The recession and credit crisis have significantly altered the financial relationships between customer and supplier as all wait for the next business turnaround.
Despite very high unemployment, there have been a few signs of stabilization in the manufacturing sector over the last few months, including an uptick in The Conference Board's leading economic indicators, real GDP, Purchasing Managers Index and capacity utilization. While these measures suggest that the recession may have bottomed out, analysts are divided on when the broader turnaround will begin. Until such time, OEMs and suppliers, some of whom have cut to the bone to survive, attempt to carry on. However, it is unclear if short term cuts were so severe that reaction to the inevitable turnaround in the manufacturing sector will hinder long term success.
What's more, given the market volatility and record number of business failures, monitoring the financial health of your supply base is now a requirement. Similar to quality, delivery and other operational metrics that companies have been using for years to monitor the performance of their supply base, keeping an eye on the financial health of your suppliers is critical to avoid supply disruptions and minimize financial exposure.
Since late 2007, manufacturers have reassessed their strategy to ensure survival. Over 130 lenders have failed in 2009, the highest level since 1992. Other lenders have exited certain sectors and reduced credit availability. Commercial and industrial loans outstanding from U.S. Commercial Banks declined 10% over the past 12 months. Business bankruptcies are up over 50% from 2008 year to date levels, and are at their highest level in over 10 years. Scores of others have gone out of business quietly. In reaction, manufacturers have curtailed discretionary spending, slashed payrolls and compensation, sold noncore assets, and stretched working capital to its limits, among other actions.
Reductions in the workforce have resulted in a U.S. unemployment rate of 10%, the highest rate in 26 years. Contrary to some improving economic indicators, unemployment is predicted to get worse before it gets better. While a large pool of candidates appears readily available when business picks up, employers will be challenged in hiring and retraining the workforce to coincide with the timing of the recovery.
The recovery will be hindered by deteriorating working capital. A Grant Thornton sampling of 25 large OEMs suggests their average days payables outstanding have increased from around 51 days as of September 2007 to about 58 days as of September 2009. Conversely, a review of the trend in average days sales outstanding of 261 public manufacturers with sales between $10 million and $750 million suggests their customers are paying slower as days sales outstanding have increased from 56 days in late 2007 to 62 days as of September 2009. The impact is being further pushed down the tiers. Based on the sample, the 261 public manufacturers are paying their vendors slower on average, up from 41 days as of September 2007 to 48 days as of September 2009.
Innovation may also be compromised as manufacturers are cutting research and development related expenditures. For those in the sample that reported having R&D costs, such costs on average as a percentage of sales have also declined steadily from almost 10% of sales in 2007 to 7% in late 2009. Since product development research spending cycles often precede related revenue by several years, the short term impact of such cuts will likely not impact suppliers until late 2010 and beyond. Capital spending on average remained flat over the same period, however, focus likely shifted from new acquisition to maintenance. Furthermore, since funding for capital projects is typically committed to months or years in advance, capital spending could very well trend downward over the next 12 months as the impact of recent cuts filter through.
What About Me?
Although the federal government provided bailouts of $700B to the financial sector and $60 billion to certain automotive OEMs, the manufacturing base has largely been unassisted, despite pleas for help. On December 8, 2009, President Obama committed $50 billion to help small businesses get credit, less than was provided to General Motors and Chrysler combined. While such assistance will help some, it may be too little too late and may never reach much of the manufacturing base. Accordingly, suppliers are continuing to change the way they do business and flexibility is critical. For example, upfront costs previously amortized over years in piece prices are more commonly funded up front, volume expectations are now factored into pricing decisions, and extraordinary costs are increasingly passed through to customers. The current lack of credit availability is forcing customers to rethink how and when they assist critical suppliers.
For a long time, OEMs and tier suppliers have monitored operational metrics such as on time delivery, quality, and scrap; however, the fragility of the supply base and record number of business failures has necessitated active and enhanced financial monitoring as well. Key financial and economic risks between the OEMs and suppliers are commonly acknowledged and disclosed. In particular, suppliers often note customer concentration risk whereas OEMs note that components are single sourced and a financial crisis is likely to have a severe impact on suppliers and disrupt production. This interdependency, combined with the current economic environment, is prompting OEMs and large tier suppliers to take more proactive steps to evaluate and monitor each other.
The benefits of enhanced supplier financial evaluation, scoring and monitoring is both qualitative and quantitative. Costs of supply chain distress include opportunity costs, lost time, professional fees, reputation and image risk, and lost market share/sales, which can easily run tens of millions of dollars annually. Enhanced and proactive supplier financial monitoring and evaluation can mitigate such costs. What's more, it also allows suppliers to obtain objective feedback on how customers view them and may increase efficiency by standardizing information sharing with multiple customers.
Less is More
Financial evaluation and scoring is also increasingly being used to help pick the preferred suppliers and as a basis for new business awards. In May 2009, General Motors announced it intended to reduce its supply base by over a quarter from 1,500 suppliers to 1,100 by 2011. Consolidation is not limited to the troubled auto sector. In May, Sony announced it was cutting the number of its suppliers in half; Kraft followed suit in September. Other opportunistic manufacturers will eliminate underperforming and redundant vendors to increase efficiency, reduce costs, and enhance the prospects for preferred suppliers. However, reducing the number of suppliers inherently creates a higher reliance on fewer suppliers, potentially increasing the severity when financial distress does occur.
The current and near term prospective economic climate has changed the financial relationship of the customer and supplier. Despite the 2009 rebound in many domestic stock market indices and certain economic data, the real estate slump, credit market woes, and depressed manufacturing demand has resulted in a fragile manufacturing supply base. Extraordinary levels of loan defaults and business failures in 2009, combined with steadily rising debt maturities over the next several years suggest the New Year has potential to be just as bad. Absent sufficient credit to fund working capital expansion and grow payrolls, suppliers will be ill prepared to react to any sustainable or dramatic uptick in orders, hindering the overall recovery until 2011. In the interim, opportunistic OEMs will continue to rationalize marginal suppliers via natural attrition as well as managed consolidations, using far more sophisticated financial evaluation and monitoring programs to identify and quantify financial risks which previously may have gone undetected or under-detected.
Bob Lack is a Director with Grant Thornton's Manufacturing Transaction Services group in Chicago where he assists OEMs and Tier 1s in the development of proactive financial evaluation and monitoring systems. See Grant Thornton's Industrial Manufacturing Area.
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