For many manufacturers, a sole-source agreement with a supplier can be an efficient way to get the right materials in the right place at the right time. In fact, sometimes it can be the only way. Yet, by its nature, a sole-source agreement can put the manufacturer at risk – not only the risk of unanticipated or unavoidable disruptions in supply, but also the risk of accounting-related errors or even fraud.
How can a company help protect itself against being overcharged, whether the mistakes in billing are accidental or intentional? With a solid contract that is enforced by periodic reviews or audits.
Generally, the customer (i.e. the manufacturer) wants a contract which will include the right to conduct an accounting review at any time – a right that can be exercised without any hesitation or embarrassment. Exercising the right to review a supplier’s charges is not a personal matter; it is good business practice.
Some of the “red flags” forensic accountants look for when they review a sole-source supplier’s accounting include the following:
Pumped up costs: In an analysis we conducted for a high-tech manufacturer, we found a sole supplier had passed through invoices relating to its own internal team-building parties – parties for teams that were not even working on the manufacturer’s business. The goods buried in a general invoice included clothing with the supplier’s logo, airfare and hotels for employees, as well as food and other party favors. Not only were these charges inappropriate; the supplier had added on a “cost-plus” mark-up – in this case, a contractually agreed to rate of 10 percent!
Passed through penalties: The same supplier was also paying its own bills late, incurring “past due” charges and passing these penalties on to the manufacturer – again, with its double-digit mark-up. In other words, the supplier was making a tidy profit being delinquent in its own accounts. While the agreement between the manufacturer and the supplier did not expressly forbid this type of activity, at a minimum this behavior reflected poorly on the supplier’s business management practices; and more to the point, it violated the spirit of the relationship.
Hoarded refunds: A different supplier in the consumer packaged goods industry passed costs to the manufacturer, but not a single savings. When the supplier negotiated and received refunds, rebates, and other credits from its vendors, for the manufacturer’s work, the supplier kept those savings for itself, continuing to charge the manufacturer the full cost of the materials.
Shared labor and facilities: For one supplier in the automotive industry, the largest component of its costs was warehouse labor. In this case, the supplier took advantage by charging its sole-source customer for non-productive time (coffee breaks and lunches), overtime spent on other customers’ work, and related expenses (such as health insurance and taxes) that should have been dispersed among several customers.
Smoke screen: When analyzing a supplier’s accounting, a forensic accountant also takes notice of a supplier’s reaction to requests for information. For example, when the supplier hesitates to respond to requests by putting up roadblocks – such as requiring the manufacturer to execute a strict non-disclosure agreement, making the protection of proprietary information an excuse for non-compliance, or not allowing its employees to talk to the accountants without an attorney or member of senior management present – such actions can be “red flags.” While in certain instances such behavior may be justifiable, in the case of the company we were analyzing, this defensive behavior was used to cover inappropriate actions in several areas.
Protect your business: Suppliers who take advantage of sole-source relationships might be only a few “bad apples” – but even a few “bad apples” can do a lot of damage. One of your first defenses can be the contract itself.
Before signing on the dotted line, you should consider taking a few precautions:
- Consult with your attorney(s) to analyze whether all terms and conditions are clearly defined. For example, you may want to analyze whether the “right to audit” the supplier’s books is defined appropriately. Also, the two parties may want to identify a point person (one for each side) for administering the contract.
- Consult with experienced forensic accountants to define scope. Forensic accountants have experience in analyzing books, records, and other documentation. They can help you assess and define the records that should be open to an audit, as well as provide assistance with the handling of costs, savings, rebates, refunds, and other accounting issues. With a good contract in place, you are more likely to have access to relevant accounting information in the event of a dispute, which may also be far less likely.
- Do your homework. Before entering into the sole-source agreement, you may want to perform due diligence on the supplier and its executives, including the contract’s point person. You could also ask to see the company’s financial statements. Finally, it might be a good idea to ask your forensic accountants to interview the supplier’s personnel to gain an understanding of the processes and procedures they will follow to ensure compliance with the contract.
Exercise your right to a supplier review.
As the customer in the relationship (regardless of the type of relationship), you should feel free to exercise your right to conduct a review as appropriate. It is important to remember that the contract is between two parties and that supplier audits are an important part of comprehensive, proactive risk management.
Scott Shaffer is a Partner and Mark Pearson is a Senior Manager in the Forensic & Dispute Services Chicago practice of Deloitte Financial Advisory Services LLP. For more information, contact Scott Shaffer at email@example.com or Mark Pearson at firstname.lastname@example.org.
As used in this document, “Deloitte” means Deloitte Consulting LLP. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte & Touche USA LLP and its subsidiaries.