Controllership: The Work of the Managerial Accountant (Controllership)

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Author: Janice M. Roehl-Anderson | Steven M. Bragg

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00_title_pages.fm Page iii Wednesday, December 10, 2003 4:16 PM

CONTROLLERSHIP THE WORK

MANAGERIAL ACCOUNTANT SEVENTH EDITION

OF THE

JANICE M. ROEHL-ANDERSON STEVEN M. BRAGG

John Wiley & Sons, Inc.

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CONTROLLERSHIP

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BECOME A SUBSCRIBER! Did you purchase this product from a bookstore? If you did, it’s important for you to become a subscriber. John Wiley & Sons, Inc. may publish, on a periodic basis, supplements and new editions to reflect the latest changes in the subject matter that you need to know in order to stay competitive in this ever-changing industry. By contacting the Wiley office nearest you, you’ll receive any current update at no additional charge. In addition, you’ll receive future updates and revised or related volumes on a 30-day examination review. If you purchased this product directly from John Wiley & Sons, Inc., we have already recorded your subscription for this update service. To become a subscriber, please call 1-877-762-2974 or send your name, company name (if applicable), address, and the title of the product to: mailing address:

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00_title_pages.fm Page iii Wednesday, December 10, 2003 4:16 PM

CONTROLLERSHIP THE WORK

MANAGERIAL ACCOUNTANT SEVENTH EDITION

OF THE

JANICE M. ROEHL-ANDERSON STEVEN M. BRAGG

John Wiley & Sons, Inc.

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This book is printed on acid-free paper. Copyright © 2004 by John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, e-mail: [email protected]. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.

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ABOUT THE AUTHORS Janice M. Roehl-Anderson, MBA, is a principal with Deloitte, with over 20 years of consulting experience. She specializes in information systems security; ﬁnancial and cost accounting system analysis, design, selection, and implementation; long-range information systems planning; and information management reviews/audits. She has also worked for US West. In addition to earning her BA in Business at the University of Washington, and MBA in Accounting and Information Systems at the University of Southern California, Jan has successfully completed the CPA exam, and has co-authored over 10 books, including The Controller’s Function: The Work of the Managerial Accountant. Steven Bragg, CPA, CMA, CIA, CPIM, has been the chief ﬁnancial ofﬁcer or controller of four companies, as well as a consulting manager at Ernst & Young and auditor at Deloitte. He received a master’s degree in ﬁnance from Bentley College, an MBA from Babson College, and a Bachelor’s degree in Economics from the University of Maine. He has been the two-time President of the 10,000-member Colorado Mountain Club, and is an avid alpine skier, mountain biker, and rescue diver. Mr. Bragg resides in Centennial, Colorado. He has written the following books: Accounting and Finance for Your Small Business (Wiley) Accounting Best Practices, 3rd Edition (Wiley) Accounting Reference Desktop (Wiley) Advanced Accounting Systems (Institute of Internal Auditors) Business Ratios and Formulas: A Comprehensive Guide (Wiley) Cost Accounting: A Comprehensive Guide (Wiley) Design and Maintenance of Accounting Manuals: A Blueprint for Running an Effective and Efﬁcient Department, 4th Edition (Wiley) Essentials of Payroll: Management and Accounting (Wiley) Financial Analysis: A Controller’s Guide (Wiley) Just-in-Time Accounting: How to Decrease Costs and Increase Efﬁciency, Second Edition (Wiley) Managing Explosive Corporate Growth (Wiley) Outsourcing: A Guide to...Selecting the Correct Business Unit...Negotiating the Contract...Maintaining Control of the Process (Wiley) Sales and Operations for Your Small Business (Wiley) The Controller's Function: The Work of the Managerial Accountant, 2nd Edition (co-authored with Janice M. Roehl-Anderson, Wiley) The New CFO Financial Leadership Manual (Wiley)

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ACKNOWLEDGMENTS With the rapidly changing business environment, it was essential that the material contained in this volume be accurate, up-to-date, and relevant. Accordingly, in addition to the chapters written or revised by the two co-authors, these contributing authors, listed alphabetically, wrote or revised the chapters indicated: Alan R. Arnold, Manager Ernst & Young LLP, Irvine, California Chapter 42, Systems Performance Management Karen L. Bassett, Manager Ernst & Young LLP, Denver, Colorado Chapter 39, Software Testing E. Edward Bassett III, Senior Systems Security Engineer Denver Technological Laboratories Chapter 43, Information Security Systems Chapter 46, Digital Signatures Kevin Church, Senior Manager Deloitte, San Francisco, California Chapter 51, Organizations Embrace Shared Services—Big and Small David Drach, Director of Business Analytics FRx Software Corporation, Denver, Colorado Chapter 44, Enforcing Information Security Policy Pak Fong, Senior Manager Deloitte, San Francisco, California Chapter 50, How to Implement a Successful CRM Solution Marty Gold, Senior Manager Ernst & Young LLP, Denver, Colorado Chapter 61, Tax Records and Procedures Susan Hogan, Principal Deloitte, Atlanta, Georgia Chapter 51, Organizations Embrace Shared Services—Big and Small Sara J. Moulton-Reger, e-Business Strategy Consultant IBM Global Services, Denver, Colorado Chapter 47, Change Management Chapter 48, Project Risk Management Chapter 49, Effective Project Communications Jill M. Weisbrod, Manager Ernst & Young LLP, Denver, Colorado Chapter 39, Software Testing Tanya Whiteing, Senior Manager Deloitte, Foster City, California Chapter 38, Testing Strategies for Financial Systems vi

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PREFACE Since the ﬁrst publication of this book in 1952, the role of the controller has greatly expanded. It has moved from that of a simple technician who must properly process transactions to a business executive with a wide-ranging knowledge of total business operations, best practices, and corporate strategy. To address these changes, Controllership has evolved into a comprehensive guide to accounting management, planning, computer systems, and administration—in short, a repository for all the skills that a modern controller needs. While the sixth edition addressed such key issues as the fast close, best practices, information security systems, outsourcing the accounting function, and software testing, we felt it necessary to issue a new edition that addresses a wide range of additional topics that have become more important in the last four years. The following new items are addressed in depth: • Logic steps for ethics-related decisions • Summaries of essential GAAP pronouncements • Cost accounting systems and methodologies • Throughput costing • Composition and role of the audit committee • Taxation strategy • Business cycle forecasting • Payroll compensation and tax issues • Management reporting formats • Reporting to the Securities and Exchange Commission • Acquisition due diligence checklists • Accounting manual preparation and maintenance These new topics address many of the concerns of the modern controller: what information to examine during an acquisition due diligence review, how to integrate throughput costing decisions into the ﬁnancial analysis toolbox, and how to alter accounting systems to take advantage of taxation strategies. We have attempted to include in this volume practical commentary on the various aspects of controllership. Given the growth in complexity and the rapid changes taking place in the many functions of accounting, we have secured assistance from a number of knowledgeable practitioners and writers in the relevant ﬁelds of endeavor. These contributing authors are identiﬁed in the Acknowledgments section. In short, the seventh edition of Controllership is the complete business advisor for today’s controller. Janice M. Roehl-Anderson Cherry Hills Village, Colorado Steven M. Bragg Centennial, Colorado January 2004

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CONTENTS

PART 1

THE BROAD MANAGEMENT ASPECTS

OF

CONTROLLERSHIP

1 Accounting in the Corporation Tasks of the Accounting Function 3 Role of the Accounting Function 5 Role of the Controller 6 Impact of Ethics on the Accounting Role Evolving Role of Accounting 9

1 3

7

2 Controller’s Responsibilities

11

Variations on the Title 11 Planning Function 12 Control Function 12 Reporting Function 13 Accounting Function 13 Additional Controller Functions in Smaller Companies 14 Controller’s Job Description 16 Relationship of the Controller to the Chief Financial Officer 18 Future Changes in the Controller’s Origins and Responsibilities 19 Managing Explosive Growth 20

3 Chief Financial Officer: From Controller to Facilitator of Change Understanding What Chief Executive Officers Want 23 Task of the CFO 24 Develop and Communicate a Compelling Finance Agenda Build a Commitment to Change within Finance 26 Change Executive Management Practices 29 Enlist the Support of the Chief Executive Officer 30 Mobilize the Organization 31 Institutionalize Continuous Improvement 32

4 Accounting Principles and Standards

23

24

35

Committee on Accounting Procedure 35 Accounting Principles Board 36 Financial Accounting Foundation 36 Financial Accounting Standards Board 36 Government Accounting Standards Board 37 International Accounting Standards Board 38 Accounting Standards 38

Because of the rapidly changing nature of information in this ﬁeld, this product may be updated with annual supplements or with future editions. Please call 1-877-762-2974 or email us at [email protected] to receive any current update at no additional charge. We will send on approval any future supplements or new editions when they become available. If you purchased this product directly from John Wiley & Sons, Inc., we have already recorded your subscription for this update service.

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Contents

Accounting Research Bulletins 39 Opinions: Accounting Principles Board 39 Interpretations: FASB 41 Statements of Financial Accounting Standards: FASB 44 Statements of Financial Accounting Concepts: FASB 53 Technical Bulletins: FASB 54

5 Cost Accounting and Costing Systems

57

Purpose of Cost Accounting Information 57 Input: Data Collection Systems 58 Processing: Data Summarization Systems 60 Processing: Job Costing 62 Processing: Process Costing 66 Processing: Standard Costing 69 Processing: Direct Costing 71 Processing: Throughput Costing 73 Processing: Activity-Based Costing 76 Processing: Target Costing 79 Outputs: Cost Variances 80

6 Ratio and Trend Analysis

85

How to Use Ratios and Trends 85 A Caveat 86 Measures for Profitability 88 Measures for the Balance Sheet 90 Measures for Growth 94 Measures for Cash Flow 96 Measures for Nonfinancial Performance 97 Interrelationship of Ratios 110 Setting Up a System of Ratios and Trend Analyses

7 Internal Control Systems

110

115

Objectives 115 Responsibility for Internal Controls 116 Examples of Internal Controls 117 When to Eliminate Controls 119 T ypes of Fraud 121 Preventing Fraud 122 How to Deal with a Fraud Situation 125 Foreign Corrupt Practices Act 126

8 Internal Audit Function

129

Reporting Relationships 129 Composition of the Audit Committee 130 Role of the Audit Committee 131 Internal Audit Objectives 132 Internal Audit Activities 134 Managing the Internal Audit Function 136

9 Globalization: Complexities and Opportunities Changing Nature of International Trade

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140

139

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Contents

Impact of Global Trade on Segments of the U.S. Economy 140 Determining and Implementing Successful Global Strategies 142 Organization Structure in a Global Enterprise 143 Virtual Corporation 145 Technical Aspects of the Controllership Function under Globalization

146

10 Recruiting, Training, and Supervision Recruiting Sources 159 Factors to Consider when Recruiting 162 Factors to Consider When Promoting 163 Importance of Reduced Turnover 164 Importance of Developing Career Plans for Employees Importance of Communications with Employees 169 How to Motivate Employees 171

xi

159

167

11 Controller’s Role in Investor Relations

173

Objectives of the Investor Relations Function 174 Evolving Nature of the Function 174 Communication Vehicles for Investor Relations 174 Investor Relations Message Recipients 175 Information Needs of the Financial Analyst 176 Information Needs of Other Groups 178 Disclosure Policy 178 Organization Structure for Investor Relations 179 Role of the Controller and Other Principals 180 Changes in the Capital Markets 182

PART 2

THE PLANNING FUNCTION

OF

CONTROLLERSHIP

12 Business Plans and Planning: Interrelationship of Plans, Strategic Planning Business Planning Defined 188 Framework for Business Planning 188 Time as Related to Planning 188 Planning Period: How Long Is “Long Range”? 189 System of Plans 190 Strategic Plan: An Overview 190 Corporate Development Plan 191 Operations Plan 191 Basic Elements in Any Plan 191 Planning Process 192 Plan Frequency 194 Plan Guidelines 194 Who Should Do the Planning? 195 Supplemental Planning: Alternative Scenarios 196 Planning Timetable or Schedule 196 Strategic Planning: An In-Depth Review 196 Environmental Analysis 198 Critical Success Factors 199 Business Mission or Purpose 200 Long-Range Business Planning Objectives 202

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Contents

Developing Strategies 205 Strategies and the Planning Period 208 Role of the Controller 208 Improving the Strategic Planning Process

210

13 Financial Impact of the Strategic Plan: Long-Range Financial Plan Key Elements Of A Strategic Plan 211 Contrast Of Strategic Plan (Financial Aspects) with the Annual Plan Capital Investments 213 Risk Analysis 214 Key Relationships 215 Objectives of the Long-Range Financial Plan 215 Consolidation and Testing Process 216 Representative Financial Content of a Long-Range Plan 216 Illustrative Financial Exhibits in the Plan Presentation 217 Role of the Controller 230

211

212

14 Profit Planning: Annual Plan

233

Profit Planning Defined 233 Purpose of Budgeting 234 Planning Benefits 234 Coordination Benefits 235 Control Benefits 236 Annual Planning Cycle : Illustrative 237 Supportive Financial Statements and Budgets 238 Sales Budget 239 Production Budget 240 Purchases Budget 240 Direct Labor Budget 241 Manufacturing Expense Budget 241 Inventory Budget 241 Operating Expense Budget 243 Capital Expenditures Budget 243 Cost of Goods Sold 243 Statement of Estimated Income and Expense 243 Cash Budget 245 Statement of Estimated Financial Condition 245 Approval of Budget 246 Control Function 247 Controller’s Role: A Key Player 247 Management Approval of the Plan 253

15 Profit Planning: Supporting Financial Analysis for the Annual Plan Basic Approach in Profit Planning 255 General Comments on the Cost–Volume–Profit Relationship Break-Even Chart 256 Changes in Sales Revenue 258 Changes in Sales Mixture 259 Changes in Sales Price 260 Changes in Costs 261 Marginal Income Ratio and Margin of Safety 262

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255

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xiii

Analysis by Product 262 Application of Cost–Volume–Profit Analysis 263 Selecting the Most Profitable Products 265 Minimum Selling Price 266 Unit Costs at Different Volume Levels 266 Increased Sales Volume to Offset Reduced Selling Prices 266 Most Profitable Use of Scarce Materials 267 Advisability of Plant Expansion 267 Break-Even Analysis to Evaluate a Forecast 269 Workable Statement of Income and Expense 271 Some Practical Generalizations 272 Statistical Techniques for Planning 272 Program Evaluation Using Discounted Cash Flow 277 Financial Analysis of Unacceptable Operating Results 277 More Sophisticated Analyses 294

16 Taxation Strategy

295

Accumulated Earnings Tax 296 Cash Method of Accounting 297 Inventory Valuation 297 Mergers and Acquisitions 297 Net Operating Loss Carryforwards Nexus 299 Passive Activity Losses 300 Project Costing 300 Property Taxes 301 S Corporation 301 Sales and Use Taxes 302 Transfer Pricing 303 Unemployment Taxes 305

PART 3

PLANNING

AND

298

CONTROLLING OPERATIONS

307

17 General Discussion of Accounting/Statistical Standards: Benchmarking Meaning of Accounting/Statistical Control 309 Extent of Accounting/Statistical Control 310 Need for Standards 310 Definition of Standards 311 Advantages of Standards 312 Relationship of Entity Goals to Performance Standards Types of Standards Needed 314 Trend to More Comprehensive Performance Measures Benchmarking 320 Balanced System of Performance Measures 321 Setting the Standards 322 Use of Standards for Control 323 Procedure for Revising Standards 326 Recording Standards 327 Application of Standard Costs 328 Management Use of Standard Costs 328

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309

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Contents

18 Planning and Control of Sales

329

Sales Management Concerns 330 Controller’s Assistive Role in Sales Management Problems 331 Controller’s Independent Role in the Planning and Control of Sales Control of Sales 334 Sales Analysis 334 Sales Planning: Basis of All Business Plans 338 Steps in Developing the Near-Term Sales Plan/Budget 339 Control Phase 341 Methods of Determining the Sales Level 341 Useful Sources of Forecasting Information 344 Forecasting the Business Cycle 345 Sales Standards 350 Sales Reports 354 Product Pricing: Policy and Procedure 355

333

19 Planning and Control of Marketing Expenses

371

Definition 371 Significance 372 Factors Increasing the Difficulty of Cost Control 372 Sales Manager and Marketing Expenses 373 Basic Approach in the Planning and Control of Marketing Expenses 373 Marketing Expense Analysis 373 Types of Analyses 374 Planning Marketing Expenses 386 Special Comments on Advertising and Sales Promotion Expense 392 Control of Marketing Expenses 397 Marketing Expense Standards 397

20 Planning and Control of Manufacturing Costs: Direct Material and Direct Labor General Aspects of Manufacturing 403 Direct Material Costs: Planning and Control Labor Costs: Planning and Control 416

403

408

21 Planning and Control of Manufacturing Costs: Manufacturing Expenses Nature of Manufacturing Expenses 425 Responsibility for Planning and Control of Manufacturing Expenses Approach in Control of Manufacturing Expenses 427 Proper Departmentalization of Expenses 427 Variations in Cost Based on Fixed and Variable Costs 428 Variations in Cost Based on Direct Labor 429 Variations in Cost Based on Batch Size 431 Variations in Cost Based on Overhead 433 Variations in Cost Based on Time 435 Cost Estimation Methods 436 Normal Activity 439 Allocation of Indirect Production Costs 440 Budgetary Planning and Control of Manufacturing Expenses 442

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425

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xv

Revision of Manufacturing Expense Budgets 446 Securing Control of Overhead 449 Indirect Labor: A More Precise Technique 451 Other Aspects of Applying Budgetary Control 451 Other Control Procedures 453 Role of the Controller 454 Reports for Manufacturing Executives 455

22 Planning and Control of Research and Development Expenses

463

Research and Development Activities 463 Impact of R&D Activities on Corporate Earnings 464 R&D Activities in Relation to Corporate Objectives 464 Integration of R&D with Other Functions 465 Organization for the R&D Financial Functions 466 Accounting Treatment of R&D in Financial Statements 466 Elements of R&D Costs 468 Role of the Financial Executive in R&D 469 General Budgetary Procedure 470 Determining the Total R&D Budget 470 Information Sources on R&D Spending 471 Establishing the R&D Operating Budgets 472 Detailed Budgeting Procedure 476 Other Control Methods 477 Effectiveness of R&D Effort 481

23 Financial Planning and Control in a Service Company

487

Organizational Considerations 488 Data Classification 489 Cost of Services; Activity-Based Costing 490 Cost Accounting in a Service Organization 490 Planning System 492 Strategic Planning 498

24 Planning and Control of General and Administrative Expenses

499

Components of G&A Expense 499 Control over G&A Expenses 500 Reducing G&A Expenses 505 Budgeting G&A Expenses 509

25 Payroll Compensation 513 Federal Income Taxes 515 Social Security Taxes 517 Medicare Tax 517 State Income Taxes 518 Payroll Taxes for Employees Working Abroad Remitting Federal Taxes 519 Payroll Deductions for Child Support 520 Payroll Deductions for Unpaid Taxes 520 Unemployment Insurance 521

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518

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Contents

PART 4

PLANNING

AND

CONTROL

OF THE

BALANCE SHEET

527

26 Planning and Control of Cash and Short-Term Investments Objectives of Cash Planning and Control 530 Duties of the Controller Versus the Treasurer 530 The Cash Forecast 530 Cash Collections 542 Cash Disbursements 546 Internal Control 547 Reports on Cash 550 Cash Flow Ratio Analysis 553 Impact of New Information Technology and Organizational Structures Investment of Short-Term Funds 555

27 Planning and Control of Receivables

529

554

559

Granting Credit to Customers 559 Customer Margin Analysis 561 Collections Task 562 Measurement of Accounts Receivable 564 Control over Accounts Receivable 566 Budgeting for Accounts Receivable Balances

568

28 Planning and Control of Inventories

571

Costs and Benefits of Carrying Inventory 571 Role of the Controller 573 Material Requirements Planning Systems 575 JIT Manufacturing Systems 576 Inventory Reordering Systems 580 Obsolete Inventory 581 Reducing Inventory 583 Inventory Cutoff 584 Budgeting for Raw Materials 585 Budgeting for Work-In-Process 590 Budgeting for Finished Goods 591

29 Valuation of Inventories

595

Significance of Proper Inventory Valuation 595 Controller’s Responsibility for Inventory Valuation 596 Emphasis on the Cost Basis 596 Inventory Characteristics and Effect of the Valuation Base 597 Selection of the Cost Base 598 Departure from the Cost Base 599 Consistency in Valuation 600 Federal Income Tax Considerations in Valuing Inventories 600 Interim Statements 601 Other Inventory Valuation Problems 601 Inventory Reserves 602

30 Accounting and Reporting for Selected Investments and Employee Benefit Plans Improving the Investment Decision Process

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603

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Contents

xvii

Relevant Financial Accounting Standards 604 Role of the Controller 605 Accounting Records for Selected Investments 606 Financial Reports On Selected Investments 609 Accounting and Disclosure Requirements and Practices for Employee Benefit Plans 609

31 Planning and Control of Plant and Equipment or Capital Assets

623

Impact of Capital Expenditures 623 Controller’s Responsibility 624 Capital Budgeting Process 625 Establishing the Limit of the Capital Budget 626 Information Supporting Capital Expenditure Proposals 627 Methods of Evaluating Projects 628 Payback Method 629 Operators’ Method 630 Accountants’ Method 630 Discounted Cash Flow Methods 632 Hurdle Rates 636 Cost of Capital—A Hurdle Rate 637 Inflation 638 Foreign Investments 638 Impact of the New Manufacturing Environment 639 Impact of Activity-Based Costing 639 Classifying and Ranking Proposed Capital Projects 639 Board of Directors’ Approval 641 Project Authorization 645 Accounting Control of the Project 648 Postproject Appraisals or Audits 648 Other Aspects of Capital Expenditures 649

32 Management of Liabilities

659

Liabilities Defined 659 Objectives of Liability Management 660 Direct Liabilities 660 Illustrative Provisions of Credit Agreements 662 Planning the Current Liabilities 666 Standards to Measure and Control Current Liabilities Corrective Action 668 Risks of Too Much Debt 668 Some Benefits from Debt Incurrence 669 Sources of Information on Debt Capacity 669 Standards for Debt Capacity 669 Bond Ratings 670 Leverage 671 Contingencies 671 Long-Range Financial Plan 672 Managing Liabilities: Some Practical Steps 672 Accounting Reports on Liabilities 673 Internal Controls 674

33 Management of Shareholders’ Equity Importance of Shareholders’ Equity Role of the Controller 686

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685 686

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Contents

Growth of Equity as a Source of Capital 687 Return on Equity as Related to Growth in Earnings Per Share Growth in Earnings Per Share 688 Cost of Capital 688 Components of Cost of Capital 690 Calculating the Cost of Debt 691 Calculating the Cost of Equity 692 Calculating the Weighted Cost of Capital 694 Dividend Policy 695 Long-Term Debt Ratios 697 Other Transactions Affecting Shareholders’ Equity 698 Long-Term Equity Planning 698 Short-Term Plan for Shareholders’ Equity 704 Other Considerations 704

PART 5

FINANCIAL

AND

687

RELATED REPORTS

709

34 Internal Management Reports

711

Rules of Reporting 711 Status Reports 714 Margin Reports 714 Cash Reports 719 Capacity Reports 728 Sales and Expense Reports 730 Payroll Reports 730 Graphical Report Layouts 737

35 Reports to Shareholders

743

Purpose of the Annual Report to Shareholders 744 Controller and the Annual Report 744 General Contents of the Annual Report 744 Report of Management’s Responsibilities 755 Importance of Form 757 Standardization in Annual Reports 758 Other Reports to Shareholders 758 Information for Security Analysts and Investment Advisors

36 Securities and Exchange Commission Securities Act of 1933 762 Securities Exchange Act of 1934 762 Public Utility Holding Company Act of 1935 Trust Indenture Act of 1939 763 Investment Company Act of 1940 764 Investment Advisors Act of 1940 764 Regulation S-X 764 Regulation S-K 767 Regulation S-B 768 Regulation FD 768 SEC Forms 769 EDGAR Filing System 773 Going Private Transaction 775

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759

761

763

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Contents

PART 6

COMPUTER SYSTEMS

AND

RELATED TECHNOLOGY

37 Selecting a Financial Information System

xix

777 779

Reasons to Purchase Software 780 Ways to Define Systems Requirements 780 Existing System Documentation 782 Joint Sessions 783 Preparing the Request For Proposal 785 Distribution of the RFP 786 Review of the Vendor’s Completed Proposal 788 Reference Calls 792 Demonstration 792 Site Visits 793 Cost of the System 793 Final Selection 794 Contract Negotiations 794 Appendix: Vendor Evaluation Criteria 794

38 Testing Strategies for Financial Systems Testing Duration 797 Use of Real Versus Mock Testing Data Test Scenarios 798 Security Testing 799 Volume Testing 799 Issue Tracking and Resolution 799 Sign-Off Criteria 799 Testing Participants 800

797 798

39 Software Testing Testing Considerations 801 Testing Packaged Financial Systems Test Strategy 803

801 802

40 IT Support Models for Finance Organizations Inadequately Trained End Users 815 Need for Mixed Skill Sets 816 Geographic Challenges 816 Month-End Close Support 816 Staff Retention 816 Complicated Systems Architecture 817 Lack of an Established Escalation Process 817 Lack of Documentation 818 Changing Management Reporting Requirements

815

818

41 How Much Is Too Much? Asset Ledger Detail in ERP ERP Systems 819 Integration of the ERP and EAM Systems Grouping Approach 821

820

42 Systems Performance Management Define Your Organization’s Performance Methodology 824 Six Essential Steps: A Performance Methodology 825

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823

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Contents

Performance Details 827 Flow of Performance Information within the Organization

828

43 Information Security Systems

831

Types of Security Threats 832 Basic Security Principles 833 Components of an Effective Security Program 834 Enterprise Security Strategies 840 Controller’s Role in Information Security 841

44 Enforcing Information System Security Policy

843

Creating an Enforceable Information System Policy 844 Implementing Information System Security Policy 845 After an Information System Security Infraction Occurs 846

45 e-Commerce Security

851

e-Commerce Architectures 851 Critical Security Measures 854

46 Digital Signatures

861

Digital Signature Technology Overview 862 Demand for Digital Signature Technology 866 Legal Issues 867

47 Change Management

869

Defining the Change Management Challenge

870

48 Project Risk Management Project Risk Categories 880 Project Risk Management Approach

879 881

49 Effective Project Communications

887

Communication Program Overview 888 Communication Strategy 888 Communication Campaign Definition 891 Communication Plan 895

50 How to Implement a Successful CRM Solution Define a Business Case to Drive Shareholder Value Clearly Communicate the Change Imperative 900 Building a Winning Team 901 Prepare for the Worst 902

899 900

51 Organizations Large and Small Embrace Shared Services Executive Summary 904 About the Survey 904 Business Case 905 Implementation 906 Operations 908 Customer Relations 908 Next Steps 911

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Contents

PART 7

SOME ADMINISTRATIVE AND SPECIAL ASPECTS OF THE CONTROLLER’S DEPARTMENT

xxi

913

52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

915

History of Acquisitions and Mergers 916 Relation of Acquisitions to Corporate Objectives 916 Reasons for Divestments 917 An Overview of the Acquisition Cycle 917 Acquisition Criteria 919 Sources of Acquisition Information 920 Acquisition Team 921 Evaluating the Prospect: In-Depth Analysis 922 Objectives of Financial Analysis 928 Impact of Differing Accounting Policies 929 Valuation of an Acquisition 929 Comparing the Values 938 Multinational Business Valuation 939 Leveraged Buyouts (LBOs) 941 Accounting for a Business Combination: Purchase Method Tax Considerations in Acquisitions and Mergers 947 Financial Impact of an Acquisition 949 Financial Report on a Potential Acquisition 950 Mistakes by Management 962 Effective Integration 964 Divestments 965

53 Advanced Accounting Systems

943

967

Process Centering 967 Partnering 969 Internet 973 ISO 9000 976 Paperless Office 977 Electronic Cash 980 Virtual Corporation 982 Data Warehousing 984

54 World-Class Accounting Systems

985

Overview 985 Manufacturing Resource Planning 985 Integrated Distribution Management 988 Just-In-Time 993 Product Design 997 Computer-Integrated Manufacturing 1001

55 Accounting Best Practices Sixty-Six Best Practices

1005 1005

56 Reporting Period and How to Close It Selecting the Fiscal Year 1021 Selecting the Number of Interim Reporting Periods

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Contents

Reasons for Accelerating the Closing Period 1024 Value of Interim Reports 1024 How to Achieve a Fast Close 1025 Typical Fast Closing Schedule 1029 Reconciling Accurate Reporting against a Fast Close

1033

57 Outsourcing the Accounting Function

1035

Finding a Supplier 1035 General Advantages of Outsourcing 1037 Function-Specific Advantages of Outsourcing 1039 Risks of Outsourcing 1040 Contractual Issues 1042 Outsourcing Costs 1044 Personnel Issues Related to Outsourcing 1046 Management of Outsourcing Suppliers 1047

58 Preparation and Maintenance of Manuals

1053

Work Steps for Constructing a Procedures Manual 1054 Suggested List of Procedures 1057 Maintaining Accounting Manuals 1059 Responsibility for Maintenance of Manuals 1060 Specifications for Maintenance of Manuals 1060 Physical Construction of the Manual’s Binder 1061 Creation and Storage of the Master Manual Copy 1062 Creation and Maintenance of the Distribution Mailing List 1063 Physical Distribution Process 1064 Issuances to New Employees 1065 Manual Retrieval 1066 Benefits of Using Electronic Manuals 1066 Disadvantages of Using Electronic Manuals 1068 Basic Electronic Manual 1069 Electronic Manual with Embedded Hypertext 1069 Electronic Manual with Advanced Indexing Features 1072 Electronic Manual with Built-In Help Information 1073 Writing Tips for Electronic Manuals 1074 Example of Comprehensive Electronic Manual Features 1075 Using the PDF Format for Electronic Files 1076 Maintaining an Electronic Manual 1077

59 Records Management

1079

Record-Keeping Costs 1079 Record-Keeping Policies and Procedures 1080 Required Tax Records 1084 Computer-Based Record Keeping 1086

60 Inventory Tracking Differences Between Perpetual and Periodic Inventory Systems Setting Up a Perpetual Inventory System 1091 Auditing and Measuring a Perpetual Inventory System 1094 Physical Inventory Procedure 1095 Physical Inventory Complications: The Cutoff 1098 Reconciling Inventory Variances 1099

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Obsolete Inventory 1100 How to Avoid the Inventory Tracking Problem

1101

61 Tax Records and Procedures Tax Organization 1106 Centralized Tax Department 1107 Functions of the Tax Manager 1108 Tax Communications 1109 Tax Records in General 1109 Tax Calendar 1110 Tax Information Records 1110 Tax Working Papers and Files 1111 Internal Revenue Code and Record Requirements 1111 Differences Between Income Tax Accounting and Book Accounting Proper Classification of Accounts 1114 Other Taxes 1114 Income Taxes and Business Planning 1115 Special Tax Reports 1115

62 Risk Management

xxiii

1105

1113

1117

Risk Management Policies 1117 Risk Management Procedures 1118 Trends in Insurance Coverage 1121 Manager of Risk Management 1121 Types of Insurance Companies 1122 Claims Administration 1123 Insurance Files 1124 Annual Risk Management Report 1125

Appendix A

1127

Interest Tables Simple Interest Table 1127 Compound Interest (Future Amount of 1 at Compound Interest Due in N Periods) 1127 Compound Interest (Present Value of 1 Due in N Periods) 1128 Present Value of Ordinary Annuity of 1 per Period 1128 Future Amount of Ordinary Annuity of 1 per Period 1128

Index

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PART

THE BROAD MANAGEMENT ASPECTS OF CONTROLLERSHIP

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CHAPTER

1

ACCOUNTING IN THE CORPORATION 1.1 INTRODUCTION 3

1.4 ROLE OF THE CONTROLLER 6

1.2 TASKS OF THE ACCOUNTING FUNCTION 3

1.5 IMPACT OF ETHICS ON THE ACCOUNTING ROLE 7

1.3 ROLE OF THE ACCOUNTING FUNCTION 5

1.6 EVOLVING ROLE OF ACCOUNTING 9

1.1 INTRODUCTION Before a controller can delve into the speciﬁcs of the controller job description, it is ﬁrst necessary to determine how the accounting function ﬁts into the rest of the organization. This used to be a simple issue; the accounting staff processed transactions to support business operations — period. This required a large clerical staff managed by a small cadre of people trained in the underlying techniques for processing those transactions. In this environment, the stereotypical image of an introverted controller pounding away at a calculator was largely accurate. The role has undergone a vast change in the last few decades, as technological improvements, the level of competition, and a shifting view of management theory have resulted in a startlingly different accounting function. This section describes how the accounting function now incorporates many additional tasks, and can even include the internal auditing and computer services functions in smaller organizations. It then goes on to describe how this functional area ﬁts into and serves the needs of the rest of the company, and how the controller ﬁts into the accounting function. Finally, there is a discussion of how ethics drives the behavior of accounting employees, and how this shapes the way the accounting staff and controller see their roles within the organization. In short, this chapter covers the high-level issues of how the accounting function and its controller ﬁt into the modern company, not only to process its transactions, which was its traditional role, but also to provide additional services.

1.2 TASKS OF THE ACCOUNTING FUNCTION The accounting function has had sole responsibility for processing the bulk of a company’s transactions for many years. Chief among these transactions have been the processing of customer billings and supplier invoices. Though these two areas comprise the bulk of the transactions, there has also been a long history of delegating asset tracking to the accounting function. This involves all transactions related to the movement of cash, inventory, and ﬁxed assets. Finally, the accounting staff has been responsible for tracking debt, which can involve a continuous tracking of debt levels by debt instrument, as well as the payments made to reduce them. These have been the transactionbased activities of the accounting staff. A multitude of changes in the business environment have altered the role of the accounting function. One change has been the appearance of the computer services function. In a larger company, this function is managed within its own department and does not fall under the responsibility 3

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Ch. 1 Accounting in the Corporation

of the controller. However, it is common for the computer services group to fall under the management umbrella of the controller in a smaller company. Likewise, the internal auditing function frequently falls under the controller’s area as well. This function has expanded in importance over the last few decades as companies realize the beneﬁts of having an internal watchdog over key controls. Though it should report directly to the board of directors, it is common for a small internal auditing staff to report instead to the controller. It is becoming more common for the computer services and internal auditing functions to be integrated into the role of the accounting staff, especially in smaller companies. Besides adding new functional areas, the accounting staff has other new responsibilities that have arisen due to the increased level of competition. With worldwide barriers to competition crumbling, every company feels the pinch of lower competitive prices and now asks the accounting staff to provide analysis work in addition to the traditional transaction processing. These tasks include margin analysis on existing or projected product lines, geographic sales regions, or individual products. In addition, the accounting staff may even be asked to serve on new product design teams, so that they can determine the projected cost of new products, especially in relation to target costs. Further, the accounting staff must continuously review and report on nonproduct costs, which can range from advertising to utilities. This level of cost review and reporting calls for a different kind of accounting staff than the traditional kind that did nothing but process large volumes of transaction-related paperwork. It now requires highly trained cost accountants and ﬁnancial analysts, almost always with college degrees and professional certiﬁcations, to conduct the work. In addition, technology has drastically altered the skill levels required of the accounting staff. For example, employees must now know how to implement and operate accounting software, electronic data interchange systems, paperless systems using digitized documents, and electronic cash. Because most of these elements of technology directly impact the transaction processing staff, it is necessary to raise the standard of knowledge for these people. Consequently, the education level of even the lowest people in the accounting hierarchy must be improved to deal with changing circumstances. The world of business has become more international. Many companies are doing an increasing volume of business with companies based in other countries. This greatly increases the complexity of accounting, for a company must now determine gains and losses on sales to other countries. There may even be bartering transactions with organizations that do not have ready access to currency. In addition, if there is no separate ﬁnance function, the accounting staff may be called on to handle letters of credit and hedging transactions that are designed to reduce the level of risk that goes with foreign dealings. All of these issues call for a level of skill that was not required in the days of simple transaction processing. In the face of more intensive competition, many companies are also merging or acquiring subsidiaries. This adds a great deal of complexity to the accounting staff’s work, for it must now coordinate a multitude of additional tasks in other locations. This includes setting up standard procedures for the processing of receipts, shipments, and cash. Also, closing the ﬁnancial books at the end of each reporting period becomes much more complex, as the accounting staff must now coordinate the assembly and consolidation of information from multiple subsidiaries. Even if a company decides to consolidate all of its accounting facilities into one central processing location to avoid all this trouble, it still requires the management expertise to bring together the disparate accounting systems into a smoothly operating facility. This is not an easy task. The environment of mergers and acquisitions greatly increases the skill needed by the accounting staff. The tasks of the accounting function are itemized below. The tasks that belong elsewhere—but are commonly given to the accounting staff in a small company—are noted under a separate heading. • Traditional accounting tasks Accounts payable transaction processing Accounts receivable transaction processing Asset transaction processing Debt transaction processing

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• New accounting tasks Bartering transactions Coordination and consolidation of accounting at subsidiaries Currency translations Margin analysis Nonproduct cost analysis Selection, implementation, and operation of accounting software and related systems Target costing • New tasks assigned to the accounting function of smaller companies Computer services systems installation and maintenance Hedging and letter of credit transactions Internal auditing programs Given today’s highly volatile and ever-changing business environment, the only safe statement to make about the new activities presented in this section is that they will only become more complex, requiring even greater skill by the accounting staff to be accomplished in a manner that is both efﬁcient and effective.

1.3 ROLE OF THE ACCOUNTING FUNCTION Having noted the expanded number of tasks now undertaken by the modern accounting function, it is important to also note how the role of the accounting staff has changed in relation to the rest of the company. When the number of accounting tasks was more closely deﬁned around transaction processing, it was common for the accounting staff to be housed in an out-of-the-way corner of a business, where it would work without being impeded by other functions. Now, with a much greater number of tasks, the accounting staff ﬁnds itself involved in most major decisions. For example, the cost accountant is expected to serve on product design teams and to let other team members know if new designs will have costs that will meet targeted cost goals. An accounting analyst may be asked by the sales manager to evaluate the proﬁtability of a lease deal being extended to a customer. The controller is frequently asked to sit in on executive committee meetings to give opinions on the cash ﬂow issues for acquisitions or purchases. The accounts receivable clerk may work closely with the sales staff to collect overdue invoices from customers. For these reasons and others, the accounting function now ﬁnds itself performing a variety of tasks that make it an integral part of the organization. A particularly important area in which the role of the accountant has changed is related to processes. When another area of the company changes its operations, which is increasingly common, the accounting staff must devise alterations to the existing systems for processing transactions that will accommodate those changes. For example, if the manufacturing function switches to justin-time production or computer-integrated manufacturing, this has a profound impact on the way in which the accounting staff pays its bills, invoices customers, monitors job costs, and creates internal reports. Also, if the materials management staff decides to use material requirements planning or integrated distribution management, these new systems will issue information that is of great use to the accounting staff; it should connect its systems to those of the materials management staff to access that information. To alter its processes, the accounting staff must ﬁrst be aware of these changes, requiring the accounting staff to engage in more interaction with other parts of the company to ﬁnd out what is going on. The most historically important role that the accounting staff must change is that of being a brake on other activities. Because most accountants are trained in implementing controls to ensure that assets are not lost, the accounting staff tends to shoot down changes proposed by other departments — the changes will interfere with the controls. The accounting personnel must realize that changes put forward by other functions are not intended to disrupt controls, but to improve the

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Ch. 1 Accounting in the Corporation

company’s position in the marketplace or to increase its efﬁciency. This means that some controls must be modiﬁed, replaced, or eliminated. It is very helpful for the accounting personnel to have an open mind about altering systems, even when the new systems interfere with the accounting staff’s system of controls. In today’s increasingly competitive environment, it is very important for companies to develop strong relationships with their key suppliers and customers. These business partners will demand extra services, some of which must be fulﬁlled by the accounting staff. These changes may include using electronic data interchange transactions, providing special billing formats to customers, or paying suppliers by electronic transfer. If these steps are needed to retain key business partners, then the accounting staff must be willing to do its share of the work. Too frequently, the accounting staff resists these sorts of changes, on the grounds that all transactions must be performed in exactly the same manner. The accounting department must realize that altering its way of doing business is sometimes necessary to support ongoing business relationships. Altering the focus of the accounting staff from an introverted group that processes paper to one that works with other parts of a company and is willing to alter its systems to accommodate the needs of other departments is required in today’s business environment. This is in great contrast to the accounting department of the past, which had a minimal role in other company activities, and which was its conservative anchor.

1.4 ROLE OF THE CONTROLLER The controller has traditionally been the one who manages a few key transaction cycles, monitors assets, and delivers ﬁnancial statements. Though the details of the position are covered in Chapter 2 sufﬁce it to say here that the position has expanded to a great extent. As noted earlier in this chapter, the accounting function as a whole is now required to take on additional tasks, to work with other departments more closely, to continuously offer advice to senior management, and to alter systems to match the changing needs of other areas of the company. All of these changes have had a massive impact on the role of the controller within the organization. The key factor is that, due to the vastly increased interaction with other departments, the controller must be highly skilled in interdepartmental dealings. This involves constant interactions with fellow department heads, attendance at a swarm of meetings, and the issuance of opinions on a variety of topics regarding the running of functions with which the controller previously had no connection. Because of this changed role, the controller must now have top-notch interpersonal and management skills — the former to deal with other departments and the latter to oversee the changes needed by the other departments. In addition, the controller must govern a group of employees that is much more educated than was previously the case. This requires constant attention to the professional progress of each person in the department, which requires goal setting, mutual discussion of training requirements, and continuous feedback regarding employee performance. This clearly calls for management skills of an order far higher than formerly required of a controller that presided over a clerical function. Also, the wider range of functions managed by the controller now requires a wider range of knowledge. Besides the traditional training in accounting, a controller now needs at least a passing knowledge of computer systems, internal auditing, and administrative functions (because this area frequently falls under the controller’s area of responsibility). In addition, traditional accounting functions have now become more complex; a controller must know about outsourcing accounting functions and managing in a high-speed growth environment, as well as the increasing complexities of tax laws, Securities and Exchange Commission (SEC) ﬁlings, and generally accepted accounting principles. It would take a perpetual student to have an in-depth knowledge of all these areas, so it is more common for the controller to manage a cluster of highly trained subordinates who are more knowledgeable in speciﬁc areas, and who can advise the controller as problems arise. In short, the role of the controller has expanded beyond that of a pure accountant to someone with broad management and interpersonal skills who can interact with other departments, as well as manage the activities of an increasingly well-educated group of subordinates, while also working

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with them to further their professional careers. This is a much more difﬁcult role for the modern controller, requiring someone with at least as much management experience as accounting knowledge.

1.5 IMPACT OF ETHICS ON THE ACCOUNTING ROLE With the globalization of business, competition has become more intense. It is possible that the ethical foundations to which a company adheres have deteriorated in the face of this pressure. There have been innumerable examples in the press of falsiﬁed earnings reports, bribery, kickbacks, and employee thefts. There are vastly more instances of ethical failings that many would perceive to be more minimal, such as employee use of company property for personal use, “smoothing” of ﬁnancial results to keep them in line with investor expectations, or excessively robust sales or earnings forecasts. The controller and the accounting staff in general play a very large role in a company’s ethical orientation, for they control or have some inﬂuence over the primary issues that are most subject to ethical problems—reported earnings, cash usage, and control over assets. This section discusses how the accounting function can modify a company’s ethical behavior—for good or bad. The accounting function can have a serious negative impact on a company’s ethical standards through nothing more than indifference or lack of caring. For example, if the controller continually acquiesces to management demands to slightly modify the ﬁnancial statements, this may eventually lead to larger and larger alterations. Once the controller has set a standard for allowing changes to reported earnings, how can the controller deﬁne where to draw the line? Another example is when the accounting staff does not enforce control over assets; if it conducts a ﬁxed-asset audit and ﬁnds that a television has been appropriated by an employee for several months, it can indirectly encourage continuing behavior of this kind simply by taking no action. Other employees will see that there is no penalty for removing assets and will then do the same thing. Yet another example is when the accounting staff does not closely review employee expense reports for inappropriate expenditures. Once again, if employees see that the expense report rules are not being enforced, they will gradually include more expenses in their reports that should not be included. The accounting staff has a signiﬁcant negative inﬂuence over a company’s ethical standards simply by not enforcing the rules. The previous argument can be turned around for an active accounting department. If the controller and the rest of the accounting staff rigidly enforce company policies and procedures and acquire a reputation for no deviations from these standards, the rest of the corporation will be dragged into line. It is especially important that the controller adhere closely to the highest standards, for the rest of the accounting staff will follow the controller’s lead. Conversely, if the controller does not maintain a high ethical standard, the rest of the accounting staff will have no ethical leader, and will quickly lapse into apathy. Accordingly, the controller is a company’s chief ethics ofﬁcer, for the position has such a strong inﬂuence over ethics. It is a rare week that passes without some kind of ethical quandary ﬁnding its way to the controller for resolution. It is not sufﬁcient to merely say that the accounting staff must uphold high ethical standards, if the standards are not deﬁned. To avoid this problem, the controller should create and enforce a code of ethics. This document may not originate with the controller—many chief executive ofﬁcers (CEOs) prefer to take on this task. However, the controller can certainly push for an ethical code to be developed higher in the organization. Some illustrative topics to include in a code of ethics are: • Bidding, negotiating, and performing under government contracts • Compliance with antitrust laws • Compliance with securities laws and regulations • Conﬂicts of interest • Cost consciousness • Employee discrimination on any grounds • Gifts and payments of money

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Ch. 1 Accounting in the Corporation

• Hazardous waste disposal • International boycotts • Leave for military or other federal service • Meals and entertainment • Political contributions • Preservation of assets • Restrictive trade practices • Standards of conduct • Use of company assets • Workplace and product safety The wide range of ethical topics, some going well beyond the ﬁnancial arena, make it obvious that the CEO really is the best source of this document, rather than the controller, though the controller can certainly contribute to those portions relating to ﬁnancial issues. Once the code of ethics has been created, it must be communicated to all employees. Once again, this is the CEO’s job, but the controller should constantly reinforce it with his or her staff. It is especially helpful if the controller visibly refers to the ethical code whenever an ethical issue arises, so that the accounting staff knows that the controller is decisively adhering to the code. A code of ethics becomes the starting point in the series of judgments a controller must follow when confronted with an ethical issue. The logical series of steps to work through are: • Consult the code of ethics. Having a corporate code of ethics is a great boon to the controller, for he or she can use it as the basis for any ethics-related decision. A senior company ofﬁcer would have difﬁculty forcing the controller to adopt a different course of action than what is prescribed by the code of ethics, since this would go against a directive of the Board of Directors. If the controller feels it is necessary to take a course of action contrary to what is stated in the code, then the reasons for doing so should be thoroughly documented. If there is no code, then proceed to the next step. • Discuss with immediate supervisor. The controller’s immediate supervisor is probably either the Chief Financial Ofﬁcer (CFO), Chief Operating Ofﬁcer (COO), or CEO. These are the most senior positions in the company, occupied by people whose behavior should be at an ethically high standard. Consulting with them for advice is a reasonable second step in the absence of a code of ethics. However, if the supervisor is the one causing the ethical problem, then skip this step and proceed to the next one. • Discuss with a trusted peer. There is usually someone within the company in whom the controller places a great deal of trust. If so, consult with this person in regard to the proper course of action. Be more circumspect in doing so with a person outside the company, since this runs the risk of spreading information elsewhere, with possible deleterious consequences. If there is no one with whom to discuss the issue, then proceed to the next step. • Discuss with the company’s ethics committee. If there is an ethics committee, this is a good forum for discussion. Unfortunately, many companies do not have such a committee, or it meets so infrequently that the immediate needs of the controller may not be met through this approach. In either case, proceed to the next step. • Discuss with the Board’s audit committee. Many boards have an audit committee, which should be comprised entirely of independent directors. If so, the controller should take his or her concerns to this group. Keep in mind that this is a serious step, since the controller is now going around the corporate reporting structure, which may have unenviable consequences later on if the controller chose not to tell senior management of this action. • Consider leaving the company. If all these avenues are untenable or result in inadequate advice, the controller should seriously consider leaving the company in the near future. Reaching this ﬁnal step probably means that the ethical issue is caused by senior manage-

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ment, and also that there are no outside checks on their ethical behavior, such as an audit committee of the Board of Directors. It is extremely important that the controller issue consistent rulings on ethical issues, so that employees know they are being treated fairly. Though it may seem like a vast increase in paperwork, it may be useful for the controller to record all ethical rulings in a single document, so that there is a good reference source in the event of future ethical problems. This allows the controller to go back and see what judgment was given in previous cases, thereby giving the controller adequate grounds for treating new issues in a similar manner. In summary, the accounting staff has a large role in enforcing ethical standards throughout a company, since it has such strong inﬂuence over several key areas that require ethical judgments, such as the quality of reported earnings, control over assets, and the uses of cash. Accordingly, it is very much in the controller’s interests to have a code of ethics that the accounting staff can adhere to in enforcing the appropriate ethical standards.

1.6 EVOLVING ROLE OF ACCOUNTING Though there are many variables that can impact the direction of the accounting function and the controller’s role in the future, there are a few broad trends that are likely to continue, and from which one can predict the evolving role of accounting. The accounting function is in the midst of a fundamental change from being a clerical group without signiﬁcant training to a cadre of very experienced technicians and managers. Though there will always be a need for clerical help (indeed, this group will continue to comprise the majority of the department), there will be an increasing focus on bringing in more experienced personnel. This prediction is based on the technological trend that brings continued levels of automation to the accounting function, thereby reducing the need for clerks. Also, the same trend toward more technology means that a greater proportion of the accounting employees must have better training in how to use the new hardware and software. These trends will force the accounting department of the future to stock up on highly trained personnel with good management skills. The accounting department is likely to become a more common route to top management positions. The accounting area has always been a fertile one for training people in the nuts and bolts of transactions, and how they must function. This is useful for a lower-level manager, but now that the department also handles a multitude of additional tasks, such as cost analysis, target costing, and advanced ﬁnance functions, it becomes a much better training area for higher-level managers. The company of the future will not only see large numbers of well-trained people advancing out of accounting, but they will also see a large proportion of new recruits clamoring to get into it, so that they too can receive the necessary training and experience. This section discussed some evolutionary changes to expect in the role of the accounting function and the controller. It is likely that there will be a decrease in the proportion of purely clerical positions in the accounting area, in favor of more senior personnel with extra technical and management skills. Also, because of the greater breadth of responsibility to be obtained in this area, it will become more common for senior management personnel to come out of this area.

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CHAPTER

2

CONTROLLER’S RESPONSIBILITIES 2.1 INTRODUCTION 11

2.8 CONTROLLER’S JOB DESCRIPTION 16

2.2 VARIATIONS ON THE TITLE 11 2.9 RELATIONSHIP OF THE CONTROLLER TO THE CHIEF FINANCIAL OFFICER 18

2.3 PLANNING FUNCTION 12 2.4 CONTROL FUNCTION 12 2.5 REPORTING FUNCTION 13

2.10 FUTURE CHANGES IN THE CONTROLLER’S ORIGINS AND RESPONSIBILITIES 19

2.6 ACCOUNTING FUNCTION 13 2.7 ADDITIONAL CONTROLLER FUNCTIONS IN SMALLER COMPANIES 14

2.11 MANAGING EXPLOSIVE GROWTH 20

2.1 INTRODUCTION A controller’s job can vary dramatically based on a company’s size and whether it has other managers in place who handle related functions. If a company is small and there are few other managers, the controller may end up with a formidable list of tasks on the job description. However, as a company grows in size, the role becomes more precisely and narrowly deﬁned. This chapter covers the full range of the activities that may be assigned to a controller, beginning with the classical management areas of planning, controlling, reporting, and maintaining key accounting processes, and expanding into ancillary functions that may become part of the controller’s job, depending on the circumstances. In addition, the chapter touches on variations in the controller’s title, and why the term controller, though most commonly used, is perhaps not the best description for the job. The chapter concludes with a review of the relations between the controller and chief ﬁnancial ofﬁcer (CFO), the future job description of the controller, and how to manage in an explosive growth environment. This wide-ranging discussion gives the reader a comprehensive view of the controller’s job.

2.2 VARIATIONS ON THE TITLE Numerous titles can be applied to the position of the chief accounting ofﬁcer; however, the most common title used is controller. The duties are sometimes assumed by a chief accountant, ofﬁce manager, comptroller, treasurer, assistant treasurer, or secretary. However, with the increased emphasis on accounting control, increased management duties, and for additional statistical and ﬁnancial decision-making information, the duties of the position are more frequently being segregated into the role of a separate manager called the controller. This is especially true in larger organizations, where there is much more specialization. The term controller is an unfortunate one, for it seems to emphasize the control function only; as the reader will ﬁnd after reading this chapter, there are a number of other basic functions this person performs, such as planning, reporting, and management, that are just as important as the control function. The chief accounting ofﬁcer (CAO) title is a more complete description of the position; however, due to common usage, the term controller will have the same meaning as CAO in this book. 11

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Ch. 2 Controller’s Responsibilities

2.3 PLANNING FUNCTION The establishment and maintenance of an integrated plan of operation is a major function of the controller. The business objective is proﬁt, and planning is necessary to fulﬁll it, for proﬁts do not “just happen.” Visualize, then, the role of the modern controller in business planning. First, there is a responsibility to see that a plan exists and that it is supported by all levels of management. The implication of an integrated plan is that all parts will link together to support the business objective. For this reason, all members of management must participate willingly and contribute to the information in the plan. It must be the company’s plan and not the controller’s plan. The controller’s primary task is to act as the coordinator who assembles and maintains the plan, which results in a statement of forecasted income and expense, as well as a set of supporting schedules and assumptions. In more detail, the following points describe the controller’s key tasks related to the plan: • Verify that the sales plan or forecast supports known corporate policies and objectives, such as geographic areas to enter and types of products to sell. • Verify that the sales plan appears to have realistic assumptions, such as an expected sales amount per salesperson that is valid based on past history. • Verify that the production plan supports the sales schedule. This involves comparing the amount projected to be sold to the amount to be produced, while factoring in the amount of ﬁnished goods inventory already on hand. • Verify that the production plan is within facility capabilities. This involves comparing projected production volumes to the company’s history of production rates, also factoring in the addition of extra shifts. • Verify that expense levels are in proportion to other activities. For example, the utilities expense must go up if the company is adding a facility, while the travel expense must increase if there will be a larger sales staff. • Verify that there is sufﬁcient funding for the projected activity. If there is not a sufﬁcient amount of debt or equity funding, the plan must be recast on a smaller scale. Once the plan has been completed, the controller should test or appraise its adequacy and report to the CFO or chief executive ofﬁcer (CEO) on the results of this analysis. It must be judged based on the following concerns: • In light of past experience, is it realistic? • Does it reﬂect economic conditions that are expected to prevail in the period of the plan? • Have the related expenses for product lines designated to be discontinued, such as production equipment or inventory disposal, been considered? • Does it meet the company’s requirements for return on investment and such other ratio or other tests as may be applicable? Some of the testing and analysis will be accomplished as preliminary plans are formulated, and the rest will await the total picture. However and whenever it is done, the controller is the counselor and coordinator, extending advice and suggestions to all who need it during the plan preparation. Final responsibility for the plan rests with the CEO, and responsibility for each operating function must be that of the manager in charge of each function. Nonetheless, though responsibility for the plan lies elsewhere, the controller should be deeply immersed in the underlying mechanics and assumptions of the plan; the company relies on the controller to perform this function.

2.4 CONTROL FUNCTION The management function of control is the measurement and correction of performance so that business objectives and plans are accomplished. Management control seeks to compel performance to a plan or standard. The controller assists in this function by providing information to the managers

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2.6 Accounting Function

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of each function, so that they can enforce control-related issues. The controller cannot enforce control issues in other departments, since there is no managerial oversight of those areas, but the controller does correct control-related problems within the accounting function. Activities in the control function absorb a large portion of the accounting staff’s time. Some control information is provided to management by the accounting staff every day; other data are prepared less frequently, as circumstances require. For example, larger companies that are labor intensive may ﬁnd that hourly or daily information on labor performance may be helpful, or weekly manufacturing expense ﬁgures may be needed. However, the controller’s involvement does not end with the mere feedback of reporting information to various parts of a company. Instead, the controller must devote a great deal of time to ﬂowcharting existing systems, examining the results for control issues, and implementing process changes that will eliminate the control problems. Only after all this activity will a controller be able to issue reports on the results of controls. A manager cannot control the past. Instead, one can study past action to determine the place and cause of deviation. Here, as in planning, the best kind of control is forward looking. The controller must keep this orientation in mind while participating in the control function, giving constant thought to steps that might be taken before the operating action to ensure the desired performance level. This is preventive or anticipatory control. A controller must become heavily involved in all stages of the control function, which extends from system analysis through problem identiﬁcation and change implementation, ending in control reports that note the results of the control alterations. This is one of the most crucial tasks for the controller.

2.5 REPORTING FUNCTION Insofar as it concerns internal management, the reporting function is closely related to both the planning and control functions. Reporting is essential to make planning and control effective. Yet the reporting function is not merely one of presentation of tabulations and is not wholly routine, although some phases can be automated. Moreover, the management that makes decisions often cannot be kept adequately informed solely from periodic statements regardless of how well designed they may be. The reporting function encompasses the interpretation of the ﬁgures, and the controller’s duty is not discharged until management actually understands what is being presented. Ensuring that management understands what it reads calls for an entirely separate set of skills than those given a controller in business school. This requires constant informal meetings with all recipients of accounting reports, not only to go over excessively large variances, but also simply to ensure that they understand what they are reading. A good supplemental method is to construct a formal training program that describes the nature and signiﬁcance of the information being issued, and to constantly update and again present this training to management. Even a quarterly reiteration of the training is not always sufﬁcient. In addition, the controller may be required to report to outside entities, which usually calls for some reformatting of the internal reports. Typical recipients of reports are shareholders, creditors, the general public, customers, the Securities and Exchange Commission (SEC), and the Internal Revenue Service (IRS). The controller is not only responsible for assembling data on a large number of topics into easily readable reports for consumption both inside and outside the company, but also for ensuring that the recipients understand what they are given.

2.6 ACCOUNTING FUNCTION The systematic recording of ﬁnancial transactions is often regarded as the principal function of the controller. The controller is expected to apply sound accounting principles and practices within the company, as well as to stay current on the latest technological advances, so that this can be done in the most effective and efﬁcient manner possible. The last few decades have revealed fur-

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ther advances in management theory that a controller is now expected to implement in the accounting function, including: • Benchmarking key practices. A controller should regularly compare the performance of the accounting department for various tasks against the results of other accounting functions at other companies, not necessarily in the same industry, to see if anyone else is doing it better, and, if so, to copy their practices into the accounting department. This results in a major improvement in the department’s operating effectiveness. • Converting to electronic transactions. Many of the larger companies now send transactions to each other with electronic data interchange, rather than with paper-based transactions. This is a boon to the accounting department, because the transactions can be automatically entered into the accounting computer system (since it is already in electronic format) without any error-prone manual rekeying of information. • Reducing cycle time. The controller should actively engage in cycle time reduction, so that the time required to complete the primary transactions are greatly reduced. This allows a company to act more quickly, as well as to generate information about the results of its actions, both of which allow it to compete at a higher level. • Outsourcing accounting functions. The controller should look into handing some or all accounting functions over to suppliers who are better equipped to handle key transactions. For example, many companies now outsource their payroll processing to suppliers that calculate taxes, make tax deposits, and pay employees by direct deposit. The controller should review this option for other accounting functions, too. • Reengineering key functions. Some accounting functions may require so much effort to complete that it is best to scrap the system and start with a new approach that vastly reduces the effort, error rate, and cost of the old function. All of these new methodologies ensure that today’s controller will be armed with enough tools to greatly improve the operational effectiveness of the accounting function.

2.7 ADDITIONAL CONTROLLER FUNCTIONS IN SMALLER COMPANIES The controller of a smaller company will ﬁnd that the position includes a number of additional tasks besides those already enumerated in the last section. This is because a small company cannot afford to also hire a CFO, an ofﬁce manager, a computer services manager, and a human resources director. Consequently, all of these functions may fall on the controller. When applying for a controller position with a small company, it is useful to see if these other positions are ﬁlled — if not, the controller will have a much wider range of job activities. The main activities in each of those areas will probably fall under the controller’s managerial umbrella. The most common additional functions that a controller will take on are those in the ﬁnance area. These tasks are normally handled by the CFO, which is a position that many small companies dispense with if they have minimal funding needs or are not publicly held. The primary tasks of the ﬁnance function are: • Acquiring insurance coverage • Conducting public offerings • Dealing with investors • Dealing with lenders • Determining customer credit levels • Investing pension funds • Investing surplus funds Of the tasks normally handled by a CFO, the controller usually has little trouble in managing insurance, credit, and investment decisions. However, conducting a public offering is usually well

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outside the experience of most controllers, and so it would behoove a controller to recognize this inadequacy and bring in qualiﬁed help if a company decides in favor of a public offering. A small company, usually one with less than 100 employees, frequently does not have a human resources manager. This means that the function, once again, must be managed by the beleaguered controller. Many of these new functions are administrative and procedural in nature — tasks for which most controllers are amply qualiﬁed. However, others, such as career planning and recruiting, are not. These later tasks are sometimes shifted elsewhere in the organization, depending on who is most qualiﬁed to handle them. The most typical human resources functions are: • Administering changes to the pension plan • Administering new-employee paperwork • Conducting employee safety training • Conducting recruiting for all positions • Devising a career plan for key managers • Maintaining employee ﬁles • Processing medical claims • Processing workers’ compensation claims • Updating the employee manual Given the large proportion of clerical tasks in the human resources function, which are similar to the clerical functions of the accounting area, most controllers are fairly comfortable in administering this department. Some tasks, such as safety training and administering the pension plan, require some extra knowledge to handle. The most uncommon tasks for a traditional controller are creating stafﬁng plans and recruiting. These tasks are so different that the CEO sometimes hands them off to someone else in the organization. The most common additional function for the controller to manage is administration. This includes the secretarial pool (if any), the reception function, all ofﬁce equipment, and the telephone system. Because this area impacts all functions, it is common to have a disproportionate volume of complaints about it that take up an excessive amount of a controller’s time. Accordingly, it is frequently handed off to an assistant controller. In addition, it is wise to outsource the repair and maintenance of all ofﬁce equipment and the telephone system to a qualiﬁed supplier. This reduces the controller’s day-to-day management to contacting suppliers and ensuring that the administrative staff is supplemented by a sufﬁcient number of temporary help to complete short-term projects, such as special mailings, that pass through this area. The most common administrative functions are: • Answering incoming calls • Ensuring that all copiers and fax machines are operational • Ensuring that the telephone system is operational • Managing administrative staff • Planning for the timely replacement of aging ofﬁce equipment • Sorting and delivering incoming mail • Stamping outgoing mail • Working with temporary help agencies to bring in personnel for special projects Finally, the controller sometimes manages the computer services function. Most small companies maintain only the minimum number of computer applications, and these are usually packaged software, which allows them to avoid a full-time department to handle this function. Instead of a separate department, the controller is in charge of backing up the computer system, ensuring that it is repaired promptly, that the system is expanded as the situation requires, and that new software is implemented in an efﬁcient manner. Due to the highly technical nature of this work, a controller is well advised to outsource as much of this work as possible rather than dealing with it internally; not only does this approach reduce the controller’s workload, but it also brings in much more qualiﬁed

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personnel than most small companies can afford to keep in-house. The main computer services functions are: • Backing up the computer system • Enforcing computer security standards • Expanding the systems as needed • Installing new hardware and software as needed • Maintaining all hardware and software • Maintaining and repairing the computer network • Providing system training to employees The controller must be especially careful to make provisions for system crashes. This means that there must not only be daily backups of the software, but also off-site storage of the backups to ensure that they are not damaged if the main facility is destroyed. This should also include power backup systems to ensure that the computers remain operational even if the main power source goes down. The controller should also consider a disaster recovery plan that details how to make the system operational again as soon as possible in the event of a major problem. Though other parts of the computer services function can be outsourced, this one must be handled internally, and correctly — if the controller does not prevent a serious computer crash that renders key systems inoperable, this may have a major, and negative, impact on senior management’s view of how the controller is performing. There are additional areas that the controller of a smaller company may ﬁnd him- or herself supervising. The most likely areas are human resources, administration, computer services, and ﬁnance. The controller is well advised to outsource as much of this extra work as possible in order to put it in the hands of experts from suppliers, while also handing off selected tasks to other members of the organization who may be more qualiﬁed to perform them. The remaining tasks must be managed by the controller or a subordinate. Because these are areas in which most controllers are only partially trained, this can involve a very rapid and intensive learning experience.

2.8 CONTROLLER’S JOB DESCRIPTION Though the previous sections brieﬂy discussed a number of the main aspects of the controller’s job, they do not show a complete view of the position’s responsibilities. This section answers that need by showing a complete controller job description. If a controller needs a job description for a company procedures or human resources manual, the description noted here is in sufﬁcient detail to be “lifted” out of this book for immediate use, with some modiﬁcation based on each controller’s circumstances. The description is summarized into subheadings, so that tasks are noted under such categories as ﬁnance, human resources, or computer services, which allows the reader to ignore those broad functional areas that do not apply to him or her. The tasks are noted in the order in which they are most likely to be the controller’s responsibility, starting with accounting, ﬁnance, and administration, and then progressing through the computer services and human resources functions. Also, the description assumes that there is a staff handling all transactions, so it does not refer to actually handling speciﬁc transactions, only ensuring that they are correct. The description is as follows: • Position Title: Controller • Reports To: Chief Financial Ofﬁcer • Supervises: All accounting, ﬁnance, administration, computer services, and human resources personnel (varies by size of company and presence of other managers). • Tasks: Accounting Assist in the annual audit as required. Ensure that accounts payable are not paid earlier than required.

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2.8 Controller’s Job Description

Ensure that accounts receivable are collected promptly. Ensure that all reasonable discounts are taken on accounts payable. Ensure that customer billings are issued promptly. Ensure that job costs are calculated. Ensure that the monthly bank reconciliation is completed. Issue interim management reports as needed. Issue timely ﬁnancial statements. Maintain an orderly accounting ﬁling system. Maintain the chart of accounts. Manage outsourced functions. Manage the accounting staff. Manage the production of the annual plan (budget). Process payroll in a timely manner. Provide ﬁnancial analyses as needed. Review systems for control weaknesses. Finance

Arrange for banking services. Arrange for debt ﬁnancing. Conduct public offerings. Invest excess cash. Invest pension funds. Issue credit to customers. Maintain insurance coverage. Maintain lender relations. Manage the ﬁnance staff. Monitor cash balances. Administration

Bring in temporary personnel for special projects. Ensure that incoming mail is properly distributed. Ensure that ofﬁce equipment is operational. Ensure that outgoing mail is sent in a timely manner. Manage outsourced maintenance work. Manage the secretarial staff. Upgrade ofﬁce equipment as needed. Computer Services

Back up the computer system. Implement hardware and software. Maintain a current disaster recovery plan. Maintain computer security systems. Manage the computer services staff. Manage outsourced functions. Provide system training. Select hardware and software. Human Resources

Administer safety training.

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Administer the pension plan. Maintain employee beneﬁts paperwork. Maintain employee ﬁles. Maintain employee manual. Manage career planning. Manage the human resources staff. Process medical claims. Process workers’ compensation claims. Recruit employees. This generic and very wide-ranging controller job description can be used as the basis for a more customized description that is tailored to individual circumstances.

2.9 RELATIONSHIP OF THE CONTROLLER TO THE CHIEF FINANCIAL OFFICER In a larger company, there is a clear division of tasks between the controller and the CFO. However, there is no clear delineation of these roles in a smaller company, because there is usually no CFO. As a company grows, it acquires a CFO, who must then wrestle away some of the controller’s tasks that traditionally belong under the direct responsibility of the CFO. This transition can cause some conﬂict between the controller and CFO, which is discussed in this section. In addition, the historical promotion path for the controller has traditionally been through the CFO position; when that position is already occupied, and is likely to stay that way, there can be some difﬁculty with the controller. This section also discusses that issue. In a small company, the controller usually handles all ﬁnancial functions, such as setting up and maintaining lines of credit, cash management, determining credit limits for customers, dealing with investors, handling pension plan investments, and maintaining insurance policies. These are the traditional tasks of the CFO, and when a company grows to the point of needing one, the CFO will want to take them over from the controller. This can turn into a power struggle, though a short-lived one, because the controller always reports to the CFO and will not last long if there is no cooperation. Nonetheless, this is a difﬁcult situation, for the controller has essentially taken a step down in the organizational structure upon the arrival of the CFO. For example, the CFO replaces the controller on the executive committee. If the controller is an ambitious one, this will probably lead to that person’s departure in the near term. If the controller is a good one, this is a severe loss, for someone with a detailed knowledge of a company’s processes and operating structure is extremely difﬁcult to replace. The controller should take a job elsewhere if he or she perceives that the person newly ﬁlling the CFO position is a roadblock to further advancement. However, this does not have to be a dead-end position. The controller should talk to the CFO about career prospects within the company and suggest that there may be other responsibilities that can replace those being switched to the CFO. For example, a small minority of controllers manage the materials management department; this will become increasingly common as controllers realize that much of the paperwork they depend on originates in that area and that they can acquire better control over their processes by gaining experience in this area. There may also be possibilities in the areas of administration, human resources, and computer services, which are sometimes run by controllers. The fact that there is a new CFO does not mean that a controller should immediately quit; there may be other opportunities involving related tasks that can shift the controller’s career in other directions. The CFO position is one with an extreme emphasis on money management, involving such tasks as determining the proper investment vehicles for excess cash, dealing with lenders regarding various kinds of debt, making presentations to ﬁnancial analysts, and talking to investors. None of these tasks are ones that the controller is trained to perform. Instead, the traditional controller training involves handling transactions, creating ﬁnancial statements, and examining processes. The requirements for the CFO position and the training for the controller position are so different

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that it seems strange for the controller to be expected to advance to the CFO position, and yet that is a common expectation among accountants. As noted in the next section, the controller may not want to assume that the CFO position is an obvious next step, and that perhaps the controller position may now lead into other management areas. There can be some difﬁculty between the controller and the CFO, especially when a CFO is brought in for the ﬁrst time. This commonly results in the departure of the controller if that person perceives that the next promotion step is the CFO position. This problem can be ameliorated by looking for opportunities to shift the controller into other functional areas. These opportunities are noted in the next section.

2.10 FUTURE CHANGES IN THE CONTROLLER’S ORIGINS AND RESPONSIBILITIES The accounting function has changed drastically over the last half-century, and the controller has changed along with it. Where the position used to require someone with a tight focus on processing transactions and ﬁnancial statements, the job now requires much more managerial skill, as well as a general idea of such diverse bodies of knowledge as taxation, business process improvement, outsourcing, and computer systems. This calls for a controller with a much more diverse background than was previously the case. It also points toward a different career direction for the controller of the future. The controller of the future will come from a different educational and experience background. Most companies currently call on the “Big Four” auditing ﬁrms for their controllers, and many auditors enter the Big Four on the assumption that they will eventually be hired by their clients into that role. However, auditors are trained in the areas of generally accepted accounting principles, verifying the accuracy of ﬁnancial statements, and reviewing underlying accounting processes to ensure that they function correctly. Though these tasks are still part of the controller’s job description, and will remain so for the foreseeable future, an increasing proportion of the controller’s job now includes tasks for which an auditor is not prepared. These new tasks include computer systems selection, implementation, and management, as well as outsourcing, cycle time reduction, benchmarking, and process reengineering. Because of these new tasks, company management will ﬁnd that it can ﬁll the position with more thoroughly qualiﬁed personnel from other sources. One source will be the certiﬁed management accountant (CMA) program, which emphasizes a greater body of knowledge than the certiﬁed public accountant (CPA) exam. The better companies will also look to consulting ﬁrms for people with a detailed knowledge of process improvement and systems management. Finally, top management will eventually realize that controllers do not have to be CPAs; on the contrary, it will be more important to have good management skills and be surrounded by a team of highly qualiﬁed accounting professionals who can advise on the more technical accounting issues. In short, controllers will come from other sources than auditing ﬁrms, because that source no longer provides people with a complete set of skills. The future direction of the controller position is probably toward something with much more responsibility. Companies are competing more and more on such issues as rapid cycle times and low costs, and the controller is an integral part of the work required to improve them. As management realizes that the controller has an enormous impact on these most critical competitive areas, it will place the controller in charge of them. This means that the controller of the future will become more of a chief process ofﬁcer (CPO), with general authority to alter processes. This function will cross department lines as much as the processes that the controller is ﬁxing, so the position must have added authority to make changes. This added authority will raise the controller in the management hierarchy to a point above those of other department heads. We may also ﬁnd that the controller will be more likely to manage new areas that are heavily driven and inﬂuenced by processes, especially materials management. The controller of the future will occupy a more inﬂuential position, due to his or her inﬂuence over company-wide processes. As the controller position adds company-wide processes to its area of authority, the controller will ﬁnd that, due to this extra responsibility, promotional opportunities will veer away from the CFO position and toward the chief operating ofﬁcer (COO) position. This does not mean that there

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will be a wholesale abandonment of the CFO position, since that remains the goal of most controllers, but controllers will have such an in-depth knowledge of all of a company’s operations that they will become the ﬁrst choice for promotion to be COO, or at least be one of the heavy favorites for the position. There are changes already underway that are preventing many controllers from reaching the coveted CFO position, and which may provide further impetus in the direction of promotions to the COO position. The trouble with the CFO position is that its job requirements are signiﬁcantly different from those of a controller, and few controllers are trained to take over the job. It involves lender and investor relations, as well as making the proper investments of spare cash. The job requirements for the CFO position really call for someone with experience in the treasury side of the business, or perhaps from Wall Street, to take it over. If we do see CFOs being promoted from directions other than the controller position, this also calls into question the traditional reporting relationship that has the controller reporting to the CFO. If the CFO does not have a background that yields any knowledge of the accounting ﬁeld, then it does not make much sense to have that person control the function. Instead, it may become more appropriate to have the controller report straight to the CEO, alongside the CFO. Due to the new sources of CFO hiring, there are ample reasons for shifting the controller out from under the management of the CFO. The controller of the future may come from many sources, rather than straight from an auditing ﬁrm, and that the promotion path of the position will include the COO position, rather than the usual CFO position. This path will open up because the controller will become more involved in company-wide positions, as well as because CFOs will increasingly be drawn from the ranks of Wall Street.

2.11 MANAGING EXPLOSIVE GROWTH A controller sometimes ﬁnds him- or herself in a situation in which a company has just released a “hot” product, it embarks on a massive expansion of sales territories or it goes on an acquisition binge, either of which result in a phenomenal rate of growth. This frequently results in a difﬁcult situation for the controller, because there are never enough resources to handle the ﬂood of transactions swamping the department. This section discusses how to prioritize tasks in such an environment. It also notes the same issues for the ﬁnance, computer services, and human resources functions, in case the controller is in charge of those areas as well. In an explosive growth environment, the key focus of the accounting staff is on the conservation of cash. This is because a growing company is constantly investing cash in working capital and facilities, leaving little cash available for further growth or as a reserve in case of a sudden downturn in company fortunes. The controller plays a major part in cash conservation. The following points note the most important areas in which the controller can affect cash ﬂow: • Send invoices promptly. It is difﬁcult to collect cash from customers if they have not yet been billed. To avoid this problem, the controller must pay strict attention to the billing process, especially the speed with which invoices are created and sent. This may also involve a switch to electronic invoicing, an alteration in payment terms to encourage faster payment, or delivery of the invoice with the shipment. Any of these system modiﬁcations will result in a faster cash ﬂow. • Collect accounts receivable promptly. Increasing the speed of collections also improves the cash ﬂow. The controller can do this by adding more staff to the collections effort, concentrating the bulk of the collection effort on the largest overdue invoices, working closely with the sales staff to obtain payments, concentrating on issuing accurate invoices that customers cannot complain about, and tightening the terms of credit being offered; all of these actions will slowly improve the speed of collection. • Minimize mistakes. Customers do not pay their bills on time if they are protesting inaccuracies on the bills. To avoid this payment delay, the controller can focus on ensuring that mistakes are eliminated. This can be done by using constant feedback from the collections staff

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to ﬁx recurring problems in the customer billing database (e.g., mailings to the wrong address or target person). Another approach is to have the accounting software ﬂag any invoices that are missing critical information, especially a customer purchase order number. In addition, there can be a mandatory proofreading of all very large invoices prior to issuance, so that there will be no problems with any invoices that can seriously impact cash ﬂow. • Conduct cost accounting promptly. A growing company must know immediately if it is selling a product that is not returning enough of a proﬁt; otherwise, it will not spin off enough cash ﬂow to sustain a high rate of growth. The controller can push for a very rapid costing review of new products, both before they are issued as well as after they have been produced for a short time, to see if there are signiﬁcant variances from expected margins. The results of these costing studies should be immediately communicated to upper management, so that steps can be taken to revise the product costs or prices to yield better proﬁts. These accounting functions all have the most immediate bearing on cash ﬂow. If there is a question of having to allocate resources away from other accounting activities in order to emphasize these cash ﬂow areas, the controller should consider some outsourcing, which will leave more staff time available for these tasks. For example, the payroll function is normally handled by clerical personnel who are equally capable of becoming involved in billings or cash collections. If the controller also manages the ﬁnance function, there are several additional issues to consider in a high-growth environment. The main one is predicting future cash ﬂows. This is because an accurate cash forecast tells management how much extra cash it will need from outside sources, as well as the timing of that need. This becomes the foundation for efforts to acquire additional debt or equity funding. In addition, the controller should keep a close watch over the risk and return of any investments, in order to maximize the company’s investments while maintaining as low a risk proﬁle as possible. Finally, the controller must devise an orderly system for clearing incoming payments through a system of lockboxes, funneling these payments into a central account, and then disbursing the money back out for accounts payable through outlying banks that take extra time to clear payments. This system of lockboxes and controlled disbursements maximizes the amount of a company’s cash on hand, as well as the time period during which it can be used. These are the key ﬁnance-related tasks for a controller to manage in an explosive growth environment. If the controller also manages the computer services function, the key factor is not to let problems with the computer systems bog down other company operations that are relying on it. The main reason for this factor is that computer services is a support function that is the linchpin of nearly all transaction processing, and if it is not operational, the company cannot function. This principle requires the controller to take several actions. One is to back up the system regularly, as well as to make provision for rapidly bringing the system back on line if it goes down (usually through redundant systems or rapid on-site servicing). Also, if there is a conversion to new hardware or software, the controller must ensure that some sort of system is still supporting company operations at all times — it may be the old system or the one replacing it, but a growing company must be assured of having some sort of computer system up and running at all times. Thus, the controller’s role in the computer services area is a conservative one: Just make sure that the systems do not fail. A controller may also be responsible for the human resources function in a high-growth situation. If so, the primary focus is on where to ﬁnd qualiﬁed candidates for positions throughout the company. Without enough staff, no company has a chance of continuing its growth, so this is absolutely crucial. There are a variety of techniques available for ﬁnding new staff, such as the Internet, recruiting ﬁrms, newspaper advertising, paying bonuses to in-house staff to bring in acquaintances, and using targeted publications that are distributed to speciﬁc trade disciplines. Also, since the human resources staff is usually overwhelmed by its recruiting work, the controller can ease the work burden by outsourcing other tasks. For example, beneﬁts and pension administration can go to a supplier. In short, the controller must focus on recruiting when in charge of the human resources function of an explosive growth company.

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This section summarized the controller’s management functions in an explosive growth situation. The management goals change drastically in this environment. For example, the accounting and ﬁnance areas must focus on cash management. Computer services to key functional areas must not be interrupted. The human resources staff must focus on recruiting new employees, to the exclusion of any other activities. These are the key controller tasks in an explosive growth environment.

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CHAPTER

3

CHIEF FINANCIAL OFFICER: FROM CONTROLLER TO FACILITATOR OF CHANGE 3.1 INTRODUCTION 23

3.6 CHANGE EXECUTIVE MANAGEMENT PRACTICES 29

3.2 UNDERSTANDING WHAT CHIEF EXECUTIVE OFFICERS WANT 23 3.3 TASK OF THE CFO 24

3.7 ENLIST THE SUPPORT OF THE CHIEF EXECUTIVE OFFICER 30

3.4 DEVELOP AND COMMUNICATE A COMPELLING FINANCE AGENDA 24

3.8 MOBILIZE THE ORGANIZATION 31

3.5 BUILD A COMMITMENT TO CHANGE WITHIN FINANCE 26

3.9 INSTITUTIONALIZE CONTINUOUS IMPROVEMENT 32

3.1 INTRODUCTION Years ago, chief executive ofﬁcers (CEOs) were satisﬁed with ﬁnance chiefs who could manage the analysts on Wall Street, implement ﬁnancial controls, manage initial public offerings (IPOs), and communicate with the board—in other words, possess strong ﬁnancial skills. However, in today’s business climate in which competitors appear out of thin air, where e-commerce is changing entire industries, the ability to change quickly has become a necessity for growth, if not for survival. Chief executive ofﬁcers are no longer satisﬁed with ﬁnancial acumen. They are demanding more from their ﬁnance chiefs. They are looking for individuals who can ﬁll a multitude of roles: business partner, strategic visionary, communicator, conﬁdant, navigator, and creator of value. Bottom-line CEOs want someone who will drive improvement quickly—a facilitator of change. This chapter focuses on how to drive change in an organization. It is not about running a meeting or facilitating groups, but about implementing critical management practices that will help chief ﬁnancial ofﬁcers (CFOs) implement major business changes.

3.2 UNDERSTANDING WHAT CHIEF EXECUTIVE OFFICERS WANT Facilitating change sounds simple until one is in the trenches trying to make signiﬁcant improvement in how a business operates. Chief executive ofﬁcers want creators of value, but often do not see that redeﬁning the role of ﬁnance from controlling to driving operational improvements requires changing how the senior team operates and interacts with ﬁnance and following a systematic approach. In some organizations, line managers see ﬁnance as a necessary but unpopular support function that always changes budget numbers. In other organizations, norms have developed within the senior management group where there is an unwritten rule: “You don’t ask too many tough questions about my area and I won’t ask you too many questions about your area.” In one particular case, a relatively new CFO saw large opportunities for improvement. These opportunities just happened to be in the operational areas and the president of those businesses did not need 23

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Ch. 3 Chief Financial Officer: From Controller to Facilitator of Change

“the new guy” telling him what to do. Even though the new CFO had a good relationship with the CEO, any immediate improvement efforts became mired in political turmoil. Moving from controller to facilitator of change is not an easy transition. However, it can be done if CFOs focus on several key concepts.

3.3 TASK OF THE CFO In today’s business climate, the quote “There are the quick and then there are the dead” is quite true. How does a CFO drive change quickly? Creating value and becoming the business partner so many CEOs demand means facilitating change that not only affects ﬁnance but also directly impacts the operating units. To accomplish this end, CFOs must become skilled in several key management practices. The CFO must: • Develop and communicate a compelling ﬁnance agenda. • Build a commitment to change within ﬁnance. • Change executive management practices. • Enlist the support of the CEO. • Mobilize the organization. • Institutionalize continuous improvement. By applying these concepts, CFOs can begin to accelerate the implementation of major organizational changes, as seen in Exhibit 3.1.

3.4 DEVELOP AND COMMUNICATE A COMPELLING FINANCE AGENDA Chief executive ofﬁcers say they want ﬁnance chiefs who can bring their organization to another level of performance. They want CFOs who are strategic thinkers and aggressive implementers, who can execute successfully. Because the ﬁnance agenda may affect the operating groups, an important skill is creating commitment around what is to be accomplished. One of the key reasons that

Leadership Team CEO

CEO goals Strategic agenda Leadership team management practices and processes Individual relationships

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CFO goals Finance agenda Finance team management practices and processes

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Mobilizing the Organization

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change often fails is a decrease in organizational commitment. This often occurs when senior executives continuously change priorities, do not focus, or do not show their personal commitment to an effort by spending time on managing the effort. To implement and then institutionalize change, senior executives need a constancy of purpose — some stability in a normally chaotic world. The question becomes how do you create stability and yet stay ﬂexible and dynamic to address market changes. The ﬁrst step in creating a constancy of purpose and building commitment is developing a clear ﬁnance agenda. The ﬁnance agenda describes the ﬁve to seven key outcomes to be accomplished in the next 12 months, stated in crisp, deﬁnitive language where there will be no doubt when they have been accomplished. Essentially, the ﬁnance agenda is an organization’s objectives for the year. It is a set of objectives that the CFO has memorized and can describe within two minutes at any moment and in any location. For example, a strategic agenda may look as follows: • A fully functional shared services group for ﬁnance in the Americas • A simpliﬁed and focused rolling budget process • Books closed within three days • A simple value-based scorecard and a value-based measurement system for each business • Return-on-investment (ROI) calculations for any software implementation and process for measuring the ROI on subsequent module installations • Accurate monthly ﬁnancial summaries for each of the business units Interestingly enough, creating this agenda sounds simple, and many executives say they already have clear objectives. But the key questions are: Are you ﬂuent in your ability to describe them from memory? Is your organization clear? When asked speciﬁcally, “What are the ﬁve to seven key outcomes that you need to accomplish this year?”, less than 60 percent of the executives can explain what they need to accomplish from memory in speciﬁc, crisp language in only a few minutes. Some need to go to their desk drawer to pull out their objectives. If I ask, “How many of the people reporting to you could articulate the key outcomes that you need to accomplish (i.e., those for the organization)?”, the number drops to less than 50 percent. And if asked, “How well do your peers on the executive staff know your speciﬁc objectives?” or “How well does the entire ﬁnance organization know your overall objectives?”, the number is well below 50 percent. Imagine less than 50 percent of the people or peers knowing what a senior executive (in other words, what their organization) needs to accomplish. Chief ﬁnancial ofﬁcers may be thinking that they already have clear goals and wondering why this is so different. On the surface it looks similar to any standard goal-setting process, but in reality it is fundamentally different. The difference is in how ﬂuent one is in describing the objectives, how focused they are, and whether they are “top of mind” or stored in a desk drawer. How does this affect organizational behavior? Competing priorities is a reality in today’s organizations, yet it is an executive’s job to help focus the energy of the organization on what is important and build commitment around those objectives. The ﬁrst question people ask is whether the executive is personally committed. They draw their conclusions by observing his or her behavior. Communicating a clear set of objectives is critical in telling the organization what is important. However, in today’s information-overload work environment, a few presentations will not sufﬁce. Communication experts say that senior executives often need to use every opportunity to repeat their messages to the point where they are literally “sick of repeating themselves.” Only then do people begin to remember the message. Furthermore, this begins to reinforce the executive’s personal commitment to the objectives. Bob Galvin at Motorola constantly spoke about Six Sigma quality. By communicating this message every opportunity he had, the organization began to believe that he was serious in his personal commitment to the change. This was then followed by actions that continued to reinforce the organization’s belief that Six Sigma was important. Forcing oneself to memorize strategic agenda and carrying it around in his or her head allows one to communicate continuously. Imagine a CFO is standing in the elevator and a new business analyst asks him a question about the ﬁnance department. Or the CFO is in the cafeteria and a manager wonders whether what he is doing is adding value. If within two minutes he can clearly, simply,

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and speciﬁcally cite what ﬁnance is trying to accomplish, the analyst in the elevator knows the focus. That person can then communicate the focus to peers with little translation error. Furthermore, a manager can immediately determine if what he or she is doing contributes to the overall direction of the ﬁnance organization, because the manager knows exactly what the CFO is trying to accomplish. This type of clarity, constancy of purpose, and reinforcement helps individuals commit to a direction. Another beneﬁt is that by keeping the agenda focused, speciﬁc integration among functions is much easier. For example, if a key objective for ﬁnance is implementing a balanced scorecard in the businesses, it is easy to determine whether the line executives also have that on their strategic agenda. If not, there is a disconnection, and it can be surfaced immediately. If a CFO is having lunch with one of the business unit presidents, who asks if the organization could design a new supply-chain reporting mechanism, the CFO can immediately mentally scroll through his or her strategic agenda and understand the implications of this request. If this is not part of the agenda, the CFO can tell the unit president that this will not be possible for another several months or begin negotiating. Because many decisions happen in informal dialogue by the CFO and the organization, by knowing exactly what it needs to accomplish, people can determine trade-offs on an ongoing basis. They can determine the value of activities immediately since if something does not contribute to the overall ﬁnance agenda, it may not be worth doing. Eventually, the organization becomes fast and ﬂexible. Several years ago, a general manager strongly believed in this model. He knew exactly what he needed to accomplish and could state his objectives anywhere, anytime. He would use any and every opportunity with people in his organization and his peers to reinforce his message. Over time, everyone knew exactly what the business needed to accomplish. People began to realize how committed he was to accomplishing those objectives. They knew exactly what he wanted to achieve, and could make a personal decision on whether they wanted to be on board. The majority decided to stay and help him meet those objectives; some who did not like where the organization was headed decided to leave. However, no one questioned the direction or his commitment to change. Also, because he was ﬂuent about his objectives and his focus, any time another general manager or the senior vice president asked for help or additional work, he immediately knew how this would affect his goals. Because everyone knew what he was trying to accomplish, any time his organization was asked to do other work, he could use the strategic agenda to negotiate, because there would always be trade-offs. By observing his behavior, the organization began to mobilize around the required changes. There was no question about leadership spending enough time, no question about leadership driving change, and no question about what was important to the business. This organization consistently surpassed its ﬁnancial, customer satisfaction, and employee satisfaction targets.

3.5 BUILD A COMMITMENT TO CHANGE WITHIN FINANCE Once some thought has been given to the strategic agenda, it is time to build commitment around what the CFO wants to accomplish. If the CFO has developed a compelling ﬁnance agenda, the most important step toward commitment has already been taken, clearly describing what the CFO and the function need to accomplish. It is amazing how often this type of clarity is neglected, either because of not understanding how powerful this can be, political maneuvering to keep accountabilities hazy, or just little time to be speciﬁc. Yet when people are asked to commit to something, the more they can understand the speciﬁc implications, the easier it is for them to make a decision about commitment. Also, a common misunderstanding is that people will only commit to something in which they have been involved in every step. This is not necessarily true. People want to be able to inﬂuence the direction (what needs to be done) and the approach (how things will be done) and have an open authentic dialogue around the realism of the objectives. They do not always need to be involved in every step. Some executives exhibit reluctance in communicating their agenda and providing direction because they want it to “evolve from the team.” This often leads to several consequences. First, people often become frustrated by the lack of direction and then make comments like “He’s

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not managing this department” or “She’s getting the executive salary, but we always have to ﬁgure out what needs to get done.” Second, people believe that most executives must be goal-driven, and therefore managers know what they want to accomplish; by not stating it explicitly, people begin to wonder. They wonder if the manager has a hidden agenda, if it is a test, or they begin to doubt the manager’s leadership skills. It is much more effective to know what one wants to accomplish, use a straw model to begin the discussion, and openly listen to the staff and allow them to inﬂuence the agenda. Another attempt to build commitment is often labeled “team building.” Managers often believe that if they conduct a series of team-building exercises or off-sites, their team will suddenly be committed to driving change. Unfortunately, in most cases, people engage in the team-building exercises, but under the day-to-day pressures the new behaviors are most likely forgotten and rarely reinforced — especially if the senior executive only talks change, but does not reinforce the message with his own behavior. There is a mountain of evidence in the learning and training literature about how little learning transfers from external or simulated learning events back to on-thejob behaviors. Team building can be much more effective if it is integrated into day-to-day work. For example, several years ago, an executive requested team building to increase commitment for his staff. The conversation went like this: Consultant: “I’m sure we could help, but before talking about team building, let’s talk about what are you seeing that suggests team building is the answer? What do you want them to commit to?” Executive: “Our meetings are totally unproductive—all we do is talk and talk with no decisions; no one is on the same page, and we can never wrap up.” Consultant: “What has been the impact of this?” Executive: “We keep revisiting decisions, never coming to closure. Last time, we talked about whether we were going to assemble parts in Taiwan for almost two hours with no decision.” Consultant: “It sounds like there is a lot going on and not something we’re going to address with one team-building session. It sounds like we need to begin addressing how the executive team works together. I have found that most managers hate dealing with all this touchy-feely stuff. They see no value in it. However, if we begin to address some of these issues as part of trying to accomplish an objective, people tend to be more open about the process. What’s pressing right now that you need to accomplish in the short term?” Executive: “We do need to ﬁnalize our strategic marketing plan.” Consultant: “Now there is something people can probably sink their teeth into. We can address some of these behavior issues that you’ve cited as part of developing the strategic plan. We can include some team-building activities. Of course, to begin implementing some of these changes, you will need to play an active role and be open to some of my coaching. Are you okay with that?” Executive: “Sure. Why don’t we set aside some time on Friday to think through the agenda and the process.”

Focusing on a clear business objective that is tied to the overall strategic agenda and clarifying that behavior change does not occur overnight; integrating team-building activities into operational issues can help build commitment. A prerequisite to many of these activities is the CFO’s ability to explain what he wants to accomplish and why. The CFO must understand his personal motivations and convictions. He should spend a few minutes reﬂecting. The CFO needs to understand his personal motivations for why he wants to achieve certain goals. What drives him? Why is he passionate about these goals? If he is not passionate about a certain goal, why is he pursuing it? What will he do to ensure success? After he has had time to develop his agenda and the reasons why it is important, the CFO should think about and practice how he will tell his staff. There are a variety of ways that this can be done. The most critical factor is that the CFO engage in genuine dialogue with the staff, listening to their views and allowing them to inﬂuence his opinions. The CFO’s ﬁnance agenda literally becomes the ﬁnance team’s goals. Because the CFO is the head of the function, the agenda that he creates with his direct reports becomes the agenda for ﬁnance. Some executives conduct an off-site in which they discuss the strategic agenda; others embed the discussions in their regular staff meetings.

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Having an open dialogue with the staff is critical. It is amazing how many teams have never had this type of open, honest dialogue, or the dialogue is complex, discussing a litany of actions and no one understands the “big picture.” Following is an adaptation from a director of ﬁnance’s (George’s) off-site. “As you see on the agenda today, we are going to spend most of our meeting talking about the agenda for ﬁnance and speciﬁc goals. I’ve had some time reﬂecting on what I think we need to accomplish this year and have captured this on my list of goals. Realize that this strategic agenda is what ﬁnance needs to accomplish this year. I’d like to spend the next few minutes describing each goal and why I think it’s important. After that I’d like us to have an open discussion on whether these items make sense since your individual and department goals will be tied to this agenda.” The director goes on to explain each of his seven goals. The dialogue around one particular goal is worth highlighting. “One of the items I’ve listed is to create tighter ﬁnancial controls.” One of the other directors challenges the goal. “George, is that really something we want to focus on. We just spent months decentralizing some of the processes because we were constantly getting complaints that we’re like the audit police, always saying what the business could and could not do.” George replies, “Bill, I understand your reluctance. I struggled with this one myself. But look at our numbers, almost everywhere you look we’re struggling. Look at our new product development, over 50 percent of our new products produce little to no proﬁt. Our travel expenses and miscellaneous expenses are totally out of sync with industry standards. I truly believe that successful businesses have ﬁscal discipline and rigorous controls. The challenge will be in how we help our operating managers take more accountability for the numbers. We can’t remain in the cop role. That’s why this objective is tied to my second goal, which is the reconﬁguration of ﬁnance so that we have our best analysts dedicated to different business units providing analytic support. I also intend to raise the issue of ownership of the numbers and ﬁnance’s role with the CEO and my peers at an upcoming executive meeting.” Bill responds, “I still don’t like it, but I can understand your point. We’ll see how this plays in front of the executive committee.” “Absolutely,” says George, “we need to think of this as version one, and that’s why I wanted your input. We will probably have to revisit this after my discussions at the executive meeting. We will also have to set more speciﬁc targets so that we can tell when we’ve been successful.”

This type of dialogue is important in building commitment. The key factor is how well the CFO maintains the balance between setting a deﬁnitive direction and letting the staff have input. The CFO should also help his staff understand that this is not a linear process. After his discussion with them, the ﬁnance agenda still needs to be discussed at the executive meeting, where the focus might change. However, it is important to solicit their input prior to that meeting. A key element in obtaining commitment is the CFO’s own behavior. Everyone has heard the cliche, “It’s not what you say, but what you do.” Too often, we forget. In one project, a senior vice president told his team that he would dedicate at least 50 percent of his time to the effort. One week after the effort started, he was spending at most two hours per week on the project. People started to question his leadership and his commitment. His reaction was, “They should know I’m committed. I authorized the effort and I am providing the budget.” Unfortunately, that is not enough. In many organizations, commitment is measured by how much time people spend on what they say is important. Time has become our most precious resource. Needless to say, in this case, people interpreted the executive’s behavior as a lack of leadership, they never fully committed themselves, and the effort stumbled. A CFO is a role model whether he or she wants to be or not. CFOs must remember to demonstrate the outcomes and behaviors that they want, and then clearly set an expectation that their staff will continue the process, for example, clarifying that they are soliciting input prior to the meeting, telling them that once the ﬁnance objectives are ﬁnalized they expect them to communicate with their staffs. The CFO should clearly state that he or she expects their direct reports to have a similar session with their managers. They should ﬁrst think about the key goals in their areas, why they want to focus on those goals, and how those goals link to the overall strategic agenda, and then conduct similar meetings where their staff has input. This approach allows the CFO to begin changing the basic operating style of the department.

