The current global Covid-19 crisis has placed severe strain upon the apparel industry supply chain, with garment manufacturers and related ancillary industries feeling the financial effects of the global collapse in clothing retail. The crisis has also thrown into sharp focus the inadequacies of the existing system of supplier payment terms.
As fashion brands and retailers around the world face dwindling customer numbers, enforced store closures and mounting stock inventory, the immediate reaction of a large proportion has been a scaling back or delay of current production orders. This has caused major problems to apparel manufacturers around the globe, as their cashflow is immediately affected and they struggle to raise the necessary funds to pay their workers, their suppliers and to cover overheads and utility bills.
The immediate question might be: How can such a situation have come about? In order to answer that, we need to consider the existing payment structure within the apparel supply chain that has resulted in a catastrophic collapse in the financial security of the global apparel manufacturing community.
Evolution of payment terms
Payment terms within the apparel industry are varied and differ sharply from normal trade practices. It would be easy to assume that if a customer orders goods for production, that they would then pay for the same, as with other trade or retail transactions. More often than not, this is not the case, with a system of payment terms that benefits the customer but exposes the supplier to financial risks.
Historically, the traditional purchasing model involved the use of telegraphic transfers (TTs) whereby the manufacturer would receive 60-70% of the order value of the goods being purchased in advance, in order to be able to procure the necessary raw materials (fabric and trims) to produce the items. The buyer would then settle the outstanding balance once the finished production had been shipped.
Over the course of time, with the evolution of the apparel manufacturing sector, particularly in expanding countries such as Bangladesh, where I run my garment facility, different payment terms evolved. First and foremost was the use of Letters of Credit (LCs). A letter of credit is basically a guarantee from a bank that a particular seller will receive the payment due from a particular buyer. The bank guarantees that the seller will receive a specified amount of money within a specified time. In return for guaranteeing the payment, the bank will require that strict terms are met and will want to receive certain documents – for example shipping confirmation and inspection reports for the goods – as proof that production has been completed to the customer’s required standards and satisfaction.
LCs can carry different payment terms, normally at sight (whereby the manufacturer receives payment upon satisfactory completion of production and the shipment of the order) or deferred, with payment delayed for a pre-determined period of time after goods have been shipped by the supplier. The payment deferral period can vary depending upon the sourcing region and the customer/supplier relationship, from anything between 30 and 150 days, post-shipment.
Although the LC system offers manufacturers some financial security in that they are guaranteed payment if goods produced comply to the customers’ requirements, it also necessitates the customer having to satisfy the lending bank’s credit rating checks, requires the management of another tier of financial bureaucracy, and can add time to the whole production process.
As relationships between buyers and manufacturers have developed over recent years, a prevalent payment system that has emerged in the apparel industry is that of the Sales Contract (SC). Under this system a manufacturer will rely on a Purchase Order (PO) from a customer to execute an order. Based on the PO the manufacturer and customer will create a Sales Contract (SC) to allow the manufacturer to raise his own LC to procure the necessary raw materials to complete the customer’s order to the required standard. Under the terms of the SC, the buyer commits to making payment for the goods after receiving copies of the documents relating to shipment of the order.
Under the terms of the standard SC the manufacturer has a legal right to receive payment for goods produced under the proviso that the goods comply with the customer’s terms outlined in the order, and a manufacturer can take legal action against a buyer if no payment is forthcoming.
Revised set of rules
The flaws in the SC payment system have been harshly exposed by the Covid-19 pandemic as customers – citing the extraordinary circumstances caused by the virus – are withholding payments or cancelling orders, leaving the manufacturer, without the security of a bank guarantee, financially exposed.
It is fair to suggest that the current payment terms in the apparel industry benefit the customer to such an extent that they are untenable for the future. A new system of payment terms needs to be established for the industry and monitored by a recognised international body, such as the World Bank or International Monetary Fund (IMF).
A revised set of rules will need to be implemented, making the process of order execution against SCs internationally invalid and no longer binding. This might well hamper the relationship between buyers and their manufacturers so a compromise scenario could well be that an advance payment is made to manufacturers to allow them to purchase the necessary raw materials, with the balance payment guaranteed by a sales contract or by LC at sight, or settlement upon shipment for any finished goods. Similar payment terms exist within the industry already, so are not a totally alien concept – what we need is a global set of terms that are recognised by all parties.
What is important is that whatever payment term system is adopted by the apparel industry, it needs to be clearly recognised that existing payment terms are no longer fit for purpose. In tandem, buyers and suppliers alike need to be open about the issues that have been raised over the last few weeks since the effects of the pandemic started to bite.
The industry needs to recognise that the current system, with its unhealthy bias in favour of the buyers, is no longer tenable and apparel manufacturers can no longer be expected to bear the financial burden of this or any other economic meltdown that may arise.
When the world returns to normal, or the new post Covid-19 normal, the apparel industry must collectively establish a payment system that is endorsed by international agencies and is respected by all participants. Only then can we be assured that apparel manufacturers will no longer be exposed to the financial risks that they are experiencing during these current troubling times.
Click on the following link to see just-style’s coverage of How coronavirus is impacting the global clothing industry.