Fixing procurement incentive plan flaws and the “fake savings” they promote isn’t an easy task, but it is one that should be tackled says Rich Ham, CEO at Fine Tune. He makes the case for why fixing these flaws in the system will elevate the profession.
Back on September 9, we learned Kraft Heinz (KHC) had paid $62 million in fines for what SEC enforcement division director Anita Bandy called “…improper expense management practices that spanned many years and involved numerous misleading transactions, millions in bogus cost savings and a pervasive breakdown in accounting controls.”
The SEC complaint cites among its grievances that Kraft Heinz employees negotiated a range of new supplier agreements loaded with front-end and short-term benefits tied to future commitments and then “…prematurely and improperly recognize(d) the expense savings.”
This revelation caught my attention because—for multiple years now—I’ve been writing and speaking about the pervasive phenomenon I’ve been calling “fake savings,” and the underlying issues with procurement department incentive plans that perpetuate it.
The phenomenon is especially prevalent in the indirect services arena, where many of the most complex expenses reside. Here’s what we’ve been seeing in this space: Leaned-out procurement departments—vulnerable and under siege by their indirect suppliers—have reported savings initiative after savings initiative, only for those same initiatives to never implement properly to begin with and then rapidly erode after category managers have moved on to other projects.
If you’re a procurement professional, the KHC “bogus savings” episode shouldn’t just cross your radar as a story about corrupt practices in someone else’s organization. Rather, it should serve as a warning to the entire procurement enterprise that if your output isn’t real, consequences will follow, whether in the form of millions of dollars in fines or simply in the loss of credibility and prestige within an organization.
Now, let me be clear: the “fake savings” I’ve been writing and talking about is, in fairness, less nefarious than the sorts of blatant misrepresentations cited in the SEC complaint against KHC (and, it should be said, it seems KHC has employed a number of corrective measures since the offenses occurred).
I would argue, though, that the pattern of reported “savings initiatives” failing to fully materialize in the P&L—and then even more consistently failing to stick as intended—is only a couple of stones’ throws away from the phenomena at the core of the KHC matter. And while the sorts of “bogus savings” considered crimes by the SEC may be relatively rare, the sort of “fake savings” I’m talking about isn’t just commonplace, it’s the norm in many complex indirect categories.
The (Flawed) Rules of the Game
It would be easy to argue that the fundamental problem responsible for creating “fake savings” is a lack of resources. Fair enough, leanness is a reality—and not one likely to change anytime soon. This reality does indeed create vulnerabilities in the natural, ongoing buyer-seller “joust,” but it is a reparable problem. In 2021, the marketplace offers many opportunities for procurement resources to augment in-house resources with outside solutions to drive results and efficiencies, and to hold suppliers accountable.
No, the main problem is the rules of the game—the incentive plans handed to procurement departments, the ways credit and rewards are meted out—and the behaviors these rules promote. Chief among them are the following:
1. Rewards Before Results
To be blunt, it is nonsensical that procurement-led “savings initiatives” are credited and rewarded in most companies before a single dollar of the supposed savings has hit the P&L. In many categories, the list of factors that threaten to render intended savings as “fake” is a long one, and procurement resources are typically ill-equipped to defend against these threats.
Now, measuring what actually happens (especially in more complex expense categories) in a landscape that inevitably shifts over time is not an easy task. But it’s also not impossible. Developing an understanding of specific problematic expenses and arriving at appropriate systems of measurement –including normalization mechanisms based on a changing landscape – is something which can and should be prioritized by smart businesses. Once these systems of measurement are in place, a business has set the stage to measure – and reward – procurement’s efforts based on actual results, not theoretical and often flawed projections.
Without doing the work required to measure true P&L impact rather than projections of savings, procurement departments will be doomed to continue doling out credit for “fake savings.”
2. Counting Only the Good
“Pat the Purchaser” owns $100MM in indirect expenses and is handed a 5% “reportable savings” expectation each year across these expenses. In most companies, attainment of that 5% comes from tabulating the projected dollar value of the approved savings initiatives during that fiscal year. Pat won’t typically drive initiatives in ALL her categories in a given year, so if Pat owns 10 categories, each representing $10MM in annual spend, it’s likely her $5MM in reportable savings comes from initiatives in only half of those 10 categories (or 10% average savings across five categories totaling $50MM).
Here’s the flaw: If Pat’s other five categories experience cost increases beyond their intended spend levels (indeed, often spend levels that are a product of prior years’ reported initiatives), this tends to have no impact on Pat attaining her “numbers” for the year.
This tendency NOT to hold procurement resources accountable for flawed savings projections or savings erosion due to myriad factors (many of which are predictable and manageable) belies the very definition of the phrase category management. Further, this flaw actively promotes “fake savings.” If category managers were required to net cost escalations in other categories with current-year reported savings initiatives, “fake savings” would dramatically reduce as procurement resources would prioritize P&L impact in a way that is generally not required in 2021.
3. Over-Valuing the Short Term (and Under-Valuing the Long)
A dollar in your hand today is indeed more valuable than a dollar in your hand three years from now. As I type, today’s dollar is about 10% to 15% more valuable than October 2024’s dollar. But looking at the 2021 procurement landscape, you’d think 2024’s dollar was almost worthless – and this promotes illogical and counterproductive decision-making.
A specific culprit in this context is the tendency to view all expenses – even those where multi-year supplier commitments are the norm – through a year-over-year lens.
Suppose the last five-year hazardous waste contract signed by ABC Widgets led to a five-year spend of $20MM, and as that deal approaches expiration, Pat finds a way to drive 20% out of those costs through effective negotiations (and then finds a way to manage the category to ensure the savings sticks). It is hard to argue Pat didn’t add $4MM in value for ABC Widgets in this scenario. And yet, in almost every procurement department, the rules of the game assign no value to the impact Pat’s work has made on years two through five of this contract.
The net of these three deep flaws in corporate procurement plan structures is not just a lack of incentive to effectively manage expenses and advance the company’s long-term interests—but indeed often a disincentive to do these seemingly obvious activities for any ownership-minded businessperson. By many departments’ incentive structures, Pat can do quite well submitting a stream of “savings initiatives” that take short-term gains in exchange for longer-term sacrifices, and which never quite hit the P&L as intended and rapidly erode from there, creating “low-hanging fruit” to do it all over again in a few years.
It’s completely unproductive and it’s pervasive.
The True Lessons of the KHC Story
Turning directly to procurement professionals, I say this, channeling my inner Robin Williams: It’s not your fault.
Firstly, you’re overburdened and understaffed. You’re all being asked to do the work of two to three people. Secondly, it’s hard to ask human beings to choose more productive behaviors if easier, less productive behaviors might more directly serve their personal financial interests. And beyond your leanness, the rules of the game in your departments are driving the “fake savings” phenomenon more than anything else.
There is some good news in all this, though. These common issues in the 2021 procurement landscape do provide opportunities for new waves of leadership to emerge and employ more ownership-minded strategies to produce lasting P&L impact and advance the business’ long-term interests. Identifying flaws in the system and taking charge of the repairs is, after all, a thing that good leaders do.
Fixing procurement incentive plan flaws and the “fake savings” they promote is no small challenge, but it is one that should be tackled. Good fixes in this realm will elevate the profession and leave practitioners feeling better about their roles and reputations in their companies.