Expense management is in a tragic state for most organizations — especially in complex indirect service categories. This is horrifying from the CFO's perspective, as expense reduction is one of the most valuable activities in which an organization can engage, with saved dollars typically dropping straight to the bottom line.
Even in large organizations with sufficient resources, buying power, protective terms, agreements, etc., we see the same results time after time in complex indirect expense categories. Reasonably well-negotiated contracts designed to promote healthy cost levels reside in file folders on procurement department computers, while in the field, indirect suppliers are rapidly eroding the intended effects of those deals and growing their margins. We call this phenomenon “Good Contract, Bad Deal.”
Given that expense management is of paramount importance for all businesses, why are the results so poor?
The Indirect Expense Roller Coaster
The management goal with every expense should be simple — find the optimal cost level and stay there.
Negotiate a favorable deal, get what you signed up for, limit internal resources required to manage, and make incremental improvements when opportunities arise.
Unfortunately, with complex indirect services, the routine typically goes like this:
- Procurement negotiates a new contract every few years, then quickly moves on to other projects, engaging in little to no post-deal expense management;
- Procurement is rewarded for projected year-one “savings;”
- Those projections are often flawed and rarely materialize even in year one;
- In categories involving multi-year contracts, years two and beyond get even worse, with spend typically escalating 8-12% per year;
- Procurement staff pay no price for these steps backward, and indeed these cost escalations create the “low-hanging fruit” for their next “savings initiative;
- The unproductive cycle continues every 3-5 years.
The dirty little secret is that an unproductive and P&L-damaging “roller coaster” works just fine for procurement departments; given their deeply flawed incentive plans, delivering lasting P&L impact is not the goal.
The incentive problem also infects budgeting processes that are tied to resource allocation: health systems with reimbursements tied to expenses, correlations between spend under management and departmental headcount, etc. Saving money in certain instances is viewed as undesirable, as it reduces departmental budget size, whereas cost escalations can yield budget increases.
We see it time and again: year one projected savings is all that matters — as if the ensuing years of contractual obligations are meaningless. Counterproductive departmental definitions of “savings” create incentives to sacrifice outsized longer-term consideration for shorter-term gains in deals, and no incentives whatsoever to engage in post-deal program management.
So, how did we get here? There are a host of reasons, starting with the simple fact that expense management is hard and only getting harder.
- Flawed incentives are the starting point. Without proper incentives, there is no motivation to correct embedded P&L-damaging behaviors.
- The threat of lost business has been diminishing over time with fewer marketplace options and fewer internal resources to take on supplier transitions. As a result, there has been a gradual shift of power in the marketplace as many industries have consolidated and vendors have begun to deploy increasingly anti-competitive behaviors. Furthermore, as suppliers have been emboldened by the success of these strategies, we have seen less and less adherence to contractual obligations.
- As you move to larger and larger organizations, even if you have good expense data, it is increasingly hard to coordinate multiple departments involved in expense management — we call this organizational disconnect. As the expenses get more complex, more departments are involved (procurement, operations, accounting, finance, quality, HR, sustainability, security, legal, etc.) and coordination problems can cause major cost escalation.
- Data challenges are also problematic. We are shocked at how bad expense or spend data is for most organizations — multiple systems, complex invoice delivery and data entry processes, missing contracts, missing locations, etc. Many organizations are in a perpetual state of “garbage in/garbage out.” This problem is only getting more acute as bad data can make it more difficult to leverage AI.
- Finally, departmental turnover creates its own challenges to long-term success in various expense categories.
What Can Today’s Bottom-Line-Focused CFO Do?
Though this is clearly a complicated problem with no simple solution, here are a few essential steps for implementing a P&L-focused expense management strategy:
- Align procurement with actual P&L savings instead of single-year projected savings. This is the most critical measure of all, as it will incentivize departmental resources to implement all the other improvements that follow.
- Get control of your spend data and have a process to maintain, clean, and improve it. To properly execute the overall goal in step one, you must get better and more category-specific measurement tools in place. Without sophisticated spend data, you are in the dark ages and completely defenseless in complex indirect categories.
- Track true normalized savings for the life of contracts. It is hard to track true baseline/normalized spend for all of your important expense categories, but not impossible — there are tools and services in the marketplace that can assist with this. With the better data from step two above, and the right knowledge and proper support, you’ll have a better understanding of what it takes to properly understand baselines and actual “savings.” The math shouldn’t be left to procurement departments—normalization of baselines and savings calculations should be supported by accounting and finance functions.
Reorienting your procurement department’s processes to better align with the company’s bottom line won’t be an overnight fix, but the rewards for escaping the unproductive indirect expense roller coaster will be significant and lasting for your organization.