“Designing a Procurement Function”

FEATURE

Designing a Procurement Function Mitigate Financial, Operations and Fraud Risks While Increasing Profitability and Efficiency

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By Mike Stein, CPA, CIA

enior business managers in Texas want to preserve margins and retain cost-cutting measures.

That emphasis is understandable as businesses continue to rebound from the country’s recent economic downturn. That emphasis, though, may adversely affect their views of the procurement function.

Procurement may be viewed as an ancillary back-office function that increases general and administrative expenses. A formal procurement function, though, actually mitigates the operational, fraud and financial reporting risks that could negatively affect a company’s bottom line and its reputation.

Senior leaders or operations managers may be making material and immaterial purchasing decisions in a company that lacks a formalized procurement function. That distracts those individuals from focusing on generating additional revenues, increasing efficiencies and reducing costs. Those individuals typically draw higher salaries, too. That means the company would be paying more than it should for executing procurement processes.

An informal procurement function may create instances where quality and specifications for raw materials or equipment vary from one purchase to another. Those variances lead to difficulties adhering to production schedules. Without a formal, centralized procurement function, individuals throughout the company do not know if someone else already acquired goods or services they just ordered. Such duplicate purchases increase inventory carrying costs.

Some vendors have poor industry reputations, unreliable delivery histories, or provide goods or services of questionable quality. Perceived product quality and value declines if the company buys from those vendors. Ultimately, the company’s reputation suffers. Without a formal process for negotiating purchasing agreements, a company may not receive favorable 30

terms (e.g., payment discounts). That negatively impacts the company’s float or cash flow.

Informal procurement practices lacking defined segregations of duties may also cause cash flow difficulties. In such instances, certain individuals can make material purchasing decisions and obligate company funds without attaining proper approval. This practice may not allow the company to deploy its capital to the highest and best use. For example, cash tied up in the purchase of unnecessary goods or services may not be used to take advantage of purchase discounts or short-term interest rates.

In companies with information procurement functions, the factors constituting “best value” need to be defined. Without such definition, purchases may be based solely on cost, convenience or location without considering what is best for the company as a whole. For instance, using prices as the sole basis in a purchasing decision may result in the acquisition of poor quality materials or result in untimely delivery. As a result, the company may lose customers and gain a poor reputation.

So many opportunities for fraud also arise amid informal procurement functions. Transactions between related parties may go unnoticed and unevaluated for appropriateness. Fictitious vendors may be created to divert funds. Employees may receive kickbacks for directing business toward a particular vendor even though that vendor may not provide the goods and services considered to be the best value for the company. Without a formal procurement function, such improper activities may go undetected for considerable spans of time.

Companies vary in the particular risks they face. They vary in the controls they have to mitigate those vulnerabilities or to take advantage of potential opportunities. A formalized procurement function that includes policies and procedures mitigates operational, financial and fraud risks while enhancing the bottom line Today’sCPA

Establishing a Formalized Procurement Function Companies differ in resources, staffing levels and other factors, so there is no “one size fits all” design for a procurement function. For a smaller company, the procurement function may start with a lone purchasing agent, with more staff members added as business growth needs dictate. Regardless of the procurement function’s size, its procurement policies and procedures should ensure the company is attaining the best value, utilizing high-level personnel to their highest and best use, and establishing internal controls to mitigate risks of fraud or errors in financial reporting.

Senior management must define the procurement function’s responsibilities and authority to incorporate appropriate levels of accountability. Once the objectives and responsibilities of the procurement function are defined, senior management should communicate the role of the procurement function throughout the organization. Any questions and concerns that arise then should be addressed. That communication prompts individuals and other departments to embrace the procurement function.

The procurement function’s first priority should be developing detailed policies and procedures relating to the following activities: • vendor evaluation, selection and monitoring, including vendor master file review; • bid solicitation, evaluation and selection; • purchasing authority levels and purchase order requirements; • verification of receipt for goods and performance of services; and • reviewing the vendor master file records for fictitious, duplicate or dormant vendors.

Vendor Evaluation, Selection and Monitoring The vendor evaluation process should verify the vendor: • actually exists; • can produce the goods at the specified quantity or perform the requested services; • enjoys a good industry reputation; • meets the company’s ethical standards; and • does not have any going concern considerations.

