Vance Jochim's List of Operational Audit Case Studies
Vance Jochim was a Certified Internal Auditor (CIA) for 18 years. Internal auditing is a different field than "Financial Auditing" practiced by Certified Professional Accountants (CPA's). Internal audit focuses on audits of both financial and non-financial operations (like production, purchasing, quality control) to evaluate the efficiency, effectiveness and economy of operations. Audits are unstructured and rely on the auditors judgement as opposed to CPA financial audits which follow rigid standards to audit financial statements.
Below are case studies of actual operational or performance audits and their results.
I periodically write in this blog about operational audits, performance audits or benchmarks needed in local government operations. It is important to understand that local government agencies always have annual financial statements audited by their CPA's, who issue an opinion on the "fairness" of the presented financial data. Government financial statements follow an arcane presentation method called "fund accounting" and the annual "audited" financial statements are usually called "CAFR's" or Comprehensive Annual Financial Report. No one understands these reports except fund accounting experts because they split costs for programs among different funding sources (i.e. the funds) so you can't get a clear picture of individual program costs and revenues in one place. They also sometimes add in one time capital costs into budget totals, throwing off any comparison from year to year. What is needed is a second set of statements that follow "program budget accounting" methods to assemble all revenue, staffing and expense information for each specific government program so you can see total results and who all works on the program. This is not done in Lake County.
Here is a list of actual operational audits and results I have been involved with over the years. Most were in corporations, but some are from government. Most of the firms mentioned are either shut down, changed owners or merged to the point where no one is there that was involved in the reported issues.
This provides clear examples between financial audits practiced by CPA's, compliance or financial auditors, and the results from pure operational or performance audits.
For example, a compliance or financial audit of a construction project would most likely be to audit all the spending after the end of the project, and is called a close out audit. The work includes verifying contract compliance, and that expenditures were properly approved, invoiced, paid, etc.
In contrast, a performance audit would start by reviewing the work process of construction and contract procedures at the FRONT END of the project, identifying problems like missing controls, etc. and fixing the problems before spending starts. Then, the auditor might run cost ratios, verify delivery dates, examine how the contractor overhead works that results in billings, etc and usually will find thousands or millions in savings. In my opinion, there is a significant difference in the skillsets required for financial vs operational audits. Financial audits follow defined standards, while operational audits are performed in an unstructured environment where nothing is routine or defined. Only some people are skilled at working in unstructured work environments and are able to find measurable cost savings.
So, here are some examples of larger value operational audits over the years:
vj
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Operational Audit Case Studies
by Vance Jochim
Certified Internal Auditor
www.FiscalRangers.com
These are from more than 18
years of corporate troubleshooting experience saving clients $1 to 25-million
including ARCO (Oil , now part of BP), Nissan Motor Corp., the GAP, the US State
Department's 2004-2005 management of the $22-billion Iraq Reconstruction
Program, and other firms including a $200-million software
firm, the 80,000 employee County of Los Angeles, and a $160-million 80 location
construction materials firm (now part of Rinker Corp.).
Case Examples
- Two firms with about 1800 employees were being priced out of business due to increasing group health insurance costs. Our review of the group health insurance contract and a walk through of their insurance providers’ regional claims processing centers found enough improvements to the processes and to the contract terms to reduce their annual $5-million group insurance costs by 16%. Other customers of the providers benefited from the review including a 40,000 employee Los Angeles bank, because the improvements were rolled out to other customers.
- We found that a Japanese
auto firm had an incorrect actuarial formula in their computer system that
increased auto warranty insurance reserves by over $1-million above that
actually needed. Correcting the formula resulted in the
immediate availability of the $1-million for the bottom line.
- An oil company had a
$400-million 3-year contract with a large, international engineering
construction firm to procure and ship needed oil recovery system
components to the Alaskan Pipeline in the 1980’s. The
contract was cost plus, so the engineering firm in Pasadena assigned very weak
managers to the project (since they could bill any extra expenses to the oil
firm) and did not implement any performance tracking systems.
