Performance Measurement

A Japanese multinational agro chemical company had launched its premium product in India. It could not perform well on account of incorrect strategy and management accounting system.

At first, the sales & marketing team was given a target to increase the sales and distributorship on a pan India basis. Business Managers entered into a big sales contract with other company for selling its premium product to them after packaging in their brand name. Distributorships were increased without proper background checking. Amount of expenses incurred on all distributorship a like without considering performance levels. Production was based on faulty sales forecasts to accumulate inventory and it was not based on confirmed orders in spite of possibility of less throughput time.

The Company started to increase its sales but incurred a huge amount on sales commissions and sales schemes to the distributors. Later on the company was facing huge sales returns from these distributors as product was not proving successful in the market. There were also dispute within the business heads and there were various schemes of misappropriation involved.

Consultants had been called from all renowned accounting companies who mainly reported on the accumulation of inventory and expired inventory, lack of approvals for sales returns, incorrect commission or scheme benefit paid, lack of approval for cash transactions, non calling of proper quotations etc. They suggested change in authorization levels and new standard operating procedures etc.

With top management pressure, the business managers now had been given a target to reduce inventory. The business managers now were devoting their huge time in selling near expiry stocks instead of fresh stocks. The product was sold in various sizes. Few big sizes which were over produced, the business managers had decided repack these into smaller sizes to reduced inventory although which only added to cost of re-packaging.

Also, there was incorrect decision with respect to product positioning and product pricing. The Company was competing with its own product on many occasions. The premium product was not successful and they had to change usage method instructions several times. There was problem with product costing and cost allocations too.

Management accounting must adapt to dynamic environments and organizations. Warning signals indicate that the management accounting system is not working and needs a change. It is clear that the consultants were not able to reach to the correct root causes to give solutions to the problems due to faulty frame of mind and approach.

One sign of management accounting system not working is dysfunctional behavior of the on part of the business managers due to inappropriate performance measures. Managers make decision to influence performance measure. If these performance measures are not consistent with the organisation's goals, management might make decisions that do not coincide with organizational goals. When organizational mangers are acting at cross-purposes with each other, the management accounting system is not working and should be changed.

Organisations must think about changing its management accounting system based on organization's non-ability to correctly forecast or to win a bid or gain competitive advantage in terms of effectiveness, efficiency and value chain benefit.

Organization should not look necessarily to the latest management accounting buzzwords to give them direction for changing their management accounting system. TQM, Six Sigma, JIT and activity based costing ( ABC) for example are appropriate to certain type of organizations and in particular environments. Some features of these concepts might be beneficial, while other might not contribute for creating value for the organization.

The Forgotten Chapter

Independence and Objectivity of Internal Audit is on top priority list of the new Corporate Governance requirements. Reporting to Audit Committee Internal Audit has achieved the so called glare of Independence. Although now we have new definition for Internal Audit, something has been deliberately missed out due to global business trends.

The new definition of Internal Audit has two objectives in very simple words.

• To add value by improving organization's operations.
• To evaluate & improve the effectiveness of Internal Controls.

For second objective the global businesses are following COSO Internal Control framework. Either it be Sarbanes Oxley or Clause 49 in India, efforts are to improve the effectiveness of Risk Management & Internal Controls with respect to financial reporting objective of the COSO.

Now the question is how Internal Auditors are achieving the first objective? What frameworks or methodologies Internal Auditors are to pursue to achieve it? Do Audit Committees are concerned about the Operations or they finite themselves with financial reporting objective? Internal Auditor are facing disadvantage of not reporting to the Management as they are taking advantage of reporting to the Audit committees. Independence gained at the cost of objectivity.

No doubt Internal Auditors needs to work in their domain area and audit charter should define clearly scope and responsibilities, I see following four areas for Internal Audit to focus on in addition to risk management with respect to financial reporting to achieve the first objective of the new IA definition. The management should define the role of the Internal Audit to make it responsible and accountable to add value in the following.

• Management Accounting
• Resource Management
• Financial Management
• Knowledge Management

Above is nothing but the components of an Operational Audit and Value for Money Audit with assertions Economy, the measure of Input, Efficiency, the measure of relationship between input and output and the Effectiveness, the measure of output.

Steam engine describes the operational cycle, each component contributing towards the locomotion, the whole system being composed of interrelated parts, failure of one causing failure of the system. Risk Management is needed to be better understood holistically as it is not just internal control management of financial reporting or strategic/ operations risk in isolation.

