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Microsoft word - scf_new dimension to b2b trade_poms_conf.doc
Dynamic Payables Discounting: A Supply Chain
Department of Operations and Information Management
Department of Operations and Information Management
Dynamic Payables Discounting: A Supply Chain
Supply Chain Finance (SCF) is emerging as the next frontier in Global Supply
Chain Management that firms are focusing on to drive financial advantage over
their competitors. A wide variety of innovative trade solutions are currently being
developed by merging physical supply chain information with financial supply
chain data. Based on event triggers, SCF providers are offering much needed
liquidity at different points of the supply chains. These SCF products are
transforming traditional working capital management. In this paper we study the
payables management problem of a buying firm in a supply chain scenario with
SCF enabled “Early Payment Program”
implemented. In this paper we develop a
stochastic dynamic programming model to capture the uncertainties and the
temporal aspects of short-term cash management.
(Global Supply Chain Management, Supply Chain Finance, Working Capital Management, Stochastic Dynamic Programming)
The focus of Supply Chain Management (SCM) to date has been streamlining and automating
the physical supply chain in order to reduce costs. Significant improvements have been
achieved in physical supply chain management over the last few decades. However as physical
supply chains have become more and more optimized, savings have become harder to realize.
This has prompted supply chain managers to focus their attention on other aspects of the
supply chain in order to achieve further gains.
One aspect of the supply chain that has been largely overlooked is the financial side of
SCM. Managers till now have not been able to fully leverage the earning potential of business-
to-business (B2B) trade. For every physical order working its way up the supply chain, a
financial transaction moves in the other direction. Firms today compete on a global platform. To
achieve cost benefits, retailers often source materials from suppliers in countries with lower
labor and raw materials costs like China, India or Vietnam. This production outsourcing has
helped retailers achieve significant reduction in their operating costs. But when it comes to their
treasury operations, the buyer and the supplier perform roles that are in conflict. Due to this lack
of collaboration in treasury management, supply chains fail to achieve potentially large financial
In a typical supply chain scenario the buyer’s primary motivation is to stretch payables
and earn interest off the float. This tendency of the buyer improves its working capital position
but adversely affects the cash flows of its suppliers. Global suppliers, who are mostly in the
emerging markets, have constricted access to short term financing and a much higher cost of
capital. To meet their business needs such suppliers have to arrange for financing at exorbitant
rates. Cost shifting to suppliers result in better Days Payables Outstanding (DPO, a metric that
indicates how many days on average an organization takes to settle its payables) for the buyers
but leads to a financially unstable supply base and to higher costs of the products.
In the last few years supply chain service providers and financial institutions have come
up with many solutions to release trapped value in B2B trade. This has led to the emerging field
of Supply Chain Finance (SCF). SCF can be defined as a combination of technology and trade
financing that unites the buyer, the supplier and a financial intermediary electronically to provide
financing triggers based on one or more supply chain events. Using these services, buyers can
not only extend their DPOs but also leverage their higher credit ratings to provide better
financing for their suppliers and as a result improve the overall performance of the supply chain.
The main focus of these solutions is to provide supply chain partners with more control over
their financial processes and more options on how to optimally use cash and credit. Financing
is made possible at different points of the supply chain based on event triggers like purchase-
order issuance, invoice issuance, advanced shipping notices and invoice approval.
In this paper we focus on one of the key aspects of SCF, the Early Payment Discount
from the standpoint of payables management for the buyer (see Figure 1).
Figure 1: Early Payment Discount Program
Early Payment Discount Program
Businesses typically focus on getting paid as quickly as possible reducing their days sales
outstanding (DSO) and delaying paying suppliers for a long as possible by extending days
payables outstanding (DPO). This leads to an obvious conflict of interest between the buyers
and their suppliers based on working capital management objectives.
In order to reduce their DSO, which is an important measure of an organization’s
operational efficiency on their sales side, and to obtain cash early, supplier’s offer early payment
discounts to its buyers. One of the most common trade terms used by the suppliers is “2/10, Net
30”. This allows the buyer to take a two percent discount on the face value of the invoice if they
pay within ten days. Otherwise, they must pay the full amount within thirty days. Since global
suppliers need access to capital which is limited and expensive, it is worthwhile for them to give
discounts on their invoices and be paid faster rather than obtaining loans using their own credit
Taking advantage of a 2% discount to pay 20 days early amounts to a buyer realizing an
annualized return of almost 36%. This high rate of return far outweighs almost any other short
term investments the buyer may consider. So it’s imperative for the buyer to take the early
payment discounts rather than extend payables. But for a typical buyer this cash earning
opportunity goes unrealized as they may not have the technology in place to take advantage of
the early payment discounts. Lack of visibility in the payables management system leaves too
many early payment discounts out of reach of the buyer.