We found so many process errors with lost blueprints, backlogged deliveries,
etc. that the oil firm did not renew the contract and never did business with
the engineering firm for at least 15 years. We had discovered
that all the managers for the engineering firm were retired officers from the
Air Force and they had no experience in establishing cost or performance
tracking systems. (Note: Later that same
firm was ranked in 2009 as the worst performing contractor in Iraq by the
Special Inspector General for Iraq Reconstruction - SIGIR.mil ).
- A California county
government agency processed $16-billion worth of cash receipts and payments a
year. They were receiving revenue and cost sharing checks
from several different Federal and State governments without any central cash
management system. Our analysis found that hiring two cash
management specialists to track down and ensure incoming checks were recorded
and deposited immediately would increase treasury interest income by $9-million
a year. Unfortunately, the promoted social workers who
managed the personnel budget couldn’t understand cash flow, and would not
approve the two positions. A year later, the County was sued
for a $90-million difference in funds owed an investment banking house because
County management also ignored separate control recommendations we provided in
audit reports for the same audit. The county Treasurer was
understaffed, thus they had a faulty method of tracking investment orders given
to the investment bankers, and lost track of order positions, resulting in
significant losses in stock values. After several months, the stock market went
up, reversing the losses to a "wash" position, and the lawsuit was dropped.
- $26-million Surprise Write
Off Generated By Hiring an Unskilled CPA as Controller - An
auto maker had a $25-million racing subsidiary as part of its marketing
strategy. It was formed by buying a well known racing
organization who raced it’s cars. Since the unit was paid for
out of marketing budgets, the marketing department set up the subsidiary and
hired a local CPA who had only worked as a Controller at a local Savings & Loan
firm. She in turn hired friends from the savings & loan
business. None of them had cost accounting or manufacturing
experience. The race organization was very sophisticated and
won two seasons in their class. They used carbon fiber
technology; central on-board computers designed internally, and used the latest
performance parts. The Controller’s staff didn’t like the
“dirty” work areas and could not achieve credibility with the race program
managers who mostly came from the aerospace industry and had advanced degrees.
As a consequence, the engineers developed their own cost tracking system
and our review indicated it was on target. However, the
Controller’s staff didn’t understand inventory accounting and the need to ensure
the increasing inventory valuation was based upon parts that still retained
their value. But, since the race staff ordered numerous parts
which were booked into inventory, then not used because their technology became
obsolete in weeks or months, the inventory valuation built up to $26-million.
That is when we reviewed operations and found that almost all inventory
was obsolete and had to be written off. At the time,
Corporate Management was under profit pressure and decided to close the entire
125 employee operation due to the surprise write off.
The morale of the story is always ensure your accountants understand the proper
ways to account for expenditures in your business, AND that the parent
controller should be involved in the establishment of any separate unit, even if
under the marketing budget.
- A $200-million software
firm, Ashton-Tate (publisher of dBase) had an "office" type of
software developed in the US (Ashton-Tate’s Framework ), but it was mostly
selling well in Europe, with over $20-million every year in Europe.
The US managers were starving the development of the software to spend
funds on another favored product, which caused a lot of friction with the
European region sales staff. After listening to arguments and
accusations between the US and European region managers, we suggested to the CFO
that the four remaining software developers and responsibility for design be
given to the European office. They did that, and the
Europeans upgraded the software and it was a profitable product for several more
years. Sometimes all it takes is listening to verbal disputes to propose a
solution (we attended board meetings and also had visited the European office
and knew the staff there was very competent).
- A $12-million
manufacturing plant in Houston was plagued with a constant loss of 3% of sales
for three years due to an extremely competitive environment.
The parent company had a policy to never sell below cost, and had a very good
cost accounting system so they knew the costs were accurate, but losses
continued. A Big 6 firm audited the plant for three years in
a row because of their high inventory, but never proposed a solution.
