Procurement and moral hazard

In the wake of the banking crisis we have heard a lot about moral hazard. At first a seemingly arcane term from the insurance industry it seems to be emerging as a useful decision evaluation concept.

First, what is moral hazard? The New York Times defines it simply as “the undue risks that people are apt to take if they don’t have to bear the consequences”. In 1975 Sam Peltzman surprised us with the unexpected negative consequences of devices such as seat belts as an example of moral hazard. He demonstrated that as cars were made safer, drivers took more risks because they felt better protected. What has become known as the Peltzman effect demonstrates that we need to be careful in the development of any process, methodology or regulatory system that we don’t create moral hazard because the decision maker operates with the “I was following the process” mindset. A bad decision is not my fault – it is the result of the process we have to follow.

So, what does this have to do with procurement? Well, quite a lot really. At the extremes following the 6, 7 or 9 step procurement process closely becomes the primary objective and subverts the goal of achieving the best commercial result. A particular danger in the public sector which is strenuously regulated under EU procurement law (at least for now.)

Procurement is the business of making decisions on behalf of other people. Very rarely do we make procurement decisions where we in procurement are the recipients of the good or services to be provided. As you move the point of decision away from the point of use the potential for moral hazard to creep in begins to appear. As the decision point moves further and further away (Centralised procurement, Global procurement, Outsourced procurement) the scope for moral hazard increases with each step.

Consider the factory manager responsible for maintenance. When they make a decision who to buy their bearings, spare parts or consumables from they may not be making the best procurement decision but they will bear the full consequences of the decision they make. If the components are late – they miss their maintenance window. If the components are poor quality – they have to fix it. If the service is poor and the items are out of stock – they have to shop around to find an alternative. If the chosen product doesn’t last as long as the alternative – they have to replace components and interrupt production more often. All the time the direct consequence of the decision (the risk) rests with them.

Now look at the same example when a corporate sourcing decision is made in a headquarters location to have one country-wide MRO supplier. Now, if any of the above problems occur who feels the pain? It is still the maintenance manager who has the stopped production line and the angry colleagues looking at lost production, possibly lost sales and maybe even lost customers. Where does the corporate buyer who has achieved their supplier rationalisation and cost savings objectives fit in? Perhaps they might get a monthly report on performance or exchange stern emails with the account manager at the supplier but they are unlikely to be the people up at midnight waiting on a part to get the line running again. In a small way, the buyer makes a procurement decision and does not bear the consequences of it.

The question is not whether moral hazard exists in procurement decisions but how we account for it and reduce the occurrence of it. Especially in indirect and services procurement, failure to account for moral hazard will isolate procurement from the business users and could even antagonise the very people we are supposedly serving.

We have to be careful that we don’t treat legitimate worries or criticism of procurement decisions as whingeing or people being unwilling to change. Sometimes it is simply the fact that our change has consequences for the people who will be receiving the service or using the products that we (and possibly they) are unaware of at the time.

In his book Miracle on the Hudson, Chesney Sullenberger (Sully) describes how on January 15th 2009, US airways flight 1549 was hit by a catastrophic bird strike. In the early moments after the bird strike on his plane and the loss of both engines, the pilots reached for the procedures manual that informs them what to do in the event of an emergency. “Previously”, he writes, “these manuals would have had extended tabs to make the sections easy to find.” As part of a cost cutting exercise these tabs were removed to make printing and production easier and cheaper. Who would have thought that a simple decision to save a few pennies or maybe a few dollars on a book would have left the person using it in an emergency struggling to find the section they need when there are only seconds to spare?

Moral hazard as an economic consequence implies that people take more risks when they know (or at least believe they won’t) be accountable. Look at people’s behaviour on line versus face to face as an example. This isn’t necessarily a cynical position. Economists argue that it is down to information asymmetry – you don’t know the risk you are incurring on someone else’s behalf or you know it in general terms but can’t quantify it? Each time we make a decision in procurement we will have an impact on the day to day experiences of the users of the products and services we procure and their ability to do their job. Are we always fully informed about the effects we will create post hoc? Moral hazard, it can then be argued, is inherent in procurement.

How then to reduce moral hazard?

Two options present themselves:

1 Improve the information available to the procurement decision maker.

Much is made of the need for stakeholder engagement in category management. Unfortunately, too often this is about engaging stakeholders to ensure compliance, persuade them to change their views or accept a procurement strategy. Stakeholder engagement has a big role to play in reducing moral hazard by improving information flow and understanding.

Procurement needs to develop closer intimacy with the business community. When we talk about stakeholder engagement, a part of that has to be to get into their world and understand where the service, operational and performance risks lie:

• What happens if service is poor or inconsistent?
• What will the impact be of seemingly small changes in the user experience or the way they have to work – especially in times of stress or emergency?
• Who will pick up the slack and what will that mean if supplier performance is at or about (or just below) the contracted standard?

Only when we have clearly understood the decision we are taking on other people’s behalf and worked through the implications can we say that we have understood moral hazard.

This has implications for the role of the procurement manager, how they spend their time and the overall resources necessary to build and develop this intimacy. The knowledgeable business partner, facilitating commercial decisions is very different from the detached sourcing partner running a process.

2 Develop accountability.

People take more risks when they feel safer – either because of protective devices or through lack of knowledge or understanding of the consequences of a poor decision.

To bring the consequences home, perhaps we should make the decision maker accountable for the outcome. Gordon Tullock (a renowned professor of law and economics) proposed that cars would be safer if they were fitted with a large, sharp spike on the steering wheel! Perhaps, then, we might brake a little bit earlier.

How often have you had a delivery fail to turn up?” No problem”, they say, “we will have it back out to you tomorrow or the day after”. Does that really make up for the day off work, cancelled trades people, the missed birthday? “Not our fault” is the response “the courier let us down. It happens. What can you do?” Might they be less sanguine about the failure if they had to pick up the costs of unused labour, give you back your day of annual leave or host a replacement party?

Maybe we have to measure procurement teams or outsourced procurement partners on supplier performance and make some of the appraisal and remuneration based on the performance of the suppliers they choose and the contracts they draft. How about an appraisal system where buyers are assessed based on the end users’ and budget holders’ assessment of the suppliers in their category?

Let me know what examples of moral hazard you see and how you are dealing with it.

First published by Rob Maguire on LinkedIn.