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Are companies paying too much for services? in the wake of recent billing scandals, CFOs could be forgiven for suspecting that they are.
Don Durfee, CFO Magazine
April 1, 2004
In December, PricewaterhouseCoopers LLP settled charges that it had overbilled clients by hundreds of millions of dollars by not passing on rebates received from travel agencies (class-action suits against KPMG and Ernst & Young are still pending). The new year brought the indictment of executives at ad agency Ogilvy & Mather, which is charged with instructing employees to falsify time sheets for work done on a U.S. government account. And then there are the charges swirling around Halliburton, including the allegation that one of the firm's food-service subcontractors vastly overcharged for meals provided to U.S. soldiers in Iraq.
One thing is certain—companies spend a great deal on services. According to CAPS Research, an organization that tracks corporate purchasing, the average company devotes 33 percent of its total spending to services, a broad category that ranges from legal and consulting advice to process outsourcing. The number can vary widely—for financial-services firms, such spending can exceed 80 percent of the total. And although companies cut many forms of spending during the downturn, services spending has continued to rise an average of 3.5 percent annually.
Fraud or Foolishness?
Although it grabs headlines, outright fraud appears to be relatively rare. More common, say experts, are simple carelessness and poor recordkeeping on the part of many service providers. "Overcharges happen all the time, but it's rarely intentional," says Stephen Broderick, chief operating officer at FirmDecisions, a London-based company that conducts audits of ad-agency compliance with client contracts. "It's because [the agency] doesn't have the systems to track [costs], doesn't understand the agreement with the client, or is so busy looking ahead to the next year that the housekeeping is not really taken care of." The recession has made matters worse as firms reduce back-office staff, including the finance professionals who handle billing.
To be sure, the errors—intentional or not—can be costly. Broderick cites a recent audit that revealed that an ad agency mistakenly billed a client $84,000 for 12 hours of secretarial work. In another example, a law firm's partners were found to be charging all of their meals and transportation costs to a client, regardless of the time actually spent on the client's work, according to Judie Bronsther, president of New York-based Accountability Services Inc., a company that provides advice on legal bills.
Companies can also fall victim to the pressure some professionals feel to extract additional business from clients. According to Tom Rodenhauser, president of Consulting Information Services LLC, in Keene, New Hampshire, one common tactic of management consultants is to come in for one project and use the opportunity to identify additional, expensive problems. "The challenge is for the client to keep the contract tight enough that the provider can't navigate its way around the contract to get more business," says Rodenhauser.
The Problem with Services
Overbilling can often be caught through an audit or prevented in the first place by developing a detailed billing policy (see "Grilling Your Lawyer," at the end of this article). But what about the self-perpetuating consulting engagement (which most consultants would argue is a legitimate way of sustaining their business)? Or services for which a company is unknowingly paying above-market rates? Or services that may be unnecessary in the first place?
The answer, according to procurement professionals, is to apply the same rigor to buying services that many companies do to purchasing physical goods. Today, most big companies have centralized the procurement of supplies and use the company's aggregate buying power to obtain lower prices from suppliers.
Spending on services isn't controlled nearly as well. One reason is that it's hard to put a value on advice. Unlike when buying paper clips or personal computers, it's inadvisable to merely specify a quantity for a service and shop around for the best price. And because quality can vary dramatically from provider to provider, unit costsuch as an hourly rateis relatively unimportant. Second, service contracts are usually complex. A project may have many components and intricate pricing—for example, payments linked to milestones and various contingencies (such as on-time performance). According to Pierre Mitchell of Boston-based AMR Research, all of this can be hard to capture cleanly in an E-procurement system, meaning that such spending is often left out entirely. This in turn ensures that supplier contract management remains fragmented at many companies.
There is also the way companies account for these costs. Money spent on materials used in manufacturing affects a business's cost of sales directly. Saving 10 percent on these purchases yields an immediate improvement in the bottom line. By contrast, services are budgetary. If there is $5,000 in the budget for advertising, a manager will probably spend the full amountif not out of need, then out of fear that not spending it will mean losing it in next year's budget. For the same reason, securing a better rate for advertising may just encourage the manager to use more.