Our visit took 3-days to find that the plant accountant partied and drank
a lot, didn't know accounting well, and was related to a HQ employee who was
very well regarded, thus the plant manager didn't try to fire her.
In addition, she was using a pricing formula based upon a scribbled note
given to her by the prior accountant, and had never questioned it.
We ran various scenarios using the "pricing formula" which always
resulted in prices being about 3% below cost. Once the
Division President was informed, he gave permission to the plant manager to fire
the accountant, the formula was changed, and the problem didn't exist any more.
- An acquired $40-million
concrete pipe manufacturing subsidiary was allowed to continue using
a very limited cost accounting system that placed emphasis on
manufacturing larger concrete products that resulted in better manufacturing
efficiency numbers for monthly reports. The problem was that
the larger pipe was not in demand and inventory kept increasing in the storage
yard, and profits were negative. None of the old style
managers understood how to analyze the problem. We found that the
inventory carrying cost of the excess, large pipe exceeded the profit margins
for existing sales. Their system didn't link carrying cost as
part of profit calculations. Within two months the
parent company made the acquired firm to adopt and roll out their more
sophisticated system.
- The software development
division of a software firm was under tight pressure to meet a product launch
deadline which was slipping because newly hired programmers were not producing
code as expected. We were interviewing the development
project manager to identify process constraints, and the recently appointed
software Development Manager from IBM became very angry that we were taking
staff time and threw us out. However, we had enough
information already to know that the problem was that ordered computers for the
programmers were backlogged, so they could not work until the computers arrived.
We tracked the orders down to the CFO's in-basket in another town.
He had been sitting on them because he didn't believe the requested
computers were critical. Once we explained the situation to
the CFO (my boss), he processed the orders and the programmers finally got their
computers so they could be productive.
- In 2003-2007, the US State
Department Embassy in Baghdad, Iraq, had responsibility for the management of
the $22-billion Iraq reconstruction program, including renovation of hospitals,
schools, fire departments, rolling equipment, electrical system components,
$20-million generators, water processing plants, etc.
Responsibility for procurement of about $4-billion in materials was assigned to
the US Army Core of Engineers. However, the Federal
government uses a heavily decentralized, rigid, bureaucratic procurement process
and not all their systems would interface in Iraq. Thus
the requisition and procurement process was split among 7 major Federal agencies
who used manual systems to process their segment of the procurement process.
Acting as a troubleshooter for a small group in the reconstruction
program, we found NO ONE was managing accuracy or throughput of all requisitions
through the system, so it was not uncommon to find 20 unprocessed requisitions
for materials, or guns and ammo to be sitting in one department because there
were no handoff or batch processing systems to ensure all requisitions had
accurate delivery & contact info, and they were moving through the system on a
timely basis. In several instances, requisitions had not been
processed into orders for over a year. When we asked
the US Army command structure why there was no quality control over purchase
orders, or status tracking, we were yelled at by full Colonels, and the
responsible Brigadier General filed complaints about me to the Ambassador.
However, we had a higher ranking general who upheld our opinion after
discussions and the Army had to create an adhoc tracking system to detect all
the lost orders. Then, we found there were huge
warehouses containing unlabeled and undelivered incoming shipments because there
were no disciplined receiving procedures when shipments arrived in the
Iraqi ports or airports. A computer analysis located about
112 pages of ordered items worth millions sitting in warehouses because they did
not have identifying data for proper notification to the customer.
This resulted in a presentation of all the data to the Senior Advisors
for the 12 critical economic sectors (Oil, Gas, Water, Agriculture, etc.) so
they could look through the lists to see what inventory was theirs.
In one case, the Senior Advisor position for improving the Iraqi Hospital
and Health system turned over so often the current Sr. Advisor never knew about
a huge number of lost orders for critical hospital equipment that were ordered
by earlier advisors and either had not actually been ordered, or had been
sitting in warehouses for more than a year. Using the
inventory report, they found millions of dollars of Hospital equipment that had
been sitting in the warehouses for over 18 months.