Due diligence procedures for a particular vendor should align with the anticipated volume or significance of the purchase. That alleviates unnecessary delays and assures proper allocation of company resources. Potential due diligence tasks include: • facility or site visits; • reference contacts; • reviews of available financial information; and • background checks.

Following vendor evaluation and approval, the procurement function needs to decide whether a master service agreement (MSA) should be negotiated and executed. The MSA documents contractual terms reached with vendors that provide substantial amounts of materials or services. Such agreements typically pertain to one large purchase or recurring procurement activities involving the same product, service or vendor. Items addressed Today’sCPA March/April 2015

in the MSA may include payment terms, bulk discount rates, warranties, delivery terms, service response times or other items of importance to the company.

The MSA provides clarity and reduces the potential for disputes or unmet expectations to arise between a purchaser and vendor. MSAs also eliminate the need to draft lengthy, detailed contractual terms for each recurring purchase. In addition, MSA agreements provide greater uniformity and efficiency for procurement activities.

Periodic analysis of MSA transactions should address the vendor’s adherence to the agreement’s terms and conditions.

Perhaps changing facts or circumstances affect the vendor’s ability to meet specified MSA terms and conditions. The MSA may need to be rewritten to address such changes. MSA analysis also identifies factors that could affect the production process or the company’s reputation. Such analysis illustrates instances where a company may choose not to retain a current vendor.

Bid Solicitation, Evaluation and Selection A formalized bidding process establishes procurement thresholds and requirements. That allows for the efficient procurement of goods and services that meet the company’s needs, and it assures appropriate due diligence is performed for the type of goods or services being acquired. A formalized bidding process also assures that related party transactions meet arms-length standards and that the company receives best value for its capital.

A formal bidding policy for a particular company might dictate that no bids are necessary for purchases of less than $10,000, whereas the purchases of goods or services with prices ranging between $10,000 and $25,000 would require at least three informal cost inquiries. Required information for those inquiries might include the vendor names, price quotes and various conditions. The purchaser might also be required to use a vendor covered by a company MSA. A purchase between $25,000 and $50,000 might require three formally documented quotes from requested vendors. A purchase in excess of $50,000 might require use of a detailed, formal request for a quote (RFQ) package.

The bid policy should include guidance on how the bids or RFQs received should be evaluated and documented. The policy should not be so restrictive that it requires the lowest bid or use of an existing or a previous vendor. The policy needs to focus on selecting a vendor whose products and services constitute the best value for the company. The rationale for selecting a bid that is not the lowest cost alternative needs to be documented.

A company, for example, may need to purchase widgets. A particular vendor may sell those widgets at a lower cost than any other vendors. That particular vendor, though, may have a smaller facility that is running at capacity. That particular vendor might require payments upfront or have a spotted delivery history.

Therefore, a different vendor charging a higher per-unit price may be deemed to provide the best value, because that vendor continued on next page 31

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has greater production capacity and does not require upfront payments. That additional capacity reduces the likelihood of production down time or late deliveries. Not having to pay up front also benefits the company’s cash flow situation. That reasoning would be documented.

Purchasing Authority Levels and Purchase Order Requirements The procurement function should establish thresholds for the review and approval of purchases. Such thresholds determine what procurements require purchase orders and what routes of approval must be followed for various types of purchases. These policies ensure that all transactions are valid and that requested purchases receive the appropriate level of approval.

Overall, such policies promote efficiency by aligning the review and documentation requirements to the significance of the purchase. Authority limits for purchase approvals should allow for small re-occurring purchases without lengthy approval processes. Conversely, large one-time purchases should require authorization by senior management.

The delegation of purchasing authority may be tiered by position, department or individuals, or by single or aggregated purchase value. Some purchases may require dual forms of approval. Other purchases may have authority limits that fluctuate based on the individual’s area of expertise or division.

For instance, the director of operations may have a $100,000 32

approval authority for equipment purchases or maintenance, but have a $15,000 limit for office expenses. The delegation of purchasing authority should be reviewed, at least annually, by executive leadership to evaluate whether defined authority levels remain appropriate.

Purchase order policies should dictate thresholds and documentation required for various procurements. For instance, purchases ranging in cost from $5,000 to $25,000 might require a detailed purchase order, while single purchases exceeding $25,000 might require the MSA. Formalizing the approval and review processes reduces the amount of time senior management must commit to approving and reviewing purchases. Company leaders then have more time to focus on running the business.

