Procurement and Fraud

Procurement/Purchasing is a critical function within supply chain.  I was part of some great organizations where Procurement aggressively contributed to the supply chain success by providing sustainable cost advantage over competition.  In order to maximize the competitive spirit among the suppliers, organizations classify the suppliers into three different categories such as Strategic suppliers, Tactical Suppliers and Transactional Suppliers. This classification helps organizations to develop customized strategies for the three categories.  Some organizations do classify suppliers into two categories. The first category is known as Relationship purchasing and the second category is known as transactional purchasing.  Depending upon the organization and product characteristics, companies classify the suppliers in order to maintain healthy relationship and micro manage each supplier in order to avoid organizational fraud in the procurement process.

But what is Fraud?

According to Chartered Institute of Management Accountants (CIMA), “Fraud Risk Management: A guide to good practice”.

“Dishonestly obtaining an advantage, avoiding an obligation or causing loss to another party”

In short fraud means gaining undue advantage over competition deceitfully.  Some fraud could end at winning the business, some may extend up to compromising product quality, and some may go beyond and systematically demolishing the organization.  In my opinion fraud cannot be committed by one party.  Both supplier and a representative/s of buying organization would be involved in order to fulfil their personal objectives.

The possibility of procurement fraud is a great threat to integrity of any organization.  The fraudulent practices within the organization could work against Total Customer Experience (TCE). TCE deals with providing satisfactory experience to customers in the buying process apart from providing quality products and services.  The fraudulent process may lead to compromised product quality which in turn could harm the TCE.  Hence, it is essential to recognize the fraud and eliminate such processes in order to maximize the TCE. Supply Chain Managers world wide recognize the importance of maintaining integrity in the buying process and constantly look for indications of procurement fraud.  Again, it is not a rocket science to identify fraud, it is just common sense.  Some of the indicators include the following:

• No formal supplier audits and visits;
• Supplier payments unchallenged;
• In a multiple supplier environment, one supplier being favored;
• Product specifications favoring one particular supplier;
• Suppliers enjoying questionable influence within buying organizations;
• Increasing production line rejections;
• Inconsistent delivery schedules;
• Huge variance in total cost of the product when compared with competition;
• Supplier hospitality to select few in the organization;
• Change in life style of procurement staff;
• Increasing Inventory levels;
• Absence of alternative source of supply.

The Fraud Prevention:

We all agree that “prevention is better than cure”.  In order to prevent fraud, organizational culture plays a vital role.  Organizations which encourage integrity and transactional transparency end up avoiding fraud to great extent.

What is Employee Integrity?

Truthfulness of an employee in discharging his/her day to day job responsibilities without favouring any one and maintaining transparent business process and also exposing his/her actions for audits.  There are several tests to test the integrity of a prospective employee at the time of recruitment.  I personally believe a clever guy can fake the test results.  In my opinion, organizational culture encourages integrity among employees.  A corrupt organization will never encourage integrity within their workforce.

Cartoon source: http://www.opendemocracy.net/content/articles/260/images/0164_Bendell_cartoon2_240702.gif

Transactional Transparency:

Transactional transparency is about establishing clear and visible business process in executing the transaction to enable truthfulness.  In case of procurement process, there are several ways one can establish transparency.  Some of them include:

Approved Vendor List:

One of the important steps in the procurement process is to identify and establish pool of approved vendors who meet the criteria identified by the organization.  The selection criteria include; sustainability, quality, competitive pricing, integrity and willingness to collaborate.  In case of multiple suppliers for the same component/product, all are treated based on their past performance recorded through Supplier Performance Score Card.  Never allow procurement from outside approved vendors, if necessary qualify the new vendor and add the vendor to the approved list.

Creating checks and balances:

It is important that “checks and balances” are created in the process.  This means distribution of power among the executives and also able to audit/influence the actions of another executive in the business process.  According to Cary Meiners, VP of Financial and Professional services at St. Paul Travellers, an insurance company, “For example, you can’t have the same person approving contracts and doing the audits.”  This means there are no checks and balances in the process.  Encourage more external audits in order to develop a robust business process.  The audit reports from these external audits should reach the top management.

Take employees/customers feedback seriously:

Every organization will have whistle blowers.  Allow employees involved in the system should be allowed to share their feedback without fear.   Organizational fraud is most likely detected by the tip from an employee than by the audits.  What is the guarantee that auditor is not part of the fraud?  Hence, allow feedback to flow though seamlessly and at the same time avoid rumour mongering.

Some times poor quality feedback from customers could lead to procurement fraud detection within the organization.  Take customer feedback with regard to product quality seriously.

Observe Employee Life style change:

Easy money makes people to invest on their life style needs.  If the employee displays un-proportionate wealth or assets, it is an initial indication of easy money.  A deep investigation could reveal the secrets of unexplainable life style of an employee.

Disband cartels:

Fraud is generally a group activity.  According to Association of Certified Fraud Examiners (ACFE) one of fraud report, “When multiple perpetrators conspire to commit a fraud, this makes it easier to circumvent anti-fraud controls”.  Identify such groups who work towards their collective individual goals by defeating organizational objectives.  The ACFE estimates business losses at $400 billion per year or about 6% of total annual revenue in US alone.

Reward Ethical Behaviour:

Organizations develop practice to reward employees not only for meeting financial goals but also for ethical behaviour. Procurement personnel should know that meeting price competitiveness is not only measure of success and integrity at work place will also get them rewards.

Employee Dishonesty Liability Insurance:

It would be a smart move to insure organization against the fraudulent practices of an employee or a group of employees involved in the procurement process.

Above are some of the fraud preventive recommendations. Of course, they do not make organization fraud free.  According to Schnatterly, “There are always going to be smart people who are going to find ways of getting in under the radar”. However, above steps will help organizations to dodge the bullet if not make organizations bullet proof.

Who are these fraudsters?

“Male employees commit four times as much fraud against their employers than do female employees. Business losses due to fraud by employees over 60 years old are 28 times greater than those by employees 25 years old or younger. Approximately 58 percent of reported fraud is committed by non-managerial employees, 30 percent by managers, and 12 percent by owner executives.” (Source: Criminal Law, Business Fraud and Theft – http://criminal-law.freeadvice.com).

“According to a report by KPMG’s forensic division, the procurement function of an enterprise is the area that is targeted second most by fraudsters. According to national head of the forensic department of KPMG in the United Kingdom stated that the procurement function always faces a higher possibility of fraud, as this is the way in which many enterprises spend money.

David Sherwin, an Ernst & Young partner, concurs with the previous statement and adds that collusion between the procurement function of the enterprise and suppliers is the most common form of corporate fraud of all. It appears that procurement functions are globally targeted by the perpetrators of fraud and that this occurrence may cause financial and other economic damage estimated at millions of rands.” (Source: “A procurement fraud risk management model” by AC Venter, Department of Auditing, University of Pretoria).

“The first and worst of all frauds is to cheat oneself” – Philip James Bailey. Unless we exercise personal integrity, it is very difficult to avoid fraud practices. In order to encourage personal integrity, organizations should encourage and reward ethical behaviour.  There is no full proof methodology/model/process to prevent fraud in the system, but organizations should focus equally in preventing as well as detecting and eliminating the fraud from time to time.  Apart from encouraging personal integrity, organizations should create checks and balances in the system and encourage transparent business processes to avoid fraud. I would like to end this article with my favourite quotation, “Rather fail with honour than succeed by fraud.”