As your customers seek to expand their margins through better supply chain management, it’s not uncommon for the converter – whether an aerospace machining company, an injection molder, or a food processor – to get squeezed. The financial impact can be significant. Take the following example:
OEM CUSTOMER negotiates with raw material SUPPLIER to secure best pricing on raw materials. The CONVERTER (choose your industry) buys the raw material at the negotiated pricing. Most likely, to secure that pricing, the OEM CUSTOMER agreed (or didn’t require otherwise) that SUPPLIER could ship the raw material in its most efficient batch size and expect payment from CONVERTER rather quickly (let’s assume net 30 day terms). Due to batch sizing, CONVERTER won’t be able to use all of the raw material for 4 months.
Separately, OEM CUSTOMER demands that CONVERTER receive payment on net 90 day terms (though in the real world OEM CUSTOMER often pays later than that). Let’s assume that the CONVERTER sends 1 shipment a week to CUSTOMER, that each shipment is $100,000 in sales and $50,000 in raw material, that CONVERTER could borrow money at 8% and that if CONVERTER could hire more operators those operators would yield 30% gross margin (the actual number is likely much higher).
In our example, it takes CONVERTER 17 weeks to use up the batch of raw material it must purchase from SUPPLIER. That means at any given time it has, on average, 8.5 weeks of raw material on its shelves valued at $425,000 when it only needs 1 week of raw material (for that week’s shipment). The result is that CONVERTER has – throughout the year – $375,000 in excess raw material. It pays for that material 30 days from receipt but doesn’t get paid (on average) for another 120 days on average (60 days (90-30) for the first week going to 172 days for the material used in week 17). If CONVERTER borrowed the money, this inventory “stretch” costs CONVERTER roughly $30,000 per year! And if COVERTER could have otherwise used that money to grow its business, it would have an additional $90,000 in gross margin for the year. And remember – if you’re selling your business, that $90,000 could result in you receiving some multiple (say 5 times, but perhaps more) in purchase price.
Fortunately, we can help, though a combination of (i) smart commercial contracting, (ii) supplier negotiation and (iii) making sure the conditions of your quote are clear. Customers – particularly those in procurement – understand that real cost increases should warrant price increases – including when their treasury departments demand extended payment terms and their sourcing teams negotiate pricing with raw material suppliers that adversely impact the converter stuck in the middle.