Is your procurement reporting incentive-compatible with the organisational goals?

Before we dive into procurement savings reporting, let’s first entertain a simple fictional example:

Imagine each year you buy a 5kg bunch of apples at a greengrocer for an event you are hosting (it’s one of those healthy events... ??). The price you paid in the past years has been 10 EUR.

This year you decide to negotiate a deal with the greengrocer for a lower price if you agree to buy from him for the following 3 years. This leads to an agreement of 9 EUR for each 5kg bunch for the coming 3 years. So instead of spending 30 EUR across 3 years, you now spend 27 EUR and have saved yourself 3 EUR. Right?

Well…this is not necessarily true, as in many organisations you have only saved 1 EUR from a financial reporting perspective. This is because Procurement is only allowed to report savings on improvements made compared to the previous year. Meaning from year 1 to year 0, from year 2 to year 1 and from year 3 to year 2 etc. This means that in our example there can only be savings reported for year 1 (10 minus 9 EUR) and nothing for years 2 and 3 (9 minus 9 EUR).?

Now imagine a parallel fictional universe where you buy the same apples from the same greengrocer but have instead made a 3-year agreement to buy at 9.70 EUR in year 1, 9.30 EUR in year 2 and 9.00 EUR in year 3. In this universe you will spend 28 EUR in 3 years and save 2 EUR.

Now, by the same Procurement financial reporting logic described earlier, the savings Procurement can report in this example are also 1 EUR: 0.30 EUR in year 1 (10 minus 9.70 EUR) plus 0.40 EUR in year 2 (9.70 minus 9.30 EUR) plus 0.30 EUR in year 3 (9.30 minus 9.00 EUR).

So, from a reporting perspective we would have no preference which of these results has been agreed, as both save 1 EUR on paper and lead to the same price after year 3 (9 EUR).

It should be obvious that these scenarios are not the same though and if we translate this example into a B2B setting we can begin to see potential incentive issues for a Procurement organisation.

Comparing apples to apples may not be that simple when it comes to savings reporting... ;-)

Incentive compatibility issues

The manner of procurement being able to report savings versus the previous years gives a number of issues (some bigger than others), which I would like to address in this article:

1.??????? There is little incentive for the procurement organisation to source longer-term agreements with the supply base if on paper it does not bring them additional value. Even though a longer contract duration equals a bigger scope to be sourced and therefore additional value to be generated. So, this leads to shorter-term agreements on average, more frequent opportunities to negotiate and thus more opportunities for the supply base to coordinate its actions.

2.??????? Procurement is not fully acknowledged for the value it is contributing to the bottom line of the organisation. In the first example given, the recognition is only 1/3rd of the total value contributed. This also means that the standing of Procurement in the organisation might be undervalued as a result.

3.??????? Procurement is / can be incentivized to make knowingly suboptimal deals. Early on in my procurement career (early 2000’s) I was at a negotiation training and discussing upcoming low-cost Chinese suppliers with a procurement colleague from another business unit. He indicated that he could very easily get his new Chinese supplier to reduce with 20% directly, but only asked for 5% year-on-year, because that was also what his KPI was. He argued “Why should I get 20% now and then next year miss out on my performance KPI when I miss the 5% target?” This is not a situation that an organisation would like to end up in, but this is what this manner of savings reporting is incentivizing. Many will likely not act on these incentives, but why create the poor incentives to begin with?

4.??????? Looking at point 3. above from a different angle, we can also find that if suppliers realize the impact of this type of reporting (e.g. by reading this article… ??) they can engineer commercial proposals that satisfy the needs of the buyer at a much lower cost. If the greengrocer in my example would understand that the apple buyer has a target of 1 EUR under the mentioned reporting rules, then instead of offering 9 EUR straight away (and conceding 3 EUR of value over 3 years) he can optimize his commercials by offering a year-on-year annual reduction that also gives 1 EUR saving to the buyer and save himself 2 EUR. While in the apple example this is not a massive impact value wise, imagine that in a lot of B2B tenders the scope is 1 million times bigger. In those cases, the payoff for properly understanding these dynamics and acting on them start to be increasingly more attractive. A good sales negotiator would see a very good ‘win-win’ opportunity here to offer 1.10 EUR in savings by offering 9.70 EUR (Y1), 9.30 EUR (Y2) and 8.90 EUR (Y3) instead of 9 EUR in year 1.

Conclusion

Taking the above-mentioned dynamics into account, I would argue that:

Procurement should agree with financial controlling on an adjusted manner of savings reporting in the case of multi-year agreements, such that they incentivize Procurement to negotiate deals that are in the best interest of the organisation.

Leaving the door open for suppliers to engineer worse deals that are artificially better deals does not seem like a great idea.

Please let me know your thoughts on this topic, as well as how you see your organisation approach this topic.

#procurement #KPIs #savings #gametheory #incentives