Supplier Terms: The Hidden Cost You Didn’t Realize You Were Paying
Supplier terms seem great on the surface, but not so much after looking under the hood. What do we mean by that? Well, as the old adage goes, nothing in life is free, and that includes supplier terms. Most contractors don’t consider terms to be a form of financing, but they are (we’ll unpack that more below). Now, don’t get me wrong, financing can be (and many times is) a really smart business decision, but only if you’re able to properly evaluate the cost to your business. And if you don’t think of supplier terms as financing, you will undoubtedly miss that.
It’s safe to say that supplier terms are the industry standard for subcontractors. Subcontractors working large commercial projects are often in the driver’s seat when it comes to negotiating terms with their suppliers. It’s easy to see why; large material purchases are sought after and no supplier wants you going to one of their competitors. In many of these instances, suppliers may be willing to flex their terms to 30 or 60 days just to ensure the business.
Statistics show that when terms are available, subcontractors use them. According to the 2022 National Subcontractor Market Report, 89% of subcontractors have terms with their supplier. 69% of subcontractors reported they prefer supplier terms over other forms of payment. It’s a seemingly attractive proposition: rather than paying upfront, you’re given a “free” 30 days to pay for materials when you start a new project.
What could be wrong with that?
A lot, actually. Especially when you consider the opportunity costs.
In this article, we’ll explore the hidden cost of supplier terms, despite it not being crystal clear on their quotes.
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Supplier Terms Come At a Cost; Let’s Explore:
You might be wondering, if suppliers aren’t charging explicit interest on their terms, then what’s the cost? It’s pretty simple, actually: the opportunity cost of lost discounts. Most suppliers offer meaningful discounts for subcontractors who pay upfront, a discount you forfeit every time you use terms. These discounts vary from 3% to as high as 8% when materials are paid for upfront. If you use terms, you don’t see the discount.
Why do suppliers offer the discount? Upfront payments are advantageous for suppliers. From the supplier’s perspective, the benefits of a subcontractor paying upfront include:
- Reduced risk of non-payment and the costs associated with the collection process
- Savings from not having to send liens on projects
- Improved cash flow by lowering their DSO (Days Sales Outstanding)
- Enhanced cash flow and ability to meet their own payment deadlines, since they are also likely on net 30 terms with their manufacturers
By forgoing the discount, you’re unnecessarily paying inflated prices when you didn’t need to. The higher prices of materials you pay can be substantial. This is why supplier terms can often be likened to financing the cost of the materials; there is an associated fee, it just doesn’t carry the title of “interest.”
For example: Let’s say you purchase $2,000,000 worth of materials each month under 30-day supplier terms. You pay them off at the end of each month. Because you make a new purchase at the beginning of each month, you maintain a $2,000,000 balance with your supplier all year. Assume that the supplier’s cash discount is 3.5%, or $70,000 per purchase (suppliers generally offer anywhere from 1-5% for paying upfront). By not paying upfront, you’re paying $70,000 more than you would have otherwise. Over the course of 12 months (assuming you make this size purchase each month), this amounts to paying $840,000 more than if you hadn’t used the supplier’s terms.
The APR (Annual Percentage Rate) of Supplier Terms
Now that we know the cost of supplier terms in an isolated example, let’s talk about what that means in terms of APR (annual percentage rate). First off, a quick refresher on APR. APR is the annual percentage rate associated with a loan or financing transaction. Investopedia defines APR as the yearly interest generated by a sum that’s charged. That APR generally includes any fees or additional costs associated with the transaction.
If you’re not thinking of supplier terms as financing, you’re likely not paying attention to the APR. To that end, supplier terms do have an APR if you consider the cost of the terms to be the higher prices paid for the materials, and the APR can be sizable in many situations.
On a balance of $2,000,000, that equates to an effective APR of 42%. Wait, 42%?! Yes, here’s how:
Every month, you forfeit the supplier’s $70,000 discount by not paying upfront.
12 months x $70,000 = $840,000 in higher material prices
$840,000 unnecessary costs ÷ $2,000,000 balance = 42% of your balance
That 42% or $840,000 becomes your APR — the cost of using supplier terms instead of paying up front, based on a 3.5% upfront discount.
What if you pay your supplier earlier than the 30-day terms? Does that become a better or worse deal? What about if you slow pay your supplier and repay in 60 days instead of 30? Let’s take a look:
Effects of Paying Sooner: Let’s say you happen to pay down the balance with your supplier within 15 days on the same $2,000,000 monthly purchase. What changes? On the surface, nothing. However, reading between the lines, there is a difference. You don’t get any financial benefit for paying your supplier 15 days earlier (assuming there’s no net-10 or net-15 discount) and the financing (the opportunity cost of a discount) still costs you $70,000. However, when you shorten your payment timeline, you’re effectively paying the same amount for less optimal cash flow (given the shorter repayment timeline). And in this case, your APR jumps from 42% to 84% because the cost stays the same, but the duration is cut in half.
Effects of Waiting Longer to Pay: Let’s be clear, there are risks to slow paying your supplier. First and foremost, your supplier relationships will likely suffer. On top of that, slow-paying your supplier may hinder your business’s ability to obtain additional material if you need it. With that said, your APR effectively gets cut in half when you double the length of the term. Slow paying an extra 30 days (and instead paying in 60 days) will cut your APR in half from 42% to 21%. Despite the APR improvement, this is not a recommended solution.
Beyond the Hidden Cost
Once you’ve internalized the fact that supplier terms aren’t free, it allows you to take a step back and assess the overall value of those terms. Ideally, the cost of those supplier terms are justified by the other benefits those terms provide. However, at just 30 days (only 4% of subcontractors have terms of 60 days or more), supplier terms are ‘nice to have’ at best, and completely insufficient at worst. The 2022 National Subcontractor Market Report found that 70% of subcontractors have terms of 30 days or less, while 78% of subcontractors wait more than 30 days to receive payment from a GC after they submit their pay apps. While supplier terms are designed to give subcontractors the buffer they need to ensure they’re paid for their work prior to coming out of pocket for materials, in reality that is rarely the actual outcome.
Compared to 90+ day construction payment cycles, 30-day supplier terms just do not support subcontractors the way they’re intended to. And considering the hidden costs associated with them, it should give you pause the next time you reach for terms from your supplier.
A Better Alternative to Supplier Terms Already Exists: Material Financing
To quickly recap, it’s clear that suppliers’ “free terms” aren’t actually free — in reality, they involve an opportunity cost that could be quite costly without much of the benefit. By not paying upfront, you may be leaving money on the table. To make it worth it, the benefits that supplier terms offer should offset the cost of higher prices for the materials. If you’re going to gravitate towards terms, you should choose terms that justify the cost, and offer benefits beyond just 30 or 60 days.
Material financing is what most large subcontractors are shifting toward, especially those that are growing. Material financing allows you to pay your supplier in full, upfront, and take advantage of those discounts. But, rather than cutting the payment timeline short at 30 days, it affords you an entire 120 days to repay the costs of your materials to more closely align with your payment cycle. This can help you have the ultimate flexibility with cash flow, which means you can continue to take on projects and grow your business, without constraints.
If you’re interested in learning more about how Billd’s flexible financing solutions can help you achieve your business goals, you can enroll for free today.
About Billd: At Billd, we provide a payment solution that enables commercial construction contractors to free up cash for material purchases while enjoying the flexibility of 120-day payment terms. You get financing for commercial materials upfront with the freedom to pay it back at your own pace. Learn more about how we can help eliminate your company’s cash-flow problems so you can win more bids and grow your business.Learn More