While negotiating product X supplier A offered net 75 payment terms, supplier B offered net 60, and supplier C offered 2% 30 net 60.  It is clear that net 75 is preferred over net 60, but is 2% 30 better than net 75?  Why are extended payment terms preferred over standard payment terms and how to account for these differences when evaluating suppliers will be reviewed and shared in this entry.  To be able to answer these questions and properly evaluate the above suppliers we need to understand our company’s cost of capital.

Cost of capital is a closely guarded company percentage, it’s a figure that can fluctuate daily, and typically the cost of capital shared with the company’s Sourcing department is intended more to drive supplier behavior than to reflect a true cost of capital.  I’d worked for a company whose chairman was a hedge fund manager; at one point our treasury department was providing a cost of capital of over 25%, (frustrating that our 401k did have similar returns).  My management then shared with me that the high percentage was intended to drive supplier behavior because for Direct Import purchases we wanted to get our suppliers to net 75+.

There are many reasons why a company would look to extend its payment terms with a supply base.  First reason is extended terms increases a company’s working capital, this happens by increasing the number of turns a company has on its investment before having to pay.  For example if we were to buy product domestically from a supplier who gives us net 60 payment terms we may sell enough of that product in 2 months to cover the cost to the supplier (who we haven’t paid yet).  Extended payment terms and the increase of working capital reduces the need for corporate loans, and provides more cash stability during the peaks of expense flow.  Another benefit to receiving extended terms from the supply base is the perception of your company’s stability and supplier trust.  Wall Street analysts review average payment terms as an indicator of a company’s strength with its supply base, for example a weak or unstable company wouldn’t be able to get favorable payment terms.  Determining the cost of capital and quantifying all the benefits is a complicated formula; but when we are given the cost of capital it is crucial to evaluate the supply base on this metric.

Supplier A net 75, Supplier B net 60, Supplier C 2% 30 net 60 

How do we evaluate this if our treasury department has given us a cost of capital of 8%, and each supplier has submitted an annual spend quote for 10,000,000 USD?  Fortunately the answer is much easier than developing the cost of capital.  (Similarly if the program historically supported net 30, this formula helps quantify additional savings in your sourcing project)

Cost of Capital / 365 * # of Net Days= Payment term Benefit

 Annual Spend * Payment term benefit= Annual spend incorporating Payment term benefit

  1. Supplier A (net 75): 8%/365*75 = 1.64%
Supplier A (10,000): $10,000 * (1-1.64%) = $9,836.00
  1. Supplier B(net 60): 8%/365*60 =1.32%
Supplier B (10,000): $10,000 *(1-1.32%) =$9,868.00
  1. Supplier C (2% 30 net 60): (8%/365 *30)+2% = 2.66%
  2. Supplier C (2% 30 net 60): (8%/365 *60)= 1.32%

Supplier C (10,000): $10,000 *(1-2.66%) =$9,734

In evaluating the proposals above Supplier C had the largest payment term benefit based on the 8% cost of capital with 2% net 30.  The next step is to evaluate Supplier C against the baseline which was $10,000 with payment terms of Net 45; in this case Supplier C’s proposal shows a savings of $167.00 or 1.69%