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3.6 CHANGE EXECUTIVE MANAGEMENT PRACTICES Changing the ﬁnance organization is often hard work, but because the CFO has direct responsibility for that function, it is often easier than driving change across the operating units. Yet in many cases, change also needs to occur in those units. To begin this process, the executive team must develop a set of management practices that allows the CFO to implement his or her ﬁnance agenda and begin to function as an advisor and consultant to not only the CEO but also the operating units. Unfortunately, many executive teams develop management practices that are often counterproductive to implementing change quickly. Following is an example of several executive meetings that highlight how patterns often develop: • Team 1. The group rarely gets together to discuss operations. When they do get together, there is an unwritten rule that no one points out a deﬁciency in someone else’s area. The prevailing climate is “don’t mess with mine and I won’t mess with yours.” Executive meetings are characterized by a lot of dialogue, but little or no action. Rarely are action items or decisions documented. Individuals rarely challenge each other and almost never challenge the CEO. • Team 2. This team does get together to discuss operations. However, everyone needs to fully agree with a recommendation before it is acted on. The constant drive to consensus often takes so long that participants turn off and agree just to move on. Rarely is substantive conﬂict present. The meeting is characterized as nice and cordial. Meeting minutes may be taken, but they are lengthy and difﬁcult to understand. • Team 3. This team also meets, but many one-on-one meetings have taken place before or outside of the meeting either between the CEO and other executives or between executives. There is no common database of knowledge; no one is on the same page. The CEO or senior executive drives the meeting, pushing forward through the agenda. Others participate when their area is up for discussion and spend the time reading e-mail or ﬁnishing administrative tasks. Minutes might be taken. • Team 4. These meetings are brawls. Managers get together and ﬁght. Conﬂict rules the session; people challenge each other and debate each other. Debates are often subjective interpretations of data or opinions. There are no clear processes on how to work through information and come to resolution. Although these are sample meetings, many meetings are similar to one or more of these proﬁles. For a CFO, the focus is on ways in which to help the management team understand his or her new role, what he or she wants to accomplish, and how they need to contribute to those objectives. Therefore, understanding the management practices of the executive team is important. Changing these practices and the dynamics of the executive team is the ﬁrst challenge in moving into a change agent role. Executive teams that are able to drive change through the organization, who operate work toward a common agenda, and are able to work through many organizational challenges have the following characteristics (practices): • Regular meetings. The executive team meets regularly to discuss operations. Research and practice have shown that if management teams do not meet on a regular basis to discuss work, the group slowly begins to splinter. Individuals may still be able to run their areas effectively, but cross-boundary issues become harder to resolve. • Constructive confrontation. Because all individual executives are accountable to meet the business or function goals and are accountable as a team to meet the overall business goals, there is a clear expectation to question and challenge each others’ operations. • Listening. All executives actively listen to and are able to stimulate substantive and honest dialogue about issues and potential solutions. • Shared agenda. The executive group reviews and challenges each others’ strategic agenda to ensure consistency and integration across organizations. All of their goals directly and clearly reinforce the CEO’s goals.

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• Clear feedback. Managers have clear review processes in which they review operations, make course corrections, provide feedback, and ensure accountability. • Decisive, fast-paced meetings. Meetings are held regularly to discuss operations in which it is expected that each participant provides input and advice to other areas and solicits input for his or her area. The pace is fast, yet the meeting is comprehensive. Decisions are made; actions are determined, documented, and communicated in a comprehensive manner. • Consensus with qualiﬁcation decision making. Participants debate and look at all angles of a recommendation or impending decision. If consensus cannot be achieved after listening to all the options, the most senior individual will make the decision and everyone will be committed to its outcome. Decision is data driven and made quickly. • Data driven. Decision making is driven by data, and clear procedures and templates for the type of data needed are developed for decision-making purposes. • Role of support functions. Support functions act as consultants to the operating units, challenging and working with them to improve performance. • Role models. Executive leadership role models desired behavior. • Continuous improvement. The executive team periodically steps back and looks at its own management processes to assess effectiveness. Based on these assessments, continuous improvement actions will be taken. If an executive team does not operate in this manner, if ﬁnance is not given the liberty to challenge the operations, or if ﬁnance is not seen as a strategic partner, changes in how the executive team operates may be in order. To begin this change, it is important to remember that this is the boss’s team. The CFO is one among many peers, and in some cases, depending on the relationships, the power may be unequally distributed. The CFO might be able to inﬂuence some of the behaviors, but few major changes will take place unless the CEO is aware of the improvement potential and willing to play a role. So how does the CFO begin the process of changing the practices of the management team? .

3.7 ENLIST THE SUPPORT OF THE CHIEF EXECUTIVE OFFICER An important step in change is creating the awareness that change is necessary. One of the most difﬁcult areas to change is management process. Most successful executives have honed their managerial skills over many decades and have strong opinions of what works and what does not. Therein lies the opportunity. Today’s business environment is quite different than that of just a few years ago. Often, the management team has new players, or the challenges confronting the organization are more intense. Those organizations that are able to change their management practices are those that have a greater likelihood of success. And those practices start at the top. Consequently, enlisting the support of the CEO in reshaping the management practices of the executive team will be critical. To begin this process, the CFO must ﬁnd a way to create awareness about required changes. One way to do this is: Step 1. Lay out the agenda for ﬁnance. Step 2. Determine what will be required to implement the strategic agenda. Step 3. Determine how the executive team will need to change and what is required from them to manage the implementation of the ﬁnance agenda. Step 4. Develop an action plan on helping the CEO see the team’s current dynamics, how they may need to change, and his role in that change effort. Step 5. Meet with the CEO to discuss the strategic agenda and what will be needed from the executive team and from the CEO. Step 6. Jointly develop a way to raise any issues with the executive team. One approach to help create awareness is to look at best practices or use white papers, articles, or other print material as a way to help educate the CEO on what could be. Begin creating an

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awareness on how to improve the senior team dynamics. Discussing an article or summary can be a powerful way to begin the dialogue around change. In some cases, it may be effective to bring in an outsider to counsel the group on how it can be even more effective. Once the CFO understands the CEO’s reaction to reshaping the executive team’s management practices, he or she can jointly develop an action plan on how to introduce these changes. An approach that can be used is to spend a few minutes during the next meeting having people read a brief overview of the new practices and then have a short discussion. Following is an example of how one ﬁnance executive addressed the issue. The CFO met several times with his boss to discuss his observations and used an article as a neutral way to begin questioning some of the management practices. After several discussions, the senior vice president understood and agreed that there were improvement opportunities. Given the formal authority of the senior vice president and his ownership of the meeting, they decided that he would introduce the topic and lead the discussion at the next staff meeting. Andre, the senior vice president starts the meeting. Our agenda is quite full today, so why don’t we get started. You’ll notice one of the ﬁrst items is about our management practices. Several weeks ago, Cathy came to me with an article that she saw in a recent CFO magazine. Based on her reading, she thought that this would be of value to all of us. After a few discussions and after looking at the article myself, I think she’s right. There are some interesting concepts in here. I don’t necessarily agree with all of them, but I think it is something we should discuss implementing. There are some ideas I deﬁnitely want to put in place. So, I’d like each of you to spend ﬁve minutes reading this article and then we’ll spend another 15 minutes talking about what elements we will implement.

After everyone ﬁnishes reading, he talks about the management practices he wants to put in place and solicits people’s input and opinions. The executive group decides to bring in an outside advisor to talk to individual executives, assess the team’s management practices by observing several key meetings, and then facilitate a workshop in which they will decide on some of the recommendations.

3.8 MOBILIZE THE ORGANIZATION Results can be achieved quickly when a large part of the organization is mobilized. Mobilization goes beyond communication, which is often characterized as a two-way exchange of information, to enlisting the active involvement of individuals. Communication is necessary, but not sufﬁcient, in driving major organization changes quickly. Unfortunately, in many change efforts, this concept is misused in several ways: • A project team spends weeks or in some cases months preparing a business case, a new design (new processes, new systems, new structure), and an implementation plan. These are then communicated to the organization through an elaborate communication plan that often involves challenge sessions or other activities to “involve” the organization. The assumption is that the organization is then mobilized and committed to the effort. Unfortunately, this is rarely so. In many cases, the executive team has never had the opportunity to clearly debate the plan in detail, they have not come up the learning curve together, and the most senior executive does not clearly demand that operating executives take accountability for the implementation. Consequently, it is often unclear whether the executive team is fully committed and this message ﬁlters throughout the organization, causing a hesitancy to proceed and a lack of commitment. The organization is not mobilized. • In other large change efforts, organizations spend weeks preparing elaborate communication plans incorporating the most advanced delivery mechanisms. In some cases, senior executives will give one or two presentations to show their commitment to the project. Yet the strategic agenda and how the project ﬁts into the agenda is not clear. Maybe the executive team went through several executive education sessions, but few executives have integrated the project into their objectives. Even fewer regularly talk about the project in their regular operations reviews. In some cases, the implementation is managed by a separate steering committee, further separating operating executives from the accountability for project results. The

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project may or may not be discussed at the executive meetings. The organization intuitively senses these disconnects and mobilization becomes much harder. • In some change efforts, communication is often seen as a separate activity. There is a separate communication team with their own charter and work plan. The logic is that if this is not done, communication does not occur. There is some truth to this, and therefore having people focus on communication is important. However, more important is the fact that managers are responsible for communication. Communicating to the organization is one of the primary responsibilities of management, and if managers neglect this task the organization cannot be mobilized. Mobilization occurs around a speciﬁc purpose and speciﬁc individuals. People do not mobilize around a communications team. The communications team supports, with the exchange of information, an executive’s efforts around mobilizing his or her people around a strategic agenda. People also become mobilized if they see the executive team devoting their attention to these objectives. The CFO has already completed the ﬁrst steps in mobilizing an organization by clarifying the strategic agenda, using every opportunity to communicate his or her objectives, and working with the executive team to create shared understanding and common management practices. As mentioned before, a primary mode of learning in an organization is by observing behaviors, determining what works and what does not, and then modeling those behaviors. Once the organization understands what the CFO is trying to accomplish and is mobilized, he or she will need to sustain that momentum. This is usually accomplished by ensuring operating executive accountability and involvement, determining speciﬁc measures, having clear operations review processes in which the projects are discussed, providing feedback, and communicating as a normal course of action. As mentioned earlier, communication is often seen as a separate activity. To maintain momentum, communication must be seen as an integral part of the managerial process. Communication should not be seen as separate from managing the daily operations, and a key success factor is how well the CFO integrates communications. Several years ago, the general manager of a small $100 million business ﬁrmly believed in integrating communications into daily operations. Although she did have a communications manager, she set a clear expectation that communications was the responsibility of each director. This organization had one of the best communications efforts around—measurement-driven, clear expectations around communication, regular senior management involvement, communication events, communications integrated in performance reviews for supervisors and managers, and so on. Because this organization was measurement-driven, they could tell how well they were doing. Communication, however, left some room for improvement. After a brief analysis was conducted, it was determined that the issue was the way in which information received was actually communicated. There was a breakdown in communications after executive team meetings. People wanted to know what was decided. How often are decisions captured from executive team meetings in a way that people can immediately understand what was decided? The decision was made that during the executive meeting all major decisions would be documented, and then prior to the end of the meeting the decisions would be reviewed and the group would decide what could be posted. In some cases, because of the highly conﬁdential nature of discussions or because of the timing of decisions, not everything could be posted. This information was then posted on the intranet, and directors would review these decisions in their staff meetings. By integrating communications as a part of normal operations and making it a managerial responsibility, this organization dramatically improved its communication effectiveness.

3.9 INSTITUTIONALIZE CONTINUOUS IMPROVEMENT Facilitating change is an ongoing process — the more effective a CFO is at instituting a continuous improvement mentality and process, the easier it will be to keep driving change. A continuous improvement mentality suggests that we are constantly reviewing and questioning how we are doing and using a systematic measurement-driven approach to improving performance. Many organizations have implemented processes such as total quality management, Six Sigma, and continuous

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improvement to help sustain changes. The most common methodology is characterized by the following approach: deﬁne, measure, analyze, improve, and control. This approach was developed by the manufacturing industry to improve efﬁciencies given ever-shrinking margins, but it is now expanding into other industries. The philosophy of continuous improvement is: • Deﬁne a problem to solve; it should be realistic and doable. • Measure current performance to set a baseline and determine measures. • Analyze what is causing the gap. • Determine a realistic target and then implement the improvements. • Implement control mechanisms to ensure that the new activities become institutionalized. The most effective teams also use this process to continuously improve their management practices. One group of executives periodically reviewed their management practices in an effort to improve how they managed the business. They reviewed how well they made decisions, how well they held each other accountable, how open they were to other opinions, whether their meetings included substantive dialogue, how well they communicated expectations to presenters, and so forth. By institutionalizing a process by which management openly and honestly questions not only what they are doing, but also how they are managing, implementing changes quickly and effectively becomes a core competency.

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CHAPTER*

4

ACCOUNTING PRINCIPLES AND STANDARDS 4.1

INTRODUCTION 35

4.8

ACCOUNTING STANDARDS 38

4.2

COMMITTEE ON ACCOUNTING PROCEDURE 35

4.9

ACCOUNTING RESEARCH BULLETINS 39

4.3

ACCOUNTING PRINCIPLES BOARD 36

4.10

OPINIONS: ACCOUNTING PRINCIPLES BOARD 39

4.4

FINANCIAL ACCOUNTING FOUNDATION 36

4.11

INTERPRETATIONS: FASB 41

4.5

FINANCIAL ACCOUNTING STANDARDS BOARD 36

4.12

4.6

GOVERNMENT ACCOUNTING STANDARDS BOARD 37

STATEMENTS OF FINANCIAL ACCOUNTING STANDARDS: FASB 44

4.13

4.7

INTERNATIONAL ACCOUNTING STANDARDS BOARD 38

STATEMENTS OF FINANCIAL ACCOUNTING CONCEPTS: FASB 53

4.14

TECHNICAL BULLETINS: FASB 54

4.1 INTRODUCTION Who creates the basic rules of accounting that guide the accounting practices of so many accountants? There are several entities that contribute to these basic rules, as will be discussed in this chapter. We also summarize many of the accounting pronouncements that have been issued by these organizations, and describe where to go to obtain more detailed information about them.

4.2 COMMITTEE ON ACCOUNTING PROCEDURE The Committee on Accounting Procedure (CAP) was created in 1939 by the American Institute of Accountants (now known as the American Institute of Public Accountants, or AICPA). It issued a total of 51 Accounting Research Bulletins that responded to speciﬁc accounting problems as they arose; this tight focus led to an increasing number of complaints against the CAP over time, because it did not attempt to create an overall accounting framework to which speciﬁc accounting pronouncements could then be attached in an orderly manner. Another problem was that it was accused of not conducting a sufﬁcient volume of detailed research to back up the reasoning behind its pronouncements. Yet another issue was the perception that it acted in the interests of the American Institute of Accountants, which was considered a conﬂict of interest. Furthermore, its pronouncements were not binding on any organizations that issued ﬁnancial reports. On the plus side, it

* Reprinted with permission from Chapters 4–5 of Steven M. Bragg, Accounting Reference Desktop (Hoboken: Wiley, 2002).

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developed a uniform accounting terminology that was widely used thereafter. Because of the preceding problems, the CAP was eliminated in 1959 in favor of the Accounting Principles Board.

4.3 ACCOUNTING PRINCIPLES BOARD The Accounting Principles Board (APB) was formed in 1958 by the AICPA. Its 18- to 21-member Board and supporting staff was active in conducting research on accounting issues and promulgating standards. Even though it was phased out in 1973, its APB bulletin numbers 43, 45, 46, and 51, as well as 19 opinions still form a part of GAAP. The APB gained more regulatory force than its predecessor, because the AICPA required its member CPAs to identify and justify any departures from the APB’s opinions and statements, while it also gained support from the Securities and Exchange Commission. Nonetheless, it foundered due to its direct support by the AICPA — a more independent organization was needed, which resulted in the Financial Accounting Foundation.

4.4 FINANCIAL ACCOUNTING FOUNDATION The Financial Accounting Foundation (FAF) was founded in 1972. Its 16-member Board of Trustees is expressly independent from the AICPA, since they come from a number of sponsoring organizations, such as the AICPA, the Financial Executives Institute, the Institute of Management Accountants, the Securities Industry Association, and others. It also has a number of at-large trustees who are not tied to any sponsoring organizations. The FAF does not directly promulgate any accounting standards — rather, it raises funds for the operation of the Financial Accounting Standards Board (FASB) and Government Accounting Standards Board (GASB) that conduct this work, as noted in the following sections. Its fund-raising function is enhanced by its being a 501(c)(3) taxable entity, so that contributions to it are tax-deductible. It also exercises general oversight of the FASB and GASB by appointing Board members to them, as well as two advisory councils to those entities. It also approves their annual budgets. The FAF, FASB, and GASB are all located in Norwalk, Connecticut.

4.5 FINANCIAL ACCOUNTING STANDARDS BOARD The successor to the Accounting Principles Board is the Financial Accounting Standards Board (FASB) created in 1973. It has a Board of seven members, each of whom have a ﬁve-year term, and who can be reelected once. It has a staff of about 40 personnel. The organization is funded through the FAF. Its mission is to “establish and improve standards of ﬁnancial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of ﬁnancial information.” It maintains a web site at www.rutgers.edu/accounting/raw/fasb/welcome.htm. The FASB’s authority to issue statements on and interpretations of accounting standards comes from several sources. One is the Securities and Exchange Commission, which designated it as the source of accounting principles to be used as the basis for ﬁnancial statements ﬁled with it. The FASB received similar support from the AICPA through its Rule 203. However, the FASB has no enforcement powers whatsoever — it needs continuing support from the SEC, AICPA, and state boards of accountancy to ensure that its rules are followed. The FASB works with the Financial Accounting Standards Advisory Council, which is appointed by the FAF. The council’s 30 members advise the FASB about technical issues, project priorities, and the selection of task forces to deal with speciﬁc accounting issues. There is a basic ﬂow of work that the FASB pursues when constructing a new accounting pronouncement: 1. Admission to agenda. The FASB’s criteria for inclusion of an accounting issue in its work schedule are that there is diverse practice in dealing with it that causes varying ﬁnancial reporting results that can be misleading; there must also be a technically feasible solution and an expectation that a solution will be generally accepted.

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2. Early deliberations. The FASB clariﬁes the issues and obtains opinions regarding each accounting item on its agenda. If a prospective pronouncement appears to be a major project, it will appoint an advisory task force of outside experts to review it, which tends to involve the services of about 15 people. The FASB staff will then write a discussion memorandum with the assistance of this group. 3. Public hearing. The FASB will announce a hearing date that is 60 days in advance. Depending on the issue, these meetings may be very well attended by interested parties. 4. Tentative resolution. Two-thirds of the Board votes in favor of issuing an exposure draft, which includes a proposed effective date and method of transition to the new accounting rule. This document is not the ﬁnal one, being rather a draft that is made available for public discussion. 5. Final deliberations and resolution. Once responses from the public to the exposure draft have been made, the FASB will make minor adjustments to it and take a ﬁnal vote. The ﬁnalized standard, which includes dissenting views, is then published. 6. Follow-up interpretations. There may be some issues related to a new standard that do not become apparent until after it has been in use for a short time. If so, the FASB may clarify or elaborate on the newly issued statement. These interpretations must also be made available for public comment for at least 30 days before being ﬁnalized and published. The process just noted requires a considerable amount of FASB resources, and so cannot be used to address all accounting issues. To provide more rapid resolution to more urgent or minor issues, it may choose to shift them to its Emerging Issues Task Force (EITF). The EITF is a very active group that is mostly composed of public accounting people who are aware of emerging issues before they become widespread. The chief accountant of the SEC attends its meetings. If it can reach a rapid consensus on an issue, then its ﬁndings are published at once, and become a basis for GAAP. If there is less consensus, then the issue is shifted to the FASB to be resolved through the more tortuous process just described. The EITF has been criticized because less public discussion is involved in its proceedings than under the more formalized FASB review process. The FASB also issues technical bulletins when it addresses issues not covered by existing standards, which will not cause a major change in practice, which have a minimal perceived implementation cost, and which do not result in a unique new accounting practice — in short, technical bulletins address less controversial topics. A potential problem over the long term is that the SEC, which is a prime sponsor of the FASB, wants it to issue standards that are oriented toward publicly held companies, over which the SEC has reporting control. However, this means that the more onerous reporting requirements intended for larger public companies are also being forced on smaller private ﬁrms that do not have the resources to comply with them. Though there would be great inefﬁciencies involved in setting up a double accounting standard, one for public and one for private companies, this will be an ongoing cause of tension within the FASB as it continues to churn out pronouncements.

4.6 GOVERNMENT ACCOUNTING STANDARDS BOARD The entity that establishes accounting principles for state and local governments is the Government Accounting Standards Board (GASB), which was created in 1984. It is the successor organization to the National Council on Governmental Accounting, whose standards are still in force unless the GASB has issued speciﬁc changes or replacements to them. The GASB’s methods of operation (and basic rule-making procedures) are nearly identical to those of the FASB, which is its sister organization. It has seven Board members and a staff of about ten employees. Like the FASB, it works with an advisory council, this one being called the Government Accounting Standards Advisory Council, which is appointed by the FAF. This council consults with the GASB about technical issues, project priorities, and the selection of task forces to deal with speciﬁc issues. An interesting variation from the FASB’s council is that this one periodically conducts an annual membership survey to identify emerging issues.

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Its funding comes from the FAF, as is the case for the FASB. The primary source of funding that goes to the FAF is from state and local governments, as well as the General Accounting Ofﬁce. The GASB’s pronouncements are recognized as authoritative by the AICPA, but there is no entity like the SEC supporting it (which only deals with publicly held companies), and so it tends to have less overall inﬂuence than the FASB. Also, since its funding sources are fewer than for the FASB, it has a substantially smaller staff. The GASB maintains a general web site at www.rutgers.edu/accounting/raw/gasb/welcome. htm, as well as another web site at www.seagov.org that is dedicated to the measurement of government performance standards.

4.7 INTERNATIONAL ACCOUNTING STANDARDS BOARD A large number of organizations now do business in multiple countries, and so must deal with different accounting standards within each country where they have subsidiaries. Though a company’s headquarters may be located in the United States, which forces the entity as a whole to report under FASB standards, it may be required to make reports, such as loan-related ﬁnancial statements, at the local level that require different accounting standards. Also, companies that are based abroad but that want to issue securities within the United States must restate their ﬁnancial results to comply with American accounting rules. In an attempt to standardize the accounting rules of many countries, the International Accounting Standards Board (IASB) was created in April 2001. It is the successor body to the International Accounting Standards Committee (IASC), which in turn was formed in 1973 through an agreement made by the national professional accountancy bodies of Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, Ireland, the United Kingdom, and the United States. Its 14-member Board members serve ﬁve years, which can be renewed once. The IASB is controlled by a parent organization, which is the IASC Foundation, a Delaware nonproﬁt corporation. Its role is quite similar to that of the FAF in relation to the FASB and GASB — that is, it provides funding and general oversight to the IASB, while also appointing its members. Meanwhile, the IASB is solely responsible for setting international accounting standards, with the support of the Standards Advisory Council and the Standing Interpretations Committee, both of which are funded and supported by the IASC Foundation. The IASB’s staff works on the development of a single set of international accounting standards, coordinating its efforts with the national standards-setting bodies, stock exchanges, and securities regulatory agencies in many countries, as well as such international groups as the United Nations and World Bank. It accounting standards are issued in the form of International Financial Reporting Standards, which are devised through the same process used by the GASB and FASB.

4.8 ACCOUNTING STANDARDS Generally Accepted Accounting Principles (GAAP) come from the pronouncement of the Accounting Procedures Committee of the AICPA (which concluded its operations in 1959), the Accounting Principles Board of the AICPA (which concluded its operations in 1973), and the Financial Accounting Standards Board (FASB), which is now the primary authoritative source of GAAP. Account Research Bulletins (ARB) are the ofﬁcial pronouncements of the Accounting Procedures Committee, while the Accounting Principles Board issued numbered Opinions. The FASB uses a number of pronouncements, including Interpretations, Statements, Statements of Financial Accounting Concepts, and Technical Bulletins. Its Emerging Issues Task Force (EITF) also issues a voluminous number of Abstracts. In addition, the AICPA issues a number of Statements of Position (SOPs). The identifying numbers, titles, and summaries of all of these GAAP sources, with the exception of EITF abstracts and AICPA Statements of Position, are included in the following sections. The summaries noted here are not intended to provide the full range of information needed by the accountant to fully research a particular GAAP issue. Instead, one can peruse the list to see which reference sources are most applicable to the problem at hand. At that point, one should refer

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to the source document to obtain the greatest possible detail. In many cases, source documents also include examples that are invaluable in determining the application of the principles under discussion to actual situations. There are several sources of GAAP documents. One can go to the FASB web site, located at http://raw.rutgers.edu/raw/fasb, to ﬁnd the complete text of all FASB Statements. A more complete source of nearly all GAAP documents is the excellent three-volume set of Original Pronouncements, published by the AICPA. It contains all FASB Statements, Accounting Research Bulletins, Opinions of the Accounting Principles Board, AICPA Interpretations, FASB Interpretations, FASB Concept Statements, and FASB Technical Bulletins. The documents show only those pronouncements that have not been superseded, and also highlight any text that has been superseded or modiﬁed by later pronouncements, thereby eliminating some potential confusion regarding which pronouncements constitute current accounting standards. It can be purchased from the AICPA web store for $99, which is located at www.cpa2biz.com. As of this publication date, the Original Pronouncements could be purchased only by AIPCA members — the membership application can be found at the AICPA web site, which is located at www.aicpa.org. The information contained within the Original Pronouncements is current up until June 1 of each year, and so the most recent year’s publication is not usually available until late summer or early fall. Statements of Position can be ordered separately from the AICPA under the title of AICPA Technical Practice Aids. It is also available through the AICPA Web store, and can be purchased there at an AICPA member price of $80 and $100 for nonmembers. Abstracts published by the EITF are available on an annual subscription basis for $338 per year, or may be purchased individually for $44.75 each. They can be ordered by calling the FASB at 800-748-0659, or by ordering on-line by accessing http://stores/ yahoo.com/fasbpubs.

4.9 ACCOUNTING RESEARCH BULLETINS The Accounting Research Bulletins in Exhibit 4.1 are only those that have not been superseded by later accounting standards. Note that the ﬁrst one listed, ARB No. 43, is a summary of all preceding ARBs.

4.10 OPINIONS: ACCOUNTING PRINCIPLES BOARD The Opinions listed in Exhibit 4.2 are only those that have not been superseded by later accounting standards. Several of these Opinions, such as APB Nos. 9, 14, 16, 17, 20–22, and 25, are still the primary source documents for key accounting issues. Number

Title

Description

43

Restatement of Revision of Previous Bulletins

45

Long-Term Construction-Type Contracts Discontinuance of Dating Earned Surplus Consolidated Financial Statements

46

51

E XHIBIT 4.1

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Represents a revision and summary of the ﬁrst 42 Accounting Research Bulletins, covering such topics as the form of ﬁnancial statements, working capital, inventory pricing, intangible assets, contingency reserves, capital accounts, depreciation, taxes, government contracts, pension plans, and pension plan annuity costs. Describes the use of the percentage-of-completion method and the completed contract method to account for construction contracts. Cancels the dating of an earned surplus following a quasireorganization. Discusses the consolidation procedure, the treatment of minority interests, the treatment of stock dividends of subsidiaries, and the uses of both combined and parent company ﬁnancial statements

C URRENT A CCOUNTING R ESEARCH B ULLETINS

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Number

Title

Description

2

Accounting for the Investment Credit

Discusses the presentation and recognition of the investment tax credit arising from the Revenue Act of 1962.

4

Accounting for the Investment Credit

Discusses the impact of the Revenue Act of 1964 on the investment tax credit, as well as an additional allowable method for reporting the credit, net of reported federal income taxes.

6

Status of Accounting Research Bulletins

Contains revisions to those sections of ARB No. 43 relating to Treasury stock, current assets and liabilities, stock dividends and splits, and depreciation and appreciation.

9

Reporting the Results of Operations

Concludes that net income should include all proﬁt and loss transactions, with the exception of prior-period adjustments. It also speciﬁes the separate treatment of extraordinary items in the income statement.

10

Omnibus Opinion — 1966

Covers the allocation of income taxes among different reporting periods, offsetting securities against taxes payable, and denies the use of the installment method of accounting.

12

Omnibus Opinion — 1967

Covers the classiﬁcation and disclosure of allowance accounts, depreciation disclosure, and the reporting of changes in equity, and afﬁrms the use of the interest method when amortizing debt discounts and premiums.

14

Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants

Discusses the applicability of accounting for stock purchase warrants separately from attached debt instruments.

16

Business Combinations

Discusses the purchase and pooling methods of accounting for a business combination, and the circumstances under which each one can be used. It also covers the treatment of acquisition costs, contingent compensation, and the amortization of goodwill.

17

Intangible Assets

Speciﬁes the types of intangibles that may be recorded as assets, how to arrive at their cost, and how they may be amortized.

18

The Equity Method of Accounting for Investments in Common Stock

Speciﬁes the circumstances under which the equity method of accounting can be used, as well as how it should be calculated and then disclosed on the investor’s ﬁnancial statements.

20

Accounting Changes

Discusses the proper treatment of changes in accounting principle, estimate, and reporting entity, as well as of errors in previously issued ﬁnancial statements, plus how this information is to be disclosed in the ﬁnancial statements.

21

Interest on Receivables and Payables

Discusses the determination of the proper valuation of a note when it is exchanged for either cash, property, or services. It also covers the selection of an appropriate present value discount rate, as well as the disclosure of discounts or premiums from the face value of a note.

22

Disclosure of Accounting Policies

Requires the disclosure of signiﬁcant accounting policies alongside the ﬁnancial statements.

23

Accounting for Income Taxes —Special Areas

Discusses the proper accounting for income taxes in relation to the undistributed earnings of subsidiaries, investments in corporate joint ventures, bad debt reserves of savings and loan institutions, and the policyholders’ surplus of stock life insurance companies.

E XHIBIT 4.2

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4.11 Interpretations: FASB

Number

Title

Description

25

Accounting for Stock Issued to Employees

26

Early Extinguishment of Debt Interim Financial Reporting

28

29

Accounting for Nonmonetary Transactions

30

Reporting the Results of Operations

E XHIBIT 4.2

S UMMARY

OF

41

Speciﬁes the rules to use when accounting for stock awards. The core principle is that the accounting is based on the intrinsic value of the award, which is the difference between the compensation value of the award, measured as the number of shares multiplied by the fair market value per share, and employee value, measured as the employee price per share multiplied by the number of shares. Requires that gains or losses from the early extinguishment of debt be recognized in the current period. Describes the information that should be contained within interim ﬁnancial reports, including changes in accounting principles and the disclosure of summarized interim ﬁnancial data by publicly traded companies. Veriﬁes that nonmonetary transactions should be valued based on their fair values, except in a limited number of cases where nonmonetary exchanges are not considered to be the culmination of an earnings process. Discusses the proper disclosure of discontinued operations, as well as the reporting of gains or losses from business disposals. It also deﬁnes those transactions that should be categorized as extraordinary items.

C URRENT A CCOUNTING P RINCIPLES B OARD O PINIONS (C ONTINUED )

4.11 INTERPRETATIONS: FASB The Interpretations listed in Exhibit 4.3 are intended to clarify or expand on any accounting pronouncements that have previously been issued, usually addressing very speciﬁc topics. Number

Title

Description

1

Accounting Changes Related to the Cost of Inventory

4

Applicability of FASB Statement No. 2 to Purchase Business Combinations

6

Applicability of FASB Statement No. 2 to Computer Software

7

Applying FASB Statement No. 7 in Statements of Established Enterprises

E XHIBIT 4.3

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If there is a change in the costs included in inventory, this is considered an accounting change that must be justiﬁed based on some improvement in the level of ﬁnancial reporting, and not just on favorable income tax results. When using the purchase method to account for a business combination, costs should be allocated to assets both resulting from and to be used in research and development activities of the acquired entity. However, assigned R&D costs must then be expensed at the time of the combination if the related assets have no identiﬁable future use. Speciﬁes that the purchase or development of a process for internal sales or administrative purposes is not classiﬁed as research and development costs. The cost associated with the purchase or lease of computer software for use in R&D activities should be charged to expense unless it has an alternative future use. Software development costs through the preproduction phase are considered R&D costs, while programming and testing costs incurred for the improvement of a production model are not considered R&D expenses. Describes the situations under which a consolidating entity should report the effect of a development stage subsidiary’s change in accounting principle, based on the requirements of FASB Statement No. 7.

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Number 8

9

14

18

Title

Description

Classiﬁcation of a Short-Term Obligation Repaid Prior to Being Replaced by a LongTerm Security Applying APB Opinions Nos. 16 and 17 When a Savings and Loan or Similar Institution Is Acquired in a Purchase Business Combination Reasonable Estimation of the Amount of a Loss Accounting for Income Taxes in Interim Periods

19

Lessee Guarantee of the Residual Value of Leased Property

20

Reporting Accounting Changes Under AICPA Statements of Position Accounting for Leases in a Business Combination Leases of Certain Property Owned by a Governmental Unit or Authority Leases Involving Only Part of a Building

21

23

24

26

27

28

Accounting for Purchase of a Leased Asset by the Lessee During the Term of the Lease Accounting for Loss on a Sublease

Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans

E XHIBIT 4.3

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Requires the reporting of a short-debt repayment as a current liability if the repayment occurs prior to the incurrence of longterm debt that was intended to pay for the short-term debt repayment.

Disallows the use of the “net spread” method for assigning costs to the assets of an acquired company; it also provides guidelines for assigning costs to accounts receivable and payable, as well as intangible assets and savings deposits due on demand.

Speciﬁes the conditions under which losses can be accrued.

Describes the computation of interim-period income taxes and related disclosures, applies the computation to speciﬁc situations, and describes special computations that are applicable to multiple jurisdictions. Describes the speciﬁc situations under which a lease provision can be construed as being a lessee’s guarantee of the residual value of leased property, as well as the maximum limitations on the amount of such a guarantee. Notes that any change made to a company’s ﬁnancial statements under an AICPA Statement of Position (SOP) shall do so in accordance with the requirements of the speciﬁc SOP. Notes that a lease’s classiﬁcation as noted in FASB Statement No. 13 shall not be changed because of a business combination, unless the lease’s provisions have been speciﬁcally modiﬁed. Narrows the range of leases of government property to be categorized as operating leases, based on the presence of four criteria. Notes that one can reasonably determine the fair value of a partial building lease based on other types of information, if comparable sale data are not available. Speciﬁes that an asset purchase under the terms of a capital lease, and the corresponding lease termination, are covered by a single accounting transaction that may call for an adjustment in the carrying amount of the lease obligation. Allows the recognition of a loss on the difference between a lease and a sublease, and also speciﬁes that this loss is to be included in the overall gain or loss reported on the disposition of a business segment. Speciﬁes that a company must record a compensation expense at the end of each reporting period for the amount by which the market price of its stock exceeds the option price for any stock appreciation rights or similar plans.

C URRENT FASB I NTERPRETATIONS (C ONTINUED )

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4.11 Interpretations: FASB

Number

Title

43

Description

Accounting for Involuntary Conversions of Nonmonetary Assets to Monetary Assets Applying FASB Statement No. 34 to Oil- and GasProducing Operations Disclosure of Indirect Guarantees of Indebtedness of Others Criteria for Applying the Equity Method of Accounting for Investments in Common Stock

Requires that a gain or loss be recognized when corporate assets are involuntarily converted to cash, even in cases where the cash is subsequently reinvested in replacement assets.

36

Accounting for Exploratory Wells in Progress at the End of a Period

Notes that the costs incurred through the end of a reporting period for an exploratory well that is discovered to be a dry hole prior to the date of statement issuance shall be charged to expense within the period.

37

Accounting for Translation Adjustment Upon Sale of Part of an Investment in a Foreign Entity

Holds that an accumulated foreign currency translation adjustment be recognized upon the sale of part of an investment in a foreign entity in proportion to the amount of the investment being disposed of.

38

Determining the Measurement Date for Stock Option, Purchase, and Award Plans Involving Junior Stock

Speciﬁes that the measurement date for award plans involving junior stock is the date when it is known the exact amount of the common stock for which the junior stock can be exchanged.

39

Offsetting of Amounts Related to Certain Contracts

Deﬁnes the right of setoff under which an accountant may net assets and liabilities on the balance sheet, as well as its applicability to conditional or exchange contracts.

40

Applicability of Generally Accepted Accounting Principles to Mutual Life Insurance and Other Enterprises

Requires that mutual life insurance and other enterprises cannot state that they have prepared ﬁnancial statements in accordance with GAAP in cases where they have actually diverted from GAAP in order to comply with other regulatory accounting practices.

41

Offsetting of Amounts Related to Certain Repurchase and Reverse Repurchase Agreements

Modiﬁes FASB Interpretation No. 39, regarding setoffs of assets and liabilities, to allow this practice in the statement of ﬁnancial position for receivables and payables that are related to repurchase agreements and reverse repurchase agreements.

43

Real Estate Sales

States that sales of real estate with property improvements or integral equipment that cannot be removed and used separately from the real estate without incurring signiﬁcant costs should be accounted for under FASB Statement No. 66, “Accounting for Sales of Real Estate.”

30

33

34

35

E XHIBIT 4.3

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Speciﬁes the conditions under which an oil- and gas-producing operation whose assets are accounted for under the full cost method may capitalize interest costs. Speciﬁes that the disclosure requirements noted in FASB Statement No. 5 for guarantees of indebtedness must also be used for indirect guarantees. Describes the conditions under which the equity method of accounting should be used to account for an investor’s stake in an investee’s voting stock of 50 percent or less.

C URRENT FASB I NTERPRETATIONS (C ONTINUED )

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Number 44

Title

Description

Accounting for Certain Transactions Involving Stock Compensation

E XHIBIT 4.3

S UMMARY

OF

Narrows the use of APB No. 25 to just employees, and clariﬁes the rules for the grant of stock awards to employees of afﬁliates of the issuer.

C URRENT FASB I NTERPRETATIONS (C ONTINUED )

4.12 STATEMENTS OF FINANCIAL ACCOUNTING STANDARDS: FASB The Statements listed in Exhibit 4.4 are considered to be the primary source of GAAP to the extent that they supersede any previous pronouncements, either by the FASB or any predecessor organization. Number

Title

Description

2

Accounting for Research and Development Costs

Requires one to charge research and development costs to expense when they are incurred, and describes the disclosure of R&D information in the ﬁnancial statements.

3

Reporting Accounting Changes in Interim Financial Statements

Describes the reporting requirements in interim ﬁnancial statements in relation to changes to LIFO inventory costing, and to cumulative-effect types of accounting changes.

4

Reporting Gains and Losses from Extinguishment of Debt

Requires that gains and losses caused by a debt extinguishment shall be reported as an extraordinary item, if material. It also describes the disclosure requirements for such transactions.

5

Accounting for Contingencies

Describes how to account for loss contingencies, including the accrual of a loss contingency if there is a probability of loss and its amount can be reasonably estimated. Alternatively, gain contingencies can be recognized only when they have been realized.

6

Classiﬁcation of Short-Term Obligations Expected to Be Reﬁnanced

Allows an entity to reclassify its short-term debt as long-term debt, but only if it both intends to complete the required reﬁnancing and has the ability to do so.

7

Accounting and Reporting by Development Stage Enterprises

Describes the types of entities that are considered to be in the development stage, and requires them to use the same accounting methods as those of established companies.

10

Extension of “Grandfather” Provisions for Business Reporting

Extends the grandfather provisions of APB Opinion No. 16 that create an exemption from some criteria used to determine the applicability of the pooling of interests method of accounting for a business combination.

11

Accounting for Contingencies —Transition Method

Requires a company to restate its ﬁnancial statements for preceding periods in order to comply with FASB Statement No. 5.

13

Accounting for Leases

Describes the proper accounting by both parties to a lease, including the determination and treatment of operating and capital leases by lessees, and the determination and treatment of sales type, direct ﬁnancing, and leveraged leases by lessors.

E XHIBIT 4.4

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4.12 Statements of Financial Accounting Standards: FASB

Number

Title

15

Accounting by Debtors and Creditors for Troubled Debt Restructurings

16

Prior Period Adjustments

18

Financial Reporting for Segments of a Business Enterprise —Interim Financial Statements Financial Accounting and Reporting by Oil and Gas Producing Companies

19

21

22

Suspension of the Reporting of Earnings per Share and Segment Information by Nonpublic Enterprises Changes in the Provisions of Lease Agreements

23

Inception of the Lease

24

Reporting Segment Information in Financial Statements that Are Presented in Another Enterprise’s Financial Report Suspension of Certain Accounting Requirements for Oil and Gas Producing Companies Classiﬁcation of Renewals or Extensions of Existing Sales-Type or Direct Financing Leases Accounting for Sales with Leasebacks

25

27

28

29

Determining Contingent Rentals

30

Disclosure of Information about Major Customers

E XHIBIT 4.4

Black process 45.0° 133.0 LPI

45

Description Describes the proper accounting by both parties to a troubled debt restructuring, including modiﬁcations to the yield of a loan, and the circumstances under which gains or losses can be recognized. Allows prior-period adjustments only if there are material errors or if there are some income tax beneﬁts associated with preacquisition loss carryforwards of a purchased entity. Stops the FASB Statement No. 14 requirement to report segment information for interim periods.

Requires oil- and gas-producing companies to use the successful efforts method to account for the costs of producing mineral resources, as well as such issues as cost capitalization and amortization, property conveyances, income taxes, and ﬁnancial statement disclosures. Suspends the requirement in APB Opinion No. 15 and FASB Statement No. 14 to report segment information, but only for nonpublic entities. Requires the current recognition of a gain or loss when new debt proceeds are used to retire existing debt, under certain provisions. Alters the lease inception date to the date of lease agreement or any earlier commitment in cases where the property to be covered by a lease has not yet been purchased or constructed. Eliminates the requirement to present segment information in some instances where additional entity ﬁnancial statements are presented alongside consolidated statements. Suspends the use of some provisions of FASB Statement No. 19 due to some variations between that statement and SEC reporting requirements. Requires a lessor to classify a lease as a sales-type lease if it is an extension of an existing sales-type or direct-ﬁnancing lease. Modiﬁes FASB Statement No. 13 to allow the recognition of some proﬁt or loss on sale and leaseback transactions if the seller has minimal usage of the property after the transaction, or if the sale proﬁt exceeds the present value of minimum lease payments due. Deﬁnes contingent rentals, as well as what payments should be included in the reporting of minimum lease payments due for this type of rental. Requires that an entity report the amount of sales made to a government entity if those sales are at least 10 percent of its total revenues.

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46

Ch. 4 Accounting Principles and Standards

Number

Title

Description

34

Capitalization of Interest

Describes the rules for capitalizing interest costs in some situations where assets are being acquired, built, or modiﬁed, and how the rules will vary if the amount of interest to be capitalized is considered material or not.

35

Accounting and Reporting by Deﬁned Beneﬁt Pension Plans

Describes the rules for the annual ﬁnancial statements associated with a deﬁned-beneﬁt pension plan, requiring the inclusion of such information as net assets available for beneﬁts, changes in these beneﬁts, and the present value of plan beneﬁts.

42

Determining Materiality for Capitalization of Interest Cost

Deletes language from FASB Statement No. 34 that might be construed as allowing one to avoid interest capitalization, and also points out that the same statement does not contain new materiality tests.

43

Accounting for Compensated Absences

Speciﬁes that a liability be accrued for the future absences of employees under certain circumstances.

44

Accounting for Intangible Assets of Motor Carriers

States that the unamortized intangible costs associated with a motor carrier’s right to transport goods across state lines should be charged against income.

45

Accounting for Franchise Fee Revenue

Describes the primary accounting concepts for franchisors, including the proper treatment of franchise fee costs and revenues, commingled revenue, agency sales, repossessed franchises, and continuing product sales.

47

Disclosure of Long-Term Obligations

Describes the ﬁnancial disclosures needed in cases where there are unconditional purchase obligations and future payments on long-term borrowings and redeemable stock.

48

Revenue Recognition When Right of Return Exists

Allows revenue recognition for transactions involving a right of return only if a set of minimum conditions are met.

49

Accounting for Product Financing Arrangements

Deﬁnes a product-ﬁnancing arrangement, and requires that it be accounted for as a borrowing transaction, instead of a sale.

50

Financial Reporting in the Record and Music Industry

Describes the accounting practices for both licensors and licensees in the music and recording industry, including revenue recognition for licensing fees, minimum license guarantees, artist compensation, and other costs.

51

Financial Reporting by Cable Television Companies

Describes how to account for the revenues and expenses related to cable television systems, both while under construction, in the prematurity period, and when in operation.

52

Foreign Currency Translation

Describes the treatment of foreign currency translation adjustments in accordance with the operating status of a foreign subsidiary, as well as the treatment of foreign currency transactions with other entities.

54

Financial Reporting and Changing Prices: Investment Companies

Avoids the previous requirements in FASB Statement No. 33 which requires investment companies to make disclosures regarding the effects of changing prices.

E XHIBIT 4.4

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4.12 Statements of Financial Accounting Standards: FASB

Number

Title

47

Description

57

Related-Party Disclosures

Describes the rules to follow when reporting on related-party transactions.

58

Capitalization of Interest Cost in Financial Statements that Include Investments Accounted for by the Equity Method

Limits the capitalization of interest costs on an investor’s ﬁnancial statements in a limited number of situations involving the use of the equity method of accounting for an investment in another business entity.

60

Accounting and Reporting by Insurance Companies

Describes the reporting to be used for insurance entities in relation to the treatment of contracts, premiums, claims, and investments.

61

Accounting for Title Plant

Requires that costs incurred to build a title plant be capitalized until activated, and also speciﬁes the treatment of maintenance expenses that are incurred thereafter.

62

Capitalization of Interest Costs in Situations Involving Certain Tax-Exempt Borrowings and Certain Gifts and Grants

Speciﬁes situations in which interest costs are to be capitalized, as well as situations where the capitalization of interest costs is not allowed.

63

Financial Reporting by Broadcasters

Describes the reporting requirements for broadcasters, including treatment of exhibition rights, license agreements, barter transactions, and network afﬁliation agreements.

64

Extinguishment of Debt Made to Satisfy Sinking Fund Requirements

Speciﬁes that the classiﬁcation of gains or losses that result from the extinguishment of debt that is required by a sinking fund need not be reported as extraordinary items.

65

Accounting for Certain Mortgage Bank Activities

Speciﬁes that mortgage loans and similar loans be reported at the lower of cost or market. It also notes the treatment of loan origination and commitment fees, loan placement fees, and premiums paid to service loans.

66

Accounting for Sales on Real Estate

Describes the rules for recognizing the proﬁtability of real estate sales. Different standards apply to land sales than to other types of sales, to which the percentage of completion or installment methods may be applied.

67

Accounting for Costs and Initial Rental Operations of Real Estate Projects

Sets forth the rules regarding the types of costs that may be capitalized in relation to real estate projects, as well as the point after which costs may no longer be capitalized.

68

Research and Development Arrangements

Describes the accounting for research and development activities that are performed by a company for other entities. If there is a repayment obligation, its amount must be recorded as a liability.

69

Disclosures about Oil- and Gas- Producing Activities

Describes the disclosures required by oil- and gas-producing entities, and reduces or eliminates many of the disclosures by those entities that are not publicly held.

71

Accounting for the Effects of Certain Types of Regulation

Describes the accounting by most types of public utilities for regulation of the variety that allows utilities to set prices that will recover the cost of and capital cost of services provided.

E XHIBIT 4.4

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48

Ch. 4 Accounting Principles and Standards

Number

Title

Description

72

Accounting for Certain Acquisitions of Banking or Thrift Institutions

Requires that the fair value of liabilities assumed in the acquisition of a bank or thrift entity over the fair value of acquired assets be amortized by the interest method. Also, any ﬁnancial assistance obtained from a regulatory agency as part of the combination shall be recorded as an asset if the amount of the receipt can be determined and is likely to be received.

73

Reporting a Change in Accounting for Railroad Track Structures

Requires that railroads change their reporting of depreciation for railroad track structures, including a restatement of this information in prior reporting years.

78

Classiﬁcation of Obligations that Are Callable by the Creditor

Requires that long-term liabilities callable by creditors be classiﬁed as current liabilities on the balance sheet, subject to some qualiﬁcations.

79

Elimination of Certain Disclosures for Business Combinations by Nonpublic Enterprises

Eliminates APB Opinion No. 16’s requirement for nonpublic entities to report pro forma results of combinations under the purchase method.

84

Induced Conversions of Convertible Debt

Requires that the debtor recognize an expense equal to the fair value of any extra consideration given to creditors in order to persuade them to convert their convertible debt holdings to equity.

85

Yield Test for Determining Whether a Convertible Security Is a Common Stock Equivalent

Replaces the cash yield test as previously speciﬁed in APB Opinion No. 15 with the effective yield test to determine if convertible securities shall be designated common stock equivalents for the purpose of computing primary earnings per share.

86

Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed

States that software development costs shall be expensed as research and development costs prior to the point when technological feasibility has been proven, after which they may be capitalized and then amortized over the remaining estimated life of the product.

87

Employers’ Accounting for Pensions

Establishes new standards for the treatment of pension accounting, superseding previous releases. The primary change is the accounting for a single-employer deﬁned-beneﬁt pension plan.

88

Employers’ Accounting for Settlements and Curtailments of Deﬁned Pension Beneﬁt Plans and for Termination Beneﬁts

Describes the accounting for the settlement of obligations under a deﬁned-beneﬁt pension plan, termination beneﬁts, and the curtailment of such a plan. It also deﬁnes settlement and curtailment.

89

Financial Reporting and Changing Prices

Replaces FASB Statement No. 33 and its later amendments. It also speciﬁes that the disclosure of current cost and constant purchasing power information is voluntary.

90

Regulated Enterprises— Accounting for Abandonments and Disallowances of Plant Costs

Describes the accounting for abandonments of utility plants, as well as the disallowance of plant costs by regulators for the calculation of rate changes. Abandoned assets that are to be included in rate-making calculations should be included at their present value, while disallowed costs should be recognized as a loss.

E XHIBIT 4.4

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4.12 Statements of Financial Accounting Standards: FASB

Number

Title

49

Description

91

Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans

Describes how to account for the costs related to lending, or buying a loan, as well as costs related to leasing activities.

92

Regulated Enterprises— Accounting for Phase-In Plans

Modiﬁes FASB Statement No. 71 to account for phase-in plans, which are intended to reduce the impact of utility rate increases that are tied to the implementation of expensive new power-generation facilities.

93

Recognition of Depreciation by Not-for-Proﬁt Organizations

Requires that not-for-proﬁt organizations disclose depreciation information, though not for some types of art or historical treasures.

94

Consolidation of All MajorityOwned Subsidiaries

Requires that majority-owned subsidiaries be included in the corporate parent’s ﬁnancial statements on a consolidated basis unless there is no control or control is temporary.

95

Statement of Cash Flows

Describes a new format for cash ﬂow reporting that replaces the statement of changes in ﬁnancial position and which is to be a key part of all ﬁnancial statements. It categorizes cash ﬂows by operating, investing, and ﬁnancing activities.

97

Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments

Describes the accounting for universal life–type contracts, as well as for limited-payment long-duration insurance contracts and investment contracts. It also revises the reporting for realized gains and losses that was originally itemized in FASB Statement No. 60.

98

Accounting for Leases: Sale-Leaseback Transactions Involving Real Estate, Sales-Type Leases of Real Estate, Deﬁnition of the Lease Term, and Initial Direct Costs of Direct Financing Leases

Itemizes the types of accounting required by the parties to a sale-leaseback transaction, while also modifying a number of issues originally set forth in FASB Statement No. 13.

99

Deferral of Effective Date of Recognition of Depreciation by Not-for-Proﬁt Organizations

Changes the effective date of FASB Statement No. 93 to ﬁscal years beginning on or after January 1, 1990.

101

Regulated Enterprises — Accounting for Discontinuation of Application of FASB Statement No. 71

Speciﬁes how a company should report in its ﬁnancial statements that it is no longer subject to certain types of regulation, including the elimination of any actions by regulators that had been itemized as assets or liabilities in previous ﬁnancial reports. The proﬁt impact of any such changes should be recorded in the current period as extraordinary items.

102

Statement of Cash Flows — Exemption of Certain Enterprises and Classiﬁcation of Cash Flows from Certain Securities Acquired for Resale

Exempts some employee beneﬁt plans and certain types of investment companies from following the dictates of FASB Statement No. 95, regarding the presentation of a statement of cash ﬂows.

E XHIBIT 4.4

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50

Ch. 4 Accounting Principles and Standards

Number 104

106

Title Statement of Cash Flows —Net Reporting of Certain Cash Receipts and Cash Payments and Classiﬁcation of Cash Flows from Hedging Transactions Employers’ Accounting for Postretirement Beneﬁts Other than Pensions

107

Disclosures about Fair Value of Financial Instruments

109

Accounting for Income Taxes

110

Reporting by Deﬁned-Beneﬁt Pension Plans of Investment Contracts

111

Rescission of FASB Statement No. 32 and Technical Corrections Employers’ Accounting for Postemployment Beneﬁts

112

113

114

Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts Accounting by Creditors for Impairment of a Loan

115

Accounting for Certain Investments in Debt and Equity Securities

116

Accounting for Contributions Received and Contributions Made

117

Financial Statements of Not-for-Proﬁt Organizations

E XHIBIT 4.4

Black process 45.0° 133.0 LPI

Description Allows banks and similar entities to report in a statement of cash ﬂows some cash ﬂows related to deposits and loans.

Requires that postretirement health care beneﬁts be accounted for by accruing the expected cost of future beneﬁts at the time when employees are still working for the company. Requires all organizations to itemize the fair value of all ﬁnancial instruments in the statement of ﬁnancial position, if this information can be determined. Outlines the bases and resulting rules upon which one should account for income taxes, focusing on an asset and liability approach to the presentation of income tax information. Mandates that an investment contract held by a deﬁned-beneﬁt pension plan be stated at its fair value, while only contracts including mortality risk can be recorded at their contract value. Rescinds FASB Statement No. 32, and also makes technical corrections to several other documents. Requires that the liability associated with postemployment beneﬁts be recognized if several requirements are met, as well as that the amount of the liability can be reasonably estimated and it is probable that a liability has been incurred. Describes how insurance entities should account for the reinsuring of insurance contracts, requiring reinsurance receivables and prepaid reinsurance premiums to be reported as assets. Describes the proper accounting for the impairment of some types of loans by creditors, requiring that these loans be recorded at their discounted present values. Describes the different types of reporting for debt and equity securities. Debt that is intended to be held to maturity is reported at amortized cost, while both debt and equity securities to be sold in the near term are reported at fair value, with unrealized gains or losses included in current earnings. Finally, debt and equity that falls into neither category is reported at fair value, with any unrealized gains or losses reported in shareholders’ equity. Describes the standards to be used when making or receiving contributions. Essentially, contributions are made and received at their fair value, while conditional contributions are recognized only when all associated conditions have essentially been met. Describes the reporting format to be used by not-for-proﬁt organizations.

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4.12 Statements of Financial Accounting Standards: FASB

Number

Title

51

Description

118

Accounting by Creditors for Impairment of a Loan— Income Recognition and Disclosures

Modiﬁes FASB Statement No. 114 to allow creditors to use existing methods for recognizing interest income on an impaired loan.

120

Accounting and Reporting by Mutual Life Insurance Enterprises and by Insurance Enterprises for Certain Long-Duration Participating Contracts

Increases the coverage of FASB Statements Nos. 60, 97, and 113 to assessment enterprises, fraternal beneﬁt societies, and mutual life insurance organizations.

121

Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of

Describes how to account for the impairment or disposition of long-lived assets, some identiﬁable intangibles, and goodwill related to those assets. The basic requirement is to periodically review these assets for impairment by comparing expected future cash ﬂows to their carrying value.

123

Accounting for Stock Compensation

Describes the required reporting for employee compensation plans that include the use of company stock, such as stock appreciation rights, stock options, stock purchase plans, and restricted stock.

124

Accounting for Certain Investments Held by Not-for-Proﬁt Organizations

Describes how not-for-proﬁt organizations must use fair value when reporting on equity securities whose fair values can be determined, as well as all investments in debt securities.

125

Transfers of Financial Assets and Extinguishment of Liabilities

Describes the reporting requirements related to the transfer of ﬁnancial assets and the extinguishment of liabilities through the recognition of those ﬁnancial assets under a business’s control and derecognizing both those over which control no longer exists and those liabilities that have been extinguished.

126

Exemption from Certain Required Disclosures about Financial Instruments for Certain Nonpublic Entities

Modiﬁes FASB Statement No. 107 to make the reporting requirements in that document optional if the business is nonpublic, its total assets are less than $100 million, and the business has not been involved with any derivative-related transactions during the reporting period.

127

Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125

Adds new criteria to those listed in FASB Statement No. 125 for determining whether a sale or a pledge of collateral for debt has occurred when a transfer of assets arises. It also describes how to account for pledged collateral.

128

Earnings per Share

Describes how to compute and report on earnings per share information, replacing the use of primary earnings per share with basic earnings per share. Requires the use of a dual presentation of basic and diluted earnings per share if a business has a complex capital structure.

129

Disclosures of Information about Capital Structure

Itemizes the standards for reporting a business’s capital structure, and spreads this requirement to nonpublic businesses.

E XHIBIT 4.4

Black process 45.0° 133.0 LPI

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52

Ch. 4 Accounting Principles and Standards

Number

Title

130

Reporting Comprehensive Income

131

Disclosures about Segments of Enterprise and Related Information

132

Employers’ Disclosures about Pensions and Other Postretirement Beneﬁts

133

Accounting for Derivative Instruments and Hedging Activities

134

Accounting for MortgageBacked Securities Retained After the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise Rescission of FASB Statement No. 75 and Technical Corrections

135

136

137

138

139

Transfers of Assets to a Not-for-Proﬁt Organization or Charitable Trust that Raises or Holds Contributions for Others Accounting for Derivative Instruments and Hedging Activities —Deferral of the Effective Date of FASB Statement No. 133 Accounting for Certain Derivative Instruments and Certain Hedging Activities — An Amendment of FASB Statement No. 133 Rescission of FASB Statement No. 53 and Amendments to FASB Statements Nos. 63, 89, and 121

E XHIBIT 4.4

Black process 45.0° 133.0 LPI

Description Describes how to report comprehensive income, as well as related revenues and expenses in the ﬁnancial statements. Replaces FASB Statement No. 14; describes reporting requirements about operating segments, products and services, geographic area, and major customers, both in annual and interim ﬁnancial statements. This is not applicable to not-for-proﬁt and nonpublic businesses. Describes the types of disclosures required for employers’ pension and related retirement plans, which include information about changes in beneﬁt obligations, as well as the fair values of plan assets. It also allows nonpublic companies to have reduced reporting requirements. Requires that a business entity recognize all derivatives within the statement of ﬁnancial position, and that they be measured at their fair value. This Statement encompasses the use of derivatives that are embedded in other types of contracts. Modiﬁes paragraphs 4 and 6 of Statement No. 65 (Accounting for Certain Mortgage Bank Activities) and paragraph 12(a) of Statement No. 115 (Accounting for Certain Investments in Debt and Equity Securities).

Rescinds Statement No. 75 (Deferral of the Effective Date of Certain Accounting Requirements for Pension Plans of State and Local Governmental Entities) in favor of GASB Statement No. 25. It also excludes beneﬁt pension plans sponsored by government entities from the scope of Statement No. 35. Describes the proper accounting for transactions where a donor contributes assets to a not-for-proﬁt entity that then shifts the assets to a donor-speciﬁed third beneﬁciary. Amends paragraphs 48 and 50 of Statement No. 133.

As noted in the title. It is effective for all ﬁscal quarters and years beginning after June 15, 2000.

Substitutes Statement of Position No. 00-2 (Accounting by Producers or Distributors of Films) for FASB Statement No. 53. It also revises earlier FASB statements related to accounting by broadcasters, changing prices, and the impairment or disposition of long-lived assets. It should be applied to all ﬁscal years beginning after December 15, 2000.

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4.13 Statements of Financial Accounting Concepts: FASB

Number

Title

140

Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities

141

Business Combinations

142

Goodwill and Other Intangible Assets

E XHIBIT 4.4

53

Description Describes the accounting standards to be used for transactions related to the transfer and servicing of ﬁnancial assets, as well as the extinguishment of liabilities. It retains most of Statement No. 125’s pronouncements, but revises the rules for accounting for securitizations and related transfers of ﬁnancial assets. Describes the use of the purchase method of accounting to account for business combinations; it eliminates the use of the pooling of interests method of accounting. Describes how to report intangible assets in the ﬁnancial statements, though not intangible assets acquired through a business combination. It also notes how intangible assets should be accounted for on an ongoing basis.

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4.13 STATEMENTS OF FINANCIAL ACCOUNTING CONCEPTS: FASB The seven Concepts standards that have been listed in Exhibit 4.5 issued by the FASB (of which No. 3 has been superseded) are designed to provide the accountant with a background for the understanding of accounting standards. Number

Title

1

Objectives of Financial Reporting by Business Enterprises

2

Qualitative Characteristics of Accounting Information

4

Objectives of Financial Reporting by Non-business Organizations

5

Recognition and Measurement in Financial Statements of Business Enterprises Elements of Financial Statements

6

7

Using Cash Flow Information and Present Value in Accounting Measurements

E XHIBIT 4.5

Black process 45.0° 133.0 LPI

Description Speciﬁes that ﬁnancial reporting is designed to allow one to predict cash ﬂows, entity resources and how they are used, and information that the reader can use to make economic decisions. Speciﬁes that accounting information should be comparable and consistent between periods, as well as understandable, reliable, and relevant. Establishes the objectives of ﬁnancial reporting by nonbusiness organizations, which are similar to those for business organizations. It deﬁnes nonbusiness organizations, identiﬁes transactions common to them that are uncommon for business organizations, and notes that ﬁnancial reports for these entities should provide additional information about the level of services provided and the quality of stewardship by managers. Speciﬁes the types of information to include in ﬁnancial statements, and the timing of its presentation.

Deﬁnes the core elements to be found in ﬁnancial statements, which are comprehensive income, revenue, expenses, gains, losses, owner investments, owner distributions, assets, liabilities, and equity. Describes why and when present value, fair value, and the interest rate method for amortization are used to provide valuations, and how future cash ﬂows can be used to determine this information.

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54

Ch. 4 Accounting Principles and Standards

4.14 TECHNICAL BULLETINS: FASB Technical Bulletins, summarized in Exhibit 4.6, are intended to clarify or elaborate on underlying accounting standards. They typically address narrow subject areas that are not directly addressed by existing accounting standards; part of the resulting discussion may lead to some variations from GAAP that are targeted only at the tightly deﬁned areas that are directly addressed by the Technical Bulletins. Any such changes are not expected to create major variations from current GAAP, nor should they be costly to implement.

Number

Title

Description

79-1

Purpose and Scope of FASB Technical Bulletins and Procedures for Issuance

Notes that technical bulletins are intended to provide guidance in applying the opinions, statements, and interpretations previously issued by both the FASB and its predecessors, as well as to address issues not directly covered by those GAAP standards.

79-3

Subjective Acceleration Clauses in Long-Term Debt Agreements

Does not authorize the restatement of long-term debt as short-term debt in situations where there are subjective acceleration clauses in debt agreements, and where there is little likelihood of acceleration.

79-4

Segment Reporting of Puerto Rican Operations

Speciﬁes that a domestic corporation’s Puerto Rican operations should be considered part of its domestic operations, and not a foreign entity.

79-5

Meaning of the Term “Customer” as it Applies to Health Care Facilities Under FASB Statement No. 14

Speciﬁes that an insuring entity is not a customer of a health care facility, for the purposes of reporting on customers who represent at least 10 percent of an entity’s business.

79-9

Accounting in Interim Periods for Changes in Income Tax Rates

Speciﬁes the method for determining the reduction in the corporate tax rate resulting from the Revenue Act of 1978 for those entities not using a calendar year as their ﬁscal year.

79-10

Fiscal Funding Clauses in Lease Agreements

Speciﬁes that the presence of a ﬁscal funding clause will not result in a lease being considered cancelable if the probability of the clause being invoked is remote.

79-12

Interest Rate Used in Calculating the Present Value of Minimum Lease Payments

Allows a business to use its secured borrowing rate when determining the present value of minimum lease payments, as long as that rate is reasonable and would be representative of the type of ﬁnancing used for the lease.

79-13

Applicability of FASB Statement No. 13 to Current Value Financial Statements

Requires that the provisions of FASB Statement No. 13 be applied to ﬁnancial statements that have been prepared on a current value basis.

79-14

Upward Adjustment of Guaranteed Residual Values

Prohibits the use of upward adjustments of estimated residual values resulting from renegotiations of the guaranteed portions of residual values.

79-15

Accounting for Loss on a Sublease Not Involving the Disposal of a Segment

Describes a loss on a sublease, and speciﬁes that it be recognized as soon as it is expected to be incurred.

79-16

Effect of a Change in Income Tax Rate on the Accounting for Leveraged Leases

Requires that the income effect of a change in the statutory tax rate be recognized in the period immediately after the change becomes law.

E XHIBIT 4.6

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4.14 Technical Bulletins: FASB

Number

Title

55

Description

79-17

Reporting Cumulative Effect Adjustment from Retroactive Application of FASB No. 13

States that the cumulative effect of modifying ﬁnancial statements to comply with the provisions of FASB Statement No. 13 should not be included in the net income of any presented year unless the year prior to the earliest year presented could not be restated.

79-18

Transition Requirements of Certain FASB Amendments and Interpretations of FASB Statement No. 13

Describes the ﬁnancial reporting and disclosure requirements associated with the changes required by FASB Statement No. 13.

80-1

Early Extinguishment of Debt Through Exchange for Common or Preferred Stock

Notes that the provisions of APB Opinion No. 26 do apply to the extinguishment of debt through the issuance of common or preferred stock, and also describes its presentation in the ﬁnancial statements.

80-2

Classiﬁcation of Debt Restructurings by Debtors and Creditors

Allows different accounting interpretations of the presence of a troubled debt restructuring by debtors and creditors.

81-6

Applicability of Statement No. 15 to Debtors in Bankruptcy Situations

Speciﬁes that FASB Statement No. 15, which describes troubled debt restructurings, does not apply to bankrupt companies that restructure their debt as part of a general restructuring of all of their liabilities, but does apply if there is not a general restatement of the debtor’s liabilities.

82-1

Disclosure of the Sale or Purchase of Tax Beneﬁts Through Tax Leases

Requires that a company engaged in the sale or purchase of tax beneﬁts through tax leases disclose the method of accounting for them, as well as the methods used to recognize revenue and allocate income tax beneﬁts and asset costs to both current and future periods.

84-1

Accounting for Stock Issued to Acquire the Results of a Research and Development Arrangement

Requires that stock exchanged for the results of a research and development arrangement be recorded at either its fair market value or the fair value of the consideration received.

85-1

Accounting for the Receipt of Federal Home Loan Mortgage Corporation Participating Preferred Stock

Requires that the 12 district banks of the Federal Home Loan Banking System record the receipt of participating preferred stock from the Federal Home Loan Mortgage Corporation at its fair value as of the date of receipt, with any resulting income being recorded as an extraordinary item.

85-3

Accounting for Operating Leases with Scheduled Rent Increases

Requires that scheduled rent increases be recognized on a straight-line basis over the lease term unless there is another systematic allocation system available that better represents the time pattern during which the leased property is being used.

85-4

Accounting for Purchases of Life Insurance

Speciﬁes that life insurance be reported as an asset, with the change in cash surrender value during the period being offset against payments made in order to determine the amount of the insurance expense.

85-5

Issues Relating to Accounting for Business Combinations

Speciﬁes that the costs incurred to close duplicate facilities as a result of a business combination shall be charged to expense, and shall not be included in the accounting for the business combination.

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Ch. 4 Accounting Principles and Standards

Number 85-6

86-2

87-2

87-3

88-1

90-1

94-1

97-1

Title

Accounting for a Purchase Speciﬁes that if Treasury stock is acquired at a price signiﬁcantly higher than its market price, the difference of Treasury Shares at should be accounted for as being consideration for a Price Signiﬁcantly in other services provided by the company, unless no other Excess of the Current consideration can be identiﬁed. Also notes that corporate Market Price of the payments to a shareholder for a standstill agreement Shares and the Income be charged to current expense. Also, any costs incurred Statement Classiﬁcation to defend against a takeover attempt should be charged of Costs Incurred in to operating expenses, not extraordinary expenses. Defending Against a Takeover Attempt Accounting for an Interest Requires that an unconditional right to own a leased asset at in the Residual Value of the end of the lease term requires the lessee to account for it a Leased Asset as an asset. It also discusses the valuation of the residual value of leased assets for lessees, lessors, and lease brokers. Computation of a Loss on Describes the accounting for deferred income taxes a Abandonment associated with abandonments and the assets remaining thereafter, with separate treatment for regulated entities. Accounting for Describes the accounting treatment for the impact of Mortgage Servicing Fees estimated future net servicing income from a reﬁnanced and Rights loan on the amortization of capitalized costs related to the acquisition of the mortgage servicing rights for the superseded loan. Issues Relating to Describes the proper accounting treatment of leasing issues Accounting for Leases related to incentives in an operating lease, wrap lease transactions, money-over-money lease transactions, the time pattern of the physical use of operating lease property, and the applicability of leveraged lease accounting to a lessor’s existing assets. Speciﬁes that income from a separately priced warranty Accounting for Separately or maintenance agreement be amortized to income on a Priced Extended straight-line basis over the term of the agreement, except Warranty and Product in situations where there is historical proof that some other Maintenance Contracts amortization schedule would more accurately reﬂect the incurrence of related costs, and also describes the proper treatment of losses on such contracts. Speciﬁes that any restructured loans arising from a troubled Application of Statement debt restructuring are subject to the provisions of FASB No. 115 to Debt Statement No. 115 if it meets the deﬁnition of a “security” Securities in a Troubled as deﬁned in that Statement. Debt Restructuring Describes the situations in which the fair value measurement Accounting Under technique is used to value awards under various types of Statement No. 123 for employee stock purchase plans with look-back provisions. Certain Employee Stock Purchase Plans with a Look-Back Option

E XHIBIT 4.6

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CHAPTER*

5

COST ACCOUNTING AND COSTING SYSTEMS 5.1 INTRODUCTION 57

5.7 PROCESSING: STANDARD COSTING 69

5.2 PURPOSE OF COST ACCOUNTING INFORMATION 57

5.8 PROCESSING: DIRECT COSTING 71

5.3 INPUT: DATA COLLECTION SYSTEMS 58

5.9 PROCESSING: THROUGHPUT COSTING 73

5.4 PROCESSING: DATA SUMMARIZATION SYSTEMS 60

5.10 PROCESSING: ACTIVITY-BASED COSTING 76

5.5 PROCESSING: JOB COSTING 62

5.11 PROCESSING: TARGET COSTING 79

5.6 PROCESSING: PROCESS COSTING 66

5.12 OUTPUTS: COST VARIANCES 80

5.1 INTRODUCTION Cost accounting is one of the most crucial aspects of the accounting profession, for it is the primary means by which the accounting department transmits company-related performance information to the management team. A properly organized cost accounting function can give valuable feedback regarding the impact of product pricing, cost trends, the performance of cost and proﬁt centers, and production and personnel capacity, and can even contribute to some degree in the formulation of company strategy. Despite this wide array of uses, many controllers rarely give due consideration to the multitude of uses to which cost accounting can be put. Instead, they think only of how cost accounting will feed information into the ﬁnancial statements. This orientation comes from a strong tendency in business schools to train students in generally accepted accounting principals (GAAP) and how they are used to create ﬁnancial statements. In this chapter, we will focus on how one can collect data, summarize it, and report it to management with the goal of helping the management team to run the business.

5.2 PURPOSE OF COST ACCOUNTING INFORMATION The cost accounting function works best without any oversight rules and regulations, because, in accordance with its stated purpose of assisting management, it tends to result in hybrid systems that are custom-designed to meet speciﬁc company needs. For example, a company may ﬁnd that a major requirement is to determine the incremental cost that it incurs for each additional unit of production, so that it can make accurate decisions regarding the price of incremental units sold (possibly at prices very close to the direct cost). If it were to use accounting standards, it would be constrained to only use a costing system that allocated a portion of overhead costs to product

* Adapted with permission from Chapter 26 of Steven M. Bragg, Accounting Reference Desktop (Hoboken: Wiley, 2002).

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Ch. 5 Cost Accounting and Costing Systems

costs—even though these are not incremental costs. Accordingly, the cost accounting system used for this speciﬁc purpose will operate in contravention of GAAP, because following GAAP would yield results that do not assist management. Because there are many different management decisions for which the cost accounting profession can provide valuable information, it is quite common to have several costing systems in place, each of which may use different costing guidelines. To extend the previous example, the incremental costing system used for incremental pricing decisions may not be adequate for a different problem, which is creating proﬁt centers that are used to judge the performance of individual managers. For this purpose, a second costing system must be devised that allocates costs from internal service centers to the various proﬁt centers; in this instance, we are adding an allocation function to the incremental costing system that was already in place. Even more systems may be required for other applications, such as transfer pricing between company divisions and the costing of inventory for external ﬁnancial reporting purposes (which does require attention to GAAP guidelines). Consequently, cost accounting frequently results in a multitude of costing systems, which may follow GAAP guidelines only by accident. The controller’s primary concern is whether the information resulting from each system adequately meets the needs of the recipients. Any cost accounting system is comprised of three functional areas: the collection of raw data, the processing of this data in accordance with a costing methodology, and the reporting of the resulting information to management in the most understandable format. The remainder of this chapter is split into sections that address each of these three functional areas. The area that receives the most coverage is the processing function, for there are a number of different methodologies available, each of which applies to different situations. For example, job costing is used for situations where speciﬁcally identiﬁable goods are produced in batches, while direct costing is most applicable in situations where management does not want to see any overhead allocation attached to the directly identiﬁable costs of a product. The large number of processing methodologies presented here is indicative of the broad range of options available to the controller for processing raw data into various types of reports for management use.

5.3 INPUT: DATA COLLECTION SYSTEMS The ﬁrst step in setting up a data collection system is to determine what types of data to gather. One can simply collect every conceivable type of data available, but this will result in immensely detailed and cumbersome collection systems that are expensive and require a great deal of employee time to collect and record. A better approach is to determine what types of outputs are required, which can then be used to ascertain the speciﬁc data items needed to create those outputs. This allows the controller to ignore many types of data, simply because no one needs them. However, the process of determining data requirements from projected outputs must be revisited on a regular basis, for changes in the business will require changes in the required cost accounting reports, and therefore changes in the types of data collected. The process of backtracking from a required output to a set of required data elements is best illustrated with an example. If a company is manufacturing a set of products whose components and assembly are entirely outsourced, then it is logical to create management reports that focus on the prices being charged to the company by its suppliers, rather than creating an elaborate time recording system for the small number of quality inspectors who are responsible for reviewing completed goods before they are shipped out to customers. In this case, the bulk of the data used by the costing system will come out of the accounts payable and purchasing records. Another example is a software company, where the costing focus is on the labor time charged to speciﬁc development projects and the ability of project managers to meet their deadlines, rather than on the minor cost of purchasing compact disks, packaging, and training materials that are shipped to customers. In this case, most of the cost accounting data will come from the timekeeping and project-tracking databases. Thus, the nature of the business will drive the decision to collect certain types of data. Once the controller knows what data to collect, there is still the issue of creating a data accumulation system. There are several factors that will inﬂuence this decision. One is cost; if there are many employees who will be recording information continuously, then the unit cost of the data collection device cannot be too expensive, or else its total cost will exceed the utility of the col-

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59

lected data. Another issue is data accuracy; if the data collected absolutely, positively must be correct, then a more elaborate solution, such as bar code scanning, which is designed to yield superaccurate results, should be the preferred solution. However, if the level of required accuracy is lower, then perhaps manual keypunch entry or handwritten data sheets would be acceptable. Another factor is the employees who will use the data collection systems; if they are highly trained, then they can be relied on to use complex keypunching systems, whereas a poorly trained work force that has no idea of what data it is collecting, or why it is being used, should be allowed to collect only data that will be heavily cross-checked for errors. Of additional concern is the timeliness of the data collected. If there is a need for up-to-the-minute transmission of data to managers, then the only solution will be some form of automated data gathering. On the other hand, only an occasional report to management may require a slower manual data gathering approach. Another factor to consider is the existing level of automation within the company. For example, if there is a clear production path for all products that sends every completed item down a speciﬁc conveyor belt, then the installation of a ﬁxed bar code scanner on that conveyor is a reasonable approach for recording data about production quantities. However, this would be a poor solution if products were being hand-carried away from a multitude of production processes to the warehouse, since many of the items created would never pass by the bar code scanner. A ﬁnal consideration is the production methodology currently in use. If it is a lean manufacturing system, such as just-in-time, there will be a strong orientation away from requiring employees to conduct any data entry work, since extremely focused and efﬁcient workﬂows are the key to success in this environment — which is interrupted if data entry tasks are included. In these cases, one should avoid any type of manual data entry, focusing instead on more automated approaches. Given the above parameters, it is clear that the controller must devise a wide array of data collection tools in order to collect data in the most appropriate manner. The following bullet points describe a number of the more common (and upcoming) data collection tools: • Punch clocks. A data collection tool that is proving to have a great deal of longevity is the punch clock. This is used by hourly employees to record the times when they arrive for work and leave at the end of the day. The process is a simple one; take your time card from a storage rack, insert it into the top of the clock, which stamps the time on it, and return your card to the storage rack. The payroll staff then uses these cards to calculate payroll. The greatest advantage of this approach is that a time clock is very inexpensive. However, it requires conversion of the time card data by the payroll staff into another format before it can be used, which introduces the likelihood of computational errors. Also, it is difﬁcult to use for recording time worked on speciﬁc jobs. • Electronic time clocks. This clock allows employees to swipe a badge through a reader on the side or top of the clock. This results in a computer entry for the time of the scan, which is also associated with the employee code that is embedded in the card, through the use of either a bar code or a magnetic stripe. A more advanced version uses the biometric measurement of the outlines of one’s hand to determine the identity of the employee (thereby eliminating the need for an employee badge, which might otherwise be lost or used to make a scan for someone who is not on the premises). This represents a signiﬁcant advance over the punch clock, because there is no need for secondary calculations that might result in an error. It also yields greater control over the time-recording process, since it gives immediate feedback to supervisors regarding missed or late scans. An additional beneﬁt is that employees can enter job numbers as part of the scanning process, so that time is charged to speciﬁc jobs. However, the electronic time clock costs up to $2,000 each, and so is usually restricted to high-volume applications where there are many employees—punch clocks are therefore only used in high-volume locations where they are more cost-effective. • Bar code scanners. A bar code scanner is a device that reads bar code labels with either a ﬁxed or rapidly rotating laser beam, and converts the bar code symbology into a characterbased format that is then stored in the computer system. These scanners come in many shapes and sizes, ranging from a $100 ﬁxed-beam scanner that looks like a pen (but which may require a number of scans to read a bar code) to a $10,000 ﬁxed-position scanner that is bolted to a conveyor belt, and which emits 30 scans per second as bar-coded packages move

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Ch. 5 Cost Accounting and Costing Systems

past it. There are also portable scanners, which are heavily used in warehousing operations, that can store scanned information in local RAM memory for later uploading to a computer, or that contain direct radio frequency access to the company computer, and can therefore transmit the data immediately. The type of scanner purchased will depend on the level of automation required, and the budget available for this purpose. Bar code scanning is highly recommended for repetitive data entry situations where the same data is collected many times. On the other hand, it is of less use where the data collected changes constantly, or involves a large quantity of text that would require an extremely large bar code. Nonetheless, some portion of most data entry applications can involve the use of bar code scanning. • Terminal data entry. An increasingly common form of data entry is to not use any new data collection devices — instead, just buy lots more computer terminals and make them available to users throughout the company. Employees can then be given direct access to the computer screens that require input from them, and can enter information directly into the computer system. This avoids the middleman data entry person, as well as the risk that the data entry staff might misinterpret the data on an employee’s form and type in the wrong information. The process can be facilitated by the use of error-checking protocols within the computer software, so that users will be ﬂagged if they make entries that are clearly outside of a narrow band of expected responses. Also, computer screens can be devised for individual users that are designed to assist them in entering only the data they have access to, and in the most efﬁcient manner. However, it can be expensive to rig all locations in a company with computer terminals and all linking wiring, while some employees may move around so much that having them use a ﬁxed terminal is not a viable option. Consequently, this approach may have limited applicability, depending on the situation. • Paper-based data entry. Despite all of the other forms of advanced data entry noted here, the most common method for collecting data is still from a paper document. This approach is inexpensive, requires no web of interlinked electronic devices throughout a facility, and is familiar to all employees as a method of data capture. However, it does not result in a fast ﬂow of data through an organization, since it may be days or weeks before the information contained on a form is re-keyed into the computer system. Also, it is easy to lose forms, especially when they are being used throughout a facility and there is no rigid tracking of individual forms to ensure that none are lost. Furthermore, this approach requires the services of an expensive data entry person to interpret the data on the forms (sometimes incorrectly) and type the results into the computer system. Given these problems, it is no surprise that the proportion of data gathering that uses this approach is shrinking — nonetheless, it still comprises the majority of all data gathering techniques in most organizations. • Electronic pen data entry. A very new data gathering approach is the electronic pen. This is a pen that not only marks in ink on paper, but also tracks its exact position on a pad of “smart” paper (that has a built-in identifying grid that tells the pen where it is touching the paper). The pen transmits its position via the new Bluetooth data transmission protocol to any nearby receiver that is tuned to the pen’s transmission frequency. This results in a digital copy of the writer’s penmanship that can then be converted into text, which in turn can be stored in the company database. Though this is a nascent technology, it may become an important form of data collection in the years to come. Thus, there are a wide range of data entry systems available. In most instances, the controller who is designing a data collection system will need to use a mix of these options to ensure that the correct mix of high data accuracy and low collection cost is achieved.

5.4 PROCESSING: DATA SUMMARIZATION SYSTEMS Having covered the data collection portion of cost accounting, we now move to the various costing methodologies that are available for processing the raw data into a format that is most useful for management consumption. The primary advantages and disadvantages of the systems whose functions are noted in the following sections are:

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• Job costing. This is a commonly used system that is primarily targeted at production situations where customized goods are produced for speciﬁc customers. It is very useful for tracking the exact cost of individual products, and is the only valid technique for accumulating costs for cost-plus contractual arrangements. It can also yield accurate results about the ongoing costs of a current job, which is useful for monitoring purposes. However, this system requires a large quantity of detailed data collection and data entry, which is expensive. It also runs the risk of including some inaccurate data, which requires expensive control systems to minimize. Furthermore, there may be a signiﬁcant allocation of overhead costs to each job, which may be inaccurately applied. • Process costing. This is also a heavily used system, and is most common in situations where large quantities of exactly the same product are created. Costs are collected in bulk for entire time periods, and then allocated out to the volume of entire production runs during that period. This results in a fair degree of accuracy when costs are averaged out and assigned to individual units. However, some degree of estimation is required when determining total production quantities completed, since some units may be only partially completed at the end of the production period. Consequently, there is some room for variation in ﬁnal production costs. This method requires much less data collection than job costing, but the level of information accuracy is correspondingly less. • Standard costing. This methodology has been installed in many companies as an adjunct to both the job costing and process costing systems. It is designed to set standard costs for all material and labor costs incurred by a company, against which actual results can be compared through variance analysis. This can result in excellent control over company costs, but only if the accounting staff is diligent in uncovering the reasons for variances from costing standards, and the management team is helpful in correcting the discovered problems. It is also useful for budgeting, setting prices, and closing the ﬁnancial books in a rapid manner. However, it is also time-consuming to set and maintain standards; in environments where this maintenance function is not performed, standards can be so far away from actual results that variance analysis is no longer useful for management purposes. Also, a company that has adopted continuous process improvement principles will ﬁnd that any standards adopted will almost immediately become obsolete, requiring constant correction. Furthermore, most standards are set at the product level, rather than at the batch level, so there is no basis of comparison when using this method for cost control over production batches. Another problem is that comparisons to actual costs tend to focus management attention on labor variances, which have historically been a large part of the cost accounting report package, even though these costs comprise only a small proportion of total production costs in most manufacturing environments. Finally, it tends to perpetuate inefﬁciencies, if personnel use the current standard cost as a baseline for behavior; they will have no incentive to improve costs to a point that is substantially better than the pre-set standard, resulting in languishing efﬁciency levels. For these reasons, standard costing is now used in a more limited role that in previous years. • Direct costing. This is a favorite methodology for those managers who are constantly confronted with incremental costing and pricing decisions where the inclusion of overhead costs in a product’s total cost will yield inaccurate information. Thus, direct costing is an ideal approach for determining the lowest possible price at which to sell incremental units. However, it yields inaccurate results when used for long-term pricing, since it takes no account of overhead costs that must be included in a company’s standard prices if it is to assure itself of long-term proﬁtability. It is also not allowed for inventory valuation purposes by GAAP, which requires the inclusion of allocated overhead costs. • Throughput accounting. A variation on direct costing is throughput costing. This methodology holds that the only direct cost is direct materials, with even direct labor costs being thrown out when making most cost-related management decisions. The main tenet of throughput accounting is that a company must carefully manage the bottleneck operation in its production facility, so that the largest possible contribution margin is created. The main advantage of throughput accounting is that it yields the best short-term incremental proﬁts if it is religiously fol-

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Ch. 5 Cost Accounting and Costing Systems

lowed when making production decisions. However, this can result in production mixes that seriously delay the completion of jobs for some customers, which is not good for customer relations. • Activity-based costing (ABC). The ABC methodology is a much more accurate way to associate overhead costs with speciﬁc activities, which in turn can be assigned to product costs. Its main advantage is that it builds a direct correlation between the occurrence of an activity and related overhead costs, so that changes in the activity can be reliably expected to result in corresponding changes in the overhead costs. This results in valuable information for the management team, which uses it not only to gain some measure of control over its overhead costs, but also to gain an understanding of which products use more activities (and therefore overhead costs) than others. The downside of this methodology is that it requires a great deal of costing knowledge, time, and management commitment before a functioning ABC system becomes operational, and will henceforth require considerable upkeep to maintain. It also requires the construction of an ABC database that is separate from the general ledger, which can be an expensive proposition to both create and maintain. It is not really necessary in situations where there are few products, obvious process ﬂows, and minimal machine setups, because a less complex cost accumulation system will still result in reasonably accurate product costs. • Target costing. This costing methodology is the most proactive of all the methodologies, for it involves the direct intervention of the cost accounting staff in the product design process, with the express intent of creating products that meet pre-set cost and gross margin goals. This is opposed to the usual practice of accumulating costs after products have been designed and manufactured, so that managers will ﬁnd out what a product costs after it is too late to make any changes to the design. This costing system is highly recommended to any company that designs its own products, since it can result in signiﬁcant reductions in product costs before they are “locked in” when the design is completed. This technique usually requires a great deal of cost accounting staff time, and can lengthen the product development process, but is well worth the effort. This brief review of the advantages and disadvantages of each costing methodology should make it clear not only that they are wildly different from each other in concept, but also that they are all designed to deal with different situations, several of which may be found within the same company. Accordingly, a controller must become accustomed to slipping in and out of a methodology when the circumstances warrant the change, and will very likely use a combination of these systems at the same time, if demanded by the circumstances. In the following sections, we will review the workings of each of these costing methodologies.

5.5 PROCESSING: JOB COSTING Job costing involves a series of transactions that accumulate the costs of materials, labor, and overhead (of which there are two different calculations) to a speciﬁc job. For each of these costing categories, costs are accumulated through a series of transactions before they are ﬁnally charged to a speciﬁc job. In this section, we will trace the journal entries used for all of these costs. The basic ﬂow of journal entries required for direct materials is noted in Exhibit 5.1, which itemizes the general format of each sequential transaction. When raw materials are purchased, they are rarely charged to a particular job upon receipt. Instead, they are stored in the warehouse, so there is a debit to the raw materials inventory and a credit to accounts payable. Once production is scheduled, the raw materials will be sent to the production ﬂoor, which triggers another transaction, to be created by the warehouse staff — a debit to the work-in-process inventory account and a credit to the raw materials inventory account. During the production process, it is quite likely that some portion of the materials will be destroyed as part of the normal production process; if so, another entry will be required that creates a debit to the overhead cost pool, and a credit to remove the cost from the work-in-process inventory account. This normal amount of scrap will then be allocated through the overhead cost pool back

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Raw Materials Inventory Accounts Payable

63

XXX XXX

Record Raw Material Receipt

Cost of Goods Sold WIP Inventory

XXX XXX

Charge Abnormal Scrap and Spoilage to CGS

Overhead Cost Pool WIP Inventory

[Job-specific data stored in a subledger]

Charge Materials to Job

XXX

Charge Normal Scrap and Spoilage to Overhead Pool

WIP Inventory XXX Raw Materials Inventory XXX

XXX

Finished Goods Inventory WIP Inventory

XXX XXX

Move Job to Finished Goods

Cost of Goods Sold Finished Goods Inventory

XXX

Accounts Receivable Revenue

XXX

XXX

XXX

Sell Finished Goods

E XHIBIT 5.1

J OB C OSTING T RANSACTIONS

FOR

D IRECT M ATERIALS

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 10.

to product costs — we will deal with this issue shortly, when we talk about the cost ﬂow for overhead costs. If there are excessive amounts of scrap, then these will be instead charged directly to the cost of goods sold with a debit, while the work-in-process account is reduced with a credit. Once the production process has been completed (which may be a few moments for simple products, and months for complex ones), it is shifted back to the warehouse in the form of ﬁnished goods. To record this transaction, we use a debit to the ﬁnished goods inventory account and a credit to work-in-process inventory. Once the goods are sold from stock, a ﬁnal entry relieves the ﬁnished goods inventory account with a credit, and charges the cost to the cost of goods sold with a debit. One of the numerous beneﬁts of a just-in-time system is that materials are in the production process for such a short period of time that there is no point in creating transactions that move their cost in and out of work-in-process inventory. Instead, a single transaction shifts raw material costs from the raw materials inventory account to cost of goods sold (though there may be an extra entry to record the cost in ﬁnished goods inventory if completed products are not immediately sold). This greatly reduces the number of potential problems that can arise with the recording of transactions. The recording of labor costs follows a slightly different path than what is typically seen for material costs. Instead of taking a direct route into the work-in-process inventory account, labor costs either can be charged at once to the overhead cost pool or go into work-in-process inventory. The charge to an overhead cost pool is done if there is no direct relationship between the incur-

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Ch. 5 Cost Accounting and Costing Systems

rence of the labor cost and the creation of a product — this results in a debit to the overhead cost pool and a credit to the wages expense account. However, if there is a direct tie between the incurrence of labor costs and the production of speciﬁc products, then the debit is instead to the workin-process inventory (or a separate labor) account. These cost ﬂows are shown in Exhibit 5.2. If the wages have ﬂowed into an overhead cost pool, these costs will be summarized at the end of the accounting period and charged to speciﬁc products based on any number of allocation methodologies. The allocation calculation will result in another transaction that shifts the overhead costs to product costs, which can occur both at the work-in-process and ﬁnished goods Wages Expense Wages Payable

XXX XXX

Record Wages Incurred

Overhead Cost Pool Wages Expense

WIP Inventory Wages Expense

XXX XXX

Charge Wages to Overhead Pool

XXX XXX

Charge Wages to Job

[Job-specific data stored in a subledger]

[Accumulate statistical data on job activity usage]

WIP Inventory Overhead Cost Pool

XXX

Finished Goods Inventory WIP Inventory

XXX

Charge Overhead Costs to Job

XXX XXX

Move Job to Finished Goods

Cost of Goods Sold XXX Finished Goods Inventory XXX Accounts Receivable Revenue

XXX XXX

Sell Finished Goods

E XHIBIT 5.2

J OB C OSTING T RANSACTIONS

FOR

L ABOR

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 10.

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65

stages of production. Meanwhile, labor costs that have been charged directly to work-in-process inventory will then be shifted to ﬁnished goods inventory and later to the cost of goods sold in the same manner as for materials costs. As was the case for material costs, there are a large number of labor transactions that are required to track the ﬂow of labor costs through the production process under the job costing methodology. There is a high risk that transactional errors will arise, just because of the large number of transactions, so control systems must be created that keep errors from occurring and verify that completed transactions are correct. The ﬁnal job costing process under the job costing system is the allocation of costs to products. There are two ways to do this—either with the actual costs incurred during the production process, or else with standard costs that are later adjusted to match actual costing experience. The ﬁrst of these approaches is called actual cost overhead allocation, while the later is called normal cost overhead allocation. We will address the actual cost overhead allocation ﬁrst. Under actual costing, there are several sources of costs that will ﬂow into an overhead cost pool. As shown in Exhibit 5.3, all production supplies that cannot be traced to a speciﬁc product will be debited to the overhead account and credited to accounts payable (the credit may also be charged to raw materials inventory or supplies expense, if supplies were ﬁrst charged to either of these accounts). As already noted, some labor costs will also be charged to the overhead account. Also, and as previously noted under the materials costing ﬂow, normal amounts of production scrap and spoilage will be charged to overhead. Indirect wages and other indirect costs will also ﬂow into the overhead cost pool. At the end of the accounting period, the cost pool is charged out to various products based on a variety of possible allocation calculations, which are addressed in the activity-based costing section later in this chapter. Once overhead costs have been assigned to speciﬁc products, they follow the usual pattern of being moved to the ﬁnished goods inventory while their associated completed products are held in storage, and from there to the cost of goods sold upon sale of the product. The allocation of costs to speciﬁc jobs can be delayed for some time under the actual cost overhead allocation method, because some costs can be compiled only at the end of the month, or perhaps not until several weeks thereafter. This is a problem for those companies that want more immediate costing information. We use normal overhead cost allocations to resolve this problem. Normal costing means that a company charges out costs in the short-term using a historical average for its overhead costs, rather than actual costs. This process is shown in Exhibit 5.4. This allows costs to be charged to jobs at once. To ensure that the historical average being used for allocations does not stray too far from actual results, it is periodically compared to actual costs (which must still be accumulated), and adjusted as necessary. When actual and normal costs are compared, there should be a small variance, which can be disposed of in several ways. One approach is to charge off the entire variance to the cost of goods sold, though this can create an unusually high or low cost of goods sold. Another approach is to spread the variance among the cost of goods sold, work-in-process inventory, and ﬁnished goods inventory, based on the total balances remaining in each account at the end of the reporting period. A ﬁnal approach is to retroactively charge the variance to every job. These three options require an increasing amount of work to accomplish, in the order described. For that reason, the ﬁrst option is the most commonly used, while allocation to individual jobs is a rarity. The very large number of transactions required in a job costing system makes it a very inefﬁcient costing methodology from the perspective of the accounting department, which must verify that all of the transactions entered are correct. It can also call for the purchase of large quantities of data collection equipment, such as automated time clocks and bar code scanners, which can be quite expensive. Furthermore, this system requires some participation by production personnel in the data collection process, which detracts from their primary mission of manufacturing products. However, given the need for job costing information, a company may ﬁnd that there is no reasonable alternative to using this system. If so, the controller should carefully review the need for each type of data that can be potentially produced by the system, and collect only those that will result in valuable information — this will create a more efﬁcient data collection environment that focuses only on the key cost elements.

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Ch. 5 Cost Accounting and Costing Systems

Overhead Cost Pool Accounts Payable

XXX XXX

Record Material Supplies Receipt

Overhead Cost Pool Wages Payable

Overhead Cost Pool Wages Payable

XXX XXX

Record Indirect Wages Incurred

Record Unassigned Direct Wages Incurred

[Job-specific data stored in a subledger]

[Accumulate statistical data on job activity usage]

WIP Inventory Overhead Cost Pool

XXX XXX

Record Indirect Expenses Incurred

Overhead Cost Pool WIP Inventory

XXX XXX

Overhead Cost Pool Accounts Payable

XXX XXX

Record Normal Spoilage and Scrap

XXX XXX

Charge Overhead Costs to Job

Finished Goods Inventory XXX XXX WIP Inventory

Move Job to Finished Goods

Cost of Goods Sold XXX Finished Goods Inventory XXX Accounts Receivable Revenue

XXX XXX

Sell Finished Goods

E XHIBIT 5.3

J OB C OSTING T RANSACTIONS

FOR

A CTUAL O VERHEAD A LLOCATIONS

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 10.

