Procter & Gamble: Basis Point Wise, Percentage Point Foolish

Apr.18.13 | About: The Procter (PG)

Procter & Gamble (NYSE:PG) is about to lose money thanks to CFO hubris. It won't be the only large corporation, however, to get caught up in false economy. The Wall Street Journal reported that P&G will extend its payment terms to suppliers. This sounds like normal corporate practice, and it is. But normal is not always good.

Many companies try to slow down their cash outlays. The large corporations are the tightest, it seems, on payment terms. They often wait 60 days or more to pay vendors. It's simply a way of saying to vendors, "If you want me to sell your product, make me an interest-free loan."

I understand working capital management, but many of these corporations don't understand. Let's look at some numbers. P&G has a Aa credit rating on its bonds. It can probably float 60-day commercial paper for 0.10%. Small companies with bank lines are often borrowing at 3.5% to 4.5% interest. Many small businesses, though, are not eligible for bank lines. They may use finance companies to factor receivables, or even the owner's credit card. So 4.0% is very conservative as an estimate of borrowing cost for small business.

What's worse for small business is that many of them are constrained and cannot get all the credit they need. They are holding back on their growth because they don't have enough working capital. Their banks are super-cautious, because conservative bank examiners are looking over shoulders.

Let's say that the small business sells the large corporation $100,000 of materials. Instead of paying in 10 days, the corporation demands 75 day terms. OK, that extra 65 days save the corporation $8. (60/365 times 0.10% times $100,000.) What does it cost the small business to let the payment wait an extra 65 days? $329. (60/365 times 4.0% times $100,000.) So the big fish saves $8, costing the small fish $329.

Here's a better tactic for the big fish: Get a reputation for paying quickly, but ask for more of a discount. If the large corporation gets a price discount of one-quarter of 1%, it saves $250. It's additional interest expense of $8 is more than outweighed by the price discount. The small business? It's cheaper to give up $250 in price than $329 in interest.

If one of the parties in a transaction has to borrow, it should be the party with the cheaper debt cost.

Far too often corporations remove the payment decision from the purchasing manager. The CFO believes that the purchasing manager is leaving money on the table. This is the hubris mentioned at the beginning of the article, an inflated ego that eventually costs the company money.

Some CFOs will say that they can get both a discount from vendors, plus slow payment. They must think they are living in a strange world, in which they can push costs on to business partners with no consequence. More likely, the vendor will learn to negotiate to recover the interest triggered by the late payment.

Small business owner, what should you do when faced with a slow-paying large customer? When you figure out what price you should ask for, calculate your interest cost on the receivable. When the sales rep asks for a price discount, tell him you've already given a substantial discount in terms. Tell him your cost of credit and work through the example.

Some small businesses are constrained by lack of working capital. They should decline to take orders from slow payers. To get maximum use from the working capital you have, focus on fast paying customers.

One of my past clients, Jeld-Wen, developed a tremendous reputation for prompt payment. The late Dick Wendt, when he was CEO, once learned that an minor error had delayed payment of my consulting fee. He personally offered to have his treasurer cut me a check that day. I told him that was unnecessary; I could easily wait for the next payment cycle. What Wendt got was great loyalty from me and all of his vendors. When supplies of wood got tight and small lumber mills had more orders than they could fill, they gave first priority to Jeld-Wen. The corporation always bargained hard on price, but it was the preferred customer to many small businesses.

Simply put, companies that can borrow at lower cost than their business partners should do the borrowing. It's not a large expense at today's interest rates, but it shows whether the corporate executives understand basic economics.

Update -- Comment from Procter & Gamble:

You focused on credit and the interest rates charged to smaller businesses. You left out that P&G has developed its own Supply Chain Financing (SCF) program as part of this decision. This was mentioned in The Wall Street Journal's piece, and it makes this a win-win for P&G and our suppliers. As part of our SCF program, P&G's external business partners are able to leverage P&G's AA credit rating and obtain financing at a much reduced rate than they otherwise could. In this case, suppliers actually get paid at a much faster rate of 15 days or less.

P&G understands this issue, and I should not have implied that it didn't. However, it leaves my basic conclusion intact. P&G's help, according to the Journal article, can bring a supplier's borrowing costs down to something like 1.3%. They get paid promptly through a bank loan collateralized by the receivable. The 1.3% loan cost is much lower than the 4% I used in my article. Still, P&G is borrowing at an even cheaper rate. In effect, their effort to get a bigger piece of the pie shrinks the pie (though not by as much as I first mentioned).

What's the point of the whole program? The idea mentioned in the article was to "free up cash," but cash is readily available from cheaper sources. Perhaps Wall Street would rather see "accounts payable" on the balance sheet than "commercial paper outstanding." After the recent financial crisis, one can get nervous about commercial paper becoming unavailable. However, any company dependent on its suppliers needs to also worry about the suppliers' credit being jerked away. History is full of examples of small businesses losing access to credit, to the detriment of their customers.

Finally, let's pause and think about what's happening without the veil of finance. P&G is buying materials and services from a number of companies, so that it can sell products to consumers. (Disclosure: I shave with their products. But not on Saturdays.) The focus of both parties to each supply agreement should be how to provide better products at lower cost. When one party gets too focused on getting the better side of the bargain, then the joint effort is less likely to succeed.