Preventing Financial Leakage with Effective Contract Compliance Audits
CFOs, have you ever encountered difficulties in observing the financial benefits after your CPO has secured seemingly favorable commercial terms with suppliers, promising significant cost reductions? This challenge may stem from a widespread misunderstanding within organizations regarding the distinct roles of Contract Compliance auditors compared to Internal Audits.
Numerous leading global companies have implemented formal Contract Compliance audit programs to effectively manage and minimize financial leakage, even within enterprises with sophisticated procurement, internal audit, and finance systems. It is typical for Contract Compliance audits to uncover error rates between 1-5%, suggesting that suppliers correctly fulfill billing 95-99% of the time. While this high level of accuracy may appear comforting, even minor inconsistencies can accumulate, leading to substantial financial leakage over time. For instance, if a company has an annual spend of $100 million, a 1% error rate would result in $1 million in potential overpayments or under-recoveries each year. Over a decade, this could amount to $10 million in financial leakage.
What is the contract management lifecycle?
Within the contract management life cycle, organizations understandably spend considerable time and effort onboarding new expense vendors — a process that includes identifying, vetting, negotiating, contracting, and integrating suppliers.
The problem is that all of this work happens on the front end of the agreement… which means that, despite these efforts, many organizations still lack a robust monitoring and risk management program to ensure that the hard-negotiated contract is executed according to the agreed-upon terms. This lack of oversight frequently results in financial leakage, undermining the anticipated gains from these contracts.
Find out how to negotiate procurement contracts and enhance supplier relationships with smarter, stronger contract language in our recent blog, “5 Tips for Better Contracts: How to Improve Contract Negotiation in the Procurement Process” >
Where is there risk in the contract management lifecycle?
Financial leakage in business transactions is a common occurrence, but it's crucial to identify and address these issues to prevent them from affecting profitability in the future. Leakage that results from billing errors might fall into three categories:
Contract Compliance Risk #1: Mistakes
These are typically simple data entry errors and oversights. This type of risk may also arise from misinterpretation of handwriting, miskeying of numbers, or misunderstandings of complex pricing schedules. Most mistakes are easily caught if they are large, but smaller mistakes can go unnoticed and can accumulate in high-volume transactions.
Contract Compliance Risk #2: Misunderstandings
Some leakage results because a supplier bills something they think the contract allows, but it does not. This often occurs when the person executing the agreement is not the same person who negotiated the agreement. These misunderstandings can also stem from vague or poorly defined contract terms, leading to different interpretations of what is permissible.
Contract Compliance Risk #3: Mischief
In rare cases, there is fraud-like behavior where suppliers take advantage of the lack of transparency behind amounts billed. Fraud is more common when a supplier experiences financial pressure, can rationalize a case to make an unintended profit, and has the opportunity to disguise the behavior.
Some behavior is not technically fraud, but certainly fraud-like, where a supplier bills something the contract does not support, but also does not explicitly restrict.
While it is crucial to identify and address the various forms of financial leakage — the effectiveness of any corrective actions greatly depends on the robustness of the contract management lifecycle. Without comprehensive oversight and proactive management, these efforts can be insufficient. Once an organization recognizes this need, implementing a Contract Compliance program becomes essential. These programs not only address the risks but also align closely with broader organizational strategies for risk management.
Many organization leaders often conflate the role of Contract Compliance auditors with Internal Audit. While internal audits do have a role to play in mitigating financial risk, their role does not extend into the Contract Compliance realm.
Internal Auditors focus on maintaining strong accounting practices that conform to generally accepted accounting principles (GAAP) and assessing the overall accuracy and reliability of financial reporting systems which are crucial for maintaining the integrity of financial information. However, they do not ensure that a supplier has billed properly and according to the terms of individual contracts.
This gap highlights the need for Contract Compliance, which involves interpreting contractual terms and ensuring they are executed as agreed. Unlike internal auditing, Contract Compliance focuses on the nuances of contractual obligations and verifying adherence to the terms.
Your ERP might catch a lot of your errors - but it’s not perfect. Find out how to flag ERP errors with our recent blog “10 Common Errors in Your ERP System + How to Avoid Them” >
How do I optimize my contract compliance program?