5.6 PROCESSING: PROCESS COSTING Process costing is used in those situations when it is impossible to clearly differentiate the cost of individual units of production. For example, it is a prime candidate for use in an oil reﬁnery, where it is impossible to track the cost of an individual gallon of diesel fuel. The most common method for calculating process costs on a per-unit basis is to accumulate all production-related costs during the accounting period and calculate a weighted average per-unit cost based on these totals and the amount of production that was completed during the period, or which is currently still in process. An example of this calculation is shown in Exhibit 5.5.

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5.6 Processing: Process Costing

67

[Create Standard Allocation Rate for Jobs]

WIP Inventory Overhead Cost Pool

XXX XXX

Charge Standard Overhead Costs to Jobs

Overhead Cost Pool Accounts Payable

XXX XXX

Record Material Supplies Receipt

Overhead Cost Pool Wages Payable

Overhead Cost Pool Wages Payable

Record Indirect Wages Incurred

XXX

[Subtract Standard Allocations from Overhead Pool]

For Fin'l Statement Reporting

Small Variance

XXX

Write Off Variance to Cost of Goods Sold

E XHIBIT 5.4

XXX

XXX

Record Unassigned Direct Wages Incurred

Cost of Goods Sold Overhead Cost Pool

XXX

XXX

Finished Goods Inventory WIP Inventory Costs of Goods Sold Overhead Cost Pool Prorate Variance to Ending Account Balances

J OB C OSTING T RANSACTIONS

FOR

Overhead Cost Pool Accounts Payable

XXX XXX

Record Indirect Expenses Incurred

Overhead Cost Pool WIP Inventory

XXX XXX

Record Normal Spoilage and Scrap

For Highest Job Record Accuracy

XXX XXX XXX XXX

WIP Inventory Overhead Cost Pool

XXX XXX

Allocate Variance to All Jobs

N ORMAL O VERHEAD C OST A LLOCATIONS

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 10.

In the exhibit, there are three blocks of calculations, each one segregated by a horizontal line. The top block contains a conversion calculation, which converts the amount of completed and work-in-process units into units to which materials and other costs can be allocated. The ﬁrst column of numbers contains the calculation for the allocation of direct materials costs, while the ﬁnal column of numbers calculates the allocation of all other production costs. For the purposes of this calculation, we assume that there are two types of costs — direct materials, which are typically added at the beginning of the production process, and all other costs, which can be added at a multitude of other points during the manufacturing sequence.

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Ch. 5 Cost Accounting and Costing Systems

Units Summary

Completed Units Ending Units in Process Unit Totals Unit Cost Calculation

Beginning Work-in-Process Cost Current Period Costs Total Costs Unit Totals (see above) Cost per Unit Unit Cost Allocation

Cost of Completed Units Cost of Ending WIP Units Totals E XHIBIT 5.5

Direct Material Units

Conversion Factor

1,000 350 1,350

60%

Conversion Cost Units 1,000 210 1,210

Direct Materials $20,000 $28,000 $48,000 1,350 $35.556

Conversion Costs $15,000 $21,500 $36,500 1,210 $30.165

Direct Materials $35,556 $12,444 $48,000

Conversion Costs $30,165 $ 6,335 $36,500

Totals $35,000 $49,500 $84,500

Totals $65,721 $18,779 $84,500

W EIGHTED A VERAGE C OSTING C ALCULATION

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, John Wiley & Sons, 2001, Chapter 11.

Since materials costs are assumed to occur at the earliest stage of production, the calculation of equivalent units for direct material cost allocation is quite easy — just use the number of ﬁnished goods completed (1,000) and the number of units in work-in-process inventory (350). However, for the purposes of allocating all other production costs, we must reduce the amount of work-in-process inventory by an estimate of their aggregate level of completion, which in the example is 60 percent. This results in total converted units of production of 1,210. In the middle block of calculations, we accumulate the total cost of production and divide it by the equivalent number of units of production to determine the cost per unit. This calculation includes the costs that had been carried over in the work-in-process inventory from the preceding accounting reporting period, totaling $35,000. We add to this the current cost of production, which is $49,500, to yield a total cost of $84,500 that must be allocated to units of production. When divided by the slightly different units of production being used for direct material costs and all other production costs, we arrive at a direct material cost per unit of $35.556, and all other costs per unit of $30.165. The lowermost block of calculations requires us to multiply the cost per unit (as determined in the middle block) by the total number of units (as determined in the top block). The calculation is identiﬁed with arrows. The result is $48,000 in direct material costs, of which $35,556 are charged to completed units and the remainder to work-in-process units. Total other production costs are $36,500, of which $30,165 are charged to completed units and the remainder to work-in-process. As a cross-check, we can see that the total allocated is $84,500, which matches the total amount of funds that were to be allocated, as noted on the far right side of the middle block. This method is a simple one that requires very little data collection. However, some companies like to make the task even easier by avoiding the collection and interpretation of actual costs at the end of each accounting period. Instead, they prefer to use standard unit costs for their calculations, which allows them to calculate total costs more frequently and with no related data collection costs. This type of calculation is shown in Exhibit 5.6. In the exhibit, the ﬁrst block of calculations does not change—we still assume that a conversion factor must be applied to the ending work-in-process inventory for the purposes of assigning other

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5.7 Processing: Standard Costing

Units Summary

Completed Units Ending Units in Process Unit Totals Unit Cost Calculation

Standard Unit Cost Unit Cost Allocation

Standard Cost of Completed Units Standard Cost of Ending WIP Units Standard Cost Totals

Direct Material Units

Conversion Factor

1,000 350 1,350

60%

69

Conversion Cost Units 1,000 210 1,210

Direct Materials $32,000

Conversion Costs $31,500

Direct Materials $32,000

Conversion Costs $31,500

Totals $63,500

$11,200 $43,200

$ 6,615 $38,115

$17,815 $81,315

$20,000 $28,000 $48,000 $43,200 $ 4,800

$15,000 $21,500 $36,500 $38,115 $(1,615)

$35,000 $49,500 $84,500 $81,315 $ 3,185

Period Variance

Beginning Standard Work-in-Process Cost Current Period Actual Costs Total Period Costs Standard Cost Totals Cost Variance E XHIBIT 5.6

W EIGHTED A VERAGE C OST A LLOCATION M ETHOD U SING S TANDARD C OSTS

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 11.

production costs than direct materials. The difference arises in the second block, where we use only a standard cost per unit, rather than a summarization of actual costs. This cost is then carried forward into the third block of calculations, where we see that a total of $81,315 has been allocated to the ending ﬁnished goods and work-in-process inventory. However, this ending ﬁgure varies from the $84,500 that resulted from the preceding actual costing calculation in Exhibit 5.6. The difference of $3,185 was caused by a slight variance between the pre-set standard cost and the actual cost. The presence of this variance causes us to add a fourth block of calculations at the bottom of the exhibit, in which we compare the actual costs incurred during the period to the standard costs, which shows that more costs than expected were incurred in the direct materials column, while fewer costs were incurred under the other production costs column. The main issue for the controller is what to do with this variance. If negligible, it can be charged off to the cost of goods sold. If it is so large that expensing the difference will result in an appreciable impact on reported earnings, then a more accurate approach is to apportion the variance among the cost of goods sold, work-in-process inventory, and ﬁnished goods inventory. The data collection and calculations required for a process costing system are substantially simpler than what is required for a job costing system, and so is a favorite approach for those who wish to pare their data collection costs or who produce such large volumes of similar products that there is no point in attempting to track the costs of individual products.

5.7 PROCESSING: STANDARD COSTING The ﬁrst step in the creation of a standard costing system is to create a set of standard costs in a variety of different areas. The industrial engineering staff is assigned the task of creating direct

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labor standard costs, while the purchasing staff is most typically assigned the chore of creating standard costs for purchased goods, and the controller is called on to coordinate the development of a set of standard overhead costs. If there are subproducts created during the production process that may be valued at the end of each accounting reporting period, then the industrial engineering staff will calculate these standards. It is also possible to reduce the areas in which standard costs are used, with actual costs being accumulated in other areas. This mix of costing types can arise when there is some concern that reasonably accurate standard costs cannot be constructed, or if existing actual costing systems already produce reasonably accurate results. Another issue to settle as soon in the standard cost development process as possible is the timing of changes to these standards. This can be done quite infrequently, perhaps once every few years, or as rapidly as once a month (which results in standard costs that are nearly indistinguishable from actual costs). The key determinant inﬂuencing the pace of change is the perceived pace at which actual costs are changing. If there are minimal changes to a manufacturing process, then there is certainly no reason to constantly review the process and set new standards. Conversely, a company that has installed an aggressive continuous improvement strategy will ﬁnd that its standard costs are constantly falling behind changes in actual costs, which requires constant revisions to standards. The assumptions used to create standard costs must also be addressed. For example, an industrial engineer must make some assumptions about the speed of efﬁciency improvements being realized by the production staff (known as the learning curve) in order to determine the future standard cost that roughly matches these expected changes in efﬁciency. Similarly, a standard cost must be matched to the expected production equipment conﬁguration to be used, since this has a considerable impact on the overhead costs that can be assigned to a product. Another key assumption is the volume of production, since a large assumed production run will spread its setup cost over many units, whereas a short production run will result in higher setup costs on a per-unit basis. Yet another factor is the assumed condition of the equipment to be used in the manufacturing process, since poorly maintained or old equipment will be in operation for fewer hours than would otherwise be the case. The production system being used, such as just-in-time or manufacturing resource planning, will also have a signiﬁcant impact on standard costs, since different systems result in the incurrence of different types of costs in such areas as machine setup time, equipment depreciation, materials handling costs, and inventory investment costs. An issue that is particular to direct labor is the anticipated result of union negotiations, since these directly and immediately impact hourly wage rates. A ﬁnal issue to consider is the presence and quality of work instructions for the production staff; the absence of detailed and accurate instructions can have a profound and deleterious impact on costs incurred. Given the large number of issues involved in the setting of accurate standard costs, it is no surprise that this task can require the ongoing services of an experienced group of professionals, the cost of which must be considered when making the decision to use a standard costing system. A ﬁnal factor to consider when creating standard costs is the level of attainability of the costs. One option is to devise an attainable standard, which is a cost that does not depart very much from the existing actual cost. This results in reasonable cost targets that employees know they can probably meet. Another alternative is to use historical costs as the basis for a standard cost. This is generally not recommended, for the resulting costs are no different from a company’s existing actual cost structure, and so gives employees no incentive to attempt to reduce costs. The diametrically opposite approach is to create a set of theoretical standards, which are based on costs that can only be achieved if the manufacturing process runs absolutely perfectly. Since employees cannot possibly meet these cost goals for anything but very short periods of time, it tends to result in lower employee morale. Thus, of the potential range of standard costs that can be set, the best approach is to set moderate stretch goals that are achievable. Finally, we are ready to begin using standard costs. But for what purpose do we use them? One common usage is in budgeting. By creating detailed standard costs for all budgeting line items, company managers can be presented with ﬁnancial statements that compare actual results to standard costs, so that they can see where actual results are falling behind expectations. However, this is a simple approach that requires little real attention to the setting of standards at the product level.

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71

Another reason for using standards is to create benchmarks for inclusion in a manufacturing resources planning (MRP II) production system. This commonly used system multiplies a production forecast by a detailed set of product labor, materials, and capacity requirements to determine how many direct labor personnel and speciﬁc materials and how much machine capacity will be needed. This system requires extremely detailed and accurate standards to be successful. The standards needed by MRP II are for units of labor, materials, and capacity, rather than their costs. In other words, a direct labor standard for an MRP II system may be 12 minutes of labor, rather than its cost for those 12 minutes of $4.58. Yet another use for standards is in product pricing. The company sales staff frequently asks the engineering staff to provide it with cost estimates for new product conﬁgurations, many of which are only slightly different from existing products. However, the engineering staff may take days or weeks to provide the sales personnel with this information — which may be too long to satisfy an impatient customer. By using standard costs, the sales staff can compile product costs very quickly with only a brief approval review from the engineering staff. Or, if the engineering staff is still in charge of creating new product cost estimates, then they can also use standard costs to more rapidly arrive at their estimates. In either case, customers will receive reliable price quotes much more rapidly than was previously the case. A very common use for standard costs is for the valuation of inventory. Many companies do not want to be bothered with the time-consuming accumulation of actual inventory costs at the end of each accounting period, and so they create standard costs for valuation purposes, which they occasionally compare to actual costs to ensure that the inventory valuation is accurate. It is not worth the effort to create standard costs for this purpose if a company’s inventory levels are extremely low, or if a just-in-time manufacturing system is in use, since the amount of time that will be saved in valuing inventory is small, given the minor quantities of stock that will be kept in the warehouse. However, manufacturers with large inventory balances will ﬁnd that this is still an effective way to rapidly determine the value of inventory. Unfortunately, the use of standard costs for inventory valuation is also subject to control problems, for deliberate manipulation of standards can result in large changes in the value of inventory, which in turn impacts the reported level of company proﬁts. For example, the standard cost for a ﬁnished goods item can include an assumption for the amount of production setup costs allocated to each item, which is heavily inﬂuenced by the assumed number of units produced in a manufacturing run. By shifting the assumed length of the production run downward, the amount of cost allocated to each unit goes up. This type of interference with standard costs can result in wildly inaccurate reported ﬁnancial results. If standard costs are used for inventory valuation, the accounting staff will periodically compare standard to actual costs to ensure that there are not excessively large differences between the two. If a company is audited at year-end, then the auditors will require a comparison to actual costs, and a write-off of the difference to the cost of goods sold (if standard costs are higher than actual costs) or an increase in the inventory balance (if actual costs are higher than standard costs). Since a signiﬁcant difference between the two types of costs can result in a startling change in the reported level of income during the period when this adjustment is made, it is wise to review some of the large-cost items on a regular basis in order to ensure that there will be no surprises at the time of reconciliation to actual costs. Consequently, we can see that there are still several areas in which standard costs can be used to create greater efﬁciencies in selected areas of activity. However, the number of viable applications has fallen with the advent of new computer systems and production methodologies, so one should carefully review the proposed applications for standard costs before conducting an implementation.

5.8 PROCESSING: DIRECT COSTING A direct cost is a cost that is directly associated with changes in production volume. This usually restricts the deﬁnition of direct costs to direct materials and direct labor (and a strong case can be made for not using direct labor, since this cost tends to be present even when production volumes

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vary). For example, the materials used to create a product are a direct cost, whereas the machine used to convert the materials into a ﬁnished product is not a direct cost, because it is still going to be sitting on the factory ﬂoor, irrespective of any changes in production volume. The use of direct costing results in a slightly different income statement, as shown in Exhibit 5.7. The only difference between the income statement shown in Exhibit 5.7 and a more traditional format is that all nondirect costs have been shifted below the gross margin line and into the production department’s costs. Though this seems like a subtle change, it focuses the attention of the management team on the incremental changes in the cost of goods sold that are usually masked by a large and relatively ﬁxed amount of overhead costs. By focusing solely on the direct cost of a product or activity, a controller can provide valuable information to management regarding prospective changes in costs that will arise as a result of some management action. For example, if a change to a more efﬁcient type of processing equipment is contemplated, then the direct cost of a product may be lowered if this will result in less material usage. This may also result in less direct labor cost if the machine takes over some tasks previously performed by employees — this will cut direct costs, but may increase overhead costs if the cost of the machine is higher than that of the machine it is replacing. Yet another example is when a customer wants the lowest possible price for a product, and the company has some free capacity available for producing what the customer needs; the use of direct costing will reveal the lowest possible cost that must be covered by the price charged to the customer in order to break even. Direct costing can also be used to determine which customers are the most proﬁtable, by subtracting the direct cost of their purchases from the prices paid, which yields the amount they are contributing toward the company’s coverage of overhead costs and proﬁt. Another very good use for direct costing is to include the concept in the budgeting system, where it is used to change budgeted variable costs to match the actual sales volumes achieved; this approach achieves a much closer match between the budgeted and actual cost of goods sold, because the budget now ﬂexes with the actual volume level experienced. For all of these reasons, direct costing is a highly recommended costing system. However, there are a number of situations in which direct costing should not be used, and in which it will yield incorrect information. Its single largest problem is that it completely ignores all indirect costs, which make up the bulk of all costs incurred by today’s companies. This is a real problem when dealing with long-term costing and pricing decisions, since direct costing will likely yield results that do not achieve long-term proﬁtability. For example, a direct costing system may calculate a minimum product price of $10.00 for a widget that is indeed higher than all direct costs, but which is lower than the additional overhead costs that are associated with the product line. If the company continues to use the $10.00 price for all product sales for well into the future, then the company will experience losses because overhead costs are not being covered by the

Revenue

$1,000,000

Cost of Goods Sold Direct Materials Direct Labor

$320,000 170,000

Total Direct Costs Gross Margin Operating Expenses Production Department General and Administrative

325,000 115,000

Total Operating Expenses

$ 440,000

Net Proﬁt

$

E XHIBIT 5.7

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$ 490,000

I NCOME S TATEMENT F ORMATTED

FOR

50,000

D IRECT C OSTING

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5.9 Processing: Throughput Costing

73

price. The best way to address this problem is to build strict boundaries around the circumstances where incremental prices derived from a direct costing system are used. Another problem with direct costing is that it assumes a steady level of unit costs for the incremental costing and pricing decisions for which it is most often used. For example, a company receives an offer from a customer to buy 5,000 units of product X at a ﬁxed price. The cost accounting staff may determine that the proposed price will indeed yield a proﬁt, based on the direct cost per unit, and so recommends that the deal be approved. However, because the staff has focused only on direct costs, it has missed the fact that the company is operating at near full-capacity levels, and that to process the entire 5,000-unit order will require the addition of some costly machinery, the acquisition of which will make the proposed deal a very expensive one indeed. To avoid this problem, anyone using a direct costing system must have access to company capacity information, and should coordinate with the production scheduling staff to ensure that capacity levels will permit their incremental pricing and costing scenarios to be achieved. A subtle issue that many users of direct costing systems miss is that the types of costs that fall within the direct costing deﬁnition will increase as the volume of units in a direct costing decision goes up. For example, the only direct cost involved with a single unit of production is the direct materials used to build it, whereas a larger production volume will likely involve some change in the related number of manufacturing employees needed on the production line; these are wellaccepted concepts. However controllers frequently forget that additional direct costs will be included when the production volume rises to even higher levels. For example, if the direct costing decision involves an entire production line, then all of the equipment and supervisory costs that are tied to that production line are now also inﬂuenced by the decision to produce or not produce, and so should be included in the direct costing system. At an even larger level, the decision to use the production of an entire facility should include every cost needed to run that facility, which may include utilities, rent, and insurance—costs that are not normally included in smaller-volume production decisions. Consequently, direct costing analysis must be conducted within narrowly deﬁned volume ranges, with careful attention to what costs are likely to vary with the volumes that are under review. Direct costing cannot be used for inventory valuation, because it is disallowed by GAAP. The reason for this is that, under a direct costing system, all costs besides direct costs are charged to the current period. There is no provision for capitalizing overhead costs and associating them with inventory that will be sold off in future periods. This results in an imbalance between the reported level of proﬁtability in each period and the amount of production that occurred. For example, a manufacturer of Christmas ornaments with a direct costing system may sell all of its output in one month of the year, but be forced to recognize all of its nondirect production costs in every month of the year, which will result in reported losses for 11 months of the year. Under GAAP, these nondirect costs would be capitalized into inventory and recognized only when the inventory is sold, thereby more closely matching reported revenues and expenses. Given the wide disparity between the reported results, it is no surprise that GAAP bans the use of direct costing for inventory valuation.

5.9 PROCESSING: THROUGHPUT COSTING A costing methodology that focuses on capacity utilization is called throughput accounting. It assumes that there is always one bottleneck operation in a production process that commands the speed with which products or services can be completed. This operation becomes the deﬁning issue in determining what products should be manufactured ﬁrst, since this in turn results in differing levels of proﬁtability. The basic calculation used for throughput accounting is shown in Exhibit 5.8. This format is a simpliﬁed version of the layout used by Thomas Corbett on page 44 of Throughput Accounting (North River Press, Great Barrington, MA: 1998), though all of the numbers contained within the example have been changed. The exhibit shows a series of electronic devices that a company can choose from for its nearterm production requirements. The second column describes the amount of throughput that each of

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Ch. 5 Cost Accounting and Costing Systems

Maximum Constraint Time: 62,200

Product 19 Color Television 100-Watt Stereo 5 LCD Television 50 HighDeﬁnition TV

Throughput $/Minute of Constraint

Required Constraint Usage (min.)

Unit Demand/ Actual Production

Cumulative Constraint Utilization

$8.11 7.50 6.21

10 8 12

1,000/1,000 2,800/2,800 500/500

10,000 22,400 6,000

5.00

14

3,800/1,700

23,800

Throughput Total Operating Expense Total Proﬁt Proﬁt Percentage Investment Return on Investment E XHIBIT 5.8

Cumulative Throughput/ Product $ 81,100 168,000 37,260 119,000 $405,360 375,000 30,360 7.5% 500,000 6.1%

T HROUGHPUT A CCOUNTING M ODEL

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 15.

the products generates per minute in the bottleneck operation; “throughput” is the amount of margin left after all direct material costs have been subtracted from revenue. For example, the 19 Color Television produces $81.10 of throughput, but requires ten minutes of processing time in the bottleneck operation, resulting in throughput per minute of $8.11. The various electronic devices are sorted in the exhibit from top to bottom in order of largest throughput per minute. This ordering tells the user how much of the most proﬁtable products can be produced before the total amount of available time in the bottleneck (which is 62,200 minutes, as noted at the top of the exhibit) is used up. The calculation for bottleneck utilization is shown in the “Unit Demand /Actual Production” column. In that column, the 19 color Television has a current demand for 1,000 units, which requires 10,000 minutes of bottleneck time (as shown in the following column). This allocation of bottleneck time progresses downward through the various products until we come to the 50 HighDeﬁnition TV at the bottom of the list, for which there is only enough bottleneck time left to manufacture 1,700 units. By multiplying the dollars of throughput per minute times the number of minutes of production time, we arrive at the cumulative throughput dollars resulting from the manufacture (and presumed sale) of each product, which yields a total throughput of $405,360. We then add up all other expenses, totaling $375,000, and subtract them from the total throughput, which gives us a proﬁt of $30,360. These calculations comprise the basic throughput accounting analysis model. Now let’s reexamine the model based on a re-juggling of the priority of orders. If the cost accounting manager were to examine each of the products based on the addition of allocated overhead and direct labor costs to the direct materials that were used as the foundation for the throughput dollar calculations, she may arrive at the conclusion that, when fully burdened, the 50 HighDeﬁnition TV is actually the most proﬁtable, while the 19 Color Television is the least proﬁtable. Accordingly, she recommends that the order of production be changed to reﬂect these “realities,” which gives us the new throughput report shown in Exhibit 5.9. The result is a signiﬁcant loss, rather than the increase in proﬁts that had been expected. Why the change? The trouble is that allocated overhead costs have no bearing on throughput, because allocated costs will not change in accordance with incremental production decisions, such as which product will be manufactured ﬁrst. Instead, the overhead cost pool will exist, irrespective of any modest changes in activity levels. Consequently, it makes no sense to apply allocated costs to the production scheduling decision, when the only issue that matters is how much throughput per minute a product can generate.

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75

Maximum Constraint Time: 62,200

Product 50 HighDeﬁnition TV 100-Watt Stereo 5 LCD Television 19 Color Television

Throughput $/Minute of Constraint

Required Constraint Usage (min.)

Unit Demand/ Actual Production

Cumulative Constraint Utilization

$5.00 7.50 6.21

14 8 12

3,800/3,800 2,800/1,125 500/0

53,200 9,000 0

8.11

10

1,000/0

0

Throughput Total Operating Expense Total Proﬁt Proﬁt Percentage Investment Return on Investment E XHIBIT 5.9

R EVISED T HROUGHPUT A NALYSIS B ASED

ON

Cumulative Throughput/ Product $266,000 67,500 0 0 $333,500 375,000 41,500 12.4% 500,000 8.3%

A LLOCATED C OSTS

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 15.

Capital budgeting is an area in which throughput costing analysis can be applied with excellent results. The trouble with most corporate capital budgeting systems is that they do not take into consideration the fact that the only valid investment is one that will have a positive impact on the amount of throughput that can be pushed through a bottleneck operation. Any other investment will result in greater production capacity in other areas of the company that still cannot produce any additional quantities, since the bottleneck operation controls the total amount of completed production. For example, the throughput model in Exhibit 5.10 shows the result of an investment of $28,500 in new equipment that is added later in the production process than the bottleneck operation. The result is an increase in the total investment, to $528,500, and absolutely no impact on proﬁtability, which yields a reduced return on investment of 5.7 percent. Maximum Constraint Time: 62,200

Product 19 Color Television 100-Watt Stereo 5 LCD Television 50 HighDeﬁnition TV

Required Constraint Usage (min.)

Unit Demand/ Actual Production

Cumulative Constraint Utilization

$8.11 7.50 6.21

10 8 12

1,000/1,000 2,800/2,800 500/500

10,000 22,400 6,000

$ 81,100 168,000 37,260

5.00

14

3,800/1,700

23,800

119,000

Throughput Total Operating Expense Total Proﬁt Proﬁt Percentage Investment Return on Investment E XHIBIT 5.10

Cumulative Throughput/ Product

Throughput $/Minute of Constraint

R EVISED T HROUGHPUT A NALYSIS B ASED

ON

$405,360 375,000 30,360 7.5% 528,500 5.7%

A DDITIONAL I NVESTMENT

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 15.

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A more proﬁtable solution would have been to invest in anything that would increase the productivity of the bottleneck operation, which could be either a direct investment in that operation, or an investment in an upstream operation that will reduce the amount of processing required for a product by the bottleneck operation. As another example, the cost accounting staff has conducted a lengthy activity-based costing analysis, which has determined that a much higher amount of overhead cost must be allocated to the high-deﬁnition television, which results in a loss on that product. Accordingly, the product is removed from the list of viable products, which reduces the number of products in the mix of production activity, as shown in Exhibit 5.11. The result is a reduction in proﬁts. The reason is that the cost accounting staff has made the incorrect assumption that, by eliminating a product, all of the associated overhead cost will be eliminated, too. Though a small amount of overhead might be eliminated when the production of a single product is stopped, the bulk of it will still be incurred. Throughput accounting does a very good job of tightly focusing attention on the priority of production in situations where there is a choice of products that can be manufactured. It can also have an impact on a number of other decisions, such as whether to grant volume discounts, outsource manufacturing, stop the creation of a product, or invest in new capital items. Given this wide range of activities, it should ﬁnd a place in the mix of costing methodologies at many companies. We now shift to a discussion of activity-based costing (ABC), whose emphasis is the complete reverse of throughput accounting—it focuses on the proper allocation of overhead.

5.10 PROCESSING: ACTIVITY-BASED COSTING An ABC system is designed to match overhead costs as closely as possible with company activities. By doing so, overhead costs can be reasonably associated with products, departments, customers, or other users of activities, which tells managers where overhead costs are being used within a company. This results in much better control over overhead costs. There are several ways to allocate overhead costs. Some overhead costs, such as utilities, are associated with speciﬁc machines. For example, a machine may require ten cents of electricity per minute. If so, this overhead cost can be charged out to those products that are run through the machine, based on the time spent being worked upon it. Other overhead costs are associated with a speciﬁc product line, and can reasonably be allocated to the activities performed within that product line. Maximum Constraint Time: 62,200

Product 19 Color Television 100-Watt Stereo 5 LCD Television

Throughput $/Minute of Constraint

Required Constraint Usage (min.)

Unit Demand/ Actual Production

Cumulative Constraint Utilization

$8.11 7.50 6.21

10 8 12

1,000/1,000 2,800/2,800 500/500

10,000 22,400 6,000

Throughput Total Operating Expense Total Proﬁt Proﬁt Percentage Investment Return on Investment E XHIBIT 5.11

R EVISED T HROUGHPUT A NALYSIS

WITH

Cumulative Throughput/ Product $ 81,100 168,000 37,260 $286,360 375,000 88,640 30.9% 500,000 17.7%

O NE L ESS P RODUCT

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 15.

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77

For example, there is typically a supervisor who is assigned to a single product line. If so, the fully burdened salary of this person can be charged to such related activities as production and maintenance scheduling. Still other overhead costs may be grouped by commodity used in the production process. For example, each member of the purchasing staff may be responsible for the procurement of a speciﬁc commodity. If so, this overhead cost can be distributed to individual products based on their usage of the commodity. Clearly, there are many valid ways to allocate overhead costs to various activities, and from there to users of those costs. An ABC system creates a structured approach to the accumulation, storage, and allocation of overhead costs using many of these activity measures. An ABC system is a difﬁcult and complex one to create, because of the wide variety of costs that must be accumulated, tracked in relation to different types of activities, and charged off. Here are the primary steps involved in creating such a system: 1. Determine the scope of the system. A fully developed ABC system that encompasses all costs throughout a company is a massive undertaking that may not yield any results for several years. A better approach is to conduct a gradual rollout of the system that produces results more quickly. Accordingly, a key factor is limiting each incremental rollout of the system to a carefully deﬁned segment of the business. The determination of scope should also include a review of the level of detailed analysis that the system is to produce, since an excessive focus on detail may result in a system that is too expensive in relation to the utility of the information produced. 2. Set aside direct costs. There will be several direct costs that can be clearly and indisputably traced to speciﬁc products. These costs should be identiﬁed early in the design phase, so that they will not be erroneously added to the ABC allocation system. 3. Locate costs in the general ledger. The next step is to identify each of the overhead costs in the general ledger that will be allocated by the ABC system. This can be a difﬁcult undertaking, for the required costs may be lumped together in the ledger, and must be segregated through a new data collection system that involves the creation of a new general ledger account number. Alternatively, the split may be achieved less accurately by allocating a percentage of the cost in a single general ledger account to several overhead cost items that will then be allocated. 4. Store costs in cost pools. All of the costs that have been identiﬁed within the general ledger must now be stored in a series of cost pools. Each cost pool accumulates costs that are similar to each other. For example, a building cost pool will include the costs of insurance and maintenance for a building, whereas a product line cost pool may include the marketing and supervisory costs that can be traced to a speciﬁc product line. A third type of cost pool is one that is related to a speciﬁc production batch, and can include such costs as production control labor, tooling, materials handling, and quality control. The total number of cost pools used will have a direct impact on the maintenance costs of an ABC system, so the design team must balance the increased allocation accuracy associated with more cost pools with the extra labor needed to maintain them. 5. Determine activity drivers. Having summarized overhead costs into a set of cost pools, we must now allocate them, which we do with an activity driver—this is a variable that reasonably explains the consumption of costs from a cost pool. For example, some accounts payable costs are closely associated with the number of checks printed and mailed, while some engineering costs vary directly with the number of design changes added to a product. Examples of other activity drivers are the number of machine setups, the number of maintenance work orders, the number of purchase orders, and the number of customer orders processed. Whichever activity driver is chosen as the basis for cost pool allocation should be easy to calculate, require minimal data collection, and have a reasonably close cause-andeffect relationship with a cost pool.

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Ch. 5 Cost Accounting and Costing Systems

6. Spread costs from secondary to primary cost pools. Some of the cost pools include costs that are, in turn, distributed to other cost pools. These costs are usually for internal company services, such as management information systems services that are provided to other departments. These secondary cost pools must be allocated to primary cost pools. 7. Calculate the overhead cost per activity unit. We then divide the total number of occurrences of each activity driver into the total amount of costs in the primary cost pools for the accounting period, which results in a dollar ﬁgure per unit of activity. 8. Assign activity costs to cost objects. The ﬁnal step is to calculate the usage of each activity driver by a cost object (which is anything that uses activities, such as products or customers). For example, if a product requires the creation of two purchase orders (which are activity drivers) and the ABC system has determined that each purchase order requires $32.15 to create, then the amount of overhead charged to the product will be $64.30. In brief, the ABC process involves taking costs out of the general ledger and assigning them to either secondary or primary cost pools, which are then distributed to cost objects through the use of activity drivers. The overall process is shown in Exhibit 5.12.

General Ledger

Secondary Cost Pool

Secondary Cost Pool

Direct Cost Pool

Batch Cost Pool

Product Line Cost Pool

Facility Cost Pool

Activity Driver

Activity Driver

Activity Driver

Cost Object

E XHIBIT 5.12

ABC P ROCESS F LOW

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 17.

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5.11 PROCESSING: TARGET COSTING Most of the costing methodologies described in this chapter are primarily concerned with the interpretation of costing data after it has already been incurred. Target costing differs from them in that it describes the costs that are expected to be incurred, and how this will impact product proﬁtability levels. By describing costs in a proactive and future-oriented manner, managers can determine how they should alter product designs before they enter the manufacturing process in order to ensure that the company earns a reasonable proﬁt on all new products. To use this methodology, the controller is assigned to a new product design team, and asked to continually compile the projected cost of a product as it moves through the design process. Managers will use this information not only to make product alterations, but also to drop a product design if it cannot meet its cost targets. There are four basic steps involved in target costing. First, the design team conducts market research to determine the price points that a company is most likely to achieve if it creates a product with a certain set of features. The research should include information about the perceived value of certain features on a product, so that the design team can add or subtract features from the design with a full knowledge of what these changes probably will do to the ﬁnal price at which the product will be sold. The second step is to subtract from the prospective product price a gross margin that must be earned on the product; this can be a standard company-wide margin that must be earned on all new products, or perhaps a more speciﬁc one that management has imposed based on the perceived risk of the project. By subtracting the required margin from the expected price, we arrive at the maximum amount that the product can cost. This total cost ﬁgure drives the next step. The design team then uses value engineering to drive down the cost of the product until it meets its overall cost target. Value engineering requires considerable attention to the elimination of production functions, a product design that is cheaper to manufacture, a planned reduction of product durability in order to cut costs, a reduced number of product features, less expensive component parts, and so on — in short, any activity that will lead to a reduced product cost. This process also requires the team to conﬁrm costs with the suppliers of raw materials and outsourced parts, as well as the processing costs that will be incurred internally. The controller plays a key role at this stage, regularly summarizing costing information and relaying it not only to the team members, but to the managers who are reviewing the team’s progress. A standard procedure at this point is to force the team to come within a set percentage of its cost target at various milestones (such as being within 12% of the target after three months of design work, 6% after four months, and on target after ﬁve months); if the team cannot meet increasingly tighter costing targets, then the project will be canceled. Once these design steps have been completed and a product has met its targeted cost level, the target costing effort is shifted into a different activity, which is follow-on activities that will reduce costs even further after the product has entered its production phase. This ﬁnal step is used to create some excess gross margin over time, which allows the company to reduce the price of the product to respond to presumed increases in the level of competition. The sources of these cost reductions can be either through planned supplier cost reductions or through waste reductions in the production process (known as kaizen costing). The concepts of value engineering and kaizen costing can be used repeatedly to gradually reduce the cost of a product over time, as shown in Exhibit 5.13. In the exhibit, we see that the market price of a product follows a steady downward trend, which is caused by ongoing competitive pressure as the market for the product matures. To meet this pricing pressure with corresponding reductions in costs, the company initially creates product A, and uses value engineering to design a preset cost into the product. Once the design is released for production, kaizen costing is used to further reduce costs in multiple stages until there are few additional reductions left to squeeze out of the original design. At this point, the design team uses value engineering to create a replacement product B that incorporates additional cost savings (likely including the cost reduction experience gleaned from the kaizen costing stages used for product A) that result in an even lower initial cost. Kaizen costing is then used once again to further reduce the cost of product B, thereby keeping the cost reduction process moving in an everdownward direction. The entire target costing process, incorporating all of the preceding steps, is shown in Exhibit 5.14.

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Ch. 5 Cost Accounting and Costing Systems

Stages of Cost Reduction

Cost

Profit

Design Cost, Version A Kaizen Cost Reductions

Market Price

Design Cost, Version B

Kaizen Cost Reductions

Time

E XHIBIT 5.13

S TAGES

IN THE

C OST R EDUCTION P ROCESS

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 18.

5.12 OUTPUTS: COST VARIANCES A costing methodology of any type is not of much use if there is no output from it that gives valuable information to the management team. One of the primary outputs that is expected is a listing of costing variances, which are actual costs that depart from expectations. There are a number of standard variance calculations that can be summarized into a report, and which we will cover in this section. Variances fall into three categories. The ﬁrst is a price variance, and is the difference between the standard purchase cost of an item and the actual cost at which it was purchased, multiplied by the actual number of units purchased. It can be used to describe the variances in the general cost categories of purchased parts, direct labor, and overhead, and so is seen in three different places on cost variance reports. The second type of variance is the efﬁciency variance. This is the difference between the actual quantity of resources needed to manufacture something, less the standard quantity, multiplied by its standard cost. This variance can also be broken down into three subvariances: a direct labor efﬁciency variance, a yield variance that relates to materials usage, and a variable overhead efﬁciency variance. There is no efﬁciency variance related to ﬁxed overhead costs, since they are not expected to change with volume, and so have no targeted level of efﬁciency against which to compare. The ﬁnal variance is the volume variance. It applies to only one cost type, as opposed to the other variances; this is ﬁxed overhead costs. Fixed overhead costs are charged to the cost of goods sold, or other parts of the income statement, as a ﬁxed amount per accounting period, rather than as a percentage of the volume of production. Because of this difference in the method of cost allocation, a change in the actual production volume from the level that was expected when the allocation was set will result in a volume variance. It is calculated by multiplying the ﬁxed overhead

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5.12 Outputs: Cost Variances

Conduct Customer Research

Conduct Competitor Research

81

Phase One: Conduct Market Research

Clarify Customer Requirements

Phase Two:

Determine Product Features

Determine Margin and Cost Feasibility

Determine Margin and Cost Feasibility

Finalize Value Engineering Results

Phase Three: Meet Margin Targets through Design Improvements

Finalize Design and Process Information

Phase Four: Initiate Product Production

E XHIBIT 5.14

Implement Continuous Improvement

Implement Continuous Improvement

T ARGET C OSTING P ROCESS

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 18.

portion of the overhead rate by the number of units produced, and then subtracting this amount from the total ﬁxed overhead cost pool. An example of these variances, and the calculations used to derive them, is shown in Exhibit 5.15. In the upper-left corner of the variance report, we see that there is a total variance of $61,725.

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Ch. 5 Cost Accounting and Costing Systems

Actual

Budget

Variance

Cost of Goods Sold 265,000

203,275

(61,725)

Material Price Variance: Total actual price/unit paid Total standard price/unit paid = Variance per unit Number of units consumed = Material price variance

Account Number 4000-020 4000-030 4000-040 4000-050

Account Name

Actual

Budget

Direct Materials Direct Labor Variable Overhead Fixed Overhead

102,500 34,000 50,000 78,500 265,000

76,500 29,450 36,550 60.775 203,275

Fixed Overhead Price Variance:

=

=

Total actual price/unit paid Total standard price/unit paid Variance per unit Number of units consumed Fixed overhead price variance

=

=

Variance (26,000) (4,550) (13,450) (17,725) 61,725

Material Yield Variance: Total actual units consumed Total standard units consumed = Unit variance Standard price per unit = Material yield variance

10,000 8,500 1,500 9 13,500

Labor Price Variance: 7.85 7.15 0.70 10,000 7,000

Fixed Overhead Volume Variance: Standard overhead rate per unit Number of units consumed Total overhead charged to exp. Actual overhead cost pool Volume variance

10.25 9.00 1.25 10,000 12,500

Total actual price/hour paid Total standard price/hour paid = Variance per hour Number of units consumed = Labor price variance

8.00 7.75 0.25 4,250 1,063

Labor Efficiency Variance: 7.15 10,000 71,500 60,775 10,725

Total actual units consumed Total standard units consumed = Unit variance Standard price per unit = Labor efficiency variance

4,250 3,800 450 7.75 3,488

Variable O/H Price Variance: Total actual rate/unit paid Total standard rate/unit paid = Variance per unit Number of units consumed = Variable O/H price variance

5.00 4.30 0.70 10,000 7,000

Variable O/H Efficiency Variance: Total actual units consumed Total standard units consumed = Unit variance Standard price per unit = Variable O/H efficiency variance

E XHIBIT 5.15

10,000 8,500 1,500 4.3 6,450

C OST V ARIANCE R EPORT

Reprinted with permission: Steven M. Bragg, Cost Accounting: A Comprehensive Guide, Wiley, 2001, Chapter 16.

The block of costs immediately below this shows the cost categories in which the variance arose, which sum to $61,725. Below and to the side of these variances are subsidiary variances that are linked back to the four major cost categories. For instance, the materials price variance in the upper-right corner reveals that the price paid for materials is $1.25 higher than expected, while the material yield variance located directly below it shows that 1,500 more units of materials were used for production than had been anticipated. The total variance from these two calculations is $26,000, which traces back to the total direct materials variance on the left side of the report. All of the variances trace back through the report in a similar manner. This is a good format for showing how variance calculations are derived, and how they ﬂow through the accounting reporting system. A company may not choose to report on all of these variances, since the detailed investigation of each one can be extremely time consuming. Thus, the variance for the direct labor price may not

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be reported on the grounds that management has little control over it when pricing is ruled by a formal agreement with a labor union. Similarly, the ﬁxed overhead volume variance may not be reported because it relates more to ongoing production volumes than to management’s ability to control the size of the overhead cost pool. Variances that are more commonly reported on are the material price variance and all types of efﬁciency variances; the material price variance is used to monitor the performance of the purchasing staff, while efﬁciency variances are used to oversee the entire manufacturing process. Some variances are not worthy of regular reporting, because they require an inordinate amount of data collection work in exchange for information that is not of much use to management. For example, a detailed scrap variance that itemizes every item that was thrown out during a reporting period, alongside the reasons for each one, calls for a very large amount of investigative effort. The resulting report will contain information that may result in some long-term savings, but probably not enough to justify the work required to create the report. Thus, report compilation work should be considered when reporting on variances. Once the cost variance report has been completed, the accounting staff either will be asked to conduct an investigation into the causes of speciﬁc variances, or should do so on its own. If so, it is useful to know in advance what types of problems are most likely to cause variances, so that investigative work can be ﬁrst targeted at these items. The most common causes of each major variance are: • Fixed overhead spending variance Suppliers have increased their prices for products and services that fall into this expense category. Review related supplier contracts for scheduled price increases. The company has increased its usage of the products or services recorded in this category. If so, the costs may actually be variable, and should be shifted to a variable overhead account. • Labor price variance The standard rate has not been altered to match changes in the union’s labor contract. The standard does not include extra charges, such as shift premiums, bonuses, or overtime. The people actually conducting work are at different pay rates than those that were assumed to be doing the work when the labor standards were created. • Material price variance The actual price paid is based on a different purchasing volume than what was assumed when the price standard was originally set. The standard price was erroneously copied from a similar product that has a signiﬁcantly different price. The purchasing staff is now buying replacement parts that have a different price than the parts that were the basis for the standard. • Selling price variance Products were sold with different options than the products used to set selling price standards. Customers have ordered in different unit volumes than those used to determine the standard price. Customers have paid prices different from the invoiced prices (which will require investigation to resolve). Customers were given promotional discounts on prices paid. • Variable overhead spending variance The supplier has changed its per-unit pricing. Look for a contractually mandated change in the per-unit price. The company is purchasing in different volumes, which alters the per-unit price paid. There are misclassiﬁcations in costs between the variable overhead and other accounts.

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Though there are certainly other causes for variances, these are among the most common ones, and so should be investigated ﬁrst. Also, the accounting staff will ﬁnd that the same causes are likely to crop up over and over again, so it is useful to develop and continually update a list of variances caused from previous reporting periods. This becomes the accounting staff’s “short list” of variance causes that can be used to track down similar problems in the future.

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CHAPTER

6

RATIO AND TREND ANALYSIS 6.1 INTRODUCTION 85

(b) (c) (d) (e) (f)

Customer Service Measurements 99 Distribution Measurements 100 Engineering Measurements 101 Human Resources 103 Materials Management Measurements 105 (g) Production Measurements 106 (h) Sales and Marketing Measurements 108 (i) Cycle Time 110

6.2 HOW TO USE RATIOS AND TRENDS 85 6.3 A CAVEAT 86 6.4 MEASURES FOR PROFITABILITY 88 6.5 MEASURES FOR THE BALANCE SHEET 90 6.6 MEASURES FOR GROWTH 94 6.7 MEASURES FOR CASH FLOW 96

6.9 INTERRELATIONSHIP OF RATIOS 110

6.8 MEASURES FOR NONFINANCIAL PERFORMANCE 97

6.10 SETTING UP A SYSTEM OF RATIOS AND TREND ANALYSES 110

(a) Accounting 98

6.1 INTRODUCTION This chapter describes the analysis of a business by using ratios and trends. The most common accounting measurements are included here; these are good for analyzing the balance sheet, the income statement, and relationships between the two. In addition, there are a number of performance measurements in this chapter that do not directly relate to accounting, but rather to other functional areas, such as customer service, engineering, and materials management. These additional measures are necessary, because a controller cannot do an adequate job of maintaining systems, reporting on operating results, or recommending changes without a complete understanding of all company operations and how they interact. Consequently, the controller is well advised to develop a set of ratios and trend analyses for measurements that step beyond the usual accounting measurements to encompass the operating aspects of all departments. This chapter not only shows how to calculate each ratio, but also describes why each one is useful as well as any shortcomings it may have. The chapter concludes with a discussion of how ratios interrelate, as well as their limitations. The chapter is intended to give a controller enough information to set up a complete system of ratios and trends for the continuing analysis of all company operations.

6.2 HOW TO USE RATIOS AND TRENDS Ratios are very useful for determining the interrelationships between numbers. For example, without a ratio, a manager has no way of knowing if the amount of accounts receivable is an acceptable one or if there should be a major collection effort underway to bring in old accounts receivable. Similarly, only a comparison of inventory to the cost of goods sold will tell if there is an excess amount of inventory on hand. Finally, one must compare interest expense to earnings to see if there is a risk of not paying for at least the interest on debt, which could result in corporate liquidation. All of this information is critical, and ratios are the best possible tool for determining it. 85

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Ratios do not have to be used solely for analyzing ﬁnancial information. For example, a ratio can reveal the extent to which a company has become top-heavy by comparing the number of indirect labor people to the number of direct labor employees. Another example is a comparison of sales to salespeople to see how many sales are being obtained, on average, by each salesperson. These measures are just as important as ﬁnancial ones, but their components are not all found in the ﬁnancial statements. Despite their uses, there is a problem with ratios—they give no historical perspective on a measurement. For example, a ratio may reveal the amount of inventory turnover, but this does not tell a controller how the ratio is changing over time. For this information, one must list a series of measurements on a trend line. This can be listed on a simple bar chart or a more complex three-dimensional one, or even on a primitive numeric table — the format is important only in that it must clearly show the reader any changes in the ratio. When using ratios and trend lines together, a controller has a powerful analytical tool. A trend line does not have to contain only ratios. They are commonly used to plot revenues or speciﬁc expense line items. This information is also useful, because management can see general trends that may require correction. The most common trend line uses only revenue data, because the sales and marketing manager wants to know the trend of sales for various divisions, product lines, and products. Once armed with this information, the sales and marketing staffs can take action to either continue hot sales growth or bolster ﬂagging growth. Trend lines do not have to be plotted with only ratio information. An important consideration when using ratios or trend lines is that they must be used consistently. There is nothing more confusing to a management team than to receive an entirely different set of measurements every month. Some measures may be so difﬁcult to understand that management does not have the time to interpret the newest batch of measurements, and so ignores them; this does not assist in management’s control of the business! Another problem is that inconsistent use of measurements eliminates one’s ability to create any trend lines; after all, a trend line requires a series of measurements, not just one. A trend line does not provide a sufﬁcient degree of information if it contains less than a half-dozen data points, which will not happen without a consistent measurement program.

6.3 A CAVEAT The majority of this chapter covers the measurements that give a controller a better idea of the status of company operations. The key word is better, for one should not rely solely on these measurements to judge company operations. It is unfortunate that many controllers manage their departments strictly “by the numbers,” and make recommendations for changes elsewhere in the company based solely on that information. A good manager uses measurements only as part of the body of knowledge required to do a thorough job of effectively and efﬁciently running a business. Other items that a controller should know about in order to plot a strong management course in the sea of business uncertainty are: • Branding. Some companies, such as Coca-Cola, PepsiCo, or any automobile manufacturer, spend enormous amounts of money on marketing activities to build up the public’s image of their brands. This may seem like a waste of money to a typical cost-conscious controller, but it has been proven time and again that consumers will pay a signiﬁcant premium for branded products. Consequently, a controller should have a sufﬁcient knowledge of corporate branding activities before releasing a report to management that recommends deep cuts in marketing costs in order to save money. • Company organization. There may be quirks in how a company is organized that have a direct impact on the measurements that a controller sees. This is especially common for a large, multidivision company, where constant reorganizations result in reallocations of reporting relationships. For example, a controller may ﬁnd that the sales department expenses for a division are rapidly surpassing the budget; a knowledge of the organizational structure might reveal that there is no one in that position due to a recent reorganization. This changes the con-

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troller’s action from a stinging memo to the general manager of the division regarding cost controls to a strong request to the human resources staff to hire a new sales manager. • Competitors. The actions of competitors have a profound impact on company operations. A competing product may be priced sharply lower than the company’s product, resulting in a matching price drop that is initiated by the marketing staff. Alternatively, a sudden drop in sales may simply be caused by the entrance of a new competitor, while a rapid sales increase may be caused by the demise of a competitor, sending all of its customers to the company. For example, a controller may strongly recommend a doubling of production capacity based on a sudden up-tick in revenues, though a knowledge of the industry would have revealed that a close competitor has gone out of business, and the up-tick should be expected to only roughly match the sales of that defunct business, which is not sufﬁcient to warrant the expense of more production facilities. • Goals. If a company has established stretch goals that will be difﬁcult to reach, a controller should expect strains on the organization that will appear in measurements. For example, an aggressive production plan will probably result in excessive levels of overtime and extra machine repair and maintenance; knowing about the goals would keep the controller in this example from spending too much time reviewing those measures that were clearly altered by the higher levels of production. • Labor relations. Several of the measurements in this chapter require close tracking of direct labor hours. However, a controller may ﬁnd that labor relations are so tense that additional measurements might be seen as an excessive (and unacceptable) level of control. Also, poor labor relations may mean that employees are deliberately charging their hours to incorrect activities. The ﬁrst problem voids the controllers’ ability to create measurements, while the second issue weakens their reliability even if they can be created. For example, a controller may see that measurements show a very low gross margin for a product line and launch a major cost investigation, only to ﬁnd that the labor component is wildly incorrect. Previous knowledge of labor problems might have allowed the controller to restructure the components of the gross margin calculation, so that a trend line would have immediately shown that labor costs were the problem. • Management team. The character of the management team has a profound impact on measurements. If it is unethical, there may be problems with the period-end cutoff, because this is a prime area for manipulating the volume of sales. The problem may pervade the organization, creating difﬁculties due to loans to owners and managers, incorrect commission payments, or difﬁculties with missing assets. For example, a measurement may reveal that inventory turnover is much worse than the historical average; based only on that measurement, a controller might enter into all sorts of calculations and investigations to root out the problem, whereas the knowledge that the owners are trying to inﬂate inventory values to underreport the cost of goods sold will lead the controller straight to the warehouse for an in-depth audit of inventory quantities. • Marketplace. The market for a company’s products is rarely a completely stable one. It may be seasonal, resulting in wide revenue swings depending on the month, or it may be going through a period of rapid expansion or contraction. For example, a controller may be tracking a trend line of revenue levels and notice a sudden, sharp drop in revenues for a product line. A frantic call to the sales staff might not have been so frantic if the controller realized that the product line was lawn mowers, and that sales always drop by the middle of the summer. • Monopoly situations. It is not uncommon for a company to have a small number of products in its product portfolio that have no signiﬁcant competition. This minority of products typically carry prices and correspondingly high margins, which may generate sufﬁcient cash ﬂow to make a signiﬁcant difference to a company’s bottom line. A controller must know enough about a company’s competitive situation to know which products are in a monopoly situation, because these “breadwinner” products are critical. For example, a controller should carefully track price points, unit volume, and gross margins on all monopoly items in order to warn

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management of any price or margin erosion; controllers who do not know which products are breadwinners will probably not segregate them for measurement, possibly resulting in no one knowing about market changes that will have a major impact on company proﬁts. • New market activities. Most companies attempt to enter new markets from time to time. This is a very expensive activity, because potential new customers must be educated about the company, research and development costs must be incurred to create new products for the market, a distribution system must be created, and a variety of policies and procedures realigned to better service the new markets. Many controllers take the conservative approach and protest these activities because of the large up-front cost. However, a more knowledgeable controller will realize that new markets drive company sales, and the expenses needed to enter those markets are the necessary costs of getting into them. • Policies and procedures. A company collects information in a more uniform manner if there are policies and procedures to cover all major transactions. If not, information may be accumulated into the wrong revenue and expense accounts, which plays havoc with a controller’s measurements. For example, telling employees to break out all entertainment expenses on their travel reports resulting in all these expenses being recorded as travel expenses. A controller who does not know about this problem may be led to believe that the high travel costs are caused by excessively high air fares, and recommend a clamp down on corporate travel. • Product pricing. A company may base its sales strategy on having the highest or lowest product price in the marketplace. This is not something that a controller typically measures, because the most common sales-related measures track only total revenues, not the component parts, which are prices and unit volumes. However, if the strategy is to maintain the highest or lowest price, then the controller must track this information and compare it to competing prices, so that management can maintain the appropriate price points. • Recruiting methods. A company that is situated in an industry in which there is only a small available pool of qualiﬁed applicants, such as an engineering or software design company, incurs tremendous recruiting costs. This may involve overseas trips to recruit foreign candidates, or perhaps paying exorbitant fees to outside recruiters to locate potential employees. In these industries, very high recruiting costs are simply a part of doing business. If a controller does not know this, the human resources staff may be on the receiving end of a series of complaints, accusing them of using the most expensive recruiting approaches, when in fact they may be doing a very cost-effective job of locating new employees. • Training. Poor employee training leads to poor transaction completion; because transactions are the basis for many measurements, this results in poor measurements. For example, poor training of the billing clerk may result in revenues being charged to an incorrect product line, which will skew both the revenues and cost of goods sold for the product line. If a controller knows where the training weaknesses lie in the organization, this makes it much easier to identify the problem and correct it, rather than assuming that the measurement is correct and that the gross margin for the product line is the real problem. The previous points illustrate why a controller must know an organization’s strengths and weaknesses, because they have a strong impact on measurements. This knowledge can be used in another way as well, for the measurement system can be altered to take advantage of corporate strengths, and bolstered to support the weakest areas. As discussed in Section 6.9, it is clear that the peculiarities ensconced in every company require a controller to change, add to, and delete from the existing set of measurements to arrive at a measurement system that properly tracks weaknesses while only exerting the lightest control over organizationally strong areas.

6.4 MEASURES FOR PROFITABILITY A controller needs to accurately judge the amount of proﬁt extracted from a company’s operations, which means knowing the exact margin earned by division, product line, and product. A controller

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must also have a good knowledge of ﬁxed costs and how they impact company proﬁts at different sales levels, as well as a thorough understanding of the amount of overhead and how that relates to the cost of goods sold. This section provides the ratios and percentage calculations needed to extract this information from the income statement. The measurements are: • Break-even point. A crucial measurement for a controller to be aware of is a company’s break-even point. This is the sales level at which, given a predetermined gross margin rate, a company will make a proﬁt of zero. This is important, because a company may have such a high ﬁxed-cost structure or low gross margins that it is nearly impossible to turn a proﬁt unless there are extraordinarily high sales. By spotting this problem, a controller can push for sales of higher-margin products or a reduction in ﬁxed costs. To calculate break-even, simply divide operating expenses for the reporting period by the company’s historical average gross margin. For the gross margin ﬁgure, it is best to use a recent average, so that the measurement accurately reﬂects any recent changes. • Number of times interest is earned. This is an excellent measure of the risk a company undertakes when it adds debt. If the continuing amount of cash ﬂow cannot cover interest payments on existing debt, then a company is in serious trouble and must take steps to reduce the level of debt immediately. The measure is also good for companies considering acquiring more debt; a poor ratio will tell them not to do so. To calculate the measurement, determine the amount of interest charged on debt for a typical period (perhaps an average of the interest payments for the last quarter). Then obtain the net income ﬁgure from the income statement and add back any noncash expenses, such as amortization and depreciation, which yields the actual cash ﬂow. Then divide the average interest expense by the cash ﬂow amount to determine the number of times that interest is earned. The ﬁgure can be skewed if there are interest balloon payments that are not factored into the average interest expense. • Operating margins by division, segment, product line. A company must have sufﬁcient operating margins. Otherwise, all other management decisions become superﬂuous, since inadequate margins do not allow a company to throw off enough cash ﬂow to stay in business. Consequently, the controller must calculate margins in a variety of ways—by division, segment, and product line—and pass this information along to management as frequently as possible. In particular, if the controller spots a rapid drop in margins, this information must go out to management immediately, rather than waiting until the next monthly ﬁnancial reporting package. Information about operating margins is too time-critical to wait. The calculation for this measurement varies somewhat depending on the type of margin being measured, but is best calculated by creating a standard report for each variation using the accounting system’s report writer to extract data from the general ledger and recast it in an income statement format. This may require some changes to the chart of accounts to ensure that there is enough segmentation of information to ensure reporting accuracy. • Overhead rate. A primary area of competition is based on price, and the only way a company can succeed in that arena is to have extremely low costs. Costs are grouped into three areas, one of which is overhead. This can be a very large amount of money, especially for those organizations with bloated organizational structures. The amount of overhead is allocated to individual products, which has a major impact on the value of work-in-process and ﬁnished goods inventory. Allocation is based on an overhead rate that is calculated by compiling overhead costs for the period and dividing by the amount of direct labor expended during the period. The resulting overhead cost per direct labor hour is then allocated to inventory based on the amount of labor hours charged to the products. This method of charging costs to products can be highly inaccurate if the overhead rate per labor hour is extremely high, because a slight change in hours charged can result in a massive change in the overhead cost of the product. Also, because many products now require very few hours of work to produce, many companies are coming to the conclusion that direct labor is a poor basis for spreading overhead costs and are switching to more accurate allocation methodologies, such as activity-based costing (ABC).

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• Percentage return on net sales. This is the single most commonly reviewed measure in most companies. It is a good indicator of how well all aspects of the business are performing in order to arrive at a proﬁt. It is best tracked on a trend line to see how the proﬁt percentage compares to that of previous periods, and is especially useful when tracked by product line, where there should be a considerable amount of consistency in the percentage from period to period. To calculate the measurement, simply divide the proﬁt into net sales for the same period. However, one must be aware that the proﬁt percentage is subject to manipulation, because it is possible to modify accruals and noncash expenses (e.g., depreciation and amortization) to ﬁt the proﬁt number that management wants. • Ratio of sales returns and allowances to gross sales. This is an excellent way to determine the quality of goods sold or of the excess amount of inventory in the distribution pipeline. A company that ﬁnds customers sending back an inordinate amount of product, either has a faulty product that requires immediate corrective action, or has stuffed so much inventory into the distribution pipeline that retailers simply cannot sell it all. The latter calls for a different approach to selling the product. Tracking this information on a trend line is especially helpful, in order to see problems that may develop over several months. To calculate the measurement, divide the total sales returns by gross sales; both numbers should be aggregated separately in the general ledger. The ratio can be misleading, however, because sales returns invariably relate to sales from a previous period, not the current one against which the ratio is being measured. • Sales/proﬁts per person. Some companies have very large staffs, and, because the payroll expense is large, they choose to use it as a major indicator of internal efﬁciency. When they see the sales or proﬁts per person falling, their typical reaction is to cut staff to bring the numbers back into line with expectations. To calculate the measurement, simply accumulate the number of personnel from payroll records and divide it into either sales or proﬁts, both of which can be obtained from the general ledger. However, the measure is easily skewed if a company uses a large number of part-time workers; if so, these people must be converted to full-time equivalents. Also, the number can be drastically changed if a company outsources its more labor-intensive functions, essentially negating the value of the measure. It is important to use all of the measures and not just a selection, for each one tracks different information that is critical to a complete understanding of a company’s costs, margins, and break-even points. The measures are summarized in Exhibit 6.1.

6.5 MEASURES FOR THE BALANCE SHEET One of the most heavily measured areas is the balance sheet. When used properly, the ratios and percentages noted in this section reveal a great deal of information about a company’s ﬁnancial health, as well as its ﬁnancial strengths and weaknesses. For example, several measures cover the size of a company’s debt holdings, as well as how this bears on the ﬁrm’s overall level of ﬁnancial risk. Other ratios deal with the relative proportions of assets needed to create revenues and proﬁts, which an astute controller can use to compare company performance to that of competitors as well as to that of “best practices” organizations that may lie outside the industry. Other measures can be used to determine a company’s short-term liquidity (which is of particular concern to lenders), as well as the age of assets. Finally, more advanced organizations are now trying to relate their assets to market valuations to determine their success in creating value in excess of the worth of their assets; there are several ratios here to assist in these calculations. The measurements are: • Debt/equity ratio. To a lender, one of the most important measures is the debt to equity ratio. This reveals the degree of leverage that management has imposed on the balance sheet by acquiring debt. If the amount of debt in relation to equity is excessively high, it may be difﬁcult for a company to service the debt or to pay it off. When a lender sees this high ratio, it may be reluctant to issue additional debt without some other assurances from management, such as personal guarantees. To calculate the measurement, simply add up all long-term and

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6.5 Measures for the Balance Sheet

Ratio

Derivation

Break-even point

Sales ----------------------------------------------------Average gross margin

Number of times interest earned

Average interest expense -----------------------------------------------------------Cash flow

Operating margin

Revenues -------------------------------------------Cost of goods sold

Overhead rate

Overhead expenses -----------------------------------------------Direct labor

Percent return on net sales

Net sales ----------------------Net profit

Ratio of sales returns and allowances to gross sales

Sales returns and allowances --------------------------------------------------------------------Gross sales

Sales/proﬁts per person

Sales ---------------------------------------------------------------Total full-time equivalents or Net profits ---------------------------------------------------------------Total full-time equivalents

E XHIBIT 6.1

91

P ROFITABILITY M EASUREMENTS

short-term debt and divide it by total equity. However, management can play with the degree of leverage by moving some debt into operating leases, which are not recorded on the balance sheet. • Return on assets. This is an excellent measurement when a controller wants to know how well a company is utilizing its assets to generate revenue. If the amount of assets required in proportion to revenues is increasing, then there are inefﬁciencies, or at least unnecessary assets, in the organization that the controller should investigate. The components of the return on assets are shown graphically in Exhibit 6.2. Note in the exhibit the large number of components that a controller can investigate in this complicated measurement; problems can occur in such diverse areas as sales or accounts receivable that have a direct impact on the measurement. To calculate it, divide total sales by total assets, the major components of which are usually cash, accounts receivable, inventory, and ﬁxed assets. However, this measure is not useful and can be downright misleading, when applied to a ﬁxed asset-intensive business, such as an oil reﬁnery, where there is a large investment that cannot be reduced, irrespective of the amount of sales generated. • Return on shareholder equity. This is one of the most important measurements for a shareholder. When a shareholder has a choice between investing funds in a company or doing so elsewhere, it makes sense to compare this measure to alternative investments, and to choose the higher of the two, while factoring in various risk issues. To calculate it, simply divide net income by shareholder’s equity, both of which can be found in the general ledger. The trouble with this measure is that it does not delineate changes in risk that may go hand-in-hand with changes in net income. For example, a company can increase its return on equity by incurring debt to buy back shares; however, the increased debt makes the investment more risky, so investors should also consider the debt/equity ratio alongside this one, in order to match changes in returns to changes in risk. • Current ratio. A common way to measure a company’s liquidity is to use the current ratio. This compares the amount of short-term assets to short-term liabilities. A good ratio is one that yields enough liquidity to pay off all current assets. If the ratio does not reveal this ability, it is possible that the company has a sufﬁcient degree of liquidity difﬁculty that it is in

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Return on Assets

Multiplied by

Earnings Ratio

Turnover

Divided by Earnings

Divided by Sales

Sales

Minus Sales

E XHIBIT 6.2

Total Assets

Plus Cost of Sales and Expenses

Working Capital

Fixed Assets

Cash

Accounts Receivable

Inventory

C OMPONENTS

OF THE

R ETURN

ON

A SSETS

danger of going bankrupt. To calculate this measurement, divide all current assets by all current liabilities. It can be misleading if there is a disproportionately large amount of inventory in the current assets ﬁgure, because this measure is primarily designed to track liquidity, and inventory is not a very liquid asset. • Quick ratio. A controller who regularly uses a quick ratio instead of a current ratio probably has a problem with inventory. This is because the primary difference between the two ratios is inventory. The reason why inventory is dropped from the quick ratio is that it is not a very liquid asset, whereas the other components of the ratio are usually easily liquidated. This ratio gives one a good idea of how quickly a company can convert its current assets into cash to pay for current liabilities, which makes it an excellent measure of short-term liquidity. To calculate the measurement, add together all cash, accounts receivable, and temporary investments, and divide by current liabilities. • Ratio of sales to accounts receivable. A controller should keep a close watch over the proportion of sales to accounts receivable, since a change in the historical rate may be indicative of worsening collection problems. To calculate the measurement, divide the amount of credit sales by the accounts receivable balance for the reporting period (both numbers should be recorded in the general ledger). The ratio should be tracked on a trend line, so that problems are more easily revealed in comparison to previous periods. The measure can be inaccurate if there is a large dollar volume of cash sales included in the sales ﬁgure; also, if the accounts

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receivable balance is primarily composed of a few large invoices, having even one invoice moderately overdue will severely skew the measurement. • Accounts payable turnover. This ratio indicates the number of times that accounts payable were paid, or turned over, in a reporting period. It is an effective means for tracking the timeliness of payments. When tracked on a trend line, it is easy to spot when a company is entering ﬁnancial difﬁculties, for the ratio will clearly worsen as the company delays payments. The ratio is also useful for predicting future accounts payable balances based on expected levels of purchasing. To compute the measurement, divide total purchases during the period by the ending accounts payable balance (though the average balance for the entire period is more accurate). This measure can be skewed if a company changes to or from taking early payment discounts, especially if this impacts a signiﬁcant proportion of the accounts payable. • Ratio of repairs and maintenance expense to ﬁxed assets. It is extremely useful to determine the condition of a company’s ﬁxed assets, because one can thereby determine the need for expensive replacement equipment that may signiﬁcantly cut into cash or borrowing reserves. The best way to do this without making a physical inspection of the equipment is to compare the size of the repairs and maintenance expense to the amount of ﬁxed assets. When tracked on a trend line, one can easily spot any jumps in the ratio compared to previous time periods, which indicates an aging set of ﬁxed assets. To calculate the measurement, obtain the repairs and maintenance expense from the general ledger, and divide it by the gross ﬁxed asset cost (i.e., before depreciation). The ratio will be much more accurate if the accounting staff splits off unrelated repair and maintenance expenses, such as for grounds upkeep, and stores this information in a different general ledger account. • Ratio of depreciation to ﬁxed assets. It is important to know the age of a company’s ﬁxed assets, because an excessively old asset base may soon require replacement. One of the best ways is to simply compare the amount of accumulated depreciation to the amount of assets; a large amount of depreciation is a good indicator of old assets. To calculate the measurement, obtain the accumulated depreciation ﬁgure from the general ledger and divide it by the total ﬁxed asset valuation (also obtained from the general ledger). The measure can be skewed if a company uses highly accelerated depreciation methods, such as double declining balance depreciation, because this appears to show an older asset base than is really the case. • Fixed-asset turnover. This measurement is most useful when plotted on a trend line. It shows how much of a ﬁxed-asset investment is needed for management to achieve a speciﬁc level of sales. If the ratio increases, then the amount of assets required has gone up, which will probably also lead to a reduced return on assets (unless margins increase). To compute the measurement, divide sales by ﬁxed assets. Both of these numbers are located in the general ledger. • Ratio of retained earnings to capital. A lender or investor uses this measurement to see how many earnings have been allowed to accumulate in the company. This is an especially important factor in a privately held company, where it is common for the owners to extract as much of the retained earnings as possible in the form of distributions, leaving few assets for continuing operations; this requires constant infusions of debt to keep the company aﬂoat, and effectively shifts much of the risk from the owners to the lenders. To compute this measurement, divide retained earnings by total stockholder’s equity, both of which are found in the general ledger. • Economic value added (EVA). Many controllers do not track the returns on capital that their companies are achieving. If a company’s return is lower than its cost of capital, then it is making inefﬁcient use of that capital. In fact, it may be better for investors to take their money out of such a company and invest it elsewhere. To calculate the measurement, multiply the amount of net investment (the amount of cash invested in the business, net of depreciation) in the company by the difference between the actual return on assets and the required minimum rate of return. Shrinking the amount of working capital or ﬁxed assets, or increasing the rate of return on those assets will improve the EVA.

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• Market value added (MVA). From the perspective of a shareholder, a company is successful if its market value in terms of the value of its shares on the open market is in excess of the amount of capital invested in the business. If its market value is less than the amount of invested capital, then management has done a poor job of generating adequate returns. To calculate the measurement, multiply the number of shares outstanding by the share price, add in the market value of preferred stock and debt, and then subtract the total amount of invested capital. • Working capital productivity. It is becoming increasingly important for companies to operate their businesses on the leanest possible asset base. Not only does this improve the return on assets, but it also reduces the risk of losing assets by investing too much in a business. Much of a typical company’s investment goes into working capital, which is accounts receivable plus inventory, minus accounts payable. However, the amount of dollars in working capital is not a good way to judge it, because there is no way to compare it to some other measure of activity. This is where working capital productivity is useful. To calculate it, simply divide the amount of working capital into annual net sales. The resulting number is most useful when tracked over time and when compared to the similar number for competitors, for it tells the amount of working capital needed to support each incremental dollar of sales. These measurements are used to create an understanding of a company’s level of ﬁnancial risk, liquidity, age of assets, and ability to leverage assets into revenues. It is very useful to track all of this information continuously and plot it on a trend line, so that management can spot any worrisome trends and act to correct them as soon as possible. The measures are noted again in summary form in Exhibit 6.3.

6.6 MEASURES FOR GROWTH Some companies ﬁnd themselves on an extremely rapid growth path. When this happens, there are ﬁnancial pressures on the corporation that require different measurements to discover. For example, there will be great strains on cash ﬂow, so there must be a close watch over the percentage change in cash ﬂow. Other issues include changes in sales and market share; these two measures can provide contraindications by moving in opposite directions, so it is helpful to track both measures side by side. Finally, investors want to know if all of the growth pains are worth it, so the controller should track changes in earnings per share. The measurements are: • Percentage change in cash ﬂow. A change in cash ﬂow is one of the ﬁrst indicators of a variety of problems elsewhere in a company. For example, a decline in cash ﬂow can be evidence of a decline in sales or gross margins, or it may be a sign of increased sales, general and administrative (SG&A) expenses, increased ﬁxed asset expenditures, or even of a stock buyback. Whatever the reason, this is a good ﬁrst indicator of trouble, and as such, the controller should rely upon it. There are two ways to calculate the measurement. The ﬁrst and more accurate way is to add proﬁts to all noncash and ﬁxed asset expenditures. The “quick and dirty” alternative is to simply track the current cash balance. In either case, it is best to track the information on a trend line in order to spot any period-to-period problems. • Percentage change in earnings per share (EPS). A company may ﬁnd that its sales, proﬁts, and market share are continuing to improve, but that the EPS are not keeping pace. This can understandably cause concern by investors. The key factor causing this problem is the number of shares. An equity placement that adds to the number of outstanding shares can water down the EPS to the point where even enhanced proﬁts will still result in a decrease in the EPS. The simplest way to calculate this trend is to divide net earnings by the number of outstanding shares and plot this on a trend line. • Percentage change in market share. The best absolute measure of a company’s performance is its market share. If the share increases, then the company is performing better than its competitors. To track it, use the market share results issued by industry trade organizations and plot the data points on a grid chart. However, a company may be gobbling up market share

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Ratio

95

Derivation

Debt/equity ration

Long-term debt short-term debt ---------------------------------------------------------------------------------Total equity

Return on assets

Total sales ---------------------------Total assets

Return on shareholder equity

Net income ----------------------------Total equity

Current ratio

Current assets -----------------------------------------Current liabilities

Quick ratio

Cash accounts receivable investments ------------------------------------------------------------------------------------------------------Current liabilities

Ratio of sales to accounts receivable

Net sales ------------------------------------------------------------Total accounts receivable

Accounts payable turnover

Total purchases ------------------------------------------------------------------------------Ending accounts payable balance

Ratio of repairs and maintenance expense to ﬁxed assets

Total repairs and maintenance expense --------------------------------------------------------------------------------------------Total fixed assets before depreciation

Ratio of depreciation to ﬁxed assets

Accumulated depreciation --------------------------------------------------------------Total fixed assets

Fixed asset turnover

Net sales ----------------------------Fixed assets

Ratio of retained earnings to capital

Retained earnings --------------------------------------------------------------Total stockholder’s equity

Economic value added

(Net investment) actual return on assets required minimum rate of return)

Market value

(Number of shares outstanding share price) (market value of preferred stock and debt) (invested capital)

Working capital productivity

Annual net sales --------------------------------------Working capital

E XHIBIT 6.3

B ALANCE S HEET M EASUREMENTS

and still be losing sales if the overall market is shrinking, so it helps to track the size of the market alongside the market share trend line. • Percentage change in sales. A controller should closely track the trend line for sales, not only for the company as a whole, but also for individual product lines. A continuing upward slant on a growth chart is obviously encouraging, but sometimes the most important trend to track is the rate of growth. Any decline in the rate of growth must not only be factored into future growth projections, but may also result in a discussion with the sales force to see if management should expect a sudden drop-off in sales volume — something that impacts lots of functional areas. To create the trend line, simply extract the periodic sales information from the computer system, usually with the use of a report writer to extract sales by product or product line, and then plot the data points on a grid chart. These measures are necessary for determining the amount of cash required to continue growth, the degree of growth occurring, and the extent to which investors are proﬁting from it. Because there are so many different factors to determine, it is necessary to track all of the measures noted in this section. The measures are summarized in Exhibit 6.4.

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Ratio

Derivation

Percentage change in cash ﬂow

Incremental change in cash flow -----------------------------------------------------------------------------Cash flow from previous period

Percentage change in EPS

Incremental change in EPS ----------------------------------------------------------------EPS from previous period

Percentage change in market share

Incremental change in market share ------------------------------------------------------------------------------------Market shart from previous period

Percentage change in sales

Incremental change in sales -----------------------------------------------------------------Sales from previous period

E XHIBIT 6.4

G ROWTH M EASUREMENTS

6.7 MEASURES FOR CASH FLOW A company may look great on paper—sales spiraling upward, surging proﬁts, and a vast backlog — and still go bankrupt. Cash ﬂow measurements can see through all of the favorable indicators to ascertain the true health of the organization. The measurements in this section focus on stripping away extraordinary cash ﬂow items to see how continuing operations are doing, as well as the ability of a corporation to cover continuing expenses for items not appearing on the income statement, such as debt repayments and ﬁxed-asset purchases. The measurements are: • Cash ﬂow adequacy. It is critical to know if the cash ﬂow from operations is sufﬁcient to meet all major payment commitments. These commitments do not include basic payments that are included in the income statement, such as payments for materials, utilities, or taxes; this is for non–income statement payments, such as debt payments. To calculate the measurement, divide cash ﬂow from operations by all scheduled payments for long-term debt, asset purchases and dividends. However, this measure is not sufﬁcient if management is in the habit of making unscheduled payments, such as for ﬁxed assets that are not on the annual ﬁxed-asset purchases schedule. • Cash ﬂow return on assets. Though most companies just use the return on assets, this is a variation that may be worthwhile in some situations. Rather than dividing proﬁts by total assets, just divide cash ﬂow by total assets. Any difference in the two measures will be due to any noncash expenses. If there is a large amount of noncash expenses, then the cash ﬂow return on assets can be substantially higher than the simpler return on assets. This can be used to explain company performance to investors when large depreciation or amortization charges are cutting into earnings. • Cash ﬂow to sales. This is perhaps a better measure of proﬁtability than a simple gross or net margin on sales. It reveals the total amount of cash ﬂow attributable to each sales dollar. To compute it, divide cash ﬂow from operations by revenues. Because the measurement strips out all noncash expenses, such as depreciation, it gives a good view of actual cash ﬂows to be expected from operations. • Dividend payout ratio. An investor who relies on company dividends wants to know the likelihood of the company’s being able to continue paying out at the same rate. This measurement provides that information. By comparing the amount of cash ﬂow to the dividend payout rate, one can easily track the proportion of cash that goes to dividends; if the ratio worsens over time, it is likely that the dividend will be cut. To calculate the measurement, divide the total amount of dividends by the total cash from operations. It is best to track this information on a trend line to spot changes over time. • Long-term debt repayment. A controller must be able to judge a company’s ability to repay debt, so that recommendations can be made to alter operations in favor of reducing debt, if the chief ﬁnancial ofﬁcer (CFO) decides that to be a prudent strategy. Many companies that

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are not ﬁscally sound can convince themselves otherwise, simply by continuing to pile on the debt. A controller can tell if a company is truly solvent by tracking debt levels over the course of a year to see if there are periods when short-term debt is completely paid off. If not, a company frequently rolls over short-term debt into long-term debt with a ﬁxed repayment schedule; this too can be a sign of ﬁscal trouble if the controller ﬁnds that the excessive amount of debt is leading to an unfavorable debt/equity ratio or if the number of times interest is earned is dropping. If a controller just wants to see if a company is capable of paying off continuing long-term debt payments, which are composed of both interest and principal, divide the total amount of long-term debt payments by cash from operations. If the ratio is unfavorable, it is probably time to extend the terms of the debt, so that the periodic payments are smaller. • Operating cash ﬂow. There are many factors that can impact cash ﬂow, and many of them are extraneous ones that rarely repeat. Though one would think that these extraneous factors will eventually go away, there always seem to be a few that interfere with the determination of cash ﬂow from basic operations. This measurement is based on only operating elements, excluding all other factors. This gives a controller the best information about the true status of cash ﬂows. To compute the measurement, add noncash expenses to proﬁts, and then adjust for changes in working capital (accounts receivable, accounts payable, and inventory). Just as important, the measure excludes any changes caused by investment income, ﬁxed-asset sales, or extraordinary items such as income from legal or insurance settlements. Compiling cash ﬂow measurements should be at or near the top of the controller’s “to do” list when the true health of a company needs to be obtained. If there is a problem, the controller can immediately get to work on ﬁxing the underlying problems. If a controller does not regularly review this information, there is a risk that the company will ﬁnd itself in a difﬁcult cash position simply because the controller did not exercise enough foresight to accumulate the necessary information in advance. The measures are summarized in Exhibit 6.5.

6.8 MEASURES FOR NONFINANCIAL PERFORMANCE This section deals with measures that a controller is not so accustomed to measuring — nonﬁnancial performance. These measures can cover an extraordinarily wide range of activities, ranging from engineering to sales and marketing. Many companies are now realizing that nonﬁnancial performance in these other areas is just as important to corporate success as the purely ﬁnancial measures that they are more accustomed to perusing. This section divides nonﬁnancial performance measurements into the traditional departmental functions. (e.g., accounting, production, etc.), and

Ratio

Derivation

Cash ﬂow adequacy

Cash ﬂow from operations All scheduled payments for long-term debt, asset purchases, and dividends

Cash ﬂow return on assets

Cash flow ---------------------------Total assets

Cash ﬂow to sales

Cash flow from operations ---------------------------------------------------------------Total revenue

Dividend payout ratio

Total dividend payments ---------------------------------------------------------------Cash flow from operations

Long-term debt repayment

Total long-term debt payments for the period -----------------------------------------------------------------------------------------------------------Cash flow from operations for the period

Operating cash ﬂow

Proﬁts noncash expenses changes in working capital

E XHIBIT 6.5

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describes a variety of measurements for each area that are extremely helpful for determining their efﬁciency, effectiveness, speed, and level of experience, all of which are direct contributors to corporate success. (a) ACCOUNTING. This section covers the performance measurements that a controller should use to manage the accounting department. The most heavily reviewed item is the average collection period for accounts receivable, because inattention to this area can lead to severe cash ﬂow problems. It is also common to closely review the percentage of accounts payable discounts taken, so that the accounting department is not inadvertently responsible for extra expenses that could have been avoided. In addition, it is increasingly common to track the number of days required to release ﬁnancial statements, with many companies even tying a controller’s bonus to this measure. Finally, an increasingly common set of measures is to track the efﬁciency of the accounting staff, much as the production staff has historically been tracked, by determining the number of errors committed and transactions completed per person. These are the primary measures used by a controller to manage the accounting department: • Average collection period. This is one of the best ways to determine the quality of accounts receivable. It shows the number of days that the average account receivable has gone unpaid. If the number of days resulting from the calculation is close to the number of days before which invoices are due (e.g., payable in 30 days), then it is unlikely that there are very many old accounts receivable, which highlights the ability of the accounting staff not only to issue error-free bills that are promptly paid, but also to rapidly collect overdue invoices. Conversely, an excessive number of collection days points to probable issues on the same topics. To calculate the measurement, divide average annualized receivables by average daily credit sales. • Percentage of accounts receivable. One of the primary measurements on which the controller is judged is the ability of the accounting staff to collect accounts receivable on time. If this does not happen, a company ends up with an excessive investment in accounts receivable, which is a poor use of funds. Also, older accounts receivable are at a greater risk of not being collected. To calculate this measure, print out an aged accounts receivable report, which should list at the bottom the total receivable amount in 30-day time buckets. Add up the summary totals for those time buckets that are considered to be overdue (e.g., everything over 60 days old), and divide it by the total of all accounts receivable. • Ratio of purchase discounts to total purchases. A company can save a fair amount of money by taking advantage of early payment discounts. Only a small percentage of suppliers offer early payment discount options, but if a company takes advantage of them all, the savings can add up to a tidy sum. The amount saved as a percentage of all purchases does not change much over time, so tracking the percentage of discounts taken is an easy way for the controller to discover if the accounts payable staff is missing out on some discounts. To calculate it, track the purchase discounts in a separate general ledger account, and divide this monthly ﬁgure by total purchases. Then track the resulting percentage on a trend line. • Time to produce ﬁnancial statements. In today’s competitive environment, it is no longer acceptable to wait a month to receive the results of the previous month’s performance. Most managers need ﬁnancial information as fast as possible, so that they can rapidly spot problems and correct them. The calculation is an easy one; just add up the days from the end of the month to the point when ﬁnancial statements are issued. However, the measure is less meaningful if the accounting staff is already issuing interim reports before the ﬁnancial statements that contain the most critical operating and ﬁnancial information. • Transaction error rate. One of the most time-consuming activities in the accounting area is ﬁxing errors. If something is wrong, the best person to ﬁnd the error and ﬁx it is a senior staff person or manager, and this type of person is usually already in short supply and certainly overworked. Consequently, there tends to be a long backlog of problems that the accounting department has in its queue, which may involve wait time by other departments, suppliers, or

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customers. Clearly, the controller must pay close attention to the transaction error rate, since it has such a major impact on workﬂows in the accounting area. This is not a measure that can be easily tracked by an automated system. Instead, the best approach is to review the transaction journals at the end of each month and add up the number of special debits and credits that were entered in the system — each one usually represents the correction of a previous problem. Then divide the number of errors by the total number of transactions, which also comes from the transaction logs. The main issue with this measure is that it only tracks items that have been corrected, not those that are still pending (which may be far larger than the number being corrected). • Transactions processed per person. Above all others, the accounting department is driven by the need to process large quantities of transactions, such as billings and payments to suppliers. Because of the large volume, this calls for extremely high levels of efﬁciency. By tracking the number of transactions processed per person, the controller can benchmark internal performance against that of other organizations to see if there are grounds for revamping processes to increase efﬁciency. The calculation varies somewhat by type of transaction, but it essentially requires that the controller accumulate data on the number of transactions processed during a speciﬁc time period, and the effort required to process them. It is easiest to do this with a periodic study, which may call for the services of a consultant. All controllers must be efﬁcient in producing ﬁnancial statements, collecting accounts receivable, taking purchase discounts, and processing transactions, and these measurements are the primary control point over those activities. The measures are summarized in Exhibit 6.6. (b) CUSTOMER SERVICE MEASUREMENTS. If there is a separate customer service department (or even if not), the measurements noted in this section are useful for determining the degree of customer satisfaction. Customer turnover shows the extent to which a company can retain its existing customer base, while two other measures note the types and quantities of complaints received, as well as the company’s speed in responding to them. The measurements are: • Customer turnover. A company expends a vast amount of resources to acquire new customers. It is much more inexpensive to simply retain the ones it already has than to ﬁnd new ones, but this is sometimes lost on aggressive sales managers who celebrate acquiring new customers; the loss of an old one tends to pass unnoticed. The controller can point out this problem by reviewing the billing records to see which customers have not done business with the company for a long time. To calculate it, compare the billing database to the list of customers to whom the company has sold products or services in the past year and determine Ratio

Derivation

Average collection period

Average annualized accounts receivable -----------------------------------------------------------------------------------------------Average daily credit sales

Overdue accounts receivable

Total of overdue accounts receivable ---------------------------------------------------------------------------------------Total accounts receivable

Ratio of purchase discounts to total purchases

Total purchase discounts taken -------------------------------------------------------------------------Total purchases

Time to produce ﬁnancial statements

(Financial statement issue date) (First day of the month)

Transaction error rate

Number of errors --------------------------------------------------------------------Total number of transactions

Transactions processed per person

Number of transactions completed Number of full-time equivalents required to complete transactions

E XHIBIT 6.6

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how many have not been invoiced in the last quarter (or some other time period, as determined by management). Divide the number of noncurrent customers by the total number of customers to determine turnover. • Number of customer complaints. Any well-run company should know exactly how many customer complaints have been received, as well as the issues to which they pertain and how they were resolved. This information should be contained in a customer complaints database that is accessible to as many employees as possible. Only by tracking this information and taking corrective action as necessary can a company ﬁx those problems that irritate customers enough to lead them to contact the company. To calculate the number of complaints, simply access the complaints database and summarize the number of complaints by time period. It is even more effective to summarize the complaints by type of complaint, which tells management what areas need the most corrective action. • Response time to customer complaints. If a customer complains and then does not receive a response within a reasonable time period, that customer is probably gone for good. By closely tracking the time it takes to respond to customer problems, management can alter the response system, which results in more satisﬁed customers who will continue to buy from the company. To calculate it, create a complaints database in which all contacts are logged; then subtract the response date from the initial contact date. An even better measure is to track the time it takes to completely resolve each complaint, rather than just the time to make an initial contact. These measures are summarized in Exhibit 6.7. (c) DISTRIBUTION MEASUREMENTS. Many companies seem to think that their jobs are complete once they have manufactured products; however, there is an art to delivering products to customers as quickly and with as little damage as possible. This section covers the primary measurements to use when evaluating this key function. The ﬁrst measure covers the time needed to deliver products to customers, while the second explores the proportion of deliveries that meet expectations. The ﬁnal measure is useful for discovering the amount of damage to products during transit. The measurements are: • Average delivery time. The distribution function is responsible for picking products, packaging them, and delivering them to the customer. If the customer is in a hurry to receive the product, the time needed to get the product into the mail is critical. To calculate this measurement, note in the company’s computer system the date and time when an order is sent to the shipping area, and compare this to the date and time when the order was listed in the shipping log as having been shipped. This is an easy calculation if the ordering and shipping functions are linked in the computer system, but otherwise very difﬁcult. It rarely makes sense to track the time required to actually deliver the product to the customer, because the customer may specify a slow delivery method that will skew the measurement. • Percentage of on-time deliveries. It is very important that the company deliver products on the date requested by the customer. Many customers are now using just-in-time (JIT) manufacturing systems, and so they want deliveries on a speciﬁc date,. which means that they cannot Ratio

Derivation

Customer turnover

(Total customer list) (Invoiced customers) ----------------------------------------------------------------------------------------------------------Total customer list

Number of customer complaints

Summarize complaints from complaints database for speciﬁed date range

Response time to customer complaints

(Response date) (Initial contact date) or (Final resolution date) (Initial contact date)

E XHIBIT 6.7

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be delivered early or late. To calculate this measurement, there must be a requested delivery date entered into the computer system for each customer purchase order; otherwise, it is impossible to determine when an order is supposed to ship. Next, there must be a shipment date recorded, against which the controller can match the required date. The computer system can then subtract the delivery date from the required date and summarize the difference for all deliveries. However, there must also be an adjustment to the calculation for the estimated shipment time to the customer. It is very useful to add a detailed listing of all “problem” shipments to this measurement, so that management can see where problems have occurred and correct them. • Percentage of products damaged in transit. Most companies do not deliver their own products to customers; a third-party carrier does it for them. The company must know if the carrier is damaging any of the delivered products, because this is not exactly good customer service, so that it can take steps to switch to a new carrier. This is a difﬁcult measure to calculate unless customers tell the company about the damage; consequently, the best measurement point is customer complaints, which should be logged into a complaints database. The controller can then select only those complaints pertaining to damaged products, and divide this number by the total number of products shipped. If these measures are not tracked regularly, management will have no way of knowing the performance of its distribution function. The measures are summarized in Exhibit 6.8. (d) ENGINEERING MEASUREMENTS. The engineering department has a direct impact on product costs, as well as the efﬁciency of other departments, such as materials management and production. The measurements in this area are necessary to ensure that the key engineering functions are running properly, thereby improving the efﬁciency of other downstream operations. The bill of materials accuracy measurement is mandatory for ensuring that the correct quantities and types of parts are available for production. There are also several measurements, which can be used together or separately to determine the engineering department’s speed in completing new product designs as rapidly as possible, which is of considerable importance in an economy where market windows open and close very fast. A parts usage measure is crucial for determining the engineering staff’s ability to use existing parts in new products, greatly easing the work of the materials management staff, which must procure and store new parts. Finally, another measure determines the ability of the engineering staff to meet target costs; this skill is crucial for ensuring that a company prices its products at a price point that gives it a proﬁtable share of the market. The measurements are: • Bill of material (BOM) accuracy. The engineering department has a major impact on the efﬁciency of the materials management department, in that it must specify in advance the materials needed to produce products. Without this information, the materials management personnel are reduced to guessing about the contents of new products, which commonly results in purchases of items that are never used, which contributes to an excessively large inventory. The materials list is commonly known as a bill of materials. To calculate its accuracy, review a bill of materials with the engineering, warehousing, and production staffs to ensure that all parts are actually needed. Each mistake, either in terms of quantities or item codes, is an error. Divide the number of accurate parts by the total list of parts needed to derive the accuracy percentage. Ratio

Derivation

Average delivery time

(Delivery date) (Date order was sent to shipping area)

Percentage of on-time deliveries

(Required date) (Actual delivery date)

Percentage of products damaged in transit

Damage-related complaints in complaints database -------------------------------------------------------------------------------------------------------------------------Total complaints in complaints database

E XHIBIT 6.8

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• Number of patent applications ﬁled. Leading-edge research gives a company a good basis for building products that no one else can match. A good sign of this research is the number of patent applications ﬁled during the period. It is easily tracked by the legal staff, which usually assists in creating and ﬁling the necessary documents. However, ﬁling a patent application and translating this into new products that generate sales requires lots of other activities, so patent activity is not a sure sign of future success. • Percentage of sales from new products. The previous measurement showing the number of new products is not as important as the percentage of sales being derived from them, since this is a more sure measure of corporate health. To calculate it, summarize the sales from new products (it is helpful to arrange the chart of accounts in advance to track this information) and divide by total sales. • Percentage of new parts used on products. The engineering staff should always strive to reduce the number of new parts in each product design to the absolute minimum, because not doing so entails buying from additional suppliers, as well as stocking extra parts in the warehouse, which requires an additional investment. To track it, compare the bill of materials for each new product to the existing list of parts in inventory to see which items are new. Then divide the number of new parts by the total number of parts used in the product. • Percentage of new products introduced in the period. A key measure of a company’s ability to thrive in the marketplace is the percentage of its products that are new. An old product line generally leads to declining sales, so the reverse is also true—constantly replenishing the product line leads to more revenues. To calculate the measurement, add up the number of new products introduced during the period and divide by the number of products available at the beginning of the period. This measure can be signiﬁcantly skewed by how one deﬁnes a new product; if a minor product enhancement is deﬁned as a new product, the company is only fooling itself into believing that it is creating new products. • Percentage of products reaching market before competition. It is not very useful to a company to release fabulous products to the market long after the competition when there is no one left to buy them. Instead, a company must tightly focus on bringing products to market as soon as possible, even if they are not quite as perfect as the designers would like. A good way to measure this is to manually track the product release date, and then keep abreast of release dates by competitors to see when they release similar or competing products. However, the measurement is quite judgmental, because it is sometimes difﬁcult to determine if a competitor’s product is really similar to what a company has already released. • Percentage of released designs matching target costs. A new product will not be very proﬁtable if the costs designed into it are so high that the company either cannot obtain a proﬁt when selling at a competitive price, or must sell at an exorbitant price in order to obtain a proﬁt. Instead, the controller should verify that product designs are being released that have costs matching expectations (the target cost). To calculate the measurement, simply summarize all actual costs for a product and divide them by the original target cost, which should be noted in the engineering documentation. It may also be useful to track the percentage by which released designs are missing their targets, so that management can work on gradually dropping costs down to target levels. • Time from design inception to production. The engineering staff must be able to produce new product designs as rapidly as possible in order to beat the speed with which competitors are introducing products. This is an ever-declining time period, so it is best to track the design time on a trend line, working toward extremely short design periods. To calculate it manually, note the design start and end dates and subtract the former from the later to derive the total number of design days. The design time will vary greatly by product, of course, since they may vary greatly in complexity, so it is best to track this information separately for each product line. Many companies treat their engineering departments as something of a “black hole”— they feed money into it, and new products come out from time to time, though no one knows their

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exact conﬁgurations, nor when they will be released. A better approach is to use the measurements in this section to determine the speed with which new products are being created, the efﬁcient use of old parts in new products, and the level of detail that the department is providing the materials management personnel in terms of the parts needed to build each product. The measurements can also be used to determine the impact on sales of new product introductions. Finally, the department must be responsible for hitting prearranged target costs; there is a measurement here for determining that information. In short, this section provides the tools to attain a high level of control over the engineering department. The measures are summarized in Exhibit 6.9. (e) HUMAN RESOURCES. The human resources department fulﬁlls a wide variety of tasks, some of which must be completed properly if a company is to avoid government ﬁnes, promptly ﬁll new positions, and avoid excessive levels of overhead. The measure that is central to the needs of a growing ﬁrm that has an insatiable need for new employees is the time needed to ﬁll requested positions. Other ﬁrms with lesser hiring needs may concentrate on fulﬁlling government requirements, such as the percentage of minorities on the payroll. There are several other measures covering the trend of fringe beneﬁts or indirect labor to direct labor, which are useful for determining the trend of employee-related costs. For a more progressive company that wants to have a highly trained staff, there is also a measurement for tracking the percentage of employees with certiﬁcations. Some combination of these measurements will fulﬁll the requirements of most human resources departments. The measurements are: • Average time to ﬁll requested positions. One of the human resources department’s most important tasks is to assist in ﬁnding good candidates for requested positions throughout the company. In an explosive growth company, where continued growth is almost entirely dependent on ﬁnding additional staff, this is the department’s most critical function. To calculate it, create a log book in which the date of all new position requests are received by the human resources staff, as well as the date on which offer letters are accepted by recruits; the difference between the two dates is the average time to ﬁll requested positions. • Average yearly wage per employee. It is of moderate use to management to know the average annual pay of its employees, since this gives it some idea of the company’s pay levels as compared to the industry. For example, if the employee turnover rate is high and the average Ratio

Accuracy

BOM accuracy

Number of accurate parts per BOM ------------------------------------------------------------------------------------Total list of parts on BOM

Number of patent applications ﬁled

Number of applications logged in as having been sent during the period

Percentage of new products introduced in the period

Number of new products introduced in the period Number of products available at the beginning of the period

Percentage of sales from new products

Revenues from new products ---------------------------------------------------------------------Total revenues

Percentage of new parts used on products

Number of new parts in BOM ---------------------------------------------------------------------------------Total number of products released

Percentage of products reaching market before competition

Number of products released before competition -------------------------------------------------------------------------------------------------------------------Total number of products released

