This summer our department at work published a global guideline on procurement. A colleague of mine did great work on managing a project where existing rules, guidelines, processes and tools were brought together, harmonized and supplemented. The result is a guideline that helps all company employees in procurement activities, whether it is about doing a demand and a supplier market analysis, preparing a tender, negotiating a contract or improving collaboration with existing suppliers.
In the following weeks after the publication, I gave trainings to colleagues from other departments on the most relevant policies and rules, available tools and the benefits of using the provided tools and processes. I was also contacted by some colleagues who were in need of procurement support, e.g. asking for help in initiating a supplier search. Being able to refer to the new guideline and the tools was a huge help for me. It reduced my workload immediately, and the people contacting me were happy to have such a clear guide on what to do and how to do it.
After these experiences, I was obviously convinced that soon we would have more of our colleagues buying more professionally and spending less. After all, procurement is something we do everyday in our personal lives: we buy food, bus tickets, plan buying a house, compare prices and so on. Still, companies have dedicated procurement departments. If procurement is so easy and intuitive, why doesn’t it work in larger companies the way it works in our private lives? Why do sensible people spend money less sensibly, when they are spending company money?
I think there are multiple factors here at play, at least two:
- Lack of experience and information
- Lack of incentives
Of these two, I find the latter to be the more convincing one, since it also contributes to the first one, but I’ll first briefly discuss the first point. When we do our everyday shopping, we have experience on what the goods usually cost, who are the market players and what is the quality we should expect. We are also usually quite able to define what we want. For example, I roughly know what a kilogram of apples costs in the nearby grocery stores so I know the market. I also know, what to expect from first class apples, so I am aware of the standard product quality. I can also define my preferences regarding apples, e.g. whether I like sweet or the more sour ones.
When you work for a company, you might often need external goods or services. If you do not purchase the same goods or services often, you lack market knowledge, including prices and the usual quality of the goods. For example, if you need a tax consultant, your knowledge on the competitive situation between consultants, their regular service spectrum and potential services might be unknown to you. Thus, even if you can define in detail what you want and what you are prepared to pay for it, you do not know if that is a good deal on the market. And should you be unable to define your needs and not know what kind of opportunities the market provides, you might be lured by a slick salesman in to buying some nearly related good or service that does not fulfill your needs or contains features you do not need at all. Continuing with the previous fruit analogy, you might not be able to define whether you want pears, prunes or apples and might end up leaving the farmer’s market with a cucumber in your bag.
A logical question is then, why we don’t dig out the necessary information and gather the experience. This is, of course, a matter of cost. The learning curve in the beginning is quite steep, and if you are, for example, a research engineer, the opportunity cost for learning the intricacies of the market for different sensors, for example, might be too high. Thus, we have dedicated procurement functions. But this leads to another question, namely, why do we see maverick buying, that is, people not using selected suppliers and the services of the centralized procurement function to gain market knowledge with smaller opportunity costs? Or why might it be that people do not use provided self-service tools that make tendering and offer comparison much easier, reducing the opportunity cost for the company significantly?
I get a penny, I lose a penny
Even if the most evident opportunity cost of getting competing offers from suppliers and doing solid offer comparisons is reduced, the added benefit for the single employee is not necessarily very high. In the case of the research engineer, getting to know the supplier market for sensors has the opportunity cost of doing research and development work that might lead to new products and income sources for the company. For the engineer there is an opportunity cost of potential bonus if the new products can be patented.
With a centralized procurement function the opportunity cost of the research engineer’s time may be reduced from the company’s perspective, if the engineer can quickly do an offer comparison and thus save a few thousand or more when buying the sensor. The generated savings would compensate the lost time in development work. However, for the engineer there might be nearly no benefit from doing this offer comparison. Assuming he is working on a new product and expecting to get additional remuneration from a potential patent, by doing offer comparisons he is not working towards his expected bonus for patent. Even if he reaches savings in excess of a thousand dollars, his payoff is practically zero, since those savings are either flowing in to the company’s profits or divided between all employees. In a very large company, dividing a thousand dollars between all employees, results in pennies per person.
On the other hand, our development engineer also does not suffer very much from using excess funds for buying the sensor. If he uses a couple of thousand dollars too much, this is again divided between all the company employees, incurring an effective loss of less than a dollar per person in a very large company. This leads us to a free-rider problem, where no one has the incentive to be the one to generate the savings and has therefore little reason not to spend excessively.
The problem here is that employees are not incentivized to use company money as if it were their own, since they usually do not see the effect of personally generated savings: it does not increase their salary or their bonus. Of course, excess saving, and lack of investments, today can endanger a company’s existence tomorrow, so we also a have a temporal problem. This kind of situation is also familiar in game theory, where certain games pose the question, under what circumstances people forego today’s added benefit for the anticipated future payoffs. Unsurprisingly, the present value of the future payoffs have to be large enough in comparison to the temptation created by the payoffs one would receive today. This is a question of time-preferences and the nominal values of the future payoffs.
In order to have employees use company money more effectively and efficiently, we need mechanisms that incentivize such behavior. Procurement professionals are sometimes paid based on achieved savings, but this might also be too naive a solution. For example, if the savings are measure against initial supplier offers, we can be quite sure that the procurement manager always comes with astronomically high initial offers, just to seal the deal with significant price reductions that conveniently guarantee him a good pay.
A mechanism to generate savings
The previously presented problem of aligning the incentives of the company and its employees is a principal-agent problem that can be solved with mechanism design. The principal, or the company, designs the mechanism, in this case the salary or the bonus structure of the employees, in such a way that each employee has the incentive to generate savings. Here it is assumed that the achieved savings exceed the potential opportunity costs for the company and for the single employee. After a quick Google-search I did not find any literature on this specific topic, but the principal-agent problem and mechanism design are broadly studied areas in game theory.
Concluding the previous discussion, a good mechanism that incentivizes all company employees to use the company money responsibly, should have at least the following features:
- When a person generates savings, he profits from them more than other employees do per head;
- Compensation for generated savings is at least as high as the employees opportunity cost, e.g. expected patent remuneration fees;
- Compensation for generated savings is at least as high as the employees The net savings for the company are at least as high as the opportunity cost for the company, e.g. delay in new product development and market launch;
- Generating long-term savings is more profitable for the individual than quick wins, thus arbitrary reduction of profitable investments is discouraged;
- Savings are not measured against the initial supplier offer.