SCF providers now offer buyers automated services to better manage their accounts
payables and in turn optimize their working capital. This is a win-win for both buyer and seller, it
helps the buyer extend their DPOs and at the same time provides fast access to capital for the
suppliers. This is the way it works – the supplier sends the goods to the buyer along with the
invoice and checks the intermediaries B2B site for material acceptance and the clearing of the
invoice, when a material is accepted by the buyer the SCF site is informed and if the supplier
decides to give a discount the financial intermediary is directed to pay off the invoice (less
discount) to the supplier in the specified time (10 days with discount), the supplier is
immediately informed by the intermediary and the payment made. The whole process is now
continuously visible by all parties. On the regular maturity of the invoice the buyer pays off the
financial intermediary. The early payment discount gets shared between the intermediary and
the buyer and the seller obtains the cash early which in turn serves his purpose. The
intermediary provides the cash based on the credit rating of the buyer as the credit is secured
against the accounts payable of the buyer. In this setup the buyer can avail third party credit to
capture the early payment discounts and at the same time extend the payable to the maturity
date of the invoice, the suppliers can get cash early and improve their trade cycle and the
financial intermediary can inject capital at a lower risk (Figure 1).
In this paper we analyze payables management of a buyer who has an early payment
program implemented through SCF. A two percent discount on the face value of an invoice may
not sound too exciting but for larger buyers who have billions tied up in payables this may result
in savings of millions of dollars. As we have seen above, capturing the early payment discounts
is extremely imperative from the buyer’s perspective. But even the strongest buyer does not
always have cash sitting around to take the early payment discounts when the need arises and
in many circumstances are forced to extend payables. Hence it’s essential for the treasury
manager of the buying firm to develop a payable mechanism that combines the use of its own
cash reserves and SCF provided financing to create a cost-advantaged supply chain. In this
paper we develop optimal decision rules for the accounts payable management of the buyer
Working Capital Management and SCF
Corporate finance, on a broad level, can be classified based on long-term and short-term
decisions and techniques. Capital investment decisions like which projects receive investment,
whether to finance that investment with equity or debt, merger and acquisitions policies or
whether and when to pay dividends to shareholders are termed as long-term financial decisions.
On the other hand, cash flows connected with the day-to-day operations of the firm are grouped
under short-term financial management. Short-term financial management encompasses
decisions about activities that affect cash inflows, cash outflows, backup liquidity like bank credit
line or loan management and internal cash flows. These short term financial decisions are
grouped under the heading "Working Capital Management"(WCM).
Efficient WCM is vital towards functioning of any corporation. It directly impacts the
operating cash flows of the firm. Incorrect evaluation of a firm’s working capital requirements
may cause severe losses and adversely affect its long-run prospects. Similarly proficient short
term financial decisions can generate significant improvement to a firm’s return on investment
and improve share holder’s value. Because of its importance to the survival of firms, WCM
occupies major portion of a treasury manager’s time. Lack of synchronization between cash
inflows and outflows and the intrinsic difficulty in forecasting these quantities on a day-to-day
basis make WCM really complex and challenging. The key to competent WCM lies in adjusting
the firm’s asset and liability mix continuously to smoothen the stochastic variations in cash
flows. Here we look at the academic literature on short-term financial management.
WCM is multidimensional in nature and requires active involvement of the finance,
production and marketing departments. Hence researchers from various fields such as finance,
economics and operations management have studied the working capital and liquidity
management problem. The earliest work on cash management is by Baumol (1952). He
examined the cash-balance problem as an inventory management problem of some physical
commodity. The problem setting was deterministic where the net cash flow was known with
certainty. Miller and Orr (1966) also considered stochastic cash management problems. They
derived the control-limit policy parameters for optimal cash holdings. Eppen and Fama (1969,
1971) and Constantinides (1976) also developed analytical models to capture the uncertainty
and temporal aspect of the cash management problem. These models provide insight into the
qualitative structure of the optimal cash-balance policy and the transactions demand for cash.
Girgis (1968) and Neave (1970) formulated the cash management problem as a multi period
inventory problem. Extensive surveys of the development of this literature was provided by Elton
and Gruber (1975) and Ziemba and Vickson (1975).
Other prominent studies in the field of short-term financial management include work by
Maier and Van der Weide (1978) and Robichek et al
. (1965). To capture the stochastic element
of the cash management problem researchers developed chance-constrained and linear
programming under uncertainty models (LPUU). Charnes and Thore (1966) and Pogue and
Bussard (1972) developed chance-constrained programming models of the cash management
problem. LPUU models developed by Kallberg et al (1982) provide another approach to treat
the uncertainty associated to cash management.