Percentage of released designs matching target costs

Summary of actual product costs ------------------------------------------------------------------------------Summary of target costs

Time from design inception to production

(Completed design and signoff date) (Design start date)

E XHIBIT 6.9

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pay rate is low, this may be an indication that the company must start offering higher pay rates in order to retain staff. To calculate it, use a report writer to create a standard report listing everyone’s pay rate; this usually requires two lists, one for the hourly staff and one for the paid staff. Then summarize each list. Multiply the total on the hourly employee list by the total number of standard hours worked in a year (usually 2,080), and multiply the total on the salaried employee list by the total number of pay periods. Then add the two lists together and divide by the total number of employees. This calculation may be slightly skewed if there are many part-time employees, since this will translate into a very low annual pay rate. • Employee turnover rate. By far the most important measurement in the human resources area is employee turnover. It is exceedingly expensive to recruit and train new employees, so management must tightly focus on retaining all current staff. To calculate it, add up the number of people who have left the company, and divide by the number of employees at the beginning of the measurement period. It may be useful to subdivide this measurement so that the most critical departments, such as engineering, are tracked separately. • Indirect to direct personnel ratio. Management may want to know if a company is becoming top-heavy with an excessive number of people in the overhead areas, such as administration, accounting, or engineering. Changes in this proportion are most clear when tracked over time (perhaps annually). To calculate it, summarize the number of personnel in overhead positions (the easiest way is to use the payroll system to list personnel by department) and divide that number by the total in direct labor positions (i.e., the production department). Another way to measure this is to use payroll dollars instead of headcount, which gives a more accurate picture of a company’s proportional investment in indirect labor. • Minorities percentage. Depending on the size of a company, there may be federal government reporting requirements for the percentages of various types of minorities in a company. If so, the best way to track this information is to record a minority code in the payroll or human resources computer systems for each person, so that a simple computer query can extract the information needed for various government reports. • Percentage of employees with certiﬁcations. A company with many certiﬁed employees is a company with a great knowledge base that will contribute toward constant system improvements. Certiﬁcations fall into nearly every functional area, from certiﬁed management accountants to certiﬁed engineers. This information can be recorded in the human resources database with a code, and can be extracted with a simple query. To calculate it, divide the total number of people with certiﬁcations by the total number of employees. This measurement can be subdivided into departments, so that management can determine the skill levels by functional area. • Ratio of fringe beneﬁts to direct labor. The human resources staff is responsible for the cost (though not necessarily the types) of fringe beneﬁts offered to the staff, which is principally comprised of medical insurance. Senior management sometimes looks at the ratio of fringe beneﬁts to direct labor to see if too much is being spent on fringe beneﬁts, and may cut back in this area if they perceive that to be the case. To calculate it, manually summarize the fringe beneﬁt cost per person (or else accumulate the information through general ledger accounts) and divide it by the direct labor cost, which is usually obtained through the payroll system. • Trend of headcount. Some managers like to review the number of people in each department, preferably on a trend line, to spot unusual changes in headcount. This is most informative when tied to various activity measures (usually revenues), so that there is a direct relationship between an activity and headcount. Headcount is easily extracted from the payroll database, though one must be careful to translate any part-time staff to full-time equivalents to ensure comparability across time periods. There are many measurements available to track the performance of the human resources staff, or of the employees for whom they are responsible. Not all of these measurements should be used at one time, however. For example, a rapidly growing company will focus primarily on the department’s ability to rapidly recruit new people and will want to know about employee turnover, but a

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more staid organization may be more interested in obeying rules and regulations, and so will focus on minority percentages. For this area, the controller must ﬁt the measurements to the circumstances. The measures are summarized in Exhibit 6.10. (f) MATERIALS MANAGEMENT MEASUREMENTS. Recent developments in the materials management area can make this one of the most streamlined operations in a company. Measurements are needed to verify the extent of the department’s efﬁciency. For example, inventory accuracy is needed to ensure that a material requirements planning (MRP) system operates properly. Also, an inventory turnover measurement is needed to verify the outcome of MRP and JIT systems. In addition, there are several measures for determining the department’s success in shrinking the number of suppliers, as well as of switching to more efﬁcient electronic commerce systems. It is also important to track the percentage of on-time parts delivery, since this impacts the ability of the production department to complete new products on time. The measurements are: • Inventory accuracy. The inventory database must accurately reﬂect the quantities, part numbers, and locations of all inventory in stock. If not, the materials management staff cannot be sure about what materials are in stock, and will probably purchase extra materials to cover this level of uncertainty, which increases the inventory investment as well as the potential level of obsolescence. To measure it, print out a listing of the inventory and its locations and audit a signiﬁcant sample from the listing. Divide the number of test items with correct information by the total number sampled to obtain the accuracy percentage. • Inventory turnover. An extremely important measure is inventory turnover. This tells management the proportion of inventory in stock (as raw materials, work-in-process, and ﬁnished goods) as compared to the cost of goods sold. A high proportion of inventory indicates that there is an excessive investment in working capital that is a good target for reduction. To calculate it, add up the cost of all inventory and divide by the annualized cost of goods sold. This calculation can be skewed if there is a large amount of ﬁnished goods on hand (which can ﬂuctuate widely if sales are highly seasonal). Ratio

Derivation

Average time to ﬁll requested positions

(Date offer letter is accepted by recruit) (Date of receipt of position request)

Average yearly wage per employee

(Summary of all hourly wages number of annual working hours) (Summary of all salaries) Number of employees

Employee turnover rate

Number of employee departures -----------------------------------------------------------------------------------------------------------Number of employees at beginning of period

Indirect to direct personnel ratio

Number of personnel in overhead positions ------------------------------------------------------------------------------------------------------------Number of personnel in direct labor positions or Total payroll of overhead positions ----------------------------------------------------------------------------------------Total payroll of direct labor positions

Minorities percentage

Summarize by minority code in payroll or human resources systems

Percentage of employees with certiﬁcations

Number of employees with certifications -------------------------------------------------------------------------------------------------Total number of employees

Ratio of fringe beneﬁts to direct labor

Total fringe benefit expense ------------------------------------------------------------------Total direct labor expense

Trend of headcount

(Total full-time employees) (Total full-time equivalents for part-time employees)

E XHIBIT 6.10

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• Number of suppliers used by commodity code. The materials management staff can become overwhelmed if it is managing too many suppliers. It is better to utilize the services of a smaller number of suppliers, so that a company has enough time to implement supplier rating systems, electronic data transfers, and mutual product designs with a limited group of business partners. An excessive number of suppliers in each commodity code is a clear indicator that some shrinkage of the supplier base is in order. To calculate it, use the accounts payable database to create a list of all suppliers from whom the company has made purchases in the last year, and sort the list by commodity code. • Obsolete inventory percentage. An excessive amount of obsolete inventory is an indicator of too much inventory on hand (since not all of it is being used), an inadequate materials management system (since it is not using up in-house parts), or of the unwillingness of management to dispose of old parts. In any of these cases, a controller needs to emphasize that eliminating the root causes of obsolescence are a primary method for reducing materials costs. To calculate it, use the materials management system to extract all inventory records for which there has been no inventory movement for a long time (which can vary from a few months to years, depending on the industry); when the costs of these inventory items are divided by the total inventory cost, this yields a rough measure of total obsolescence. The measure can be skewed by items that are old, but which can be sold—a review by management will easily uncover these items. • Percentage of on-time part deliveries. The most important function for the materials management staff is to ensure that materials arrive on time, so that the production process is not held up. This requires tight control over the arrival of needed materials. To calculate this measurement, create a report in the computer system that compares the requested arrival date on all company purchase orders to the dates on which parts were actually received (which should be entered by the receiving staff). If these portions of a company’s systems are not run with computers, the measurement is nearly impossible to calculate. • Percentage of suppliers using electronic data interchange (EDI). The materials management staff can operate more efﬁciently if it conducts electronic purchasing and other transactions with suppliers. By doing so, it reduces the time required to transfer information, and, depending on the interfaces used, can even lead to the near-automation of most transactions. To measure it, manually summarize the number of suppliers with whom the company has EDI links, and divide by the total number of suppliers with whom the company did business in the past year (which is obtained from accounts payable records). • Total number of components. Many companies are overwhelmed with an excessive number of parts, many of which have not been used in a very long time, but which the materials management staff must still track. If there is an excessive amount, the best management action is to undertake a detailed review of parts usage to see what can be eliminated from stock. To calculate this measurement, simply run an inventory listing for all items currently in stock, and add up all the line items. It is also helpful to compare the number of parts to sales, since the number of parts will probably increase with revenues. It is also useful to create a “where used” report that shows the products for which each part is used; if a part is in stock but is not used on any current products, then it is a prime candidate for elimination. Today’s competitive pressures almost always result in some changes in the materials management area, either to electronically link to suppliers and customers, or to increase the speed or efﬁciency with which materials are procured and sent to the shop ﬂoor. The amalgam of measurements in this section will serve the controller in determining departmental performance for almost any performance improvement project. The measures are summarized in Exhibit 6.11. (g) PRODUCTION MEASUREMENTS. The production department has been greatly impacted by JIT production methods, and to a large extent the measurements in this section are needed to identify its success. A key JIT concept is reducing equipment setup times, so there is a measurement for that. Also, there is a measure for tracking the proportion of successfully completed products;

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Ratio

107

Derivation

Inventory accuracy

Number of accurate test items -----------------------------------------------------------------------Number of items sampled

Number of suppliers used by commodity code

Sort accounts payable list of suppliers by commodity code

Obsolete inventory percentage

Cost of inventory items with no recent usage ----------------------------------------------------------------------------------------------------------Total inventory cost

Percentage of on-time part delivery

(Actual arrival date) (Requested arrival date)

Percentage of suppliers using EDI

Number of suppliers with EDI linkages ---------------------------------------------------------------------------------------------Total number of suppliers

Total number of components

Summary of all inventory line items

E XHIBIT 6.11

M ATERIALS M ANAGEMENT M EASUREMENTS

under JIT, this should be very nearly 100%. The turnover of work-in-process inventory should also increase under a JIT system, so there is a supporting measurement here for that. There are also more traditional measures that are not used in JIT, such as the percentage of scrap, and labor productivity. The measurements are: • Average equipment setup time. In a just-in-time manufacturing environment, it is critical to only produce what is immediately needed. However, most companies still make long production runs, even though this generates more products than are needed. They do this because the production equipment takes so long to set up that it is only cost-effective to make long production runs. The solution, then, is to reduce the length of the equipment setup times. This is tracked separately for each piece of equipment, and is usually done by either the production or process engineering staffs. The calculation is simply the time (in hours, minutes, or seconds) required to switch a machine over from one type of production to another. • Percentage of acceptable products completed. Management should know what proportion of every production run results in good products that are acceptable for sale. This is absolutely critical in an industry such as chip wafer manufacturing, where yield rates may be as low as 20 percent. To calculate the measurement, create a system for collecting and counting all unacceptable products from a production run, and then divide this amount by the total of all products created in the run (either acceptable or not). It may only be necessary to aggregate this information for a single monthly measurement, but it is more common to run the measurement by product line, since yield may vary dramatically by type of product. • Percentage of scrap. A good way to determine if the production department is making efﬁcient use of materials is to track the amount of scrap falling out of the manufacturing process. An excessive scrap amount is an indicator of a variety of items, such as improper machine setup (which requires extra material to test it), employee theft of materials, and faulty products that are detected during the production process and thrown away. Due to the large number of underlying problems, this measure should be considered only a symptom of the real problem, with much additional work required to discover the underlying issues. There are several ways to calculate the measurement. The most inaccurate is to throw all scrap into scrap bins, and then periodically weigh the bins to estimate the cost of what is inside. A more accurate approach is to use an MRP system to determine the material cost that should be required for scheduled production, and then compare this to the actual cost to determine the difference. It can be especially difﬁcult to determine the cost of products that were scrapped after some amount of labor and overhead had already been applied to them. • Unit output per employee hour. A company that operates along traditional lines, using long production runs, wants to know about the ability of its employees to churn out products at the highest possible speed. This measurement is no longer used in a JIT environment, where the

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emphasis is on only producing what is needed, rather than producing at the fastest possible rate. Also, focusing on this measure tends to increase the production error rate, since employees will complete products irrespective of problems, because they are being judged on their speed, not their accuracy. Nonetheless, if a controller still wants to calculate this measurement, the best approach is to aggregate all personnel in an assembly line or on a speciﬁc job, add up the hours worked from payroll records, and divide this amount by the number of products completed during the same time period. This number will be inaccurate if the payroll hours include a holiday for which employees are being paid. The number will also be incorrect if the output is based on direct labor dollars (instead of hours), because the dollar amount can be considerably increased by overtime or shift differentials. • Work-in-process (WIP) turnover. A company that is focusing on improving its JIT manufacturing systems uses the WIP turnover rate as one of its primary measures of success. This is because a properly functioning JIT system requires very little inventory in the manufacturing process, so the WIP turnover rate should be very high. To calculate the measurement, take the period-end work-in-process ﬁgure from the general ledger and divide it by the cost of goods sold for the year. This measure should be tracked on a trend line, since anyone involved in a JIT system will want to track it as direct evidence of the success of the system. Traditional production systems focus on improving the speed of output, while newer systems tend to focus on product error rates and the amount of work-in-process. This section has the measurements a controller needs to track the performance of either type of system. The measures are summarized in Exhibit 6.12. (h) SALES AND MARKETING MEASUREMENTS. The sales department represents the controller’s leading edge of information about conditions in the marketplace. Measurements for this area must be constructed that yield as much market information as possible. One is market share, which reveals a company’s share of the market “pie.” Another key factor is a company’s ability to convince customers to sole source their purchases through it. Also, several other departments depend on the sales staff to keep a steady ﬂow of orders coming into the company; a backlog measurement is a prime advance indicator of potential trouble. Finally, there are several sales trend lines to watch that indicate problems with the rate of sales growth (or decline) that are of use when planning for new products or upgrades to existing products. These measurements follow: • Market share. Sometimes an upward trend in sales volume disguises a decline in market share. For example, upward sales growth in the computer industry means little, when everyone’s sales are growing; only growth that exceeds the growth of competitors matters, because this allows a company to exercise economies of scale, thereby lowering costs and reaping greater proﬁts than competitors. Market share is a difﬁcult item to measure; the best calculation is to fund an industry trade group that releases an annual or quarterly market share surRatio

Derivation

Average equipment setup time

(Start time for new production run) (Stop time for last production run)

Percentage of acceptable products completed

Number of rejected products ------------------------------------------------------------------------------------------Number of products in production run

Percentage of scrap

(Actual cost of goods sold) ( Standard cost of goods sold ) -----------------------------------------------------------------------------------------------------------------------------------------------Standard cost of goods sold

Unit output per employee hour

Aggregate output per production area -------------------------------------------------------------------------------------------Total hours worked in production area

WIP turnover

Total work-in-process -------------------------------------------------------------Annual cost of goods sold

E XHIBIT 6.12

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vey. If there is no trade group, the marketing staff must conduct its own research, which will probably be moderately inaccurate; nonetheless, either method will reveal changes in market share over time that management should act on as necessary. • Number of major accounts for which the company is the preferred supplier. The ultimate goal of any sales department is to make the company the sole supplier to the best customers. This allows it to incrementally raise prices enough to reap good margins, while at the same time avoiding an excessive number of sales contacts, which merely increase overhead costs. To calculate it, the sales staff must contact suppliers to determine company sourcing status; the total number of these customers must then be divided by the list of active major customers. This is a difﬁcult measurement to construct, for there may be some debate regarding what constitutes a major account; the best approach is to set a hard limit on sales volume from each customer during the previous year—if a customer exceeds that level, it is designated a major account. • Ratio of backlog to sales. The sales department must support the production department in having enough sales on hand to avoid a signiﬁcant slippage in the ﬂow of production, which may result in major layoffs in the production area. It helps to maintain a consistent pattern of sales, too. A good control point is to constantly compare the dollar volume of backlog to a short-term record of sales to see if there are sudden changes in the backlog that require immediate action by the sales force. To calculate it, summarize the dollar value of all orders not yet in production (which is usually available on the production backlog report), and divide it into a rolling average of the last three months’ sales. • Sales trend by product line. The sales and engineering staffs need to know when the trend of product sales is beginning to slow or decline, so that they can either run promotions to increase sales (a function of the sales and marketing staffs) or renew sales with replacement products. To do this, there should be a trend line, preferably in graphic form, for each product line. To calculate it, accumulate product sales under different sales codes or general ledger accounts, and transfer the monthly sales information to a graphical display. It is dangerous to report this information on an excessively summarized level, since it may hide a multitude of sales variations for separate products or product lines that are being grouped into a single trend line. A controller should track all of the measurements in this section, because each one shows a different aspect of the sales and marketing functions, and all of them are important. One must track market share, as well as the trend of sales by product line, while it is always prudent to determine the size of the backlog. Finally, the sales staff should always strive to achieve sole-source status with suppliers, and the controller should remind them of this responsibility by tracking that information and reporting it back to them. All of these measures are key to controlling the sales and marketing department. The measures are summarized in Exhibit 6.13. Ratio

Derivation

Market share

Dollar volume of company shipments -----------------------------------------------------------------------------------------Dollar volume of industry shipments

Number of major accounts for which the company is the preferred supplier

Number of major sole-source customers -----------------------------------------------------------------------------------------------Number of major customers

Ratio of backlog to sales

Dollar volume of all orders not yet in production --------------------------------------------------------------------------------------------------------------------Average of sales for last three months

Sales trend by product line

Summary of sales by product code or (Summary of current period sales by product code) (Summary of previous period sales by product code) Summary of previous period sales by product code)

E XHIBIT 6.13

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AND

M ARKETING M EASUREMENTS

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(i) CYCLE TIME. There is one measurement that cuts across all departmental boundaries. That is cycle time, which is used to determine the time taken to complete a transaction. Because many transactions cut across departmental boundaries, the measurement is placed here, rather than under the previous department headings. This is also done to emphasize the importance of the measurement. Poor cycle time leads to very slow customer service, which is bad for customer retention and therefore revenues. This is a very important item for a controller to track. Major processes, such as order fulﬁllment, run through multiple departments, and so are not actively tracked by individual departments (they just blame problems on the other departments that are also involved in the process). However, these are frequently the cause of major inefﬁciencies in a company, and so the controller should periodically review the time required to process transactions through them, so that management has a clear understanding of the time interval (or “cycle time”) needed. The calculation will vary depending on the process, but the basic method is to create a set of standard transactions and run them through a process, taking note of the beginning and ending dates (or times). The average transaction length becomes the ofﬁcial cycle time for the process. It is very important to not only know the time needed to process transactions, but also to constantly strive for better performance. Thus, a controller should continually track cycle times to enhance a company’s level of performance and competitiveness. The measure for cycle times is summarized in Exhibit 6.14. Ratio Cycle time E XHIBIT 6.14

Derivation (Process end time) (Process start time) C YCLE T IME M EASUREMENT

6.9 INTERRELATIONSHIP OF RATIOS Focusing on a problem ratio and resolving the underlying issues can create problems with other related ratios. For example, a company’s debt covenant may specify a current ratio of 2:1. If the ratio is 1.5:1, the controller can borrow money and retain the cash to improve the current ratio. However, the controller’s action also worsened the company’s ratio of long-term debt to shareholder’s equity. The controller must be aware of changes to other ratios that may result from ﬁxing seemingly unrelated measurements. A number of impacts on related ratios are noted in Exhibit 6.15.

6.10 SETTING UP A SYSTEM OF RATIOS AND TREND ANALYSES There are enough measurements in this chapter to keep even the most analytical controller happy. However, there are so many that issuing all of them will drown the management team in a ﬂood of data that it has no time to read. The controller must select only a portion of all measures for perusal by management. The controller must know how to pick the correct measures and how to present them in a clear and understandable format. The ﬁrst step is to match the measurement system to company objectives. Some management teams are driven by strong revenue growth, because they have a tight focus on grabbing as much market share as possible; this is common in a new industry. For this situation, there should be a preponderance of measures that closely track all changes in revenue streams. Other companies are in slow-growth industries where the focus is on gaining a slight edge in proﬁtability over the competition. In this case, the bulk of the measures should track gross and net margins and the key components thereof. Another common occurrence, especially in high technology industries, is for corporate success to be largely driven by the organization’s ability to acquire and retain the best employees. In this case, the most important measurements may not even be ﬁnancial — they are human resources related, such as employee turnover percentages and the time needed to ﬁll open positions. Consequently, company objectives play a strong role in a controller’s choice of measures to report.

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A Change in This Ratio

111

Impacts These Ratios

Current ratio

Management improves the ratio by borrowing money and retaining the cash: the ratio of long-term debt to sharedholder’s equity worsens because debt has increased.

Ratio of long-term debt to shareholder’s equity

Management improves the ratio by liquidating short-term investments to pay down the long-term debt; the current ratio worsens because investments have been reduced.

Ratio of net sales to receivables

Management improves the ratio by factoring receivables: the ratio of net proﬁts to net sales worsens because there is a service charge associated with factoring the receivables.

Turnover of inventories

Management improves the ratio by selling off inventories; the ratio of gross proﬁt to net sales worsens because management must pay premium prices to buy raw materials on short notice and ship it to the company by express freight.

Ratio of net sales to working capital

Management improves the ratio by extending payables; the ratio of gross proﬁt to net sales worsens because suppliers will not ship additional raw materials, so management must pay premium prices to buy raw materials on short notice and ship it to the company by express freight.

Ratio of repairs and maintenance to ﬁxed assets

Management improves the ratio by cutting the amount of maintenance work on equipment; the ratio of net income to net sales worsens because production capacity drops when equipment breaks down.

Number of times ﬁxed charges are earned

Management improves the ratio by using cash on hand to pay down debt; the current ratio worsens because the cash is used.

Ratio of gross proﬁt to net sales

Management improves the ratio by increasing prices; the ratio of net income to net sales worsens because fewer people buy the product at the higher price.

Ratio of operating expenses to net sales

Management improves the ratio by reducing the accounting department’s payroll; the ratio of gross proﬁt to net sales worsens because there is no cost accountant to review increased product costs.

Ratio of net income to net sales

Management improves the ratio by selling manufacturing equipment and recording a gain on the sale; the ratio of gross proﬁt to net sales worsens because production capacity is reduced, and production must be given to subcontractors at a higher cost.

E XHIBIT 6.15

I MPACT

ON

R ELATED R ATIOS

Another important consideration for creating a measurement system is the strengths and weaknesses of a company’s controls. For example, if there are many divisions, all of which handle a large amount of cash, it is reasonable for a controller to create many cash-related measurements that track cash receipts and disbursements, as well as the company’s ability to collect the cash from all divisions and properly invest it. Another example is inventory systems; if there is a strong JIT manufacturing system in place, then there is little need to expend an excessive amount of company resources on measuring the small amount of inventory needed to maintain it. However, a befuddled manufacturing system may call for a considerable amount of inventory measuring — perhaps weekly or even daily — as well as constant tracking of obsolete inventories. If there are strong controls already in place, such as a billing system that creates perfect customer billings, then there is little need to measure it. However, strong controls frequently become strong because employees know that they are being measured; completely removing the measurement tells employees that

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the control is no longer important, so they do not expend the same effort to keep the control strong. Consequently, it is less necessary to measure strong control points than weak ones, but these measurements should not be completely eliminated; instead, they should be conducted less frequently. A key consideration that is all too frequently ignored is the time needed to collect information that forms the basis for a measurement. If the data collection systems needed to calculate a measurement are not in place, a controller should seriously consider abandoning the measurement unless it is absolutely critical or it is only needed for a single measurement, not to be repeated. For example, if a controller receives a request for sales broken down by product but ﬁnds that the accounting system will not easily divulge this information, the only option in the short term may be to go through all invoices issued for the month and manually summarize the information. Clearly, this is not a viable option for the long term. If the controller cannot ﬁnd a more automated approach to collecting the information, it is time to discuss the cost of collecting the data with the person requesting the information to see if it is really needed. Too often, a controller simply goes on wasting time month after month, issuing measurements that require vast amounts of manual labor, when the information was only needed once. Continual communications with management is the key to keeping away from using labor-intensive measurements. Another approach is for a controller to track all possible measurements, but to only report those results to management that do not meet expectations. For example, the accounting staff can track every conceivable measurement related to the engineering department, but only reveal those measurement results that show problems. Though this approach will tightly focus management attention on problem areas, there are several reasons for not using it. One is that, even though only high-variance measures are being reported, some of these measures may be in areas so unimportant that management is simply being distracted from more important tasks. For example, high employee turnover among the distribution personnel may not be an issue if the company is a newspaper, where high turnover among the newspaper delivery people is an expected part of the business. Another reason is that this approach puts a large burden on the accounting staff. Many measures must be manually calculated, and doing this for a very large number of measures is not a good use of staff time. Finally, management can become confused when it is presented with a different set of measurements every reporting period; some measures may be unfamiliar, so the controller must retrain management to understand the new measures. This not only wastes the controller’s time, but it also interferes with the orderly conduct of management work. Consequently, tracking all measures and reporting by exception is probably too labor intensive and complicated to be an effective measurement presentation approach for most companies. An example of how to determine what ratios to track follows: Leforto Electronics designs circuits for other manufacturing companies. It has no inventories, and most of the staff is in the engineering department. The company is growing at a very rapid rate through increasing sales to a small number of key accounts. In this case, the controller can safely avoid measurements for inventory. Because engineers are generally hard to come by, there should be a measurement to track employee turnover, as well as one to track the time needed to acquire new recruits. Given the small number of customers, a customer turnover statistic may be of some importance. Also, since the company does nothing but design circuits, it is reasonable that proﬁtability is closely tied to the speed with which the engineers complete their design work, so a measurement should track the percentage of design jobs completed on time. Finally, given the small number of customers, it is possible that there are a few large invoices to customers, which makes cash receipts very “lumpy.” Given this issue, there is a strong need to monitor the age of accounts receivable, as well as short-term cash forecasts. This is a simple example, but it is evident that the measurement systems needed for Leforto Electronics will vary considerably from companies in other industries, where the underlying operating conditions might make all of Leforto’s measurements useless, while calling for a completely different set of measures. A good example of a company that must use an entirely different set of measurements is a manufacturing company. This one we shall call Manfred Manufacturing. This company builds a large number of products, which requires a large number of component parts. It sells them to a large number of distributors, most of whom buy in small quantities; some are old friends of the owners. The industry is a mature one, so proﬁt margins are low. The direct labor content of most products

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is high. In this case, there is no need to track engineering variances at all. Instead, there must be a strong emphasis on inventory tracking as well as obsolescence, since this probably constitutes a large part of the balance sheet. In addition, there must be careful margin tracking for all products and product lines in order to ﬁnd and correct the prices of products with low margins. Also, because some customers are friends of the owners, it seems likely that their credit standing is being ignored, so close tracking of overdue accounts receivable is critical. Finally, because of the large labor component in product costs, the controller should adopt measurements for tracking labor efﬁciency as well as hours charged to speciﬁc jobs. In comparing these two examples, it is evident that a controller must take into account such disparate items as a company’s industry, number of customers, preponderance of certain departments, and even owner friendships when devising a good set of performance measurements.

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CHAPTER

7

INTERNAL CONTROL SYSTEMS 7.1 INTRODUCTION 115 7.2 OBJECTIVES 115 7.3 RESPONSIBILITY FOR INTERNAL CONTROLS 116 7.4 EXAMPLES OF INTERNAL CONTROLS 117 7.5 WHEN TO ELIMINATE CONTROLS 119

7.6 TYPES OF FRAUD 121 7.7 PREVENTING FRAUD 122 7.8 HOW TO DEAL WITH A FRAUD SITUATION 125 7.9 FOREIGN CORRUPT PRACTICES ACT 126

7.1 INTRODUCTION Historically, the reason a company places emphasis on its internal control systems is to keep fraud from occurring. Although reducing fraud losses is still a valid concern, more companies are now emphasizing internal controls because they monitor the consistency with which transactions are completed. This change in emphasis has been brought about by the realization that a company can generate a signiﬁcant competitive advantage by improving the quality and speed of delivery of its products by tightly monitoring its systems. Thus, internal controls are used not only to combat fraud but also to monitor the consistency and completion speed of transactions. Besides objectives, this chapter also notes how responsibility is assigned for various controls. This is not a simple issue, because controls spread across many departments, making it difﬁcult to pin down the reason for a control failure. In addition, the chapter contains an elementary set of control points that are useful for controlling the most basic company functions. Though by no means complete, they give the reader a rough overview of the types of controls that a controller should consider installing. In addition, controls may eventually outlive their usefulness due to changes in the business. Accordingly, guidelines are provided on how to spot and eliminate these controls. Fraud is then discussed: the types of fraud one encounters, how to detect it, and how to prevent it. Most controllers will encounter a case of fraud at some time in their careers, though it may be as minor as petty cash pilferage, so these sections serve as a good reference point for how to identify, prevent, and deal with such problems. Finally, the chapter notes the main points of the Foreign Corrupt Practices Act, which is a federal law that directly impacts a company’s internal control systems. In short, this chapter provides an overview of controls—why they are used, how to create them, and when to eliminate them.

7.2 OBJECTIVES It is not sufﬁcient to scatter a large number of controls throughout a company’s transaction processing systems, because this random approach may result in an insufﬁcient number of controls over key risk factors, while adding an excessive number of controls in areas where there are few risks. The upshot of a control system that is poorly planned is a high-risk transaction environment that is nonetheless burdened with an excessive number of controls. This section discusses the primary 115

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control objectives that a controller should consider in order to implement only those controls that are most important for a speciﬁc set of transactions. The main control objectives are: • Authorization. Was the transaction authorized by management? This could be evidenced in a general way by establishing related policies, contract authorization limits, investment limits, and standard price lists; or speciﬁc authorization may be needed in a given situation. • Reconciliation. Periodic reconciliations of physical assets to records, or control accounts, should be made. This can include bank reconciliations, securities inventories, physical inventories of raw materials, and comparison of work-in-process and ﬁnished goods to control accounts. • Recording. Transactions should be recorded, not only in the proper account, but also at the proper time (i.e., proper cutoff ) and with the proper description. No ﬁctitious transactions should be recorded, and erroneous material and incomplete descriptions should be avoided. • Safeguarding. Physical assets should not be under the physical custody of those responsible for related recordkeeping functions. Access to the assets should be restricted to designated individuals. • Valuation. Provision should be made for assurances that assets are properly valued in accordance with generally accepted accounting principles (GAAP) and that the adjustments are valid. These ﬁve control objectives relate to the prevention of errors and the detection of any errors or irregularities in transactions. They must be considered when the evaluation of an internal control system is made.

7.3 RESPONSIBILITY FOR INTERNAL CONTROLS Although the controller has a major involvement in the design and maintenance of internal controls, he or she is not the only one responsible for internal controls. This is an especially important factor to consider because of the Foreign Corrupt Practices Act (see Section 7.9), which can entail jail terms for senior company management if there are inadequate control systems. In addition to this factor, there are many control systems that extend beyond the reach of a typical controller’s jurisdiction; therefore, other people within a company must take a hand in creating and maintaining those systems. This section discusses the various positions within a company that are responsible for internal controls, as well as the extent of that responsibility. They are noted as follows, in descending order by position: 1. Board of Directors. This group is ultimately responsible for a company’s control systems, as it is responsible for total company performance. Unfortunately, it operates at such a high level that it cannot adequately monitor, or even have a knowledge of, all key control systems. It can alleviate this problem by forming an audit committee to which the internal audit department reports; this allows the Board to closely monitor all reviews of the control system, which allows it to mandate changes that are deemed necessary by the internal audit staff. 2. Senior management. Although the Board of Directors is theoretically responsible for the adequacy of controls, it is senior management that actually has this responsibility from a practical perspective. This is because senior management is “closer to the action,” with a much more detailed knowledge of operating conditions. Accordingly, the senior management team must ensure that there is an efﬁcient and effective system of internal controls that results in accurate ﬁnancial information, as well as the safeguarding of assets. Senior management must: • Assume responsibility to shareholders for the accuracy of ﬁnancial reporting. • Create and maintain a properly documented internal control system. • Create and maintain the proper environment to enforce the necessary controls. This may require the use of policies, procedures, and statements of ethical standards to enforce.

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• Identify the risks inherent in the business and the potential for errors and irregularities in various parts of the transaction processing systems. 3. Financial management. Though other members of management have responsibility for the adequacy of controls, this burden falls heaviest on the members of the ﬁnancial management team, for they are presumed to have the highest degree of training and experience in this area. Also, the majority of control points are typically installed in areas that are under the direct control of the ﬁnancial managers. Consequently, from a practical perspective, these employees have the bulk of the real responsibility for controls. The ﬁnancial management team must: • Know the technical requirements of a sound ﬁnancial control system and how to create such a system based on the nuances of the existing business. • Verify that a sufﬁcient number of controls are installed and that they operate in a satisfactory manner. • Enforce conformance to all controls, as noted in policies and procedures. • Assume direct responsibility for the accuracy of the information contained in periodic ﬁnancial statements and accompanying notes. 4. Internal audit staff. This group has a major impact on the presence of adequate control systems. It is responsible for reviewing the existence and effectiveness of control systems in a variety of areas, and reports to management on the adequacy of those controls, as well as any deﬁciencies. However, the audit program followed by this group is usually approved by the internal audit committee, which is a subset of the Board of Directors. If this program is inadequate, the internal audit staff will not conduct a sufﬁcient number of reviews to ensure the adequacy of internal control systems. Also, this group is not empowered to change any control systems; instead, it only reports on problems. This limits the effectiveness of the internal audit staff in forcing necessary changes to control systems. 5. Independent auditor. This position is listed as the lowest of the management positions, although in reality it is located here simply because it is the only position in the list that falls outside of the corporate hierarchy. As part of an outside auditor’s audit of a company’s ﬁnancial statements, it is customary to determine the strength of the underlying control systems that support those statements. If weaknesses in the control systems are discovered, the auditor is in a unique position to report this information to senior management as well as the Board of Directors as part of a management report that frequently accompanies the audited ﬁnancial statements. The reported weaknesses can also be accompanied by recommendations to improve the situation. If management wants additional assistance from the auditors, they can be called on to provide educational materials or training to the company, as well as a more complete review of the control systems. However, a controls review is considered only to be part of the audit work for a full audit, and not for a review or compilation; these two lesser forms of ﬁnancial review are increasingly common for many companies, so in these cases, the external auditor has minimal impact on or responsibility for the state of a company’s control systems. Responsibility for the adequacy of a control system is spread throughout a company, with theoretical responsibility residing in the Board of Directors and practical responsibility sitting squarely on the shoulders of the ﬁnancial and senior managers. This group is assisted by the internal and external auditors, who can recommend changes to existing controls but do not have the authority to make any changes.

7.4 EXAMPLES OF INTERNAL CONTROLS This section provides a “laundry list” of controls that are commonly used. Controllers can pick from this list when creating control systems for their companies. However, do not be misled into

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believing that the only crucial controls are noted below. On the contrary, there are many controls that are industry-speciﬁc that will not be found anywhere in this book. To gather information about these special controls, it is useful to consult with an external auditing ﬁrm that has experience in a speciﬁc industry, or obtain advice from an industrial trade group with similar expertise. Conversely, it is not necessary to implement every control listed in this section, because this would introduce a great deal of inefﬁcient control redundancy. The best use of this section is as a reference for carefully selecting controls that can be shaped and altered to ﬁt a company’s speciﬁc needs. The controls are grouped by balance sheet and income statement category. They are: • Cash Compare check register to actual check number sequence. Control check stock. Control signature plates. Perform bank reconciliations. Review uncashed checks. • Investments Impose investment limits. Require authorizations to shift funds among accounts. Verify that investments do not exceed federally insured limits. • Accounts receivable Require approval of bad debt expenses. Require approval of credits. Require constant review of old accounts receivable. • Inventory Conduct inventory audits. Require approval to sign out inventory beyond amounts on pick list. Restrict warehouse access to designated personnel. • Employee advances Continually review all outstanding advances. Require approval of all advance payments to employees. • Fixed assets Ensure that ﬁxed-asset purchases have appropriate prior authorization. Verify that correct depreciation calculations are being made. Verify that ﬁxed-asset disposal are properly authorized. Verify that ﬁxed assets are being utilized. • Accounts payable Compare payments made to the receiving log. • Notes payable Require approval of the terms of all new borrowing agreements. Require supervisory approval of all borrowings and repayments. • Revenues Compare all billings to the shipping log. • Cost of goods sold Compare the cost of all completed jobs to budgeted costs. Pick from stock based on bills of material.

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Purchase based on blanket purchase orders and related releases. Reject all purchases that are not preapproved. Require approval of all overtime expenditures.

• Travel and entertainment expenses Audit expense reports at random. Issue strict policies concerning allowable expenses. Require supervisory approval of all expense reports. • Payroll expenses Require approval of all overtime hours worked by hourly personnel. Require approval of all pay changes. • Occupancy expenses Compare the cost of employee furnishings to company policy. Compare the square footage per person to company policy. • General Audit credit card statements. Impose a total monthly dollar limit on credit card purchases. Impose single transaction limits on credit card purchases. Impose supplier exclusions on credit card purchases. Require supervisory approval of credit card statements. • Other: Contracts Require monitoring of changes in contract costs. Require monitoring of when contracts are due for renewal. Require speciﬁc authorizations for various levels of monetary commitment. The controls noted in this section are among the most common ones used, irrespective of the type of industry. Although a controller may select the majority of his or her controls from this list, it is important to consider special controls that are indigenous to speciﬁc industries and do not appear on this list.

7.5 WHEN TO ELIMINATE CONTROLS Most controllers are good at imposing new controls, but few give any thought to eliminating them. This is an extremely useful exercise, because fewer controls translate into less work by the staff and (sometimes) quicker transaction processing times. This section discusses how to set up an orderly system for reviewing controls at regular intervals and eliminating those that are no longer necessary. In order to review the need for controls, one must ﬁrst know what they are. Many controllers have no idea of the types of controls a company uses, because they have inherited an informal mass (or mess) of controls from the previous controller, and never trouble themselves to understand the system. Accordingly, the ﬁrst step is to conduct a broad-ranging series of interviews with employees to understand the ﬂow of transactions throughout the company, and then convert this information into a set of easily understandable ﬂowcharts. A quarterly control review can be scheduled in which the controller scans the existing controls to see if any controls have become unnecessary; this happens when changes in business conditions, such as new operating procedures, outsourcing, or reengineering, render existing controls obsolete. Any additions to or deletions from a company’s control systems must be reﬂected in the ﬂowcharts, so they must be updated regularly, even if the formal control review takes place only quarterly. Using ﬂowcharts and a scheduled control review allows a controller to eliminate unnecessary controls.

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Although ﬂowcharts are an excellent method for tracking control points, a controller can take the concept too far. It can take an enormous amount of time to convert every conceivable process into a ﬂowchart, and more time to ensure that it stays correct. To avoid too large a time investment, those systems that have no signiﬁcant ﬁnancial impact, such as the scheduling for janitorial services, should be ignored and concentration should be on key transactions, such as order fulﬁllment. Once key controls have been documented, the controller should determine how much it costs to have them in place. This step is very important, for a controller is responsible for installing controls that are cost effective, not ones that require so much effort that company operations are severely burdened by them. To determine control costs, a controller should observe controls in action to see how much labor and material costs are required to maintain them. This is a very inexact science, and a controller may be forced to rely on nothing more than the opinions of the employees who use the controls. Still, even estimates of costs are better than no information at all. A controller should also categorize each control as being a major or secondary control. Most control systems have multiple controls that focus on solving a control problem, with a few controls being extremely important and others being relatively unimportant. For example, a primary control over inventory is installing a fence around the warehouse to eliminate pilferage, while a secondary control is bonding the warehouse staff so that a company can obtain reimbursement if an employee is caught stealing inventory. By categorizing controls in this manner, a controller can see which controls are necessary and which can be deleted. The ﬁnal step in determining which controls can be eliminated is to add control costs (as previously determined) to the chart that categorizes controls as being major or secondary. This allows a controller to quickly skim through the list of controls and see whether there are any secondary control points that are very expensive. If so, these are prime candidates for elimination. Before deleting these controls, however, a controller should ﬁrst make a determination of the risk of not having them. Even an expensive secondary control point may have some value if it provides control over a potential asset loss that is so large that the control is still worth having. Risks that fall into this category include loss of investment accounts due to embezzlement or the loss of entire facilities due to ﬁre damage. For these situations, which are admittedly few in number, it may still be worthwhile to retain controls that would otherwise be eliminated. A simpler, though less effective, way to review controls is to constantly review the need for control reports. All companies rely on a large number of reports that list transactions; when regularly reviewed, these reports act as controls over a large number of activities. A controller can determine whether these reports are needed by tracing them to report recipients and quizzing them regarding the need for the reports. This can result in a major reduction in the number of reports used, which is a major time savings if the reports are being manually prepared. A more common method of reducing the number of controls is to conduct an intensive review of controls whenever there are signiﬁcant changes to the business, such as reengineering projects, outsourcing of major functions, or downsizing. When these events occur, the controller should be heavily involved in examining proposed system changes, which will likely result in the elimination of large numbers of controls. It is common to enroll the internal audit staff in these reviews, because it is largely concerned with the adequacy of existing controls. However, although there will almost certainly be some reduction in the number of controls as a result of these changes, there may be a need for an entirely new set of controls that are just as, if not more, expensive than the controls being eliminated. When a controller decides to eliminate a control, it is best to review the decision with anyone who may be using the control for other reasons. This is a major concern when the control point is a report that contains valuable information. For example, a control report that lists all ﬁxed assets may also be used by an accounts payable person to determine the value of assets to be reported to the government for the calculation of property taxes. When these types of controls are eliminated, there may be so much extra work required by other parts of the company to “ﬁll the gap” of the information that is no longer available that the cost of stopping the control may exceed the cost of leaving it in place. Thus, checking with potential users is key prior to stopping a control point. Finally, it is common to order the elimination of a control point, only to ﬁnd that the controller’s order is ignored by the staff. This happens when employees are so overwhelmed with work

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that there is a strong predilection toward keeping systems the way they are, rather than working through the details of system changes. It is also common when control changes are not properly thought out; the staff frequently realizes that there are unresolved issues and balk at making changes until these issues have been resolved. In the ﬁrst case, the controller should request the assistance of the internal audit staff, which can conduct periodic reviews of processes to see if changes have actually been implemented. In the second case, the controller is well advised to listen to staff objections and work through changes with them, which usually results in altered systems that are more clearly understood and which have greater staff acceptance. Proper follow-up and attention to staff objections are critical to ensuring that control system changes are completely implemented. In short, a controller can eliminate unnecessary controls by conducting a periodic review of existing controls, itemizing why they are used, and including the cost of each one as well as the changes in risks if they are eliminated. A detailed review of this information will usually reveal a number of control points that are too expensive for the level of incremental control they provide. It is important to review proposed control eliminations with other employees to ensure that there are no undocumented uses for the controls that may justify their continued existence; this review may also uncover objections to changing the system, which the controller should deal with prior to making alterations. By following these steps, a controller can keep the number of controls to a minimum, while still ensuring that a company’s major control objectives are met.

7.6 TYPES OF FRAUD All controllers must be aware of the primary types of fraud. By knowing them, a controller can design effective control systems for their prevention. This knowledge is also useful for those controllers who are interested in increasing transactional efﬁciency by reducing some control points—only by knowing how employees can take advantage of a reduced set of controls to commit fraud can a controller judge which controls can be safely eliminated. All types of fraud involve the theft of company assets. However, within the broad category of “assets” lie a large number of subcategories, such as ﬁxed assets, employee advances, and cash. The type of fraudulent activity needed to take each of these subcategories of assets away from a company differs for each category, and is described in the following list by subcategory: • Expense account abuse. Employees run extra expenses through their expense reports that are not allowed by company policy, or use false receipts to charge extra expenses that did not actually occur. Employees may also charge expenses that are higher than allowed by company policy. For example, employees may take ﬁrst-class plane trips, charge through exorbitant meals, and expect reimbursement for nonbusiness expenses, such as gifts or clothes. • Nonpayment of employee advances. Employees who have requested an advance payment of their paychecks or an advance to cover trip expenses will not pay back the company for these expenses. This tends to be a passive activity, for they do not actively try to bilk money from the company—they just do nothing to pay back what they have already been paid. • Purchases for personal use. Employees can take advantage of the authorization systems built into the purchasing system to order items for their personal use. This is most common when a company has high approval limits, so that employees can order items with no fear of review by their supervisors. This is also common when companies exercise little control over company credit cards, so that employees can charge through purchases that are not in any way related to company business. • Supplier kickbacks. Employees in the purchasing function can arrange with suppliers to buy their products and services at inﬂated costs in exchange for direct payments back to the employees. Depending on the quantities purchased, the amount of these kickbacks can be enormous. • Theft of cash and investments. The primary target of many employees who commit fraud is cash. This can be done in a variety of ways. One is to steal a blank check and make it out to

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the employee. Another is to gain control of bank account authorization codes and wire large amounts of funds to an employee-controlled bank account. Yet another approach is to steal cash. However, from a practical perspective, this tends to be the most difﬁcult area in which to steal a large amount, for most companies tend to focus their controls on this asset area. • Theft of ﬁxed assets. Fixed assets that are not bolted down, are small in size, and have a high resale value are subject to theft. This is especially true if the assets are rarely used or stored in out-of-the-way locations, so that no one will notice a theft for some time. This type of fraud is especially common in companies in which there is minimal tracking of assets. Conversely, large and heavy equipment that requires immense effort to move is practically immune to theft. • Theft of inventory or supplies. Employees can remove supplies and inventory from the company, either for personal use or for resale. Supplies are especially easy to remove, because they are not tracked as carefully as inventory items and are not normally stored in a restricted area. This is an especially large problem if inventory items have a high street value, are small enough to be easily concealed, and are not rigorously tracked. Large and inexpensive inventory items are much less likely to be stolen. These asset areas correspond roughly to the asset section of the balance sheet. The most commonly recognized fraud areas involve cash and investments, but it is actually much easier for an employee to steal assets in other areas, such as inventory, because the greatest concentration of controls cover the cash area, with much weaker controls elsewhere.

7.7 PREVENTING FRAUD According to the Association of Certiﬁed Fraud Examiners, the cost of fraud is now $400 billion per year. For some ﬁrms, the amount is so crippling that at a minimum it takes a large bite out of proﬁts, and in some cases takes down the entire company. Even if the amount being stolen is small, most controllers feel as though fraudulent activities are a personal affront, for it means that someone has found a way to circumvent the control systems that were personally installed by the controllers. Accordingly, this section is designed to give a controller a list of warning signs for how to spot fraudulent activities, and what to do about it. There are two sets of fraud indicators. The ﬁrst is at a high level: How management acts and its way of running the company are either direct indicators of fraud by management or indicate a general pattern of behavior that, if duplicated lower down in the company, will create an environment in which fraud will ﬂourish unchecked. The high-level indicators are frequently missed, because the controller is so wrapped up in managing at this level that the signs are too close to see. It is best to ask the company auditors for their opinions regarding fraud indicators at this level, for they can provide a more balanced, outside view of the situation. The high-level fraud indicators are: • Management creates an overly complex organizational structure. If there are so many interlocked organizations that it is difﬁcult to track transactions through the myriad of entities, it is possible that senior management has purposely created this level of complexity in order to hide fraudulent transactions. • Management has an excessive emphasis on meeting proﬁt goals. If the management team cares for nothing but meeting proﬁt goals, this channels everyone’s activities in that direction. This may seem innocuous, but if the goals are extremely hard to reach, there is a considerable temptation for employees to fabricate proﬁts by any number of means in order to meet their goals. This is particularly a problem when large bonuses are awarded when proﬁt goals are met. • Management has an aggressive attitude toward ﬁnancial reporting. The management team may use the loosest possible interpretations of the accounting rules in order to recognize revenue and income. When this is present, it is possible that management is also engaged in other activities that are beyond the accounting rules. Surprisingly, controllers do not always see this, because they may have been in the accounting department so long that they accept the loose accounting interpretations as normal.

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• Management is unwilling to pay for good controls. A management team with an undue focus on proﬁts may not want to pay for the more expensive control points that will prevent large-scale fraud. Employees will eventually determine where there are no controls or weak ones, and some will be tempted to exploit the situation. • Management is dominated by one person. If there is a strong owner or chief executive ofﬁcer (CEO) running the company who brooks no discussion of decisions made, there is a strong risk of fraud, probably by that person. The risk is especially high in this situation, because the CEO has absolute authority to do anything—no controls will be effective in this situation. • Management prefers excessive decentralization. The management team may have a preference for minimal control from the headquarters facility; instead, it favors a “hands off ” approach for all subsidiaries. This is a laudable approach in many situations, but there should be a sufﬁcient level of oversight to at least ensure that adequate control systems are in place at all subsidiaries. • Management turnover is high. When there is a large amount of churning among the management ranks, it may indicate that there are ongoing activities that are questionable, and that the departing people have chosen to leave rather than be associated with the company. • Customers or suppliers are suing the company. There may be lawsuits pending related to not paying suppliers or not providing complete services to customers, and which may be caused by fraud on the part of senior management. These lawsuits frequently escape the attention of the controller, because they are handled through the legal department. • Management is forcing a rapid pace of growth. If a company is going through a period of explosive growth, it is extremely difﬁcult to maintain control systems. Also, because so many people are being hired during this period, it is difﬁcult to conduct an adequate level of screening of incoming employees, so there is a greater likelihood of hiring someone who has committed fraud in the past. • Management is acquiring a large number of companies. When management acquires a series of companies at high speed, it is possible that it will buy into a company where fraud is present. This is because a newly acquired company may have poor control systems that allow this to happen. The real problem is that, because of the pace of acquisition, the controller may not have sufﬁcient time to create and monitor controls at each newly acquired company, which means that there is an environment in which fraud can continue to ﬂourish. There are a number of warning signals to look for at an employee level that may be indicators of fraud. These indicators require no special control system; a controller simply needs to be aware of them in order to identify situations in which there is a stronger likelihood of a possibly fraudulent situation. If a number of the following factors are present, a controller is justiﬁed in conducting an especially careful audit to determine whether there are fraudulent activities occurring. The warning signs are: • 401k withdrawals. An employee is more likely to commit fraud if short on cash. One sign of this is repeated withdrawals from a 401k plan or reductions in the amount of paycheck withdrawals that go to the plan. Another sign of this is a long history of asking for advances on paychecks. • Bad debt write-offs. There appears to be a large proportion of bad debt write-offs occurring. There may not be any increasing trend line indicating this, since fraudulent write-offs may have been going on for a long time, so an alternative way to tell is to compare the rate to industry standards. • Inventory discrepancies. If there are constant discrepancies between expected inventory records and actual counts, this is a sign of possible inventory theft; this also applies to manufacturing tools, which are especially easy to sell. Continuing losses of small quantities of easily salable items are a major indicator of theft. • Invoicing discrepancies. A common type of fraud is to intercept incoming checks and hide the theft by constantly modifying customer invoices with adjustments of various kinds to

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make them match a smaller amount of customer payment. A large number of invoice adjustments is a sign of this problem. • Lack of supervision. Some employees, for whatever reason, have not been subjected to close management for a long time, which gives them an opportunity to devise fraudulent activities in the absence of any oversight. • Large personal expenditures. Some employees spend their fraudulently acquired funds in a very public manner; seeing an employee arrive in a new and expensive car is an indicator of this, especially when combined with a change of home address (which they usually give to the payroll person so that paychecks are mailed to the correct location), which may indicate the purchase of a more expensive home. • No competitive bidding. A number of contracts are being awarded without any competitive bidding, which indicates that suppliers may be paying purchasing personnel to do this. However, this is increasingly difﬁcult to prove, because just-in-time manufacturing principles dictate that sole sourcing is a better purchasing technique than using competitive bidding. • No payment from the sale of assets. When a controller notices that there are fewer assets, either from sale documents or a ﬁxed asset audit, it is useful to see if cash was received as part of the transaction. If there does not appear to be any compensation for transferring the asset to the recipient, the controller should suspect that funds were pocketed and investigate further. • No vacations. Key staff people somehow never manage to take any vacation time for years on end, which may indicate that they are afraid of having their activities detected in their absence. • Supplier addresses match employee addresses. A virtually certain indicator of fraud is when an employee sends in invoices from a ﬁctitious company and has the payments sent to his or her home address. Though it can be difﬁcult to compare the list of employee addresses to the same information for suppliers, it may be worth the effort if a controller suspects that there are problems with supplier payments. Though these indicators of fraudulent activities are legitimate, a controller must realize that there are also real reasons for many of the same activities, so it is easy to receive a false impression that someone is committing fraud. For example, an employee may not have taken vacation during the past year, but this may be due to a workload that was so severe that there really was no way to take it. To avoid false indicators, it is better to rely on a combination of factors. For example, if a billing clerk suddenly arrives in a new sports car, and this is coincident with a number of billing irregularities, then there are excellent grounds for conducting an investigation. While noting that several indicators in combination represent a reasonable warning of the presence of fraud, it is even more likely that the vast majority of fraud cases leave no warning signs at all. Many perpetrators conduct their activities on such a low level, taking assets worth very small amounts, that it is very nearly impossible for anyone to spot them. In these cases, the controls that would be necessary to prevent or ﬁnd fraud would be so onerous that the cost of the controls would very likely exceed the cost of the fraud. For example, employees may be using the company postage machine to send out personal mail. The control over this might require installing a lock on the machine as well as direct supervision when it is in use. Doing this may be more expensive than the cost of any lost postage. In short, many fraud cases involve losses on such a small scale that it is not worth the effort of installing controls to ensure that it does not happen. Other fraud cases do involve potentially large losses. A controller must act to prevent these situations from occurring, since they can have a large impact on company cash ﬂow and proﬁts. The best way to determine the extent of potential fraud is to review all areas of the company and estimate the largest amount of fraud that can possibly occur in each function. To use the previous example, the upper limit on losses through a postage machine is the amount of postage stored in it, which rarely exceeds $1,000 and is usually considerably less. However, the potential for inventory theft in a large warehouse area may run into millions of dollars. Another example is sending wire transfers; if a person can send one for all available company funds to a numbered Swiss bank account, this can bankrupt a company. Of the three examples, it is clear which areas require a

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broader range of controls. Accordingly, a controller should ﬁrst evaluate all functional areas to determine the degree of potential loss and hone in on those areas in which the company can lose large sums. When a controller reviews a business to locate potentially high-risk fraud situations, there is a great likelihood that the review will miss some potential situations if the controller does not have a strong knowledge of the business. For example, if a manufacturing company hires a controller from one of the service industries, that controller will not have a good knowledge of internal controls over manufactured goods, and of how materials can be removed from the system without detection. In this situation, a controller can ﬂowchart the main processes of the company, which also yields an excellent knowledge of operations. However, many controllers, especially new ones, do not have time for such an in-depth review. In these cases, the controller can bring in the company auditors, who have presumably audited many similar companies, and who have a great store of knowledge of control systems. The auditors can conduct the review and make a large number of recommended system changes in a very short period of time. In short, assessing the existing control environment requires a good knowledge of systems, which may call for outside assistance in conducting the review. Aside from the use of control systems to combat fraud, there are other ways to detect it, such as notiﬁcation by fellow employees. In many cases, other employees are well aware of fraud situations and make the (false) assumption that management knows about it too and has chosen to take no action. The best way to clear up this level of employee uncertainty as well as to be on the receiving end of information about fraud problems is simple accessibility. It is very helpful if a controller or someone on the controller’s staff is a gregarious type who mixes constantly with other people in the company. By making themselves available, the accounting staff puts itself in a better position to be trusted by other employees, which results in information about improprieties. Notiﬁcation by employees is an important second source of information about fraud. There are many warning signs that indicate the presence of fraud. A controller is well advised to review this information from time to time to determine whether there are conditions at a company that make it easy for fraud to occur. In addition, there should be a continual review of control systems to monitor the risk and amount of loss at various points in the company. If there have been changes in these factors since the last review, a controller should consider altering the controls. Finally, it is almost as important to keep lines of communication open between the accounting staff and the rest of the company, for hints from employees run a close second as a good method for spotting fraud cases. By using general indicators and good control points, and by being receptive to employees, a controller will have a much better chance of ﬁnding fraud in the company.

7.8 HOW TO DEAL WITH A FRAUD SITUATION A controller faces difﬁcult choices when confronted with a fraud situation—should the company go public and push for criminal charges against the perpetrator, or is it better to reach a private resolution? Some companies even accept payment back from the problem employee and then retain that person! This section discusses the factors in favor of and against each option. The following list notes the primary options available to a company when resolving a fraud situation. The ﬁrst point is the most drastic resolution, with succeeding options declining in severity. For each item, there is a discussion of the likely results of each action, as well as any moral considerations. • Bring criminal charges. This option sends the clearest message to employees—that the company will not tolerate fraud under any circumstances. Therefore, it tends to have a positive impact on reducing subsequent fraud. Also, from a moral standpoint, it is the correct action to take, because there is now a public record that a person has committed an illegal act, which gives adequate notice to other companies that may hire the individual. However, publicly held companies tend not to take this route, because a public display of corporate incompetence that originally allowed the fraud to take place does not give the company a positive public image, and may even lead to the ﬁring of top management by the Board of Directors. Consequently, and unfortunately, many companies tend to shy away from this option.

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• Demand restitution and ﬁre the employee. This option is the most common one. A company is certainly justiﬁed in demanding restitution, and should always ﬁre anyone committing fraud, as this avoids the chance of any recurrence of the situation. Also, because there are no legal proceedings, stockholders will not ﬁnd out about the fraud situation, which upholds the reputation of the company as well as senior management. However, this does not create a public record that the wrongdoer has committed fraud, so other companies that hire this person will have no way of knowing that they are hiring a “bad apple.” Thus, this option is not as morally acceptable as the ﬁrst option. • Dismiss employee for cause. Many companies take this approach if there is no reasonable chance of recovering missing funds or other assets. This approach also avoids any legal controversy that may result in adverse publicity. However, it creates no public record of wrongdoing, so the perpetrator is free to commit fraud again elsewhere. • Permit employee to resign. This approach is sometimes allowed for employees who have committed fraud but who occupy such high-proﬁle positions that their ﬁrings would excite comment by the business community. The same option may be extended to employees who have worked for a company for such a long time that management feels it has some obligation to allow a quiet departure. However, from a moral perspective, this is one of the worst options; another company will have no reason to suspect that there was a criminal situation at a previous company, because there is no record of a ﬁring. By selecting this option, a company allows a perpetrator to continue fraudulent acts at other organizations. • Demand restitution and permit the employee to stay. Though this option allows a company to recoup its losses, it runs the substantial risk of having the perpetrator commit fraud yet again. Also, other employees will see that there was no drastic action taken, so they will either be encouraged to commit fraud themselves, or will at least have a minimal incentive for reporting future cases of fraud to management. Despite these drawbacks, companies continue to select this option for two reasons — either the person committing fraud is a member of the family that owns the company, or management feels that it has a better chance of getting its money back by having direct control over the payroll deductions that will gradually return the cash. • Do nothing. Companies pick this option primarily because the person committing fraud is a co-owner of the business, which makes it difﬁcult to take any action. This has a demoralizing effect on other employees who see illegal activities taking place without any fear of retribution, and frequently leads to excessive levels of employee turnover, as people ﬁnd other companies with more upright moral standards. The range of actions that management can take to combat fraud is very broad. The best approach is to take a stern stand against all cases of fraud, which has the multiple beneﬁts of setting a good example for other employees to see, giving a company some chance of reacquiring lost assets, and of leaving a public record of criminal activity, which gives other companies due notice of a prospective employee’s character. The other options for dealing with fraud will result in increasing levels of difﬁculty, such as no return of lost assets, reduced employee morale, possible increases in employee turnover, and additional fraud cases at other companies as employees emigrate to new companies and commit crimes again. In short, management should react strongly to any cases of fraud, including prosecution to the fullest extent of the law.

7.9 FOREIGN CORRUPT PRACTICES ACT Congress enacted the Foreign Corrupt Practices Act in 1977. This Act was passed because of disclosures by the Ofﬁce of the Watergate Special Prosecutor and the Securities and Exchange Commission (SEC) of the use of U.S. corporate funds for domestic political contributions and for the bribery of foreign government ofﬁcials. Some of these payments were clearly illegal and others questionable, while some payments appeared to have been made by avoiding internal control systems. To prevent these problems from occurring in the future, the Act requires a publicly traded

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company (it does not apply to privately held companies) to keep in reasonable detail “books, records and accounts” that accurately and fairly reﬂect its transactions and disposition of assets, and maintain an adequate system of internal controls. The control system must have the following attributes: • Transactions must occur under the authorization of management. • Transactions must be properly recorded. • There must be reasonable controls over access to assets. • There must be periodic reconciliations of recorded to actual assets, with an investigation of any differences. This Act is particularly applicable to multinational organizations, so the controllers of these organizations must be aware of it and its ramiﬁcations for enhanced control systems. To be in compliance with the Act, a controller should be particularly mindful of the adequacy of company control systems, as well as of subtle changes in ﬁnancial results that may indicate the presence of control problems.

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CHAPTER

8

INTERNAL AUDIT FUNCTION 8.1 INTRODUCTION 129

8.5 INTERNAL AUDIT OBJECTIVES 132

8.2 REPORTING RELATIONSHIPS 129

8.6 INTERNAL AUDIT ACTIVITIES 134

8.3 COMPOSITION OF THE AUDIT COMMITTEE 130

8.7 MANAGING THE INTERNAL AUDIT FUNCTION 136

8.4 ROLE OF THE AUDIT COMMITTEE 131

8.1 INTRODUCTION A key factor in the internal audit function is the manager to whom the function reports, since an incorrect reporting relationship can lead to skewed audit programs that avoid the areas supervised by that manager. Another issue is the objectives that the internal audit function should follow; too narrow a set of objectives may avoid reviews of key areas that are in serious need of help, while an excessively broad range of objectives will water down the department's ability to complete a reasonable set of target programs in a timely manner. A wide range of suggested activities for the internal audit staff are listed in this chapter, which are of use when determining a set of audit programs for the upcoming period. Finally, key factors are noted to consider when creating and maintaining a management system that provides an effective degree of control over the internal auditing staff. This chapter consists of an overview of the internal audit function, why it exists, what it does, and how to manage it.

8.2 REPORTING RELATIONSHIPS Many companies adopt a reporting relationship between the accounting and internal auditing functions that leads to strained relations between the two functions. This section analyzes the problem and suggests a solution. Many companies have the head of the internal audit department report to either the controller or (more commonly) the chief ﬁnancial ofﬁcer (CFO). They do so on the grounds that the bulk of the work performed by the internal audit staff addresses accounting and ﬁnance issues, so it makes sense to cluster the departments together. In addition, the internal audit staff is usually trained in accounting and is probably looking toward a promotion into the accounting and ﬁnance staffs once they have completed a tour of duty in the internal audit area. By keeping the two departments “under one roof,” the accounting and ﬁnance staffs get a close look at the internal audit staff and can use this knowledge to promote them into the most appropriate positions. There are valid reasons for having the internal audit staff report to the manager of the accounting or ﬁnance functions. Unfortunately, this relationship does not work very well. The reason is that the job of the internal audit staff is largely to review and report on the operations of the accounting and ﬁnance staffs. Because these reports tend to focus on problems, they do not cast the management of the accounting and ﬁnance departments in an overly favorable light. Consequently, if the internal audit staff reports to this area, it is common for the controller or CFO to design audit programs that focus on relatively innocuous areas, or else to focus on other parts of the company, while ignoring the 129

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accounting and ﬁnance areas. An alternative result is for the internal audit reports to be buried, so that senior management does not review any information that is critical of the way in which the accounting and ﬁnance areas are being managed. All of these outcomes tend to focus minimal internal audit attention on key accounting and ﬁnance processes, which is the precise area in which the auditors should be spending most of their time. The reporting relationship has a direct bearing on the review work performed by the internal audit staff. If the internal audit staff is to conduct unencumbered reviews of the accounting and ﬁnance areas, it is necessary to shift the reporting relationship away from them. This allows the internal audit staff to avoid any problems caused by managers who do not want to have deleterious results shown to senior management. However, moving management of the function to a different area of the company raises similar problems, for anyone to whom the function reports will also not want the group to conduct any internal audits on areas that may reﬂect poorly on the manager. Consequently, the internal audit function should only report to positions at the top of the organization, where the manager is responsible for the entire company, and thus has no reason to avoid poor results in speciﬁc areas. This position can be the chief executive ofﬁcer (CEO), but if this person is engaged in questionable activities, he or she may try to quash all internal audit activities. The best alternative is the board of directors, which is responsible for no company functions, and who is only concerned with maintaining the most efﬁcient and effective operations, as well as appropriate levels of control over assets. The board can direct the internal audit staff by forming an audit committee. This committee can approve suggested audit programs, besides its usual function of selecting and overseeing the activities of the external auditors. This solution gives unﬁltered information to the board, while also allowing it to target those areas of the company that it feels may be in most need of a review. Since this section has recommended that the internal audit staff not report to the controller, one might ask why this chapter is even included in this book—after all, if it is not managed by the controller, why discuss it? The reason is that the controller can still have a considerable amount of control over the annual list of audits that the department conducts. This happens for two reasons. First, the controller is the senior accounting ofﬁcer in the company, and as such is in the best position to spot problem areas and request audits that will highlight any problems. Second, whether there is a direct reporting relationship or not, the manager of the internal audit staff will recognize that the controller is more senior in the corporate hierarchy, and so it is a good idea to at least listen to any recommendations for future audits. For these reasons, the controller still has a considerable amount of inﬂuence over the activities of the internal audit staff, no matter who is the manager of the function. In short, it is inappropriate for the internal audit staff to report directly to the controller or CFO, because they can skew audit programs or hide results to show the accounting and ﬁnance areas in the best possible light. It is better to assign the audit staff to the audit committee of the board of directors, which is a much more impartial management group.

8.3 COMPOSITION OF THE AUDIT COMMITTEE The audit committee should be a standing committee of the Board of Directors, and should be comprised primarily of non-ofﬁcer directors. These directors should not be involved in the management of the company, nor have previously been its ofﬁcers. These restrictions are intended to create the most independent overview environment possible for the committee. The committee is generally comprised of between three and ﬁve members, not all of whom must have an accounting, auditing, or ﬁnance background. It can be more useful to have some directors with a solid operational knowledge of the industry in which the company operates; these people can spot potential control weaknesses, based on their knowledge of how transactions ﬂow in an industry-speciﬁc environment. Nonetheless, at least one committee member should have considerable training or experience in the accounting and ﬁnance arena. The committee should be expected to meet on at least a quarterly basis. The CFO is rarely a member of this committee. Instead, sometimes she will be asked to attend its meetings in order to advise committee members on speciﬁc issues, or to answer questions about

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problems that the committee has uncovered through its review activities. The CFO should certainly maintain a strong line of communication with committee members, in order to inform them of possible accounting rule changes or prospective policy changes that may impact the reporting of ﬁnancial information. The CFO should also educate committee members about key ﬁnancial topics, such as corporate lines of business, accounting policies, legal obligations, regulatory ﬁlings, and industry accounting practices. The director of the internal audit function usually reports to the CFO, but can report instead to the audit committee. The most common reporting relationship is for the internal audit director to be supervised by the CFO, but to have unimpeded access to the audit committee at any time; this reporting system is designed to give committee members direct access to the results of internal audits, while at the same time giving the internal audit director the ability to go around the CFO if that person appears to be obstructing the dissemination of internal audit results. In short, the audit committee’s structure is intended to be as independent of the management team as possible, while still giving it direct access to key accounting and audit personnel within the management team.

8.4 ROLE OF THE AUDIT COMMITTEE The goal of the audit committee is to assist the Board of Directors by providing oversight of the ﬁnancial reporting process and related controls. The committee is not empowered to make any decisions—rather, it recommends actions to the full Board, which may then vote on its recommendations. The exact range of tasks granted to the audit committee will vary, but are generally conﬁned to the following issues: • Tasks related to company management: Review expenses incurred by the management team. Used to spot any excessive use of corporate funds by managers. Review business transactions between the company and the management team. Used to ensure that managers are not enriching themselves at the expense of the company, as well as not holding their personal interests above those of the company. • Tasks related to external auditors: Recommend the hiring of external auditors. Used to ensure that a truly independent auditor is used, rather than one having connections with the company in some way that may inﬂuence its review of the company’s ﬁnancial statements. The audit committee should also base this recommendation on the auditor’s expertise in the industry, the quality of its services, the extent to which it performs other services for the company, and the amount of its quoted fees for the audit. Review auditor recommendations. Used to ensure that control issues spotted by the auditors are properly dealt with by the management team, resulting in a stronger control environment. Review disputes between the external auditors and management. Used to determine if the management team is attempting to force the auditors to agree with an alternative accounting treatment for transactions. Review the use of external auditors for other services. Used to determine if the external auditor has obtained such a signiﬁcant amount of extra business with the company that it may be less inclined to issue an unfavorable audit opinion, due to the risk of losing the additional business. • Tasks related to internal audits: Review the replacement of the internal audit director. Used to verify that the internal auditor director is being replaced for reasonable cause, rather than because the CFO wants to install a more malleable director. Review the internal audit staff ’s objectives, work plans, training, and reports. Used to verify that the internal audit staff is appropriately targeted at those areas of the company

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that are at greatest risk of control problems, and that the audit staff is appropriately trained to handle the audits. A detailed review of the annual work plan will reveal if the internal audit director has allocated a sufﬁcient amount of time to each audit, or has sufﬁcient staff available to complete all goals. Review the cooperation received by the internal auditors. Used to spot possible areas of fraudulent activities, since minimal cooperation is a signal that an auditee may be hiding information from audit teams. Review disaster recovery plans. Used to ensure that adequate recovery plans have been created and tested for the most likely disaster scenarios. • Tasks related to ﬁnancial systems: Investigate fraud and other forms of ﬁnancial misconduct. Used as the grounds for a direct investigation of any situation possibly involving deliberately inaccurate ﬁnancial reporting or the misuse of company assets. Review corporate policies for compliance with laws and ethics. Used to ensure that all corporate policies, irrespective of their relationship to ﬁnancial systems, are constructed in accordance with local regulations, and meet the restrictions of the corporate statement of ethical activities. Verify that ﬁnancial reports address all information requirements of lenders. Used to ensure that lender-required ﬁnancial information is reported to them at the appropriate times and in the correct formats, so there is minimal risk of losing vital credit lines as a result of missing information. Review all reports to shareholders, including special reports, for consistency of information. Used to verify that all reports present a consistent picture of corporate ﬁnancial health to investors. This is of particular concern for special reports, which tend to include different types of measures (such as EBITDA instead of the net income ﬁgure found on ﬁnancial statements) and bullish statements by management that do not always match the tenor of information presented in the standard set of ﬁnancial reports. Of special interest is the audit committee’s emphasis on the review of a wide range of ﬁnancial activities—with the exception of one item: The audit committee is empowered to investigate fraud and other forms of ﬁnancial misconduct, rather than review the results of such an investigation by someone else. The reason for this direct action is that employees are probably involved in the fraudulent activities, which may possibly involve members of management, so the audit committee can obtain an unbiased review of the situation only by doing so itself. Thus, in all cases besides the investigation of ﬁnancial misconduct, the audit committee’s role is to examine the results of a variety of audits and other investigations to ensure that the company’s system of ﬁnancial reporting fairly represents actual operating results.

8.5 INTERNAL AUDIT OBJECTIVES It is extremely important to determine the correct set of objectives for the internal audit staff. These objectives are used as the framework for constructing audit programs, as well as for determining the most appropriate skill set for the staff, plus the number of people needed to staff the department. Devising the correct set of objectives has a direct bearing on both the structure and work of the department. This section describes a typical set of objectives, as well as some changes to the list that are appropriate under certain circumstances. There is a broad range of internal audit objectives that a company can adopt. The exact number and type of objective can vary greatly, depending on the anticipated size and skill of the audit staff, as well as the perceived need for audit reviews (which is frequently based on the past history of the company) by the management team that creates or approves the list of objectives. For example, a company may have had a great deal of trouble convincing its staff to follow a speciﬁc set of procedures, and so it will place great emphasis on an objective that hones in on the consistent use of

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policies and procedures. Another company may have had trouble with fraud or harrassment in the past, and so one of its key objectives will be to ensure that the company's code of ethics is being followed. Yet another company may have been burned by inconsistent ﬁnancial reporting, which calls for an objective that tracks this issue. The most common minimum objectives for the internal audit department will address the need to safeguard assets and create accurate ﬁnancial statements. These objectives are strictly ﬁnancial in nature, and can be handled by an audit staff with a traditional ﬁnancial background and a minimum training in company procedures. These are also useful objectives when the audit staff is so small that there is no room to pursue a wider-ranging set of objectives. These objectives are: • That control systems will adequately safeguard company assets • That company ﬁnancial statements follow generally accepted accounting principles (GAAP) and are accurate These objectives can be widened to include reviews of operating policies and procedures. This is a very common objective if there are perceived problems in this area. Also, problems in operations tend to have an impact on the accuracy of the ﬁnancial statements, so many companies take the view that this objective goes “hand in hand” with the earlier objective for ﬁnancial statements and therefore must be included. However, this requires a broader range of skills and a much larger work plan, so this objective tends to result in a larger and more experienced audit staff. This objective is: • That the company is following operating policies and procedures Given the prevalence of computer systems and the degree to which they are now integrated into a company’s most crucial operations, it is also common to specify an objective that addresses this area. By doing so, a company must add a highly skilled group of computer system auditors to the internal audit staff. Any review work involving computer systems requires a considerable degree of knowledge, primarily of systems design and testing. Some more detailed reviews may even require a knowledge of programming languages, though it is customary to contract out this more specialized audit work, since it is difﬁcult to ﬁnd and retain personnel with such unique skill sets. It is sometimes necessary to contract out virtually all computer-related audit work, given the difﬁculty of ﬁnding qualiﬁed staff people to conduct the work. This objective is: • That computer systems are accurately processing data It is common for companies to also require reviews of ethical standards by the internal audit group. This requirement is frequently a result of a highly public scandal that has damaged the company’s reputation or of a large lawsuit settlement that could have been avoided if there had been higher ethical standards (e.g., kickbacks, sexual harassment, etc.). Since this type of audit tends to fall outside of the experience of a typical internal auditor, it is customary to bring in a consultant to advise on how to construct and follow through on ethics audits (with the primary focus being on audits of scheduled ethics training of employees). This objective is: • That the company is following an approved set of ethical guidelines There should be an objective that requires the internal audit staff to support the activities of the external auditors. This objective is necessary because the fees charged by the outside auditors can be reduced by supplementing their work with that of the internal auditors. There is a limit to how much work the inside auditors can perform, because an excessive degree of assistance by them would interfere with the independence and objectivity of the external auditor’s work. Nonetheless, the outside auditors may rely on them for a signiﬁcant volume of work. This objective is: • That the department adequately supports the activities of external auditors The previous objectives have addressed key areas of a company that must be reviewed. In addition, there should be an objective that requires the internal audit manager to prepare an annual internal audit plan for reviewing the previous objectives. This is important, because it forces the manager to address such issues as the importance of various audits, the degree to which some

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objectives are being addressed at the expense of others, and the adequacy of the department's staffing and expense budget. This objective is: • That it creates an annual audit plan that addresses all of these objectives The ﬁnal objective relates to the output from the work of the internal audit department. While the previous objectives have established a direction for the audits to be conducted or the management of that work, there is no provision for what the department is supposed to do with the results of all this work. Accordingly, the ﬁnal objective requires the department to create reports that detail all ﬁndings and make recommendations to resolve problems. In addition, the objective should require that the reports be distributed to those levels of management that can use the information to resolve the problems. This ﬁnal objective closes the loop on all activities required of the internal audit department. This objective is • That it provides written reports of its ﬁndings to those levels of management needing the information in order to correct faulty systems The bulk of these objectives relate to the types of audit work to be conducted by the department, with the key areas including the safeguarding of assets, accuracy of ﬁnancial statements, and reviews of operations and computer systems. Many of these objectives are discussed again in the next section, where we derive internal audit activities based on each of the objectives.

8.6 INTERNAL AUDIT ACTIVITIES This section is based on the objectives that were described in the previous section. Though there are a few activities noted here, the reader should not rely on this list to create a comprehensive set of activities for an internal audit department. The reason is that there will certainly be additional activities that are unique to each company; also, there may be a number of activities that are speciﬁc to particular industries. A manager who is compiling activities for this department should talk to consultants, external auditors, and trade associations that have considerable experience in speciﬁc industries to obtain input on additional activities for the department. This will yield a more comprehensive set of tasks for the internal audit department. The eight internal audit objectives noted below are all followed by a variety of related audit activities. 1. Objective: That control systems will adequately safeguard company assets Cash: Verify that there are adequate controls over petty cash. Fixed assets: Verify that there is a sufﬁcient degree of control over borrowed assets. Verify that there is a sufﬁcient degree of control over the acquisition and disposal of assets. Inventory: Verify that there are sufﬁcient safeguards against the loss of inventory. Verify that there is a sufﬁcient degree of control over consigned inventory. Supplies: Verify that there is a sufﬁcient degree of control over the purchase, storage, and use of supplies. 2. Objective: That company ﬁnancial statements follow GAAP and are accurate Cost of goods sold: Verify that product bills of material are accurate. Verify that the cost of goods sold is correctly computed. Verify that there is a proper cutoff of receipts and shipments at the end of the reporting period. Expenses: Verify that all expense accruals are correctly calculated. Verify that all prepaid expenses are expensed in the correct periods. Verify that expenses are incurred only up to budgeted levels. Verify that paychecks are only calculated and paid for current employees. Verify that payroll amounts are correctly calculated. Verify that the assumed resale values of ﬁxed assets are reasonable, based on a current review of asset values. Verify that the authorization for incurring expenses is appropriate. Verify that the time period over which depreciation is taken is reasonable, based on industry standards and historical usage.

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Revenue: Verify that billings are only made for services and product sales that are actually

completed. Verify that invoices are recorded in the correct periods and amounts. 3. Objective: That the company is following operating policies and procedures Determine labor productivity. Investigate and determine the cause of transactional errors. Review the appropriateness of expenses for new construction. Review the ﬁxed asset purchasing goals after-the-fact to see if goals were met. Review the obsolescence of existing equipment. Verify the appropriateness of pay levels based on experience and education. Verify from a sample of expense reports that only those approved types of travel expenses are being reimbursed. Verify that bank reconciliations are regularly performed and reviewed. Verify that ﬁnancial statements are published within speciﬁed due dates. Verify that machine run rates are within expected levels. Verify that product quality levels match minimum standards. Verify that production scrap rates are within expected levels. Verify that shipments are made on scheduled ship dates. Verify the accuracy and timeliness of all key transactions. 4. Objective: That computer systems are accurately processing data Verify from a sample of transactions that the computer system is correctly calculating accounting transactions. Verify that data from an acquired company is accurately entered into the existing computer system. Verify that new systems under development are designed with an appropriate number of control points to ensure proper processing of transactions. Verify that there are a sufﬁcient number of safeguards built into the system to ensure a rapid recovery from catastrophic computer damage. Verify that there is sufﬁcient testing of systems and data during a conversion of computer systems to a replacement system. 5. Objective: That the company is following an approved set of ethical guidelines Follow up on reported ethics cases and determine the extent to which formal ethics training programs would have avoided the situations. Verify from training records that each employee has received at least the minimum number of ethics training hours per year. Verify that the training materials used to teach ethics to employees contain information that matches and supports the principles described in the company's ofﬁcial ethics policy. 6. Objective: That the department adequately supports the activities of external auditors Verify that the internal audit staff completed the tasks assigned to it by the external auditors. Verify that the tasks assigned to the internal audit staff to support the external auditors were completed to the satisfaction of the external auditors. Review the entire external audit program and make recommendations to increase the share of work completed by the internal audit staff, in order to reduce fees charged by the external auditors. 7. Objective: That the department creates an annual audit plan that addresses all of these objectives Verify that a broad range of managers are consulted regarding the contents of the annual audit plan.

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Ch. 8 Internal Audit Function Verify that the annual audit plan contains some reviews for all of the previous audit objec-

tives related to control over assets, ethics, operations, ﬁnancial accuracy, and operations. Verify that the key control problems pointed out by the external auditors are being addressed

by the annual audit plan. 8. Objective: That the department provides written reports of its ﬁndings to those levels of management needing the information in order to correct faulty systems Verify that feedback is solicited from auditees regarding the ﬁndings and recommendations made in audit reports. Verify the degree to which recommendations have been implemented, subsequent to the release of audit reports. This section presented a wide-ranging list of internal audit activities that are closely tied to the audit objectives described in the last section. However, this is not a comprehensive list, so other industry-speciﬁc sources should be consulted in order to compile a more complete listing of activities.

8.7 MANAGING THE INTERNAL AUDIT FUNCTION The internal audit department is not a line function, so there are no regular outputs to examine, nor are there any direct cost savings or added revenues attributable to it. This lack of clear results makes it somewhat more difﬁcult to manage the function. This section describes the main steps that a manager should complete in order to create a management system for the internal audit function, as well as a means for determining the status of activities, and controlling it based on that information. The ﬁrst step in managing the department is to create and disseminate a clear set of responsibilities for the internal audit staff. This gives the department deﬁnitive guidelines to follow, as well as direction in its daily activities. A typical responsibility statement should include: • That control systems will adequately safeguard company assets • That company ﬁnancial statements follow GAAP and are accurate • That the company is following operating policies and procedures • That the company is following an approved set of ethical guidelines • That computer systems are accurately processing data • That the department adequately supports the activities of external auditors • That it creates an annual audit plan that addresses all of these objectives • That it provides written reports of its ﬁndings to those levels of management needing the information in order to correct faulty systems Once these objectives are in place, the manager can focus on the primary output — the annual audit plan—as the easiest means for managing the department. The annual plan is usually a brief document that lists every audit to be completed during the year, as well as a brief description of the objectives of each audit. For example, it might include the following audit: Review the method for recording additions, changes, and deletions of ﬁxed assets to and from the accounting records for the Andersonville facility. The audit will verify that the correct capitalization limit is being observed, that there are documented and justiﬁed reasons for making alterations to the ﬁxed asset records subsequent to additions, that deletions are recorded properly, and that the sale amounts of assets are reasonable.

Though this audit description gives one a good idea of what will happen during an audit, it does not yield a sufﬁcient degree of additional information, such as the number of hours budgeted for the work, who will be assigned to the project, or when it will take place, for a manager to achieve tight control over the department. This requires a more detailed audit budget for the year, such as the one shown in Exhibit 8.1. The primary information contained in this budget are the budgeted hours scheduled for each job, and the estimated range of dates during which work will be completed.

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137

Division

Project

Hours

Start Date

End Date

Personnel

Denver Denver Boston Chicago Chicago Atlanta Atlanta

Fixed assets Billings Fixed assets Fixed assets Billings Fixed assets Billings

240 280 240 240 280 240 280

01/01/XX 01/01/XX 02/16/XX 04/01/XX 02/22/XX 05/16/XX 03/08/XX

02/15/XX 02/21/XX 03/31/XX 05/15/XX 03/07/XX 06/30/XX 04/21/XX

Smith/Jones Barnaby/Granger Smith/Jones Smith/Jones Barnaby/Granger Smith/Jones Barnaby/Granger

E XHIBIT 8.1

S AMPLE I NTERNAL A UDIT B UDGET

Once armed with the internal audit budget, a manager can exercise a much greater degree of control over the internal audit department. The budget information allows a manager to use the following controls: • Compare budget to actual hours worked. • Compare budget to actual project start dates. • Compare budget to actual project completion dates. • Compare budget to actual stafﬁng requirements. In addition to these quantitative control points, there are a variety of other controls that a manager can use. These extra controls tend to supplement the quantitative controls, and can be “mixed and matched” to derive a set of controls that are best suited for speciﬁc situations. The extra controls are: • Compare the written objectives of the department to its actual activities. • Ensure that the internal audit staff coordinates its work to support that of the external auditors. • Ensure that there is an up-to-date policies and procedures manual that clearly shows how audit work is to be conducted. • Review audit reports for activities conducted, ﬁndings noted, and recommendations given. • Review comments from departments that were the subject of audits. • Review the mix of scheduled reviews to see if there is a lack of attention to speciﬁc areas, such as reviews of accounting, computer, or operational controls. • Review work papers to ensure that audits were completed in as thorough a manner as possible. • Verify that audit recommendations are being acted on. • Verify that auditors have a sufﬁcient educational background to conduct speciﬁc types of audits (some audits are so specialized that outside expertise must be brought in). • Verify that the audit committee is satisﬁed with departmental performance, and follow up on any shortcomings. • Verify that the department is reviewing the controls being built into new computer system projects. • Verify that the department is sufﬁciently large to accomplish all planned goals. • Verify that there are scheduled reviews of the company's ethical standards. • Verify that there have been no restrictions of departmental activities due to intransigence by auditees, and bring up exceptions with the audit committee for action. It is important to have prior knowledge of the activities of and conditions in the internal audit department before selecting from the previous list of management controls, because this information has a direct bearing on which controls are selected. How does one gather this information? There are a variety of information sources that can be consulted, including: • The depth and accuracy of audit planning. An internal audit is a project, and as such must be adequately planned and then managed against that plan to ensure that audits are completed on time.

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• The image of the department. The department manager and any staff members who are in direct contact with other departments must present a positive and professional image, especially when conducting reviews, discussing recommendations, or presenting ﬁndings. • The opinion of the outside auditors. The external auditors are accustomed to working with the internal audit staff from time to time, and can usually provide an opinion regarding the quality of the department's work. • The quality of personnel practices. The members of the internal audit staff should have a high level of training, possess adequate knowledge of the areas being audited, have clear career paths that are well documented, and be conversant in the use of any new technologies that assist them in conducting their jobs. • The reaction of departments that have been reviewed. Any auditees should have a positive view of the internal audit department (unless it discovered massive problems!), since auditors should conduct their reviews in a professional manner and keep auditees well informed of their progress and recommendations. • The reaction of senior management and the board of directors. These managers should feel that the internal audit group has provided meaningful insights on company operations, as well as made solid improvement recommendations. • The types of recommendations in previous audit reports. If there is a large proportion of less important recommendations, this is a sign that the internal audit staff is either not well acquainted with the systems it is reviewing, or that the quality of work conducted is so low that no signiﬁcant recommendations are likely to be found. Only by reviewing this information can a manager determine the particular strengths and weaknesses of an internal audit department, which can then be used to select the speciﬁc control methods necessary to manage the department. In general, a successful internal audit manager should utilize all of the quantitative measures noted in this section, and supplement them with a selection of qualitative controls (also noted in this section) that are tailored to the speciﬁc circumstances of the department. Only by doing so can a manager create a management system that is both efﬁcient and effective, which will result in a high-performance internal audit department without an excessively burdensome management system.

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CHAPTER

9

GLOBALIZATION: COMPLEXITIES AND OPPORTUNITIES 9.1 INTRODUCTION: PERVASIVE NATURE OF GLOBALIZATION 139 9.2 CHANGING NATURE OF INTERNATIONAL TRADE 140 9.3 IMPACT OF GLOBAL TRADE ON SEGMENTS OF THE U.S. ECONOMY 140 9.4 DETERMINING AND IMPLEMENTING SUCCESSFUL GLOBAL STRATEGIES 142 9.5 ORGANIZATION STRUCTURE IN A GLOBAL ENTERPRISE 143 9.6 VIRTUAL CORPORATION 145

9.7 TECHNICAL ASPECTS OF THE CONTROLLERSHIP FUNCTION UNDER GLOBALIZATION 146 (a) Open Communications 147 (b) Uniform Data Requirements 147 (c) International Accounting Requirements 148 (d) Measuring Foreign Operations. 149 (e) Evaluating Capital Expenditures 152 (f) Transfer Pricing 154 (g) Taxation 155 (h) Import/Export Regulations 157 (i) Managing Currency Risk 157 (j) Foreign Corrupt Practices Act 158

9.1 INTRODUCTION: PERVASIVE NATURE OF GLOBALIZATION Those active in business know that change is constant. It seems some subjects are emphasized, then deemphasized and later emphasized again, for example, benchmarking, reengineering, empowered workteams, leveraged buyouts, mergers and acquisitions, explosion of new technologies, the changing nature of capital markets. And now we have globalization. In the 1970s and 1980s, international trade, in the eyes of many, focused on North America, Europe, and Japan — the most developed markets. Now vast new markets have opened for Western goods in Asia, South America, and Eastern Europe. It is these still developing areas, which include the Paciﬁc Rim, India, Latin America, China, and Africa, that need attention. This is where the largest growth will be. With the greatly expanded global horizon, the ﬁnancial executive should be aware of these aspects: • The expanded markets for U.S. goods and services, and the related impact on speciﬁc industries, required changes in packaging and product design, and distributions to meet local tastes. • Potential changes in sources for raw materials and supplies. • Widened ﬁnancial investment opportunities, with differing rates of return and diversiﬁcation possibilities in foreign stocks (including ADRs — American Depositary Receipts), bonds, and global mutual funds speciﬁc to a particular county or region. • Possible impact on organization structure, including top management structure and related local management chain of command and ﬁnancial management structure. 139

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While the subject of globalization is currently popular, it bears mentioning that though many managements may attempt to do business globally, a very large number do not. Converting a local business to a global basis is difﬁcult. The differences in style of management required, in control and lack thereof, and in business practices, causes some management to shy away from globalization. (see Section 9.7.) But the rewards, if successful, are great — shared resources, shared management talent, broadened markets, lessened impact of a local economy downtrend. Globalization under the proper conditions can open up a world of opportunity. • Possible changes in corporate or entity relationships, including the virtual corporation. • Changes in policies and procedures relating to planning and control responsibilities or other activities required by U.S., foreign national, or local laws and regulations—as well as transfer pricing guidelines.

9.2 CHANGING NATURE OF INTERNATIONAL TRADE U.S. companies have engaged in international trade for many years by exporting U.S. produced goods or services, importing selected foreign products, and utilizing factories in foreign countries to assemble products for sale in the United States. With the emergence of huge trading blocks in North America (including the implementation of the North American Free Trade Agreement [NAFTA], Europe [the European Union], and East Asia [the Paciﬁc Rim]) and the growth in other areas, major changes are taking place as to the manner in which global or multinational organizations are doing business. Cross-border trade and investments are both rising dramatically. These speciﬁc developments illustrate the trend: • Many U.S. companies are increasing their foreign capital investments in plant and equipment. • U.S. investors are putting record funds into foreign investment — ADRs, some stocks, bonds, and mutual funds. • Some U.S. corporations are engaging in sophisticated or advanced research and development (R&D) in foreign laboratories instead of the United States. • U.S. owned companies are beginning to employ large numbers of foreign workers relative to the number of U.S. employees. • Many U.S. owned corporations are exporting foreign produced goods to the United States. Conversely, some foreign-owned companies are establishing manufacturing plants and distribution facilities in the United States for the sale of their U.S. produced goods. • Many non-U.S. companies with facilities in the United States are exporting a signiﬁcant value of U.S. produced goods to foreign markets. For many years, U.S. global companies regarded foreign plants as appendages for the manufacture and sale of products designed or engineered in the United States. Given competitive pressures, the superior knowledge that foreign nationals have about local practices or customs in their country, and perhaps a less dominant position of some U.S. products and services, there is now more of a cross ﬂow of technology, capital, and talents in many directions. In reality, the nationality of a company is not as clear as it once was; and the chain of command may include many U.S. citizens as well as foreign nationals. All these developments add to the complexities of doing business on a global basis.

9.3 IMPACT OF GLOBAL TRADE ON SEGMENTS OF THE U.S. ECONOMY It should be of general interest to know how global trade affects different segments of the U.S. economy. How does it impact a particular industry or company? Because U.S. government statistics do not provide much assistance, Business Week made its own review after dividing the U.S.

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economy into three segments: (1) exporting trade, (2) import-competing trade, and (3) domestic trade.1 The makeup of the sectors and the general conclusions are: 1. Exporting trade. The exporting sector consists of industries that are competing effectively in markets at home and abroad. To be included, the industry group must export at least 10% of its output. The exporting sector includes industries such as: Financial services Higher education Instruments International communications and transportation Lumber and paper products Moviemaking and other entertainment

Aircraft Business services (e.g., consulting and accounting Chemicals Computers Drugs Electronic equipment and components

The Business Week report indicates that workers in the exporting sector are winners in the trend toward a global economy. Exporters have expanded output and sales, and they also have boosted productivity by reducing jobs and substituting capital for labor. Although employment was ﬂat, average real wages increased by 5.2% since 1980. As one economist stated, “Export success means rising wages.” 2. Import-competing trade. Industries in the import-competing category import no more than 10% of foreign goods into the U.S. market. This sector includes the following categories of industry: Automobiles and motorcycles Cement Clothing Consumer electronics Furniture Machine tools Mining

Most industrial machinery Screws, nuts, and other small hardware Shoes and luggage Steel, aluminum, and other metals Tires Toys

Employees in this segment have been hurt by the direct and indirect effects of foreign competition. Jobs have become scarce, and wages, once good, have fallen. 3. Domestic. This category includes industries that do little importing or exporting. Most are service industries, although some manufacturing is included (e.g., concrete blocks) when local tastes, standards, or economics limit international trade. The domestic sector includes these industries: Business services Commercial printing Concrete products Construction Domestic transportation and communications Education (primary and secondary) Financial services, real estate, and insurance

Food processing Health services Personal services (e.g., hair dressing and automobile repair) Publishing Rubber and plastic products Wholesale and retail trade

Global competition has pushed down wages in the domestic sector. While it may be relatively easy to ﬁnd work, pay has decreased and is getting lower. Moreover, as imports or increasing productivity reduce the number of jobs in other categories, many employees have migrated to the service sector, making competition a more important factor. Global trade can affect just about everyone in every sector of the economy. 1. Michael J. Mandel, and Aaron Bernstein, “Dispelling the Myths That Are Holding Us Back,” Business Week, Dec. 17, 1990, p. 67.

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9.4 DETERMINING AND IMPLEMENTING SUCCESSFUL GLOBAL STRATEGIES A great many factors inﬂuence whether a particular entity will be successful in the global marketplace. Perhaps no factor is more important than the selection of the proper strategies; and this includes determining the strategy decided upon in the proper manner. It is a reﬂection of the “NIH” syndrome—not invented here. A key player in carrying out global strategies is the subsidiary top manager. Some research into the viewpoints of these managers revealed these conclusions as to the process by which strategies should be determined.2 • It is important that the head ofﬁce executives become familiar with local conditions. Only where the subsidiary managers believe the head ofﬁce executives understand how the local market operates do they respect the decisions reached, and make a greater effort to follow them. • Two-way communication is essential. Subsidiary top managers value the ability to voice their opinions and exchange ideas with the home ofﬁce in reaching a strategic decision. • Subsidiary managers must regard the decision-making practices as consistent. In other words, strategic decision making is a political process as well as any economic and competitive process. Subsidiary managers must not conclude that those on the “inside track” will be heard, but that all others will be overlooked. • Subsidiary managers must believe they have the ability to reﬂect or openly challenge the head ofﬁce decision. In such an environment, the subsidiary managers think the head ofﬁce may better recognize that strategic decisions will be of a higher quality, and will be made in the overall economic interest — not primarily a political interest. • Subsidiary top managers think it is only fair that the head ofﬁce explain the reasons for the ﬁnal global strategic decisions. When such a procedure is followed, many subsidiary managers tend to believe that the head ofﬁce at least considered the subsidiary position, and that they thereby acted in a fair and impartial manner. The existence of a fair process of establishing global strategies is key to making the strategy successful. It tends to cause subsidiary managers to pursue voluntary execution—doing more than is required — rather than compulsory execution—meeting minimum requirements. The traditional mechanism for strategy enforcement—incentive compensation, auditing or monitoring systems, heavy-handed disciplining by the head ofﬁce, and other rewards or punishments — are of some worth. But these mechanisms are of declining value by reason of such trends or factors as these, among others: • Increasing size of subsidiary units • A growth in unique or distinctive skills in the subsidiaries • Growing and extensive communication between the subsidiaries in comparing ideas (and excluding the home ofﬁce) • Growing importance of subcultures • Increasing difﬁculty in monitoring efforts in enforcing the prescribed strategy—due to an inability to distinguish the cause of failure — whether the result of factors beyond the control of the manager, or poor implementation that he or she can control • Growing loss of control by the central ofﬁce The growing complexities in the global marketplace make a participative management approach, perceived as fair and equitable, increasingly important. Aside from the psychological environment, the most important factor is the actual strategy adopted. The predominant philosophy or type of

2. W. Chan Kim, and Renee A. Mauborgne, “Making Global Strategies Work,” Sloan Management Review, Spring 1993, pp. 11– 26.