- The US auto and parts
distribution division for a Japanese auto firm was used to receiving batches of
new cars by boat from Japan which were ordered by staff in Japan, not the US
management. The Japanese used a cost transfer system
where they charged the US Division a price per vehicle that included fat profits
recognized by the Japanese to make their numbers look good, however the transfer
price method left no margin for the US to report a profit after marketing and
distribution expenses. In addition, the Japanese would
improve their production efficiencies by sending entire boatloads of a single
model of car with the same color and accessories, although there was not enough
demand for the model sent to get dealers to take them. As a
consequence, we visited the inbound receiving yards and found over 7,000 cars in
storage. The company did NOT use a system that tracked
inventory carrying charges. We also found that the main lot
only held 3,000 cars, so they incurred constant trucking charges to move new
vehicles to outside lots, then move them back when they were processed for
shipment to dealers. Our calculation of inventory
carrying costs per vehicle showed the cost exceeded the budgeted profit per car.
In this case, Japanese management didn't want to deal with the problem
and took no action. (Later the company had to sell a
controlling interest to a French car company which finally turned them around.)
- In Iraq, from 2003
forward, many US reconstruction projects were run by various government and
contractor firms. There was a formal order process used
by the contractors, who had staff to monitor and expedite orders for
construction projects, There was a separate system for units
that did not have construction projects, but needed to order “non-construction”
goods totaling about $4-billion in value, such as vehicles, guns, office
supplied, copiers, repair and maintenance parts, etc.
The orders were processed by an Iraq based Contracts Office, and information
transmitted to the US based payables office. That office, due
to the US Prompt Pay Act, would automatically pay vendors within 30 days,
regardless whether the order had been shipped or received by the ordering party.
In my direct experience, we had orders that never shipped to my unit in
Iraq for 6-12 months, or never were received. Normally, in
properly controlled business environments, payments would never be sent to a
vendor until the ordering unit received the items, inspected them, and sent in a
receiving report to accounting to match to the invoice.
However, this control was completely waived to meet Prompt Pay Act requirements.
Thus there were millions of dollars in goods that were not shipped, or
never were delivered to the ordering units (for many reasons) , but financial
reports we had showed the vendors were paid automatically 30 days after they
submitted an invoice. Complaints about this problem were
never acted on by IRMO or the Contracts Office management, and were not
disclosed until a DoD Inspector General audit report in 2008.
Investigators from the DoD IG interviewed me for three hours about procurement
process weaknesses, including the Prompt Pay Act problem. This is a
case where good operational audit skills can identify a problem and solution,
but poor management would not act on the proposed solution.
- A Japanese auto firm used
an external marketing services firm to handle dealer sales incentives and
contests, including travel to resorts for award winners and Sales Contests where
winners went to extravagant Super Bowl events costing $7-million.
The marekting services contract was valued at about $40-million.
We walked through the work processes of the vendor at their out of state
headquarters in Kansas City to identify improvements that would reduce costs
billed to the auto firm. We found the vendor was split into
four separate divisions, each with a controller and staff.
They had no incentives to reduce processing time or costs once a long term
"service" purchase order was cut. We found that each division
was adding their own overhead charge to transactions, boosting invoiced costs
significantly. When we told the vendor VP, they were quite
embarrassed, and reduced their overhead billing charges to a more reasonable
level. We also found a number of incorrect billings, that if
extrapolated to the $40-million level, would require repayment of over
$1-million. The lesson learned here is that a physical walk
through and review of vendor internal systems can find cost reduction
opportunities that don't hurt product quality or pricing, thus improving
profits. This audit took about 4 man weeks.
- The same auto firm paid
out about $600-million annually in contest or volume discounts to auto dealers
for meeting various monthly or quarterly sales targets, which could be defined
narrowly by State, and type of car sold.