A Stochastic Dynamic Programming Model
We develop a finite horizon stochastic dynamic programming model to capture the uncertainty
and the inter-temporal aspect of the cash management problem. Here our focus is on the
payables management of the buying firm that has implemented an early payment program with
its suppliers. Early payment discount terms like “2/10 Net 30”, “3/20 Net 60” are quite common
in B2B trade. With SCF provided early payment solutions in place the treasurer has an
additional option to settle accounts payables (A/P). He can pay the invoices either with his firm’s
own cash reserves, or based on liquidity requirements, he can extend the payables and go for
SCF provided financing. Capturing the early payment discounts with own cash reserves is
always worthwhile as involving an intermediary requires profit sharing. But due to uncertainty in
future cash flows it is not obvious at each time period whether and by what amount should the
treasury use own cash reserves or go for SCF financing.
In our model we consider trade credit terms of the form “ r
/10 Net 30” where r
any discount percentage e.g. 2%, 3%, etc. The discount period is taken as ten days and the
invoice maturity is thirty days. Other trade terms can be easily incorporated into the model. The
sum total of invoices arriving at any time period t
is denoted by i
. The accounts receivable (A/R)
and the cash on hand, i.e., the firm’s own cash reserves in any period are a
respectively. We interpret a
as the net inflow of cash at any time period. Here a
be positive or negative based on the cash flows and the payable decisions.
At the beginning of each time period t
, the treasurer looks at the values of c
decides what amount of i
would be settled by own cash reserves and what would be funded by
SCF sources. Uncertainty in the payables management problem comes from future A/R and
respectively, which are stochastic and follow discrete probability distributions.
From period to period they are assumed to follow independent identically distributed probability
The actions in our model are the amounts of own cash reserves that the treasurer uses
at each time period. Then the amount of SCF provided cash used at any period would be the
difference of the invoice amount and the own cash used. For notational simplicity we call the
treasurer’s cash reserves “own cash”
and SCF arranged credit “SCF cash”
assume that at each time period payments are made in discrete units h
, …, h
cash” where 0 ≤ h
< . < h
] . The invoice amount that is paid through
own cash at t
gets deducted from the cash reserves immediately. But the amount paid by SCF
cash affects the cash reserves after three time periods since the treasure has to repay the SCF
intermediary only at the maturity of the invoice.
denote the invoice amount that is funded through SCF sources at
− 2 and t
− 1 and that needs to be paid at t
+ 1 and t
+ 2 respectively. For analytical tractability
we have aggregated ten days as one time period. Let T
be the time horizon for the problem.
Then the state of the system in a time period t
can be specified by (c
) be the maximal discounted net present value of being in state
) when optimal actions are taken in each time period from period t
remain reluctant to use their credit capacity to fund early payment discounts as they require
bank loans and sound credit lines for other daily operations. In our model we assume that the
treasurer opts for bank loans only when he does not have adequate cash on hand to pay off an
invoice amount that had been stretched through SCF provided credit. In other words bank loan
is taken only to repay SCF credit. To ensure that the dynamic programming solution avoids
those states where bank loans are required we penalize them by a large rate of interest for the
be the discount percentage that is earned by the buyer if the invoice is funded
through the SCF solution (r
) . We assume that after the payable decision has been made
the left-over cash is invested in a single period sweep account to keep the funds as liquid as
possible since the objective of the treasury is to avail as much of the discount with own cash.
Hence the cash invested at t
matures at t
+ 1 and the treasury has that amount on hand before
he makes his decision at t
+ 1 . Let r
be the rate of return on the one period sweep account
) . Let β be the discount factor. Then the following recursive functional
) + β
E f T
) = r h
) + r
is the single period reward function;
[ f T
) f T
) + r i
+ β E
The boundary condition for this model is:
) = c
Recent developments in the financial supply chains have made it imperative to analyze working
capital management in view of B2B trade financing. The innovative SCF products have started
to transform the traditional practices in short-term cash management. In B2B trade, early
payment discounts are often offered by suppliers in order to improve their cash flows. Most of
the times these discounts are out of reach of the buying organization because of lack of visibility
into the procure-to-pay cycle. With automated payables enabled by SCF providers, the buyer
now has an added opportunity to avail these early payment discounts. Through innovative
financing made possible by third party financers, buyers can simultaneously capture the early
payment discounts and extend the payables till the maturation of the invoice.
In this paper we develop a stochastic dynamic programming model to incorporate the
temporal and the uncertainties associated with short-term cash management and examine
payables management of a firm engaged in B2B trade. We are currently working on extensive
numerical analysis to gain critical managerial insights.
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