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strategy will depend, among other things, upon the product, the industry, the speciﬁc market, and the nature of the competition. A study of styles of competition in the semiconductor business made by a Fordham University Graduate School of Business professor concluded that, in this instance, U.S. ﬁrms tended to develop a unique strategy while the effective Japanese competitors tended to win by implementing in a superior manner a not-so-unique strategy.3 A comparative summary of different competitive actions in this speciﬁc market are shown in Exhibit 9.1. Dominant Competitive Style Action

U.S. Company

Securing unique product-market advantage Role of process technology (which transfers a product design into marketable products)

Sources of process technology know-how

Withdrawal from the market

Status of vertical integration

E XHIBIT 9.1

Attempts to develop unique advantage for each product line Great variance from company to company. Large ﬁrms may attempt to stay in the forefront of process technology, whereas ﬁrms that rely most heavily on product-market differentiation may consider process technology less important Often depends on external sources — e.g., by engaging in collaborative research, by outright purchase, or by seeking assistance from equipment manufacturers Tends to withdraw from product-market segment when clear advantage cannot be gained, often after competitive pressures make segment unproﬁtable Generally values such integration only when related products contribute uniqueness

Japanese Company Does not seek unique productmarket advantage; relies on low cost and high quality Emphasizes staying at the forefront of technology—both for product development and for capital improvement

Tending to favor internal development

Seldom withdraws from market; tends to remain in product segment and to strive for proﬁtability through efﬁciency

Highly values vertical integration as part of drive to self-sufﬁciency

C OMPARATIVE C OMPETITIVE S TYLES

As might be expected, the dominant competitive style inﬂuences any industry structure, which in turn inﬂuences the industry’s member ﬁrms, their suppliers, and their customers. Exhibit 9.2 compares the impact of the two competitive styles on some important industry factors and characteristics. Note that the impact could be either an advantage or a disadvantage for any given particular ﬁrm.

9.5 ORGANIZATION STRUCTURE IN A GLOBAL ENTERPRISE The removal of trade barriers and the trend toward a global economy is changing the manner in which companies do business and, as a consequence, often also causes a change in some organizational arrangements. As entities become global, new threats appear in the home market as well as

3. See William G. Egelhoff, “Great Strategy or Great Strategy Implementation — Two Ways of Competing in Global Markets,” Sloan Management Review, Winter 1993, pp. 37– 50.

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Competing Style

Distinguishing Characteristics Impact on Factor Strategic variety

Industry concentration Industry survival pattern Industry Characteristics Product life cycle

Risk of technological or environmental change Proﬁt margins E XHIBIT 9.2

“Superior” Strategy

More Effective Implementation

Greater variety of strategies results in greater range of products as well as greater segmentation of markets

Fewer strategies, resulting in more direct competition between products and product substitutes, with emphasis on quality and cost Only a few successful competitors and high industry concentration Efﬁcient competitors survive and dominate industry, with lower turnover among leaders

Many successful competitors and low industry concentration Innovative competitors survive and dominate industry, with high turnover among leaders

Strategy is most effective in early stage of product life cycle, when technological and/or environmental change is rapid and a variety of feasible product designs exist Entity risks losing competitive advantage when there are fewer such changes and when imitators enter market Less direct competition, resulting in higher proﬁt margins

Strategy works best in later stages of product life cycle, when technological and/or environmental change is slow and the basic designs have evolved Entity risks losing competitive advantage when technological and/or environmental change dominates market More direct competition, resulting in lower proﬁt margins

“S UPERIOR S TRATEGY ” VS . M ORE E FFECTIVE I MPLEMENTATION N ONUNIQUE S TRATEGY

OF A

the foreign market. New products enter the marketplace, and competition increases for existing as well as new customers. These competitive forces are causing these changes: • Increased customer demands. Customers tend to require faster deliveries, improved quality, and more numerous other related services. • Quicker responses. It becomes increasingly necessary to react quickly to competitive actions, as well as changing market conditions, and to shorten the time for development of new products and services. • Improved outsourcing or subcontracting. Another frequent requirement is the developing of closer relations with key suppliers so as to facilitate just-in-time delivery of materials or parts or other fast response needs. • Strengthening core competencies. With the need to assemble and strengthen core competencies, some entities are forming ﬂexible partnerships — as discussed in Section 10.7. These business adaptations, coupled with the changes in information technology and the inﬂexibility of traditional, cumbersome, and bureaucratic structures, excessive management layers, and onerous procedures, are resulting in some new organization structures. Some may be recognized in a realigned organization, and others are reﬂected in “new organizations” that are not usually a part of the typical organization chart. A few of these new relationships are reﬂected in the phenomena listed next. • High-performance teams. This is a group of individuals with differing skills brought together to function as a team and to completely reengineer a process—such as ﬁlling customer orders or a manufacturing sequence. The team works as a group using shared information and groupware— especially designed software to support collaborative effort.

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145

• Integrated organization. In reality this is a change in the access and ﬂow of information. Instead of, for example, three separate resource areas (a) ﬁnancial, (b) physical assets, and (c) human resources, a new integrated information system lets executives directly access the required data. This new information system removes layers of management and modifying inﬂuences. • The extended business. With the help of industry standards, computer systems are extending outward and linking with both customers and suppliers. In a sense, a change is taking place from a vertical organization to a horizontal entity. Again, some of this change is seen in the virtual corporation. We see the impetus of international competition forcing the elimination of layers of management, and effective working groups built around key processes instead of single functions or departments. Moreover, knowledge of local markets and important customers argues for a great deal of decentralization. In the context of organization structure, two other changes are occurring: 1. Unit headquarters. In this increasingly global economy, many U.S. companies are transferring abroad the world headquarters of important business units. Astute managements are recognizing that they must operate near key customers and closer to competitors — not in a far-away location. Many large business are ﬁnding that a company cannot be run from a single location; several different headquarters may be required for different product lines or competitive postures. With such changes, some loss of control may result. Hence, the controller must be sensitive to these developments. 2. The ﬁnance organization. Just as the principle of decentralization applies to the marketing function, it could be advantageous in the ﬁnance organization. The chief ﬁnancial planning and control ofﬁce of the subsidiary unit should report administratively to the local unit manager. This structure tends to make the ﬁnancial executive a member of the local management, and not be perceived as the eyes and ears of the corporate ofﬁce. Also, it should make the local ﬁnancial manager more responsive to the needs of local management. The corporate controller could then provide functional guidance, such as the ﬁnancial procedures to be used, internal control procedures, and report requirements for the home ofﬁce. The staff relationship of the unit controllers to the corporate controller is illustrated in Exhibit 9.3.

9.6 VIRTUAL CORPORATION In the context of meeting global competition, a new form of organization—the virtual corporation— is emerging to more quickly take advantage of new economic opportunities. This development in organization structure warrants discussion in a separate section. While often used in connection with outsourcing, the concept may spread to other functions. Webster’s Ninth New Collegiate Dictionary deﬁnes “virtual” as “being such in essence or effect though not formally recognized or admitted.” By this deﬁnition, a virtual corporation is an entity that, although not formally recognized or admitted as a corporation, is such in effect. As typically described, it is a temporary, ﬂexible network of independent organizations linked by information technology for the purpose of sharing skills, costs, and access to one another’s markets. It is a means of quickly meeting competitive pressures. The principal characteristics of this form of organization are: • Excellence. Each participant in the organization commits its “core competence” to the joint effort — with the result that each function or process can be world class in a faster time than other methods. A single corporation only rarely can achieve world class status in most of its functions. • Opportunistic and temporary. The association is less likely to be either permanent or formal than other arrangements. The entities band together to meet a particular need or to take advantage

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E XHIBIT 9.3

G LOBAL O RGANIZATION S TRUCTURE ( WITH E MPHASIS ON THE F INANCIAL O RGANIZATION )

of a particular opportunity. When the need no longer exists, or the beneﬁts have been realized, then the organizations disband. But beneﬁts have accrued for each member. • Existence of indeterminate borders. With the many contacts among suppliers, customers, and perhaps competitors, the corporate boundaries often become blurred. • Technology dependent. The new information technology enables the widely dispersed entities to communicate and work cooperatively. The electronics interchange reduces greatly the time required for legal decisions, or link-ups, or making changes. • Codependence. The nature of the new relationship makes each participant quite dependent on the other members of the group. • Loss of control. The various characteristics listed above results in some loss of control over some operations, with possible related difﬁculties. This form of organization should be considered by some global entities.

9.7 TECHNICAL ASPECTS OF THE CONTROLLERSHIP FUNCTION UNDER GLOBALIZATION The bulk of the preceding discussion in this chapter has related to those general aspects of globalization or international trade of which the controller should be aware. Additionally, in properly carrying out the duties of a controller in a situation involving multicountry operations, as contrasted with single country activities, these subjects are germane and speciﬁc to the task — and they are all interrelated: • Open communications • Need for uniformity in data deﬁnition • Complying with international accounting requirements

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• Measuring foreign operations • Translating ﬁnancial statements • Evaluating foreign investments —capital expenditures, R&D projects, operating programs (such as designing and constructing an aircraft), and so on • Transfer pricing • Taxation • Import/export regulations • Managing currency risk • The Foreign Corrupt Practices Act (FCPA) (a) OPEN COMMUNICATIONS. Two factors contribute to communication problems in an international operation. They are language and distance. It is important for a controller to address these problems and develop a satisfactory solution. The most obvious way to handle the language problem is to ensure that someone with good bilingual skills is representing the controller in the overseas operation. This individual must be able to deal effectively with the local country ofﬁcials and employees and then communicate important and necessary information back to the parent. The communication can be in person, by phone, by letter, and by data transmission. In larger operations, private communications systems will allow easy teleprocessing and telecommunications. In smaller organizations, careful planning of when calls and data are transmitted will result in good communications. However, even after placing a qualiﬁed representative in the foreign operation, the controller must remain aware of the importance of clear information exchange. The need becomes even greater as the company expands into more countries and as the foreign operations become a bigger part of the business. One technique that has proved effective is to issue written instructions on important matters such as: • Planning assumptions • Accounting and reporting requirements • Control assessments • Disbursement practices The instructions should be formal notiﬁcation to the subsidiaries as to what is required of them. The letters or instructions should be controlled (e.g., a sequential number assigned to each one so that all recipients are aware of all communiques). It is helpful to the subsidiaries if the parent periodically issues a summary of all such instructions that are still in force. A second, and probably invaluable, communication technique is the one-on-one meeting. It is here that all the nuances of operation are really covered. These meetings of key people (controller to controller) should take place at least once a year and probably more often if there are difﬁcult issues to be resolved. Another effective communication vehicle is the use of group meetings, seminars, and classes wherein the controller sponsors a meeting of international people perhaps from several countries at which speciﬁc items of mutual interest are discussed. This also allows people with the same problems to come together and informally talk about problems. There has proved to be a continuing beneﬁt in this approach in that the people stay in touch with one another to discuss ongoing and future problems and share solutions. New developments in groupware to provide meeting support can assist in keeping the communication lines open. (b) UNIFORM DATA REQUIREMENTS. When operating internationally it is essential that there be worldwide uniformity in data deﬁnitions for three reasons: 1. It simpliﬁes consolidation of ﬁnancial statements and reports.

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2. It allows for comparability of results. 3. It permits timely release of reports. The use of a standard schedule of accounts, developed and maintained centrally but responsive to country needs, is the most obvious way to achieve uniformity or reporting. It becomes simple then to deﬁne the aggregation of data in order to achieve usable reports. This results in one scorecard that is then used by all parts of the organizations within the company. To be effective, use of a standard reporting chart of accounts requires that headquarters have a knowledge of the out-of-country business and how it is to be recorded and summarized. It also requires an interpretation of U.S. accounting standards, which must be articulated and promulgated to all subsidiaries so that ﬁnancial reports have a uniformity of structure and content. To sum up, a world-class accounting operation would be organized to: • Keep responsibility for recording at the country level. • Provide clear instructions to the countries as to how transactions would be summarized and reported. • Have each country prepare statements in the parent-company currency using U.S. generally accepted accounting principles (GAAP). This structure will result in uniform accounting reports to allow comparison between units. It will also permit tighter closing schedules and the resultant earlier release of information both within the company and externally. (c) INTERNATIONAL ACCOUNTING REQUIREMENTS. accounting operation the controller must address:

In putting together a world-class

• Records of a subsidiary must be kept in the local currency and language and must meet local ﬁscal, professional, and tax requirements. • The records must then (a) be adjusted to “generally accepted accounting principles” of the parent, and (b) be translated into the currency of the parent. (Less commonly, a second ledger may be maintained in the currency of the parent and in accordance with GAAP of the parent.) The record keeping of the subsidiary is generally done locally. The day-to-day transactions covering payment of salaries, purchasing of goods and services, billings to customers, and collecting cash, as well as maintaining and controlling assets and liabilities all take place locally and in local currency. The accounting for these transactions is most effectively done where and when they transpire. The accounting records must be constructed so as to provide adequate information to prepare tax returns and produce local ﬁnancial statements for regulators, creditors, unions, and other interested parties, and to facilitate reporting to the parent company. The accounting standards to be followed must be those of the host country so the record keeping must be done using those standards or easily convertible to them. This conversion is necessary if the accounting standards used are not local standards but rather are those of the parent company’s country. It should be noted that the accounting standards required by the authorities vary from country to country. The International Accounting Standards Committee (IASC) is attempting to minimize alternatives by issuing international standards, but all such standards must then be adopted by the appropriate authorities in each of the countries before they become ofﬁcial. This could be a long and tedious process. In the meantime a broad knowledge of each country’s generally accepted accounting policies must be developed and maintained by the controller of a multinational company. A listing of International Accounting Standards as issued by the IASC is available, but the acceptance by each country must be determined individually. The translation and remeasurement of local results can be done by either the local country or the parent. If done in-house by local personnel, there will be a need for each country controller to understand U.S. GAAP. This can be accomplished in several ways: through a program of individual education, through in-house seminars and workshops, and through centrally developed and

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issued accounting instructions, all of which must be directed by the corporate controller. The latter provides the best opportunity for uniformity in recording and reporting and probably will be necessary even if local ﬁnance people become knowledgeable about parent-company GAAP. If the translation and adjustments are done at the parent-company headquarters, there are several areas of concern. First, country management will not have an opportunity to review the dollar results before they are put into the consolidation process, and valuable insight into cause and effects of current operations will be missing. Second, higher management at the parent headquarters will be viewing reports that have not yet been seen at the operating level. Communications could easily become confused and important decisions delayed. Having the translation and remeasurement work done at the country level is the more effective approach. (d) MEASURING FOREIGN OPERATIONS. measurement techniques are:

In most organizations, the primary control and

• Deﬁne key objectives. • Prepare a ﬁnancial plan, compare actual results to it, and take corrective action. • Compare actual results to a prior period. The multinational company generally uses these techniques to measure the translated results of its foreign subsidiaries. The technique is effective if the variable of currency ﬂuctuation is recognized and adjusted for. As mentioned elsewhere in this chapter, translated results can present a very different picture of operations and ﬁnancial condition than local currency results reﬂect. The controller should be familiar with both sets of data and the analysis supporting them. However, it is the parent-company currency that is used for external reporting; therefore, the use and understanding of translated ﬁnancial statements will remain a key part of the controller’s work. As an overall summary of this task of measuring the ﬁnancial performance of a global unit manager, the reports should reﬂect these three objectives: 1. To reﬂect the ﬁnancial plan for all activities under the control or responsibility of the local manager. 2. To measure actual results against plan for those matters under the control of the local manager. 3. To reﬂect the planned results translated into the parent company currency; and to identify planned vs. actual results segregated between (a) those reﬂecting the entity manager’s performance and (b) those which are due to the impact of currency ﬂuctuations. (i) Comparisons with Budget or Plan. The biggest unique planning and control problem facing the controller of an international business is that of ﬂuctuations in the currency exchange rate. When plans or budgets are established an estimated exchange rate must be used to express in the parent’s currency the budget amounts developed in local currency. The “actuals” from the accounting records are translated at the current rate, which is usually different from the rate used for the plan, for example: Currency Exchange Rates 4 local currency (L/C) $1 5 local currency (L/C) $1

Plan assumptions Actual

Statement of Operations

Sales (L/C) Rate Sales ($)

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Actual

Budget

Variance (Unfavorable)

1,000,000 5:1 200,000

1,000,000 4:1 250,000

-0(50,000)

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In this example the parent-company currency, the U.S. dollar, has strengthened, and it now takes more local currency units to equal one dollar than was planned. The effect is that, when viewed from a local perspective, sales are on plan, but when viewed from a parent-company perspective (i.e., the dollar), the subsidiary is under plan and substantially so, requiring analysis and explanation. One way to give a better view of what is happening is to add two more columns to the report, showing the effect of currency. The report now tells the reader that the unfavorable variance is all due to a currency exchange movement. Statement of Operations Amount Due to

Sales $

Actual

Budget

Variance (Unfavorable)

Currency Translation

Business Performance

200,000

250,000

(50,000)

(50,000)

-0-

If the example was changed to include a modest overbudget situation in local currency, it would be reported as follows:

Sales (L/C) Exchange rate Sales ($)

Actual

Budget

Variance (Unfavorable)

1,100,000 5:1 220,000

1,000,000 4:1 250,000

100,000 (30,000)

In this example the results shown in dollars portray a misleading result, but when the currency effect is shown separately, a much clearer picture emerges. Amount Due to

Sales $

Actual

Budget

Variance (Unfavorable)

Currency Translation

Business Performance

220,000

250,000

(30,000)

(55,000)

25,000

The amount of variance due to business is calculated by either: (1) taking the variance in local currency and translating it at the current rate, or (2) more commonly since local currency results are not usually transmitted early, having the countries calculate the actual results translated at the plan rates. In the examples, both budget and actual would be translated into dollars using the plan rate of 4 L/C $1. The analyst would keep the budget amount constant at a 4:1 translation rate and prepare an “actual” using the same translation rate to produce the following result:

Sales (L/C) Exchange rate Sales ($)

Actual

Budget

Variance (Unfavorable)

1,100,000 4:1 275,000

1,000,000 4:1 250,000

100,000 25,000

The above variance is attributed to sales being higher than planned and is therefore the variance due to business operations. The difference between the total variance in translated amounts and the business variance determined above is attributed to the effect of currency changes.

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(ii) Comparisons with Prior Year. A similar problem in plan/actual comparisons occurs when current actual results are compared to the actual results of prior periods. If the exchange rates used for the two periods are different, then the results are clouded by the change. For example, if

Sales (L/C) Exchange rate Sales ($)

Current Year

Prior Year

Increase/(Decrease)

1,000,000 5:1 220,000

900,000 4:1 225,000

200,000 (5,000)

However, if the exchange rates are normalized by translating the current period using the same exchange as the period being compared to, the following picture results: Amount Due to

Sales $

Actual

Budget

Variance (Unfavorable)

220,000

225,000

(5,000)

Currency Translation

Business Performance

(55,000)

50,000

As in the plan/actual analysis, the “actual” results in both periods would be translated at the same exchange rate to produce the following result:

Sales (L/C) Exchange rate Sales ($)

Current Year

Prior Year

Increase/(Decrease)

1,100,000 4:1 275,000

900,000 4:1 225,000

200,000 50,000

By isolating the currency exchange effect, we can see that there was a growth in the business of $50,000 or 22%, rather than a 2% decline. We can also see that the currency effect was to reduce sales, in dollars, by 25%, wiping out the operating growth and resulting in a decline in reported sales compared to the prior year. (iii) Inﬂation. In a multinational company, the impact of inﬂation on the business results is not different from a national company; usually it is just more volatile. The same analyses and actions taken in regard to home-country inﬂation generally apply to translated results. However, there are many less developed nations that experience hyperinﬂation (i.e., annual inﬂation in the hundreds or thousands of percent). For these situations, some special analysis of local currency results must be made to normalize for inﬂation. Establishing a base year for currency value and then adjusting subsequent years results to that value presents a more accurate picture of growth or decline. For example, hyperinﬂationary country A experiences a 100% inﬂation rate in the current year. Its sales results for this year and last year are: Current year Prior year Increase Percentage

L/C L/C L/C

1,000,000 750,000 250,000 33%

However, using the prior years’ currency value as 1, the current year value is 0.5 after adjusting for 100% inﬂation (1 /100% 1). The current year sales value when compared to last year is L/C 500,000 (1,000,000 0.5). So instead of a 33% gain in sales, there has been a 33% decrease—a

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very different result and one requiring further analysis and action. This is called constant currency and the results are: Current year Prior year Decrease Percentage

L/C L/C L/C

500,000) 750,000) (250,000) 33%

As indicated above, this inﬂation move is reﬂected in currency translation rates and translated results therefore have only the parent-company inﬂation rate included. (e) EVALUATING CAPITAL EXPENDITURES. When the question “Should we invest overseas?” is raised, all the analyses used in making capital investment decisions in the home country will have to be made. Additionally the new risks of exchange rate ﬂuctuations and political uncertainty must be considered. Unless there are unusual circumstances (e.g., a need to maintain special know-how available in a speciﬁc location), the key consideration in the investment discussion is the return on assets or return on equity that relates to “cash ﬂow to the parent.” (i) Exchange Rate Fluctuations. The impact of currency movements on ﬁnancial statements and the analysis of them is discussed in detail in the section of this chapter titled “Measuring Foreign Operations.” Exchange rate ﬂuctuations will also have a signiﬁcant effect on the cash ﬂow to the parent of an investment in a foreign country and so must be recognized in the planning and assessment of investment alternatives. It should be noted that the analysis of investment returns when calculated in the currency of the country where the investment will be made results in a different answer than when it is done in the currency of the parent. For example, using a “net present value” analysis to determine the return in both currencies shows the comparison illustrated in Exhibit 9.4. A rule of thumb is that if this investment does not yield a positive cash ﬂow in the parent’s currency then it should not be made. If the return is positive then the required internal rate of return and/or the hurdle rate of return must be met. Another good rule of thumb is that the rate of return should at least exceed the expected interest rate of government securities in that country. Subsidiary Currency

Parent Currency

Net proﬁt before depreciation

After-tax value of dividends, interest and royalties remitted by the subsidiary

Plus Present value of terminal value (liquidation value)

After-tax recoverable amount

After-tax amount remitted to parent

Equals Total present value of cash inﬂows

Estimated amount

Translated value of remitted amounts

Minus Original investment (plant and working capital)

Translated amount

Established amount in parent currency

Present value of cash inﬂows over the life of the project

Equals Net present value E XHIBIT 9.4

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C ALCULATION

OF

N ET P RESENT V ALUE

IN

T WO C URRENCIES

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In estimating the value in the parents’ currency of future cash ﬂows, it is necessary to forecast for each of the years included in the analysis: • Exchange rates • Withholding taxes • Currency restrictions • Political risks This is a difﬁcult but doable effort. (ii) Exchange Rates. In considering the economic exposure to future foreign exchange risk, both the cash ﬂows in foreign currency and the value of dividends in the parent currency must be considered. For example, a devaluation of the foreign currency will result in a decrease in the value of foreign currency dividends in the parent currency. But, it may also lead to an increase in foreign currency proﬁt as a result of increased sales volume or sales price on exports. The net impact on the cash ﬂow to the parent is the sum of both effects. The analysis should begin with an assessment of the most likely exchange rates anticipated by year. Then simulate what would happen to cash ﬂows under a variety of “what-if ” scenarios. For example, if it is decided that the most likely case is a 5% devaluation of the foreign currency each year, a cash ﬂow plan using that premise should be prepared. It can then be varied by asking “what if ” it is less or more than 5% and the same plan and assessment done at 3% and 4%, or 6%, 7%, 10%, etc. Another scenario that should be performed is “what if ” there is appreciation rather than devaluation and the plan is assembled using 2% or 5%, etc. The relevant range of possible changes depends upon the foreign currency under consideration. Brazil can be safely expected to have its currency continually devalue, and only devalue. The range, however, is very wide and volatile, perhaps 100% to 200% per year. The Netherlands on the other hand could have its currency move in either direction but probably no more than 10% each way. After the economic analysis is ﬁnished then a probability-of-occurrence analysis should be performed and a weighting given to the results. For example, if there are two probable scenarios — a 5% devaluation and an 8% devaluation—and the probability is judged to be 80% for the 5% case and 20% for the 8% case then the following cost estimate can be made and incorporated into the estimated results: 5% devaluation NPV 0.80 A 8% devaluation NPV 0.20 B Expected value of exchange movement A B (iii) Political Risks. It is necessary to estimate the costs associated with the political risk of investing in a particular country. This risk can be deﬁned as the risk that the foreign government intervenes in some unexpected way that affects cash ﬂow to the parent. There are several exposures in this area: • Unexpected change in repatriation restrictions. In order to force reinvestment in its country, a government may forbid any funds from leaving the country or it might severely limit the amount or percent. For example, in India the amount “repatriable” is negotiable but must be approved by the authorities. • An unexpected change in withholding taxes on remittances • An unexpected change in import duties • An unexpected change in labor and wage laws • Devaluation of currency • Expropriation of assets

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In this latter extreme situation there are two effects on the cash ﬂow to the parent: 1. The assets are not paid for by the expropriating government, or the payment is less than fair market value. 2. Future cash ﬂows from operations are lost. Insurance against expropriation can be purchased in the United States through the Overseas Private Investment Corporation (OPIC), but there is a premium to be paid that represents immediate cash outﬂow that must be weighed against the present value of the possible future loss. There are sources of information on each of the political risks. For example, in the United States there is Frost and Sullivan’s World Political Risk Forecasts. This publication summarizes the expert opinions of individuals knowledgeable about each country relative to three kinds of investments: 1. Financial — loans to the country 2. Investment — direct investment in the country 3. Exporting — exports to the country It assesses the political stability of the country, government restrictions (duties, tariffs, control of natural resources), and economic policies that affect inﬂation and exchange ﬂuctuations. This information and data like it make it possible to establish ranges of probability in estimating factors over many future years that will affect cash ﬂows of foreign subsidiaries. It is the controller’s responsibility to ensure that this analysis is done as best it can be and not ignored because it is too difﬁcult or includes too much “soft” data. (f) TRANSFER PRICING. An international transfer price is the value given to goods or services produced or performed in one country for the beneﬁt or use by a related company in another country. For example, the ABC Company, an American company, has subsidiaries in Germany and France. It has a manufacturing plant in Germany that supplies products to both France and the United States. It has a computer center in France that services France and Germany. Its headquarters and research and development facilities are in the United States. Transfer prices have to be developed for: • Products shipped from Germany to France and to the United States • Information services performed by France for Germany • A share of R&D expense to be paid by France and Germany • A management fee assessed by the U.S. parent on its subsidiaries We will now examine how each transfer price could be determined. (i) Development of the Transfer Price. It is usually the responsibility of the corporate controller to develop the transfer prices that will be used in dealings between subsidiaries or between parent and subsidiaries. The price used will result in a proﬁt or loss for the exporting country and will directly inﬂuence the proﬁt or loss ultimately realized in the importing country. Such a situation has led some multinationals to develop transfer prices that are very subjective and result in the lowest proﬁt (or even losses) being reported in the highest tax rate countries and conversely the highest proﬁt being realized in the lowest tax rate countries. While this approach seems logical and defensible at ﬁrst glance, it is unfair and has resulted in more laws and restrictions by the countries that believe they are being taken advantage of. Furthermore, in recent years the Internal Revenue Service (IRS) has taken a more aggressive stance in its search for transfer pricing abuses. The use of subjectively developed transfer prices also complicates the measurement system and frustrates local management because it cannot control or inﬂuence a signiﬁcant item of cost. A more businesslike approach is for the controller to establish a uniform, objective system of transfer pricing that is: • Simple and inexpensive to administer • Understandable to the users

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• Fair in its effect on measurements An arm’s-length, objective system can take two forms: 1. Cost based 2. Market based (ii) Cost-Based System. A cost-based system, the one usually favored by American companies, uses the output of the company’s cost accounting systems and adds a markup for proﬁt to it. This proﬁt factor is usually established for the long term and not changed unless it becomes unrealistic. One approach to establishing the proﬁt factor for a country that manufactures a product is to use a long-term (e.g., ten-year) average of the consolidated company’s net-income-before-taxes margin. Other objective and fair methods can be identiﬁed by each company. Once established, the estimated transfer price should be published and used in the preparation of ﬁnancial plans by the various units. The markup on the transfer of services performed by one unit for another is more subjective and a ﬂat percentage is usually established and not changed. For example, computer services could be marked up 10%, treasury services 5%, and so on. The important factor is that after a reasonable decision is made as to amount, then it should not be changed and it should be applied uniformly in all countries. If products are marked up 15% and services 10%, there should be no exceptions made based on unique facts and circumstances. To allow deviations introduces complexity and confusion into the internal system and causes consternation and distrust on the part of country regulators and tax authorities. (iii) Market-Based System. A market-based system, the one usually favored by many European countries, starts with the expected selling price in the importing countries and reduces it by estimated locally incurred cost, expenses, and proﬁt, to arrive at a transfer price that is affordable to the importer. This price is then used by the exporter in billing the related company and should recover the actual costs incurred in the production of the goods and services along with a reasonable proﬁt. In order to make a market-based transfer-pricing system effective, the transfer price must be accurately developed and then published and used until it is revised. (iv) Royalties. Whether a cost-based transfer price system or a market-based transfer price system is used by a multinational company it will probably also employ a “royalty” system in addition. The transfer price system is used to move goods and services between related companies. A royalty system is used to recover, from the subsidiaries, compensation for “know-how,” the use of brand names, company logos, and the like. The two most common royalties charged to subsidiaries are for: • Research and development • Parent-company management The royalty for R&D is traditionally a percentage of sales. It can be based on the ratio of R&D expense of the consolidated company to total sales of the consolidated company applied to the total sales of the subsidiary company. The resultant amount, less any locally incurred R&D, would be the R&D royalty due to the parent company. A parent-company management royalty is usually not based on a ratio but is rather an apportionment of the total parent-company staff and general expense based on a relationship of the subsidiaries. One method is the percent each subsidiary contributes to gross income applied to the total parent-headquarters expense pool. Another is a negotiated fee based on number of employees, proﬁt margin, growth, and so on, but which recovers all parent-headquarters expenses. In applying these approaches to the example given at the beginning of this section, the transfer prices shown in Exhibits 9.5 through 9.8 would be developed. (g) TAXATION. Tax laws in each country are extensive, complex, and changeable. Since the impact of the laws is to share a signiﬁcant percentage of the company’s proﬁt (on average, 30% to

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a. Product manufactured in Germany at a cost of 1,000 DM

a. Computer center work done in France at a cost of 100 FF

b. ABC Company NEBT margin 12% (for last 15 years)

b. Uniform markup for all nonproduct goods and services 10%

c. Transfer price 1,000 12% (12% 1,000) 120

c. Transfer price 100 10% (10% 100) 10

Total 1,120 DM E XHIBIT 9.5

Total 110 FF

D EVELOPMENT OF T RANSFER P RICE FOR P RODUCTS

E XHIBIT 9.6

DEVELOPMENT OF TRANSFER PRICE FOR N ONPRODUCT S ERVICES

a. R&D expense for consolidated ABC Company $10,000 (average 10 years)

a. The parent-company corporate expense for current year $20,000

b. Total gross income for Consolidated ABC Company $200,000 (average 10 years)

b. Gross income by unit

c. Royalty for R&D R&D Expense Gross Income 5% of Gross Income d. Germany current year gross income Royalty at Total at 2 DM $1 France current year gross income Royalty at Total at 4 FF $1 E XHIBIT 9.7

U.S. France Germany Total

$ 10,000 $200,000

Management fee $20,000 % U.S. 63 France 12 Germany 25 Total 100%

80,000 DM 5% 4,000 DM $ 2,000 100,000 FF 5% 5,000 FF $ 1,000

$ 100,000 20,000 40,000 $160,000

E XHIBIT 9.8

% 63 12 25 100% $ 12,600 2,400 5,000 $20,000

D EVELOPMENT OF R OYALTY FOR P ARENT -C OMPANY M ANAGEMENT

D EVELOPMENT OF R OYALTY FOR R ESEARCH AND D EVELOPMENT

60%) with the various governments of the countries in which the ﬁrm does business, it is essential that local tax experts be available to the company. These local tax professionals have the responsibility to understand local tax law, interpret the law as it applies to the company business, advise local management how to minimize taxes, and handle the ﬁling and reporting of local tax returns. The local tax expert should also be aware of possible tax changes and assess the effect of such changes on the local business. He would then keep the parent’s tax executive (e.g., controller) informed of important matters. While it is essential to have local tax experts it is also important to have a coordinated tax operation. This will require an expertise that is broader but perhaps not as deep as the local requirements. It is this centralized organization that develops tax planning and strategies and thereby contributes to the overall ﬁnancial plan of the company. The senior tax executive has the responsibility of: • Estimating taxes to be paid by period • Negotiating disputes with authorities • Providing advice and counsel to local experts He should also have the authority to resolve disputes and disagreements. Aside from the complications of foreign taxes, the controller must be sensitive to the U.S. tax laws and regulations. The IRS carefully checks transfer prices. New tax laws are being enacted to eliminate loopholes. In 1993, a law was passed to eliminate “earnings stripping” by foreign

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companies. This occurs when a foreign entity uses large loans instead of direct equity investment to fund its U.S. activities. The interest payments on the loans become a tax deduction, thus “stripping” away U.S. tax exposure. The controller and tax executives minimize taxes in all legal ways; therefore, they must be continually aware of any relevant changes in U.S. tax laws. (h) IMPORT/EXPORT REGULATIONS. At one time, up until the early part of this century, the primary source of income for the various governments was from tariffs on imports. The regulations covering the tariffs are lengthy and complex. They represent an accumulation of many years of continual tinkering with the rules and laws. It is therefore of real importance that the controller have an understanding of these regulations so that he can organize and operate in the most effective manner and in the best interest of the company. Very often the import/export department does not report to the controller, but the controller must be knowledgeable about the operation and be involved in negotiations, procedural controls, and so on. Duties are usually assessed on imports not on exports. However, it is the exporter who must prepare documentation in accordance with the regulations of the country of import so that the goods delivered into the country are clearly labeled and identiﬁed. This facilitates customs clearance and should result in earlier delivery of products or services to customers and earlier receipt of payment by the exporter. There are many import/export brokers who are invaluable in helping ﬁrms ﬁnd their way through this most complex operation, worldwide. Their services should be utilized. The parent company working with subsidiary company management should identify and engage the broker best qualiﬁed to handle the kind of business in which the company is engaged. (i) MANAGING CURRENCY RISK. A controller can take some steps to lessen the impact of wildly ﬂuctuating currency on the operation of the business, insofar as imports and exports are concerned. If, for example, the parent currency is stable and strong, then billing and requiring payment in the parent’s currency will eliminate losses due to the decline in value of a foreign currency. Assume the following wherein the foreign currency has an inﬂation rate of 10% with a corresponding loss in value of its currency.

U.S. dollar Foreign currency

May 1

June 1

1 1

1.0 0.9

The U.S. company sells 1,000 units at $1.00 each on May 1 and bills the customer $1,000 to be paid in 30 days. On June 1, $1,000 is received from the customer and deposited in the bank. There is no gain or loss on the transaction. However, what happens if the U.S. company sells 1,000 units at 1 foreign currency each on May 1 and bills the customer 1,000 foreign currency. On June 1, 1,000 foreign currency is received from the customer but when converted into dollars at the bank only $900 is deposited. There is a $100 loss due to changes in exchange rates (inﬂation). What can the U.S. company do to protect itself against such a loss? There are several actions available. • Do business only in the parent company’s currency. • Require cash payment on delivery if business is done in foreign currency. • Buy a forward exchange contract if business is done in foreign currency and credit terms are offered. (i) Currency Hedging. The ﬁrst two items need little elaboration. If the transaction is made in the seller’s currency then all risk of loss is transferred to the buyer. If cash is paid on delivery there is no risk of exchange loss.

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However, in many instances, those two options are not available and the seller must do business in foreign currency and offer credit terms. In these instances, in order to mitigate the exchange loss the seller can buy a contract from a bank to sell foreign currency 30 days after the transaction. In the example, the contract would be bought on May 1 to deliver 1,000 foreign currency on June 1. The price is established by the bank (which is also entering contracts to deliver foreign currency to other customers) and might be for $950 for each 1,000 foreign currency delivered. The amount of loss is therefore known at the time the contract is entered into. This is called hedging and while it takes uncertainty out of the transaction, it will still produce some loss to the company, since the bank will charge a fee for handling the exchange contract in addition to reﬂecting an estimate in the movement of the currency. If the company is purchasing from a foreign business, similar dynamics are at work. If you buy in foreign currency you stand the risk of inﬂation impacts. If the foreign currency declines faster than the buyer’s currency there will be a gain; if slower, there will be a loss. The loss can be hedged by buying a contract to purchase foreign currency at a set price at some time in the future. Again, this will not usually eliminate the exchange loss, but it will eliminate uncertainty as to how much it will be. Hedging can be used in connection with the payment of dividends, interest, and royalties, and can also be extended further into the future to cover probable purchases (e.g., where there is a single foreign supplier) and sales in an ongoing operation. (j) FOREIGN CORRUPT PRACTICES ACT. No discussion of the controller’s role in international operations would be complete without addressing the FCPA. In the 1960s and 1970s, some multinationals had been involved in bribing foreign ofﬁcials in order to get or keep business in their countries. It was a serious problem that had to be resolved. In December 1977, the U.S. Congress passed an act making it illegal for an issuer of securities in the United States to make certain payments to foreign ofﬁcials. It also required such issuers to maintain accurate records. Following is a summary of the Act’s key requirements: 1. Payments to ofﬁcials. The act made it unlawful for American companies to offer money or gifts to any foreign ofﬁcial, political party, or political candidate in order to inﬂuence that person in his ofﬁcial capacity. Inﬂuence meant having the person fail to perform his ofﬁcial duties or having the person use his inﬂuence with others in order for the company to obtain or retain business in the foreign country. The penalties for violation of this act are ﬁnes of up to $1,000,000 for any concern convicted of the violation. In addition, individuals involved in such illegal payoffs are subject personally to ﬁnes up to $10,000 and prison for up to ﬁve years. 2. Accounting and control requirements. The act also requires that issuers of securities make and keep books, records and accounts in reasonable detail, that accurately and fairly reﬂect the transactions and dispositions of assets. Devise and maintain a system of internal accounting controls that is sufﬁcient to provide reasonable assurances that: (a) The transactions are executed in accordance with management’s general or speciﬁc authorization. (b) Transactions are recorded as necessary to permit preparation of ﬁnancial statements in conformity with GAAP. (c) Transactions are recorded to maintain accountability for assets. (d) Access to assets is permitted only in accordance with management’s authorization. (e) Asset records are veriﬁed with physical assets periodically and appropriate action taken with respect to any differences. The controller has a basic responsibility to comply with the requirements of the FCPA and any related legislation and amendments which pertain to maintaining an adequate system of internal control. (See Chapter 8.)

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CHAPTER

10

RECRUITING, TRAINING, AND SUPERVISION 10.1

INTRODUCTION 159

10.5

IMPORTANCE OF REDUCED TURNOVER 164

10.2

RECRUITING SOURCES 159

10.6

10.3

FACTORS TO CONSIDER WHEN RECRUITING 162

IMPORTANCE OF DEVELOPING CAREER PLANS FOR EMPLOYEES 167

10.7

10.4

FACTORS TO CONSIDER WHEN PROMOTING 163

IMPORTANCE OF COMMUNICATIONS WITH EMPLOYEES 169

10.8

HOW TO MOTIVATE EMPLOYEES 171

10.1 INTRODUCTION A prospective controller is well advised to peruse this chapter several times, for it contains information that is vital to the controller’s career. If the accounting staff is carefully selected, properly trained, and motivated, the controller will enjoy a huge productivity advantage over a controller who does not pay attention to these factors. The inevitable results of not doing so are slipshod work, high employee turnover, and massive inefﬁciency due to the time needed to constantly recruit and train new employees. Consequently, the recruiting, training, and supervision functions are crucial to the success of a controller. It is unfortunate, but business schools rarely give any formal training in this most important area, so controllers must pick up the requisite knowledge through either hands-on experience, a mentor, or additional training. This chapter is also a valuable source of information on the topic, but should be used as an overview. More detailed information can be obtained from books that deal entirely with business management.

10.2 RECRUITING SOURCES This section describes a number of sources a controller should consider when searching for candidates for accounting positions. There are three key factors involved in selecting a recruiting source, and these factors are discussed for each of the possible recruiting sources: 1. Recruiting cost. The cost of recruiting an accounting person can range from $100 for an advertisement in the local newspaper to one third of the hired person’s salary, which is a typical charge if the person is hired through a search ﬁrm. The recruiting cost tends to have a low level of importance if the recruiting task must be completed at once and a higher one if there is a long time line involved. Also, the lower-cost approaches tend to involve extra time by the controller to screen recruits, whereas more expensive approaches, such as using a search ﬁrm, tend to require less screening time, because this task is completed by the 159

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intermediary. In short, a cheap recruiting method takes longer and requires more effort than an expensive approach. 2. Recruiting quality. The quality of the person hired tends to go up if there is a long time interval for the recruiting process. This is because a controller can take the time to obtain a large pool of candidates, interview them at his or her leisure, and spend the extra time needed to review their references. The reverse is generally true if there is a time crunch involved. However, these assumptions are generalizations, for it is also possible to run into a perfect candidate on the ﬁrst day of a search. 3. Recruiting time. As noted in the ﬁrst two factors, the time allowed to conduct a recruiting campaign will usually result in higher costs if there is little time available, because a controller must resort to expensive sources. Also, there is a chance that the quality of candidate recruited will be lower if the recruiting period is short, because there is only enough time to meet with and evaluate a limited pool of candidates. Once a controller has determined which of these three factors (or a combination thereof) are paramount in the search for a speciﬁc candidate, it then becomes an easier matter to select the correct recruiting source. For example, if a controller needs a new payroll clerk immediately, even if there is a high cost involved, it is best to go straight to a search ﬁrm, which will charge an inordinately high price but will present a set of qualiﬁed candidates in as little as a day. However, if there is no rush to ﬁll a position, the search ﬁrm may be the last source consulted. The recruiting sources are: • Audit and consulting ﬁrms. It is common for a controller to hire from the ranks of the auditing and consulting ﬁrms that work for the company. This approach is very inexpensive, because the controller probably already knows the best performers within these ﬁrms and just calls them to see if they are interested in a position. This can also result in a fast hire, so there is a very short time line involved. The quality of the person hired also tends to be high, because the audit or consulting ﬁrms have already done the prescreening when they hired these people. In short, this is an excellent way to bring in top-notch personnel quickly and at low cost. • Authors. A rarely used recruiting technique is to hire the authors of published accounting works. This approach ensures speciﬁc knowledge by the candidate of the subject matter for speciﬁc jobs. However, there is no assurance that this knowledge equates to good job performance. Also, there are very few published authors within the geographic range of most companies, so the volume of candidates acquired through this approach is slim. The cost and time needed to hire through this approach are minimal, because the controller already knows the name of the person to hire —it is simply a matter of making contact and arranging an interview. • Campus recruiting. A good recruiting source for lower-level positions is the college campus. However, it is difﬁcult to determine the quality of the people hired, because they have never worked before. Also, this tends to require a very long lead time, since candidates must be recruited months in advance; thus, this approach is useful only for ﬁlling positions that are constantly needed and for which accurate hiring projections can be made. It is also expensive to send personnel to colleges for recruiting and costly to bring in candidates for additional interviews. • Employees. One of the best sources of recruits is current employees. This approach works best when a company offers recruiting bonuses to employees. This incentive turns the entire employee group into an enthusiastic horde of recruiters. They have the additional advantage of recruiting their own friends, which typically results in a great deal of prescreening by the employees, resulting in a high quality of recruit. This also tends to be a fast way to gain recruits. The only problem is that the recruiting bonuses paid to employees can be rather large, usually exceeding $1,000 and sometimes going higher than $5,000 for each person hired. • Former employees. A controller should go to great lengths to maintain contact with quality employees who have left the company. Sometimes, the reasons why they left (higher pay, better positions, etc.) are not good enough, and they may be willing to return to the company.

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This approach is not only quick and inexpensive, but best of all, it results in highly qualiﬁed candidates who require minimal interviewing before being hired back. This is one of the best recruiting methods, though it typically results in only a very small proportion of the people hired into the accounting department. • Internet postings and advertisements. A new recruiting method is to use the Internet. This can involve either posting a job or reviewing posted resumes. Either alternative is inexpensive but requires screening an inordinate number of potential recruits. It is a quick recruiting method that even beats the speed of newspapers, because one can access an Internet site and immediately review resumes or post a job opening, with no transactional delay. However, this approach is similar to newspapers (see below) in that the quality of recruit tends to be low. • Newspaper advertisements. This approach involves placing ads in newspapers to attract candidates. This is the most common recruiting method, but it has a major problem: It typically results in a vast number of applications, which requires a great deal of screening to arrive at a small group of qualiﬁed candidates (or none at all!). However, advertisements are inexpensive and can be placed in newspapers on very short notice. For the more senior accounting positions, this approach tends not to result in a very large pool of qualiﬁed candidates. The biggest reason for the low quality is that only those people who are actively looking for work are reviewing the advertisements; this ignores the most qualiﬁed people, who are currently working elsewhere. • Professional organizations. This approach involves meeting qualiﬁed candidates through the meetings of professional organizations. It requires a great deal of “face time” by a controller or other members of the accounting staff, who must attend many organizational functions to meet with potential recruits. Though there is a minimal direct cost, the amount of labor by the accounting staff can be excessive. Also, it takes many months of attending meetings to build up a lengthy list of potential recruits. However, this can result in high-quality candidates who have been prescreened through the organizational meetings. Due to the time involved, this tends to be a little-used recruiting method. • Professional publications. This involves advertising in a professional publication to which an accounting person subscribes, such as the Journal of Accountancy. The advantage of this approach is that only a select group of trained accountants will see the advertisement, which thereby reduces the pool of recruits to a select group, thereby increasing the quality of applicant. This tends to be a slow recruiting method, due to the lead time needed to advertise, so it works best if there are many accounting positions that must be continuously ﬁlled. • Search ﬁrms. This is the most expensive recruiting approach, for search ﬁrms typically charge between one quarter and one third of a hired person’s ﬁrst year’s salary as their fee. However, there are good reasons for using this method. One is that the search ﬁrms conduct their own screening of candidates, which results in a higher quality of applicant. Also, most search ﬁrms maintain a lengthy backlog of resumes, and so can bring in many candidates on short notice. Thus, the quality of recruits and the speed with which they can be brought to the controller may offset the high cost of this alternative. • Unsolicited applications. The lowest-cost recruiting method is to receive an unsolicited application, because there is no advertising cost at all. Also, if a company stores these applications, there is no wait time needed to collect resumes, since they are all kept on ﬁle. However, despite these favorable points, unsolicited applications tend to result in the lowest possible quality of candidate. This is because there is no screening mechanism built into the process, which results in lots of interviews by the controller to separate the chaff from the wheat. On the whole, the extremely low quality of candidates results in very few companies relying on this recruiting approach. There are a variety of ways to recruit qualiﬁed accounting candidates, based on the key factors of time, cost, and quality of recruit. A controller can pick a selection of recruiting methods from

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this list to create a mix of methods that will greatly enhance the chance of bringing in the right recruits within the required time frame and at the right cost.

10.3 FACTORS TO CONSIDER WHEN RECRUITING There are a number of applicant attributes to consider when recruiting. An applicant should possess as many of them as possible to a high degree, for any lack may lead to an excessive degree of turnover, poor job performance, or complaints by other people who work with the recruit. The key attributes fall into the categories of technical ability, communication skill, and stability. In more detail, they are: • Integrity. The accounting department has some control or inﬂuence over the disposition of assets, the reporting of ﬁnancial information, and the use of controls. If a person lacks integrity, a controller may ﬁnd that assets go astray, ﬁnancial information is incorrectly reported, or controls are not enforced. The resulting havoc occurs because accounting personnel were not concerned about doing the right thing. Instead, accounting employees must care about their reputation for honesty and objectivity, which causes them to point out unethical considerations or actions to higher management even if such things are not illegal but perhaps only misleading or unfair. Due to the extreme importance of this factor, any hint of minimal integrity on the part of a candidate should immediately disqualify that person from receiving a job offer. • Process knowledge. The accounting function is similar to manufacturing in that it involves highly predictable process ﬂows that must be carefully organized in order to reach peak levels of efﬁciency. Clearly, it is of great use if new employees already have these skills, so it is useful to include process ﬂow questions in an interview. To determine whether an applicant has these skills, interview questions should cover an applicant’s knowledge of and experience in implementing and using accounting best practices. Applicants with this kind of background are most likely to create an efﬁcient and effective accounting department. • Certiﬁcation review. If an applicant holds one of the major accounting certiﬁcations (e.g., certiﬁed public accountant, certiﬁed management accountant, or certiﬁed internal auditor), the company should contact these certifying organizations. There are two reasons for doing so. First, the company should verify that the applicant actually has earned the certiﬁcation and that it has not lapsed. Second, the company should ask if there have been any warnings (of which there are various levels, such as license suspensions or revocations) issued by the certifying organization to the applicant for misconduct in the past. Any such occurrences should be grounds for considerable additional investigation prior to issuing a job offer. Usually, given the level of trust required in an accounting position, it is not a good risk to hire someone to whom a warning has been issued. • Communication skills. An invaluable attribute is excellent communication skills. In order to succeed, a candidate should be able to actively participate in meetings with other employees, clearly summarize and present information, and create understandable written reports. It ultimately means having others understand what you want to tell them. This can be difﬁcult when ﬁnancial people communicate with nonﬁnancial people, because the complexity and jargon of the profession must be replaced with simple business language. • Drive. Though a candidate may have an overwhelming impressive set of credentials, strong interpersonal skills, great integrity, and ﬁne background experience, none of these factors will be of much use if the person lacks the drive to complete work in a timely manner and take the initiative in undertaking new projects. This is the key underlying factor impacting a person’s ability to be promoted into new and more difﬁcult positions. It is also one of the most difﬁcult issues to fully understand when interviewing a candidate. To do so, a considerable portion of the interviewing time should cover a candidate’s underlying goals and objectives — a strong goal orientation is a sure sign of a strong drive to succeed.

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• Technical capability. An accounting recruit must have the basic accounting knowledge that can be imparted only through a regular course of training, which can include a bachelor’s or MBA degree. Possessing such a degree from an accredited university should form the basis of a minimal technical qualiﬁcation. If the person does not have such a degree, then further evaluation is necessary to ensure that the person can adequately complete any assigned work. Bringing an untrained person into a professional job, no matter how good the other qualiﬁcations, will probably result in that person’s becoming dissatisﬁed and discouraged and eventually leaving the company or requiring unusual amounts of management attention. • Teamwork skills. An applicant must be able to function with the rest of the group. It is easier to identify characteristics that will inhibit integration rather than those that will guarantee it. If a candidate, who should be on his or her best behavior, comes across as abrasive, it is reasonable to expect that this person will have a negative inﬂuence on the work group. This behavior will likely turn off fellow workers and require an excessive proportion of the controller’s management attention. Both results will detract from the quality of performance of the work group as a whole. For evidence of teamwork skills, the interviewer can question the candidate about leadership roles. This can be leadership in school activities if the person is coming from college, or civic or work-related activities if the person has some experience outside of college. • Turnover likelihood. Because it is a time-consuming and expensive process to hire a professional, it follows that the people who are hired should have a high probability of staying with the company. There are many considerations in trying to assess a candidate’s staying potential. From the candidate’s perspective, some of the considerations are the likelihood of being satisﬁed with his or her professional responsibilities, prospects for advancement, and degree of comfort with the culture of the organization. From the company’s perspective, some of the considerations are the person’s ability to handle changing environments, acceptance of retraining, and ability to relocate as necessary. Evaluating these considerations may be the most difﬁcult assessment of all for a recruiter to make. Each of the above subjects should be discussed in depth and the candidate’s views and preferences carefully considered. There are a variety of factors to consider when evaluating a potential job candidate. It is useful for a controller to review this list of factors prior to extending a job offer.

10.4 FACTORS TO CONSIDER WHEN PROMOTING A controller can do a wonderful job of recruiting the best possible staff and still experience high staff turnover due to a poor promotion policy. This section discusses two kinds of promotion, as well as the reasons for engaging in one type versus the other. The most common kind of promotion is one that shifts a staff person sideways through the hierarchy of the accounting department. This type of promotion is intended to expand a person’s skill base. For example, a person who is fully experienced in the billing area can be shifted to accounts payable in order to gain experience in how that functional area operates. The same approach can be used to add to the experience of the staff in other areas, such as collections, ﬁxed assets, taxes, or producing the ﬁnancial statements. This type of promotion can be given to the entire accounting staff, which rotates among the various functional areas. Generally, it reduces turnover, because the controller is giving all employees a chance to acquire new skills. However, the reverse can also happen if a staff person does not want to shift to a new skill area, and may even quit if the change is effected. A controller must watch out for this problem by carefully interviewing the staff about prospective switches to new areas. If it is clear that a person has “maxed out” and no longer desires to learn new tasks, then it is best to leave that employee alone in order to avoid any turnover. A less common type of promotion is of the vertical variety, in which someone is shifted upward in the corporate hierarchy. This will always be less common, for there are far fewer positions available at the management level than at the clerical level. Promotion to a management position is

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based on the presence of an entirely different set of skills than are used as the basis for a sideways promotion. A controller must be extremely careful in evaluating employees for promotion to a management spot, for any missing skills may not only result in the departure of the person being promoted (who was probably an excellent performer at the lower, clerical level), but also of the staff reporting to that person, and will likely result in a great increase in the time required by the controller to handle the situation. What are the key skills needed by someone being promoted to management? Certainly, it is necessary to have a reasonable knowledge of accounting theory and practice, but the primary emphasis is no longer in these areas, especially as a person is promoted to higher levels of the organization. Instead, the main focus is on people skills: communication, team building, reviews, and interviews, as well as planning and control. The mindset of anyone in this position is to effectively coordinate the activities of the underlying personnel, not to continue doing the work that took place prior to promotion. This is an extremely difﬁcult transition for many people in the accounting profession, for it is ﬁlled with a large proportion of people who are introverted and process oriented, which results in a good clerk but a poor manager. The best approach for a controller who has just promoted someone to management is to realize the most likely traps into which the former clerk can fall, and to provide constant monitoring and advice. This should be intensive during the ﬁrst few days of the promotion, thereby giving the promotee the best possible chance of succeeding in the new position.

10.5 IMPORTANCE OF REDUCED TURNOVER The bane of many accounting departments is the turnover of the accounting staff. It results in staff turmoil, inefﬁcient transaction processing, and lots of wasted time on the part of the controller. This section describes the impact of turnover, and how to prevent it from happening. Some company departments assume that high employee turnover is a common fact of life, and that they must continually deal with bringing in a high percentage of new employees every year. This is true for many low-skill areas, such as assembly, where the entire workforce can turn over in one year. Alternatively, a highly skilled profession with lots of stress, the consulting industry, also has very high turnover, typically in the range of 25 percent to 33 percent per year. However, the accounting area should not be an excessively high-stress area, so it should not have the turnover rates common in consulting. It also requires a signiﬁcant level of skill, so its turnover rates should not match those of an assembly operation. Instead, a controller should target a turnover rate well below 20 percent, and preferably only half that amount. This means that the average accountant should stay in the controller’s department a minimum of ﬁve years, and preferably ten. By keeping the staff turnover rate as low as possible, a controller can avoid many problems that result in gross inefﬁciencies, poor customer service, high error rates, and increased costs. These problems are: • Add poorer methods. A new recruit may have his or her own ways of dealing with transactions, which may not be as efﬁcient as the ones developed during the tenure of the person being replaced. When this happens, the efﬁciency level of the position drops for some time, until the new person has reviewed and evaluated how work is completed and improved operations based on that experience. • Increased costs. Not only must a controller pay for recruiting costs to replace someone (e.g., newspaper advertisements, search ﬁrm fees, and travel expenses), but there are the added and less clearly deﬁned costs of training new employees and correcting the inevitable mistakes that they will make as they learn their jobs. In addition, the controller must pay for replacement staff to ﬁll in during the period when the old employee has already left the company and the new one has not yet started. • Increased inefﬁciency. The typical new hire, unless vastly experienced, will not reach the efﬁciency levels of the person being replaced for at least six months. This inefﬁciency will appear in several ways: the extra time required to complete tasks, the extra temporary help

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needed to support the person, and the time of other staff people needed for training. For some recruits, performance never reaches the level attained by the previous employee, in which case the controller may be forced to move the new hire to another position, or else let the person go and then spend even more time looking for another replacement. • Increased time by the controller. The recruiting process is a very time-consuming one, and the time a controller puts into it takes away from other tasks, such as preparing and evaluating ﬁnancial statements, undertaking new cost-reduction projects, or analyzing various accounting-related proposals from around the company. In short, recruiting reduces the time available for completing other aspects of the job. • Loss of specialized knowledge. Every company has a unique set of processes. When a company loses an employee, it also loses that person’s knowledge of the processes. When a new person arrives to replace the outgoing person, some of that specialized knowledge may be lost, or at least take many months before it is assimilated from the other members of the accounting department. If turnover is extremely high, there may so few “old timers” left in the department that this specialized knowledge is permanently lost. • Risk of an inappropriate hire. Bringing in a new person carries with it the risk of hiring someone who is hiding a past of improper behavior, who may attempt to take company assets once in a position to exercise control over assets (a common enough position in the accounting department). Another risk is that a controller may ﬁnd that the person hired is so inappropriate for the position that termination is the only answer, and then ﬁnd that the new employee has sued the company for wrongful termination. No matter how correct the controller’s actions may be in getting rid of the employee, the company must still expend a large amount of money to defend itself against litigation. Obviously, there are many reasons to avoid turnover. However, in today’s environment of highly mobile employees who can ﬁnd work elsewhere in little time, and who feel little association with a single company, how is it possible to drive turnover down to such low levels that a controller no longer has to deal with its effects? The answer is to meet the needs of employees. They may not feel any closer association with the company (a difﬁcult proposition), but they will react well to an enlightened style of management that is revealed by the factors noted in the following list, such as ﬂex hours, slightly higher rates of pay, and recognition programs. A controller will ﬁnd that these factors will vastly reduce turnover by giving employees no possible reason to leave the company. The ways to reduce turnover are: • Clarify jobs and related procedures. There is nothing more irritating for a new employee than to be unceremoniously dumped into a new job without any clue regarding what the job entails or how to perform tasks. This lack of information causes a great deal of stress for a new employee, who must essentially build a job description from scratch, probably making mistakes along the way. It is also difﬁcult to get a good performance review if there is no baseline job description against which to be measured. A controller can avoid this degree of uncertainty by supplying each new employee with an accurate job description that is supplemented by detailed procedures that clearly describe how each required job element can be completed. An example of such a job description is shown in Exhibit 10.1. • Improve communications. Employees want to know what is going on. For example, a controller can sit down with the accounting staff every month, after ﬁnancial statements are published, and go over the company’s results with them. This gives the staff a good feel for how the company is doing, what they can do to improve the situation, and (above all) it tells the staff that the controller is not trying to hide anything from them. This sets the tone for an open and constructive dialogue between the controller and the staff; if the controller is willing to impart information to them, they will be more comfortable with bringing information to the controller.

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Position:Assistant Controller Report To: Controller Review Dates: 1. 01/20 2. 04/20 3. 07/20 4. 10/20

Quarterly Review Quarterly Review Quarterly Review Annual Review

Pay Change Criteria: 1. If issue ﬁnancial statements within 5 days of month-end. • OK performance: ____% if reach 5 day close by end of 20XX. • Good performance: ____% if reach 5 day close by September 20XX. • Great performance: ____% if reach 5 day close by July 20XX. 2. If achieve accounts receivable turns of 9.0. • OK performance: ____% if reach 9 turns by end of 20XX. • Good performance: ____% if reach 9 turns by the end of September 20XX. • Great performance: ____% if reach 9 turns by the end of July 20XX. Overview of Tasks: Timing

Description

Daily Daily Daily Daily Daily Daily Daily Monthly Monthly Monthly Monthly Monthly Monthly Monthly Monthly Monthly Monthly Yearly Yearly

Collect accounts receivable Maintain general ledger accounts Receive and apply cash receipts Run batch jobs and backups Clear checks for accounts payable and accounts receivable Reconcile invoices with customers Take deposits to bank Calculate monthly quality bonus Complete bank reconciliations Conduct internal audit tasks Create variance report Prepare borrowing base reports Prepare ﬁnancial statements Prepare tax returns Prepare workers’ compensation insurance reports Track ﬁxed assets Track mold shop expenses Create documents for annual audit Update archives

Development Areas: 1. Financial statement preparation 2. Activity-based costing 3. Report writer training E XHIBIT 10.1

S AMPLE J OB D ESCRIPTION

• Increase pay. Many companies have a policy of paying employees the median pay rate for their job classiﬁcations. Though this ensures that a company is not paying too much for its staff, this policy does not take into account the total cost of employment. If a company loses employees to competitors who are willing to pay somewhat more than the median pay rate, it must then incur substantial additional costs to recruit and train a replacement. When this

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recruitment cost is added to an employee’s median pay rate, it becomes apparent that a company should actually pay somewhat more than the median rate in order to avoid the costs of turnover. • Look for a history of job longevity. A controller can avoid turnover up front by hiring only recruits with a history of staying with their previous companies for long periods. This avoids potential employees who are more likely to walk out for minor reasons over which a controller may have little control. • Meet special employee needs. Employees may have special needs, such as ﬂex time, so that they can handle various aspects of their personal lives that might otherwise interfere with company business. A controller should consider these needs and modify employee work routines (within reason) so that employees can continue to work for the company. It is important not to allow too many exemptions to speciﬁc employees, because this may engender ill will among other employees who do not appreciate the special favors being extended to a minority of them. • Recognize employee efforts. Some employees make exceptional efforts on behalf of the companies where they work, yet receive no recognition for these efforts. After going to extra lengths to help the company, an employee should receive some special recognition, which makes that person want to stay with the company—not because they are making more money or have a fancy title, but because they feel appreciated. This type of recognition can take a variety of forms, such as tickets to sports events, plaques, public recognition, or an employee- of-the-month parking spot. • Review employees frequently. Employees want to know where they stand in terms of performance, potential advancement, and the impression given to coworkers. It is difﬁcult for an employee to make meaningful changes to work habits in a timely manner if this information is communicated only once a year, during the annual review. Instead, a controller should schedule informal quarterly reviews to supplement the annual review, plus more frequent feedback if there are issues that require immediate corrective action. By giving frequent reviews, a controller not only ensures improved behavior by employees, but also a better sense by staff of how they are doing, which reduces their level of uncertainty. There are a number of techniques for avoiding turnover, which tend to emphasize clear job descriptions for employees, frequent communications, and paying attention to special employee needs. By taking these steps, a controller can greatly reduce the costs of turnover and increase the productivity of the accounting department.

10.6 IMPORTANCE OF DEVELOPING CAREER PLANS FOR EMPLOYEES Even though accountants are known to be a thoroughgoing and detail-oriented group, most do not engage in a sufﬁcient degree of career planning. This results in a considerable amount of movement between jobs, as they go in search of perceived incremental improvements to their positions, presumably resulting in better titles, greater responsibilities, and more pay. This behavior also results in a great deal of turnover, which, as noted throughout this chapter, is anathema to any controller. This section describes how to lock in employees for long periods of time by assisting them in developing career plans. For the typical accountant, there is no speciﬁc career plan, and for only the rare few is it even committed to paper. A more common career plan is to acquire some sort of certiﬁcation or college degree early in the career and then use these credentials to gradually work up through the ranks at a corporation until reaching the pinnacle of success, the chief ﬁnancial ofﬁcer (CFO) position. Because only a small proportion of accountants can reach this position (after all, there are not many CFO positions available), every accountant needs a great deal of preplanning to assist in achieving this goal, or to aim for goals culminating in different positions. The controller can assist

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with this difﬁculty by meeting each staff person and comparing the aspirations to the existing set of experience and skills, and determining where there must be improvements for that person to reach whatever the goal may be. This plan should clearly deﬁne required skills, a time line for achieving them, and speciﬁc action steps by the staff person as well as the controller to ensure that those steps are reached. For example, an accounts payable staff person may have no experience with payroll. To acquire it, the controller can commit to assigning the staff person as a backup to the regular payroll person for the next year. In exchange, the payroll person will become the backup for the accounts payable person for the same period. This ensures that both employees acquire more knowledge and experience. Why would a controller go to some lengths to ensure that the entire accounting staff will eventually be in a position to replace the controller? There are several reasons. First, putting every staff person on a solid career path will lock them into working for the company for a long time. For example, encouraging employees to take reimbursed college courses will keep them with the company until a degree is acquired, which can easily take six years. Also, rotating a staff person through all possible accounting areas takes a number of years, especially if the company is a large one. In both cases, a controller can effectively reduce (if not eliminate) turnover by keeping the entire staff busy with various kinds of training programs. The second reason is that very few accounting employees really have the wherewithal to become a CFO; instead, they will be promoted to the point where the job responsibilities match their abilities, and they will stop. By using career planning and reviewing progress, it will become obvious to both the staff person and the controller when this point is reached, and the controller can then shift the motivational focus to retaining that person in the same position for as long as possible. Third, a mature controller will realize that an accountant who has the ability to eventually become a controller or CFO should be allowed to do so. Rather than getting mad at an employee who has been thoroughly trained by the controller, it is best to throw a farewell party for the person and maintain relations when the person moves on to other organizations. This not only maintains goodwill between the controller and the former staff person, but also makes it easy for the person to return someday, or to refer other people to the controller for various positions. Finally, a controller can use career planning to determine the timing of changes in the department. For example, if it is obvious that a qualiﬁed subordinate should go outside the company to take a controller position elsewhere, the controller can use the career plan to make a rough estimate of when this might occur (or even discuss the issue with the subordinate), and then make plans to promote other people in an orderly fashion to ﬁll in the post that is about to be vacated. In short, career planning reduces turnover while promoting employees to the maximum level and allowing the controller to plan for employee advancement in an orderly manner. Some controllers include career planning in an employee’s annual review. This is a mistake, because the annual review is supposed to cover issues that the employee is required to do, whereas a career planning session discusses items that are optional — an employee may take additional steps to advance his or her career, but those steps can be taken at the discretion of the employee. For example, a goal that might be discussed during an annual review is the ability of an employee to issue ﬁnancial statements within a speciﬁed time period and to determine a course of remedial action if that goal has not been met. A career planning session discusses any steps an employee has taken along his or her career path, and what assistance the controller can give in furthering that person’s aspirations. In short, a controller adopts the role of a supervisor when using an annual review to cover immediate performance issues, but must switch roles to be a mentor and coach when covering career planning issues. Due to the different roles of the controller and the differing types of discussions, these two meetings should not be merged. A key part of career planning is sharing the salary ranges of targeted positions with the accounting staff. There is a considerable motivation in knowing that there is a large increase in pay associated with gaining a higher-level accounting position. Telling employees about market rates for desired positions can also keep them from making a mistake in pursuing a position that does not yield a signiﬁcant pay increase in proportion to the amount of work required to attain the position. One may think that there is some risk in appearing to promise speciﬁc pay rates to employees well in advance of their being placed in those positions, so it is important to tell employees up front that prospective pay rates fall within fairly wide pay ranges, and that they can expect to begin

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at the lowest levels of the pay rates and gradually gain additional compensation as they gain experience and skill. Informing employees of the pay rates for future positions is a key part of the career planning process. A controller should encourage the accounting staff to earn certiﬁcations. There are many accounting certiﬁcations, all of which require a considerable amount of training before one can pass the required examinations. By taking the training, an employee can improve his or her skill set, which directly beneﬁts a company by bringing more expertise to its accounting operations. To encourage the acquisition of certiﬁcations, a controller should actively pursue the purchase and distribution of study materials, as well as pay employees for the time off needed to take the tests. To really encourage acquiring certiﬁcations, a controller can even offer one-time bonuses or pay raises to those who have successfully completed their examinations. The most common certiﬁcations for an accounting person to earn are: • Certiﬁed Public Accountant (CPA). The examination is standardized, but additional certiﬁcation requirements vary by state. Contact your state’s Department of Regulatory Agencies (or such similar organization) for more details. The examination requires three days of testing. • Certiﬁed Management Accountant (CMA). The examination is standardized and requires 90 hours of CPE every three years to renew. The examination requires three days of testing. Address: Institute of Certiﬁed Management Accountants, 10 Paragon Drive, Montvale, NJ 07645. Phone: 201-573-6300 • Certiﬁed Internal Auditor. The examination is standardized and requires 100 hours of CPE every three years to renew. The examination requires two days of testing. Address: Institute of Internal Auditors, 249 Maitland Avenue, Altamonte Springs, FL 32701. Phone: 407-830-7600 • Certiﬁed Production and Inventory Manager. The examination is standardized and requires no continuing education. There is no required renewal. The examination requires the completion of six tests, which can be completed at different times. Address: American Production and Inventory Control Society, 500 West Annandale Road, Falls Church, VA 22046. Phone: 800-444-2742 • Certiﬁed Production Manager. The examination is standardized and requires 120 hours of CPE every ﬁve years to renew. The examination requires one day of testing. Address: National Association of Purchasing Management, P.O. Box 22160, Tempe, AZ 85285. Phone: 602-752-6276 Some of the certiﬁcations listed do not directly cover accounting topics. Instead, they address such areas as production, logistics, and purchasing. It is useful for an accounting person to acquire these extra certiﬁcations, because there is great value in having a broad knowledge of how a wide array of processes function throughout a company.

10.7 IMPORTANCE OF COMMUNICATIONS WITH EMPLOYEES The title of this chapter includes the words “training” and “supervision.” Communicating with employees comprises a key element of both activities. A controller should include a variety of modes of communication with the accounting staff, which can vary in frequency based on the type of communication. This section notes the different types of communication, as well as the offsetting risks of losing some conﬁdential information to competitors. There are several distinct types of communications that a controller should use. One consists of operational information. This type of information describes company performance, and that of the accounting area in particular. It can include such performance information as the number of days to issue ﬁnancial statements, accounts receivable turnover, and the dollar amount of accounts payable discounts that were not taken. It is crucial to impart this information regularly, because the accounting staff needs it to determine its own performance, as well as to form a basis

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for requesting additional improvements in the future. The information is best presented in a historical context, so that there are a string of performance ﬁgures that clearly show a trend line of performance; this is best presented in a chart or white board, so that the information is presented visually, not verbally. Another type of communication consists of ﬁnancial information. Since one of the primary functions of the accounting staff is to generate information that is summarized in the ﬁnancial statements, it makes sense to show them the result of all that work — the ﬁnancial statements. Many company managers shy away from the prospect of revealing company performance to employees, especially if performance is poor, but one of the best ways to motivate employees is to give them this information; then they are more likely to pitch in and suggest ways to improve performance. The only type of ﬁnancial information that one can legitimately withhold from employees is salary data, because this is considered conﬁdential by most managers, not to mention most employees. Financial information can also include the budget, which can be shared with the staff without divulging payroll information. The ﬁnancial statements and accompanying budget yield much greater employee understanding of a company’s overall situation. An additional type of communication is of personal performance information. This is a form of communication that many controllers do not perform well. The worst case is when controllers essentially ignore the accounting staff, never giving them any feedback on their performance. This tells the staff nothing about how they are doing, and in the absence of information, they tend to assume the worst. The next worst form of communication is going over performance only during an annual review. Though many controllers consider this to be a sufﬁcient interval for giving feedback, it is actually far too infrequent. There may be a problem with performance early in the review period, which a controller notes for the annual review but does not mention to the employee until the actual review. This means that the staff person is performing improperly for nearly a year before getting any feedback! Many controllers delay in giving feedback because they do not relish the charged emotional atmosphere that frequently results. However, by waiting until the review and churning out a long list of faults, this tends to exacerbate the situation and results in a difﬁcult review. By far the best way to issue personal performance information is by wandering through the accounting area on a daily basis and giving feedback in small doses to everyone. This gets the staff used to continual feedback and results in a vastly more relaxed working environment. In short, the frequency of feedback is very important when relaying personal performance information. A ﬁnal type of communication is of general information. This can be directives issued by senior management (such as news about a company merger), notes about the work schedule (such as when the company will observe holidays), or similar information. Though the most minor forms of general information can be communicated by such media as voice mail, e-mail, or the venerable memo, more important information, for which employees may have questions, is best communicated in person. The timing of the information may also have a bearing on the form of communication used. For example, a notice regarding when an ofﬁcial holiday will be taken is easily communicated by memo if done a month in advance, but may require an in-person discussion if it is being communicated one day in advance, because this may interrupt work schedules and require some negotiation with the staff regarding taking alternate holiday time. Thus, the form of communication used to impart general information depends on the lead time used, as well as the likelihood of answering questions from the staff. This section has focused on feeding as much information as possible to the accounting staff, on the assumption that a well-informed staff is a satisﬁed one. However, the response of senior management to this approach is frequently that of the risk to the company — what if a dissatisﬁed employee takes the information to a competitor or issues it to the press? Of course this can happen, but usually only when relations with the staff are so bad (perhaps due to a lack of information) that employees are actively looking for a way to harm the company. In this case, the controller is well advised to look for employment elsewhere, since the working environment is exceptionally difﬁcult. When staff relations are good, the risk of disseminating information outside the company is much lower. To provide additional coverage to the company, all ﬁnancial information can be marked as classiﬁed, which gives the company some recourse to legal action if it ﬁnds that infor-

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mation has left the company. Usually, it is much more beneﬁcial to issue information to the staff than to worry about the much smaller risk that the information will get out to the general public or to competing ﬁrms. The recurring recommendations in this section have been to give lots of information to the accounting staff, and to do so as frequently as possible. This is very important for maintaining good staff morale and usually results in better performance. Many old-time controllers who were brought up in an environment of “closed books” will have a hard time with this approach, especially if it requires lots of face time with employees. Nonetheless, the controller who invests time in his or her staff will reap considerable rewards in terms of a happy, well-informed, and productive department.

10.8 HOW TO MOTIVATE EMPLOYEES Motivating employees clearly improves employee morale as well as department performance, but motivation should be based on a multilayered motivation scheme that covers the long, medium, and short term. By using this multilayered approach, employees are presented with a richer environment in which to work, which is more satisfying for them, and gives them many good reasons for staying with the company. This section discusses multilayered motivational systems. A long-term motivational system is based on the career plan. As noted earlier, in the “Developing Career Plans” section, the controller should discuss career options with all accounting employees, and devise a progression of steps that will last for a number of years, culminating in greatly increased levels of experience and expertise for them. This is an excellent long-term motivator, but does not grab the attention of the typical employee on a day-to-day basis, because it is typically comprised of course work that happens only after working hours or involves occasional seminars or job switches. Something more is required that will make motivation a more immediate issue. A midrange motivational system is the annual performance goal. Many controllers set up goals for each employee to reach, which are used in determining pay raises or bonuses at the end of the year. Examples of these goals are increasing accounts receivable turnover through greater attention to collections, taking all purchase discounts, and issuing ﬁnancial statements by a speciﬁed date. These can even be tied to a speciﬁc pay raise. For example, accounts receivable turnover of 8.0 can be awarded with a 2 percent raise, while a turnover rate of 10.0 will result in a 3 percent raise. This type of motivational system is an excellent way to focus the attention of the staff on key improvement goals, while rewarding them as well. Though this is a good motivator, especially when used in concert with the longer-range career plans, it still does not focus day-to-day attention on the tasks at hand. That requires a short-range motivation system. A short-range motivation system is one that grabs and holds the attention of the accounting staff every day. This system is much more difﬁcult to arrange than the long-term and midrange motivational systems, and also requires much more work by the controller to keep it operational and meaningful. The reason for the excessive level of attention is that the motivational targets must be changed from time to time to avoid boredom, while the types of awards must also be changed for the same reason. When constructing short-term goals, a controller can devise an enormous array of potential targets, such as the cleanest desk or the fastest response to an e-mail. However, it is best to create group goals so that the entire team wins, rather than just one person. The targets are not necessarily intended to cause any long-term change. Instead, they should be fun and make employees feel better about coming to work. For example, a clean desk week may leave no lasting impression or enhance company performance, but it will give the staff something to focus their attention on in the very short term. Also, the rewards for reaching such goals should involve the group, such as a free team lunch or a block of tickets to a sporting event. The reward should always act to bring the group together by treating them as a unit, not split them apart by giving different awards to different people. A short-range motivational system is targeted at employee morale, not at reaching any quantiﬁable goals. In summary, employees can be motivated with three types of motivation systems. The ﬁrst is the long-range career plan, which requires minimal attention by the controller to maintain. The

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second is annual performance goals; this is the most common motivational system employed by controllers and also requires minimal work to maintain. Finally, there should also be brief, team-based contests or targets in the very short term (e.g., weekly) to grab the attention of the accounting staff and add some spice to the work experience. This short-term system requires the most work by the controller but also greatly contributes to a more pleasant work environment, which is a prime factor in motivating employees.

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CHAPTER

11

CONTROLLER’S ROLE IN INVESTOR RELATIONS 11.1

INTRODUCTION 173

11.7

11.2

OBJECTIVES OF THE INVESTOR RELATIONS FUNCTION 174

INFORMATION NEEDS OF OTHER GROUPS 178

11.8

DISCLOSURE POLICY 178

11.3

EVOLVING NATURE OF THE FUNCTION 174

11.9

ORGANIZATION STRUCTURE FOR INVESTOR RELATIONS 179

11.4

COMMUNICATION VEHICLES FOR INVESTOR RELATIONS 174

11.10 ROLE OF THE CONTROLLER AND OTHER PRINCIPALS 180

11.5

INVESTOR RELATIONS MESSAGE RECIPIENTS 175

11.6

INFORMATION NEEDS OF THE FINANCIAL ANALYST 176

11.11 CHANGES IN THE CAPITAL MARKETS 182 (a) Some Suggested Financial Market Objectives 182 (b) Some Suggested Methods 183

11.1 INTRODUCTION Very little has been written about the controller’s role in investor relations (IR). This is partially because many controllers, by all outward signs, are not actively engaged in this function—at least as far as the public is concerned. In Chapter 2 of this text, investor relations activities of the controller are included in the category of “Additional Controller Functions.” To many outsiders with an interest in investments, the controller is variously regarded as the “inside man,” the number cruncher, the ﬁgure man, or the introverted accountant. To be sure, many of these same representatives do not have a real understanding of what the controller should do or can do. In contrast to this view of the controller, in discussions with security analysts, they have expressed opinions to the authors concerning a preference for talking about ﬁnancial matters with the controller because “he has the facts” (while many of the nonaccounting-trained public relations persons do not). Certainly, if the chief accounting ofﬁcer wishes to climb the ﬁnancial ladder or aspire to a broader executive career, experience in the IR arena may be very useful. In reaching some conclusion concerning those duties the controller might perform in this interesting IR function, a review of the following facets may help in ferreting out those activities for which the controller might be suited, and which he or she might enjoy: • The objectives or purpose of the IR function • The nature of the function • The principal vehicles used to convey ﬁnancial information • The nature of the “customer” • What type of information is desired and limits on its disclosure • Some brief observations about organization structure in this ﬁeld 173

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11.2 OBJECTIVES OF THE INVESTOR RELATIONS FUNCTION In a general sense, it may be said that the principal purpose of the IR function, regardless of who performs it, is the enhancement of shareholder value. Isn’t this a familiar term? The stated purpose by the perpetrators of some hostile takeovers is “to enhance shareholder value”; the defense against such actions, as voiced by some chief ﬁnancial ofﬁcers (CFOs) of the targets, is an effort “to enhance shareholder values by increasing the price of the common stock.” As a matter of fact, one of the purposes of sound ﬁnancial policy is to enable the company to raise funds, on an acceptable basis, to meet its needs, so as to enhance the long-term interests of the shareholder; and a related corollary is to cause the entity to be so well regarded in the ﬁnancial marketplace that its stock will command an acceptable price/earnings ratio. Some chief executive ofﬁcers (CEOs) might still regard the IR function as a simple ﬁnancial reporting activity, with no intent to affect the stock price. But many CFOs will bluntly state that the objective is to maximize the market price so as to minimize the cost of equity capital. Executives of brokerage houses will acknowledge that a continuing IR program helps prepare the market for a public offering, and inﬂuences the credit ratings of ﬁxed-income securities. Certainly, the importance of the stock price is not lost on those CEOs engaged in sell-offs, acquisitions, or other restructuring. In the view of the authors, these enumerated purposes, however described, translate into an objective of enhancing shareholder value. In today’s environment, companies must compete for investment capital—whether in the bond market or the equity market. But to secure recognition, the story of the enterprise must be told. Just as the advantages and uses of a company’s service or product must be described and marketed, so also information about the value of an entity’s securities and its ﬁnancial prospects must be disseminated, understood, and accepted.

11.3 EVOLVING NATURE OF THE FUNCTION Investor relations has been, and probably still is, an evolving activity. About 30 years ago, it often was a part of the public relations department, perhaps viewed as a somewhat specialized communication function. In the 1950s through the 1960s and into the early 1970s, with the rapid growth of employee retirement funds, many blue-chip companies, including General Electric, used skilled communicators to “educate” portfolio managers and brokerage intermediaries about the investment merits of the company’s stock. By the mid-1970s, when many individual investors abandoned thestock market, when the market was dominated by large institutions, when many less-than-blue- chip companies felt they were neglected by the brokers and investing institutions, and when the need for more capital intensiﬁed, many managements became more aggressive, and began directly contacting potential investors, both institutional and individual, who were willing to take more risks and were often receptive to growth situations and better-than-average returns. The individuals representing these companies were variously communication specialists and security analysts. In this time frame, with the growth of dividend reinvestment plans, self registration, and an increased recognition of the need to plan and sell new security issues, the IR function became more marketing oriented. These changes also induced changes in the nature of the IR specialist. While communicators (public relations) and security analysts had predominated, gradually more and more individuals well acquainted with ﬁnance assumed a greater role. The customers became far more sophisticated about what they needed. So the IR function evolved into a combination of two disciplines—communications and ﬁnance. Accordingly, in this century, the IR function must not only communicate effectively about past performance, but it must more closely align itself with the strategic plans of management and tell its customers more about corporate goals and the entity’s strengths and weaknesses.

11.4 COMMUNICATION VEHICLES FOR INVESTOR RELATIONS At this point, perhaps a recap of the several vehicles now commonly used to communicate with “investor relations customers” may be helpful. Each is directed to a somewhat different audience,

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and each typically conveys a disparate or varied message—but always with an investor-related aspect. They are distinct in words and tone from the typical product or service advertising originating with the advertising or marketing department. The methods used to communicate investor-related messages, in no special order, include: • Annual report to shareholders • Quarterly reports to shareholders (and the ﬁnancial community) • Annual meeting with shareholders • Reports to the Securities and Exchange Commission (SEC) Annual Report Form 10-K Quarterly Report Form 10-Q Current Report Form 8-K • Regular or special meetings with security analysts, institutional investors, brokers, and large individual investors — often arranged in cooperation with one of the several associations or societies for analysts • Institutional advertising in newspapers or periodicals (ﬁnancial or general interest) • Dividend stuffers • Corporate announcements of special interest to investors or potential investors: New products or services Management changes Acquisitions and/or divestments Reorganization attempts, etc.: restructuring, unfriendly takeovers • Videocassettes dealing with ﬁnancial matters • Use of toll-free telephone numbers • Individual meetings with government representatives and the stock exchanges concerned with ﬁnancial matters (Internal Revenue Service, SEC, etc.)

11.5 INVESTOR RELATIONS MESSAGE RECIPIENTS Broadly and technically speaking, the IR function must service an unusually complex and diverse audience. For example, here is a typical listing (with some overlapping) of the vast potential “customers”: • Investors and potential stock investors (small) • Large institutional stock investors and potential investors • Security analysts • Credit-rating agencies • Financial advisory services • Brokerage ﬁrms • Bond-rating agencies • Bank loan ofﬁcers • Bondholders • Financial press • Portfolio managers • European/Japanese investors • Acquisition candidates • Government agencies dealing with ﬁnancial matters (federal, state, and local) • Employees

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Having said this, it should be realized that three broad groups with which the IR activity is primarily and continuously directed are (1) security analysts, (2) stockbrokers, and (3) large institutional investors. Practically speaking, and as discussed later, some of these information-seeking persons would deal directly with the CFO — that is, the bank loan ofﬁcer handling most of the company’s current bank borrowings, the bond-rating agency, or credit-rating agency—in some kind of one-on-one desired meeting that is heavily and technically ﬁnancial in nature. Many of the members of the three principal groups mentioned — security analysts, stockbrokers, or institutional or other large investors (or their representatives) — are quite sophisticated ﬁnancially. Each of the three groups may, and usually does, have different information needs; and each may be motivated, for different reasons, to discuss the ﬁnancial affairs of the entity.

11.6 INFORMATION NEEDS OF THE FINANCIAL ANALYST The management of a company usually desires that it be perceived in its most favorable light— hopefully without exaggeration, and as objectively determined. While communication with all segments of the IR audience on this matter is important, perhaps the key person is the ﬁnancial analyst, also called the security analyst. He is in a position to inﬂuence a large cross-section of investors. It therefore especially behooves the IR executives to know what information the analyst needs and how he will probably use it. It is imperative that the ﬁnancial executive involved (CFO or controller) properly interpret the information for this analyst and not merely infer certain conclusions. In most instances, the analyst desires information so that he can reasonably predict earnings (and hence market price, potential of the stock dividend rate, etc.). A most important source of information for the security analyst is management presentations generally made to large institutional investors, and brokers, or investment bankers, as well as the analysts themselves. The information gained from such meetings, plus that distilled from annual and quarterly reports, or Form 10-Ks and the like, together with discussions among other analysts, and other articles about the company and the industry, enable the analyst to reach certain conclusions about the entity and aid in helping him predict ﬁnancial performance. These analyst meetings present an unusual opportunity for the company to portray itself in its best light. They not only permit the company to make factual presentations, but also to subjectively inﬂuence the analyst about the depth of management and long-term objectives of the company. Moreover, they enable management to directly answer the questions of the group and fully explain troublesome events, such as complicated footnotes to the annual report and so forth. Each industry and each company has certain factors that are important to its well-being and growth. For example, in the aerospace business, the order backlog is of signiﬁcance, as well as the status of various contracts or programs. In other companies, product development might be of major interest. Facts and opinions should be divulged within the limits of prudent disclosure. Such meetings with analysts are not just public relations events. Solid and speciﬁc information is needed. While each entity has its own requirements, here is an outline of suggestions about presentation content to analysts for a well-established, reputable company. 1. To give a sense of an experienced, in-depth, and well-qualiﬁed management: (a) The CEO should be present and give the principal talk—about prospects, style of management, management development programs, market position, etc. (b) The key executives should be introduced, and usually should make some short comments about their areas of responsibility. (c) Perhaps the organizational structure and incentive system and the like should be discussed. 2. To provide an insight into the long-term prospects of the entity, the following subjects might be covered by a knowledgeable executive (CEO, executive vice-president, senior vice president of ﬁnance or controller): (a) The system or method of strategic planning (b) The short-term or annual plan process, and the related control system

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(c) Some examples of long-range objectives that have been achieved (and perhaps some that were not) (d) The long-range outlook for the industry or selected products or markets (e) The status of market penetration or dominance for some key products (f) Important research and development programs underway (Whether speciﬁc quantiﬁed projections or plans should be divulged may depend on the individual circumstances.) 3. To provide a broad ﬁnancial picture, including the ﬁnancial strength of the company, perhaps a slide presentation (graphs and charts) could be given that would identify: (a) (b) (c) (d)

Status of orders on hand Trend of sales, by product line Margins by product line, or organizational units, and trends thereof Financial position through comments about a condensed balance sheet, with emphasis on key ratios or relationships (e) The trend of long-term indebtedness, times debt service is covered, debt capacity, and so on (f) The trend of cash ﬂow by important segments: from operations, investing activities, and ﬁnancing activities, and perhaps cash ﬂow per share from operations (g) Trends on equity and earnings: Growth in equity Equity relationships (ROE) Earnings per share Return on assets

(h) By simple explanation and illustration, any aspect of the ﬁnancial statements that often causes confusion (inventory, valuation method, tax accruals, reserves, etc.) (i) Perhaps some comparative ratios with industry or selected competitors (j) Company posture regarding acquisitions or diversiﬁcation 4. The chief marketing executive probably should make a presentation that would describe and illustrate major new products, or major revenue procedures, and the sales prospects for the next year or two 5. Other executives, as appropriate, might discuss any timely topics, such as: (a) Employee relations (b) Cost reduction programs (c) Process improvements, including use of computers (d) Information resource management (e) Quality control changes (f) Any major troublesome contracts or publicity items and the like The objective should include a demonstration of ﬁnancial conservatism, stability, and ability to raise capital when needed. Interpretation of what the ﬁgures mean should be given; it should not be left to the unaided judgment of the analyst. In fact, the executives deeply involved in the process should know their audiences and determine what they need to know, so that the analysts (and others) may make a proper evaluation of the entity. These are some key points that should be covered. Experience at meetings with analysts, including their questions, will provide guidance as to other subjects of interest. The data presented to the analysts might serve as a point of departure for responding to the information needs of other groups. Above all, the presentations by management, and the responses to questions raised by the analysts, must be open, frank, and responsive to the information needs. Any sense that management is

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not forthright and will not truthfully answer reasonable questions will cause analysts to choose not to follow the company’s progress.

11.7 INFORMATION NEEDS OF OTHER GROUPS The ﬁnancial analysts and large investors of all groups, as might be expected, do the most probing. Their approach is highly analytical. Usually, when a company can adequately communicate with this group, it can deal effectively with most others. These other players have varying interests, some of which involve answers to the items raised in the preceding sections. Perhaps the typical individual shareholder is most concerned with the general progress of the company and the prospect of continued and increasing dividend payments. A highly skilled ﬁnancial background is not required to meet her inquiries. At the other extreme, a bank loan ofﬁcer will be interested in the prospects of repaying the loan on time; and it might be proper to make available to him the annual plan or budget for the next year or two, and perhaps the long-range ﬁnancial plan. His relationship is more conﬁdential than the general public, and he is entitled to such knowledge. Bond-rating agencies may be exposed to past and prospective debt service coverage and related matters. Credit agencies, who have the published annual report available, may direct their questions to the content of the balance sheet items, and prospective earnings. Many other investors may be interested in the signiﬁcance of certain litigation, or product development. The required ﬁnancial knowledge of the IR interface person will depend on the types of questions and the inquisitor’s knowledge and interest.

11.8 DISCLOSURE POLICY In providing information to or communicating with analysts, brokers, investors, or others, a matter to be resolved is: What constitutes proper and adequate disclosure? Typically, management is concerned about excessive disclosure that may harm the company. On the other side of the question, there should be sufﬁcient disclosure to enable the analysts and others to discern shareholder value. Hence, the problem is one of weighing the beneﬁts versus the costs. On the one hand, the dangers of excessive disclosure include: • Loss of competitive advantage through early disclosure of new products or marketing strategy or other strategic information • Exposing the entity to litigation by reason of allegedly providing insider information, or attempting to foreclose competition or otherwise violate antitrust laws • Generating earlier competitive reaction, or even new competitors, than would otherwise be the case • Revealing strengths or weaknesses that might invite an unfriendly takeover attempt Most analysts would prefer to get information ﬁrst, or early, but normally there is no beneﬁt to them in causing long-term share decline. And most appreciate the need to protect competitive information. While there is a danger in excessive disclosure, there are sometimes unrecognized costs of insufﬁcient disclosure. Some of these are the following, resulting in a share price lower than normally might be the case: • Failure to provide adequate data may encourage analysts and others to avoid the company and fail to follow its progress. • Lack of information may cause unpleasant or unexpected surprises—something the ﬁnancial community abhors. • If the management does not maintain good relations with analysts and investors, it usually takes much longer for positive developments to become known and reﬂected in the stock price.

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• Most importantly, lack of ﬁrsthand knowledge, such as that secured through personal contact, prevents analysts and other interested parties from “kicking the tires”— from assessing the depth and quality of management, the adequacy of the company’s controls, its ability to cope with change, as well as the quality of the product and services. The IR group and management must thoroughly weigh what constitutes a proper balance in its disclosure policy.

11.9 ORGANIZATION STRUCTURE FOR INVESTOR RELATIONS A successful IR program must, as previously mentioned, permit the exercise of two skills by company executives: the ability to (1) communicate effectively and (2) ferret out and comprehend the ﬁnancial signiﬁcance of operating trends and relationships, together with the composition of the various elements in the ﬁnancial statements and their signiﬁcance or impact. Company representatives must clearly, and often in sophisticated or knowledgeable ﬁnancial terms, discuss highly technical ﬁnancial issues with a great many types of investors or potential investors. What organizational structure best ﬁlls or facilitates this execution? Several structures may be observed in operation, but one truth is paramount: There must be a coordinated approach; the company must speak with one voice. Thus, confusion is created if the vice president of sales discusses the potential ﬁnancial impact of a new product to a group of distributors as having certain results, and the ﬁnancial vice president describes a quite different ﬁnancial impact with a group of ﬁnancial analysts. Assuming adequate and effective coordination among the company’s spokespersons, as to the presentation of ﬁnancial data, what organizational structure is desirable? One answer is, “The one that is effective.” The external or investing public of a company is viewed by many top executives as consisting of several parts of the whole. The result is a dichotomy of views about proper organization: • In some companies there is no single executive who is responsible for the external investor relations (as distinguished from employee relations). Basically, each major executive meets with his audience, e.g., a research audience, a marketing audience, a manufacturing group, a ﬁnancial group. However, whenever ﬁnancial content is involved, it would be cleared with the proper ﬁnancial executive. • In other entities, a single executive is held accountable for the IR function. Under this latter scenario, the IR activities might be a segment of the public relations department (renamed an investor relations department). Also, under such a plan the ﬁnance department, including the controller, would be considered an internal function — a resource to be made available to those responsible for the IR activities. • Some other organizational structures divide the responsibility into two segments: (1) The activity relating to preparation of the annual and quarterly reports to shareholders, institutional or ﬁnancial advertisement, small shareholder inquiries, and the like, is handled by the public relations department (and coordinated with ﬁnance)—the so-called mass media facet; (2) the unit relating principally to contacts with security analysts, large institutional or individual investors, investment bankers, rating agencies, and so forth — that audience assumed to possess considerable ﬁnancial know-how—is handled by an investor relations unit reporting to the CFO or a ﬁnancial ofﬁcer. Presumably the members of this unit have a ﬁnancial background (CPAs, accounting, investment banking) but have also been trained in communication skills. The type of “customer” determines the unit most likely assigned the task. There must be coordination with the public relations segment or unit. Finally, one other factor should be mentioned as a possible participant in the IR activity, and that is a professional IR agency. While such a ﬁrm often may be used by small companies, sometimes they can also be helpful consultants to medium-sized and larger entities in properly organizing the

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IR function. The authors should point out, however, that most investor/analyst types prefer to deal with a member of management, and not an outsider, in seeking ﬁnancial information about a company. The proper organizational structure for a speciﬁc company will depend, again, on the interests, ability, and personality (and perhaps ﬁnancial interest) of the ofﬁcers and executives who are actual or potential participants—consistent with management philosophy, style of management, available time, and so forth.

11.10 ROLE OF THE CONTROLLER AND OTHER PRINCIPALS Having provided only a very general background on the sources of ﬁnancial information about the company, the type of inquirers, and suggestions about management presentations to the security analysts in particular, the basic question is, “What should be the role of the controller?” As is often true, what functions an ofﬁcer performs depends on several factors, including his or her ability, personality, and interests, along with the interest and capabilities of the other ofﬁcers, as well as the size of the company, management organization structure, management style, and so forth. If there is a CFO as well as a controller, the duties will be shared. And in those instances where the CEO feels he himself should play a major role in IR, that will further divide the effort. If the controller is a good ﬁnancial analyst, certain activities will tend to be assigned to this position; and if the chief accounting ofﬁcer is, in addition, a good presenter or communicator, then still other duties are likely to fall in this direction. For the typical medium-sized to large company, where the CEO is somewhat active in IR, and where the CFO tends to spend some time with IR activities, a likely split of functions might be listed as: Controller 1. An information resource or source for any ﬁnancial data, for those ofﬁcers and executives who need it for IR purposes including: (a) Financial statements reﬂecting actual results and/or condition of the entity and/or any segments, such as (i) Statement of income and expense (ii) Statement of cash ﬂows (iii) Statement of ﬁnancial condition (b) Relevant ﬁnancial analyses of actual data and trends of these statements, as required for IR purposes, such as (i) (ii) (iii) (iv) (v) (vi)

Inventories Accounts receivable Long-term debt, by category of debt Plant and equipment, by location Relevant ratios, including comparisons with industry and competitors Detail and type of revenue and expenses by appropriate segment

(c) Financial statements and related analyses representing planned or forecasted results or condition, both the annual plan and long-range plan, for the consolidated entity and any segment. (This data should be available, but often should not be disclosed to the analyst groups, etc.) (d) Relevant graphs and tabulations, showing ﬁnancial trends and relationships, actual and projected. Basically, all ﬁnancial data (whether to be presented to outsiders, or simply used as background or a reference source) should be prepared under the supervision of, or by, the controller, subject to appropriate suggestions or constraints by the CFO or CEO.