Since they really were car dealers, they gamed the system, and refused to
place orders for reporting periods until the auto firm's marketing staff
panicked and increased contest awards just before quarterly reporting deadlines.
We recommended the marketing staff spread out contest deadlines
throughout quarterly periods to eliminate the last minute huge bulge in orders
which increased transportation costs, etc.
Additionally, they used a very complex software system to track awards by dealer
and payments were initiated automatically by computer. The
problem was that the "coordinator" for data entry in the system was a marketing
assistant who had no experience in accounting or batch controls, and they didn't
have any. As a consequence, wrong numbers and codes were
constantly entered into the system and it was VERY common for a dealer to call
and ask why they got a computer generated check from marketing for $300,000 when
they were not in the contest area. (Most dealers kept the
checks and didn't report the problem until one called, then the staff had to
track and get all the checks back). In one case, I had
an intern run a computer analysis and he found $12-million in excess contest
payments that had to be recovered. The company ended up
outsourcing the design of a new incentives system for $12-million when we told
them if they just used batch controls they could catch the problems before they
occurred. ( Not all of my clients were
good managers...).
- A well known fashion house
that stocks clothing boutique sections in high end clothing stores like
Nordstrom’s used a clothing manufacturer based in Los Angeles.
The CFO of the manufacturer decided that a new software workflow system
was needed to track what regional sales managers and staff were doing to ensure
they were visiting customer stores according to policy.
We started developing the system criteria to upgrade the existing system by
talking to field sales staff and region managers. We reviewed
the recent data in the system and found much of it was missing or out of date
regarding sales calls, results, etc. Discussions with
the sales people indicated the senior regional manager didn't want to fill out
the data "and be accountable" and thus no one else did either.
Then we found a new sales manager was hired, and he over-ruled the CFO's
plans to upgrade the system. The CFO was correct that the
sales staff site visit performance (they were required to visit retail centers
and maintain product displays) couldn't be tracked, but the new Sales manager
didn't want to be tracked either. Thus the planned upgrade
was killed. We almost spent thousands developing a system
that wouldn't be used, thus the project was killed. Most
consultants would not have identified that the system wouldn't be used, but we
did, which cost some business. The prime software
contractor for the project was unhappy because they lost a billing opportunity,
but the CFO's reputation was intact!
- Concurrency of Business
Unit Performance Objectives with Those set by the Parent or HQ Office -
A $40-million subsidiary was missing profit targets for the 2nd Quarter
Reports. Our visit found that the unit President had agreed
during parent company planning sessions to certain profit targets, then the
Parent President added another $400,000 to the annual profit target.
The Parent company controller recorded the adjusted target into their
unit tracking system. However, after a week of research at
the subsidiary offices, we found the adjusted figures had never been passed back
to the subsidiary Controller or staff. As a consequence, they
were right in line with their original profit targets, but not the revised
parent company expectations. There was no
reconciliation process between the parent and unit performance tracking systems,
thus the error occurred. A new system was installed to
reconcile quarterly and annual performance targets between the values at the
parent company and the subsidiaries. The opportunity cost of
the earlier system was $200,000 lost profits due to the lower targets plus loss
of morale when subsidiary management realized their bonus structure would be
affected by the new targets.
- Falling Profit Margins Caused by Acquired Management Pursuing a Business Vendetta – A $35-million subsidiary with three manufacturing plants had been acquired the previous year. Profits were falling below target at one plant, and the old management told the parent company various reasons for four months, but profitability didn’t improve, resulting in $45,000 in lost profits compared to targets. Upon our visit (at the request of the President) , we found that freight costs were much higher than normal and products were being sold at lower margins and being shipped into an area further than the normal business radius for the firm. It turned out that a remote competitor was shipping product into the plant’s sales area, and the old management started an unauthorized price war, selling into the competitor’s distant area, reducing profits considerably. The parent company had to sit down with the old company management and “have a talk” about how margins work and not to violate the parent standards regarding pricing and margins.
- end of case studies -