Procurement Incentive Plan Flaws: Part 3
In the first two installments of this series, we've identified that corporate procurement incentive plans frequently fail to promote optimal bottom-line results (Procurement Incentive Plan Flaws: Part 1) and that this underlying problem has created the phenomenon we've titled "Fake Savings" (Procurement Incentive Plan Flaws: Part 2).
In Part 3, we delve further into the “Fake Savings” phenomenon, focusing specifically on the types of expenses that are most vulnerable to it.
What expenses are most susceptible to "Fake Savings?"
The more complex the expense, the more susceptible it is to “Fake Savings.”
Long-term service contract expenses are particularly vulnerable areas—often replete with moving parts, discretionary practices, new product and service line introductions, along with the inevitable “unknown unknowns” that further complicate matters.—In these categories, you’ll find a complex and ever-changing landscape loaded with opportunities for suppliers to seize upon and grow margins.
What tends to happen in these categories?
Even before we get to all the things that happen after a new contract goes live to erode the efforts of even the finest procurement professionals, consider this: a more complex expense is more likely to be poorly represented in savings projections to begin with.
Within our areas of expertise—three highly complex service contract industries (the uniform/industrial laundering industry, the waste/recycling industry, and the pest control industry), when even the most intelligent buyers provide us their projections, they’re consistently off the mark—often wildly. This isn’t shocking, of course—many industries’ suppliers have developed contract language, billing methodologies and discretionary practices which are stealthily different from their leading competitors’, inviting flawed proposal/contract analysis unless precisely the right questions are asked along the way.
Here's a recent example: a client had been entertaining supplier proposals for his uniform rental program before meeting us and subsequently deciding to bring us in to finalize his process and optimize from there. He told us that his leading contender represented ~$800K in annual savings, based on the proposal that supplier had put forth. He shared the current supplier proposal and the analysis he had done in arriving at this $800K estimate. This was a very sharp guy and an experienced and strategic buyer. This was not his first rodeo.
However, he didn’t appreciate all the ripple-effect implications of the differences in billing methodologies between his incumbent supplier and the attractive-looking proposal he was considering. These were not obvious differences—the kind of nuance highly likely to slip by a non-insider. He couldn’t have been expected to know all the questions to ask. And it wasn’t a matter of things that were said in the proposed agreement (our client was plenty sharp enough to identify and strike unfavorable language), but rather things that weren’t addressed at all, but should have been. What he thought was $800K in savings wasn’t even $300K.
But that’s not all he didn’t know. He also dramatically underestimated his back-end liabilities with his incumbent supplier. Again, this was “in the weeds” information that even the sharpest generalists couldn’t be expected to understand. Our insiders did, though. A full eighteen months’ worth of savings (~$450K) was likely to be spent on the back end of this deal in order to save $300K.
With the sorts of complex service expenses that tend to reside in your lower 20%, this sort of flawed analysis is incredibly common. And unfortunately, so is the submission and approval of “savings initiatives” that really don’t accurately reflect what’s likely to happen, post-initiative.
But OK, let's say you do get the deal projections right
Even if the initial deal analysis is spot-on, though, with many complex services, that’s not worth much. A 25% savings gets negotiated, but when the new contract is keyed into the supplier’s system, only 15% savings hits the first invoice. Do these keying errors get caught? Not usually. Then, the commissioned service rep responsible for your account starts taking a more aggressive approach to discretionary charges, adding them to the invoices at a higher rate, in an attempt to reclaim some of the lost revenue from the new deal. 15% shrinks to 10%.
Then, over the next six months, eight new products are added to the program. Are they added at margins consistent with the rest of the newly-negotiated account?
They’re added at “book price” and that 10% shrinks to 5% or less.
Then, early in the second year of the new deal, new departmental mandates (safety, marketing, environmental, etc.) force changes to the program that simply weren’t contemplated in the new agreement. A substantial portion of the program is now added in a moment of vulnerability, at margins substantially higher than those in the negotiated contract further eroding savings.
Just 15 months prior, 25% “savings” was reported in this category and now, if there happens to be any savings left, it is disappearing by the month.
Let's recap this very commonplace sequence of events
- Buyer reports “savings” of 25% (probably more, if projections were flawed)
- Company realizes less than half of the savings reported in the initial year alone
- The little savings that is actually realized in year one is significantly eroded in year two
- In all likelihood, by the time the contract is revisited, the run rate is at or above where it was before the prior initiative
- A new buyer now responsible for this category repeats the whole “Fake Savings” process, and the cycle continues
Here is what it looks like over time:
Unfortunately, “Fake Savings” happens all the time.
Why is it important and what can you do about it?
We’ll address those questions in the next installment of this series, here at the Fine Tune Knowledge Center.