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2. As required, an interpreter of the ﬁnancial data, when asked to do so by other major ofﬁcers or executives present, to the appropriate IR audience (groups, individuals [analysts, investors], ﬁnancial information sources such as Dun & Bradstreet, TRW, bank loan ofﬁcers, etc.) 3. A communicator of ﬁnancial information to individuals and groups entitled to receive it, under the applicable working rules. This would include presentations to groups or individual analysts, investors, or brokers, and so forth, as well as the answering of their questions. It might be that the controller would (1) make presentations in the absence of the CFO, and (2) give talks to small groups regularly, with the CFO (or even the CEO) handling the larger or more important meetings. Certainly, if the controller is a good communicator he or she should be trained to be the alter ego of the CFO. 4. Either prepares, or reviews for accuracy and completeness, any ﬁnancial commentary in such ﬁnancial documents as the annual report to shareholders, quarterly report to shareholders, Form 10-K, or 10-Q, etc. 5. A reviewer for content and accuracy all news releases, special announcements, and publications of the investor relations activity (and those of other executives) dealing with ﬁnancial/ accounting matters. As applicable, the controller would make his or her recommendations or comments to the CFO, unless she is authorized to make the ﬁnal decision in the event of disagreement or needed major changes. When the controller is de facto the CFO, he or she would exercise the duties listed previously, plus those of the CFO enumerated next. Chief Financial Ofﬁcer 1. Should be the principal communicator of ﬁnancial policy, and the reasons therefor, ﬁnancial status and operating trends and relationships to major groups, including the leading security analysts of the industry, major brokerage houses, and large investors — actual or potential — whether institutional or individual. 2. Should be the principal spokesman or negotiator, subject to approval of the CEO and/or board of directors, as may be applicable, in connection with the actual and imminent raising of capital—whether equity or indebtedness. Thus, he or she would be the principal contact with investment bankers, large commercial bankers, lessors, and institutions, using such advice and assistance deemed necessary. 3. Should delegate to the controller any of the above duties, and any lesser ones, relative to investor relations when deemed to be in the interest of the company, and assuming the controller is experienced and capable. 4. Should review all major published ﬁnancial documents (annual report to shareholders, quarterly reports, ﬁnancial news releases), and receive comments from controller, for accuracy, completeness, adequate disclosure, and the like. 5. If the IR department is a part of the ﬁnancial organization, should direct its activities, establish appropriate disclosure policies, and develop a competent and professional IR staff to handle those functions not assigned to the CEO or the controller or himself. If the IR activities are under the cognizance of the CEO or the public relations ofﬁcer, the CFO should make appropriate recommendations on suggested improvements. Chief Executive Ofﬁcer 1. Preside over major meetings with security analysts, large investors, and the like and present the background and related information on such important matters as: (a) (b) (c) (d)

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2. 3. 4.

5.

6.

Ch. 11 Controller’s Role in Investor Relations

(e) Any forthcoming major events that can be announced (management changes, acquisitions, divestments, etc.) Additionally, he should answer the questions of the audience on major public matters and the like. By bearing and knowledge he should demonstrate that he is, indeed, the CEO. Meet, on a one-to-one basis or with a few individuals only, any major investor, opinion maker, banker, and so on, who wishes to see him. Discuss major points as in 1 above. As appropriate in IR meetings, refer ﬁnancial questions to the vice president of ﬁnance or controller, and certain operating questions to the operating executive present. As to important ﬁnancing matters, meet with other major players, as deemed proper: commercial bankers, investment bankers, rating agencies, institutional investors, etc. He should lend support to the proposed transactions, provide relevant background about the company, and answer questions directed to him. Ascertain that the messages in any important public statements (e.g., the annual report, quarterly ﬁnancial reports, ﬁnancial-type news releases) are as he thinks they should be, or understand why not. Address important company matters and the annual meeting of shareholders.

11.11 CHANGES IN THE CAPITAL MARKETS Among other objectives, a purpose of the IR function is to enable the company to raise funds to meet its needs, on an acceptable economic basis, so as to enhance the long-term interests of the shareholders. But the ﬁnancial environment changes, among other things, as the business cycle changes, or the perceived relative status of the company or industry changes, or, indeed, as the moods of the investor vacillates. Some recent developments include demands by some pension funds that they have a greater voice in certain company policy decisions; increased agitation by unhappy shareholders about exorbitant levels of executive compensation or perquisites; pressures by some institutional investors to make the board of directors more independent of the CEO; proposals by company management for the “protection of shareholders” in the event of an unsolicited bid for the corporation; and vastly increased volatility in the stock market. While circumstances will differ company by company, there will be instances wherein the CFO, probably assisted by the controller, will ﬁnd it necessary to become more aggressive in cultivating the ﬁnancial market, and take these actions: (1) Establish speciﬁc ﬁnancial market related objectives, which will be in the shareholders’ interest; and (2) develop some methods of helping to reach these (new) objectives. All of this is to say that the IR function is not merely a passive communication caper. (a) SOME SUGGESTED FINANCIAL MARKET OBJECTIVES. The objectives of the company, with respect to ﬁnancial markets will depend on what condition appears to need improvement or change. In the experience of the authors, here are some typical objectives, one or more of which might apply to a particular entity: • Increase the P/E ratio to X, or to the Standard and Poor’s (S&P) 500 level, or to the best in the industry. • Lengthen the average stock holding period by attracting more long-term investors. • Reacquire 25% of the present outstanding shares through stock repurchase programs. • Increase the average daily share sales volume — to, say, 100,000 (so that institutions can buy or sell in a given day without signiﬁcantly moving the stock price). • Reduce volatility by expanding the shareholder base. • Build shareholder demand (by diversifying the shareholder base). • Create a greater demand for company bonds or other debt securities. • Reduce the proportion of shares held by institutional investors. While consistent earnings growth, based on good products and capable marketing, and a sound ﬁnancial position, are fundamental in attaining and maintaining many of these objectives, another

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aid is to target particular markets and properly communicate relevant ﬁnancial information. Which targets need to be reached will require an analysis of the present shareholder types, and so forth. A few comments on this phase follow. (b) SOME SUGGESTED METHODS. A successful IR program involves providing reliable, consistent, timely, and truthful information about the company on such matters as depth of management, developments as to products and markets, probable trend of sales and earnings, and some guidance on company ﬁnancial objectives—not only to the usual array of stock brokers, security analysts, and individuals, but more especially to carefully selected institutions that probably would be a desirable type of shareholder—who could aid in meeting the objectives set out in the investor relations agenda. Some suggestions include: 1. Maintain a current, well-documented background book which is available to all key executives, and for all key contacts with the investing groups. Such an information source would provide these beneﬁts:

2.

3.

4.

5.

(a) The reader will have a better idea of what subjects are matters of concern to an investor or potential investor. (b) The executives will have a consistent and uniform response to the queries. (c) The reader will be updated on the current developments in his company which should be communicated to the investing public. In terms of content, aside from the ﬁnancially relevant information on the company itself, the data book might contain information about potential investor contacts: location, position, investment patterns, availability for conference calls, and so on. Be certain that all key internal ofﬁcers are current on new and important developments and that the investor signiﬁcance is understood. With such a background, the likelihood is reduced of making offhand comments which can be misinterpreted. Establish close one-on-one relationships with selected institutional investors where particular investor relations objectives can be furthered. It already has been mentioned that increasing the investor base by the addition of long-term investors will lengthen the average holding period. Creating closer relations with institutional investors also may reduce volatility. Volatility occurs or increases because large segments of the shareholder population decide to take the same action at the same time, for example, sell the shares. If large shareholders are kept informed about the company, this may decrease the tendency to follow the actions of other investors. These long-term investors may buy more shares while the short-horizon investors may be selling—thus creating a balance in the marketplace, and maintaining the price. The program for contacting large institutional investors or potential investors can include periodically scheduled visits (once or twice a year) to the ﬁnancial centers (New York, Boston, Chicago, San Francisco, etc.) to meet particular institutional investors and security analysts. Consider the possibility of conference calls to selected investors or security analysts. This has the advantages of (a) making one call instead of numerous ones, (b) releasing the data to many sources at the same time, and (c) tends to keep the message more consistent. A disadvantage arises of making it more difﬁcult to answer all the questions of every analyst, and so on. In some circumstances, increase the contacts with noninstitutional investors. Some corporate ﬁnancial executives have felt their company might be vulnerable to extend pressures when too large a portion—say 75 percent to 80 pe rc e nt—of the shares were in the hands of institutional investors. For example, the entity might become a target for a hostile takeover. Hence, there could be merit in expanding the ownership base through appropriate and frequent contacts with buy-side security analysts, brokers, and so on. So there is much to be said for considering certain speciﬁc investor relations objectives and developing a speciﬁc program to meet them.

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PART

THE PLANNING FUNCTION OF CONTROLLERSHIP

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CHAPTER

12

BUSINESS PLANS AND PLANNING: INTERRELATIONSHIP OF PLANS, STRATEGIC PLANNING 12.1

INTRODUCTION 187

12.2

BUSINESS PLANNING DEFINED 188

12.3

FRAMEWORK FOR BUSINESS PLANNING 188

12.4

TIME AS RELATED TO PLANNING 188

12.5

PLANNING PERIOD: HOW LONG IS “LONG RANGE”? 189

12.6

SYSTEM OF PLANS 190

12.7

STRATEGIC PLAN: AN OVERVIEW 190

12.8

CORPORATE DEVELOPMENT PLAN 191

12.9

OPERATIONS PLAN 191

12.10 BASIC ELEMENTS IN ANY PLAN 191 12.11 PLANNING PROCESS 192 12.12 PLAN FREQUENCY 194 12.13 PLAN GUIDELINES 194 12.14 WHO SHOULD DO THE PLANNING? 195 12.15 SUPPLEMENTAL PLANNING: ALTERNATIVE SCENARIOS 196

12.16 PLANNING TIMETABLE OR SCHEDULE 196 12.17 STRATEGIC PLANNING: AN IN-DEPTH REVIEW 196 12.18 ENVIRONMENTAL ANALYSIS 198 12.19 CRITICAL SUCCESS FACTORS 199 12.20 BUSINESS MISSION OR PURPOSE 200 12.21 LONG-RANGE BUSINESS PLANNING OBJECTIVES 202 (a) Illustrative Long-Range Objectives 203 (b) Linking Objectives 203 (c) Setting The Long-Range Objectives 203 12.22 DEVELOPING STRATEGIES 205 (a) Appraising Alternative Strategies 207 (b) Some Illustrative Strategies 207 12.23 STRATEGIES AND THE PLANNING PERIOD 208 12.24 ROLE OF THE CONTROLLER 208 12.25 IMPROVING THE STRATEGIC PLANNING PROCESS 210

12.1 INTRODUCTION Business planning, when properly done, is a complicated but fascinating procedure, intertwined with all the functions or departments of the entity. This chapter discusses how the various elements of the strategic plan are interrelated and provides an overview of the planning process. It seeks to review some of the basic questions raised in the planning process and to consider in some detail the elements of strategic planning. Chapter 13 further shows how the elements of the strategic plan are combined into an integrated plan, expressed in ﬁnancial terms, covering a span of several years — a task of particular importance to the chief ﬁnancial executive and the controller. Chapter 14 then provides an overview of the short-term planning process and how the parts are combined into the annual business plan. 187

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12.2 BUSINESS PLANNING DEFINED The concept of business planning is not new. Many companies have utilized formal or organized plans for years. What is different, however, is the emergence of comprehensive planning systems and a new sense of urgency about the need to plan—whether it be because of the disastrous inﬂation of the early 1980s, the heightened foreign competition of the 1990s, the instability of international currencies in the late 1990s, or the speed of technological changes. Be that as it may, the ﬁnancial aspects of planning are important to business survival and growth; and the ﬁnancial ofﬁcers of the corporation should be aware of the interrelationship of plans, methods of planning, problem areas, and the concomitant ﬁnancial implications of each. Given the need for sound planning, what, then, is a plan? It is a predetermined course of action. The process of thinking ahead and making a judgment on a course of action, giving consideration to the many feasible alternatives available is the planning process. A plan, accordingly, must recognize three factors: 1. It must involve the future. 2. It must involve action. 3. It should give recognition to the organizational structure of responsibility, authority, and accountability by which action takes place in a given business. A plan assumes a predetermination to take action, which distinguishes it from forecasting. Forecasting may involve predicting the future to some degree, but it does not necessarily involve future action by the planner or his company. It often involves future action by someone else. Hence, forecasting may be used to predict future conditions or action by other forces, such as governments, competitors, and environment. The planner determines a course of action to reach an objective. Business planning may be done only in the mind of the chief executive or may involve a well-organized effort by many individuals. The problems of what, why, and how will be discussed.

12.3 FRAMEWORK FOR BUSINESS PLANNING Perhaps the best way to understand what constitutes good business planning is to recognize three separate and related elements: 1. The system of plans that should comprise the whole—for all activities of the business and for all planning periods—and their relationship to each other. 2. The orderly process by which each plan is formulated. 3. The basic elements that should be inherent in any sound plan of action. But before the planning system and process is discussed, it may be desirable to review the “time factor.”

12.4 TIME AS RELATED TO PLANNING In a sense, planning may be described as an opportunity to consider and experiment with the valuable assets (including both employees and materials) of a company before committing them to risk. The future period for which different industries must commit these resources varies greatly as, for example, from the season-oriented apparel business to the decade-oriented orchard or ranch operations. It is obvious in the planting of citrus groves or the building of a butadiene plant that a period beyond the immediate future must be considered. This properly should involve “long-range planning.” This difference in period for which planning must be undertaken can be better viewed in the light of “generations” of product and market. A company has existing products that are being sold in present-day markets and may be described as current generation products and markets. But at an unknown time in the future these existing products and markets will be superseded and replaced by new products and/or new markets, and so on ad inﬁnitum.

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The same business judgment that recognizes the inevitability of the change or evolution of things also understands the need for a complete planning process. This continual change in business environment as related to the potential of the company is best illustrated in Exhibit 12.1. The proﬁle of projected earnings indicates a downward trend in earnings from existing products or situations. Development projects now underway will slow the deterioration. However, it may be inferred from the exhibit that this company must attain at least the growth rate of the industry — through new developments, including a reevaluation of the existing business and present research and development projects, to avoid the “gap” of lost opportunity. And this process, if carried out properly, will involve all phases of business planning.

12.5 PLANNING PERIOD: HOW LONG IS “LONG RANGE”? Strategic planning sometimes is referred to as “long-range planning.” Just how far ahead should a company plan? What are some of the factors to be considered in selecting the proper period for which to plan? Each business has characteristics that need to be identiﬁed in determining the time period of planning. A company should plan ahead only so far as it is useful. Surveys on this subject indicate that among companies that do long-range planning, the most common period is ﬁve years, although the trend is toward a greater distance into the future. Some of the factors that serve as a guide in selecting the proper planning time span are: • Lead time for product development. This includes the length of time from the idea of a new product until the design, manufacture, and distribution are completed. One company may take three months, whereas another may require several years. • Length of life of the product. The probable period before a product is considered obsolete clearly will be a factor. • Market development time. This period can vary tremendously—from several years for a complicated industrial product to perhaps only several weeks for women's fashions. • Development time for raw materials and components. Some extractive industries such as iron ore mining or oil drilling may require a decade of advance planning. Wood products companies may consider a period beyond the life expectancy of their present management.

E XHIBIT 12.1

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S OURCE OF T HE “G AP ”

A

C OMPANY ’ S N ET I NCOME —

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• Time for construction of physical facilities. For many plants a minimum of two years for design and construction of a plant and its equipment is needed. • Payout period for capital investment. Obviously, the period over which the investment in capital equipment will be recovered must be weighed. Payoff may vary from several months in a highly speculative and proﬁtable ﬁeld such as certain chemicals to perhaps more than a decade for some utilities. Thought must be given to conditions that will prevail during this payout period to focus on the probability of recovering the investment and earning an adequate return on it. Consideration of these factors, plus any other pertinent ones, will give some indication of the minimum period for strategic planning.

12.6 SYSTEM OF PLANS There are three major components in an integrated planning structure: 1. At the summit or vertex is the strategic plan. It seeks to outline in general terms the characteristics and objectives of the ﬁrm. 2. Stemming from the strategic plan is the corporate development plan that concerns itself with the development of “new” products and markets. 3. Also deriving from the strategic plan is the operations plan that focuses largely on the existing generation of products and existing markets. Each is discussed subsequently.

12.7 STRATEGIC PLAN: AN OVERVIEW Strategic planning begins with the present and extends to the most remote period selected as useful for planning purposes and therefore should be included in the planning cycle. The purpose of strategic planning is to set the guidelines and policies of the company that serve as the basis for the next echelon of plans—the development plan and the operations plan. The strategic plan focuses attention on the needs, dangers, and opportunities facing the company. It identiﬁes the key decisions that must be made and usually sets guidelines and deadlines for making them. The process guides the company in decisions about the current generation of products as well as the next and succeeding generations of products and markets. Through this thinking and communicating process it helps assure that the plans and decisions of the various units are moving the company to the same agreed-on objectives. A strategic plan generally involves the following components: • A clear and understandable statement of the company’s basic purpose. Examples of such statements are: to maintain the existing share of market; to maintain ﬁnancial performance at not less than current levels; and to develop new business capabilities that will enable the company to have a faster rate of growth than the industry. • A carefully thought-out strategy or means to accomplish this basic purpose. This should include certain speciﬁc actions, such as: eliminate Division E and market area R, accelerate advertising program in Territory B, build Research and Development competence in X product line, and diversify by acquisition into S product line. • A statement of speciﬁc goals to be achieved under the strategy and means of measuring progress toward each. Examples include ﬁnancially expressed goals, such as: By the Year a. Sales 1. Dollars 2. Percent of present product total

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200X

200Y

$160MM 75%

$350MM 55%

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12.10 Basic Elements in Any Plan

191

By the Year b. Rate of return on investment 1. On assets employed 2. On common shareholder equity 3. On net sales c. Per share earnings

200X

200Y

12% 17% 5% $2.50

15% 23% 7% $3.40

• A statement of the assumptions or conditions used or needed to achieve the goals. These may include: continued guarantees of foreign investments, favorable decisions by the U.S. Department of Justice on pending cases, increase in the gross national product (GNP) by at least 3.5% annually, availability of suitable ﬁnancing at a cost of less than 11% per annum, establishment of a computer center for scientiﬁc applications, and inﬂation rates: 2000 – 2005, 7%; 2006–2010, 6%.

12.8 CORPORATE DEVELOPMENT PLAN Auxiliary to the strategic plan is the corporate development plan. It may be said to relate principally to the new product and market activities, to the actions or methods by which the new generations of products and/or markets will join existing ones. This product- and market-oriented development activity will concern itself largely with: • The establishment of those conditions or business climates that foster and encourage the creation or discovery of new products and markets • The gathering together of pertinent data to identify those ﬁelds with the highest potential return on the corporate resources. A corollary to this effort, of course, is the establishment of the necessary procedures to identify areas of less desirable growth (including existing products, etc.). • The determination of resource requirements and the scheduling needed to implement the program as it passes into normal operations The corporate development plan has three segments: 1. The Divestment Plan, which relates to the sale or merger or shutting down of major parts or divisions of the business; 2. The Diversiﬁcation Plan, which relates to the development of new products for new markets and also considers whether entry into the markets should be by acquisition or merger on the one hand or by internal development of these new products on the other; 3. The Research and Development Plan, which involves the many aspects of research and development (R&D).

12.9 OPERATIONS PLAN The remaining indicated second echelon of planning is what is termed the “operations plan,” since it is concerned principally with current business actions. Essentially, it covers the near-term activities and extends to every function of the ﬁrm. It deals with and inﬂuences the functions directly and indirectly involved in distributing the present generation of products to existing markets. Basically, it relates to the development of the plan of operations for the next year or two. It is essentially detailed in nature and speciﬁes plans by individual function, the whole of which becomes the “annual plan” or some such designation.

12.10 BASIC ELEMENTS IN ANY PLAN The strategic plan is broad and general in nature. Conversely, the annual operations plan is quite detailed and speciﬁc—and becomes the budget or control tool for the near term.

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Plans may differ in the time period covered or in subject matter. But mature consideration will indicate that each sound plan must contain these basic qualities, some of which have been implied in the preceding discussion: • Statement of purpose. Identifying the purpose of the plan gives the reader the reason for the action required. It answers the “why” part of the question. It sets forth the objective. The purpose of the strategic plan may be broad and general. As the plans become more detailed, so also must the reasons for proposed action become more speciﬁc, more reﬁned, and more detailed. • Identiﬁcation of action to be taken. Obviously, the purpose of formulating a plan is to take action, and the plan must stipulate what kind of action need be taken. Again, the more detailed the purpose, the more speciﬁc or concrete must be the action—from broad general terms in the strategic plan to minute details in a segment of an operating plan. • Speciﬁcation of the resources to be used. The basic task of management is to use all resources wisely. A ﬁrm’s resources include not only funds but also people, plant and equipment, technical know-how, and other proprietary knowledge. Plans must indicate which resources are needed—and whether they are on hand or must be acquired—to avoid a conﬂicting assignment of their sources or a less than optimal use. • Identiﬁcation of goals. The goals deﬁne the level of accomplishment expected from the action taken. Stated otherwise, goals answer the question of what is to result from the activity. • Establishment of deﬁnite time schedules and adherence thereto. Progress toward the goals must be measured not only in degree of achievement but also in time. • Identiﬁcation of conditions to be met or assumptions made. Generally, the important underlying conditions on which the plan depends must be made known to those who must approve the recommendations. If these conditions do not come to pass, then the responsible executive must be made aware of this situation at deﬁnite checkpoints so that corrective action, including changes in plans if necessary, may be made.

12.11 PLANNING PROCESS With the various segments or elements in a strategic plan identiﬁed, it is probably easier to focus now on the planning process itself. Assume a decentralized management-type company, wherein each division management must consider the environment in which it operates, and reach conclusions about its product lines, and so on. The planning cycle at the division may be as illustrated in Exhibit 12.2— an iterative process. A brief description of the 12 steps is: 1. The management sets certain tentative goals and objectives, based in part on guidelines developed by the corporate ofﬁce. 2. An analysis is made of the expected internal and external environment in which it expects to operate for the planning period. 3.- 4. Basic assumptions are made about this environment and the division's current posture. 5. A market analysis is made to determine or conﬁrm the most effective marketing method. 6. A marketing plan is devised (taking into account the new products and markets, and status of existing markets and products) for each year of the planning cycle. 7. The market support plan by years is made (sales strategy, required staff, advertising and sales promotion, etc.). 8. Using the factors determined from steps 6 and 7, the sales estimate by years, by product, by territory, and by salesperson is developed. 9. Based on the sales estimate, the related organization and manpower needs throughout the rest of the division (production, research, services, etc.) are completed and costed on a time-phased basis. 10. Fixed asset (facilities) plans are developed by year of need and amount of expenditure.

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12.11 Planning Process

E XHIBIT 12.2

193

D IVISION S TRATEGIC P LAN C YCLE

11. The ﬁnancial plan (cash, cash generation, income and ﬁnancial condition, time-phased) is developed. 12. Conclusions are reached as to whether or not the plan is satisfactory. If not, the iterative process may begin again until an acceptable plan is developed. This plan, with assumptions and recommendations, is presented to the corporate management and, if approved, is incorporated into the total company plan. Meanwhile, at the corporate ofﬁce, comparable analyses and studies have been taking place, giving consideration to the thinking of the chief executive ofﬁcer (CEO) and other corporate executives. These reviews are intended to facilitate an independent judgment on suitable corporate objectives, as well as to provide guidance, where appropriate, to the divisions and subsidiaries. The planning cycle, including the relationship of the strategic plan to the annual operating plan of the corporate ofﬁce, is illustrated in Exhibit 12.3. There are ﬁve basic steps: 1. Selected strategic studies are made, perhaps covering a period of 30 years, and on some phases, as appropriate, in cooperation with the division having fundamental knowledge of products and markets. 2. An environmental analysis (discussed in Section 12.18) is made and tentative conclusions reached regarding the internal and external environment in which the company operates. 3. Based on the studies in steps 1 and 2, strategic guidelines are developed for the divisions, as well as the corporate functions. Company objectives and goals (tentative) are established. 4. With the corporate input as well as the division/subsidiary data, the strategic plan (for 10 years) is developed. If it is not satisfactory, adjustments are made, through an iterative process, until it is deemed acceptable. 5. When the strategic plan is approved, the appropriate sections serve as the basis for developing a detailed annual plan for the ﬁrst one or two years. The approved annual plan becomes a commitment and a budget — perhaps monthly for major programs and at least quarterly for the total company/division performance. Corrective action is taken as warranted.

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E XHIBIT 12.3

A EROSPACE C OMPANY O VERALL P LANNING

AND

R EVIEW S YSTEM

12.12 PLAN FREQUENCY A question might be asked, “How often should the business plan be updated or revised?” In general, it might be stated that planning is a “continuous” process and that as signiﬁcant developments occur, such should be inputted to the master strategic plan. Given computer technology, this task is made somewhat easier through the automated centralization and automation of information. In regard to the frequency of formal updating or revision, many companies ﬁnd it practical to update the strategic plan on an annual basis. In effect, one year is dropped, and a new one is added. Each year, as new perceptions of the business or new opportunities or threats emerge, these, in effect, are studied and incorporated into the planning process and resultant plan. The short-term business plan, of course, should be prepared each year. However, since the annual plan is not only a plan but also a control tool, it would seem prudent to review it if major events change. Thus, if a major contract is canceled, or a war occurs, or any important plant is destroyed, a new plan would be needed. However, changes in conditions per se should not be the excuse for revision of the plan because the operating group is not achieving the goals. The impact of the deviation, and expected year-end (or other period) result, can be identiﬁed without changing the plan, but by quantifying the indicated ﬁnal results for the year, and the departure from the business budget (plan).

12.13 PLAN GUIDELINES The heart of sound planning is thinking and communicating, whether for the strategic plan or the short-range plan. The expectations and instructions from top management are necessary, among other reasons, to communicate concepts vital to effective planning to all participants. The attempt should be to motivate thinking and not merely provide instruction on completing a form. Furthermore, especially from the ﬁnancial viewpoint and in decentralized operations, a somewhat structured system of reporting the plans is required. Without it, consolidation at the corporate level is difﬁcult or almost impossible. What should be included in the instructions for both division and corporate must be developed by each company. To assist division managers in communicating with top management, and top management with the board of directors, some idea of subjects covered may be gleaned from instructions in a manufacturing company regarding the content in the executive summary to be presented in the division

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195

strategic plan—with further details provided in supporting schedules and related information in the short-term plan. The contents of the executive summary should include: • Comparison to the prior year plan • The major planning assumptions (external and internal) • Growth strategy • Business goals • Perceived strengths, weaknesses, opportunities, problems, and threats • Optimization of proﬁt plans for the existing business • Programs and strategy for new business development • Financial summaries of major factors, trends, and return on assets

12.14 WHO SHOULD DO THE PLANNING? Having deﬁned plans—and discussed the types of plans, the time covered by plans, and the planning process — a logical question arises about who does the planning. This subject can best be discussed by differentiating between the strategic plan, discussed in Section 12.16, and the short-range plan, discussed in Chapter 14. There is little doubt that the CEO is responsible to the board of directors for the strategic plans of the company — the direction in which the company intends to go. Some would say the CEO is the chief long-range planner. Certainly, the CEO’s style of management will have a direct impact on the planning process. Ultimately, long-range planning must involve most elements of management. Accordingly, who does the planning will depend on circumstances. The planning could involve: • Only the CEO • The chief executive and staff • A committee, perhaps part time, composed of representatives of each major discipline, or each major operating group • A separate permanent planning department that would provide leadership and coordination in the process — with adequate support from the chief line and staff executives Which of these structures it will be hinges on several factors, including: • Stage of evolution of planning in the company. If the planning is informal and sporadic, the chances are that, in fact, the chief executive will be the chief planner— with limited assistance from others. • Attitude of the CEO. This may determine the extent or depth of the planning activity. Support from this source is a “must” for effective planning. • Size of the company. Generally, the larger the company the more likely it is to make formal long-range plans. • Nature of the company’s markets. Military suppliers, for example, often do more planning than the consumer goods manufacturers. Without getting into a prolonged discussion of organization, there are some general observations that may be helpful if a company is stafﬁng a corporate-level planning group. A balanced group containing several disciplines is desirable. Several functions must be included: marketing, engineering, ﬁnance, human resources, and research. Regardless of background, prime requisites of the individual are ﬂexibility and creativity. Excessive formalization in planning, especially strategic planning, can destroy what it is all about — the surfacing of creativity and intuition. In developing strategies, speciﬁc procedures and analysis are required. But the real beneﬁts of strategic thinking are the invention of new ideas, and not just the rearrangement of old ones.

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12.15 SUPPLEMENTAL PLANNING: ALTERNATIVE SCENARIOS Planning is usually done with the most likely set of events being the assumptions. Accordingly, it may be called the most probable scenario or case. Yet a company must be prepared if these events do not take place. Hence, alternative plans also are necessary. Management must be made aware of ﬁnancial results should certain possible but improbable occurrences happen. Financial management must have some sense of the maximum ﬁnancing needs should events proceed far better than expected. Some managements prepare supplemental ﬁnancial plans to give a sense of a reasonable range of possibilities. A typical one-year summary is shown in Exhibit 12.4. Although the emphasis may be on the most probable case, sufﬁcient analysis should be done on the alternate scenarios so that the full ﬁnancial implications are understood.

Optimistic case Most Probable case Pessimistic case E XHIBIT 12.4

Net Sales ($000)

Net Income ($000)

Earnings per Share

$ $ $

$ $ $

$ $ $

A LTERNATIVE S CENARIO F INANCIAL P LAN

12.16 PLANNING TIMETABLE OR SCHEDULE To achieve a sound strategic or short-term plan on a timely basis, it is desirable to prepare a calendar of events. With respect to the strategic plan, the calendar may be issued at the time of the chief executive's announcement of the annual strategic planning effort. A short, simple calendar of events used by an aerospace company is outlined in Exhibit 12.5. Issuance of general guidelines (environment, etc.) by the CEO to division heads and other interested parties Receipt of division plans by chief ofﬁcer Completion of review and analysis of division plans by corporate staff Preparation of consolidated and corporate position Review with top management and board of directors E XHIBIT 12.5

S AMPLE C ALENDAR

OF

April 30 July 31 September 30 October 31 November 30

E VENTS

In this instance, the cycle for the strategic plan is separated from the short-range planning cycle, among other reasons, to distribute more evenly the time spent in the planning effort. Although the dates cited indicate the latest acceptable time for completion of the activity, in fact there is a continuous interface between the corporate and division planners, and often the ﬁnancial ofﬁcer will perform alternate scenarios that are needed for the long-term ﬁnancial plans.

12.17 STRATEGIC PLANNING: AN IN-DEPTH REVIEW Various names have been attached to the business planning function that encompasses a period of time beyond the next year or two: total planning, comprehensive integrated planning, top management planning, comprehensive corporate planning, long-range planning, and strategic planning — to name a few. A practical deﬁnition is that used by George A. Steiner:1 “Strategic planning is the systematic and more or less formalized effort of a company to establish basic company purposes, objectives, policies, and strategies and to develop detailed plans to implement policies and strategies to achieve objectives and basic company purposes.”

1. George A. Steiner, Strategic Planning. What Every Manager Must Know (New York: The Free Press, 1979), p. 15.

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The strategic planning cycle, an iterative process, is depicted graphically in Exhibit 12.6. Most strategic planning processes encompass these seven steps: 1. Analysis of the industry and business environment and status 2. Determining the corporate mission or purpose (In some instances the sequence of these ﬁrst two activities, both closely related, may be reversed.) 3. Selecting the company’s long-term objectives 4. Developing appropriate strategies 5. Preparing the long-range plan, including the ﬁnancial plan 6. Measuring actual performance (of the milestones to be attained each year) against the plan 7. Analyzing the reasons for departure from the plan, and taking any appropriate action It is to be observed (in Exhibit 12.6) that the cycle has been separated into two phases: (1) the strategic planning segment where much conceptual thinking usually takes place, with emphasis on

E XHIBIT 12.6

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T HE S TRATEGIC P LANNING C YCLE

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product and marketing considerations, and (2) the long-range planning phase. This second phase often is more ﬁnancially oriented in terms of considering funding sources and timing, and ﬁnancial structure, and so forth, for the several years — a function in which the controller must play a more important role, perhaps, than in the ﬁrst phase.

12.18 ENVIRONMENTAL ANALYSIS Logically, in determining the steps a company should take to ensure its survival and long-term growth, it is important to understand the environment in which it probably will be operating. This has two aspects: 1. The external environment—those inﬂuences outside the company that are or will be dominant factors in its activities 2. The internal environment—those forces inside the entity that will be signiﬁcant forces in how it will function The external inﬂuences may be grouped for discussion purposes into these four categories, perhaps in order of importance, for most companies: 1. 2. 3. 4.

Economic Technical Legal or political Social

In deciding on certain actions, such as expanding into a new territory, or introducing a new product, or selling a segment of the business, these economic factors should be weighed: • Level or stage of the business cycle • Level of general business activity • Entrance of competitors • Industry cycle • Foreign exchange rates For other decisions, other economic factors might have to be considered. A partial list of technical factors, which may be more important in some industries than in others, relate to: • New products of the same general type • New products of a different kind that can serve the same need • New processes • New capital equipment (which can greatly impact unit manufacturing costs) Legal or political considerations that may inﬂuence company behavior include: • Legislation affecting the product or activity — local, national, foreign, or domestic • Court decisions relating to interpretation of the laws • Administrative actions — local or national, that affect the enforcement of the law Some legal developments may aid the proposed actions; some may be discriminatory. Finally, the social acceptance of the product or service sold, or the manufacturing process may be an inﬂuence. Social mores do change; and what is acceptable in one community or country may be unacceptable in another. Each of these external factors must be considered in terms of impact on the company. An equally key environmental factor is a proper evaluation of the business status — an introspective look. The management must try to objectively view itself. In looking at “what makes the company tick,” these are some matters to be considered:

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• Company strengths and weaknesses. This involves knowing the functions and areas in which the company performs well, understanding how its strengths compare with competitors’, and reaching conclusions on whether or not its strong points may be improved and its weaknesses overcome. Among the many indicators to be examined are: Product acceptability Share of market Marketing posture Proprietary product status Manufacturing costs Quality control Product deliverability (availability and speed) Patent status R&D success Raw material sources Foreign market status Plant capacity Financial strength Judgment and skill of the management Flexibility and capacity to change • “Critical success” factors. This refers to knowing what particular attributes are responsible for the company’s success. It may be such characteristics as good quality control, quick response time to sales orders, personality of the representatives, or sound engineering, etc. (see Section 12.19). • Status of each product in each market segment. Included in this grouping might be: Understanding the life cycle stage of each product—embryonic, growth, mature, declin-

ing (see Exhibit 12.9). Understanding each business segment as to market share and growth rate, according to the

Boston Consulting Group matrix2 as either:

A star—high market share, high growth rate A cash cow— high market share, low growth rate, signiﬁcant generator of cash A wild cat—low market share, high growth rate; probably a cash user until the product and market are more developed A dog — low market share, low growth; a candidate for divestment Those who know the market and the product must be able to reach objective decisions about each. Knowledge of the preceding factors in all three categories is important in deciding on the corporate mission and the strategy to reach the corporate objectives.

12.19 CRITICAL SUCCESS FACTORS The “success” factors are also called key success factors, or perhaps more popular now, in planning jargon, the critical success factors (CSFs). These normally would be identiﬁed in the environmental analysis. The characteristics that surround or identify the CSFs are: • Vital or essential to achievement of the overall corporate objectives • Expressed as actions that must be taken, either continuously or when threats appear, or as conditions develop that must be overcome

2. William Lalli (ed.), Handbook of Budgeting, 5th ed. (Hoboken: Wiley, 2003), Chap. 2.

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• Somewhat limited in number, that is, not everything that can be done is critical • Controllable by the entity to which they apply, or capable of being offset by other actions of the entity • Hierarchical by nature, that is, they may apply to the business as a whole, or for each division, or for each major function, such as marketing, manufacturing, ﬁnance, or R&D • Applicable to each entity that has the same objective in the industry While the CEO and other long-time major executives probably will have in mind some or all of the critical success factors, some logical spots to search or examine in the environmental analysis are: • Product or service areas where the greatest growth is expected • Product areas that are generating, or are expected to generate, a major portion of the sales and /or operating income • Functional or product/service areas where the greatest technological advances are expected Critical success factors may be deduced from the strategies selected by particular companies or by the major problems the management thinks it must solve. Some examples are: • For a food products manufacturer: Need to improve quality control Necessity of making packaging more attractive Need to introduce competitive product within three months of the leader • For a retail food chain: Need to increase gross margins on meats, fruits, and vegetables Necessity of expanding in more afﬂuent suburbs Desirability of adding a delicatessen • For an aircraft manufacturer: Desirability of adding a manufacturing and repair facility in country X to better service customers in that growing market Need to introduce just-in-time (JIT) inventory controls Need to penetrate foreign markets of Asia to offset declining U.S. business

12.20 BUSINESS MISSION OR PURPOSE Environmental analysis is intended to provide the background for the early step of determining the corporate mission or purpose. Of course, management may decide to tentatively establish the business purpose or mission and then see if the environmental analysis seems to indicate that conditions will reasonably permit its achievement. One of the principal tasks of top management is to formulate the basic purposes and missions of the company. As Peter Drucker has said, management must decide, “What is our business and what should it be? ”3 This requires a great deal of conceptual thinking as to what the business is all about. It is this mission statement that serves as the guideline for strategic planning. How should the mission statement be formulated? In smaller companies it tends to depend largely on the thinking and values of the CEO. But in larger companies it is done more effectively by consultation and exchange of ideas among the management—although the CEO has an important voice. An offsite planning meeting of the key management team is one way to address the issue. A questionnaire is provided to each participant before the meeting and answers are prepared. 3. Peter Drucker, Management: Tasks, Responsibilities, Practices (New York: Harper & Row, 1974), p. 75.

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Such answers may be tabulated and discussed separately. Item by item, there is a thorough review and a consensus is reached. Good conceptual thinking, based on experience and knowledge of the business, is essential. There is no uniform content of mission statement. They vary from lofty statements of principle, representing the values of the CEO, to very detailed and concrete guidelines. Excess detail may be counterproductive, and vague general statements may not be useful in formulating objectives and strategies. Perhaps a middle ground may best serve the purpose. In the words of George A. Steiner, “Carefully prepared missions have been the source of success of companies. Revised missions have turned companies around. On the other hand, poorly formulated missions have brought disaster to some companies.” 4 The list of questions may be helpful in probing subjects that are to be contained in a mission statement, and that give recognition to the unique business. For example, if the marketing channel of a pharmaceutical company is through doctors of medicine to the ultimate patient, then some statement concerning the doctors may be germane. So what factors are important to the survival and growth of the entity — in the eyes of management? Perhaps these subjects, which can be identiﬁed and/or reﬁned by the planning meetings, should be a part of the mission statement. Some suggested items for inclusion are: • Product or product line • Market and market share • Proﬁtability on sales, assets, and/or shareholders’ equity • Growth in (select some): sales, market share, speciﬁc product lines, earnings, earnings per share, jobs, and/or markets served • R&D • Productivity or efﬁciency • Flexibility in manufacturing process, R&D methods and technology, meeting customer delivery needs, responding to competitive actions, and meeting changing societal needs • Company image • Observing code of conduct • Developing managerial pool The preceding items may be in response to these basic subject categories: • Survival or continuance • Proﬁtability • Growth • Flexibility Having covered some possible subjects, what are some illustrative examples of company statements of purpose? Some concise mission statements from company policy manuals are: • To be the predominant supplier of electronics countermeasures to the U.S. Air Force • The primary mission of the [XYZ corporation] is to assist our clients in achieving cost-effective employee beneﬁt plans through the effective marketing of innovative and especially designed concepts intended to reﬂect the strengths of the client company. • The mission of the [Custom Engineering Corporation] is to maintain a viable growing business by designing, developing, manufacturing, and marketing custom engineered products and services to meet the needs of selected utility and construction companies.

4. George A. Steiner, Strategic Planning: What Every Planner Must Know (New York: The Free Press, 1979), p. 162.

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Some practical observations about mission statements are: • The principal application of a mission statement is to serve as a guide to policy decisions, to provide direction. Accordingly, it should be quite speciﬁc, and not a lofty statement of admirable purpose. • As to products or product lines, careful designation may be important—whether the product/ service is deﬁned in broad terms or more narrowly described. The wording can be signiﬁcant. Thus, a statement that company Y is in the communication business might have quite a different impact than to specify narrower business lines, such as newspapers, television, and/or radio. • The mission generally should include the scope of operations. While the mission will identify the line of business, the scope will delineate the market, for example, United States rather than worldwide. • A realistic statement of purpose probably will be inﬂuenced by these three factors: 1. The basic competence and characteristics of the entity itself, e.g., skill of the management, capital resources, operational capabilities, physical assets, geographical location, availability of skilled personnel, raw materials sources, etc. 2. The expectations of the stakeholders — those who have something at stake within the ﬁrm: the management, shareholders, creditors, employees, suppliers, customers. The relative weight of each faction's inﬂuence will help shape the relative importance of different elements of the mission. 3. The nature of the expected future external environment, for example, regulation, social trends, inﬂation rates, the stage of the business cycle.

12.21 LONG-RANGE BUSINESS PLANNING OBJECTIVES Some managements use the terms purpose, objective, and goal interchangeably. For our discussion, the term objective shall refer to a desired result or condition to be achieved by a stated time. By some deﬁnitions, a quantiﬁed objective is a goal. As shown in Exhibit 12.7, once the business purposes or missions have been determined, then the long-term objectives may be established. It should be realized, of course, that the establishment of objectives is an iterative process, closely coupled with the determination of strategies. One inﬂuences the other. In any event, the criteria for satisfactory long-term objectives include these characteristics: • Suitable. Logically, an objective should support the basic purposes and missions of the entity. Achieving the objective should move the enterprise in the direction of meeting its purpose. Achieve by Year Objective

2004

2010

Aggregate sales volume (millions) Percent of non-U.S. sales Percent of new products Operating proﬁt (% of sales) Rate of return: On total assets On net worth Earnings per share Price/earnings ratio Labor content in products Minorities as % of workforce

$560 20% 15% 17%

$1,200 25% 30% 22%

10% 19% $2.50 11% 25% 15%

12% 25% $4.25 15% 22% 20%

E XHIBIT 12.7

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S AMPLE L ONG -R ANGE O BJECTIVES

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• Feasible. Objectives should be achievable. It serves no useful purpose to set an unrealistic objective or goal. Any objective should be established giving recognition to the expected environment: competitive actions, technical achievements, political feasibility, social acquiescence, and so on. • Compatible. Each objective should be compatible with the other objectives. For example, the objective for Product A or strategic business unit X (SBU) should be in harmony with, or certainly not in conﬂict with, the objectives for the overall entity. • Measurable. Actual results should be measurable against planned results over a speciﬁed time span. Thus, if the objective is “To attain a sales level of $100 million by the year 1999,” then attainment is readily identiﬁable. Objectives may be quantiﬁed in any one of several ways: monetary units, unit quantity, cost, rate, percentage. Only when the objective is stated in concrete terms and for speciﬁed periods of time can their attainment be measured reasonably objectively. • Flexible. Objectives should not be easily changed; nor should they be immovable. When major unforeseen contingencies occur, they should be changeable to be more realistic. • Motivating. Another important characteristic of a proper objective is its motivating power. An objective should not be so easily achieved that it is certain of attainment. Nor should it be too difﬁcult to accomplish. It should be at such an effort level that those to be judged by it generally agree it can be reached. This implies that those who are to meet an objective should have a voice in setting it. The management members involved should regard it as a commitment to be met with adequate effort. (a) ILLUSTRATIVE LONG-RANGE OBJECTIVES. In practice, most enterprises have only a few long-term planning objectives. In theory, however, goals or objectives could be set for every function and every department in the business. Typically, many of the objectives are ﬁnancially expressed and relate to sales volume, proﬁtability, and market share. But measures may be developed for any number of factors that need change: labor content, share of minorities in the workforce, skill diversiﬁcation in the engineering or research staff, labor turnover rates, productivity, R&D expenditures, share of sales from nearly developed products (over a ﬁve-year span), and ad inﬁnitum. Planning objectives should be set for those critical factors essential to the success of the enterprise. (See Exhibit 12.7.) (b) LINKING OBJECTIVES. Those involved in setting overall company objectives, or, indeed, objectives for each SBU, should realize that major objectives are closely related to subobjectives. Thus, the return on shareholders' equity must be supported by a proper gross margin objective (translated to a percent of net income to sales objective) and asset turnover objective, and a satisfactory leverage factor (see Chapter 7). The margin objective in turn could relate to a product mix objective, a sales volume objective, and, perhaps, a productivity increase goal. Some sense of this interrelationship or linking of objectives and subobjectives may be gleaned from the tree shown in Exhibit 12.8. (c) SETTING THE LONG-RANGE OBJECTIVES. When a decision is to be made about the major long-range objectives, two questions may come to mind: (1) Who should set the objectives? (2) How should the objectives be established? (i) Who Should Set the Objectives? On the matter of who should set the objectives, several factors will be at play. These include the size of the company; the style of management; the organization structure; the personality and interests of the CEO; the capabilities of, knowledge of the business by, and interests of, the top management. Recognizing these elements, the following comments are made: • The CEO might establish the major long-range planning objectives—provided the CEO is knowledgeable and has a good sense of the business.

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Long-Range Objective

Subobjectives (to be Speciﬁed by Year)

Subobjectives (Most to Be Achieved by 2007)

Attain a net sales volume of $990 million by 2007

Increase market share per year for these products: X—12% Y—5% Z —9% Introduce new products that will provide 25% of sales volume by 2006 Acquire K company of equivalent in S product area

Earn a net proﬁt to sales ratio of 10% by 2007 Earn 25% on average shareholders’ equity by 2007 (Specify objective for each year) Achieve a capital structure by 2006 of: Debt 30% Equity 70%

E XHIBIT 12.8

Reduce material costs by: 25% in 2005 10% in 2006 Increase high margin product share by 40% by 2007 Reduce overhead content by 20% by 2007 Purchase common stock aggregating $250 million by 2006 Issue senior debt of $800 million (assuming proper market environment) by 2006

Attain a productivity increase of 5% per year

Change to process N in Los Angeles Robotize 10% of operations Introduce team concept in four plants by 2006

Double manufacturing capacity by 2007

Lease space in Paciﬁc Southwest Expand training programs in Arizona and New Mexico

L INKING O BJECTIVES

AND

S UBOBJECTIVES

While this procedure may be satisfactory in a small company, as the company gets larger this is less than desirable because (a) the typical subsidiary president usually resents being given a goal without any voice in setting it; and (b) the CEO often does not have the requisite product and market knowledge. • Top management might dictate the objectives. Although such a base is broader than the CEO alone, it can suffer the same deﬁciencies as mentioned previously. • In those instances in which the business is larger, and is basically on a decentralized style of organization, the objectives may be negotiated between the head of the SBU and the top management. Usually it is not satisfactory for the unit heads to establish the objectives because few top managements are willing to have targets set without their review and approval. • Finally, in the larger companies, where the SBU has its planners and the central management has its corporate planner or planning coordinator, through the iterative process of discussing alternative strategies, objectives, and the corporate mission—agreement often can be reached on what constitutes an acceptable objective. Such a base, of course, is much broader than merely the top management and the head of the SBU. (ii) Methods of Setting the Long-Term Objectives. Setting realistic long-term objectives is not quite as simple as just having one executive, the CEO, or a group, dictate a ﬁgure or goal. To be

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205

sure, the process might commence with suggestions from those sources; but it is inﬁnitely more satisfactory to have some identiﬁable points of reference recognizable by those who must meet the objective. What are these? How can they be determined? Some of the methods employed in business, depending on circumstances, are: • Past performance—with some type of trend extrapolation. In some instances, to use last year's performance and to adjust for experienced improvement or some arbitrary factor is not using the available tools, and it may be downright naive, by letting poor performance continue. • Past performance adjusted for the estimated impact of expected forces. Recognition is given to the result of expected changes, both internal and external, such as: product obsolescence, government regulations, new product developments, competitive actions, industry sales forecasts, and so on. • Competitive analysis. With the availability of the 10-K reports of competitors, analyses could be made of competitive performance. Return on assets, gross margin percentage, sales volume trends, funds spent on R&D, selling expenses, individual competitor data or group data can be used as a basis for calculating desired performance on some item. • Environmental analysis, situation analysis, or strategic analysis. In the analytical study of the operations, certain comparative relationships will become evident—some good and some poor. The impact of expanding the more productive or effective ones can be judged or calculated on such matters as sales volume (impact of advertising, or using a certain channel of distribution, changing prices, or using a given source of raw material, etc.). The best methods used in one area might be applied to other areas, etc. In turn, these actions could impact the objective. • Strategy iteration. This is similar in principle to the preceding situation analysis. New strategies may be developed and the impact could be estimated as to certain objectives. There are several bases and supporting statistical analyses of various types that can aid in the selection of suitable long-term planning objectives.

12.22 DEVELOPING STRATEGIES The ﬁnal function mentioned in Exhibit 12.6 as requiring a great deal of conceptual thinking is that of developing the appropriate strategies to achieve the business objectives. After the basic mission or purpose and long-range planning objectives have been determined, then the next step is to search out those strategies best able to achieve the objectives. As used herein, strategy means the way, path, or program by which the entity deploys its human and ﬁnancial resources and its physical assets to achieve the business purpose. A great deal has been written about identifying and evaluating strategies. Yet, the fact remains that the process is largely an art and developing a successful strategy often involves a great deal of luck. In strategic planning, the emphasis usually is on products, market, and marketing. In developing successful strategies, it is probably desirable that the company's creative talents be energized into suggesting the most ingenious and comprehensive methods or paths possible. This development task may be assigned to gifted individuals or groups in marketing, planning, or other departments who have a reasonable knowledge of the operations — with the evaluation and selection assigned possibly to other groups. Sources that might provide clues for potential alternative strategies include: • Review of company reports and records • Observation and discussion of the operations, including the known or alleged strengths and weaknesses • Review of competitive or somewhat comparable activities • Discussion of the situation and alternatives with persons familiar with the industry and the company, including consultants, educators, board of director members, think tanks, and so forth

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In any event, when the list of alternative strategies has been developed, they should be screened by knowledgeable people (perhaps the CEO and other top management) to eliminate the impractical. Then, the remaining strategies should be evaluated on both a qualitative and quantitative basis. Qualitative factors might involve the impact on other product lines or organizational units, on the corporate image, etc. Quantitative measures could include contribution margin, cost effectiveness, return on assets, market share, and operating proﬁt. In connection with evaluating alternative strategies, George A. Steiner has said, “. . . The most effective universal approach to decision making is to ask the right question at the right time.” 5 To identify and evaluate strategies, he has devised a list of 38 questions that help ensure a correct decision if asked at the right time and given proper weight.6 This art of strategy determination involves a good insight into the company's strengths and weaknesses, the problem, combined with good judgment and intuition, and a willingness to examine some new ideas. A summary of the facets of strategy development includes: • Comprehending the current status of the business and where continuance of the same policies and strategies will take it. This involves identifying such factors as: Major products Major markets Important strengths and weaknesses of the entity as compared to competition Present major strategies in the several ﬁelds Knowing the economic contribution (cash ﬂow, operating proﬁt, asset usage) of the vari-

ous segments (product, market, proﬁt center, etc.) • Understanding the company objectives and how they differ from results of continuing the present activity — the gap. (See Exhibit 12.1.) • Recognizing some of the strategies that may or could be involved in the strategic planning, and selecting the practical ones for study Product strategies. Product design, new product development, adding new products by

purchase or acquisition, product obsolescence, life cycle of products—that will inﬂuence strategy (See Exhibit 12.9.)

E XHIBIT 12.9

P RODUCT L IFE C YCLE —A N I NFLUENCE

5. Ibid., p. 192. 6. Ibid., p. 194 –195.

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Market strategies. Adding or dropping markets; changing distribution channels, methods

of sale, prices, terms of sale, delivery methods, advertising media, promotional methods Manufacturing strategies. Plant locations, subcontracting, foreign sources, manufacturing

techniques, material content, quality control R&D strategies. University afﬁliations, joint ventures, licensing, purchase of rights Financial strategies. Inventory ﬁnancing, credit terms, debt structure, ESOPs, stock issues,

control systems, planning system, inﬂation hedging, foreign exchange practices, leasing instead of purchasing ﬁxed assets, and so on Human resource strategies. Organization structure, style of management, decentralization, downsizing, recruitment programs, training programs, wage and salary levels, executive replacement • Evaluating the proposed individual strategies and judging how they will assist in meeting the business objective (a) APPRAISING ALTERNATIVE STRATEGIES. As the strategic planning cycle illustration in Exhibit 12.6 reﬂects, the last step before preparing the long-range plan is to develop the principal strategies by which the company objectives and basic purposes will be achieved. But as also stated, the process of selecting the proper strategies involves a great deal of art as well as science. Presumably, after much discussion between the principal functional ofﬁcers and the CEO, the most appropriate strategies will be tentatively selected. If the process is done properly, the chosen means will be evaluated both qualitatively and quantitatively. It is in the realm of quantitative analysis that the controller can bring to bear expertise in marshalling the ﬁnancial facts in order to present the ﬁnancial effect on the company of the strategy. Depending on the subject matter, the strategy may impact on: • Net revenues • Manufacturing costs • Selling expense and distribution costs • R&D • General and administrative expense • Assets or investment required • Liabilities assumed • Return on assets and equity • Earnings per share Evaluating the one strategy may not be enough. Business decisions usually involve the selection of alternatives. Therefore, a good ﬁnancial job would include evaluating one or two practical alternatives. And the most favorable, after full review by the management, would be that included in the formal strategic plan. In presenting the formal strategic plan to top management, or the board of directors, it may be desirable to advise the audience of the impact of the other feasible, practical, or considered likely, scenarios. The impact on earnings per share of the alternative strategies is shown in Exhibit 13.11. Should some of those more drastic, but unlikely, events be appraised, even if not formally incorporated in the plan presentation? For example, should the impact of war, or a major earthquake, or loss of a major customer (if the strategy fails) be evaluated? The answer is “yes,” within reason. By such appraisals, management will gain insight as to the effect (both cost and duration) of major unlikely events. This type of information would be restricted to the top management of the entity. (b) SOME ILLUSTRATIVE STRATEGIES. From the listing of the basic types of strategies, some alternative strategies may be deduced. However, listed below are a few speciﬁc illustrations of strategies undertaken. What strategies must be employed or changed obviously depends on the

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problems to be overcome. The strategies have been grouped into typical groupings of product strategies, market strategies, and operating efﬁciency: • Products Change the style of packaging to appeal to the middle-aged group. Change packaging to smaller quantities to attract the elderly singles. Add a related product that would use the same distribution channel and methods as the other

products. Drop line Y, which provides no contribution margin. Modify product so it will serve a function not now recognized. Consider private brands in the Southeast. • Markets and Marketing Enter growing European market through a joint venture. Change prices to meet competition of “R” chain. Increase local advertising to cover TV in markets W, X, and Y. Change from sales representatives to agents in the Northwest territory. Reduce promotional effort on product “ T” in marketplace because of its declining stage in

the life cycle. • Operating Efﬁciency Switch to “just-in-time” inventory control method in Los Angeles and San Francisco. Establish warehouse in Denver. Enforce terms of sales so as to increase receivables turnover. Dispose of Kansas City subsidiary in view of losses and lack of growth prospects. Sell Chicago ofﬁce building, in present inﬂated market, reduce space requirements, and

move to less expensive location.

12.23 STRATEGIES AND THE PLANNING PERIOD In discussing strategic planning, one more important subject relates to timing. When should a particular strategy start? Different strategies often must start at different time periods. In the context of strategic planning, it is important that the proper plan — the annual plan or the strategic plan — provide for implementation of the strategy. This is best illustrated in Exhibit 12.10. Some strategies must commence during the short-term or annual plan to be fully effective at a stipulated time in the strategic plan. Thus, strategies 1, 2, and 4 start in the indicated quarter of the annual plan. The others begin in another planning period. The annual plan, discussed in Chapter 14, must provide for those strategies which need to start in that time frame to be fully effective by a speciﬁed date in the strategic plan.

12.24 ROLE OF THE CONTROLLER It may be taken for granted that when the selected strategies and plans are combined and consolidated into ﬁnancial terms for the planning period (discussed in the next chapter), the controller will be heavily involved. What is the role in those earlier phases of strategic planning that require a great deal of conceptual thinking, such as: • Determining the corporate mission • Selecting company long-range objectives • Developing strategies

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12.24 Role of the Controller

E XHIBIT 12.10

R ELATIONSHIP

OF

S TRATEGIES

TO THE

209

P LANNING P ERIODS

It is precisely these areas that call for an extensive knowledge of the products, markets, and external environment, as well as the internal inﬂuences. It is also an area where a great deal of subjective judgment takes place in an unstructured setting. Many of the factors are not subject to measurement; and much guessing takes place. According to a survey of controllers,7 a great number of controllers desired to participate more fully in the entire strategic planning process. In a 17 percent response rate to a similar questionnaire to CEOs, the chief executives were stated as not being enthusiastic about expanding the controllers’ participation in the three phases. Obviously, the degree to which a controller should be involved depends in part on the ability to contribute something of value to the process. This, in turn, may depend on the controller's knowledge of the business — especially the markets and products — as compared to the other functional executives. Moreover, technically speaking, involvement could mean either giving informal advice, providing data or analyses, or actually making decisions, e.g., choosing alternatives. In the typical enterprise, with a highly competent managerial staff, the following are possible roles the controller can have in the planning process: • General. In those areas susceptible to ﬁnancial or economic analyses, whether based on internal and/or external data, where the controller is knowledgeable, the controller should prepare the analysis and present recommendations. This can be done based on a request or at the controller's own instigation. Additionally, if the controller has signiﬁcant information, is reasonably knowledgeable, and believes conclusions reached are based on erroneous assumptions or information, the observations should be made known (at the controller’s own risk if the correct facts are not shown or the controller doesn’t really comprehend the picture). 7. Richard H. Fern, and Manuel A. Tipgos, “Controllers as Business Strategists: A Progress Report,” Management Accounting, March 1988, pp. 25 – 29.

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• Company mission. The company mission or purpose will be determined based on a thorough knowledge of the entity’s strengths and weaknesses and a host of subjective opinions. If the controller is aware of erroneous ﬁnancial or economic assumptions used (which should be disclosed) in reaching the decisions, then the controller can and should provide alternative suggestions. Otherwise, this area should be left to the decisions of the other ofﬁcers. • Long-range objectives. As to those long-range objectives that involve conclusions based on ﬁnancial facts or calculations (such as return on shareholders’ equity), the controller should make or assist in making the necessary analysis. If the conclusions reached are erroneous or not realistic, there is an obligation to bring this to the attention of the appropriate executive and to demonstrate in what way the objective is unrealistic (or too easy of attainment) and what might be more appropriate. It would seem that there are a great many areas relating to long-range planning objectives where the expertise of the controller should be useful — but not all. • Developing strategies. In this phase, also, ﬁnancial analysis probably could be applied to some of the strategies. Suggestions would be those relative to proﬁt impact of alternative choices, relative to cost/effectiveness, unrealistic earnings estimates of proposed acquisitions, unduly optimistic economic assumptions, too high an inﬂation rate, or cost estimates that are too low. Of course, the controller has the task of selling to top management or the planning group, the usefulness of his capabilities in ﬁnancial analysis; and if the controller desires to work in the unstructured environment and more subjective arena, the beneﬁts must be demonstrated.

12.25 IMPROVING THE STRATEGIC PLANNING PROCESS We have attempted to explain the desired procedures to make strategic planning a success, but weaknesses do creep into procedures. A summary of comments which express the thoughts of many experienced strategic planners follows: • In too many companies, strategic planning has become overly bureaucratic, absurdly quantitative, and largely irrelevant (because of the changing environment). • Companies must think and act strategically every day — not just in the annual planning (once a year) cycle. • Key words are focus and ﬂexibility. Focus refers to the need to ﬁgure out what the company does best, and build on it. It means developing the “core competence” to meet customer needs. Flexibility means sketching rough scenarios of the future—the “bands of possibilities”—and being ready to use them when the opportunities arise. • The basic function of the “corporate planner” is to coordinate and advise the line managers. It is the latter who have prime responsibility for formulating and implementing the planning. • Because many companies reward short-term results, such as increasing sales or reducing costs, it is difﬁcult to encourage truly long-term, far-sighted planning. • Strategic planning still largely involves unquantiﬁable factors such as experience, instinct, guesswork, and just pure luck.

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CHAPTER

13

FINANCIAL IMPACT OF THE STRATEGIC PLAN: LONG-RANGE FINANCIAL PLAN 13.1 13.2 13.3

13.4 13.5 13.6

INTRODUCTION 211 KEY ELEMENTS OF A STRATEGIC PLAN 211 CONTRAST OF STRATEGIC PLAN (FINANCIAL ASPECTS) WITH THE ANNUAL PLAN 212 CAPITAL INVESTMENTS 213 RISK ANALYSIS 214 KEY RELATIONSHIPS 215

13.7

OBJECTIVES OF THE LONG-RANGE FINANCIAL PLAN 215

13.8

CONSOLIDATION AND TESTING PROCESS 216

13.9

REPRESENTATIVE FINANCIAL CONTENT OF A LONG-RANGE PLAN 216

13.10 ILLUSTRATIVE FINANCIAL EXHIBITS IN THE PLAN PRESENTATION 217 13.11 ROLE OF THE CONTROLLER 230

13.1 INTRODUCTION Chapter 12 dealt with the system of business plans, the essential components of each, and the general relationship of the strategic plan to the short-term annual plan. It also discussed the development of appropriate strategies for each function of the business: marketing, manufacturing, research and development (R&D) human resources, and ﬁnancial. The concepts were introduced without attaching numbers. This chapter addresses the communication of the business plans to top management and the board of directors. It identiﬁes the key elements of the strategic plan that should be discussed between the board of directors and top operating management as well as between corporate management and the heads of the strategic business unit (where applicable). Most important, the strategic plan is quantiﬁed in the format of the long-range ﬁnancial plan. This chapter also deﬁnes the objectives of the long-range ﬁnancial plan presentation. To further clarify the strategic planning process, the strategic plan is contrasted with the annual plan, business risks are discussed, and the concept of capital investment is introduced. The content of the long-range ﬁnancial plan presentation is illustrated with a complete sequence of ﬁnancial exhibits.

13.2 KEY ELEMENTS OF A STRATEGIC PLAN This discussion assumes a decentralized organization with several strategic business units. It is necessary to present the relevant data on each. If a business is not decentralized or is composed of basically one area, the same key elements discussed herein should be presented for the business as a whole. In the review of a strategic business plan, very often emphasis is ﬁrst on the basic issues without an excessive amount of quantiﬁed data. The purpose is to provide insight about the operating 211

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center, or strategic business unit (SBU). While the speciﬁc content will depend on the individual circumstances, the following eight elements probably should be included in the plan presentation: 1. A basic statement by the division general manager or subsidiary president about: The mission of the center or SBU The key issues and opportunities critical to its future The long-range objectives The basic strategies

2. The long-range plan for each business area, including: A deﬁnition of the products and services to be provided Principal markets served and the primary customers Principal competitors in each market, their primary characteristics, strengths, weaknesses,

and anticipated strategies, as well as how the operating center expects to compete with them Key issues of each business area, including the threats and opportunities Objectives for the business area Strategies to be pursued Milestones for each business area that will describe the key steps to be reached, on a

scheduled basis, as an indication of progress toward carrying out the strategy and reaching the objective The most vulnerable or weakest strategies or objectives in the strategic plan, and reasons

for this judgment 3. Summarized ﬁnancial schedules for the SBU or business area and operating center (discussed in Section 13.10) 4. Human resources overview of the operating center—a summary of the plans for growth, retention, productivity improvement, upgrading quality of management, or other key factors, external or internal, relating to this subject 5. Perhaps an information resource management overview of the data processing function for the operating center, including major systems to be acquired, renovated, or developed 6. A facilities overview of the operating center, including the impact of any changing technology, or major subcontract plans, and other signiﬁcant factors that would impact such matters as sales per square foot of covered area or square foot of covered area per employee 7. An overview of productivity improvement plan for the operating center 8. An overview of any other functional area, such as R&D activity, that is crucial to the success of the SBU or operating center. Such narrative would relate to programs, strategies, and objectives, each time-phased. These elements provide some sense of the scope of the strategic plan review, above and beyond the ﬁnancial aspects.

13.3 CONTRAST OF STRATEGIC PLAN (FINANCIAL ASPECTS) WITH THE ANNUAL PLAN The business strategic plan is discussed in Chapter 12 and this chapter; and the annual business plan is discussed in Chapter 14. As explained in Section 13.5, the strategic plan relates to many years and is concerned with basic strategies and the mission of the business entity. The annual plan deals with a much shorter time period—only a year or two—and is concerned primarily with current operations; it includes much more detail. It is the supporting or supplementing phase of the ﬁrst year of the strategic plan. Exhibit 13.1 differentiates between the ﬁnancial accumulations or groupings of the two plans. The strategic plan emphasizes the corporate mission, strategies, and key relationships; it does not

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13.4 Capital Investments

Accounting Focus Details costs by individual account (type of cost, e.g., labor) Includes departmental budgets (purchasing, receiving, etc.) Used for monthly comparison of planned with actual results Includes cash budget Includes income and expense plans Includes plan for ﬁnancial condition E XHIBIT 13.1

L ONG -R ANGE

VERSUS

Long-Range Financial Plan

Annual Plan

No

Yes

No

Yes

No Yes Yes Yes

Yes Yes Yes Yes

213

A NNUAL P LAN

deal with the very detailed expenses of each department. The strategic plan may involve substantial analyses of alternative scenarios.

13.4 CAPITAL INVESTMENTS Both long- and short-term ﬁnancial plans identify the planned investment in assets, both working capital and plant and equipment, required during the planning period, in order to achieve the planned proﬁt objectives. For plant and equipment planned expenditures, the annual plan usually includes a section on the capital budget — as explained in Chapter 31. The required facilities and purpose are described in some detail and a speciﬁc cost or expenditure for each identiﬁed. The board of directors is advised of the required cost for each signiﬁcant item, as well as the expected rate of return on the investment. In some instances, the board will grant speciﬁc authorization at the time the annual plan is approved. In other cases, when the time for making the commitment is near, the board may require a further detailed review, and then approve an acceptable appropriation. As a contrast, in the long-range planning cycle, each strategic plan usually contains only a highly condensed summary of expected plant and equipment expenditures. A plan may identify the estimated expenditure in one of these ways, depending on the relative amount of ﬁnancial resources needed, and the extent of the analysis or study undertaken to quantify the planned cost: • By a single one-ﬁgure item for each year of the strategic plan (see Exhibit 13.3.) • By identifying by plan year the amount of the planned expenditure as to purpose, such as: Expansion (higher sales volume) Diversiﬁcation (new products) Increased efﬁciency (e.g., reducing manufacturing costs) Replacement (e.g., worn out or obsolete equipment)

• By identifying the expenditures by product line or business unit, such as electronics, telecommunications, or aircraft assemblies, for each of the plan years Use of any such highly condensed presentation or disclosure in the strategic plan approval process by the board of directors or top management is usually only an approval “in principle.” It does not constitute authority to make commitments for the expenditures. Approval of a speciﬁc appropriation for the speciﬁc asset or group project is still generally required. As to the capital requirements for current assets for both the strategic plan and the annual plan, these are determined based on experienced or planned turnover rates, the expected sales volume, the expected inﬂation rate, and other factors affecting the asset investment. In the strategic or long-range plan, the estimate is general and usually is related to total product sales. In contrast, in

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Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

the more detailed annual plan, the receivable investment may be calculated based on expected speciﬁc product sales to speciﬁc large-volume buyers or groups, the terms of sales, and the expected turnover rates. Planned inventory investment in the strategic plan is based on general turnover rates. In contrast, the annual plan investment in inventories may be based on speciﬁc monthly production plans by product, by plant, and so on. With the growing trend to a reduced investment in receivables and inventories, through the use of computer technology, just-in-time techniques, and new group manufacturing methods, lower receivable and inventory levels should be planned. The rate of return on assets employed in the business is one test of the competence of management. (see Section 13.6 on key relationships.) Hence, the level of capital investment is critical.

13.5 RISK ANALYSIS Engaging in business involves the assumption of risks. The proper assessment of risks that may occur and their probability is important in both plans, but it is especially signiﬁcant in strategic planning. To the extent that it is practical, the possible impact of major risks should be incorporated in the ﬁnancial statements and alternate scenarios suggested. Some of the risks that might need consideration include: • Competitive response. Competitors will have a response to any new product introduction or expansion into a new geographic area. The response may be price cuts, lawsuits, lobbying for government regulation, or other possibilities. • Capital cost overruns. Construction projects have been known to exceed budgets. A worst-case scenario could help management anticipate funding requirements. • Nationalization of facilities. Some countries have a history of nationalizing certain industries with little or no compensation to the previous owners of expropriated facilities. If management becomes aware of such a problem, then it may wish to relocate its new facilities. • Ecological costs. Some companies (e.g., Manville Corporation, the tobacco industry, and pharmaceutical companies) have been targets of lawsuits due to products that were later found to be unsafe. In addition, any product or process that has signiﬁcant chemical waste by-products should be brought to the attention of management, because resulting lawsuits or government ﬁnes could destroy any proﬁts from sale of the product. • Sales ﬂuctuations. Sales projections are sometimes inaccurate. Management should be aware of the worst and best case scenarios. The worst case may result in signiﬁcant losses to the company, and the best case (as recently experienced by several personal computer manufacturers) may require construction of additional production facilities. • Raw material scarcity. Some raw materials are in short supply (computer chips) or are tightly controlled by the producer (oil by the Organization of Petroleum Exporting Countries [OPEC] in the 1970s). If so, sales projections may fall short due to the inability of the company to produce enough of the product to meet demand. • Deterioration of margins. Competing products may come onto the market that will force margins to deteriorate due to price cuts. The company should make some attempt to identify this risk from both national and international competitors and derive a likely range of margin percentage reductions to factor into the long-range plan. • Technological advances. Advances in technology may make a product obsolete (e.g., calculators versus slide rules). Though these advances may be hard to predict, some rudimentary technology can be found in trade literature that will allow the company to forecast a decline in its market. For example, the movie video rental market is projected to decline as on-demand movie rentals become available through cable television companies. Proper risk assessment is essential in business planning. Consideration of such exposures can help in building a plan that keeps such risks within an acceptable level.

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13.6 KEY RELATIONSHIPS Key relationships are important guides in any business planning, and they are particularly valuable in constructing the long-range ﬁnancial plan. Ratio analysis is discussed in Chapter 6, and the importance of selected ratios is reviewed in the relevant chapters of this book. Some especially signiﬁcant ratios to consider in long-range planning are: • Percentage return on assets (see Exhibit 13.16) • Percentage return on shareholders’ equity (see Exhibit 13.17) • Turnover of assets • Operating margin as a percentage of sales • Net income as a percentage of sales (see Exhibit 13.3) • Earnings per share (see Exhibit 13.11) • Book value per share (see Exhibit 13.3) • Ratios of long-term debt to net worth (see Exhibit 13.18) • Current ratio (see Exhibit 13.19) • Times ﬁxed charges are earned The importance of each of these relationships or ratios is explained in Chapter 7.

13.7 OBJECTIVES OF THE LONG-RANGE FINANCIAL PLAN Having brieﬂy reviewed the subjects that the line ofﬁcer of the SBU and/or the company planning ofﬁcer would discuss in a top-side review of the strategic plan, the remainder of this chapter will dwell on the long-range ﬁnancial plan. Chapter 12 deals largely with establishing the mission or purpose of the entity, then deciding what steps must be taken (objectives), and how they will be carried out (strategies) to reach the planned mission. In a sense, these constitute a series of actions for which the individual costs and results (income) must be determined. It is somewhat akin to locating a piece of a puzzle. These pieces or segments then must be ﬁtted together, and it must be determined that the resulting total picture is what was expected or desired. The chief ﬁnancial ofﬁcer (CFO), usually working through the controller and staff, must analyze each new segment or action in terms of costs and revenue, add it to the other continuing planned functions of the business, provide additional ﬁnancial input where appropriate, consider the ﬁnancial policy implications of each, and summarize or consolidate the various segments, on a time-phased basis, to the end that the chief executive ofﬁcer (CEO), the other top executives, and the board of directors will: • Comprehend the results of the strategic planning, in ﬁnancial terms, as to all important factors, including: Income and expense Cash sources and uses Capital (ﬁxed assets) commitments and expenditures Financial position • Be aware of the signiﬁcant ﬁnancial risks or exposures, if any. • Be assured that all reasonable ﬁnancial resources probably will be available as needed, on an acceptable basis, to meet the needs of the company. • Recognize that the planned ﬁnancial position or health of the entity must be continuously maintained in an acceptable manner so as to command respect from investors of all types (shareholders, institutional investors, commercial bankers, and others) over the longer term.

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Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

• Have conﬁdence that the terms of any existing or potential credit agreements — bond indentures, commercial bank lending agreements, long-term loan contracts—can be met without endangering the company. • Understand that shareholders’ value probably will increase. • Expect that the various approved ﬁnancial goals can be met, for example, increasing the return on shareholders’ equity, the return on assets, increasing earnings per share, and so forth.

13.8 CONSOLIDATION AND TESTING PROCESS In many companies, the focus of management, as far as the strategic plan is concerned, often is on the income statement and perhaps the statement of cash ﬂows. An astute management, and especially the CFO, knows that attention must be given to the ﬁnancial position as well as to operating results. The entity must maintain adequate ﬁnancial health to attract capital when needed, to pay dividends on a competitive basis, and otherwise enhance shareholder value. So how can the accounting process of summarizing the long-range ﬁnancial plan be described? In principle, the process of preparing the ﬁnancial statements for the strategic plan will be substantially the same as preparing the statements of actual results for each monthly closing, with these differences: • Essentially the same type of entries will be prepared for the planned ﬁgures as is done for the actual ﬁgures; that is, there will be an entry to charge accounts receivable and credit sales for the planned sales; another to charge inventory, with a credit to the various liability accounts for the cost of material, labor, and manufacturing overhead for the manufacturing activity. The entries for the long-range plan will parallel those for the regular monthly closing. However, in most instances, the entries will be made on an annual basis so that annual ﬁnancial statements can be prepared. (Thus, if it is expected that events during a given year will cause a failure to meet credit agreement standards, then—and only then—need interim statements be generated.) • Detail costs by each department and/or cost center probably need not be determined for the annual data, but only for the total function. Manufacturing costs in total should be known in order to arrive at the inventory valuation and the like. • The year-end ﬁnancial position should be checked at each year end to see that it meets acceptable ﬁnancial standards. Thus, if cash is inadequate at year end, then borrowings must be assumed or planned so that adequate cash is available, and plans for its repayment must be incorporated in other future years. If receivables appear too low, the cash collections and/or terms of sales need to be reviewed; or, if dividends on common stock appear low in relation to earnings, the assumption about payout should be checked and so forth. • Naturally, the cost or ﬁnancial impact of any proposed or planned strategy must be reﬂected in the annual accounting entries (e.g., the added expense of new salespersons or a new sales promotion program—just as in the short-term plan). The impact on income and expense, cash, and balance sheet of any planned acquisition; the result of any assumed new stock issue; and so forth must be reﬂected in the statements. Computer programs are available to assist in translating plans to ﬁnancial terms. Most of the above comments are precautionary because some ﬁnancial staff in the past have prepared ﬁnancial statements with excessive or unnecessary detail — which often clouds the issues. In other instances, the ﬁnancial plan entries have not been checked to ascertain that the cost/revenues impact of a proposed strategy has not been overlooked and so forth.

13.9 REPRESENTATIVE FINANCIAL CONTENT OF A LONG-RANGE PLAN What information should be included in the ﬁnancial commentary and related exhibits of the long-range plan, expressed in ﬁnancial terms? The intent is to communicate the important points

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217

or facts of the plan. Accordingly, it should be tailored to ﬁt the audience (executive management and the board of directors), and excessive detail should be avoided. Some relevant comments on a suitable ﬁnancial plan presentation are: • The subjects addressed should be: Those that the CEO and the CFO think are essential to a full disclosure of any signiﬁcant

ﬁnancial aspects of the strategic plan and to the direction in which the company is moving Those that are essential to convey a full appreciation of the ﬁnancial risks to be taken and the potential rewards Those in which the board (or executive management) has shown particular interest—as judged by past comments or questions in previous board meetings Finally, if not contained in the above, the underlying ﬁnancial or economic assumptions— even though the CEO and/or the CFO might regard them as implied or understood • The method of presentation should invite attention and be easy to understand. It could be a written report, but an oral presentation with visual aids might be more effective. This latter technique usually permits the immediate answering of any questions that might arise. While the usual rules for effective presentations apply, here are some reminders: Keep it simple and not in ﬁnancial jargon (if the board is not composed of experienced

ﬁnancial people). Use a largely graphic presentation in color. New computer software facilitates this. Have only a relatively few lines or ﬁgures on each chart. Show relationships, not just absolute data. Keep the monetary units large—thousands or millions, not individual units. Present the data in a logical order so that each ﬁnancial statement can be followed and the relationship to other ﬁnancials can be comprehended.

13.10 ILLUSTRATIVE FINANCIAL EXHIBITS IN THE PLAN PRESENTATION The actual exhibits to be presented to the executives will vary from industry to industry and from company to company, depending on, among other things, the critical success factors, past problem areas, and those facets of particular interest to the audience. Some of the exhibits of an actual strategic plan presentation for an electronics company have been used (all ﬁgures are ﬁctitious), as being representative of a decentralized management, with several SBUs, and a history of excessive debt load when viewed against a probable cyclical downturn and the management’s conservative standards. See the following ﬁnancial exhibits and their brief commentaries: • Exhibit 13.2: Basic Financial/Economic Assumptions. In any plan, the assumptions often are critical, and management should be advised of the important ones. • Exhibit 13.3: Financial Highlights. The exhibit shows the trend of those factors that management (and the industry) regard as key to progress. The format is highly condensed as each item later will be discussed in detail by the use of a supporting slide. • Exhibit 13.4: Statement of Consolidated Earnings. The exhibit presents a traditional income and expense statement showing net sales and the related major functional costs and can indicate the percentage of sales operating margin and net income ratios. • Exhibit 13.6: Consolidated Net Sales. The trend of planned sales for ﬁve years, compared with the actual company sales of the past year and estimated sales for the current year is illustrated.

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Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

T HE H I -T ECH C ORPORATION B ASIC F INANCIAL /E CONOMIC A SSUMPTIONS 2004–2008 S TRATEGIC P LAN Inﬂation rate (average) Interest rates (average) Prime rate Long-term (30 years) Capital expenditures Research and development expenditures Major acquisitions No change in income tax rates or base No recession Defense expenditures drastically reducing E XHIBIT 13.2

5% 10%–13% 9%–12% $670 million $320 million Not in planning period

B ASIC F INANCIAL /E CONOMIC A SSUMPTIONS

• Exhibit 13.5: Net Sales by Strategic Business Unit. In addition to consolidated sales, the sales by strategic business unit are shown. Presumably, each SBU has been discussed by the general manager. This exhibit relates the individual sales to each other and to the whole. • Exhibit 13.7: Percentage of Net Sales to U.S. Department of Defense. The management does not wish to remain highly dependent on sales to the Department of Defense and carefully monitors the trend in the volume of such business. • Exhibit 13.8: Consolidated Sales Backlog—By Strategic Business Unit. In the high-technology area, the orders on hand, the sales backlog, is an important gauge of the business trend. This exhibit reveals how much ﬁrm business has already been contracted for several years in the future, and the relative share of each SBU. • Exhibit 13.9 and Exhibit 13.10: Consolidated Net Earnings and Income (in total and by SBU). These exhibits reﬂect the trend of consolidated net income, together with the net income of each SBU. They are supported by a condensed traditional statement of income and expense for each SBU, showing the percentage operating proﬁt and percentage net income to sales — important signals in the business — as well as the absolute ﬁgures. • Exhibit 13.11: Earnings per Share. The board of directors and the management, as expected, are interested in the earnings per share and the growth rate. Incentive compensation depends on (1) achieving plan, and (2) the percentage increase from the preceding year. This chart is supplemented by one showing the growth rate imputed to each SBU. • Exhibit 13.12: Earnings per Share—Three Scenarios. Because plan achievement is never certain, the impact of selected other strategies is quantiﬁed. The reason for selecting the particular strategies in the plan was discussed at the operating center level and is repeated in condensed terms at the top management/board level. Comparable charts are prepared for cash ﬂow, return on assets, return on shareholders’ equity, and so on. • Exhibit 13.13: Statement of Consolidated Cash Flows. The sources and uses of cash are identiﬁed in this highly condensed statement—with no detail by working capital items. Supporting this statement is a similar one for each SBU. • Exhibit 13.14, and Exhibit 13.15: Consolidated Financial Position. A condensed statement of planned ﬁnancial position is presented, and points of compliance (or noncompliance) with the bond indenture requirements, important contracts, or management standards are identiﬁed. Additionally, the aging of accounts receivable, composition of inventory, makeup of accounts payable and accruals, and paydown of senior debt (before due date) may be discussed.

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Per share

E XHIBIT 13.3

F INANCIAL H IGHLIGHTS

Common shares outstanding (thousands) at year end

Return on average equity (%)

Book value per share (year end)

Research and development expense

31,050

7.45%

$ 43.03

50

115

3.09

Percentage of sales

Capital expenditures

96 1.9%

Amount

Net earnings

5,052

Net sales (consolidated)

31,110

12.59%

46.93

55

115

5.66

3.2%

176

5,500

3,750

3,600

$ 3,800 5,650

Past Year

Sales backlog (year end)

New orders

Item

This Year (Indicated Final)

Actual

13.10

31,220

9.74%

55.38

57

100

5.22

2.9%

163

5,700

3,020

8,470

2005

31,290

17.11%

63.57

64

50

10.16

5.0%

318

6,400

3,020

6,400

2006

Plan Year

31,300

20.39%

75.91

69

50

14.22

6.4%

445

7,000

3,520

7,500

2007

2008

219

31,350

23.59%

$ 93.78

70

50

20.00

7.8%

627

8,000

3,720

$ 8,200

Illustrative Financial Exhibits in the Plan Presentation 13.10

31,210

13.78%

51.87

60

420

6.79

3.5%

212

6,000

250

2,500

2004

T HE H I -T ECH C ORPORATION F INANCIAL H IGHLIGHTS 2004–2008 S TRATEGIC P LAN (D OLLARS IN M ILLIONS E XCEPT PER S HARE )

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C ONSOLIDATED E ARNINGS

$ 181 111 $ 292 $ 168 72 $ 96

OF

223 15 238 312 136 176

$4,461 40 50 41 $4,592 $ 460

S TATEMENT

4,815 41 55 39 4,950 550

$5,052

Net Sales Operating costs Manufacturing Marketing Research and development General and administrative Total Operating margin Other expenses Interest expense Other (net) Total Earnings before income taxes Income taxes Net earnings

E XHIBIT 13.4

5,500

Past Year

Item

This Year (Indicated Final)

Actual

200 15 215 385 173 212

5,204 39 120 37 5,400 600

6,000

2004

T HE H I -T ECH C ORPORATION S TATEMENT OF C ONSOLIDATED E ARNINGS 2004–2008 S TRATEGIC P LAN (D OLLARS IN M ILLIONS )

Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

190) (10) 180) 333) 170) 163)

4,995) 40) 114) 38) 5,187) 513)

5,700)

2005

7,000 5,791 46 140 43 6,020 980 100 10 110 870 425 445

5,420 42 128 42 5,632 768 180 10 190 578 260 318

2007

6,400

2006

Plan Year

50 10 $ 60 $1,140 513 $ 627

$

$6,544 52 160 44 $6,800 $1,200

$8,000

2008

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221

T HE H I -T ECH C ORPORATION C ONSOLIDATED N ET S ALES 2004–2008 S TRATEGIC P LAN (D OLLARS IN B ILLIONS )

E XHIBIT 13.5

C ONSOLIDATED N ET S ALES

T HE H I -T ECH C ORPORATION N ET S ALES BY S TRATEGIC B USINESS U NIT 2004–2008 S TRATEGIC P LAN (D OLLARS IN B ILLIONS )

E XHIBIT 13.6

N ET S ALES

BY

S TRATEGIC B USINESS U NIT

Exhibit 13.16: Return on Average Assets. Return on assets is an important measure of the management’s use of assets, particularly at the SBU level. The trend in total is discussed, and performance by each SBU is reviewed, showing the analysis by the two relevant factors: turnover and percentage return on sales.

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Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

T HE H I -T ECH C ORPORATION N ET S ALES —P ERCENTAGE TO U.S. D EPARTMENT 2004–2008 S TRATEGIC P LAN

E XHIBIT 13.7

N ET S ALES —P ERCENTAGE

TO

OF

U.S. D EPARTMENT

D EFENSE

OF

D EFENSE

T HE H I -T ECH C ORPORATION S ALES B ACKLOG BY S TRATEGIC B USINESS U NIT 2004–2008 S TRATEGIC P LAN (D OLLARS IN B ILLIONS )

E XHIBIT 13.8

S ALES B ACKLOG

BY

S TRATEGIC B USINESS U NIT

• Exhibit 13.17: Percent Return on Average Shareholders’ Equity. A key measure of this management is return on shareholders’ equity — the trend as well as the entity’s performance versus competitors.

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223

T HE H I -T ECH C ORPORATION C ONSOLIDATED N ET E ARNINGS 2004–2008 S TRATEGIC P LAN (D OLLARS IN B ILLIONS )

E XHIBIT 13.9

C ONSOLIDATED N ET E ARNINGS T HE H I -T ECH C ORPORATION C ONSOLIDATED N ET I NCOME BY S TRATEGIC B USINESS U NIT 2004–2008 S TRATEGIC P LAN (D OLLARS IN B ILLIONS )

E XHIBIT 13.10

C ONSOLIDATED N ET I NCOME — BY S TRATEGIC B USINESS U NIT

• Exhibit 13.18 on page 229 and Exhibit 13.19 on page 229: Ratio of Long-Term Debt to Net Worth, and Current Ratio. Given the preoccupation with debt, and the covenants of the indenture, the long-term debt to net worth ratio especially is reviewed, as is the current ratio.

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Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

T HE H I -T ECH C ORPORATION E ARNINGS PER S HARE 2004–2008 S TRATEGIC P LAN

E XHIBIT 13.11

E ARNINGS

PER

S HARE

T HE H I -T ECH C ORPORATION E ARNINGS PER S HARE —T HREE S CENARIOS 2004–2008 S TRATEGIC P LAN

E XHIBIT 13.12

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E ARNINGS

PER

S HARE —T HREE S CENARIOS

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E XHIBIT 13.13

S TATEMENT OF

C ONSOLIDATED C ASH F LOWS

Net cash ﬂows from (used by) ﬁnancing activities Increase (decrease) in cash and cash equivalents Cash and equivalents at beginning of year Cash and equivalents at end of year

Dividends to shareholders Changed (reduction) in short-term bank debt Additions to long-term debt Reduction in long-term debt

Cash Flows from (Used by) Financing Activities

Equity interest (Corp. X) Capital expenditures Proceeds from asset sales and retirements Net cash ﬂows used in investing activities

Cash Flows from (Used by) Investing Activities

Working capital provided by operations Increase (decrease) in operating-related working capital items Net cash ﬂows from operating activities

Net earnings Depreciation and amortization Deferred taxes, etc.

Cash Flows for Operating Activities

(303) 245 328 573

(53) (200) — (50)

— (100) 20 (80)

(221) 628

163 244 — 407

2005

(458) 43 573 616

(58) (150) — (250)

— (50) — (50)

(7) 551

318 240 — 558

2006

Plan Year

(298) 292 616 908

(58) — — (240)

— (50) — (50)

(55) 640

445 250 — 695

2007

Illustrative Financial Exhibits in the Plan Presentation 13.10

270 131 197 328

43 25 172 $197

13.10

(53) (135) 500 (42)

— (420) — (420)

149 281

212 214 4 430

2004

(52) 116 — (21)

— (118) 1 (117)

255 99

$176 174 4 354

Present Year (Indicated Final)

T HE H I -T ECH C ORPORATION S TATEMENT OF C ONSOLIDATED C ASH F LOWS 2004–2008 S TRATEGIC P LAN (D OLLARS IN M ILLIONS )

225

(413) (391) 908 $517

(63) — — (350)

(800) (50) — (850)

(45) 872

$627 200 — 827

2008

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S TATEMENT OF

C ONSOLIDATED F INANCIAL P OSITION (A SSETS )

— 2,407 792 1,615 75 1,690 $3,521

Long-Term Assets Minority interests (Corp. X) Property, plant and equipment Less: accumulated depreciation and amortization Net Other assets Total Total Assets

E XHIBIT 13.14

$ 172 576 1,037 46 1,831 — 2,522 966 1,556 80 1,636 3,811

197 614 1,320 44 2,175

2003 (Indicated Final)

Actual

Y EAR E ND

2004

AT

— 2,942 1,180 1,762 80 1,842 4,250

328 640 1,400 40 2,408

T HE H I -T ECH C ORPORATION C ONSOLIDATED F INANCIAL P OSITION 2004–2008 S TRATEGIC P LAN (D OLLARS IN M ILLIONS )

Current Assets Cash and equivalents Receivables Inventories Prepaid items Total

OF

2002

S TATEMENT

Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

Assets

226

— 3,022 1,404 1,618 80 1,698 4,021

573 510 1,200 40 2,323

2005

— 3,072 1,644 1,428 80 1,508 4,014

616 550 1,300 40 2,506

2006

At Plan Year End

— 3,122 1,894 1,228 80 1,308 4,106

908 650 1,200 40 2,798

2007

800 3,172 2,094 1,878 80 1,958 $4,315

$ 517 600 1,200 40 2,357

2008

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S TATEMENT OF

13.10

AT

4,021

30 310 1,419 1,729

750 500 110 1,360

100 50 540 160 37 15 902

2005

Y EAR E ND

4,014

20 310 1,679 1,989

500 500 110 1,110

— 50 590 170 65 20 895

2006

At Plan Year End

4,106

10 310 2,066 2,376

300 450 120 870

— 50 500 190 90 20 850

2007

$4,315

10 310 2,630 $2,940

$

— 400 120 $ 520

$

— 50 500 170 100 25 $ 845

$

2008

Illustrative Financial Exhibits in the Plan Presentation 13.10

E QUITY )

4,250

3,811 AND

40 310 1,309 1,619

800 500 110 1,410

300 — 610 200 43 28 1,181

50 310 1,150 1,460

842 — 140 982

435 21 590 212 34 27 1,319

2003 (Indicated Final) 2004

T HE H I -T ECH C ORPORATION C ONSOLIDATED F INANCIAL P OSITION 2004–2008 S TRATEGIC P LAN (D OLLARS IN M ILLIONS )

Actual

OF

C ONSOLIDATED F INANCIAL P OSITION (L IABILITIES

$3,521

Total liabilities and equity

E XHIBIT 13.15

$ 47 $ 310 1,026 $1,336

$ 863 — 142 $1,005

$ 319 21 563 187 17 26 $1,133

2002

Shareholders’ equity Paid-in capital Retained earnings Total equity

Deferred Income Taxes

Senior debt—existing Senior debt—new Other long-term obligations Total

Long-Term Obligations

Notes payable to banks Current portion of long-term debt Accounts payable Accrued items Income tax payable Other current liabilities Total

Current Liabilities

Liabilities and Equity

S TATEMENT

227

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Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

T HE H I -T ECH C ORPORATION P ERCENTAGE R ETURN ON A VERAGE A SSETS 2004–2008 S TRATEGIC P LAN

E XHIBIT 13.16

P ERCENTAGE R ETURN

ON

A VERAGE A SSETS

T HE H I -T ECH C ORPORATION P ERCENTAGE R ETURN ON A VERAGE S HAREHOLDERS ’ E QUITY 2004–2008 S TRATEGIC P LAN

E XHIBIT 13.17

P ERCENTAGE R ETURN

ON

A VERAGE S HAREHOLDERS ’ E QUITY

• Exhibit 13.20: Beyond the Five Years. Given some far-reaching changes in technology — the “supertechnology”—and the perceived opportunity for an advantageous acquisition, the technical staff brieﬂy touched on this subject during the long-range technical activity over-

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R ATIO

E XHIBIT 13.18

R ATIO

OF

229

T HE H I -T ECH C ORPORATION L ONG -T ERM D EBT TO N ET W ORTH 2004–2008 S TRATEGIC P LAN

OF

L ONG -T ERM D EBT

TO

N ET W ORTH

T HE H I -T ECH C ORPORATION C URRENT R ATIO 2004–2008 S TRATEGIC P LAN

E XHIBIT 13.19

C URRENT R ATIO

view. Because the data are not yet ﬁrm enough to quantify, but because the opportunity may develop in about three years, the CEO wanted the board of directors to be made aware of a possible major use of cash, including related debt and equity sources, and possible diversion

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Ch. 13 Financial Impact of the Strategic Plan: Long-Range Financial Plan

T HE H I -T ECH C ORPORATION

E XHIBIT 13.20

B EYOND

THE

F IVE Y EARS

of research talent. An estimate of the needs in a three-year time frame, beyond the long-range planning period, is shown.

13.11 ROLE OF THE CONTROLLER For the early phases of the strategic planning process—developing the company mission, objectives, and strategies— the controller generally provides ﬁnancial data needed by other executives and makes ﬁnancial analyses for them, to assist in setting appropriate objectives and testing the alternative strategies. But what are the controller’s functions when the task is to translate all operations and ﬁnancial conditions into a time-phase plan expressed in ﬁnancial terms? The long-range ﬁnancial plan is not the plan of the ﬁnancial executives, but rather the plan of each major executive, integrated into a single plan and expressed in ﬁnancial terms. Because the chief sales executive will be responsible for meeting the sales plan and its related milestones, year by year, the controller must make certain that the sales segment, marketing segment, and the combining of continuing strategies or plans with the newly determined strategies, translates into a plan suitable to, or agreed to, by the sales executive. Comparable assistance must be given to all other nonﬁnancial executives. In the ﬁnancial area itself, in conjunction with the CEO, the ﬁnancial operations and ﬁnancing activities must be translated into realistic plans on a year-to-year basis. Then the consolidated plan must be tested against prudent standards and the objectives set by company management. Accordingly, the responsibilities of the controller might be grouped into supportive facilitating functions, and exercise of the primarily ﬁnancial functions in consolidating and testing the plan from a ﬁnancial standpoint. A detailed outline of these responsibilities follows. 1. Supportive. In general to provide ﬁnancial-type data, together with requested analyses, to the other executives involved in developing the plan, including: (a) Provision of analytical data (i) Sales, in units and value, as appropriate, by year, by requested breakdown: products, territories, channels of distribution (ii) Proﬁt margin analyses; operating margin, contribution margin by sectors: products, territories, and the like

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13.11 Role of the Controller

231

(iii) Costs and expenses by functions, or appropriate organizational segment, type of expense, and/or other break-outs: marketing, R&D, engineering, administrative (iv) Data regarding asset utilization and/or investment (b) Assistance in organizing ﬁnancial data, as needed, for the use of the other executives in their plan presentations (c) Assistance in goal setting, such as: (i) (ii) (iii) (iv)

Return on sales (or operating margin) Return on assets Return on shareholders’ equity Turnover on assets

on an overall basis and/or by segment of the organization (division, subsidiary, etc.). 2. Directly Financial (a) Consolidate all plans in ﬁnancial terms, by year or other appropriate time segment (two years, or quarters, in some instances) for the planning period. The primary ﬁnancial statements produced would include: (i) (ii) (iii) (iv)

Statement of planned income and expense Statement of planned cash ﬂows Statement of planned ﬁnancial position Statement of planned capital (ﬁxed assets), both commitments and expenditures

(b) Evaluate or appraise the strategic plans as an overall management device against such standards as: (i) (ii) (iii) (iv)

Corporate goals Past performance or condition Selected competitors Industry performance

These tests could relate to: (i) Proﬁtability — on sales, assets, or net worth (ii) Growth rates — sales, aggregate earnings, earnings per share (c) Judge the planned ﬁnancial condition including that of any segments against such requirements as credit agreements, merger or acquisition contracts, indentures, or against selected ratios: debt to equity, current ratio, working capital, and the like. These calculations can be made to test yearly operating results or year-end condition. (d) Measure dividend policy, stock purchase plans, or other ﬁnancial policies against perceived needs, and market requirements, as related to future capital requirements. (e) Evaluate the plan, or any segments, as to reasonableness, weaknesses, attainability, undue optimism, and so forth. (f) Finally, assuming the plan will be met each year, evaluate it in the context of market expectation (analysts), P/E ratio, etc. The consolidation of the strategic plan is not a simple, routine matter of adding some numbers: It involves a complete appraisal or judging of results in the eyes of not only management, but also the ﬁnancial community. The company must be kept on a path that will enable it to secure the needed capital for growth or expansion, even under somewhat adverse economic conditions.

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CHAPTER

14

PROFIT PLANNING: ANNUAL PLAN 14.1

PROFIT PLANNING DEFINED 233

14.13 INVENTORY BUDGET 241

14.2

PURPOSE OF BUDGETING 234

14.14 OPERATING EXPENSE BUDGET 243

14.3

PLANNING BENEFITS 234

14.15 CAPITAL EXPENDITURES BUDGET 243

14.4

COORDINATION BENEFITS 235

14.16 COST OF GOODS SOLD 243

14.5

CONTROL BENEFITS 236

14.6

ANNUAL PLANNING CYCLE: ILLUSTRATIVE 237

14.17 STATEMENT OF ESTIMATED INCOME AND EXPENSE 243

14.7

SUPPORTIVE FINANCIAL STATEMENTS AND BUDGETS 238

14.19 STATEMENT OF ESTIMATED FINANCIAL CONDITION 245

14.8

SALES BUDGET 239

14.20 APPROVAL OF BUDGET 246

14.9

PRODUCTION BUDGET 240

14.21 CONTROL FUNCTION 247

14.18 CASH BUDGET 245

14.10 PURCHASES BUDGET 240 14.11 DIRECT LABOR BUDGET 241

14.22 CONTROLLER’S ROLE : A KEY PLAYER 247

14.12 MANUFACTURING EXPENSE BUDGET 241

14.23 MANAGEMENT APPROVAL OF THE PLAN 253

14.1 PROFIT PLANNING DEFINED Supportive of the long-range plan is short-range or short-term planning that usually concerns itself with the next year or two. It is the detailed planning that involves the development of operating programs that work to ensure the effective implementation of the long-range proﬁt goals but recognize the limitations and opportunities of the present and near-term resources and business environment. Proﬁt planning has been deﬁned by several authorities as the process of developing detailed plans for a speciﬁed near-term period in the future and integrating these plans into a comprehensive whole. In this proﬁt-planning process, expected revenues, costs, levels of operation, facilities, ﬁnancial resources, and personnel are all considered and interrelated. The appropriateness of levels and types of costs and expenses are analyzed and interrelated by techniques discussed in Chapter 15. Modeling techniques may be involved in this proﬁt-planning process to provide management with (1) a quantitative analysis of the probable effects on operating results, (2) the ﬁnancial condition of alternative decisions, and (3) alternative uses of resources to optimize the return to the shareholders. Proﬁt planning is an iterative process that aids the manager in revising and modifying plans until an acceptable one is reached. This entire short-term proﬁt-planning and control process may be summarized as including these elements: • Arriving at an acceptable plan or program • Measuring actual performance against the plan (and against other related standards) • Deciding on, and implementing, corrective action 233

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Ch. 14 Profit Planning: Annual Plan

The detailed planning and control process of Emerson Electric1 is a classic of its kind and has been the subject of many schools of business case studies and involves the above three segments. It seeks to identify problems before they start and commence corrective action. For an extended period, the planning sessions focused on costs, margins, and proﬁts. As a result, the managers had little incentive to emphasize growth or risky new products that would reduce near-term proﬁts. That is changing because a primary need of the company now is growth — whether by going global, by acquiring new companies, or by participating in joint ventures. The annual plan should seek to address the perceived needs of the business. This chapter describes the short-term planning process, including a simpliﬁed illustrative plan, and the role of the controller as a chief player. Chapter 15 discusses some related ﬁnancial analysis techniques that assist the company in developing an acceptable annual or short-range business plan. But, ﬁrst, what is the need for and what are the advantages of this business planning and budgeting?

14.2 PURPOSE OF BUDGETING A fundamental purpose of business budgeting is to ﬁnd the most proﬁtable course through which the efforts of the business may be directed in meeting its primary service objective. Another purpose is to assist management in holding the business as nearly as possible on that charted course. In most business concerns there are numerous decisions to be made about the policies to be followed and the methods to be used. Decisions must be made, for example, about the choice of goods and services to be made and sold; the selection of customers; the level of prices; the methods of production, distribution, and ﬁnancing; credit terms; the degree of integration of operating units; and so on, almost without limit. Which selection of policies and methods will be most proﬁtable? Can any combination be found that gives reasonable promise of an adequate return on the investment? If none can, the venture should be stopped, the business merged with another, or the capital shifted to other channels, before further losses result. If proﬁtable courses are open, each should be examined and translated into its proﬁt possibilities. Although it is easy to speak in general terms of the desirability of budgeting, the practical advantages in an actual case are not always so apparent. Conditions change rapidly in business; the actions of customers and competitors cannot be entirely controlled, and after they become known a business must, to a degree, govern itself accordingly, regardless of any previously developed program. Plans, when made intelligently, require exhaustive study and research, and this constitutes an expensive procedure. What, then, are the speciﬁc advantages to be gained? The beneﬁts of budgeting lie in three primary ﬁelds of business activity: (1) directly in the planning, (2) in the coordinating phase, and (3) in the control area. These activities are each very wide in scope and contain within themselves several supplemental or detailed advantages.

14.3 PLANNING BENEFITS Planning is needed to ensure that a company utilizes its assets in an orderly and efﬁcient manner, which avoids a great deal of waste. The following points are the primary reasons for using planning: • To base action on thorough investigation, study, and research. Perhaps the cardinal advantage of systematic budgeting is that it tends to bring the executives to an early study of their problems and instills into the organization the habit of careful study before a decision about action is made. This is not easy to achieve. Intensive study is to many a distasteful exercise. Most of us prefer to postpone difﬁcult decisions until necessity compels us to act. Businesses, like individuals, tend to become opportunist; they wait until a decision is forced, then turn quickly, often without time for careful study of the problems, in the direction offering the easiest immediate escape from their troubles.

1. Seth, Lubove, “It Ain’t Broke, but Fix It Anyway,” Forbes, Aug. 1, 1994, pp. 56 – 60.

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14.4 Coordination Benefits

235

If the executives, from general manager to foreperson, know that their plans are to be formally expressed and that they will be charged with responsibility for their execution, they can be brought to an earlier and more intensive study of the problems at hand. This habit of making plans will beneﬁt every activity. Speciﬁcally, it will relate to ﬁnancial requirements, inventory levels, production facilities, production, purchasing, advertising, selling, sales promotion, product development, organization growth or expansion, and labor relations— in short, the advantages can accrue to every function. • To enlist the assistance of the entire organization in determining the most proﬁtable course. When budgeting is undertaken in ample time and on a regular schedule, there is full opportunity to enlist the assistance of foremen, salespeople, branch managers, department heads, and all operating ofﬁcials—major and minor. In some lines of business the suggestions and counsel from such sources are essential to the development of the best operating plans, and in most lines of business such assistance is highly desirable. The ﬁnal plans should be expressive of the combined judgment of the entire organization, thereby eliminating such bias or prejudice as frequently affects the judgment of individual groups. • To serve as a declaration of policies. Nothing so restrains the enthusiasm and energy of an organization as uncertainty. The budget procedure provides a vehicle through which basic policies are periodically reexamined, restated, and set forth as guiding principles for the organization at large. Basic policies, not temporary expediency, should be the guiding factors of a business, and the organization should be schooled in such policies. • To deﬁne objectives. The successful manager must be surrounded with capable associates who will accept leadership and execute the program. But a manager must demonstrate the ability to lead. People will follow a leader when they realize that the leader has a sensible plan of action and deﬁnite objectives in mind. Such objectives should be clearly expressed and, to a certain degree, should stand as goals of attainment for the entire organization. Objectives, however, must not be the product of hope but rather the logical consequence of carefully laid plans. The executive who can clearly deﬁne objectives and delineate a program that can logically be expected to reach such objectives will command cooperation and loyalty from associates. • To stabilize employment. No employer of labor, regardless of social or economic philosophy, can longer disregard the welfare of the employees. The time has passed when workers could be laid aside at will when not needed, like ﬂasks or patterns in the foundry. To be sure, the responsibility to workers must be balanced with the responsibility to investors, and the welfare of both must be considered, but the business program must consider stability of employment. Intelligent business budgeting rather than governmental regulation offers the greatest hope for providing stability of employment. • To make more effective use of physical equipment. During the course of planning, the excess cost of idle capacity will be revealed. Moreover, in considering those plans that offer the greatest proﬁt, the maximum use of available facilities will inevitably be a factor. The result normally would be the elimination of some of the social wastes related to the uneconomical use of physical facilities.

14.4 COORDINATION BENEFITS Assets are not properly utilized across all departments unless there is close coordination of the activities of all functions. This section notes the key reasons for emphasizing a high level of coordination. • To coordinate and correlate human effort within the business structure. In some respects this is the most important purpose of budgeting. In many concerns there is a deﬁnite lack of coordination of effort. This is a restraining factor. Full steam cannot be applied in some divisions of the business because of uncertainty about the program in other divisions. Only when the effort of all divisions is properly timed and coordinated can the full power of united action be realized.

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Ch. 14 Profit Planning: Annual Plan

This, however, emphasizes another important element of budgeting—the necessity of constant review and revision of the plans. If unforeseen and uncontrollable situations arise (and in many industries this is certain to happen) that materially alter the operations of one division, the machinery must be available for quick readjustment of the program in other divisions affected thereby. Wars, ﬂoods, droughts, strikes, price wars, political changes, collapse of foreign markets, and so on give rise to such situations. The success of business budgeting should be measured not so much by the nearness of the ultimate results to the original plans as by the extent to which all executives — major and minor— know at all times just what is the immediate program and what are their respective parts therein. There must be no restraint or uncertainty if the organization is to function with full power. The chief executive is the ﬁnancial coordinating ofﬁcial, but the complexities of the modern business are such that this function cannot be exercised without the assistance and guidance of clearly deﬁned objectives and detailed plans that are projected throughout the entire organization. • To relate the activities of the business to the expected general trend of business conditions. Numerous studies have been made which indicate that proﬁts can be as much (if not more) the result of changes in fundamental conditions as of competitive efﬁciency. This emphasizes the importance of coordinating the plans of the business with the general trend of economic conditions. The failure of economists to agree on the causes of the business cycle and the frequent differences of opinion among business analysts about future trends have led many executives to the point of skepticism regarding the whole matter of forecasting. However, the fact remains that business activity moves through periods of high and low volume and that for particular businesses there are frequently signals for these changes. These signals must be watched and the plans of the business must reﬂect courage or caution, depending on the expected trend. • To direct capital and effort into the most proﬁtable channels by means of a balanced and uniﬁed program. Before spending money, serious study should be given to the amount that can be proﬁtably spent, where it is to come from, just how it should be spent, and what results may be reasonably expected. A certain amount of funds must be directed toward equipment and inventories and a certain amount to the promotion of sales, but these amounts must be kept in proper balance. No more ambitious project should be attempted than that for which there is available capital, no more production should be made than that which can be proﬁtably sold, and no sales program should be developed beyond that needed for the planned production. Such a balance of factors directed toward a deﬁnite objective represents the ideal and, although it can seldom be fully achieved in practice, its attainment will be more likely as a result of careful advance planning. Without such planning, inventories are likely to be out of proportion to sales and production requirements, customers may be excessively ﬁnanced, and irregularity is likely to arise in the use of production facilities. Where plans and decisions are made from day to day, the program frequently becomes unconsciously warped. Executives are often, through previous training or experience, biased in the direction of sales, engineering, or ﬁnance, with the result that one factor receives a disproportionate emphasis. A well-balanced program set up in advance and based on careful study will help avoid this danger. • To reveal weakness in organization. As plans are made and the responsibility for their execution delegated, weaknesses in organization will be revealed. Executives will not accept responsibility unless lines of authority are so delineated that they will be unhampered in the execution of their tasks. Where joint responsibilities are necessary, provision must be made in advance for an orderly procedure of joint action. No management activity so quickly reveals weakness in organization as the procedure of systematic budgeting.

14.5 CONTROL BENEFITS A high degree of control is needed to ensure that a company’s activities closely follow the original plan. This section notes the beneﬁts of good control systems.

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14.6 Annual Planning Cycle : Illustrative

237

• To control speciﬁc operations or expenditures. Although the primary purpose of budgeting is to ascertain the most proﬁtable course for the business to follow and to develop a balanced and coordinated program which will hold the company to that course, the budget also provides a valuable tool of control over certain business operations. Some operations and expenditures are subject to very deﬁnite control. It may be decided, for example, that $200,000 should be invested in plant expansion, that $100,000 should be appropriated for various sales promotion projects related to a new product, that 1,000 units of the new product should be sold during the period under consideration, and that these units should be manufactured at a cost of $200 each. Assuming that the plans have been predicated on careful study and the considered judgment of the entire organization, the foundation has been laid for a certain degree of control. The investment in the plant can be rigidly held to the prescribed limits in spite of the enthusiasm of production ofﬁcials to be beyond. Likewise, the expenditure for sales promotion can be deﬁnitely held to the predetermined plan. The orders for 1,000 units may not be realized. This might result from the fact that (1) external conditions have changed rapidly and such changes could not be foreseen, or (2) the production of the units— either in quantity or cost—has not met expectations. In such cases the budget provides a certain degree of control. Expenditures are limited and directed into the channels that offer the most promise. If external conditions beyond the control of management change, the program must be promptly revised. If such conditions do not change and failure of execution lies within the organization, the budget serves as a very deﬁnite tool of control. The failure of sales and production performance to meet expectation provides the signal for corrective action. • To prevent waste. This is a more general aspect of control. A searching inquiry into every contemplated expenditure and the reason therefor—an analytical approach extending to every function and every department of the business—will constitute an effective preventive of waste. It can be seen that many of these speciﬁc advantages are very closely related to all three primary reasons for budgeting. However, the segregation should assist in a better understanding of the advantages of business planning and budgeting.

14.6 ANNUAL PLANNING CYCLE : ILLUSTRATIVE Given the desirability of an annual plan, what are the basic steps involved? Assuming a company with several operating divisions, whose managers are held responsible for operating results, an overview of the process of developing a plan and budget is shown in Exhibit 14.1. The four steps may be described brieﬂy as: 1. Very speciﬁc guidelines concerning the plan are issued by the company management to the operating divisions and the corporate executives involved. Such constraints are intended to ensure: • Actions taken during the year will be consistent with corporate policy and strategy as decided in the strategic plan. • The ﬁnancial assumptions will be consistent (where applicable) and realistic, that is, federal and state income tax rates, inﬂation rates, capital expenditure limits, Social Security tax rate, independent research and development expense levels, etc. • Sufﬁcient detail is forthcoming to permit an evaluation of the division plan. 2. When received, the division plans, along with other related plans (corporate organization, special departments, etc.), are consolidated to secure the total company picture. The division plans are prepared by functional segments, as may be deduced from Exhibit 14.2. 3. The consolidated plan (and that of each operating unit, etc.) is evaluated in the corporate ofﬁce (marketing, technical, ﬁnancial, and general management). Some reiteration may be necessary to arrive at an acceptable plan (adequate proﬁt rate, etc.). 4. When the overall picture is judged satisfactory at top management and board of director levels, the division is notiﬁed of the approved plan.

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Ch. 14 Profit Planning: Annual Plan

E XHIBIT 14.1

C OMPANY A NNUAL O PERATION P LAN P ROCESS

E XHIBIT 14.2

D IVISION O PERATING P LAN

14.7 SUPPORTIVE FINANCIAL STATEMENTS AND BUDGETS Finally, a business plan is expressed in ﬁnancial terms. The plan should be summarized in these basic ﬁnancial statements: • Statement of planned income and expense • Statement of planned sources and uses of cash (or statement of planned cash ﬂows)

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14.8 Sales Budget

239

• Statement of planned ﬁnancial position Such summaries should be supported by appropriate detailed plans or budgets on an organizational basis — showing in summary and by operational element, according to responsibility, these detailed plans that become budgets or standards on ﬁnal approval: • Operational Budgets Sales budget Production budget Materials units budget Purchases budget Labor budget Manufacturing expense budget Cost of goods sold budget Administrative and general expense budget Selling expense budget Advertising budget Research and development (R&D) expense budget Other income and expense budgets

• Capital Assets Budget (including commitments) • Cash Budget • Other Working Capital Budgets Receivables Inventories Short-term liabilities Prepaid items • Other Long-Term Budgets Investments Liabilities Shareholder equity All these budgets or plans are interrelated. Changes in the capital asset budget can affect the operational budgets and vice versa. The same can be said for the cash budget and the plans for longterm liabilities or shareholder’s equity. An overly simpliﬁed summary of these budgets that nevertheless illustrates the relationship of one to the other and the extent of planning involved is shown in the following sections. The complicated nature of each of the above-mentioned budgets, and the detailed analysis necessary for the preparation of a realistic budget or plan for each department and function, are described in Parts 3 and 4 of this volume. Given the complicated nature of this planning and control process, the speciﬁc functions and the key role of the controller are reviewed in some detail in Section 14.22.

14.8 SALES BUDGET Usually, the sales forecast is the starting point in budget preparation. The Illustrative Company manufactures and sells only four products. Based on the estimate of units received from the sales manager, and the expected unit prices, the sales budget is constructed as shown in Exhibit 14.3.

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Ch. 14 Profit Planning: Annual Plan

F OR

T HE I LLUSTRATIVE C OMPANY P RELIMINARY S ALES B UDGET THE Y EAR E NDING D ECEMBER 31, 20X5

Product

No. of Units

Unit Selling Price

Total Sales

R S T U Total

20,000 30,000 50,000 5,000 105,000

$33.00 54.50 21.25 78.50

$ 660,000 1,635,000 1,062,500 392,500 $3,750,000

E XHIBIT 14.3

S ALES B UDGET

14.9 PRODUCTION BUDGET Once the tentative estimate of sales has been agreed on, the usual next step is a determination of the quantities of ﬁnished goods that must be produced to meet both the sales and inventory requirements. This calculation of units to be produced is illustrated in Exhibit 14.4.

14.10 PURCHASES BUDGET After the levels of production have been set, the next job to be undertaken is the sometimes laborious task of determining the quantities of raw material needed to meet the production and inventory requirements—a function made much easier by the personal computer. This function is, ﬁrst, a matter of extending the units of production times the units of each raw material needed as shown in Exhibit 14.5. T HE I LLUSTRATIVE C OMPANY T ENTATIVE P RODUCTION B UDGET ( UNITS ) F OR THE Y EAR E NDING D ECEMBER 31, 20X5 Products Description Quantity required for sale Desired ending inventory Total requirements Less: Beginning inventory Required production E XHIBIT 14.4

R

S

T

U

20,000 5,000 25,000

30,000 5,000 35,000

50,000 10,000 60,000

5,000 500 5,500

3,000 22,000

2,000 33,000

8,000 52,000

1,000 4,500

P RODUCTION B UDGET

T HE I LLUSTRATIVE C OMPANY C OMPUTATION OF U NITS OF R AW M ATERIAL Finished Product Raw Material AA BB CC E XHIBIT 14.5

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R

S

T

U

Total Unit Requirements

11,000 22,000 11,000

33,000 — 66,000

— 52,000 104,000

9,000 9,000 4,500

53,000 83,000 185,000

C OMPUTATION

OF

R AW M ATERIAL

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14.13 Inventory Budget

241

Then, after usage has been calculated, the value of purchases can be set, giving consideration to inventories. The dollar value is determined on the basis of expected unit cost prices that may be furnished by the purchasing department. The purchases budget is constructed basically in the manner of Exhibit 14.6. Very often it is necessary to group purchases by class of material rather than to enumerate each individual type of material. This practice is often used where unit prices are small.

14.11 DIRECT LABOR BUDGET Another budget dependent on the production budget is that relating to direct labor. This cost is computed as shown in Exhibit 14.7.

14.12 MANUFACTURING EXPENSE BUDGET Total manufacturing expenses for the expected production level must be ascertained on the basis of the activity of each type of expense and/or each department or cost center. The ﬁnal estimate, arbitrarily assumed to be 50 percent of direct labor for this overly simpliﬁed illustration, is summarized in Exhibit 14.8.

14.13 INVENTORY BUDGET All information necessary to calculate the investment in inventories is now available. The value of the ﬁnished inventory would be computed as demonstrated in Exhibit 14.9.

F OR

T HE I LLUSTRATIVE C OMPANY T ENTATIVE P URCHASES B UDGET THE Y EAR E NDING D ECEMBER 31, 20X5

Requirements Raw Material

Production

Ending Inventory

53,000 83,000 185,500

2,000 5,000 20,000

AA BB CC Total E XHIBIT 14.6

Total

Less: Beginning Inventory

Quantity to Be Purchased

Unit Price

Purchases Budget

55,000 88,000 205,500

3,000 10,000 20,000

52,000 78,000 185,500

$4.00 2.00 1.00

$208,000 156,000 185,000 $549,500

P URCHASES B UDGET

.

F OR

T HE I LLUSTRATIVE C OMPANY T ENTATIVE D IRECT L ABOR B UDGET THE Y EAR E NDING D ECEMBER 31, 20X5

Product

Quantity

Standard Labor Hours per Unit

R S T U Total

22,000 33,000 52,000 4,500

1.0 2.5 .5 2.5

E XHIBIT 14.7

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D IRECT L ABOR B UDGET

Total Standard Labor Hours

Direct Labor Budget (At $6.00 per Std. Labor Hour)

22,000 82,500 26,000 11,250 141,750

$132,000 495,000 156,000 67,500 $850,500

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Ch. 14 Profit Planning: Annual Plan

T HE I LLUSTRATIVE C OMPANY T ENTATIVE B UDGET OF M ANUFACTURING E XPENSES F OR THE Y EAR E NDING D ECEMBER 31, 20X5 Description

Amount

Indirect labor Payroll taxes and insurance (40%) Provision for vacation wages Power Supplies Repairs and maintenance Depreciation Property taxes Property insurance Total

$125,000 50,000 43,250 52,000 25,000 67,000 47,000 10,000 6,000 $425,250

E XHIBIT 14.8

B UDGET

OF

M ANUFACTURING E XPENSES

T HE I LLUSTRATIVE C OMPANY C OMPUTATION OF E STIMATED E NDING I NVENTORY OF F INISHED G OODS A S OF D ECEMBER 31, 20X5 Product

Quantity

Unit Cost

Total Sales

R S T U Total

5,000 5,000 10,000 500

$14.00 28.50 8.50 35.50

$ 70,000 142,500 85,000 17,750 $315,250

E XHIBIT 14.9

C OMPUTATION

OF FINISHED

G OODS I NVENTORY

A similar procedure would be followed with respect to raw materials, supplies, and work-inprocess. The total value of inventories might then be summarized as in Exhibit 14.10. In actual practice, these summaries would be supported by supplemental detail. These data would permit testing and checking of turnover rates and so on.

T HE I LLUSTRATIVE C OMPANY S TATEMENT OF E STIMATED E NDING I NVENTORIES A S OF D ECEMBER 31, 20X5 Raw materials Supplies and parts Work-in-process Finished goods Total E XHIBIT 14.10

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$ 38,000 4,000 97,500 315,250 $454,750

T HE I NVENTORY B UDGET

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14.17 Statement of Estimated Income And Expense

243

14.14 OPERATING EXPENSE BUDGET Through detailed budgeting and summary by individual departments, the other expenses of the business are estimated. They are summarized in Exhibit 14.11. It is assumed that the only item of nonoperating income is discount on purchases, estimated to be $5,000.

14.15 CAPITAL EXPENDITURES BUDGET Based on a detailed review of facility requirements and the availability of cash, a budget for capital expenditures is prepared in Exhibit 14.12.

14.16 COST OF GOODS SOLD The requisite information is now available to prepare a tentative statement of income and expense. First, the statement of estimated cost of goods sold is computed. (See Exhibit 14.13.)

14.17 STATEMENT OF ESTIMATED INCOME AND EXPENSE The next logical step is the preparation of the statement of estimated income and expense. (See Exhibit 14.14.) T HE I LLUSTRATIVE C OMPANY S TATEMENT OF B UDGETED O PERATING E XPENSES F OR THE Y EAR E NDING D ECEMBER 31, 20X5

Items

Selling Expense

General and Administrative Expense

Salaries —executives Salaries —salespeople Commissions—agents Fringe beneﬁts Advertising space Bad debts Traveling expenses Rent Supplies Interest expense Discount on sales Total

$ 74,000 198,000 17,500 108,800 50,000 — 220,000 12,000 21,000 — — $701,300

$ 90,000 — — 36,000 — 10,000 9,500 3,000 7,000 — — $155,500

E XHIBIT 14.11

B UDGETED O PERATING

AND

O THER E XPENSES

T HE I LLUSTRATIVE C OMPANY B UDGET FOR C APITAL E XPENDITURES F OR THE Y EAR E NDING D ECEMBER 31, 20X5 Buildings Machinery and equipment Total E XHIBIT 14.12

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B UDGET

$120,000 132,500 $252,500 FOR

C APITAL E XPENDITURES

Financial Expense $

— — — — — — — — — 1,900 18,000 $19,900

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Ch. 14 Profit Planning: Annual Plan

T HE I LLUSTRATIVE C OMPANY S TATEMENT OF E STIMATED C OST OF G OODS S OLD F OR THE Y EAR E NDING D ECEMBER 31, 20X5 Raw Materials Inventory, January 1, 20X5 Add: Purchases (Exhibit 14.6) Total Available Less: Inventory, December 31, 20X5 Transfer to work-in-process Direct Labor (Exhibit 14.7) Manufacturing Expense (Exhibit 14.8) Total charges to cost of production Add: Work-in-process, January 1, 20X5 Total Less: Work-in-process, December 31, 20X5 Transfer to ﬁnished goods Add: Finished goods inventory, January 1, 20X5 Total Less: Finished goods inventory, December 31, 20X5 (Exhibit 14.9) Estimated cost of goods sold E XHIBIT 14.13

S TATEMENT

OF

E STIMATED C OST

OF

$

52,000 549,500 601,500 38,000 563,500 850,500 425,250 1,839,250 97,500 1,936,750 97,500 1,839,250 202,500 2,041,750 315,250 $1,726,500

G OODS S OLD

T HE I LLUSTRATIVE C OMPANY S TATEMENT OF E STIMATED I NCOME AND E XPENSE F OR THE Y EAR E NDING D ECEMBER 31, 20X5

Net sales (Exhibit 14.3) Cost of goods sold (Exhibit 14.13) Gross proﬁt Operating expenses: Advertising and selling (Exhibit 14.11) General and administrative expenses (Exhibit 14.11) Total operating expenses Operating proﬁt Other income—discount on purchases Other expenses: Interest expense (Exhibit 14.11) Discount on sales (Exhibit 14.11) Proﬁt before income taxes Income taxes (40%) Net income E XHIBIT 14.14

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S TATEMENT

OF

E STIMATED I NCOME

AND

Amount

% Net Sales

$3,750,000 1,726,500 2,023,500 701,300 155,500 856,800 1,166,700 5,000 1,171,700 1,900 18,000 19,900 1,151,800 460,720 $ 691,080

100.00 46.00 54.00 19.00 4.00 23.00 31.00 .01 31.00 .01 .05 .05 30.05 12.00 18.05

E XPENSE

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14.19 Statement of Estimated Financial Condition

245

In practice, the statement of estimated income and expense might be detailed by product lines, territories, or channels of distribution. Also, other signiﬁcant relationships would be calculated for discussion purposes.

14.18 CASH BUDGET Another important budget statement relates to estimated cash receipts and disbursements. The summary of the cash transactions for the year is shown in the tabulation of Exhibit 14.15. In actual practice, the cash budget statement may simply summarize the cash receipts and cash disbursements, each separately. The source or use of cash generation may be grouped as from operations, investing activity, and ﬁnancing activity. An example of this format, although not using ﬁgures from The Illustrative Company, is shown in Exhibit 14.16. It has the advantage of reconciling planned net income with the cash budget, but has the disadvantage of not identifying the speciﬁc details of the planned cash receipts and planned cash disbursements. T HE I LLUSTRATIVE C OMPANY S TATEMENT OF E STIMATED C ASH R ECEIPTS AND D ISBURSEMENTS F OR THE Y EAR E NDING D ECEMBER 31, 20X5 Cash balance, December 31, 20X4 Estimated cash receipts: Collections on accounts receivable Proceeds from sale of common stock Proceeds from notes payable Total estimated receipts Total cash available Estimated cash disbursements: Accounts payable—materials and supplies Accounts payable—other Notes payable Salaries and wages Accrued income taxes Items —other Interest expense Dividends Capital assets Total estimated disbursements Estimated cash balance, December 31, 20X5 E XHIBIT 14.15

S TATEMENT

OF

$ 460,000 $3,672,500 500,000 50,000 4,222,500 $4,682,500 $ 580,600 428,000 300,000 1,330,000 785,050 202,050 1,900 210,000 252,500

E STIMATED C ASH R ECEIPTS

4,090,100 $ 592,400 AND

D ISBURSEMENTS

14.19 STATEMENT OF ESTIMATED FINANCIAL CONDITION The ﬁnal effect of all the planning is reﬂected in the statement of estimated ﬁnancial condition at the close of the budget period. Usually, such a statement is prepared in comparative form with the actual or expected condition at the beginning of the budget period as well as at the close. The concluding budget statement of estimated ﬁnancial condition and the related statement of retained earnings are illustrated in Exhibits 14.17 and 14.18.

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Ch. 14 Profit Planning: Annual Plan

T HE G LOBAL C OMPANY S TATEMENT OF E STIMATED C ASH F LOWS F OR THE Y EAR E NDING D ECEMBER 31, 20XX ( DOLLARS IN THOUSANDS ) Cash Flows from Operating Activities

Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation Amortization Deferred income taxes Accounts receivable Inventories Other working capital changes Net cash provided by operating activities

$12,720)

1,063 420 (115) 476 (212) 140 14,492

Cash Flows from Investing Activities

Capital expenditures Disposals of plant and equipment Acquisitions and other investments Proceeds from divestitures Net cash used in investing activities

(4,210) 863 287 191 (2,869)

Cash Flows from Financing Activities

Proceeds from long-term debt Repayment of long-term debt Purchases of treasury stock Payment of dividends Net cash used in ﬁnancing activities Effect of exchange rates on cash Net increase in cash and equivalents Cash and equivalents at beginning of year Cash and equivalents at end of year E XHIBIT 14.16

S TATEMENT

OF

806 (610) (492) (1,026) (1,322) 166 10,467 5,437 $15,904)

E STIMATED C ASH F LOWS

14.20 APPROVAL OF BUDGET This comprehensive review of budget preparation has progressed from one step immediately to the next. In actual practice, the path is not as smooth or well deﬁned. Usually, after each of the detailed budgets is prepared by the accounting staff, the ﬁgures are compared with past experience and tested by checking signiﬁcant relationships. Discussions are held with the functional supervisors or department heads to clarify or correct any seemingly out-of-line condition. Such a process can well require several revisions. When agreement has been reached on the detailed budgets, then the pieces are put together and the master budget is prepared. This overall budget is presented to the president and/or budget committee for analysis and review. If management is not satisﬁed with the operating results or the expected ﬁnancial condition, or if these executives are not convinced that the best possible program is reﬂected in the plan, then the alternative plans must be introduced and expressed in monetary terms. When the principals are in accord, the budget for the coming period may be submitted for approval to the board of directors.

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14.22 Controller’s Role : A Key Player

247

14.21 CONTROL FUNCTION Up to the stage of top-side approval, the planning function has predominated. Presumably, the best possible course of action was selected and every member of the organization was assisting with the expression of such a plan. However, once the budget is approved, the business enters a new phase. The budget must be attained; the ship must be kept on course. So the budget becomes a control tool. For this purpose, actual operating results of the day, week, or month are compared with the budget. Variances are analyzed, and corrective action is taken wherever necessary. Quite often, the strong winds force the ship off its course, so a new one must be charted; the plan or budget must be revised.

14.22 CONTROLLER’S ROLE : A KEY PLAYER The annual business plan, or budget, is the plan of all members of management, as the company moves toward its long-range objectives and goals. While it is expressed in ﬁnancial terms for many phases, it is not the plan of the chief ﬁnancial ofﬁcer (CFO) or the controller. The ﬁnancial executives, and especially the controller, usually play a key role in the planning process. Since the annual plan is quite detailed in nature—for example, by type of expense, by department, by function, by month or quarter—and because the plans of one function must be consistent and properly relate to each affected function, and must be tested or evaluated against selected criteria, either by department function, or overall, it is essential that necessary data be made available in the proper format, based on the proper assumptions, and contained within a given time frame. This section details many of the actions a controller might take in a typical entity. The ﬁnancial arm of the company, whether the CFO or budget director, but most likely the controller in most instances, should ensure that these steps take place: • Designate in detail the data to be supplied by the departmental or function executive, through appropriate channels, to the controller. For example, as to the sales function, it might include unit and dollar sales for the planning period, by product, by salesperson, by territory, and by month, compared with prior performance at certain levels. As to expenses, it could include the amount of expense by department, by type of expense and by month, for the planning period, compared with the prior period. These expenses in total, or individually, for the period also might be compared with sales, or factory output (or selected competitors, if known). Much of this same data will be used later to compare actual performance with plan — another reason for the great detail. • Provide the format in which the data should be presented. The format should ﬁt the needs of the controller and especially those of the cognizant operating executives. Instructions as to content and format are necessary to permit analysis and comparisons, and to facilitate consolidation of the ﬁnancial data. • Provide historical or related ﬁnancial data which the operating executives may use for comparable purposes in preparing the plan year data. Examples include: Prior year comparative company data Historical company trends and relationships Industry comparative data, or selected competitor ﬁgures • Provide underlying guidelines to be used in preparing the data for the planning year. Information such as this might be needed: Probable tax rates and data—federal, state, and local—including payroll tax rates property tax rates, income tax rates, and social security tax rates Selected economic data, such as inﬂation rates (in general or on speciﬁc products), gross domestic product, selected regional economic growth rate, and regional unemployment rate

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248

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E XHIBIT 14.17

C OMPARATIVE S TATEMENT

Total liabilities and shareholders’ equity OF

900,000 811,680 $2,061,680 $2,373,150

500,000 330,600 $1,080,600 $1,869,000

F INANCIAL C ONDITION (C ONTINUED )

$ 350,000

80,400 50,000 55,000 46,070 80,000 $ 311,470

$

Estimated December 31, 20X5

$ 250,000

60,000 300,000 30,000 370,400 28,000 $ 788,400

$

Actual December 31, 20X4

Liabilities and Shareholders’ Equity

T HE I LLUSTRATIVE C OMPANY C OMPARATIVE S TATEMENT OF F INANCIAL C ONDITION OF D ECEMBER 31, 20X4, AND E STIMATED AS OF D ECEMBER 31, 20X5

Common stock, $5 par value, authorized 100,000 shares; outstanding, 50,000 sharesin 20X4, & 70,000 in 20X5 Capital contributed for common stock in excess of par value Retained earnings Total ownership equity

Ownership equity

Accounts payable Notes payable Accrued salaries and wages Accrued income taxes Accrued items—other Total current liabilities

Current liabilities

A CTUAL

Ch. 14 Profit Planning: Annual Plan

400,000 481,080 $ 981,080) $ 504,150)

$ 100,000)

$ 20,400 (250,000) 25,000 (324,330) 52,000 $(476,930)

Increase (Decrease)

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E XHIBIT 14.17

Total assets

AS

C OMPARATIVE S TATEMENT

Land and land improvements Buildings Machinery and equipment Total Less: Reserve fordepreciation

Fixed assets

Cash Accounts receivable Less: Reserve for doubtful accounts Inventories: Raw material Supplies Work in process Finished goods Prepaid items Total current assets

Current Assets

A CTUAL

OF

52,000 4,000 97,500 202,500

815,000 $1,869,000

356,000 3,000 $1,054,000

F INANCIAL C ONDITION

25,000 375,000 625,000 $1,025,000 210,000

$

$

38,000 4,000 97,500 315,250

25,000 495,000 757,500 $1,277,500 257,000

$

$

20,000

15,000

235,000

$ 322,500

14.22

205,500 $504,150

98,750 — $298,650

67,500

$132,400

Increase (Decrease)

Controller’s Role : A Key Player

1,020,500 $2,373,150

454,750 3,000 $1,352,650

302,500

$ 592,400

Estimated December 31, 20X5

$ 250,000

$ 460,000

Actual December 31, 20X4

Assets

T HE I LLUSTRATIVE C OMPANY C OMPARATIVE S TATEMENT OF F INANCIAL C ONDITION OF D ECEMBER 31, 20X4, AND E STIMATED AS OF D ECEMBER 31, 20X5

249

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Ch. 14 Profit Planning: Annual Plan

T HE I LLUSTRATIVE C OMPANY S TATEMENT OF E STIMATED R ETAINED E ARNINGS A S OF D ECEMBER 31, 20X5 Balance, December 31, 20X4 Add: Estimated net income for the year 20X5 Total Less: Dividends to be paid in 20X5 Estimated balance, December 31, 20X5 E XHIBIT 14.18

S TATEMENT

OF

$ 330,600 691,080 $1,021,680 210,000 811,680

E STIMATED R ETAINED E ARNINGS

Interest rates, where applicable Goals or constraints set by top management like return on assets (in total and for each

division), expected rate of sales increase (in total and/or for selected products), expected gross margin percent, and advertising expenditures Capital asset expenditure limits • Set forth the time schedule of the due date for the relevant segment or phase of the annual plan. This may be a simple due date schedule each year of important steps as authorized by the chief executive ofﬁcer (CEO). An example could be a simple letter from the controller to each division executive and the corporate functional executive (in a decentralized organization) outlining the dates: Steps

Completion Date

1. Submission of complete business plan (including monthly and other supporting detail) to corporate controller 2. Review and analysis of division plans by corporate staff of ﬁnance, marketing, manufacturing, and R&D, etc. 3. Consolidation of division plans and corporate operations, and overall ﬁnancial appraisal by the ﬁnance department 4. Review (and revise if necessary) of ﬁnal plan by CEO and senior management 5. Review and approval by board of directors

September 15, 20XX October 31, 20XX November 25, 20XX December 10, 20XX December 22, 20XX

In larger companies, where more follow-up might be necessary, and when the sequence is critical, a Gantt chart might be useful. See Exhibit 14.19, which indicates both the plan and the present status. • Review and analyze all segments of the plan for completeness, reliability, and reasonableness. • If applicable, make suggestions for improved productivity or proﬁtability as the subplans are being prepared. • Consolidate the ﬁnancial statements to determine the overall company picture: earnings, cash, capital expenditures, ﬁnancial position, and so forth. • Evaluate the plan, and the important segments by reference to certain measures. One measure is conformance to CEO or board of director goals and constraints. Other measures are commonly used comparisons, like return on equity, return on assets, earnings per share, net income as percentage of sales, turnover ratios (receivables, inventory, and ﬁxed assets), working capital, competitive or industry performance, and ﬁnancial market expectations. Other measures to consider are conformance to major credit agreement terms, identiﬁcation of possible weak spots and effect of not meeting the plan, and using some alternative scenarios (20% less than plan, 20% more than plan) to show ﬁnancial impact or effect on working capital.

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14.22 Controller’s Role : A Key Player

251

(Status as of 10/15/20XX)

E XHIBIT 14.19

G ANTT C HART

FOR

S UBSIDIARY A NNUAL P LANNING C YCLE

• Summarize the plan in a form which communicates to management and the board of directors the signiﬁcant aspects (see Section 14.23.) The detailed instructions on data content and format for the annual plan often are included as part of a ﬁnance manual (or planning manual) as they are often quite voluminous. It is desirable that the instructions be precise and in nonaccounting terms, so that the operating staff understands them. Those aspects being handled by the ﬁnance staff should be explicit. A section from a planning manual that describes the duties of the vice president of sales for the three annual plan segments for which he is responsible is shown in Exhibit 14.20. (See also Chapter 54.) The controller must be sensitive to relevant analysis and effective communication techniques. S ECTION

FROM A

P LANNING M ANUAL —B UDGET R ESPONSIBILITIES V ICE P RESIDENT —S ALES

OF THE

Schedule Type of Budget Sales budget

E XHIBIT 14.20

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Action to Be Taken

Annually

Monthly

1. Provides product sales managers with sales history and related data, and requests sales estimates in physical quantities by product line, and by territory from product sales managers (in format denoted in this manual) 2. Requests unit price data

3 months before start of budget period

2 weeks before budget period

B UDGET R ESPONSIBILITIES

OF

V ICE P RESIDENT

~ OF

S ALES

~

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Ch. 14 Profit Planning: Annual Plan

S ECTION

FROM A

P LANNING M ANUAL —B UDGET R ESPONSIBILITIES V ICE P RESIDENT —S ALES

OF THE

Schedule Type of Budget

Advertising expense budget

Action to Be Taken

Annually

Monthly

3. Reviews sales estimates of product sales managers for reasonableness and unfavorable trends. Gives consideration to past sales experience, price policies, advertising and sales promotion policy, general business conditions, competitive situation, etc. 4. Submits tentative sales budget to budget director for review as to completeness and format 5. Accepts approved sales budget from planning group and transmits to product sales managers 6. Receives comparison of actual and budgeted sales performance from budget director 7. Explains reasons for variances and corrective action taken

2 months before start of budget period

6 business days before budget period

6 weeks before start of budget period 2 weeks before start of budget period

4 business days before budget period 2 days before budget period

1. Requests advertising manager to prepare overall estimate of advertising expenditures, including detailed projects 2. Receives proposal and reviews

3. Transmits tentative budget to budget director for review in prescribed format 4. Receives approved advertising budget

4th working day of next month 9th working day of following period 3 months before start of budget period 2 months before start of budget period 6 weeks before start of budget period 1 month before start of budget period

5. Advises advertising manager of program 6. Receives reports on budget and actual expenditures

Selling expense budget

E XHIBIT 14.20

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7. Submits comments and corrective action statement on any signiﬁcant departures from budget 8. Requests budget revision 1. Provides department managers with history of cost experience, plans for next year, etc. 2. Requests selling expense budgets in approved format 3. Reviews subjects budgets, checks reasonableness of expense correlation with sales program, etc. B UDGET R ESPONSIBILITIES

OF

V ICE P RESIDENT

5th working day of following month 10th working day of following month As needed 2 months before start of budget period

6 weeks before start of budget period OF

S ALES (C ONTINUED )

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14.23 Management Approval of the Plan

S ECTION

FROM A

253

P LANNING M ANUAL —B UDGET R ESPONSIBILITIES V ICE P RESIDENT —S ALES

OF THE

Schedule Type of Budget

Action to Be Taken

Annually

4. Passes expense budgets to budget director for review 5. Receives approved budgets and advises department managers of results 6. Receives comparison of departmental budget performance with actual 7. Secures comments from managers and reports on variances 8. Requests budget adjustments when applicable E XHIBIT 14.20

B UDGET R ESPONSIBILITIES

OF

V ICE P RESIDENT

Monthly

6 weeks before start of budget period 2 weeks before start of budget period 5th day after month end 10th day after month end As needed OF

S ALES (C ONTINUED )

14.23 MANAGEMENT APPROVAL OF THE PLAN When the annual operating plan is approved by the board of directors, the plan, in effect, becomes a commitment and budget from the corporate management to the board and by appropriate organizational segment, from the managers of the segment to the top management of the company. The plan becomes the basic control tool against which actual performance is measured. Mindful that planning is a communicating process, there are four main points to consider when approval of the short-term plan — the proﬁt plan — is sought: 1. The ﬁnancial ofﬁcers should ascertain that all signiﬁcant factors be brought to the attention of the approving authorities in a timely manner and that appropriate recommendations are made. Perhaps the highlights summary should identify whatever the crucial or signiﬁcant matters for the company or industry are—as viewed by management or the board of directors. An illustrative summary presentation is shown in Exhibit 14.21. This is supported by detailed schedules for all important elements. 2. The board of directors and top management should be made aware of the underlying major assumptions used in constructing the plan. 3. The higher levels of management should not be inundated with excessive accounting details. Only major or important data should be presented. 4. The probabilities of attaining the plan — or the degree of difﬁculty in achieving it — should be conveyed to the management. A EROSPACE I NDUSTRY I NC . 20X5 A NNUAL P LAN H IGHLIGHTS ( DOLLARS IN MILLIONS , EXCEPT PER SHARE )

Contract acquisitions Backlog Sales E XHIBIT 14.21

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H IGHLIGHTS

Increase (Decrease)

Plan

20X4 Estimated

Dollars

Percent

1,100.0 1,293.7 1,670.0

1,106.8 1,863.7 1,594.3

(6.8) (570.0) 75.7

(.6) (30.6) 4.7

OF THE

A NNUAL P LAN

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Ch. 14 Profit Planning: Annual Plan

A EROSPACE I NDUSTRY I NC . 20X5 A NNUAL P LAN H IGHLIGHTS ( DOLLARS IN MILLIONS , EXCEPT PER SHARE )

Plan

20X4 Estimated

Net income Amount Percent of sales Earnings per share Cash ﬂow from operations Capital expenditures

71.4 4.3 5.03 95.4 42.0

65.7 4.1 4.77 88.5 33.0

Percent return Assets Equity

9.3 22.9

10.1 25.8

E XHIBIT 14.21

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H IGHLIGHTS

OF THE

A NNUAL P LAN (C ONTINUED )

Increase (Decrease) Dollars

Percent

5.7

8.7

.26 6.9 9.0

5.5 7.7 27.3

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CHAPTER

15

PROFIT PLANNING: SUPPORTING FINANCIAL ANALYSIS FOR THE ANNUAL PLAN 15.1

BASIC APPROACH IN PROFIT PLANNING 255

15.2

GENERAL COMMENTS ON THE COST– VOLUME–PROFIT RELATIONSHIP 256

15.14 INCREASED SALES VOLUME TO OFFSET REDUCED SELLING PRICES 266 15.15 MOST PROFITABLE USE OF SCARCE MATERIALS 267 15.16 ADVISABILITY OF PLANT EXPANSION 267

15.3

BREAK-EVEN CHART 256

15.4

CHANGES IN SALES REVENUE 258

15.5

CHANGES IN SALES MIXTURE 259

15.6

CHANGES IN SALES PRICE 260

15.7

CHANGES IN COSTS 261

15.18 WORKABLE STATEMENT OF INCOME AND EXPENSE 271

15.8

MARGINAL INCOME RATIO AND MARGIN OF SAFETY 262

15.19 SOME PRACTICAL GENERALIZATIONS 272

15.9

ANALYSIS BY PRODUCT 262

15.20 STATISTICAL TECHNIQUES FOR PLANNING 272

15.10 APPLICATION OF COST–VOLUME – PROFIT ANALYSIS 263 15.11 SELECTING THE MOST PROFITABLE PRODUCTS 265

15.17 BREAK-EVEN ANALYSIS TO EVALUATE A FORECAST 269

15.21 PROGRAM EVALUATION USING DISCOUNTED CASH FLOW 277

15.12 MINIMUM SELLING PRICE 266

15.22 FINANCIAL ANALYSIS OF UNACCEPTABLE OPERATING RESULTS 277

15.13 UNIT COSTS AT DIFFERENT VOLUME LEVELS 266

15.23 MORE SOPHISTICATED ANALYSES 294

15.1 BASIC APPROACH IN PROFIT PLANNING A fundamental objective of business management is to ﬁnd the most proﬁtable course that effort should be directed to and hold the enterprise to that course. This, indeed, is planning and control of proﬁts. Thus the term “proﬁt planning” has become associated with the ﬂexible budget technique of planning and controlling operations. This involves, basically, a recognition of the fact that some costs or expenses vary with production or sales volume, whereas others are “time” costs and are more or less independent of volume. Changes in “time” or ﬁxed costs are accomplished generally by management action. In terms of application, the utilization of cost and income data in determining what to produce and at what price to sell is all embodied in proﬁt planning. Moreover, it involves the concept of variable costs and marginal income as contrasted with the use of conventional total costs. 255

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

It is not our purpose, in this chapter, to review budgetary procedures but rather to point out applications or problems associated with the cost –volume – proﬁt relationship in business. Proﬁt planning is here being restricted to special phases or applications of planning and control and does not involve the detailed techniques concerned with cost segregation. However, it should be emphasized that any valid cost–volume – proﬁt studies reﬂect the true cost drivers — as in activity-based costing (ABC). The cost–volume–proﬁt analyses reviewed in this chapter illustrate how the methodology may be used to answer questions that may arise in speciﬁc applications regarding alternative actions during the annual planning process.

15.2 GENERAL COMMENTS ON THE COST–VOLUME–PROFIT RELATIONSHIP Most business decisions involve the selection of alternatives — whether to accept certain business at a speciﬁed price, whether to sell aggressively products A or B, whether to expand in territory X or Y. In all these decisions, as well as in many others, three factors must be considered: volume, cost, and proﬁt. An understanding of the relationship among these three forces, and of the probable effect that any change in sales volume would have on the business, should be extremely helpful to management in a broad variety of problems involving planning and control. The interrelationship of cost, volume, and proﬁt makes up what may be described as the proﬁt structure of a company. Through the knowledge and intelligent use of such information, it is possible to predict the effect of any number of contemplated actions. The data used in a review of this relationship may come from several channels and may differ considerably in adaptability or usefulness. In companies in which a rather complete sales analysis is made, and ﬂexible budgets and standard costs are available, the records will provide the necessary information in readily usable form. Costs in all probability will have been segregated into the ﬁxed and variable elements. If such sources are not available, then the conventional historical records might be utilized. Much analysis may be necessary to isolate the effect of changes in volume, selling prices, and variable costs. Moreover, if cost control has been poor, then the relationship between volume and costs will be difﬁcult to detect and the margin of error will depend greatly on the reliability of the data and the validity of the assumptions. Very often, for investment or credit purposes, published ﬁnancial statements are used as source data in studying the effect of volume on the business. It should be kept in mind that such statements are usually highly condensed and give little indication of the factors that may greatly inﬂuence the results — such as change in product mixture. Consequently, the extent of reliability is very limited.

15.3 BREAK-EVEN CHART The proﬁt structure of a company is often presented in the familiar break-even chart form. By such a presentation, management can understand the interrelationship of cost, proﬁt, and volume much more readily than by tables. The simple chart illustrated in Exhibit 15.1 is based on the assumptions that prices will remain unchanged, that ﬁxed costs will remain the same up to the maximum capacity of the plant, that variable costs will vary in direct ratio to volume, and that income taxes will be 50% of all income before taxes. Exhibit 15.1 clearly presents the following information for management: • Fixed costs of the business are $50,000 monthly. • Under present tax laws, and with present facilities, the maximum net proﬁt is $25,000 per month, or $300,000 per year. • At present prices, a monthly sales volume of $100,000 or 50,000 units is required to break even. This makes no provision for dividends to the stockholders. • To realize a net proﬁt of $10,000 per month will require a sales volume of $140,000 per month. • Plant capacity expressed in sales dollars under existing prices and processes is $200,000 per month.

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15.3 Break-Even Chart

E XHIBIT 15.1

B REAK -E VEN C HART I LLUSTRATING V OLUME , AND P ROFIT

THE I NTERRELATIONSHIP OF

257

C OSTS ,

It may be observed that the net proﬁt is measured by the vertical line between sales income and income taxes. Income taxes have been ﬁgured only from the break-even point. Another means of showing the relationship between net proﬁt and sales volume is illustrated in Exhibit 15.2. It can be seen that some of the essential cost factors are not disclosed.

E XHIBIT 15.2

G RAPHIC P RESENTATION P ROFIT OR L OSS

AND

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OF

R ELATIONSHIPS

BETWEEN

S ALES V OLUME

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

A break-even chart that illustrates not only the operating factors but also the dividend requirements is shown in Exhibit 15.3. Needless to say, in most businesses the cost–volume–proﬁt relationship is more complex than can be shown in any single break-even chart. This is discussed in 15.10. Moreover, it is not necessary to draw a chart to ﬁnd the break-even point of a business. This can always be done by a simple calculation: Aggregate fixed expense 1 Break-even point -----------------------------------------------------------------------------Ratio of variable income to sales

15.4 CHANGES IN SALES REVENUE In analyzing the revenue factor, the controller may ﬁnd it necessary to consider three aspects of the problem: 1. Treatment of difference between sales and production volume 2. Changes in the composition of sales 3. Changes in sales prices When past experience is being analyzed, a problem is presented in which the sales volume is greatly different from the production volume, with a corresponding change taking place in the ﬁnished goods inventory. An adjustment must be made because two different indexes of activity are being used—the production volume for variable manufacturing costs and sales volume for certain selling and other expenses. The solution lies in converting to a common basis, namely, the sales dollar. First, manufacturing costs must be analyzed or compared to physical production converted to a sales basis — the sales value of production. Next, the nonmanufacturing costs are measured against

E XHIBIT 15.3

B REAK -E VEN C HART I LLUSTRATING S ALES I NCOME

AND ITS

D ISPOSITION

1. Variable income represents sales income less the variable expense applicable to such sales.

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15.5 Changes in Sales Mixture

259

the sales value. The costs can then be superimposed on each other at the respective levels, and the total costs for various levels of activity can be determined.

15.5 CHANGES IN SALES MIXTURE Most companies have a variety of product lines, each making a different contribution toward ﬁxed expenses. Changes in the break-even point as well as the operating proﬁt can result from shifts in the mixture of products sold, even though the sales prices are unchanged and the total dollar sales volume meets expectancy. Such results can occur also from changes in distribution channels or sales to different classes of customers if the rearrangement affects the contribution of the product over and above variable costs. Actually, when a break-even chart is used, an underlying assumption is that the proportion of each product sold, or sales through each channel of distribution, is unchanged. Very often this does not happen; the proportionate drop is not the same for all products. The higher-priced lines, for example, may decline much more rapidly than others. Such changes must be recognized in evaluating the data. The effect of a change in sales mixture can be illustrated by the following calculations. Assume the following proportion of sales among three products, the indicated variable costs, ﬁxed costs, and proﬁt: Sales Product A B C Total Fixed costs Operating proﬁt

%

Amount

Variable Costs

40.00 50.00 10.00 100.00

$ 4,000.00 5,000.00 1,000.00 $10,000.00

$2,600.00 4,000.00 875.00 $7,475.00

Marginal Income over Variable Costs Amount

% of Net Sales

$1,400.00 1,000.00 125.00 2,525.00 1,200.00 $1,325.00

35.00 20.00 12.50 25.25

The break-even point can be calculated as: $1,200 $4,752 ---------------.2525 If, however, sales increase on the higher-margin items, the break-even point would naturally decrease. Such a change is illustrated as:

Sales Product A B C Total Fixed costs Operating proﬁt

%

Amount

Variable Costs

60.00 35.00 5.00 100.00

$ 6,000.00 3,500.00 500.00 $10,000.00

$3,900.00 2,800.00 437.50 $7,137.50

Marginal Income over Variable Costs Amount

% of Net Sales

$2,100.00 700.00 62.50 2,862.50 1,200.00 $1,662.50

35.00 20.00 12.50 28.625

The break-even point would be: $1,200 $4,192 ---------------.28625 This break-even point has dropped by $560 only as a result of the changes in sales mixture.

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

15.6 CHANGES IN SALES PRICE On the typical break-even chart the sales value is represented by a line that starts at zero and proceeds upward as the volume increases. Sales value equals unit selling price times number of units. It can be understood that the slope of the line changes if the unit sales price changes. The effect of a 10% increase in selling prices is illustrated in Exhibit 15.4. Quite often some of the variable costs (e.g., commissions or royalties) are related to the sales price. Consequently, the variable cost line as well as the sales value line might change as a result of selling price changes. In Exhibit 15.4 it has been assumed that variable costs relate only to units sold and not to value. As a direct result of the increase in selling price, the break-even point has dropped from $100,000 to $91,650, or by 8.35%. It should be clear that a change in selling price affects the break-even point and the relationship between income and variable costs. The controller should also be aware that a change in selling price may have an even greater effect on marginal income than a corresponding percentage increase in variable costs. For example, in the following illustration, a 10% drop in selling prices is equivalent to an 11.1% increase in variable costs as regards the break-even point and marginal income: With a 10% Reduction in Sales Price

At Present Selling Prices

Equivalent Increase in Variable Costs

Amount

% of Net Sales

Amount

% of Net Sales

Amount

% of Net Sales

Sales Variable costs Marginal income Fixed costs Operating proﬁt

$50,000 20,000 30,000 15,000 15,000

100.00 40.00 60.00 30.00 30.00

$45,000 20,000 25,000 15,000 10,000

100.00 44.44 55.56 33.33 22.23

$50,000 22,222 27,778 15,000 12,778

100.00 44.44 55.56 30.00 25.56

Break-even volume

$25,000

E XHIBIT 15.4

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$27,000

G RAPHIC I LLUSTRATION E FFECT N ET I NCOME

OF

S ALES P RICE C HANGE

$27,000

ON

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15.7 Changes In Costs

261

Sales were reduced by 10% of $50,000 to a level of $45,000. As variable costs were not changed, these costs as a percentage of sales are 44.44% or an increase of 11.1% (44.44 40 4.44; 4.44 40 11.1%). Relating the revised variable cost as a percentage of net sales to the original $50,000 of sales produces a variable cost of $22,222. This is 11.1% higher than the original variable cost.

15.7 CHANGES IN COSTS Interpretation of the effect of changes in the cost level presents some interesting problems as well as opportunities for the controller. An increase or decrease in the amount of ﬁxed cost has a twofold effect: (1) the operating proﬁt is changed by a like amount, and (2) the break-even point is changed by a like percentage. To illustrate, assume a case where ﬁxed costs are reduced by $10,000 or 33 1/3%. The operating proﬁt and break-even points would be: Fixed Costs Reduces by $10,000

Present Amount

% of Net Sales

Amount

% of Net Sales

Net sales Variable costs Marginal income Fixed costs Operating proﬁt

$200,000 120,000 80,000 30,000 50,000

100 60 40 15 25

$200,000 120,000 80,000 20,000 60,000

100 60 40 10 30

Break-even point sales

$ 75,000

$ 50,000

With a reduction of $10,000 in ﬁxed costs, the operating proﬁt naturally increased by a like amount. Moreover, ﬁxed costs were reduced 331/3%, and so the break-even point also declined by 33 1/3% or from a $75,000 sales volume to $50,000. This calculation assumes that no change would take place in variable costs, but in practice a change in ﬁxed costs may be accompanied by a change in the variable costs. For example, installation of a labor-saving device may increase depreciation and maintenance charges and decrease direct labor costs and related payroll charges. Such possibilities must be considered. Needless to say, if an increase in ﬁxed costs is being discussed, the probability of an increased sales volume should be reviewed. Furthermore, it would be advisable to examine possible alternatives, such as subcontracting or renting of space and equipment in lieu of purchasing. Acquisition of permanent assets will decrease the concern’s ability to adjust its costs to lower levels should a reduced sales volume ever necessitate such action. Opportunities for the reduction of ﬁxed expenses should not be overlooked in any attempt to reduce costs. A lowering of ﬁxed costs increases the margin at any sales level and, by reducing the break-even point, enables the company to withstand a greater drop in income before losses appear. Changes in unit variable costs or expenses, of course, also affect the break-even point as well as the “marginal income” factor (see Section 15.8.) Perhaps most cost reduction programs center about this category. A great many possibilities are open. For example, changes in the type of material used, the purchase price of material, or the amount of scrap or waste, can affect variable costs. Changes in manufacturing processes, hourly labor rates, plant layout, employee training methods, or the introduction of incentive payments can all affect the labor costs. General economic conditions may inﬂuence the ability of a ﬁrm to reduce variable costs. Very often the reduced sales volume permits more effective maintenance of equipment in the shutdown periods. Then, too, in such periods the labor turnover rate and material prices are usually reduced. Of course, such conditions may force sales price reductions on the company’s own products. The effect of reduced ﬁxed and variable costs is graphically illustrated in Exhibit 15.5.

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

E XHIBIT 15.5

C HART I LLUSTRATING E FFECT AND F IXED C OSTS

ON

P ROFIT

OF

R EDUCTION

IN

V ARIABLE

15.8 MARGINAL INCOME RATIO AND MARGIN OF SAFETY In any review of the interrelationship of cost and volume, one of the most signiﬁcant ﬁgures is the marginal income ratio. This may be deﬁned as the residual value after deducting the variable cost from net sales, expressed as a percentage of the net sales. The marginal income ratio represents the share of the sales dollars remaining to cover ﬁxed expenses, income taxes, and net proﬁt. It is indeed a highly useful ﬁgure, for it can be employed to determine readily the break-even point or the added income resulting from increased sales volume. To illustrate, if sales are to be increased by $30,000 and the marginal income ratio is 40%, then such sales should result in additional income before taxes, all other factors unchanged, of $12,000 (40% of $30,000). To determine the break-even sales volume, it is necessary merely to divide total ﬁxed costs by the marginal income ratio, as mentioned earlier. The marginal income ratio is useful, also, in determining how low a price may be quoted or what sales volume is required to support a salesperson in a territory. It is probably a much more useful ﬁgure than the break-even point. Where the marginal income ratio is high, a change in sales volume has a tremendous effect on proﬁt. Thus an increase of $100,000 in sales will increase operating proﬁt by $60,000 for a company with a 60% marginal income ratio but only $20,000 for a ﬁrm with a 20% marginal income ratio. A high ratio, of course, may carry with it high ﬁxed charges. Incidentally, if the controller can prepare the income and expense statements to indicate the marginal income, the use of such statements will be greatly enhanced. Another ﬁgure often used in conjunction with cost–volume–proﬁt analyses is the “margin of safety.” It is deﬁned as the excess of actual or budgeted sales over the break-even sales volume and is a measure of the extent to which sales may drop before losses appear. The proﬁt strength of a business might be said to be proportionate to the distance between its existing sales volume and its break-even point. Over the period of a business cycle, as between any two companies of the same size with the same percentage of net proﬁt on present sales volume, the one with the greater margin of safety may have the greater earning power.

15.9 ANALYSIS BY PRODUCT Since most companies have more than one product or product line, a large number of business decisions relate to individual product lines. For this reason, it is desirable to apply the cost–volume–

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15.10 Application of Cost–Volume – Profit Analysis

263

proﬁt analysis to speciﬁc product lines so that management can better understand the effect on proﬁts of changes in volume of selected products or of the relative proportion of products sold. The same technique applied to overall operations can be applied to individual product lines. Decisions reached from such studies should be a guide in determining which products should be sold aggressively (or emphasized because of proﬁts or sold through a particular channel of distribution); which products should be continued but not promoted, merely because of some contribution toward ﬁxed expense; and which lines or commodities should be discontinued or replaced by more proﬁtable lines. Obviously, general economic conditions, relative supply and demand, and the long-range effect on customer relationships are some noncost factors that must be weighed. In making any proﬁt analyses the reliability of the results depends in part on the organizational structure and the extent or type of analysis made. To illustrate, a product manufactured in one plant and requiring all the plant’s facilities, which is then marketed through its own separate sales organization, presents few cost allocation problems. Only part of the general administrative expenses need be allocated to the line. Quite in contrast to such a situation is a product whose production and distribution facilities are shared by many other items. In such a case the allocation of ﬁxed and indirect costs requires careful attention, for the reliability of break-even points is greatly dependent on the manner in which such common costs or expenses are distributed to product lines. If, however, the objective is not the determination of break-even points but rather a knowledge of marginal income by products, then no allocation of ﬁxed costs would be necessary. The development of variable costs, depending on usage, would be relatively simple. And many companies predicate important decisions on the relative contribution of each line to ﬁxed costs and proﬁt. Any controller who has had the task of determining an overall break-even point for his company and then has determined the break-even point by product lines has perhaps been confused by the fact that the sum of the individual break-even points usually did not equal the overall break-even point. The reason for this difference is that there may be a signiﬁcant difference in the sales mix for the various product lines. For example, one product line may have an inordinate share of the overall company sales, and so its break-even level will come fairly close to the overall break-even point for the entire company; alternatively, there may be several small product lines that have outstanding margins and low break-even points, but they have little impact on the overall break-even point due to their small proportion of overall sales. In the following example, Product A has the largest sales volume, so its break-even level tends to be the dominant factor in calculating the overall corporate break-even point, even though Products B and C have substantially different break-even points. Description Sales Gross margin (%) Fixed costs Break-even sales volume

Product A

Product B

Product C

Totals

$10,000,000 30 $ 3,000,000 $10,000,000

$1,000,000 70 $ 300,000 $ 428,571

$2,000,000 10 $ 100,000 $1,000,000

$13,000,000 30 $ 3,400,000 $11,333,333

Where several product lines are being analyzed, the controller may ﬁnd it advantageous to prepare break-even charts for each product if they are useful to the executives in proﬁt planning. The relative proﬁtability can be determined by observing the slope of the proﬁt line, assuming the same relative scale is used. It is difﬁcult to construct a break-even chart for all products combined that would be of much practical signiﬁcance. Some companies have used charts similar to Exhibit 15.6. Obviously, all the factors cannot be presented.

15.10 APPLICATION OF COST–VOLUME – PROFIT ANALYSIS Even if the controller is fully aware of all the ramiﬁcations of the cost, volume, and proﬁt relationship, the question arises about how can this information be best put to work for management. The principal use of the data, of course, is in planning and policy-making decisions. The chief value of the data lies in the facility with which volume can be treated as a variable factor. Through applying

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

E XHIBIT 15.6

P ROFITABILITY

OF

P RODUCTS

IN

R ELATION

TO

B REAK -E VEN P OINT

such information, it is fairly simple to determine at various ranges of volume exactly what the effect on proﬁts will be of contemplated changes. The traditional income and expense statement simply does not permit this. A great variety of questions are asked in the management of a business such as: • What will be the proﬁt or loss at x sales level? • What additional sales volume will be needed to meet the ﬁxed charges arising from the proposed plant expansion program? • What is the possibility of earning a proﬁt on x product? • What sales volume is required to earn a certain designated proﬁt? • At a sales level of x per month, what reduction in ﬁxed and variable costs must be made to earn a proﬁt, before taxes, of some designated amount? • What will be the effect of adding a second shift operation? • What effect will a 15% increase in sales volume have on proﬁts? For questions such as these, the controller should ﬁnd the answers very easily through the analyses just described. Stated positively, a thorough understanding and analysis of cost–volume–proﬁt data can provide information for: • Sales and pricing policies Determination of proﬁt that will result from any given volume of sales Analysis of the effect of changes in selling prices Effect of change in product mixture Additional sales volume needed to support a salesperson in a territory, a warehouse, etc. Lowest prices at which business may be accepted to utilize facilities and contribute some-

thing toward net proﬁt The particular products to be emphasized to reﬂect the greatest net proﬁt

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15.11 Selecting the Most Profitable Products

265

• Financial and production problems Interpretation of proposed or alternative budgets and the effect of suggested cost and other changes—when the goals are not satisfactory to management Determination of unit costs at various volume levels Determination of the probable effect of investment in new plant and equipment Determination of most proﬁtable use of scarce materials Assistance in choice between subcontracting work or manufacturing certain articles • General General understanding of proﬁt structure of the business and effect of volume changes— for the major executives General educational purposes for plant supervision

15.11 SELECTING THE MOST PROFITABLE PRODUCTS When all the productive facilities of a company are fully occupied, and when the demand is much greater than supply, a decision must be reached about the products to be manufactured. The long-term customer reactions, the availability of material, and the probable continued price differential between different products must be weighed. But relative costs and proﬁt should be important factors in the decision. Whether one or many products are manufactured, the principle is valid. Of course, where several products are manufactured by different processes and in different departments, the bottleneck department should be considered separately. In Section 15.8 the importance of marginal income was emphasized, and the greatest marginal income is desirable because it usually results in the highest net proﬁt. However, when considering marginal income, the greatest income per piece or per pound is not the sole factor, for the effect of the rate of production must be reckoned with. To be speciﬁc, refer to Exhibit 15.7. The greatest marginal proﬁt per unit of sale, per hundredweight, is realized on product A. Product B returns only $6.67 marginal income per unit. If only this “unit” marginal contribution were considered, the business would not be making the best use of the facilities. When the operating hour is taken into account, product B returns 11.12% more than A — $100.05 per machine hour as compared with $90 for product A. Product Description Per hundred pounds Selling price Costs Variable: Material Labor and overhead Total variable Fixed Total cost Operating proﬁt

A

B

$35.00

$ 28.00

18.00 8.00 26.00 5.00 31.00 4.00

16.00 5.33 21.33 3.33 24.66 3.34

Marginal proﬁt Per machine hour Rate of production (cwt.)

$ 9.00 10

15

Operating proﬁt ($4.00 times 10; $3.34 times 15)

$40.00

$ 50.10

Marginal proﬁt ($9.00 times 10; $6.67 times 15)

$90.00

$100.05

E XHIBIT 15.7

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C OMPUTATION OF M ARGINAL P ROFIT AND PER M ACHINE

PER

U NIT

OF

$

P RODUCT

6.67

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In making decisions of this nature, other cost factors must be kept in mind, for example, cost of carrying inventories and receivables, and changes in the relationship of ﬁxed and variable expense.

15.12 MINIMUM SELLING PRICE In theory, perhaps, each product should yield a net proﬁt. However, under our competitive economy this does not usually happen. Some products bear their own direct costs, a full share of indirect expenses, and return a net proﬁt. Others may carry only a partial share of their indirect costs. In any event, the objective is to secure the greatest overall proﬁt. When all the available capacity is not being utilized, the problem arises about the lowest price to be charged that will still contribute something to the overall proﬁt. The obvious answer is recovery of variable costs, taking into account any additional maintenance or other costs. Such costs set the ﬂoor, and anything above this is making a contribution toward ﬁxed expenses. The concept of ﬁxed and variable costs is necessary to such a determination. Obviously, the controller should be realistic or conservative in the segregation of costs. Further, any legal implications — for instance, the possibility of violating the Robinson–Patman Act—must be reviewed.

15.13 UNIT COSTS AT DIFFERENT VOLUME LEVELS Another application of the cost–volume–proﬁt relationship is in the determination of unit costs. Suppose, for example, that management desires to know what the unit cost would be at various sales volume levels, with prices remaining ﬁxed. It may be assumed that, in the illustration at hand, the selling price is $2 per unit. What would be the unit cost were the sales to be increased to $240,000? It is assumed that the present sales consist of 50,000 units and that the present unit cost is $2.40, consisting of $.80 of ﬁxed costs and $1.60 of variable costs. The proposed volume is 120,000 units ($240,000 ÷ $2). The new unit cost would then be: Fixed costs ---------------------------------------------------- Present variable unit cost Proposed unit volume $40,000 ------------------- $1.60 120,000 $.333 $1.60 $1.933 At a sales volume of $240,000, the unit cost is $1.933.

15.14 INCREASED SALES VOLUME TO OFFSET REDUCED SELLING PRICES In the same illustration, let it be assumed that the sales department insists that the present low volume is due to the fact that the company’s prices are out of line with those of competing concerns or with competing products. A reduction of 10% in selling prices is advised. What percentage increase in volume will be necessary to yield a proﬁt of $5,000 if selling prices are reduced 10%? The assumptions are the same as those mentioned previously, except for the change in prices. In this case: increased sales volume required to offset reduced selling price Profit desired plus fixed costs ------------------------------------------------------------------------------------------------------------------------------------------Present variable ratio 1  --------------------------------------------------------------------------------------------------------------------------   1 Proposed percentage reduction in selling price  $5,000 $40,000 $45,000 -------------------------------------------- ------------------$80,000 1 .8 ------------------------$100,000 .9 1 ---------------------1 .10

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15.16 Advisability of Plant Expansion

267

$45,000 ------------------- $405,000 .111111 Therefore, a sales volume of $405,000 or 225,000 units must be secured to produce a proﬁt of $5,000 if prices are reduced by 10%. If this goes beyond the capacity of the plant, such a program is impossible without further increase in ﬁxed costs.

15.15 MOST PROFITABLE USE OF SCARCE MATERIALS Another interesting application of the cost and proﬁt relationship is the determination of the best use of restricted or scarce materials. Assume, for example, that only partial requirements are available of a chemical common to ﬁve products. How should the ingredient “X” be distributed, considering only the greatest net proﬁt to the company? It is assumed that rates of production are about the same and that all products are manufactured with the same facilities. The solution is evident from the following example: Unit

Product

Selling Price

Variable Cost

Marginal Income Contribution

Pounds of “X” per Lb. of Product

Marginal Proﬁt per Lb. of “X”

1 2 3 4 5

$2.00 2.50 4.00 3.00 5.00

$1.00 1.50 2.50 1.00 2.50

$1.00 1.00 1.50 2.00 2.50

.5 .3 .5 1.5 2.0

$2.00 3.33 3.00 1.33 1.25

Product 2 yields the greatest proﬁt per pound of “X,” and these requirements should be met ﬁrst, all other factors being equal.

15.16 ADVISABILITY OF PLANT EXPANSION Break-even and related data are helpful when considering plant expansion. The following information would be useful in arriving at a decision: • The relative break-even points • The sales volume required to earn existing proﬁts • The sales volume required to net a fair return on the investment • The maximum proﬁt Assume the following present average earnings statement (monthly) of the company: Net sales Costs and expenses Variable (60% net sales) Fixed Total Net proﬁt before taxes Income taxes (50%) Net proﬁt Increased ﬁxed costs with plant expansion—$50,000 Additional income desired on investment—$5,000 Maximum production in new plant—$300,000

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$500,000 300,000 100,000 400,000 100,000 50,000 $ 50,000

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

Using the available data, these four determinations can be made: 1. Break-Even Points Present facilities: Fixed costs $100,000 ----------------------------------------------------- ---------------------- $250,000 sales volume Marginal income ratio .40 Proposed: Present Additional fixed costs $150,000 $375,000 sales volume --------------------------------------------------------------------------------------------------Marginal income ratio .40 2. Sales Volume Required to Earn Existing Proﬁt Present fixed costs Additional fixed costs Existing profit ----------------------------------------------------------------------------------------------------------------------------------------------------Marginal income ratio $100,000 $50,000 $100,000 -------------------------------------------------------------------------------.40 $250,000 ---------------------.40 $625,000 sales volume 3. Sales Volume to Net a Fair Return on Added Investment Assume a fair return on the added investment to be $500 (monthly) after income taxes or $10,000 before. Then a fair return equals at least existing proﬁt, plus the above return. Present fixed costs Additional fixed costs Existing profit ---------------------------------------------------------------------------------------------------------------------------------------------------- Return on added investment ----------------------------------------------------------------------------------------------------------------------------------------------------Marginal income ratio $260,000 ---------------------.40 $650,000 sales volume 4. Maximum Earnings with New Plant Net Sales ($500,000 $300,000) Costs and expenses Variable (60% of net sales) Fixed Total Net proﬁt before taxes Income taxes (50%) Net proﬁt

$800,000 480,000 150,000 630,000 170,000 85,000 $ 85,000

These computations may be summarized as: Item Break-even sales volume (monthly) Sales volume to earn existing proﬁt Sales volume to earn 6% on new plant cost Maximum proﬁt Sales volume to earn maximum proﬁt

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Present

Prospective

Increase

$250,000 500,000 — 50,000 500,000

$375,000 625,000 650,000 85,000 800,000

$125,000 125,000 — 35,000 300,000

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15.17 Break-Even Analysis to Evaluate a Forecast

269

Management must consider the possibility of increasing sales by $125,000 monthly to maintain existing proﬁts. It must also weigh the probability of sales remaining at least $125,000 higher, for proﬁts before income taxes will be reduced by $50,000 per month if the expansion is made but sales continue at the present level. Sales must be increased by $125,000 just to retain existing profits, but this disadvantage may be offset by the higher potential earnings of $35,000 per month. Incidentally, these calculations illustrate the variety of simple arithmetical formulas that may be helpful in proﬁt planning and control.

15.17 BREAK-EVEN ANALYSIS TO EVALUATE A FORECAST The discussion of the cost – volume – proﬁt technique2 has been applied in large part to segments of the business — to individual products, or areas, or projects such as a new plant. Yet the same approach can be useful in judging the business plans of a division or a company. Typically, a projection is compared with some past year, usually the immediately preceding year, to determine whether it appears satisfactory. Such a comparison has value. It may be a gauge of the adequacy of the sales volume, and, in a general way, it may raise questions about cost or expense levels. However, such a comparison is not as sharp a tool as is available. Most of the time, the sales level and product mix in the forecast year will not be identical with that of the past year. Therefore, it may be difﬁcult to measure more precisely the propriety of the costs and expenses in relationship to sales volume. To further complicate the problem, management, when looking at a higher sales volume and a net income that appears more favorable, tends to be less critical. In most instances, if net income expressed as a percent of sales is greater than the preceding year, the forecast is gleefully pronounced satisfactory. Why not use a superior tool that permits a more effective evaluation of the volume factor? Once management has agreed on a reasonable sales objective, a volume for the year under forecast, then it becomes practical to measure the proposed forecast against the break-even structure, that is, to apply the break-even economic structure of the company to the projected sales volume. Essentially, this means that management should decide on a reasonable cost – proﬁt– volume relationship and that this standard should be used as a measure of the forecast. The results of the application of the break-even factors, as shown in Exhibit 15.8, to a projected sales volume (standard proﬁt strucT HE S AMPLE C OMPANY P ROFIT S TRUCTURE Variable Costs Description

Fixed Costs

Net sales Cost and expenses Direct material Direct labor Manufacturing expenses Selling expenses Research and development expenses General and administrative expenses

(%) Net Sales

Combined $10,000,000

$ 500,000 400,000 250,000 150,000 $1,300,000

Proﬁt before income taxes E XHIBIT 15.8

Total

$4,000,000 1,000,000 1,000,000 100,000 50,000 50,000 $6,200,000

40.00% 10.00 10.00 1.00 .50 .50 62.00%

7,500,000 $ 2,500,000

S TANDARD P ROFIT S TRUCTURE

2. Adapted in part from James D. Willson, “Practical Applications of Cost–Volume–Profit Analysis,” NACA Bulletin, March 1960, pp. 5–18.

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

ture) and the comparison of such results with the aggregate costs and expenses as set forth in an illustrative forecast, are shown in Exhibit 15.9. It is to be noted that percentage relationships are developed to aid in detecting out-of-line conditions. The exhibit portrays one of the basic considerations in the preparation of forecasts, that is, that the company must not be allowed to develop or assume a less favorable cost structure. It is necessary to apply some overall tests quite distinct, for example, from individual departmental budget performance. The greatest dollar increase and relative increase is in prime material costs. This 5% or $250,000 increase must be analyzed to determine whether the cost increase results from changes in product mix or from cost increases in any given product line. The initial break-even application has isolated this apparently excessive cost relationship. Now it should be analyzed in more depth and a decision made about an acceptable plan. Perhaps the product mix is not the optimum believed to be attainable in the forecast year. Perhaps action can be taken on cost increases to reduce or eliminate them. Second, the next largest relative increase, amounting to $60,000, is in direct labor. A similar analysis should be made to localize the cause and seek an improvement in the plan. Next, manufacturing expenses have increased by 4% or $70,000. Departmental budgets should be reviewed to determine the areas of greatest increase and their causes. Management must then decide what corrective action must be taken. If, for example, the increase is in maintenance expense, is it sound to defer projects? What is the best approach when considering the longer-term interests of the business? Similar analyses should be made of the other expense areas. If expenses are under the standard, the accountant should ascertain that no omissions have been made erroneously. It is to be observed that the break-even point has risen by 8.6% to $3,714,290. Perhaps a better way to state the case is that the forecast is based on a somewhat changed cost structure. This change may be shown graphically as in Exhibit 15.10. The solid lines indicate the acceptable cost–volume– proﬁt structure, and the dotted lines reveal the condition as planned in the forecast. Incidentally, T HE S AMPLE C OMPANY B REAK -E VEN A NALYSIS OF F ORECAST F ISCAL Y EAR 20XX Forecast Over (Under) Standard

Application of Standard Proﬁt Structure

Tentative Forecast

Net sales Cost of sales Direct material Direct labor Manufacturing expenses Total Gross margin Operating expenses Selling Research and development General and administrative Total Proﬁt before taxes Other Data

$12,500,000

$12,500,000

5,000,000 1,250,000 1,750,000 8,000,000 4,500,000

5,250,000 1,310,000 1,820,000 8,380,000 4,120,000

525,000 312,500 212,500 1,050,000 $ 3,450,000

540,000 310,000 190,000 1,040,000 $ 3,080,000

Break-even point Marginal income ratio

$ 3,421,050

$ 3,714,290

.38

.35

Description

E XHIBIT 15.9

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C OMPARISON

OF

S TANDARD

AND

Amount

%

$250,000 60,000 70,000 380,000 ( 380,000)

5.00% 4.80 4.00 4.75 ( 8.44 )

15,000 2,500) 22,500) 10,000) $370,000

2.86 ( .80 ) (10.59 ) ( .95 ) (10.72%)

$293,240

8.6%

( ( (

F ORECAST P ROFIT S TRUCTURE

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15.18 Workable Statement of Income and Expense

271

T HE S AMPLE C OMPANY P ROFIT G RAPH (S TANDARD AND F ORECAST )

E XHIBIT 15.10

P ROFIT G RAPH C OMPARING S TANDARD

AND

F ORECAST P ERFORMANCE

any change in this relationship can be readily shown on the graph, whether in sales, variable costs, or ﬁxed expense. In poor economic weather, a reasonable margin of safety is necessary. Accordingly, in the Sample Company, if management agrees that the standard proﬁt structure must be maintained, every element should be analyzed and explored by the accountant so that the ﬁnal business plan for the ensuing year retains the characteristics of this structure. As an alternative, once the most satisfactory cost – volume – proﬁt relationship is determined, including the proper product mix, then the possibility of securing additional sales volume to offset cost increases is to be considered.

15.18 WORKABLE STATEMENT OF INCOME AND EXPENSE The conventional statement of income and expense can be quite misleading. In practice, managements have been known to take action on the basis of such statements, when the action was unwarranted on the basis of actual facts. Companies have discontinued products that showed losses on the conventional statements only to ﬁnd that the loss increased as a result of the discontinuance. Further, goods have been sold at prices below cost in the belief that added volume would reduce the costs and result in a proﬁt. Of course, the controller may explain that action should not be taken on the strength of a monthly statement of income and expense, which is very true. He may emphasize that all the facts should be marshaled in making a decision—which means a detailed analysis.

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

But the fact remains that some executives may take corrective action, however ill-advised, after seeing the monthly statement. The chief accounting ofﬁcial should devise a form of statement that may be a little more informative or helpful in giving some clues and will give a better perspective of the situation. Basically, of course, this merely means making a distinction between ﬁxed and variable costs or expenses. One such statement for internal management purposes is illustrated in Exhibit 15.11. The contribution of each product line toward ﬁxed expenses and proﬁts is shown, and a great deal of information can be gleaned from the supplementary data shown thereon. Such a statement may be supported by other schedules giving the details of actual and standard manufacturing expenses, as in Exhibit 15.12. Where desirable, a statement of cost of goods manufactured can be prepared using the same principle of segregating ﬁxed and variable costs.

15.19 SOME PRACTICAL GENERALIZATIONS The primary purpose in any analysis of the cost–volume–proﬁt relationship is to permit the planning of larger proﬁts in the future. Such reviews may disclose basic weaknesses in the proﬁt structure and assist in suggesting remedies. Because the ﬁeld is so broad, it is desirable to summarize some generalizations that should be clearly understood by the controller and by other members of management as well. These general comments are: • A change in the amount of ﬁxed costs changes the break-even point by a similar percentage and the operating proﬁt by a like amount but does not affect the marginal income ratio. • A change in the selling price changes the break-even point and marginal income ratio. Such a change, percentage-wise, may be quite different in the effect on the marginal income ratio than a similar percentage change in variable costs. • A change in variable costs, likewise, changes the break-even point and marginal income ratio. • When the marginal income ratio is high, large proﬁts may result from comparatively small increases in sales volume above the break-even point. For the same reason, small declines in revenue will cut sharply into proﬁts. By like token, a low marginal income ratio requires considerable change in sales volume to reﬂect any signiﬁcant change in proﬁts. • A high margin of safety indicates that a substantial drop in sales volume can take place before losses develop. • When certain conditions exist, some general conclusions about points of attack can be suggested. Consider, for example, these two points: 1. A high marginal income ratio with a low margin of safety probably indicates an excess of ﬁxed costs for the sales volume. The remedy lies in either reducing such ﬁxed costs or increasing the sales volume. 2. A low marginal income ratio and a low margin of safety may indicate that selling prices are too low or variable costs are too high. If prices are as high as competition will allow, then variable costs should be combed for possible reductions.

15.20 STATISTICAL TECHNIQUES FOR PLANNING Business is complex, and the decisions faced by management become increasingly difﬁcult as more alternatives need to be considered. The many products, the many processes, and the constant change simply accentuate the pressure for the most modern techniques in the planning and forecasting area. Speed is necessary if adequate attention is to be paid to the various possible courses of action. Moreover, once a business plan has been conceived, a review every three months may be too infrequent. As one month closes, and as more information about probable conditions in the following 30 days is available, management wants to know the outlook for the succeeding period. An analysis of such alternatives and the need for constant projections into the future places a tremendous burden on the accounting staff unless statistical techniques are utilized. The break-even analysis approach must be combined with linear programming, statistical decision theory, and the

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E XHIBIT 15.11

(

(

37.3

51,834

OF I NCOME AND

E XPENSES

56.7 6.0 62.7

79,006 8,245 87,251

.1)

11.6 —

16,145 69

137)

45.1

62,792

WITH

(

.1)

37.4

56.6 6.0 62.6

11.8 —

44.8

100.0

% of Net Sales

S EGREGATION

133)

50,774

76,890 8,169 85,059

15,977 —

60,913

7,742 135,833

100.0

7,750 139,085

Amount $143,575

(

% of Net Sales

OF

F IXED

—

7.72

11.69 1.24 12.93

2.43 —

9.26

$20.65

Per Cwt.

PLASTIC MOLDINGS

$146,835

S TATEMENT

O VER ( OR U NDER ) S TANDARD Material and freight —price

Sales Gross sales Less: Returns and allowances Net sales Cost of sales A T S TANDARD Variable Material Manufacturing expense Royalties Total variable cost Fixed Total Standard manufacturing proﬁt

Amount

ALL PRODUCTS

AND

3)

(

.3)

42.8

53.4 3.8 57.2

8.7 —

44.7

100.0

% of Net Sales

(

.03)

4.39

5.47 .40 5.87

.89 —

4.58

$10.26

Per Cwt.

15.20

V ARIABLE M ANUFACTURING C OSTS

(

517

644 45 689

105 —

539

4 1,206

$ 1,210

Amount

PAINTS

T HE T OLEDO M ANUFACTURING C OMPANY S TATEMENT OF I NCOME AND E XPENSE BY P RODUCT L INES F OR THE M ONTH E NDED N OVEMBER 30, 20XX

1)

—

26.6

72.0 1.4 73.4

3.1 3.4

65.5

100.0

% of Net Sales

(

273

.03)

16.45

44.61 .94 45.55

1.91 2.09

40.61

$62.00

Per Cwt.

Statistical Techniques for Planning

(

543

1,472 31 1,503

63 69

1,340

4 2,046

$2,050

Amount

DISHWARE

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4.9 19.7

6,761 27,352 2,269 6,205

Operating proﬁt (or loss) Other income (net)

S TATEMENT

12.6

17,484

E XHIBIT 15.11

2.2

3,107

OF I NCOME AND

1.6 4.4

21.3

3.6 16.0

5,023 22,213

29,621

10.2 12.4

14,112 17,190

M ANUFACTURING P ROFIT Operating expense Administrative Selling and advertising Research and development Total

% of Net Sales 2.3

Amount 3,215

ALL PRODUCTS

E XPENSES WITH

$ 2,199

1.6

4.9 19.7

12.5

2.3

21.3

3.7 16.1

10.2 12.4

% of Net Sales 2.3

S EGREGATION

6,603 26,712

17,075

3,034

28,911

4,977 21,863*

13,833 16,886

Amount 3,186

OF

.33 F IXED

$

1.00 4.04

2.59

.45

4.37

.77 3.35

2.10 2.58

Per Cwt. .48

PLASTIC MOLDINGS

AND

16)

(

1.5)

5.0 19.7

12.5

2.2

18.2

2.2 24.6

22.3 22.4

% of Net Sales .4

$(

.14)

.50 2.02

1.29

.23

1.88

.22 2.51

2.29 2.29

Per Cwt. .03

$

87

99 403

258

46

490

19 53

10 34

Amount 25

V ARIABLE M ANUFACTURING C OSTS (C ONTINUED )

$(

59 237

151

27

220

27 297

269 270

Amount 4

PAINTS

T HE T OLEDO M ANUFACTURING C OMPANY S TATEMENT OF I NCOME AND E XPENSE BY P RODUCT L INES F OR THE M ONTH E NDED N OVEMBER 30, 20XX

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

Material usage Variable labor and manufacturing expense Subtotal Fixed manufacturing expense Total

274

4.3

4.9 19.7

12.6

2.2

24.0

.9 2.6

.5 1.7

% of Net Sales 1.2

DISHWARE

$ 2.66

3.00 12.18

7.80

1.38

14.84

.58 1.61

.30 1.03

Per Cwt. .76

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$

E XHIBIT 15.11

S TATEMENT

E XPENSES WITH

% of Net Sales

S EGREGATION

654,244

688,800

OF I NCOME AND

657,775

2.4 3.6

3,389 5,085

Amount

OF

F IXED

Per Cwt.

PLASTIC MOLDINGS

673,835

6.0

% of Net Sales

8,474

*See Exhibit 16.12 for details.

Proﬁt before federal income taxes Federal income taxes Net proﬁt Net shipments — pounds Production — pounds

Amount

ALL PRODUCTS

AND

% of Net Sales

Per Cwt.

1,000

3,300

Amount

15.20

% of Net Sales

DISHWARE

275

Per Cwt.

Statistical Techniques for Planning

V ARIABLE M ANUFACTURING C OSTS (C ONTINUED )

34,563

11,760

Amount

PAINTS

T HE T OLEDO M ANUFACTURING C OMPANY S TATEMENT OF I NCOME AND E XPENSE BY P RODUCT L INES F OR THE M ONTH E NDED N OVEMBER 30, 20XX

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Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

C OMPARISON

OF

T HE T OLEDO M ANUFACTURING C OMPANY A CTUAL AND S TANDARD M ANUFACTURING C OSTS OF P LASTIC M OLDINGS F OR THE M ONTH E NDED N OVEMBER 30, 20X1

Description

Actual (Over) or Under Standard

Actual

Standard

$ 41,277 3,061 44,338

$41,370 3,101 44,471

2,730 3,519 229 6,478

— 3,292 — 3,292

( 2,730) ( 227) ( 229) ( 3,186)

2,174 16,861 2,941 6,987 28,963

2,001 10,179 2,147 2,830 17,157

( 173) ( 6,682) ( 794) ( 4,157) (11,806)

873 2,016 910 2,110 1,847 1,994 9,750

862 1,698 920 1,742 1,074 1,427 7,723

38,713

24,880

(13,833)

1,204 677 11,806 850 14,537 53,250

1,016 623 7,118 803 9,560 34,440

( 188) ( 54) ( 4,688) ( 47) ( 4,977) (18,810)

$104,066

$82,203

$(21,863)

Price

Material Freight Total

$

93 40 133

Material Usage

Yield Containers Inventory shortages Total material usage Director Labor and Manufacturing Expense

Variable Direct labor Preforming Molding Polishing Packing Total direct labor Manufacturing expense Preforming Molding Polishing Packing Receiving Shipping Total manufacturing expense Total variable direct labor and manufacturing expense Fixed Expense Direct Overhead General manufacturing overhead Depreciation* Property taxes and insurance Total ﬁxed expense Total direct labor and manufacturing expense Total *Includes $4,123 applicable to prior months.

E XHIBIT 15.12

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C OMPARISON

OF

A CTUAL

AND

S TANDARD M ANUFACTURING C OSTS

( ( ( ( ( (

11) 318) 10 368) 773) 567) 2,027)

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15.22 Financial Analysis of Unacceptable Operating Results

277

use of electronic computers if a satisfactory planning job is to be done. The controller must be knowledgeable of these latest mathematical techniques.

15.21 PROGRAM EVALUATION USING DISCOUNTED CASH FLOW Given the fact that short-term plans are used for the detailed analysis and coordination of new programs or projects, often it will be found desirable to know the ﬁnancial impact in detail and to determine the expected return on assets employed and after leverage or borrowings. Assume plans to facilitate and commence the manufacture of a new electronic device. Management should know the probable rate of return and ﬁnancial requirements before authorizing the project and approving the plan. If the cutoff rate of return on assets employed is 9.5% per year, a determination is made, as illustrated in Exhibit 15.13, about what rate reasonably may be expected and whether it satisﬁed the criterion. Detailed techniques are discussed in Chapter 31. In this project evaluation, an initial capital expenditure of $10,000,000 is required, together with $2,000,000 for working capital. Additional needs are projected in later years. The investment outﬂow by years and cash ﬂow are shown. The return on gross investment calculates to be 9.9% per annum (assuming sale of the business after six years). With borrowing capacity, the return on “equity equivalent” is 41.9% per annum as shown in Exhibit 15.14. Since time value of cash received is very important, the discounted cash ﬂow technique should be considered in planning.

15.22 FINANCIAL ANALYSIS OF UNACCEPTABLE OPERATING RESULTS Given an unacceptable segment of an annual plan, or actual operating results that depart signiﬁcantly from plan, or loss operations, the ﬁnancial staff often will be called on to make an in-depth review. Assuming the proper working relations with the operating staff, joint efforts, or at least cooperation, may provide information to correct unsatisfactory ﬁnancial results. Illustrated in this section is an analysis prepared as the basis for executive discussion by the ofﬁcers of an integrated chemical company. In this case, it is assumed that the company has operated heavily in the red in one of three divisions, and the management can see no immediate prospects of improving the condition. The seven general steps in the analysis, although partially evident from accompanying exhibits, are outlined as: 1. The operations for the past year were reviewed to secure some indication of the nature of the costs and the points of apparent waste or excessive costs. 2. Unit standard costs, budgets, and variances were analyzed and segregated into their ﬁxed and variable elements. 3. Sales were analyzed to determine a representative product mixture by certain commodity groups. 4. With known product mixture, total costs and income at capacity were determined. 5. On the basis of information determined in step 4, proﬁt graphs were prepared. 6. Within each product group, marginal income for each product was determined to suggest a more proﬁtable sales mixture. 7. The data were interpreted in a narrative report containing recommendations for improvement. The remainder of this section reproduces in full the report prepared by the controller.