An efficient purchase order process with supporting documentation also helps accounting personnel more easily identify instances where purchases have been made for goods or services that have not yet been received. That enables the accounting staff to more accurately calculate accounts payable accrual at the end of a financial reporting period. In addition, purchase orders provide management with a means to verify the receipt of goods against what was ordered and expected.

Verifying and Reconciling Completed Purchases The procurement function should establish policies and procedures for verifying receipt of goods or services Today’sCPA

performance prior to remitting payment. Those policies and procedures should include verification of the pricing and quantity of goods or services received. Such practices mitigate the risks that fictitious or erroneous transactions might be recorded and processed. Those practices also reduce the likelihood that the company will experience delays in production due to inadequate or incorrect material deliveries.

An individual should be given responsibility for verifying that the quantity, item numbers and price per unit delivered match the purchase order. For a service performed, that might entail an inspection to verify the performed service met expectations and specifications. The receiving document should then be forwarded to the accounts payable department. That department would then match the receipt against the purchase order and the invoice for reconciliation purposes. If that three-way match proves satisfactory, payment would be authorized. The purchase order would also be closed so no other expenses could be attributed to that purchase order’s coding.

cost. If the company has policies requiring greater documentation for purchase requests exceeding $1,000, that unusually high number of $900 to $999.99 purchases could indicate someone is defrauding the company by claiming purchase sums not subject to a higher degree of scrutiny.

An Effective Procurement Function Reduces Risks, Promotes Efficiency and Sustains Growth A formalized procurement function mitigates operational, fraud and financial reporting risks while also promoting greater efficiencies and reducing costs. Standard procurement processes implemented throughout an organization eliminate the operational disparities and difficulties that arise when procurement activities are addressed Without a formal procurement function, informally. A purchasing department, led by a company may be spending more than procurement professionals, it should to secure various goods also enables company leaders and operational and services. managers to focus on core responsibilities.

Without a formal procurement function, a company may be spending more than it should to secure various goods and services. That drives up its cost of sales and Reviewing the Vendor Master File Records places the company at substantial economic risk. Related party for Fictitious, Duplicate or Dormant Vendors transactions, kickbacks, establishment of fictitious vendors and Processes for periodically evaluating the vendor master file other improper activities may occur without effective oversight. should be developed and implemented by the procurement A formalized procurement function helps a company identify function. That assures that fictitious, duplicate or dormant such situations and other fraud risks. vendors are identified in a timely manner and removed from A formalized procurement function also addresses potential the system. The analysis should be comprehensive enough to financial reporting risks that include improper classifications ascertain whether there are any indications of anomalies in for various transactions and allocations of expenses to the wrong payment history. reporting period. An organization gains tangible cost savings The procurement function should perform an analysis of the through establishing and maintaining a formal procurement vendor master file in conjunction with the employee master file function. Competitive bidding, bulk discounts, MSAs and at least once a year. That comparison helps identify instances of other effective procurement practices reduce costs and help improper related party transactions. An unusual increase in total ensure that an organization receives the greatest value from the payments made to a particular vendor could also indicate kickbacks array of purchases it makes. or other improper activity. In addition, the transaction detail An organization gains a variety of efficiencies, too. Uniform should be analyzed using a Benford’s Law analysis to determine processes throughout the organization direct purchasing whether statistical anomalies exist in the payment history or in a decisions and compilation of necessary documentation. Various comparison of payment history to vendor master files. types of purchases can be prioritized so the most costly or most Analysis based on Benford’s Law reveals whether a particular crucial procurements receive the greatest amounts of scrutiny. number or digit appears more times than expected. That A formal procurement function provides those degrees helps a company identify potential instances of fraud. Such an of oversight and control. The function also continually analysis, for example, might reveal a disproportionate number delivers cost savings and operational efficiencies to sustain of purchase transactions ranging between $900 and $999.99 in organizational growth. n Mike Stein, CPA, CIA

is a senior manager in advisory services in the Houston office of Weaver, the largest independent accounting firm in the Southwest with offices throughout Texas. He can be reached at 832-320-3412 or Mike.Stein@Weaver.com.

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