A New Approach to the Supply Chain Cash Flow

Competition produces winners and losers. But game theory analysis shows how everyone comes out ahead when retailers and bankers cooperate to reduce finance costs for suppliers in China and other emerging markets. Consumers ultimately score when the savings get passed down the line.

New research from Tunay Tunca, professor of management science and operations management at the University of Maryland’s Robert H. Smith School of Business, calculates the benefits of a fairly recent supply chain innovation. Rather than leaving small suppliers on their own to obtain financing, influential buyers are stepping up as intermediaries.

In effect they are functioning like loan underwriters, helping suppliers with limited credit histories get lower interest rates and mitigating their cash flow problems. At the same time, buyers are driving down wholesale prices for themselves, and bankers are getting access to new customers. So the payoffs go three ways.

JD.com, China’s largest online retailer, rolled out its own supplier finance intermediation service in 2012, and the results have been dramatic. Tunca’s analysis shows the service has increased supplier and retailer profits by more than 10 percent each, giving JD about $44 million in projected annual savings.

Competition can be brutal, but the way to win in supplier finance is to play the game nicely with your partners. Here’s how the strategy works for each player. 

Player 1: Suppliers 

Small suppliers celebrate when they land a big contract with an established retailer like JD. But they face an immediate cash flow problem. They must cover production and delivery costs up front, and then wait weeks for payment while retailers assess product defects and accommodate customer returns. 

The delay after delivery at JD is 45 days, which can be an eternity for small suppliers. Most need financing to keep their operations running.

Getting a loan with minimal credit history is hard, even under the most favorable conditions. The challenge becomes more daunting in emerging markets, which sometimes lack established financial mechanisms.

Commercial loans — when they can be found — usually come with high interest rates for small suppliers. Retailers like JD offer an alternative. By backing the debt and assuming the risk, they drive down finance costs for participating suppliers.

Player 2: Retailers

Retailers have their own vulnerabilities. They sell thousands of products every day but don’t manufacture anything, which leaves them dependent on suppliers for inventory.

Without reliable delivery and low wholesale costs, profits disappear. All of this gives retailers a strong incentive to keep their best suppliers in business.

Simply knowing which suppliers are dependable gives retailers an information advantage over banks, which do not know one small supplier from another. Retailers have access to transaction histories, including product defect rates, which affect payment amounts and the probability of loan default.

This allows retailers to bridge the gap between banks and suppliers, securing the loan back payment and pricing the risk more efficiently. As a result, banks can lend at a better rate, and the entire channel operates more efficiently. 

Player 3: Bankers

The improved efficiency allows big banks to enter the game in certain markets like China, where regulations restrict their high-risk activity. Even if these banks wanted to issue loans to unproven suppliers, they would be limited.

In such cases small suppliers are left to deal with high-interest microcredit companies. JD and other retailers offer an escape when they intervene. By backing the suppliers’ loans, JD brings interest rates to sufficiently low levels, so banks can provide the financing within their regulatory restrictions.

At the scheduled time for payment, JD settles with the bank first and then pays the supplier the remaining amount due, minus charges for product defects.

Suppliers win because financing costs go down. Buyers win because wholesale prices drop while the percentage of on-time deliveries rises. And banks win because supplier borrowing also rises. 

Read more: Buyer Intermediation in Supplier Finance is featured in Management Science.