Think Out of The Circle

When opportunity to commit fraud exist, someone has likely already exploited it. Then, the role of fraud investigators is just to determine the extent of the losses. What fraud perpetrators do? They don't play by the rules. They ignore internal controls or compromise with internal controls. Circle represents your 'As Is' internal controls and Square represents what employees really do. There is no proof in the audit books that segregation of duties is generally effective or worth its often significant cost. It depends on case to case basis. To my knowledge the segregation of duties is the most overemphasized and often least cost-effective control design option available.

Breakdown in segregation of duty is mostly a symptom of bad control design. Apparently it seems that segregation of duty will improve controls. However, the laws of human psychology and the realities of the workplace prevent segregation of duties from being an effective control.

Segregation of duties is expected to prevent fraud and error and to safeguard assets. However reality is different. Let us take couple of examples from Hospitality business; the chef picks up the phone and orders the material directly from the supplier, and purchasing prepares the paperwork after the fact, often when the invoice arrives. What happened to requisition, purchase order approvals etc? It is to be noted that chef has done nothing wrong as far as business objectives are concerned. Does it mean control objectives are not in sync with business objectives?

In a Restaurant, check voids are supposed to be approved by the Restaurant Manager and Chef to serve a dual control. However, repeated void of a same menu item due to its bad taste never gets attention for taking appropriate action. What really happens? Manager & chef sign all void check just to serve a control. Actually responsibility is not fixed in this case. When we find everything approved, we say controls are effective. What about the purpose?

Such ineffective practices are bad for the business as they block innovation and learning. Need is for analyzing risk and control within a specific process or a work groups to couch the work groups about the control practices and its effectiveness. This will help us form a reliable opinion about effectiveness of the controls. The Companies should expect occasional error, fraud, or abuse and deal with it. The organization will be healthier as a result. Trust but verify - can be a powerful cost-effective strategy.

Some companies are using ongoing surveys to seek inputs from employee on sensitive soft control issues. Tools can be simple like automated excel sheet or web based tool to increase awareness and reflect real business needs for the controls. Risk perception determines your risk management process. So let us get innovative and meaningful in our approach.

Just In Time

Best practices are like benchmarks. They are very personal and contextual. Applied incorrectly, best practices can become handcuffs. People say let's apply best practices to help improve the processes. We always look at what has worked for others and try to repurpose it for our requirements. Does that make it "best practices," though?

Best practice like Just In Time (JIT) inventory system is not just an attempt to maintain minimum or zero inventory. The JIT process involves fine tuning production and supplier scheduling systems, where inventories are supplied when needed in production and monitoring the entire value chain closely to reduce wastage and minimize inventory buffers.

An US company had known about JIT used by its Japanese counterparts with assembling cost below 20 % of its own. In an attempt to replicate the success, US Company too then implemented JIT. Although it was successful in reducing its assembly cost noticeably, it experienced dramatic problems with its major suppliers at the same time. They begun to demand price increase that more than offset the assembly plant cost saving. The company blamed its suppliers for not using JIT concept for their own operations. However, the problem was different and not realized by the US Company initially.

While the US Company reduced its need for buffer stocks, it placed major strains on the manufacturing responsiveness of its suppliers. The reason was very simple. The assembly plant of the US Company was experiencing huge and uncertain variability in their production schedules which made the manufacturing for its suppliers a nightmare. Management had ignored the idea that JIT involves partnering with suppliers down the value chain. It did not realize that the key in the success of JIT for Japanese assembly plants was schedule stability for its supplier firms.

A knowledgeable risk consultant can play important role in implementing and maintaining innovative management accounting systems like JIT, ABC & Six Sigma. The risk involved is of making incorrect planning decisions and control decisions.

Nowadays activity-based costing (ABC) is being adopted as an alternative cost accounting system that supposedly overcomes the deficiencies of the traditional cost accounting system. However, ABC has been abused by its users. It is now clear that one should understand it from Activity Based Management and strategic perspective and should not use it as an accounting system by bringing it in the general ledger system.

Proper Risk Consulting may contribute to the success of new management accounting concepts through several types of involvement: (1) audit of cost drivers, (2) audit of non-financial performance metrics, (3) Value Chain Analysis, and (4) audit of value added by ABC.

This is the future area where maximum value addition can be achieved and requires different approach in risk consulting.

Risk exists if you are not aware and not implementing a new management tool and technique when your competition is. Risk exists if you are implementing it incorrectly and your benchmarking analysis is flawed and not showing you the key factors causing the performance difference between you and your competitor.