Gaining the Upper Hand
One good step is for a company to stock its own procurement operation with services experts—for instance, an ex-consultant who can develop engagement letters or a lawyer who knows how long certain legal projects should take. Collaborating with the internal users of services, the procurement team can identify a group of core providers in different service areas and focus negotiations on these companies.
J.P. Morgan Chase & Co. does this. Since joining the firm two years ago, senior vice president and chief procurement officer Javier Urioste has been building a procurement team that includes specialists in services. "You have to have in your organization...people who know what the rates are and who understand the internal economics of a supplier, such as a consulting firm," he says. To give the company an advantage in negotiations, Urioste's team prepares by modeling the cost of a certain service for the provider. The team will present its assessment of what the supplier's costs should be, add in a profit margin for the provider, and then argue that this represents a reasonable price.
Admittedly, many companies will want to stop the bleeding before moving on to such tactics. This may call for some drastic cost-cutting, as it did at SAP Americas, a unit of the German software company based in Newtown Square, Pennsylvania. When Mark White became CFO two years ago, he found a business that spent lavishly on consultants, with little understanding of what—if any—value these advisers were creating. "We had consultants who were in the company for three or four years working on specific areas where the results had deteriorated three or four years in a row," says White. "You look at that and say, 'Something's not working.'"
In response, he cleared out the consultants, signing settlement agreements with some and allowing others to work until the end of the contract period. Today, the company is using advisers again, but far fewer and only for narrowly tailored projects. An important part of White's approach is to use very specific agreements with providers. The agreements list the hourly rates, name the team members, and define the penalties for missed deadlines. SAP, which has its own consulting business, also uses these agreements with its own clients.
Rodenhauser of Consulting Information Services says that as companies have grown wary of cost overruns and wandering consulting engagements, such contracts have become common. He recommends including a time line that shows fees relative to milestones. "The more specific the deliverables and the more pay is tied to benchmarks, the more successful the project," he says.
Curb the Impulse Buy
Just as important as managing the supplier is keeping the company's own employees in check. After all, airtight contracts and low prices count for little if employees spend too much or ignore the negotiated rates. "As you work with suppliers, and there's less and less chance to reduce prices, then the opportunity to reduce expenses relies very much on your ability to manage the demand," says Urioste.
This calls for clear spending policies. For example, a policy might require approval for projects above a certain size, limit engagements to the list of preferred providers, or direct employees to work through the central procurement function to hammer out a contract. Of course, a company also needs an enforcer for its policies—and the CFO is an obvious candidate. It's a role that White has embraced. "I sign off on all third-party transactions," he says. "It takes a sound business case and a lot of review to get my approval."
The potential for savings is significant. According to supply-chain experts, a company that hasn't previously made a serious effort to manage service providers can save 15 to 25 percent in the first year without much trouble, and an additional 15 percent annually in subsequent years.
Ironically, companies' improving finances may present the biggest obstacle to such efforts: many managers will rehire the marketers, lawyers, and consultants they fired during the recession. "As the economy becomes better, companies will be more apt to spend money on consulting and other services," says Rodenhauser. "The question is, how much are they going to fall back on old habits?"
Don Durfee is research editor of CFO.
Grilling Your Lawyer
CFOs are losing their shyness when it comes to managing lawyers. "Not long ago, companies often left lawyers' bills untouched because they thought they couldn't harm the relationship," says Judie Bronsther, president of Accountability Services Inc. in New York. "But people are beginning to realize that legal fees, like any other cost center, should be managed. And managing legal fees should not harm the relationship."
And it's a cost that deserves scrutiny. Companies that actively manage their legal fees can cut their spending by 20 to 30 percent. Bronsther argues that it's usually a mistake to expend effort haggling for a reduced hourly rate. "Billing rates are probably the least-important component in what your costs will ultimately be," she says. Instead, companies should look at other factors: how the law firm staffs the project, how it manages the matter, and how it bills for expenses.
Bronsther advises clients to develop a detailed billing guideline for their lawyers, and to insist on compliance. Some items to consider including in a billing policy: