Management: VAT incentives to stop late payments

Small companies have big companies on their backs to fleece them and big companies still bigger companies, and so on.

Every small manufacturing business knows that getting paid for things can be as much hard work as making them. As the economy turns up good businesses will go under - not because they do not have any orders but because they have too many and cannot support cash-flow requirements.

One leading manufacturing business in the UK defines Just-in-Time as maximum availability (to them) at minimum cost (to them) and implements this through on-site consignment stocks from its small suppliers paid on a 90-day credit period from time of use - in effect 100 to 120 days' worth of credit.

Interestingly, the company's own customers are required to pay, in full, seven days before delivery. So, for every pounds 10,000 of business a supplier gets, he must fund about pounds 8,000 of cash flow four months before payment. In some cases, the bought-out proportion may itself be funded by second-tier suppliers. But this only passes the parcel to another small business until you hit a 'big' supplier who insists on standard payment or no deliveries.

This situation, far from being unique, is close to the norm. At any one time it has been estimated that there are about pounds 50bn worth of overdue commercial debts - about pounds 15bn of it owed to small or medium-sized enterprises (SMEs), costing them about pounds 4m per day in interest payments.

Even more unfair is that these small businesses are often those caught in the funding trap between pounds 50,000 and pounds 1m - too small for the fund managers, too large for the secured bank loan. The truth is that large companies with easy access to cheap capital transfer the financial burden to small companies with limited access to relatively expensive capital.

In the Budget, the Chancellor acknowledged that 'late payment is corroding our business culture' and that 'the time has come to take this issue head on'. In this case, 'head on' includes studying a new British standard for payment performance - with the threat of certification withdrawal for those that do not comply, and the levying of interest on late payments - a worthy idea, except that it will not work and addresses the wrong problem.

It is not the interest cost to the small company that is the problem, it is the cash-flow requirement to pay for its own materials, labour and overheads long before it is paid by big customers.

Legislated interest payments or maximum statutory credit periods are typical lawyers' solutions - they would require confrontation between the parties and could therefore only be an expensive device of last resort.

Small suppliers would not dare to enforce them as this would result in price pressure on the supplier or even loss of the customer. Where interest charges implicitly exist now through surcharges or discounts, these are either not paid or the discount is taken anyway.

There is a simple method that would solve the late payment problem, put billions of pounds of 'free' investment money into the SMEs, raise the productivity of manufacturing industry and improve the Government's cash flow.

All that is required is to allow input VAT to be reclaimed only on invoices paid within, say, 30 days of the invoice date. To prevent obvious abuse, it would also be worthwhile to require that invoices be raised within, say, seven days of delivery of the goods or services. This would give a maximum credit period of 37 days.

This would rectify the pounds 15bn deficit currently afflicting SMEs - in effect at negative interest rates. It would also make unnecessary the employment of a large number of people involved in dealing with supplier inquiries about late payment and in chasing up payment - often a large drain on managerial resources.

It would marginally improve VAT cash flow for the Government, which would also pick up 17.5 per cent on any late payments.

It is important that non-compliance would be an infringement of the VAT legislation and monitoring would be through Customs and Excise. It would not be necessary for a small supplier to confront a customer.

So who loses? Large sloppy companies that have relied on supplier exploitation will be forced to support their own working capital requirements, factoring companies will need to focus on exporters not protected by the VAT requirement and retailers will have to fund their own stocks.

The author is professor of manufacturing strategy at Cranfield School of Management and is currently a special adviser to the Trade and Industry Select Committee on the Competitiveness of UK Manufacturing Industry.