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Payment Terms

June 21, 2010

An IACCM member asked me recently to outline my thoughts on analyzing payment terms strategy, from the perspective of a buyer. I thought I would share my answer in the hope that others will add to (or correct!) these ideas (of course, the IACCM library and training materials are full of guidance like this, for anyone who wants to know more!)

The two aspects of payment terms which require the greatest strategic thought are

  1. The trigger for payment becoming due; and
  2. The period within which payment will be made.

A third significant factor may be whether you seek to apply an ‘early payment discount’.

In principle, there is no barrier to developing consistent payment terms across all your contracts and this can offer systems efficiencies. However, there are some points to consider in establishing how feasible that single standard will be:

  1. In general, the triggering event for payment becoming due is likely to be receipt or acceptance of the supplier’s invoice. However, your readiness to accept and process that invoice is going to vary depending on the nature of the product or service. In some cases, you may accept invoicing on shipment or receipt of goods; in others you may want specific acceptance; for certain services or projects, you may accept making partial payments against particular milestones or prescribed intervals; for others, you may pay only on completion. Obviously you should define your policies as they relate to each type of acquisition. From a strategic perspective, I suggest you consider also the nature of the market and your experience in taking specific positions. In particular, how much supplier push-back, negotiation and variation is being generated? Does this end up with creating more cost than the savings from the specific standard? An obvious example here would be consultancy agreements. It may be that you would prefer to pay only on completion of the assignment. But of course the consultant will want at the very least to have some stage payments. Therefore would it make sense to either a) make your standard more balanced; or b) have a standard fall-back position to cut the frequency and duration of negotiations.  A further example would be to understand whether particular types of agreement are generally with powerful suppliers who simply will not accept your standard; once again, what is your low cost / low risk strategy for handling this? Finally, if you decide that in some deals you want to withhold payment (or have the ability to claim it back) for a substantial period, you need to appreciate that there may be local laws affecting this; and also that suppliers will have major concerns because of their ability to recognize revenue when payments are in any way conditional.
  2. Historically, the payment trigger was usually related to receipt of the supplier’s invoice. Most suppliers still use that as the term in their contracts. However, buyers have mostly switched to say ‘acceptance’ and this, of course, may be some time after receipt. There is often a lack of clarity over what the exact acceptance procedure will be and in some companies it appears to take up to 30 days as a matter of course from ‘receipt’ to ‘acceptance’. Companies often have invoices go to a specific department where they will be accepted and then forwarded to accounts payable. Internal procedures to validate complete and satisfactory supply are understandable; it is of course important to ensure these are not causing massive internal costs through inefficiency and multiple handling. I believe you should also think carefully about the effect that these delays have on your suppliers and on wider internal workload. For example, how frequently do such delays result in suppliers contacting your staff to pursue payment etc.?
  3. Most buyers have steadily extended the payment period. For large corporations, our research shows 60 days is now normal as a standard, with some having gone to 120 days. In reality, as indicated in point 2 above, the real period before payment can be considerably longer. If you have outsourced payment to a third party, you must be especially vigilant regarding the delays that they impose in the system (e.g. by rejecting invoices for minor technicalities, or by changing invoice addresses to force suppliers to start over etc). In the end, this is where you have a major economic decision to make:
    1. Suppliers price for delay. They have already paid all their costs of supply; you are simply holing their cash flow. So they will charge for the cost of money and the risk. You should be asking whether the value of the cash in your bank exceeds the benefit you might have gained by paying faster and seeking some other concession.
    2. Long payment periods impact the financial health of your suppliers. Is that a risk worth taking? What is the cost of either losing a supplier or having to bail them out?
    3. Long payment periods damage reputation. Suppliers learn about companies that take a long time (or pay rapidly and reliably) and it impacts their readiness to do business with you, relative to competition.
    4. Legislators are increasingly interested in this topic. You will increasingly find that local practices are being replaced with regulation. France has already implemented statutory maximum terms and the EU is poised to follow. If you want a global standard, it may be best to do it within the regulatory frameworks.

Early payment discounts are another supplier irritant, because they are typically not fair. Many of the customers who use them are those with the longest payment period – for example, one major software company has 90 day terms and they ensure they pay on day 89 and take a 2.5% discount. Obviously, suppliers get wise to this and price accordingly.

Overall, I suggest you aim to achieve a high degree of consistency, but in making your selection consider the true economic cost:

  • Of supplier push-back and the costs of negotiation, query handling and exception management
  • Of market reaction, with supplier’s pricing for your policy (and remember that price can be a positive or a negative, depending on your approach)
  • Of reputation cost, as a company that is fair and easy to deal with, versus unfair and hard to do business
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