I periodically write in this blog about operational audits, performance audits or benchmarks needed in local government operations.
This document was expanded and will be a Kindle eBook on Amazon.com in late 2016. I will insert the link to it's page HERE when it is published.
This document is copyrighted by Vance Jochim dba FiscalRangers.com Jan. 4, 2014. Permission to use text excerpts without modification is granted only if full credit is given to Vance Jochim and a link to this page is provided.
Here is a list of actual operational audits and results I have been involved with over the years. 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 a clear difference between 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 after all the spending, 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 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:
Operational Audit Case Studies
by Vance Jochim
Retired Certified Internal Auditor ( CIA-inactive), Certified Information Systems Auditor (CISA - inactive) & Certified Fraud Examiner (CFE - inactive)
This is a series of case studies of operational audits I have conducted or directed in my 18+ years of corporate and government internal auditing. This provides clear examples of how operational audits of unstructured areas differ from standard financial or compliance audits.
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.).
- Two firms with about 1800 employees were being priced out of business due to increasing group 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. The lesson learned is to ALWAYS schedule walk through reviews of major vendors and suppliers AT THE START of the contract, then periodic follow ups. Financial auditors never think to do that, so make sure legal includes a requirement in contracts to allow your company's internal auditors to review their systems and transactions at their site with walkthroughs. Then do it.
- 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 marketing 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 dealers and sales content winner 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 internal audit 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. As a software developer (not auditor), I 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 existing 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 subsidiary sales 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, higher 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. However, the problem was stopped after the second quarter, reversing the potential loss of another $150,000 which was not in the subsidiary sales goal reports.
- 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.
This document is copyrighted by Vance Jochim dba FiscalRangers.com Jan. 4, 2014. Permission to use text excerpts without modification is granted only if full credit is given to Vance Jochim and a link to this page is provided.
Written by Vance Jochim at FiscalRangers.com . I am on LinkedIn.
- end of case studies -