The risk and financial leakage that occurred are not covered by the scope of Internal Audit but can be addressed through a Contract Compliance program. To mitigate this risk, you need to incorporate a risk management measure into your contract renewal processes. A Contract Compliance program starts with a client sponsor who helps coordinate audit activities. Together they can determine which vendors to audit, how many audits to conduct each year, and what the objectives of the program are.
Client’s Role:
They help guide the parameters and scope of the program.
They help introduce the team to the various business owners and category managers who own the relationships with your suppliers.
They provide overall direction and a time commitment of 1-5 hours per week.
Audit’s Role:
They provide recommendations to prioritize audit candidates and audit efforts.
They plan, execute, and help to resolve audits.
They conduct audits to provide organizations with feedback on supplier performance and to mitigate future errors, improve contract language, manage costs, and prevent leakage.
Supplier’s Role:
They establish a POC to represent the organization.
They provide data and documents as requested by the audit team to support amounts billed.
They provide information about past transactions and assist with audit resolution.
Through the collaborative efforts of clients, the auditor, and suppliers, a Contract Compliance program is designed to target and rectify issues that are typically overlooked in standard internal audit processes. This targeted approach allows organizations to close gaps in contract enforcement and financial management that are not addressed by traditional auditing methods.
Traditional recovery audit practices weren’t built for the wealth of data and fast-paced environment that defines retail today. Find out how a secondary recovery audit firm makes all the difference in our blog “Why Retailers Should Consider a Secondary Recovery Audit” >
How to Prevent Contract Errors and Ensure Contract Compliance
Contract Compliance Tip #1: Have Clear Audit Rights Language + Document Retention Requirements in Every Contract
To effectively prevent contract errors, ensure that your contracts include clear audit rights and document retention requirements.
Contract Compliance Tip #2: Establish a Dedicated Contract Compliance Program within Your Organization
Secure passionate sponsorship at the executive level to drive the program’s success and ensure alignment with organizational goals. Contract Compliance often falls through the cracks because it’s no one’s job unless the organization MAKES it someone’s job. With executive backing, you ensure the necessary resources are allocated, and compliance becomes a clear responsibility within the organization.
Contract Compliance Tip #3: Enlist a Contract Compliance Expert to Help Establish or Optimize Your Contract Compliance Program
Ensure the audit team actively supports both audit negotiations and resolutions, working collaboratively with your internal teams to address findings and implement changes.
Contract Compliance Tip #4: Create a Culture of Compliance Internally AND Externally
Expect suppliers to be proactive and responsive to requests for data and information, facilitating a transparent and cooperative audit process.
Hold suppliers accountable for historical inaccuracies as well as future corrections, emphasizing the importance of accuracy and adherence to contract terms.
Contract Compliance Tip #5: Focus on Recovery and Correction
Center the primary objectives of the program on recovering losses and correcting errors, thereby enhancing Contract Compliance and financial integrity.
Share the results and insights gained from audits with key stakeholders including procurement, category managers, internal audit, finance, and executive leadership, allowing for a culture of continuous improvement.
Finally, act on recommendations to address identified gaps or update contract language promptly after closing audits, ensuring that enhancements are applied effectively and maintained over time.
Find out how establishing a contract compliance audit program helps companies stay on top of their supplier agreements in our guide, “The Ultimate Guide to a Contract Compliance Audit Program” >
How FlexTecs Can Help You Start A Contract Compliance Program
To address and mitigate financial leakage effectively, you need a partner committed to clarity and continuous improvement in all aspects of supplier agreements. FlexTecs distinguishes itself in the realm of Contract Compliance through a uniquely structured, contextualized, and tailored audit approach. This strategy allows you to harness critical insights from your most crucial, high-risk suppliers, fostering improvements across all contractual engagements. Our approach not only ensures visibility into supplier performance but also empowers your team to make smarter procurement decisions, enhancing relationships and boosting operational efficiency rather than merely reacting to issues as they arise.
Are you ready to secure and enhance the contract terms you've carefully negotiated? Reach out to FlexTecs today and discover how our Contract Compliance audit services can help you prevent financial leakage and strengthen your supplier relationships, ensuring your procurement strategy is as effective as it is robust.
