these higher inventory-carrying costs in their margin or just go out of business,” explains Hackett-REL Senior Business Advisor Mark Tennant.

Even if it is asserted time and time again that there is no free lunch, there is always someone who is trying to have it. If the slim middle is carrying all the risks of production and handling inventory, then the middle will have to find a way to operate under those conditons. If they fail to do so, the risks are suddenly transmitted to both ends of the barbell. Again, there is no free lunch anywhere in the sense that passing off one’s risk to a third party and then constraining the third party to some arbitrary performance levels is a sure recipe of inviting the risk of supply disruption into a firm’s operations.
The effect that such decisions have on the financial supply chain is illustrated below

The textile mills face similar problems. Where once they negotiated and sold products directly to the brand owner, they now may deal with as many as 200 potential suppliers for the same level of orders. This complexity greatly complicates credit management for the mills, which often only ship “cash on delivery” (COD) or against prepayment. And this, in turn, further stresses factories’ working capital, often leading to smaller, less economical, and frequently expedited shipments.

What Roland is implying is that with the decision to outsource by a large branded retailer has changed the nature of the leverage of the buyer vis a vis the suppliers of raw materials. By introducing a third party layer of contract manufacturers, the retailer has distributed the leverage over the buying needs of third party layer according to the outsourcing contracts. Also, the working capital profile of the retailer is now transferred to the third party layer and they carry the spread between COD w.r.t suppliers and open accounts w.r.t customers (branded retailer).

Forex Risks
Foreign exchange risk are part and parcel of international trade and they are now becoming part and parcel of globalized operations and I personally experienced this aspect of forex risks as I was working out of Singapore during the Asian Financial Crisis of 1997-98. The following is very important to keep in mind:

As markets increasingly go global and more value is added offshore, greater foreign exchange risk becomes embedded in value chains. This risk extends to products purchased from overseas vendors or sold to distributors on U.S. dollar terms. Supply chain managers need to be cognizant of these embedded foreign exchange risks, even when all prices are expressed in dollars. At the most basic level, the local content value costs have added a direct foreign exchange component. These costs can include the cost of labor, plant, and equipment (if purchased locally); depreciation; and local currency financing costs. Supplier profits are affected too, as these costs are typically accounted for in local currency and paid from sales revenue collected in dollars. If the dollar strengthens relative to the local currency and the product price does not change, the supplier’s margin increases.

Different states of maturity of the political systems between the developed and emerging economies of the world insert themselves into the world of business transactions. Supply chain managers have to aware of the implications of political decision making for businesses far beyond the superficial level as such decisions have a way of whipsawing through the supply chain.

Although trade in physical products and services is largely free of regulation, emerging market countries often manage the dollar exchange rate for political purposes such as preventing social unrest, maintaining price stability, or protecting and fostering favored industries. When the exchange rate is managed, unforeseen changes in the underlying global economy can create shifts in foreign exchange markets. These foreign exchange movements can be sudden, unexpected, and sometimes of even seismic proportions, acting much like the force of an earthquake unleashed by the gradual underlying movement of tectonic plates.

While the causes of the Asian Financial Crisis can be speculated (currency speculation, artifical pegs, irrational exuberance and whatever else), the effects cannot be doubted.

An example of the worst-case scenario occurred during the Asian currency crisis of 1997-1998. At that time, several Asian currencies were artificially pegged to the dollar by government fiat. Yet market pressures overwhelmed these governments’ ability to maintain the fixed-exchange-rate pegs, and the Asian currencies went into a free fall. While falling local currency prices would seem to present a great opportunity to obtain lower product prices, the scale of the devaluations effectively shut down all dollar lending activity. This meant that local producers were unable to buy raw materials to keep their factories in production, and many quickly went bankrupt. Supply chain managers were forced to find new sources of supply or assist their vendors financially to survive.

Roland makes an important point about learning from the Asian Financial Crisis and uses it as a springboard into a discussion about the forex practicse of China. I think the below elaboration along with the extent of non-performing bank loans in China should be raising red flags about the state of Chinese financial system.

Most economists agree that China maintains an artificially low exchange rate vis-à-vis the dollar today. China may have sufficient policy tools in place for maintaining control. However, it is not unthinkable that the government would either modify its policy or loosen control over the yuan. The probabilities and potential impact of such events occurring are speculative. Still, supply chain managers must be alert to the impact that a revaluation (an increase in the value of the yuan) would have on prices of Chinese-manufactured goods as well as on the global price of underlying commodities used to manufacture their products. At a minimum, the cost of local value-added content in China would become more expensive in dollar terms. Additionally, a more valuable yuan could add inflationary pressure on dollar-denominated commodity prices globally.
The experience of artificially fixed exchange rates in Asia in the late 1990s provides a valuable lesson that should not be ignored. In early 1997, many (but by no means all) economists agreed that the fixed exchange rates were unstable over the long run and that devaluations would be required. Yet while most companies were aware of these warnings, few had actually developed contingency plans to cope with the fallout. Today, we don’t know exactly what the risks are of a Chinese revaluation, but supply chain managers and CFOs should come together to think through the potential impacts.

Capital Cost Inefficiencies
Again, financing costs inefficiencies arise because of the strategic decision to outsouce one’s operations to a third party. The ability of the third party to obtain financing and the cost at which they can obtain this financing will be injected into the supply chain in one form or another i.e. lower margins for the third party or passed along as a markup in the unit costs. What I did find suprising was that even large contract manufacturers such as Flextronics have non-investment grade credit ratings whereas many brand owners such as Dell have investment grade credit ratings. Suppose Dell outsourced some of its operations to Flextronics, the difference in the cost of financing operations at Flextronics on behalf of Dell will be injected into the supply chain in some form or the other. Roland highlights the method of calculating the difference in intereste rates at which each of the two firms would be able to finance any operations:

To estimate the approximate cost-of-capital differential between two companies based upon known or estimated credit ratings, subtract the bond spread of the higher-rated company from the lower-rated company—for example, the contract manufacturer Flextronics (Ba3/BB-), which manufactures desktop personal computers and servers for Dell (A2/A). To estimate the difference in capital costs between these two companies, subtract Dell’s bond spread (40 basis points) from Flextronics (320 basis points) for a difference of 280 basis points, or 2.8 percent.

Furthermore, it should be noted

CMs have proven adept at accessing the capital markets for reasonably priced debt. During market downturns, however, CMs appear vulnerable. Working-capital requirements of outsourcers are subject to a high degree of volatility and therefore higher cost. Rapidly rising demand requires increased raw-material inventory and days sales outstanding, while falling demand often leaves CMs holding high levels of finished goods. These costs over time must be absorbed by the CM’s margin or added to their unit costs.

In the next post in this series, I will review some of the steps that firms ought to take into account when dealing with the intricacies of the financial supply chain along with Roland’s proposed solutions and recommendations.

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Category: Supply Chain Management, Supply Chain News


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November 2006