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Permanent

E XHIBIT 15.13

D ISCOUNTED C ASH F LOW

(3,000)

( 400) ( 300) ( 300)

(2,000)

Working Capital

Investment

ON

2,930

490 610 540 470 420 400

Depreciation (DDB)

10,260

950 1,500 1,880 1,930 1,930 2,070

Cash Flow $(12,000) 950 — 1,480 1,630 1,630 2,070 ( 4,240) 11,850 7,610

Cash Generation (Requirement)

T OTAL I NVESTMENT (D OLLARS IN

T HOUSANDS )

514 Discounted rate of return: 9% 1% -------------------------------- 9.9% 514 ( 51 )

7,330

460 890 1,340 1,460 1,510 1,670

Proﬁt after Taxes and Depreciation

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

0 $(10,000) 1 2 ( 1,500) 3 4 5 6 Subtotal Salvage (net of tax) Total $(11,500)

Year

278

$(12,000) 871 — 1,142 1,154 1,060 1,224 7,063 514

.596

Amount

1.000 .917 .842 .772 .708 .650 .596

Factor

Discounted at 9%

.564

1.000 .909 .826 .751 .683 .620 .564

Factor

(

6,683 51)

$(12,000) 864 — 1,111 1,113 1,011 1,167

Amount

Discounted at 10%

Discounted Cash Flow

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E XHIBIT 15.14

2,930

7,330

OF

490 610 540 470 420 400

460 890 1,340 1,460 1,510 1,670

288) 303) 328) 344) 352) 178)

(1,793)

( ( ( ( ( (

Interest Expense (Net)

( 6,033)

(12,000) 662 ( 303) 1,152 1,286 1,278 1,892

Gross Cash Generation (Requirement)

47

9,600 — 1,350 360 270 270 — 11,850 (11,850)

Borrowings ( 2,400) 662 1,047 1,512 1,556 1,548 1,892 5,817 (11,850) 11,850 5,817

Net Cash Generation (Requirement)

IN

T HOUSANDS )

15.22

1.000 .709 .503 .357 .253 .179 .127

Factor

47

(2,400) 469 527 540 394 277 240 47

Amount

Discounted at 41%

1.000 .704 .496 .349 .246 .173 .122

Factor

$(

279

5)

$(2,400) 466 519 528 383 268 231 ( 5)

Amount

Discounted at 42%

Discounted Cash Flow

Financial Analysis of Unacceptable Operating Results

Discounted rate of return: 41% 1% --------------------------- 41.9% 47 ( 5 )

10,260

950 1,500 1,880 1,930 1,930 2,070

Cash Flow

B ORROWING (D OLLARS

Depreciation (Double Declining Balance)

D ISCOUNTED C ASH F LOW , N ET

0 $(12,000) 1 — 2 ( 1,500) 3 ( 400) 4 ( 300) 5 ( 300) 6 — Subtotal Loan repayment Salvage (net) Total $(14,500)

Year

Gross Investment

Proﬁt After Taxes and Depreciation

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280

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

C HEMICAL M ANUFACTURING C ORPORATION C HICAGO D IVISION R EPORT ON P ROFIT P OTENTIAL AND B REAK- E VEN P OINTS

G ENERAL C OMMENTS Operations at the Chicago Division for the year ended December 31, 20XX, resulted in a net loss of $730,142. It may be taken for granted that the past year was one of experimentation and inefﬁciency which might be expected normally as a part of the start-up cost of a new plant. However, the question which now can be asked is: “What is the normal proﬁt expectancy, now that operating experience has been gained?” Other questions frequently posed include: • Would the company as a whole have lost less if the Chicago Division had not operated? • What are the earning possibilities of the Division? • What are the break-even points of the three major product lines? • What action can be taken to minimize losses or increase proﬁts? It is hoped that some of the facts and opinions expressed in this report will stimulate thinking as to possible corrective action. O PERATIONS

FOR THE

Y EAR 20XX

A summary of operating results is presented in Exhibit 15.15. The loss of $730,142 represents 35.95% of net sales. It will be observed that the standard gross margin is only 13.25% of net sales, and that it was insufﬁcient to cover the operating expenses. If the plant had operated close to capacity the excess ﬁxed costs of $268,082 would have largely disappeared. Furthermore, the additional income, even at a low margin rate, probably would have been sufﬁcient to offset a major share of the excess manufacturing costs and operating expenses. Even at the higher volume level, the results would have been disappointing. C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION S TATEMENT OF I NCOME AND E XPENSE F OR THE Y EAR E NDED D ECEMBER 31, 20XX

Net sales Cost of sales At standard: Material Variable expense Fixed expense Standard gross margin Over standard: Material Variable expense Fixed expense Manufacturing loss Operating expenses Operating loss Other income (net) Loss before income tax impact E XHIBIT 15.15

Black process 45.0° 133.0 LPI

S TATEMENT

$1,515,062 82,705 164,022

168,305 135,182 268,082

OF I NCOME AND

E XPENSE

Amount

% of Sales

$2,030,958

100.00

1,761,789 269,169

86.75 13.25

571,569 302,400 441,639 744,039 13,897 $730,142

28.14 14.89 21.74 36.63 .68 35.95

15_controllership.fm Page 281 Monday, December 8, 2003 3:16 PM

15.22 Financial Analysis of Unacceptable Operating Results

281

However, the overall company losses for the year would have been greater if the Chicago Division had not operated. This results from the fact that the sales income was greater than the direct out-of-pocket charges. A balance was available to cover either a share of the general ofﬁce expenses, or Illinois Division expenses, or the depreciation and insurance costs which would have continued. The net advantage of operating the Chicago Division was $185,646, calculated as: Net sales Other income (net) Total Deduct: Direct out-of-pocket costs Material Expenses Income in excess of out-of-pocket costs

$2,030,958 13,897 2,044,855

$1,683,367 175,842

1,859,209 $ 185,646

This gain is reconciled with the net loss in this manner: Allocated expenses Illinois Division expenses General ofﬁces expenses Total allocated expenses Continuing ﬁxed charges —depreciation, etc. Total costs Deduct: Income in excess of out-of-pocket costs Net loss

$510,859 214,114 724,973 190,815 915,788 185,646 $730,142

It is to be observed that the ﬁxed charges of $190,815 would not have been incurred if the Chicago Division properties had not been purchased, and that they will continue until the property is either fully depreciated or disposed of. Moreover, the income in excess of out-of-pocket expenses, an amount of $185,646, was almost enough to cover the continuing ﬁxed charges. P ROSPECTS

FOR THE

F UTURE

The severe losses of last year have prompted a thorough review of future possibilities. After extensive discussions with the General Sales Manager and Works Manager, together with a critical analysis of present sales trends and expected cost levels, it appears that present plans would result in an operating proﬁt, at plant capacity, of $28,727 per month or $344,724 per year. While this is more encouraging than a loss of $730,142, yet overall proﬁt is only 5.97% of net sales. The condensed statement by product lines is shown in Exhibit 15.16. A most serious aspect is the almost total lack of proﬁt, even at capacity levels, on our most voluminous product — paints. Quite in contrast, the coke by-products show a possible operating proﬁt of 19.31% of net sales at capacity. The Chicago Division, of course, has not yet attained 100% of plant capacity sales volume. P ROFIT P OTENTIALS

AT

V ARIOUS V OLUME L EVELS

Because the Division may experience several different monthly sales and production levels, it has been felt desirable to construct proﬁt graphs so that the operating proﬁt on any of the three product lines may be anticipated with a reasonable degree of accuracy. These are illustrated in Exhibits 15.17 through 15.19. The probable proﬁt or loss at any selected volume level is measured by the

Black process 45.0° 133.0 LPI

Black process 45.0° 133.0 LPI

.9835 18.6907 16.1591 1.1168 17.2759 1.4149 1.3827 $ .0322

14,099 267,951

231,657 16,010

247,667

20,284 19,823 461

1,433,600

$

$19.6742

$ 282,050

Per Cwt.

7.57 7.40 .17

92.43

86.45 5.98

5.26 100.00

105.26

% Net Sales

522,000

13,800 7,603 $ 6,197

85,063

75,621 9,442

4,754 98,863

$103,617

Amount

2.6437 1.4565 $ 1.1872

16.2956

14.4868 1.8088

.9107 18.9393

$19.8500

Per Cwt.

13.96 7.69 6.27

86.04

76.49 9.55

4.81 100.00

104.81

% Net Sales

Ammonia Derivatives

457,000

30,437 8,368 $ 22,069

83,862

70,308 13,554

4,521 114,299

$118,820

Amount

6.6602 1.8311 $ 4.8291

18.3506

15.3847 2.9659

.9893 25.0107

$26.0000

Per Cwt.

Coke By-Products

26.63 7.32 19.31

73.37

61.51 11.86

3.96 100.00

103.96

% Net Sales

2,412,600

$

64,521 35,794 28,727

416,592

377,586 39,006

23,374 481,113

$ 504,487

Amount

2.6743 1.4836 $ 1.1907

17.2674

15.6506 1.6168

.9688 19.9417

$20.9105

Per Cwt.

Total

13.41 7.44 5.97

86.59

78.48 8.11

4.86 100.00

104.86

% Net Sales

E XHIBIT 15.16

S TATEMENT OF

E STIMATED I NCOME AND

E XPENSE BY

P RODUCT L INE

expenses shown above are those indicated in Exhibit 15.20, except that freight costs have been deducted from sales (and not included in cost of sales) to arrive at a net sales ﬁgure consistent with the usual statement presentation.

a Variable

Net sales before freight allowance Less: Freight allowance Net sales Cost of sales Variable a Fixed Total cost of sales Manufacturing proﬁt Operating expenses Operating proﬁt Pounds manufactured and sold

Amount

Paints

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION S TATEMENT OF E STIMATED I NCOME AND E XPENSE A T P LANT C APACITY (5-D AY W EEK ) FOR O NE M ONTH

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

Description

282

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15_controllership.fm Page 283 Monday, December 8, 2003 3:16 PM

15.22 Financial Analysis of Unacceptable Operating Results

E XHIBIT 15.17

283

B REAK- E VEN C HART —P AINT W ORKS

vertical difference between the sales income line and total cost line at that level. For example, at a 50% plant capacity level, the operating proﬁt or loss would be about:

Product Paints Ammonia derivatives Coke by-products Total

Sales Volume at 50% Level

Monthly Operating Proﬁt (or Loss)

$141,025

$(17,687)

51,810 59,410 $252,245

( 5,423) 73 $(23,037)

These ﬁgures have been calculated, but a close approximation can be read on the graphs.

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15_controllership.fm Page 284 Monday, December 8, 2003 3:16 PM

284

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

E XHIBIT 15.18

B REAK -E VEN C HART —A MMONIA P LANT

These charts also indicate the break-even points at which income balances expense. The breakeven points are quite dissimilar: Break-Even Point

Product Paints Ammonia derivatives Coke by-products

Sales per Month

% of FiveDay Capacity

Pounds

Dollars

98.7 73.4 49.9

1,415,161 383,148 228,043

$278,423 76,094 59,249

The details of costs and income on which these break-even points are predicated are set forth in Exhibits 15.20 through 15.22.

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15.22 Financial Analysis of Unacceptable Operating Results

E XHIBIT 15.19

285

B REAK- E VEN C HART —C OKE B Y- P RODUCTS P LANT

The chief problem of the Chicago Division centers about the paint line, where a plant capacity operation is required in order to avoid a loss. This is, indeed, a disturbing condition; and the remaining comments relate chieﬂy to this product line. P AINTS —R ECOMMENDATIONS In reviewing the proﬁt structure, a detailed analysis was made of each of the more popular items in each product group. The total income and standard variable costs are outlined in Exhibit 15.20. The hundredweight data and marginal income per machine or kettle hour are shown in Exhibit 15.23. It will be observed that items 103 and 105 contribute the greatest income over variable expense, per machine hour, to help meet the ﬁxed expenses, income taxes, and proﬁt. It would seem desirable, and is possible in the opinion of the general sales manager, to increase the proportion of sales of these two items. As items 102 and 104 contribute the lowest marginal income, these should not be promoted. Of course, until the system is at capacity, every drum of paint sold helps reduce losses or increase proﬁts.

Black process 45.0° 133.0 LPI

Black process 45.0° 133.0 LPI

E XHIBIT 15.20

89,180.00 29,640.00

343,000 114,000

Freight

E XPENSE

Material

U SE

IN

205.80 68.40

313.20

46.98 125.28 93.96 46.98

$ 141.12 141.12 201.60 94.08 188.28 94.08 860.28

Shipping

4,372.91 1,453.39

2,278.00

341.70 911.20 683.40 341.70

$ 2,373.87 2,373.87 3,391.25 1,582.58 3,167.18 1,582.58 14,471.33

Drums $

3,352.48 1,290.94

3,480.54

541.84 1,426.10 1,027.45 485.15

924.81 928.81 1,501.58 653.86 1,264.30 568.09 5,841.21

Processing

1,919.43 621.19

450.62

80.34 152.84 158.48 58.96

$ 367.85 489.92 593.38 190.04 560.45 266.87 2,468.51

Material Handling

VARIABLE COSTS (STANDARD)

P ROFIT G RAPH

42,062.78 12,536.92

68,212.67

9,703.41 26,307.76 20,492.83 11,708.67

$ 34,958.48 37,600.48 46,783.97 27,408.48 35,005.65 23,697.81 205,454.87

FOR

3,393.30 1,127.80

4,754.38

713.16 1,901.75 1,426.31 713.16

$ 2,312.73 2,312.73 3,303.89 1,541.81 3,085.60 1,541.81 14,098.57

AND

103,617.00

522,000

V ARIABLE I NCOME

14,877.00 41,760.00 31,320.00 15,660.00

78,300 208,800 156,000 78,300

OF

$ 47,040.00 47,040.00 67,200.00 34,496.00 53,346.00 32,928.00 282,050.00

Value

235,200 235,200 336,000 156,800 313,800 156,800 1,433,800

D ETAIL

PAINTS 101 102 103 104 105 106 Total paints A MMONIA D ERIVATIVES 205 206 207 208 Total ammonia derivatives C OKE B Y -P RODUCTS 301 302

Pounds

SALES

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION B REAKDOWN BY P RODUCT OF V ARIABLE I NCOME AND C OSTS U SED IN D EVELOPMENT OF P ROFIT G RAPH

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

Product

286

— — — — — 14.11 14.11

— —

113.61

— — — 113.61

$

Royalties

55,306.70 17,098.64

79,603.02

11,427.43 30,824.93 23,882.43 13,468.23

$ 41,078.86 43,846.69 55,775.67 31,470.85 43,271.46 27,765.35 243,208.88

Total $

33,873.30 12,541.36

24,013.98

3,449.57 10,935.07 7,437.57 2,191.77

5,961.14 3,191.31 11,424.33 3,025.15 10,074.54 5,162.65 38,841.12

Marginal Income

15_controllership.fm Page 286 Monday, December 8, 2003 3:16 PM

Black process 45.0° 133.0 LPI

4,521.10

$23,374.05

$504,487.00

2,412,800

E XHIBIT 15.20

Freight

118,820.00

Value

457,000

Pounds

D ETAIL

$328,267.24

54,599.70

Material

$1,447.68

274.20

Shipping

OF

V ARIABLE I NCOME AND

E XPENSE FOR

U SE IN

682 786 — $80,375

2,055 1,660 — $245,756

15.22

546 1,436 1,371 $74,829

929 71,476

72,405.34

Total

$395,217.24

3,283 3,882 1,371 $400,960

2,793 392,424

Total $395,217

$127.72

—

Royalties

Coke By-Products $72,405

$5,459.75

2,540.62

Material Handling

287

$109,269.76

46,414.66

Marginal Income

Financial Analysis of Unacceptable Operating Results

696 78,907

1,168 242,041

P ROFIT G RAPH (C ONTINUED )

Ammonia Derivatives $79,603

$13,965.17

4,643.42

Processing

Paints $243,209

$22,575.63

5,826.30

Drums

VARIABLE COSTS (STANDARD)

Variable costs, as above Deduct: Costs assumed to be ﬁxed in nature Net Add: Assumed material losses —1% Assumed overrun on standards (20% of processing and handling) Assumed short-term excess costs Total variable costs

COST DATA USED IN PROFIT GRAPH

Total coke by-products Total variable Income and costs — All products

Product

SALES

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION B REAKDOWN BY P RODUCT OF V ARIABLE I NCOME AND C OSTS U SED IN D EVELOPMENT OF P ROFIT G RAPH

15_controllership.fm Page 287 Monday, December 8, 2003 3:16 PM

Black process 45.0° 133.0 LPI

U SE

E XHIBIT 15.21

D ETAIL

OF

M ONTHLY F IXED C OSTS IN

P ROFIT G RAPH

1,591 82

2,106 47 FOR

208 6,673

624 11,689

Vacuum boilers (labor and related costs) Total direct manufacturing expense A LLOCATED General works cost Boiler house ﬁxed costs

1,287

952

1,116

537 2,363 23 306 833

Control laboratory

$

826

$ 1,408 4,818 62 815 2,184

MANUFACTURING D IRECT Depreciation —buildings Depreciation —machinery and equipment Property insurance Real and personal property taxes Building costs (heat, lighting, janitor service, etc.)

Ammonia Derivatives

General plant costs

Paints

Product

$

2,499 1,221

— 8,305

1,765

1,530

710 2,783 31 386 1,100

Coke By-Products

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION D ETAIL OF M ONTHLY F IXED C OSTS U SED IN D EVELOPMENT OF P ROFIT G RAPH

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

Item

288

6,196 1,350

832 26,667

4,004

3,472

$ 2,655 9,964 116 1,507 4,117

Total

Budgeted cost—20X1 Budgeted cost—20X1

Actual expense —20XX Actual expense —20XX Actual expense —20XX Actual expense —20XX Average budgeted cost —20X1; allocated to products on cubic ft. basis Average budgeted cost —20X1; allocated to products on forecasted conversion cost basis Average budgeted cost —20X1; allocated to products on forecasted conversion cost basis Actual expense—20XX

Comments

15_controllership.fm Page 288 Monday, December 8, 2003 3:16 PM

Black process 45.0° 133.0 LPI FOR

U SE IN

P ROFIT G RAPH (C ONTINUED )

$35,833

M ONTHLY F IXED C OSTS

$17,045

19,823

OF

7,603

1,000 1,168 16,010

D ETAIL

400 696 9,442

2,153 13,842

Total allocated costs Total ﬁxed manufacturing expenses before adjustments Add: Share of undistributed water and steam costs 20% of processing costs assumed to be ﬁxed Total ﬁxed manufacturing costs for construction of proﬁt graph OPERATING EXPENSES Administrative, selling, and advertising, technical, etc., per Exhibit 15.22 Total ﬁxed expense for construction of proﬁt graph

E XHIBIT 15.21

1,673 8,346

Paints

Item

Ammonia Derivatives

Product

15.22

$74,800

35,794

2,000 2,793 39,006

7,546 34,213

Total

289

Expected experience —20X1 budget

Comments

Financial Analysis of Unacceptable Operating Results

$21,922

8,368

600 929 13,554

3,720 12,025

Coke By-Products

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION D ETAIL OF M ONTHLY F IXED C OSTS U SED IN D EVELOPMENT OF P ROFIT G RAPH

15_controllership.fm Page 289 Monday, December 8, 2003 3:16 PM

290

Black process 45.0° 133.0 LPI

E XHIBIT 15.22

D ETAIL OF

IN

P ROFIT G RAPH

$8,368

$7,603

$19,823 FOR

761

691

1,802

338 166 442 667 347 229 177 2,366 7,607

295 144 385 580 301 198 154 2,057 6,912

840 412 1,097 1,653 858 565 439 5,864 18,021

$ 975 3,124 456 686 5,241

Coke By-Products

$1,146 2,717 395 597 4,855

U SE

Ammonia Derivatives

$ 1,587 7,743 1,126 1,701 12,157

Paints

M ONTHLY O PERATING E XPENSES

DIRECT Advertising and sales promotion Selling Technical service Research Total direct operating expense ALLOCATED Administrative Advertising and sales promotion Selling Technical service Research Engineering Patents Total allocated operating expense Total operating expense before adjustment Add: Assumed 10% overrun on budget Total operating expense for construction of proﬁt graph

Item

Product

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION D ETAIL OF M ONTHLY O PERATING E XPENSES U SED IN D EVELOPMENT OF P ROFIT G RAPH

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

$35,794

3,254

1,473 722 1,924 2,900 1,506 992 770 10,287 32,540

$ 3,708 13,584 1,977 2,984 22,253

Total

Budget—20X1

Based on budget—20X1; allocated to Chicago Division on forecasted net sales for 20X1

冧

冧

Comments

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Black process 45.0° 133.0 LPI

$20.00 20.00 20.00 22.00 17.00 21.00

12.2632 10.9973

12.3926 12.5995 13.0861 14.9536

$14.8633 15.9866 13.9238 17.4799 11.1554 15.1134

Material

C OMPARATIVE U NIT C OSTS

26.00 26.00

BY -P RODUCTS

E XHIBIT 15.23

C OKE 301 302

A MMONIA D ERIVATIVES 205 19.00 206 20.00 207 20.00 208 20.00

P AINTS 101 102 103 104 105 106

Sales Price

AND I NCOME

1.2749 1.2749

.4364 .4364 .4364 .4364

$1.0093 1.0093 1.0093 1.0093 1.0093 1.0093

Container

2.5863 2.7266

1.7654 1.7270 1.7281 1.8108

$1.5929 1.6464 1.6668 1.5815 1.6248 1.5848

Other

Variable Costs

16.1244 14.9988

14.5944 14.7629 15.2506 17.2008

$17.4655 18.6423 16.5999 20.0707 13.7895 17.7075

Total

15.22

9.8756 11.0012

4.4056 5.2371 4.7494 2.7992

$ 2.5345 1.3577 3.4001 1.9293 3.2105 3.2925

Marginal Income

5.0768 7.0240

.5304 1.4376 1.0181 ( .7736)

$(1.7336) (2.1881) ( .1665) (1.7688) .0384 ( .2906)

Operating Proﬁt or (Loss)

895 831

963 947 985 1,032

1,032 884 943 775 852 774

Production (lbs.)

291

88.39 91.42

42.43 49.60 46.78 30.40

$26.16 12.00 32.06 14.95 27.35 25.48

Marginal Income

Per Machine Hour

Financial Analysis of Unacceptable Operating Results

4.7988 3.9772

3.8752 3.7995 3.7313 3.5728

$4.2681 3.5458 3.5666 3.6981 3.1721 3.5831

Fixed Costs and Expenses

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION C OMPARATIVE U NIT C OSTS AND I NCOME

15_controllership.fm Page 291 Monday, December 8, 2003 3:16 PM

Black process 45.0° 133.0 LPI

(000’s) Pounds

235.2 235.2 336.0 156.8 313.8 156.8 1,433.8

S TATEMENT

101 102 103 104 105 106 Total

E XHIBIT 15.24 OF

$ 5,961.14 3,191.31 11,424.33 3,025.15 10,074.54 5,162.65 $38.841.12

Marginal Income 235.2 117.0 461.0 77.5 400.0 124.6 1,415.3

(000’s) Pounds

S TANDARD M ARGINAL I NCOME G IVING E FFECT

16.4 16.4 23.5 10.9 21.9 10.9 100.0

% Total

Present Sales Mixture

TO

C HANGES

IN

16.6 8.3 32.6 5.4 28.3 8.8 100.0

% Total

Marginal Income

P RODUCTS S OLD

AND

$ 5,961.14 1,588.51 15,674.47 1,495.21 12,842.00 4,102.46 $41.663.79

Change in Sales Mixture

261.3 130.4 512.0 86.0 444.6 173.1 1,607.4

(000’s) Pounds

16.3 8.1 31.8 5.4 27.6 10.8 100.0

% Total

$ 6,725.34 1,821.95 17,637.38 1,695.06 14,453.06 5,761.98 $48,094.77

Marginal Income

10% Reduction in Cycle Time

M ANUFACTURING E FFICIENCY

C HEMICAL M ANUFACTURING C ORPORATION —C HICAGO D IVISION P AINTS D ETERMINATION OF S TANDARD M ARGINAL I NCOME AT C APACITY

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

Product

292

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15.22 Financial Analysis of Unacceptable Operating Results

E XHIBIT 15.25

P ROFIT G RAPH G IVING E FFECT TO C HANGES I NCOME AND C OSTS —P AINT W ORKS

293

IN

A review of sales indicates that 85% of the volume is secured from 15% of the customers. Furthermore, from what information we piece together, it appears our operating expenses are out of line with our competitors. There is some indication, also, that the cycle time in production is on the high side. The works manager is of the opinion that reductions can be made in production time. Such improvement would, of course, reduce the variable cost per hundredweight and increase the plant capacity and therefore the potential marginal income. On the basis of available information, it is recommended that immediate steps be taken to: • Reduce selling expenses (ﬁxed costs) by $3,300 per month through the release of three salesmen. The remaining staff can readily cover our large volume customers and contact other possible users. • Emphasize the more proﬁtable products, increasing the proportion of 103 and 105. • Concentrate on a reduction of cycle times by 10%. The effect of each successive action, detailed in Exhibit 15.24 as to marginal income, would be:

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294

Ch. 15 Profit Planning: Supporting Financial Analysis for the Annual Plan

Action

Break-Even Sales Volume (Monthly)

Monthly Operating Proﬁt at Capacity $

Present plans

(a)

$278,400

Reduce ﬁxed expenses by $3,330 per month

(b)

252,800

3,761

Change sales mixture to higher proportion of proﬁtable items, plus (b)

(c)

214,000

9,131

210,770

15,561

Reduce cycle time by 10%, plus (b) and (c)

461

The accomplishment of these objectives would result in a net proﬁt of 5.0% of sales at capacity. The proﬁt graph on paints, with these changes incorporated, would appear as in Exhibit 15.25. As a long-range program, research should be intensiﬁed on material costs so as to increase the margin of selling price over such costs. Since the net proﬁt as a percentage of investment, even with the improved results, would not be satisfactory, perhaps consideration can be given to new product lines with higher margins that could advantageously be manufactured in the paint facilities. Further details can be made available as requested. C ONTROLLER

15.23 MORE SOPHISTICATED ANALYSES The illustrations presented in this chapter have been some of the more simple applications of the cost-volume-proﬁt relationship. They deal with the more frequently asked questions relating to near-term applications where, for the volume range under discussion, the cost behavior of the elements is largely determinable; that is, the techniques for determining whether a cost is ﬁxed or variable, or for what proportion of a mixed cost is ﬁxed, are valid over a shorter period for the range in volume levels. Of course, over a longer period additions often must be made to ﬁxed costs (e.g., depreciation) to provide for greater capacity. Some would say this illustrates that ﬁxed costs are often variable.

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16_controllership.fm Page 295 Monday, December 8, 2003 3:22 PM

CHAPTER*

16

TAXATION STRATEGY 16.1

INTRODUCTION 295

16.7

NEXUS 299

16.2

ACCUMULATED EARNINGS TAX 296

16.8

PASSIVE ACTIVITY LOSSES 300

16.3

CASH METHOD OF ACCOUNTING 297

16.9

PROJECT COSTING 300

16.4

INVENTORY VALUATION 297

16.11 S CORPORATION 301

16.5

MERGERS AND ACQUISITIONS 297

16.12 SALES AND USE TAXES 302

16.6

NET OPERATING LOSS CARRYFORWARDS 298

16.13 TRANSFER PRICING 303

16.10 PROPERTY TAXES 301

16.14 UNEMPLOYMENT TAXES 305

16.1 INTRODUCTION The obvious objective of tax strategy is to minimize the amount of cash paid out for taxes. However, this directly conﬂicts with the general desire to report as much income as possible to shareholders, since more reported income results in more taxes. Only in the case of privately owned ﬁrms do these conﬂicting problems go away, since the owners have no need to impress anyone with their reported level of earnings, and would simply prefer to retain as much cash in the company as possible by avoiding the payment of taxes. For those controllers who are intent on reducing their corporation’s tax burdens, there are ﬁve primary goals to include in their tax strategies, all of which involve increasing the number of differences between the book and tax records, so that reportable income for tax purposes is reduced. The ﬁve items are: 1. Accelerate deductions. By recognizing expenses sooner, one can force expenses into the current reporting year that would otherwise be deferred. The primary deduction acceleration involves depreciation, for which a company typically uses MACRS (an accelerated depreciation methodology acceptable for tax reporting purposes), and straight-line depreciation, which results in a higher level of reported earnings for other purposes. 2. Take all available tax credits. A credit results in a permanent reduction in taxes, and so is highly desirable. Unfortunately, credits are increasingly difﬁcult to ﬁnd, though one might qualify for the research and experimental tax credit, which is available to those companies that have increased their research activities over the previous year. The only type of expense that qualiﬁes for this credit is that which is undertaken to discover information that is technical in nature, and its application must be intended for use in developing a new or improved

* Sections 16.1–16.7 were adapted with permission from Steven M. Bragg, The New CFO Financial Leadership Manual (Hoboken: Wiley, 2003,Chapter 3); Section 16.8 adapted with permission from Steven M. Bragg, Accounting Reference Desktop (Hoboken:Wiley, 2002,p. 528); Section 16.10 adapted with permission from Steven M. Bragg, Accounting Reference Desktop (Hoboken: Wiley, 2002, p. 529.)

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business component for the taxpayer. Also, all of the research activities must be elements of a process of experimentation relating to a new or improved function, or that enhances the current level of performance, reliability, or quality. A credit cannot be taken for research conducted after the beginning of commercial production, for the customization of a product for a speciﬁc customer, for the duplication of an existing process or product, or for research required for some types of software to be used internally. There are more tax credits available at the local level, where they are offered to those businesses willing to operate in economic development zones, or as part of specialized relocation deals (normally available only to larger companies). 3. Avoid nonallowable expenses. There are a few expenses, most notably meals and entertainment, that are completely or at least partially not allowed for purposes of computing taxable income. A key company strategy is to reduce these types of expenses to the bare minimum, thereby avoiding any lost beneﬁts from nonallowable expenses. 4. Increase tax deferrals. There are a number of situations in which taxes can be shifted into the future, such as payments in stock for acquisitions, or the deferral of revenue received until all related services have been performed. This can shift a large part of the tax liability into the future, where the time value of money results in a smaller present value of the tax liability than otherwise would be the case. 5. Obtain tax-exempt income. The controller should consider investing excess funds in municipal bonds, which are exempt from both federal income taxes and the income taxes of the state in which they were issued. The downside of this approach is that the return on municipal bonds is less than the return on other forms of investment, due to their inherent tax savings. There is no single tax strategy that will be applicable to every company, since the tax laws are so complex that the controller must construct a strategy that is tailored to the speciﬁc circumstances in which her company ﬁnds itself. Nonetheless, there are a number of taxation areas that a controller must be aware of when creating a tax strategy using the preceding ﬁve goals. Those areas are listed in alphabetical order through the remainder of this chapter, ranging from the accumulated earnings tax to unemployment taxes. The controller should carefully peruse these topics to see if they should be incorporated into her overall tax strategy.

16.2 ACCUMULATED EARNINGS TAX There is a double tax associated with a company’s payment of dividends to investors, because it ﬁrst must pay an income tax from which dividends cannot be deducted as an expense, and then investors must pay income tax on the dividends received. Understandably, closely held companies prefer not to issue dividends in order to avoid the double taxation issue. However, this can result in a large amount of capital accumulating within a company. The IRS addresses this issue by imposing an accumulated earnings tax on what it considers to be an excessive amount of earnings that have not been distributed to shareholders. The IRS considers accumulated earnings of less than $150,000 to be sufﬁcient for the working needs of service businesses, such as accounting, engineering, architecture, and consulting ﬁrms. It considers accumulations of anything under $250,000 to be sufﬁcient for most other types of businesses. A company can argue that it needs a substantially larger amount of accumulated earnings if it can prove that it has speciﬁc, deﬁnite, and feasible plans that will require the use of the funds within the business. Another valid argument is that a company needs an amount of accumulated earnings sufﬁcient to buy back the company’s stock that is held by a deceased shareholder’s estate. If these conditions are not apparent, then the IRS will declare the accumulated earnings to be taxable at a rate of 39.6 percent. Also, interest payments to the IRS will be due from the date when the corporation’s annual return was originally due. The severity of this tax is designed to encourage organizations to issue dividends on a regular basis to their shareholders, so that the IRS can tax the shareholders for this form of income.

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16.3 CASH METHOD OF ACCOUNTING The normal method for reporting a company’s ﬁnancial results is the accrual basis of accounting, under which expenses are matched to revenues within a reporting period. However, for tax purposes, it is sometimes possible to report income under the cash method of accounting. Under this approach, revenue is not recognized until payment for invoices is received, while expenses are not recognized until paid. The cash basis of accounting can result in a great deal of manipulation from the perspective of the IRS, which discourages its use, but does not prohibit it. As an example of income manipulation, a company may realize that it will have a large amount of income to report in the current year, and will probably have less in the following year. Accordingly, it prepays a number of supplier invoices at the end of the year, so that it recognizes them at once under the cash method of accounting as expenses in the current year. The IRS prohibits this type of behavior under the rule that cash payments recognized in the current period can relate only to current-year expenses. Nonetheless, it is a difﬁcult issue for the IRS to police. The same degree of manipulation can be applied to the recognition of revenue, simply by delaying billings to customers near the end of the tax year. Also, in situations where there is a sudden surge of business at the end of the tax year, possibly due to seasonality, the cash method of accounting will not reveal the sales until the following year, since payment on the invoices from customers will not arrive until the next year. Consequently, the cash method tends to underreport taxable income. In order to limit the use of this method, the IRS prohibits it if a company has any inventories on hand at the end of the year. The reason for this is that expenditures for inventory can be so large and subject to manipulation at year-end that a company could theoretically alter its reported level of taxable income to an enormous extent. The cash basis is also not allowable for any C corporation, a partnership that has a C corporation for a partner, or a tax shelter. However, within these restrictions, it is allowable for an entity with average annual gross receipts of $5 million or less for the three tax years ending with the prior tax year, as well as for any personal service corporation that provides at least 95 percent of its activities in the services arena. The IRS imposes some accrual accounting concepts on a cash-basis organization in order to avoid some of the more blatant forms of income avoidance. For example, if a cash-basis company receives a check at the end of its tax year, it may be tempted not to cash the check until the beginning of the next tax year, since this would push the revenue associated with that check into the next year. To avoid this problem, the IRS uses the concept of constructive receipt, which requires one to record the receipt when it is made available to one without restriction (whether or not it is actually recorded on the company’s books at that time). Besides the just-noted example, this would also require a company to record the interest on a bond that comes due prior to the end of the tax year, even if the associated coupon is not sent to the issuer until the next year.

16.4 INVENTORY VALUATION It is allowable to value a company’s inventory using one method for book purposes and another for tax purposes, except in the case of the LIFO inventory valuation method. In this case, the tax advantages to be gained from the use of LIFO are so signiﬁcant that the IRS requires a user to employ it for both book and tax purposes. Furthermore, if LIFO is used in any one of a group of ﬁnancially related companies, the entire group is assumed to be a single entity for tax reporting purposes, which means that they must all use the LIFO valuation approach for both book and tax reporting. This rule was engendered in order to stop the practice of having LIFO-valuation companies roll their results into a parent company that used some other method of reporting, thereby giving astute companies high levels of reportable income and lower levels of taxable income at the same time.

16.5 MERGERS AND ACQUISITIONS A key factor to consider in corporate acquisitions is the determination of what size taxable gain will be incurred by the seller (if any), as well as how the buyer can reduce the tax impact of the

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transaction in the current and future years. In this section, we will brieﬂy discuss the various types of transactions involved in an acquisition, the tax implications of each transaction, and whose interests are best served by the use of each one. There are two ways in which an acquisition can be made, each with different tax implications. First, one can purchase the acquiree’s stock, which may trigger a taxable gain to the seller. Second, one can purchase the acquiree’s assets, which triggers a gain on sale of the assets, as well as another tax to the shareholders of the selling company, who must recognize a gain when the proceeds from liquidation of the business are distributed to them. Because of the additional taxation, a seller will generally want to sell a corporation’s stock, rather than its assets. When stock is sold to the buyer in exchange for cash or property, the buyer establishes a tax basis in the stock that equals the amount of the cash or fair market value of the property transferred to the seller. Meanwhile, the seller recognizes a gain or loss on the eventual sale of the stock that is based on its original tax basis in the stock, which is subtracted from the ultimate sale price of the stock. It is also possible for the seller to recognize no taxable gain on sale of a business if it takes some of the acquiring company’s stock as full compensation for the sale. However, there will be no tax only if continuity of interest in the business can be proven by giving the sellers a sufﬁcient amount of the buyer’s stock to prove that they have a continuing ﬁnancial interest in the buying company. A variation on this approach is to make an acquisition over a period of months, using nothing but voting stock as compensation to the seller’s shareholders, but for which a clear plan of ultimate control over the acquiree can be proven. Another variation is to purchase at least 80 percent of the fair market value of the acquiree’s assets solely in exchange for stock. When only the assets are sold to the buyer, the buyer can apportion the total price amongst the assets purchased, up to their fair market value (with any excess portion of the price being apportioned to goodwill). This is highly favorable from a taxation perspective, since the buyer has now adjusted its basis in the assets substantially higher; it can now claim a much larger accelerated depreciation expense in the upcoming years, thereby reducing its reported level of taxable income and reducing its tax burden. From the seller’s perspective, the sale price is allocated to each asset sold for the purposes of determining a gain or loss; as much of this as possible should be characterized as a capital gain (since the related tax is lower) or as an ordinary loss (since it can offset ordinary income, which has a higher tax rate). The structuring of an acquisition transaction so that no income taxes are paid must have a reasonable business purpose besides the avoidance of taxes. Otherwise, the IRS has been known to require tax payments on the grounds that the structure of the transaction has no reasonable business purpose besides tax avoidance. Its review of the substance of a transaction over its form leads the controller to consider such transactions in the same manner, and to restructure acquisition deals accordingly. There is a specialized tax reduction available for the holders of stock in a small business, on which they experience a gain when the business is sold. Speciﬁcally, they are entitled to a 50 percent reduction in their reportable gain on sale of that stock, though it is limited to the greater of a $10 million gain or ten times the stockholder’s basis in the stock. This exclusion is reserved for C corporations, and applies only to stock that was acquired at its original issuance. There are a number of other exclusions, such as its inapplicability to personal service corporations, real estate investment trusts, domestic international sales corporations, and mutual funds. This type of stock is called qualiﬁed small business stock. The unique set of conditions surrounding this stock make it clear that it is intended to be a tax break speciﬁcally for the owners of small businesses.

16.6 NET OPERATING LOSS CARRYFORWARDS Since income taxes can be the largest single expense on the income statement, the controller should carefully track the use and applicability of net operating loss (NOL) carryforwards that were created as the result of reported losses in prior years. An NOL may be carried back and applied against proﬁts recorded in the two preceding years, with any remaining amount being carried forward for

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the next 20 years, when it can be offset against any reported income. If there is still an NOL left after the 20 years have expired, then the remaining amount can no longer be used. One can also irrevocably choose to ignore the carryback option and use it only for carryforward purposes. The standard procedure is to apply all of the NOL against the income reported in the earliest year, with the remainder carrying forward to each subsequent year in succession until the remaining NOL has been exhausted. If an NOL has been incurred in each of multiple years, then these should be applied against reported income (in either prior or later years) in order of the ﬁrst NOL incurred. This rule is used because of the 20-year limitation on an NOL, so that an NOL incurred in an earlier year can be used before it expires. The NOL is a valuable asset, since it can be used for many years to offset future earnings. A company buying another entity that has an NOL will certainly place a high value on the NOL, and may even buy the entity strictly in order to use its NOL. To curtail this type of behavior, the IRS has created the Section 382 limitation, under which there is a limitation on its use if there is at least a 50 percent change in the ownership of an entity that has an unused NOL. The limitation is derived through a complex formula that essentially multiplies the acquired corporation’s stock times the long-term tax-exempt bond rate. To avoid this problem, a company with an unused NOL that is seeking to expand its equity should consider issuing straight preferred stock (no voting rights, no conversion privileges, and no participation in future earnings) in order to avoid any chance that the extra equity will be construed as a change in ownership. If a company has incurred an NOL in a short tax year, it must deduct the NOL over a period of six years, starting with the ﬁrst tax year after the short tax year. This limitation does not apply if the NOL is for $10,000 or less, or if the NOL is the result of a short tax year that is at least nine months long, and is less than the NOL for a full 12-month tax year beginning with the ﬁrst day of the short tax year. This special NOL rule was designed to keep companies from deliberately changing their tax years in order to create an NOL within a short tax year. This situation is quite possible in a seasonal business where there are losses in all but a few months. Under such a scenario, a company would otherwise be able to declare an NOL during its short tax year, carry back the NOL to apply it against the previous two years of operations, and receive a rebate from the IRS.

16.7 NEXUS A company may have to complete many more tax forms than it would like, as well as remit taxes to more government entities, if it can be established that it has nexus within a government’s area of jurisdiction. Consequently, it is very important to understand how nexus is established. The rules vary by state, but nexus is generally considered to have occurred if a company maintains a facility of any kind within a state, or if it pays the wages of someone within that state. In some locales, the deﬁnition is expanded to include the transport of goods to customers within the state on company-owned vehicles (though nexus is not considered to have occurred if the shipment is made by a third-party freight carrier). A more liberal interpretation of the nexus rule is that a company has nexus if it sends sales personnel into the state on sales calls or trains personnel there to educate customers, even though they are not permanently based there. To gain a precise understanding of how the nexus rules are interpreted by each state, it is best to contact the department of revenue at each state government. A recent issue that is still being debated in the courts is that Internet sales may be considered to have occurred within a state if the server used to process orders or store data is kept within that state, even if the server is merely rented from an Internet hosting service. If nexus has been established, a company must ﬁle to do business within the state, which requires a small fee and a re-ﬁling once every few years. In addition, it must withhold sales taxes on all sales within the state. This is the most laborious issue related to nexus, since sales taxes may be different for every city and county within each state, necessitating a company to keep track of potentially thousands of different sales tax rates. Also, some states may require the remittance of sales taxes every month, though this can be reduced to as little as once a year if the company predicts that it will have minimal sales taxes to remit, as noted on its initial application for a sales tax license.

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Some states or local governments will also subject a company to property or personal property taxes on all assets based within their jurisdictions, which necessitates even more paperwork. Though the amount of additional taxes paid may not be that great, the key issue related to the nexus concept is that the additional time required to track tax liabilities and ﬁle forms with the various governments may very well require additional personnel in the accounting department. This can be a major problem for those organizations in multiple states, and should be a key planning issue when determining the capacity of the accounting department to process tax-related transactions. Some organizations with a number of subsidiaries will avoid a portion of the tax ﬁling work by accepting the nexus concept only for those subsidiaries that are clearly established within each governmental jurisdiction, thereby avoiding the tax ﬁling problems for all other legal entities controlled by the parent corporation.

16.8 PASSIVE ACTIVITY LOSSES Many individuals and some businesses passively participate in business activities that result in income or losses. They can claim passive activity losses on their tax returns based on these ﬁnancial results. Passive participation is deﬁned as having a trade or business activity in which one does not materially participate during the tax year, or participating in a rental activity (even if there is evidence of a substantial level of activity in the venture). One is considered to be an active investor if any of the following tests are true: • One annually expends more than 500 hours of participation in the activity. • One’s participation comprises essentially all of the activity for a business. • There were more than 100 hours of annual participation, which was at least as much as any other participant in the business. • One materially participated in the business in any ﬁve of the last ten tax years. • One materially participated in a personal service business for any three previous tax years. A limited partner is generally not considered to be materially involved in a business. A closely held corporation or a personal service corporation is considered to materially participate in a business if shareholders owning more than 50 percent of the corporation’s shares materially engage in the business. Also, an investing entity is considered to be materially engaged in a business if it has an interest in an oil or gas well that is held directly or through an entity that does not reduce its liability. Passive activity losses can be claimed only by individuals, estates, trusts, personal service corporations, and closely held C corporations. Conversely, passive activity losses cannot be claimed by grantor trusts, partnerships, and S corporations. If passive activity losses have occurred, they can be offset only against passive activity gains. Activities that are deﬁned by the IRS as not passive are gains on sale of property that has not been used in a passive activity, investment income, and personal services income. If there is an excess credit from a passive loss after all offsets have been made against passive income, then the credit can be carried forward to the next tax year for a later offset. However, all passive losses that are carried forward can be recognized at the time when the passive investor liquidates the investment. The total amount of a passive loss will be limited to the total amount to which a passive investor is at risk. For example, if an entity invests $1,000 in a business venture, then it is only at risk for $1,000, and cannot deduct more than that amount under any circumstances as a passive loss.

16.9 PROJECT COSTING A company that regularly develops large infrastructure systems such as enterprise resource planning (ERP) systems for its own use will usually cluster all costs related to that project into a single account and then capitalize its full cost, with amortization occurring over a number of years. Though this approach will certainly increase reported income over the short term, it also increases income taxes. If the avoidance of income taxes is a higher priority for the controller than reported proﬁts,

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then it would be useful to separate the various components of each project into different accounts, and expense those that more closely relate to ongoing operational activities. For example, a strong case can be made for expensing all training associated with a major system installation, on the grounds that training is an ongoing activity. Another approach is to charge subsidiaries for the cost of a development project, especially if the charging entity is located in a low-tax region and the subsidiaries are in high-tax regions. This transfer pricing approach would reduce the reported income in high-tax areas, effectively shifting that income to a location where the tax rate is lower. However, these cost-shifting strategies must be carefully documented with proof that the systems are really being used by subsidiaries, and that the fees charged are reasonable. A variation on the last approach is to create a data center in a tax haven that stores and analyzes company data and then issues reports back to other corporate divisions for a substantial fee. This approach has to involve more than simply locating a ﬁle server in a low-tax location, since the IRS will claim that there is no business purpose for the arrangement. Instead, a small business must be set up around the data center that provides some added value to the information being collected and disseminated. This approach is especially attractive if a company acquires another entity with a data center in a low-tax location, and simply shifts its own facilities to the preestablished location.

16.10 PROPERTY TAXES Local governments use property tax assessments as one of their primary forms of tax receipt. Personal property taxes are assessed based on a company’s level of reported ﬁxed assets in the preceding year, and typically paid once a year. In order to minimize this tax, the accounting department should regularly review the ﬁxed asset list to see which items can be disposed of, thereby shrinking the taxable base of assets. Also, by increasing the capitalization limit, fewer items will be classiﬁed as assets, and so will also not be taxed. Local taxing authorities can also impose a tax based on any real property owned by a business. The buildings and land that fall into this category will be appraised by the local assessor, with the resulting assessment being multiplied by a tax rate that is determined by the local government. The assessment can be challenged. If a recent assessment change results in a signiﬁcant boost in the reported value of a business’s real property, it is certainly worthwhile to engage the services of a private assessor to see if the new valuation can be reduced. If a business rents its property, the tax on real property can be either absorbed by the landlord or passed through to the business, depending upon the terms of the lease. If subleasing from another business, the property tax can be either absorbed by that entity or passed through to the business, again depending on the terms of the lease.

16.11 S CORPORATION The S corporation is of considerable interest to the controller, because it generally does not pay taxes. Instead, it passes reported earnings through to its shareholders, who report the income on their tax returns. This avoids the double taxation that arises in a C corporation, where a company’s income is taxed, and then the dividends it issues to its shareholders are taxed as income to them a second time. The amount of income is allocated to each shareholder on a simple per-share basis. If a shareholder has held stock in the corporation for less than a full year, then the allocation is on a per-share, per-day basis. The per-day part of this calculation assumes that a shareholder still holds the stock through and including the day when the stock is disposed of, while a deceased shareholder will be assumed to retain ownership through and including the day when he or she dies. An S corporation has unique taxation and legal protection aspects that make it an ideal way to structure a business if there are a small number of shareholders. Speciﬁcally, it can be created only if there are no more than 75 shareholders, if only one class of stock is issued, and if all shareholders agree to the S corporation status. All of its shareholders must be either citizens or residents of

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the United States. Shareholders are also limited to individuals, estates, and some types of trusts and charities. Conversely, this means that C corporations and partnerships cannot be shareholders in an S corporation. The requirement for a single class of stock may prevent some organizations from organizing in this manner, for it does not allow for preferential returns or special voting rights by some shareholders. There are a few cases where an S corporation can owe taxes. For example, it can be taxed if it has accumulated earnings and proﬁts from an earlier existence as a C corporation and its passive income is more than 25 percent of total gross receipts. It also can be liable for taxes on a few types of capital gains, recapture of the old investment tax credit, and LIFO recapture. If any of these taxes apply, then the S corporation must make quarterly estimated income tax payments. On the other hand, an S corporation is not subject to the alternative minimum tax. If the management team of an S corporation wants to terminate its S status, the written consent of more than 50 percent of the shareholders is required, as well as a statement from the corporation to that effect. If the corporation wants to become an S corporation at a later date, there is a ﬁveyear waiting period from the last time before it can do so again, unless it obtains special permission from the IRS.

16.12 SALES AND USE TAXES Sales taxes are imposed at the state, county, and city level — frequently by all three at once. It is also possible for a special tax to be added to the sales tax and applied to a unique region, such as for the construction of a baseball stadium or to support a regional mass transit system. The sales tax is multiplied by the price paid on goods and services on transactions occurring within the taxing area. However, the deﬁnition of goods and services that are required to be taxed will vary by state (not usually at the county or city level), and so must be researched at the local level to determine the precise basis of calculation. For example, some states do not tax food sales, on the grounds that this is a necessity whose cost should be reduced as much as possible, while other states include it in their required list of items to be taxed. A company is required to charge sales taxes to its customers and remit the resulting receipts to the local state government, which will split out the portions due to the local county and city governments and remit these taxes on the company’s behalf to those entities. If the company does not charge its customers for these taxes, it is still liable for them, and must pay the unbilled amounts to the state government, though it has the right to attempt to bill its customers after the fact for the missing sales taxes. This can be a difﬁcult collection chore, especially if sales are primarily over the counter, where there are few transaction records that identify the customer. Also, a company is obligated to keep abreast of all changes in sales tax rates and charge its customers for the correct amount; if it does not do so, then it is liable to the government for the difference between what it actually charged and the statutory rate. If a company overcharges its customers, the excess must also be remitted to the government. The state in which a company is collecting sales taxes can decide how frequently it wants the company to remit taxes. If there are only modest sales, the state may decide that the cost of paperwork exceeds the value of the remittances, and will require only an annual remittance. It is more common to have quarterly or monthly remittances. The state will review the dollar amount of remittances from time to time, and adjust the required remittance frequency based on this information. All government entities have the right to audit a company’s books to see if the proper sales taxes are being charged, and so a company can be theoretically subject to three sales tax audits per year — one each from the city, county, and state revenue departments. Also, since these audits can come from any taxing jurisdiction in which a company does business, there could be literally thousands of potential audits. The obligation to collect sales taxes is based on the concept of nexus, which was covered earlier in this chapter. If nexus exists, then sales taxes must be collected by the seller. If not, the recipient of purchased goods instead has an obligation to compile a list of items purchased, and remit a use tax to the appropriate authority. The use tax is in the same amount as the sales tax. The only differ-

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ence is that the remitting party is the buyer instead of the seller. Use taxes are also subject to audits by all taxing jurisdictions. If the buyer of a company’s products is including them in its own products for resale to another entity, then the buyer does not have to pay a sales tax to the seller. Instead, the buyer will charge a sales tax to the buyer of its ﬁnal product. This approach is used under the theory that a sales tax should be charged only one time on the sale of a product. However, it can be a difﬁcult chore to explain the lack of sales tax billings during an audit, so sales taxes should be halted only if a buyer sends a sales tax exemption form to the company, which then should be kept on ﬁle. The sales tax exemption certiﬁcate can be named a resale certiﬁcate instead, depending on the issuing authority. It also can be issued to government entities, which are generally exempt from sales and use taxes. As a general rule, sales taxes always should be charged unless there is a sales tax exemption certiﬁcate on ﬁle — otherwise, the company will still be liable for the remittance of sales taxes in the event of an audit.

16.13 TRANSFER PRICING Transfer pricing is a key tax consideration, because it can result in the permanent reduction of an organization’s tax liability. The permanent reduction is caused by the recognition of income in different taxing jurisdictions that may have different tax rates. The basic concept behind the use of transfer pricing to reduce one’s overall taxes is that a company transfers its products to a division in another country at the lowest possible price if the income tax rate is lower in the other country, or at the highest possible price if the tax rate is higher. By selling to the division at a low price, the company will report a very high proﬁt on the ﬁnal sale of products in the other country, which is where that income will be taxed at a presumably lower income tax rate. For example, Exhibit 16.1 shows a situation in which a company with a location in countries Alpha and Beta has the choice of either selling goods in Alpha or transferring them to Beta and selling them there. The company is faced with a corporate income tax rate of 40 percent in country Alpha. To permanently avoid some of this income tax, the company sells its products to another subsidiary in country Beta, where the corporate income tax rate is only 25 percent. By doing so, the company still earns a proﬁt ($60,000) in country Alpha, but the bulk of the proﬁt ($125,000) now appears in country Beta. The net result is a consolidated income tax rate of just 28 percent. Country Alpha Location Sales to subsidiary: Revenue Cost of goods sold Profit Profit percentage

$1,000,000% $1,850,000% $1,150,000% $1,111,115%

Sales outside of company: Revenue Cost of goods sold Profit Profit percentage

$1,500,000% $1,000,000% $1,500,000% $1,111,133%

Income tax percentage Income tax

$1,111,140% $1,160,000%

Consolidated income tax Consolidated income tax percentage

$1,185,000% $1,111,128%

E XHIBIT 16.1

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I NCOME T AX S AVINGS

Country Beta Location

FROM

T RANSFER P RICING

$1,111,125% $1,125,000%

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The IRS is well aware of this tax-avoidance strategy, and has developed tax rules that do not eliminate it but that will reduce the leeway that a controller has in altering reportable income. Under Section 482 of the IRS Code, the IRS’s preferred approach for developing transfer prices is to use the market rate as its basis. However, very few products can be reliably and consistently compared to the market rate, with the exception of commodities, because there are costing differences between them. Also, in many cases, products are so specialized (especially components that are custom-designed to ﬁt into a larger product) that there is no market rate against which they can be compared. Even if there is some basis of comparison between a product and the average market prices for similar products, the controller still has some leeway in which to alter transfer prices. The IRS will allow one to add special charges that are based on the cost of transferring the products, or extra fees, such as royalty or licensing fees that are imposed for the subsidiary’s use of the parent company’s patents or trademarks, or for administrative charges related to the preparation of any documentation required to move products between countries. It is also possible to slightly alter the interest rates charged to subsidiaries (though not too far from market rates) for the use of funds sent to them from the parent organization. If there is no basis on which to create prices based on market rates, then the IRS’s next most favored approach is to calculate the prices based on the work-back method. Under this approach, one begins at the end of the sales cycle by determining the price at which a product is sold to an outside customer, and then subtracts the subsidiary’s standard markup percentage and its added cost of materials, labor, and overhead, which results in the theoretical transfer price. The work-back method can result in a wide array of transfer prices, since a number of different costs can be subtracted from the ﬁnal sale price, such as standard costs, actual costs, overhead costs based on different allocation measures, and overhead costs based on cost pools that contain different types of costs. If that approach does not work, then the IRS’s third most favored approach is the cost plus method. As the name implies, this approach begins at the other end of the production process and compiles costs from a product’s initiation point. After all costs are added before the point of transfer, one then adds a proﬁt margin to the product, thereby arriving at a transfer cost that is acceptable by the IRS. However, once again, the costs that are included in a product are subject to the same points of variation that were noted for the work-back method. In addition, the proﬁt margin added should be the standard margin added for any other company customer, but can be quite difﬁcult to determine if there are a multitude of volume discounts, seasonal discounts, and so forth. Consequently, the proﬁt margin added to a product’s initial costs can be subject to a great deal of negotiation. An overriding issue to consider, no matter what approach is used to derive transfer prices, is that taxing authorities can become highly irritated if a company continually pushes the outer limits of acceptable transfer pricing rules in order to maximize its tax savings. When this happens, a company can expect continual audits and penalties on disputed items, as well as less favorable judgments related to any taxation issues. Consequently, it makes a great deal of sense to consistently adopt pricing policies that result in reasonable tax savings, are fully justiﬁable to the taxing authorities of all involved countries, and that do not push the boundaries of acceptable pricing behavior. Another transfer pricing issue that can modify a company’s pricing strategy is the presence of any restrictions on cash ﬂows out of a country in which it has a subsidiary. In these instances, it may be necessary to report the minimum possible amount of taxable income at the subsidiary, irrespective of the local tax rate. The reason is that the only way for a company to retrieve funds from the country is through the medium of an account receivable, which must be maximized by billing the subsidiary the highest possible amount for transferred goods. In this case, tax planning takes a back seat to cash ﬂow planning. Yet another issue that may drive a company to set pricing levels that do not result in reduced income taxes is that a subsidiary may have to report high levels of income in order to qualify for a loan from a local credit institution. This is especially important if the country in which the subsidiary is located has restrictions on the movement of cash, so that the parent company would be unable to withdraw loans that it makes to the subsidiary. As was the case for the last item, cash ﬂow planning is likely to be more important than income tax reduction. A ﬁnal transfer pricing issue to be aware of is that the method for calculating taxable income may vary in other countries. This may falsely lead one to believe that another country has a lower

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tax rate. A closer examination of how taxable income is calculated might reveal that some expenses are restricted or not allowed at all, resulting in an actual tax rate that is much higher than originally expected. Consultation with a tax expert for the country in question prior to setting up any transfer pricing arrangements is the best way to avoid this problem.

16.14 UNEMPLOYMENT TAXES Both the state and federal governments will charge a company a ﬁxed percentage of its payroll each year for the expense of unemployment funds that are used to pay former employees who have been released from employment. The state governments administer the distribution of these funds and will compile an experience rating on each company, based on the number of employees it has laid off in the recent past. Based on this experience rating, it can require a company to submit larger or smaller amounts to the state unemployment fund in future years. This can become a considerable burden if a company has a long history of layoffs. Consequently, one should consider the use of temporary employees or outsourcing if this will give a ﬁrm the ability to retain a small number of key employees and avoid layoffs while still handling seasonal changes in work loads. Also, if a company is planning to acquire another entity, but plans to lay off a large number of the acquiree’s staff once the acquisition is completed, it may make more sense to acquire the acquiree’s assets and selectively hire a few of its employees, thereby retaining a pristine unemployment experience rating with the local state government. The federal unemployment tax is imposed on a company if it has paid employees at least $1,500 in any calendar quarter, or had at least one employee for some portion of a day within at least 20 weeks of the year. In short, nearly all companies will be required to remit federal unemployment taxes. For the 2002 calendar year, the tax rate is 6.2 percent of the ﬁrst $7,000 paid to each employee; this tends to concentrate most federal unemployment tax remittances into the ﬁrst quarter of the calendar year. In many states, one can take a credit against the federal unemployment tax for up to 5.4 percent of taxable wages, which results in a net federal unemployment tax of only .8 percent. If a company is shifting to a new legal entity, perhaps because of a shift from a partnership to a corporation, or from an S corporation to a C corporation, it will have to apply for a new unemployment tax identiﬁcation number with the local state authorities. This is a problem if the organization being closed down had an unusually good experience rating, since the company will be assigned a poorer one until a new experience rating can be built up over time, which will result in higher unemployment taxes in the short term. To avoid this problem, one should contact the local unemployment taxation ofﬁce to request that the old company’s experience rating be shifted to the new one.

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PART

3

PLANNING AND CONTROLLING OPERATIONS

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CHAPTER

17

GENERAL DISCUSSION OF ACCOUNTING/STATISTICAL STANDARDS: BENCHMARKING 17.1

MEANING OF ACCOUNTING/ STATISTICAL CONTROL 309

17.10 BALANCED SYSTEM OF PERFORMANCE MEASURES 321

17.2

EXTENT OF ACCOUNTING/ STATISTICAL CONTROL 310

17.3

NEED FOR STANDARDS 310

17.11 SETTING THE STANDARDS 322 (a) Who Should Set the Standards? 322 (b) Method of Setting Standards 323

17.4

DEFINITION OF STANDARDS 311

17.5 17.6

ADVANTAGES OF STANDARDS 312 RELATIONSHIP OF ENTITY GOALS TO PERFORMANCE STANDARDS 313 TYPES OF STANDARDS NEEDED 314 (a) Standards for All Business Activity 314 (b) Standards for Individual Performance 315 (c) Material Quantity Standards 315 (d) Material Price Standards 315 (e) Labor Quantity Standards 315 (f) Labor Rate Standards 315 (g) Manufacturing Overhead Expense Standards 315 (h) Sales Standards 316 (i) Distribution Cost Standards 316 (j) Administrative Expense Standards 317 (k) Financial Ratios 317

17.7

17.8

TREND TO MORE COMPREHENSIVE PERFORMANCE MEASURES 318 (a) Time-Based Standards 319

17.9

BENCHMARKING 320

17.12 USE OF STANDARDS FOR CONTROL 323 (a) Technique of Cost Control 323 (b) Role of Statistical Process Control 324 (c) Who Should Control Costs? 324 (d) Level of the Standard 325 (e) Point of Control 325 (f) What Costs Should Have Standards? 326 17.13 PROCEDURE FOR REVISING STANDARDS 326 (a) Revision of Standards 326 (b) Program for Standard Revision 326 17.14 RECORDING STANDARDS 327 (a) Importance of Adequate Records 327 (b) Types of Records Necessary 327 (c) Administrative Controls 328 (d) Incorporation of Standard Costs in Accounts 328 17.15 APPLICATION OF STANDARD COSTS 328 17.16 MANAGEMENT USE OF STANDARD COSTS 328

17.1 MEANING OF ACCOUNTING/STATISTICAL CONTROL Control by deﬁnition assumes that a plan of action or a standard has been established against which performance can be measured. To achieve the objectives that have been set forth for the business enterprise, controls must be developed so that decisions can be made in conformance with the plan. 309

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In small plants or organizations, the manager or owner personally can observe and control all operations. The owner or manager normally knows all the factory workers and by daily observation of the work ﬂow can determine the efﬁciency of operations. It is easy to observe the production effort of each employee as well as the level of raw materials and work-in-process inventory. In most cases, by the observation of the factory operation, inefﬁciencies or improper methods can be detected and corrected on the spot. The sales orders can be reviewed and determinations made about whether shipments are being made promptly. Through intimate knowledge of the total business and communicating on a daily basis with most employees and customers, the owner is able to discern the effectiveness of sales effort and customer satisfaction with the products. However, as the organization grows, this close contact or direct supervision by the owner or manager is necessarily diminished. Other means of control are required to manage effectively, such as accounting controls and statistical reports. By the use of reports, management is enabled to plan, supervise, direct, evaluate, and coordinate the activities of the various functions, departments, and operating units. Accounting controls and reports of operations are part of a well-integrated plan to maintain efﬁciency and determine unfavorable variances or trends. The use of the accounting structure allows for the control of costs and expenses and comparison of such expenditures to some predetermined plan of action. Through the measurement of performance by means of accounting and statistical records and reports, management can provide appropriate guidance and direct the business activities. The effective application of accounting controls must be fully integrated into the company plans and provide a degree of before-the-fact control. The accounting/statistical control system must include records that establish accountability and responsibility to really be effective.

17.2 EXTENT OF ACCOUNTING/STATISTICAL CONTROL Effective control extends to every operation of the business, including every unit, every function, every department, every territory or area, and every individual. Accounting control encompasses all aspects of ﬁnancial transactions such as cash disbursements, cash receipts, funds ﬂow, judicious investment of cash, and protection of the funds from unauthorized use. It includes control of receivables and avoidance of losses through inappropriate credit and collection procedures. Accounting control includes planning and controlling inventories, preventing disruption of production schedules and shipments or losses from scrap and obsolescence. It involves generating all the necessary facts on the performance of all functions such as manufacturing, research, engineering, marketing, and ﬁnancial activities. It is mandatory that management be informed about the utilization of labor and material against a plan in producing the ﬁnished goods. The effectiveness of the sales effort in each territory or for each product must be subjected to review by management. Control relates to every classiﬁcation in the balance sheet or statement of ﬁnancial position and to each item in the statement of income and expense. In short, accounting/statistical control extends to all activities of the business. The accounting system that includes the accounting controls when integrated with the operating controls provides a powerful tool for management to plan and direct the performance of the business enterprise. Statistical control also may relate to the nonﬁnancial quantitative measurement of any business functions and their effect, for example, customer satisfaction, development time for new products, cycle time from receipt of customer order to delivery of product.

17.3 NEED FOR STANDARDS As industry has developed, grown, and become more complex, the need for increased efﬁciency and productivity has become more imperative. The successful executives developed more effective means of regulating and controlling the activities. It is no longer sufﬁcient just to know the cost to manufacture or sell. There is a real need to know if we are using the most economical manufacturing techniques and processes. The distribution and selling costs must be evaluated and measured against some predetermined factors. Performance measurement should be applied to all activities. It is essential that a yardstick of desirable or planned results be established against which actual

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results may be compared if the performance measurement is to be effective. It is natural to compare current performance with historical performance such as last month, last quarter, or last year. Such a comparison points out trends, but it also serves to perpetuate inefﬁciencies. This comparison only serves a useful purpose if the measuring stick or past performance represents effective and efﬁcient performance. Furthermore, changes in technologies, price levels, manufacturing processes, and the relative volume of production tend to limit the value of historical costs in determining what current costs should be. There certainly is a compelling need for something other than historical costs for the standard of performance. For planning and pricing, management needs cost information that is not distorted by defective material, poor worker performance, or other unusual characteristics. Scientiﬁc management recognizes the value and need for some kind of engineering standards to plan manufacturing operations and evaluate the effectiveness with which the objectives are being accomplished. Engineering standards, expressed in ﬁnancial terms, become cost standards; these standards, based on careful study and analysis about what it should cost to perform the operations by the best methods, become a much more reliable yardstick with which to measure and control costs. Standards are the foundation and basis of effective accounting control. Standards provide the management tools with which to measure and judge performance. The use of standards is as adaptable to the control of income or expense as to the control of assets or liabilities. Standards are applicable to all phases of business and are an extremely important management tool.

17.4 DEFINITION OF STANDARDS A standard of any type is a measuring stick or the means by which something else is judged. The standard method of doing anything can usually be described as the best method devised, as far as humanly possible, at the time the standard is set. It follows that the standard cost is the amount that should be expended under normal operating conditions. It is a predetermined cost scientiﬁcally determined in advance, in contrast to an actual or historical cost. It is not an actual or average cost, although past experience may be a factor in setting the standard. Since a standard has been deﬁned as a scientiﬁcally developed measure of performance, it follows that at least two conditions are implied in setting the standard: 1. Standards are the result of careful investigation or analysis of past performance and take into consideration expected future conditions. They are not mere guesses; they are the opinions, based on available facts, of the people best qualiﬁed to judge what performance should be. 2. Standards may need review and revision from time to time. A standard is set on the basis of certain conditions. As these conditions change, the standard must change; otherwise, it would not be a true measuring stick. Where there is really effective teamwork, and particularly, where standards are related to incentive payments, the probability of change is great. Most of the foregoing comments on standards relate to that phase of the deﬁnition on which there is general agreement. There are, however, differences of opinion that seem to relate principally to the following points: • Whether a standard should be (1) a current standard, that is, one that reﬂects what performance should be in the period for which the standard is to be used, or (2) a basic standard, which serves merely as a point of reference. • The level at which a standard should be set — an ideal level of accomplishment, a normal level, or the expected level. Where standard costs are carried into the formal records and ﬁnancial statements, the current standard is generally the one used. Reference to the variances immediately indicates the extent to which actual costs departed from what they should have been in the period. A basic standard, however, does not indicate what performance should have been. Instead, it is somewhat like the base on which a price index is ﬁgured. Basic standards are usually based on prices and production levels

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prevailing when the standards are set. Once established, they are permanent and remain unchanged until the manufacturing processes change. They are a stationary basis of measurement. Improvement or lack of improvement involves the comparison of ratios or percentages of actual to the base standard. The level at which standards should be set is discussed later in this chapter under the subject of standards for cost control.

17.5 ADVANTAGES OF STANDARDS It has already been mentioned that standards arose, as part of the scientiﬁc management movement, from the necessity of better control of manufacturing costs. The relationship between this need and the advantages of standards is close. However, the beneﬁts from the use of standards extend beyond the relationship with cost control to all the other applications, such as price setting or inventory valuation. Therefore, it may be well to summarize the principal advantages of standards, and the related scientiﬁc methods, by the four primary functions in which they are used: 1. Controlling costs Standards provide a better measuring stick of performance. The use of standards sets out the area of excessive cost that otherwise might not be known or realized. Without scientifically set standards, cost comparison is limited to other periods that in themselves may contain inefﬁciencies. Use of the “principle of exception” is permitted, with the consequent saving of much time. It is not necessary to review and report on all operations but only those that depart significantly from standard. The attention of management may be focused on those spots requiring corrective action. Economies in accounting costs are possible. Clerical costs may be reduced because fewer records are necessary and simpliﬁed procedures may be adopted. Many of the detailed subsidiary records, such as production orders or time reports, are not necessary. Again, if inventories are carried as a standard value, there is no need to calculate actual costs each time new lots are made or received. Still further, much of the data for month-end closing can be set up in advance with a reduction in peak-load work. A prompter reporting of cost control information is possible. Through the use of simpliﬁed records and procedures and the application of the exception principle, less time is required to secure the necessary information. Standards serve as incentives to personnel. With a fair goal, an employee will tend to work more efﬁciently with the consequent reduction in cost. This applies to executives, supervisors, and workers alike. 2. Setting selling prices Better cost information is available as a basis for setting prices. Through the use of predetermined standards, costs are secured that are free from abnormal distortions caused by excess spoilage and other unusual conditions. Furthermore, the use of standard overhead rates eliminates the inﬂuence of current activity. A means is provided to secure, over the long run, a full recovery of overhead expenses, including marketing, administrative, and research expense. Flexibility is added to selling price data. Through the use of predetermined rates, changes in the product or processes can be quickly reﬂected in the cost. Furthermore, adjustments to material prices or labor rates are easily made. Again, the use of standards requires a distinction between ﬁxed and variable costs. This cost information permits cost calculations on different bases. Since pricing is sometimes a matter of selection of alternatives, this ﬂexibility is essential. Prompter pricing data can be furnished. Again, the use of predetermined rates permits the securing of information more quickly.

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3. Valuing inventories A “better” cost is secured. Here, too, as in pricing applications, a more reliable cost is secured. The effect of idle capacity, or of abnormal wastes or inefﬁciencies, is eliminated. Simplicity in valuing inventories is obtained. All like products are valued at the same cost. This not only assists in the recurring monthly closings but also is an added advantage in pricing the annual physical inventory. 4. Budgetary planning Determination of total standard costs is facilitated. The standard unit costs provide the basic data for converting the sales and production schedules into total costs. The unit costs can readily be translated into total costs for any volume or mixture of product by simple multiplication. Without standards, extensive analysis is necessary to secure the required information because of the inclusion of nonrecurring costs. The means is provided for setting out anticipated substandard performance. A history of the variances is available, together with the causes. Since actual costs cannot be kept exactly in line with standard costs, this record provides the basis for forecasting the variances that can reasonably be expected in the budget period under discussion. This segregation permits a determination of realistic operating results without losing sight of unfavorable expected costs.

17.6 RELATIONSHIP OF ENTITY GOALS TO PERFORMANCE STANDARDS Much of the discussion in this chapter relates to detailed performance measures or standards. However, prior to any review of such standards, a key relationship to certain company goals or broad ﬁnancial standards should be emphasized. Some of the overall ﬁnancial goals for a business, as outlined in Chapter 6, include (1) measures of proﬁtability, such as return on shareholder equity, return on assets, return on sales; (2) measures of growth, such as increase in sales, increase in net income, and increase in earnings per share; and (3) cash ﬂow measures, including aggregate operating cash ﬂow or free cash ﬂow. But is there, or should there be, any relationship between such overall goals, which are a type of standard, and more speciﬁc performance measures, such as the direct labor hour standard in cost center 21 for manufacturing product A? A business usually has goals or objectives as well as strategies for reaching them. It is only logical, therefore, that the goals or standards of a cost center, or factory, or function or division, support the entity goals. The hierarchy of goals, or performance measures or standards, may be pictured as a pyramid. (see Exhibit 17.1.) In examining performance measures, beginning at the top of the pyramid (company goals) and moving down the structure, these characteristics exist (although not all are identiﬁed): • Performance measures usually become narrower and more speciﬁc. • The planning horizon becomes shorter. • In the lower levels, cost factors tend to dominate more; and the measurement or activity period shortens considerably from years to months, days, or even hours. Performance measures at the lower levels should be expressed in terms of what an individual employee can do. For example, an accounts payable clerk might have as a standard the number of invoices processed per day or the number of cash discounts taken (or lost). This activity level performance cannot be directly measured against a percent return on assets goal. As the standards are expressed in terms of smaller, speciﬁc tasks, the time span between assigning the task, accomplishing the task, and rewarding the employee should grow shorter. Care should be taken that objectives at the lower levels are not contradictory. For example, encouraging higher throughput should not be at the expense of causing excess inventories in another department. A given individual, cost center, or department should not be overpowered by having to meet too many different standards. Standards should be current; that is, they should relate to the

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Achieve a 20% return on equity by 20XX. Enhance shareholder value by 5% each year, over 5 years. Attain a 10% return on assets. Reach agreed-on profit levels. Gain 2% market share. Achieve market dominance. Expand profitably in another country. Reduce new product development time to 6 months. Increase on-time deliveries to 97%.

Company

Group Meet annual budget. Achieve quality goals. Integrate electronic data system. Division

Achieve quality goals. Complete just-in-time inventory system. Meet target quantity goals.

Function

Achieve output target on all products. Reduce scrap by 5%. Meet daily labor standards.

Factory

Cost Center E XHIBIT 17.1

H IERARCHY

OF

P ERFORMANCE M EASURES

processes or methods in use — not obsolete ones. They should be updated minimally each year, ideally, each quarter. Formulating consistent standards that move the company objective forward takes a great deal of thought and time and is a management task of great importance.

17.7 TYPES OF STANDARDS NEEDED (a) STANDARDS FOR ALL BUSINESS ACTIVITY. Managerial control extends to all business functions including selling, production, ﬁnance, and research. It would appear highly desirable, therefore, to have available standards for measuring effort and results in all these activities. The word standard in much of the accounting literature applies to manufacturing costs. But the fact remains that the principles underlying the development of standards can and should be applied to many nonmanufacturing functions. Business executives generally do not question the need or desirability of standards for the control of administrative, distribution, and ﬁnancial activities; they do, however, recognize the difﬁculties involved. Some activities are more susceptible to measurement than others, but application of some standard is generally possible. Moreover, as business processes change, some performance standards will increase in importance, while others will decrease, for example, the use of a labor standard in which “direct” labor is less crucial and will be combined with related service support labor standards such as inspection or quality control.

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(b) STANDARDS FOR INDIVIDUAL PERFORMANCE. Costs are controlled by people. It is through the action of an individual or group of individuals that costs are corrected or reduced to an acceptable level. It is by the efforts of the individual salesperson that the necessary sales volume is secured. It is largely through the operational control of the departmental foreperson that labor efﬁciency is maintained. As a result, any standards, to be most effective, must relate to speciﬁc phases of performance rather than merely general results. In a manufacturing operation, for example, standards should relate to the quantity of labor, material, or overhead in the execution of a particular operation rather than the complete product cost standard. In the selling ﬁeld, a sales quota must be set for the individual salesperson, perhaps by product, and not just for the branch or territory. Thus the setting of standards and measurement of performance against such yardsticks ﬁt into the scheme of “responsibility accounting.” Keeping in mind these general comments, speciﬁc types of standards can now be examined. In addition to the remarks in this chapter, further observations are made in some of the chapters in which the relevant function is reviewed. (c) MATERIAL QUANTITY STANDARDS. In producing an article, one of the most obvious cost factors is the quantity of material used. Quantitative standards, based on engineering speciﬁcations, outline the kind and quantity of material that should be used to make the product. This measuring stick is the primary basis for material cost control. This quantity standard, when multiplied by the unit material price standard, results in the cost standard. When more than one type of material is involved, the sum of the individual material cost standards equals the total standard material cost of the product. (d) MATERIAL PRICE STANDARDS. To isolate cost variances arising out of excess material usage from those arising because of price changes, it is necessary to establish a material price standard. Usually, this price standard represents the expected cost instead of a desired or “efﬁcient” cost. In many companies, this price is set for a period of a year, and, although actual cost may ﬂuctuate, these changes are not reﬂected in the standard unit cost of material used. In other words, every piece of material used is charged with this predetermined cost. (e) LABOR QUANTITY STANDARDS. The labor content of many products is the most costly element. But whether it is the most costly or not, it is usually important. Because we are dealing with the human element, the labor cost is one of the most variable. It is indeed a fertile ﬁeld for cost reduction and cost control. For these reasons, it is necessary to know the amount of labor needed to produce the article. The technique, determining the time needed to complete each operation when working under standard conditions, involves time and motion study. (f) LABOR RATE STANDARDS. The price of labor is generally determined by factors outside the complete control of the individual business, perhaps as a result of union negotiations or the prevailing rate in the area. In any event, it is desirable to have a ﬁxed labor rate on each operation to be able to isolate high costs resulting from the use of an excess quantity of labor. Also, the utilization of labor within a plant is within the control of management, and some rate variances arise due to actions controllable by management. Examples are the assignment of the wrong people (too high a rate) to the job or the use of overtime. The standard time required, when multiplied by the standard rate, gives the standard labor cost of the operation. (g) MANUFACTURING OVERHEAD EXPENSE STANDARDS. One of the many problems most controllers must resolve is that of determining standards for the control of manufacturing overhead as well as absorption into inventory. The determination of these standards is somewhat more complicated than in the material or labor standards. Several conditions complicate their determinization:

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• Manufacturing overhead consists of a great variety of expenses, each of which reacts in a different fashion at varying levels of plant activity. Some costs, such as depreciation, remain largely independent of plant activity; others vary with changes in production, but not in direct proportion. Examples are supervisory labor, maintenance, and clerical expense. Still other overhead expense varies directly with, and proportionately to, plant volume. This may include certain supplies, indirect labor, and fuel expense. • Control of overhead expenses rests with a large number of individuals in the organization. For example, the chief maintenance engineer may be responsible for maintenance costs, the factory accountant for factory clerical costs, and foremen in productive departments for indirect labor. • The proper estimate of the rate and amount of production must be made to serve as the basis of setting standard rates. An improper level of activity not only affects the statement of income and expense, but also gives management an erroneous picture of the cost of an insufﬁcient volume of business and distorts inventory values. Overhead expenses are best controlled through the use of a ﬂexible budget. It requires a segregation of ﬁxed and variable expenses. Proper analysis and control permit a realistic look at overhead variances in terms of cause: (1) volume, (2) rate of expenditure, and (3) efﬁciency. Standards for manufacturing overhead can be expressed in the total amount budgeted by each type of expense as well as unit standards for each item, such as power cost per operating hour or supplies per employee-hour. Such standards should reﬂect the impact of just-in-time (JIT) production techniques as well as the “cost drivers” (see Chapter 21). (h) SALES STANDARDS. Sales standards may be set for the purpose of controlling and measuring the effectiveness of the sales or marketing operations. They also may be used for incentive awards, stimulating sales efforts, or the reallocation of sales resources. The most common form of standard for a territory, branch, or salesperson is the sales quota, usually expressed as a dollar of physical volume. Other types of standards found useful in managing and directing sales effort are: • Number of total customers to be retained • Number of new customers to be secured • Number of personal calls to be made per period • Number of telephone contacts to be made per period • Average size of order to be secured • Amount of gross proﬁt to be obtained (i) DISTRIBUTION COST STANDARDS. Just as production standards have been found useful in controlling manufacturing costs, so an increasing number of companies are ﬁnding that distribution cost standards are a valuable aid in properly directing the selling effort. The extent of application and degree of completeness of distribution cost standards will differ from production standards, but the potential beneﬁts from the use of such standards are equally important. Some general standards can be used in measuring the distribution effort and results. However, more effective standards are those measuring individual performance. Some illustrative standards are: • Selling expense per unit sold • Selling expense as a percentage of net sales • Cost per account sold • Cost per call • Cost per day • Cost per mile of travel • Cost per sales order

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In addition to individual performance standards, another type of control relates to budgets for selling expenses. The procedure for setting budgets is similar to that used for manufacturing operations. (j) ADMINISTRATIVE EXPENSE STANDARDS. As business expands and volume increases, there is a tendency for administrative expenses to increase proportionately and get out of line. The same need for control exists for these types of expenses as for manufacturing or production costs. Control can be exercised through departmental or responsibility budgets as well as through unit or individual performance standards. The general approach to control administrative expenses is essentially the same as for control of selling and manufacturing expenses. It is necessary to develop an appropriate standard for each function or operation to be measured. Examples of types of standards to be considered are: Function

Standard Unit of Measurement

Purchasing Billing Personnel Trafﬁc Payroll Clerical

Cost per purchase order Cost per invoice rendered Cost per employee hired Cost per shipment Cost per employee Cost per item handled (ﬁled)

(k) FINANCIAL RATIOS. The types of standards discussed to this point relate primarily to human performance associated with elements of the statement of income and expense—sales revenues, cost factors, and expense categories of several types. Yet another category of standards deals with the utilization of assets or shareholders’ equity, or the liquidity of the entity. These measures relating to ﬁnancial condition and proﬁtability rates are of special interest to the ﬁnancial executives in testing business plans and the ﬁnancial health of the enterprise. Chapter 6 dealt in some detail with many ﬁnancial and operating ratios, but a short list of some of the more important measures includes: • Current ratio • Quick ratio • Ratio of net sales to receivables • Turnover of inventory • Turnover of current assets • Ratio of net sales to working capital • Ratio of net sales to assets • Return on assets • Return on shareholders’ equity • Other proﬁtability ratios: Ratio of net income to sales Gross margin percentage Generally speaking, the standards for these ﬁnancial ratios may be developed from several sources: • Ratios accepted by the industry of which the company is a member, perhaps developed by the industry association • Ratios ascertained from the published ﬁnancial statements of the principal competitors of the entity, or industry leaders • Ratios developed by computer modeling • Ratios based on the past (and best) experience of the company or on the opinions of its ofﬁcers

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17.8 TREND TO MORE COMPREHENSIVE PERFORMANCE MEASURES The majority of the standards described relate to very speciﬁc activities and are largely cost standards (labor cost per unit). Additionally, some relate to number or size of functions performed (number of sales calls made), or ﬁnancial relationships. It is common practice in U.S. companies to compare hourly, daily, weekly, or monthly actual performance with such a standard, or a budget, or prior experience. Such comparisons with the relevant internal activity of a prior period or calculated proper measure are useful. Managements are discovering that other types of measures may be helpful for a number of reasons: • Some non–cost-related measures can highlight functional areas that need improvement, for example, number of new customers, number of customer complaints, product development time. • For some activities, comparisons with an external standard, such as industry average or performance of a principal competitor, may provide useful guidelines. Examples include inventory turnover and research and development expenditures. • Quantiﬁed standards may cause supervisors to focus attention on the wrong objective. For instance, attention to the average size of sales orders may take attention away from the need for a proﬁtable product mix. • On occasion, emphasis on output can create problems in, or transfer problems to, other departments (defects, excessive inventory, or wrong mix of parts). • Some standards may conﬂict with other management efforts, such as attempting to reduce indirect manufacturing expense as related to direct labor, when the overall trend is to automation. In the search for a broader base than accounting or ﬁnancial standards to check or measure company performance, the controller, perhaps in collaboration with other functional executives, could take these actions: • Discuss with management members the critical success factors of the company, suspected areas of weaker performance, and what changes might be examined. • Review existing performance measures and try to ascertain whether they are relevant to the newer techniques or processes (JIT purchasing, delivery and manufacturing). • Seek to determine if the measures relate to the true cost drivers of the function under review. • Update practices, using the current literature or periodicals for possible leads to examine. • Talk with controllers, line managers, or workers, in other companies about the performance measures and other guides they use. • Consider hiring outside consultants to review areas of suspected weaknesses and to make recommendations. Such a review might lead to a starting list of (1) cost measures and (2) noncost performance measures for important internal activity checking (based on trends and relative internal importance, and relative cost and noncost measures when examined or compared to external factors). A sample outline of what could be measured is: 1. Internal Factors (a) Cost Measures Direct labor costs Direct material costs Manufacturing expense Marketing expense Research and development (R&D) costs Delivery costs Inventory carrying costs Accounts receivable carrying costs

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(b) Noncost Measures Length of design cycle Number of engineering changes Number of new products Manufacturing cycle time Number of parts/raw material deliveries Number of on-time customer deliveries Number of suppliers Number of parts 2. External Factors (Relative Measurement) (a) Cost Measures Relative R&D expense Relative material content cost Relative labor cost content Relative delivery expense Relative selling expenses (a) TIME-BASED STANDARDS. One group of standards receiving attention are time-based measures. Management which uses these diagnostic tools believes that time analysis is more useful than simple cost analysis because activity review identiﬁes exactly what occurs every hour of the working day. It seems to encourage such time-oriented questions as: Why are the two tasks done serially and not in parallel? Why is the process speeded up in some departments only to then let the product lie idle? When points of time are identiﬁed, then related cost reduction possibilities can be examined. Examples of time-based standards that have been found useful in four key functions include: 1. Decision-making process: Time lost in waiting for a decision Product development Manufacturing Marketing Finance (accounting) 2. New product development Total time required from inception of idea to marketing of product Number of times (or percent) company has beat a competitor to market Number of new products marketed in a given time period 3. Manufacturing or processing Cycle time from commencement of manufacture through billing process Inventory turnover Total elapsed time from product development to ﬁrst time acceptable output Value added per factory hour Credit approval time Billing cycle time—from receipt of shipping notice to completion of invoice preparation Collection time—from mailing of invoice to receipt of payment 4. Customer service Number (or percent) of on-time deliveries Response time to customer questions

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17.9 BENCHMARKING The practice by a company of measuring products, services, and business practices against the toughest competitor or those companies best in its class, or against other measures, has been named “benchmarking.” Technically, those who consult about the process differentiate between three kinds, depending on the consultant. Distinctions are made about these three types: 1. Competitive benchmarking 2. Noncompetitive benchmarking 3. Internal benchmarking Competitive benchmarking studies compare a company’s performance with respect to customer-determined notions of quality against direct competitors. Noncompetitive benchmarking refers to studying the “best-in-class” in a speciﬁc business function. For example, it might encompass the billing practices of a company in a completely different industry. Internal benchmarking can refer to comparisons between plants, departments, or product lines within the same organization. The benchmarking studies involve steps such as: 1. 2. 3. 4. 5. 6. 7.

Determining which functions within the company to benchmark Selecting or identifying the key performance variables that should be measured Determining which companies are the best-in-class for the function under review Measuring the performance of the best-in-class companies Measuring the performance of the company as to the function under study Determining those actions necessary to meet and surpass the best-in-class company Implementing and monitoring the improvement program

Although benchmarking has produced some legendary corporate successes, it often has not produced an improvement on the net income line. In part, this reﬂects the fact that it is a complicated process and does not consist merely of some random observations of different methods used by some businesses, or some short ﬁeld trips. A successful benchmarking effort must be undertaken in a clearly deﬁned and systematic manner. A benchmarking study wherein the only product or result is a report to management, with no modiﬁcation of a substandard activity, could be regarded as a failure. To put the topic of benchmarking in the proper perspective, it should be recognized that successful benchmarking efforts have addressed a wide variety of issues, including: • Increased market share • Improved corporate strategy • Increased proﬁtability • Streamlined processes • Reduced costs • More effective R&D activities • Improved quality • Higher levels of customer satisfaction In those instances when benchmarking activity has not met expectations, some of the reasons include: • Top management did not comprehend the full potential of the proposed changes and consequently did not push aggressively for their adoption.

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• The functions or activities selected for improvement may in fact have been improved, but the greater efﬁciency was too small to have a meaningful impact on overall business performance. • The study team made observations but failed to develop an actionable plan. • In some instances, the analysis was incomplete: the study team learned what the best-in-class companies were doing, but it did not learn how the actions were implemented. Another facet of benchmarking that should be noted is the makeup of the study team. It should include people in the company who have been performing the function. Those selected should be highly knowledgeable about the function, should be good communicators, and should be curious and highly analytical. It probably is preferable to have consultants, not company employees, make contacts with competitors. In some circumstances, the presence of a member of the board of directors might be the means of better communicating to the board the complexities and potential impact of the study. In summary, benchmarking is a complicated process, and full preparation should be made.

17.10 BALANCED SYSTEM OF PERFORMANCE MEASURES Performance measures range from broad company standards to detailed functional standards applied to a daily departmental manufacturing activity. Moreover, many of these standards are used for both planning and control purposes. Then, too, some are cost-related and others are noncost measures; some address the important subject of customer satisfaction, and others simple efﬁciency; and ﬁnally, some deal with innovation while others emphasize routine operations. Many years ago, the use of one type of standard (generally cost type) for control purposes was the point of emphasis. Since that time, management has recognized that it cannot rely on one set of measures to the exclusion of all others. Rather, a combination of measures are necessary that must properly relate to each other and take into account the critical success factors of the enterprise. This is to say that management needs a balanced set of performance measures. The article by Kaplan and Norton mentions a company that grouped its performance measures into four types, each with separate measures of performance, and each critical to the future success of the entity.1 The four measurement groups discussed, together with some added goals and measures of individual performance mentioned earlier in this chapter follow.

Financial Perspective Goals

Measures

Customer Perspective Goals

Measures

Survive

Cash ﬂow

New products

Succeed

Sales and income growth Return on equity

Customer supply

Prosper

Preferred supplier

Internal Business Perspective Goals Manufacturing excellence New product introduction

Measures

Percentage of sales from new products Number of on-time deliveries Share of key account purchases

Innovation Perspective Goals

Measures

Unit cost cycle time

Time to market

Versus competition

Actual vs. planned introduction schedule

Technology leadership

Time to develop new process

1. Kaplan, Robert S., and David P. Norton, “The Balanced Scorecard — Measures That Drive Performance,” Harvard Business Review, Jan. – Feb. 1992, pp. 71–79.

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17.11 SETTING THE STANDARDS (a) WHO SHOULD SET THE STANDARDS? Standards should be set by those who are best qualiﬁed by training and experience to judge what good performance should be. It is often a joint process requiring cooperation between the staffs of two or more divisions of the business. Fundamentally, the setting of standards requires careful study and analysis. The controller and staff, trained in analysis and possessing essential records on the various activities, are in an excellent position to play an important part in the establishment of yardsticks of performance. Since standards are yardsticks of performance, they should not be set by those whose performance is to be measured. Sufﬁcient independence of thought should exist. The standards should be reviewed with those who will be judged by them and any suggestions considered. However, ﬁnal authority in establishing the standard should be placed in other hands. Exactly which staff members cooperate in setting standards depends on the standards under consideration. Material quantity standards, for example, are generally determined by the engineers who are familiar with the operation methods employed as well as the product design. Assisting the engineers may be the production staff and the accounting staff. The production people can make valuable contributions because of their knowledge of the process. Furthermore, permitting the production staff to assist usually enlists their cooperation in making the standards effective. The accounting department assists by providing necessary information on past experience. The determination of material price standards is usually the responsibility of both the purchasing and accounting departments. The purchasing department may indicate what expected prices are. These should then be challenged by the accounting department, taking into account current prices and reasonably expected changes. In other instances, the accounting department sets the standards, based again on current prices, but takes into consideration the opinion of the purchasing department about future trends. Quantitative labor standards are usually set by industrial engineers through the use of time and motion study. This is properly an engineering function in that a thorough background of the processes is necessary. On occasion, the accounting department furnishes information of past performance as a guide. Standard labor rates are set by the department that has available the detailed job rates and other necessary information, typically the cost department. The cost department must also translate the physical standards into cost standards. Manufacturing overhead standards, too, are often a matter of cooperation between the accounting and engineering departments. Engineers may be called on to furnish technical data, such as power consumption in a particular department, or maintenance required, or type of supplies necessary. However, this data is then costed by the accounting staff. In other instances, the unit standards or budgets may be set in large part on past experience. The role played by the accountant tends to be much greater in the establishment of overhead standards due to the familiarity with the techniques of organizing the data into their most useful form for cost and budget reporting. Setting the standards for distribution activities is best done through the cooperation of sales, sales research, and accounting executives. Reliance is placed on the sales staff for supplying information pertaining to market potentials and sales methods. The accountant contributes the analysis and interpretation of past performance, trends, and relationships. The sales and accounting executives jointly must interpret the available data as applied to future activity. Unit standards for the measurement of administrative expenses are usually determined on the basis of time and motion study by industrial engineers, observation of the functions, or a detailed analysis of past performance to ensure that standards reﬂect the norm. In many instances, the accountant is involved in either costing the data or analyzing past experience. Financial and operating ratios should be set by the controller based on the objectives for the company, experience in the particular company or industry, and special analysis or consideration of factors that have a signiﬁcant inﬂuence on the ratio or external sources. In many instances, it may be desirable to have the assistance of independent consultants. For example, when sources outside the company are to be contacted, as in “benchmarking,” these noncompany personnel may be especially helpful.

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(b) METHOD OF SETTING STANDARDS. Those aspects of setting standards that are beyond the sphere of accounting responsibility are adequately covered in various management and engineering literature. Only the general steps taken in the establishment of standards will be considered here. Any outline of procedure regarding standards is basically only the application of logic and prudent judgment to the problem. The eight phases involved in the setting of standards are summarized below: 1. Recognition of the need for a standard in the particular application. Obviously, before action is taken, the need should exist. This need must be acknowledged so that the problem can be attacked. 2. Preliminary observation and analysis. This involves “getting the feel” of the subject, recognizing the scope of the problem, and securing a general understanding of the factors involved. 3. Segregation of the function, or activity, and/or costs in terms of individual responsibility. Since standards are to control individual actions, the outer limits of the responsibility of each individual must be ascertained in the particular application. 4. Determination of the unit of measurement in which the standard should be expressed. To arrive at the quotient, the divisor is necessary. And in many applications, the base selected can be one of many. 5. Determination of the best method. This may involve time and motion study, a thorough review of possible materials, or an analysis of past experience. It must also involve consideration of possible changes in conditions. 6. Statement or expression of the standard. When the best method and the unit of measurement have been determined, the tentative standard can be set. 7. Testing of the standard. After analysis and synthesis and preliminary determination, the standard must be tested to see that it meets the requirements. 8. Final application of the standard. The testing of a standard will often result in certain compromises or changes. When this has been effected, when the best judgment of all the executives concerned has been secured, then and only then can the standard be considered set and ready to be applied.

17.12 USE OF STANDARDS FOR CONTROL The fact that management has set standards for cost control by no means assures control of costs. It takes positive action by individuals to keep costs within some predetermined limits. It is a management challenge to communicate the value of standards to all concerned and convince them how the yardsticks can be utilized in accomplishing the goals and objectives. To be effective it must be demonstrated that the standards are fair and reasonable. The controller must have sufﬁcient facts to illustrate the reasonableness of the standards when questions arise or the yardsticks are considered unfair. When standards are shown clearly to be unreasonable, the controller must be prepared to gather new data and make appropriate adjustments. (a) TECHNIQUE OF COST CONTROL. In the ﬁnal analysis, the objective of cost control is to secure the greatest amount of production or results of a desired quality from a given amount of material, manpower, effort, or facilities. It is the securing of the best result at the lowest possible cost under existing conditions. In this control of performance, the ﬁrst step is the setting of standards of comparison; the next step is the recording of actual performance, and the third step is the comparing of actual and standard costs as the work progresses. This last step involves: • Determining the variance between standard and actual • Analyzing the cause of the variance

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• Taking remedial action to bring unfavorable actual costs in line with the predetermined standards Control is established through prompt follow-up, before the unfavorable trends or tendencies develop into large losses. It is important that any variances be determined quickly, and it is equally important that the unfavorable variance be stated in terms that those responsible will understand. The speed and method of presentation have a profound bearing on the corrective action that will be taken and, hence, on the effectiveness of control. (b) ROLE OF STATISTICAL PROCESS CONTROL. One approach to cost control is to determine the variance between a standard and actual performance, seek out the cause of the variance, and take remedial action. Yet global competition is causing management to adopt more sophisticated strategies to remain or become competitive. Among these devices are automatic JIT, total quality management (TQM), and statistical process control (SPC). This latter technique can assist in properly setting standards and in better evaluating or interpreting variances. SPC is based on the assumption that process performance is dynamic, that variation is the rule. Consequently, proper assessment of performance requires correct interpretation of the variation over a period of time. Charts or graphic aids are used in SPC to understand and reduce the ﬂuctuations in processes until they are considered stable (under control). A stable process would have only the normal variances. On the other hand, an unstable process is subject to uncommon ﬂuctuations resulting from special causes. The performance of a stable process can be improved only by making fundamental changes in the process itself, while an unstable production process can be stabilized only by locating and eliminating the special causes. The statistical approach assists in identifying the character of the variance. An incorrect decision that a process is operating in an unstable manner may result in costs from searching for special causes of process variation that do not exist. An incorrect decision that a process is operating in a stable manner will result in failure to search for special causes that do exist. Sufﬁce it to say that SPC is a complex subject that seeks to provide long-term solutions. Someone with a high level of statistical knowledge ordinarily will be needed to assist in implementing the strategy. Management accountants should understand the SPC approach. (c) WHO SHOULD CONTROL COSTS? Costs must be controlled by individuals, and the question is raised about who should control costs, the controller representing accounting personnel or the operating executive in charge of the activity (manufacturing sales or research) to be cost controlled. It has already been explained that operational control preceded accounting control. In many thousands of small businesses, operating control is the only type used. Cost control is not primarily an accounting process, although accounting plays an important part. Control of costs is an operating function. The controller, in the capacity of an operating executive, may control costs within the accounting department. Beyond this, the function of the controller is to report the facts on other activities of the business so that corrective action may be taken and to inform management of its effectiveness in cost control. The part played by the controller is advisory or facilitative in nature. In many instances, the development of the standards to be used in measuring performance is largely the work of nonaccountants, whether product speciﬁcations, operational methods, time requirements, or other standards. Likewise, decision about the corrective action to be taken is generally up to the operating personnel. However, the controller is in an excellent position to stimulate and guide the interest of management in the control of costs through the means of reports analyzing unusual conditions. The controller’s work is usually conﬁned to summarizing basic information, analyzing results, and preparing intelligently conceived reports. It follows that the controller must produce reports that a non–accounting-trained executive or operator can understand and will act on. To do this requires being thoroughly conversant with the operating problems and viewpoints. The effectiveness of any cost control system depends on the degree of coordination between the accounting control personnel and the operating personnel. One presents the facts in an understandable manner; the other takes the remedial action.

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Cooperation at all levels is essential in the control of costs. Cooperation is secured, in part, through the application of correct management policies. The use of standards, when fully understood, should be of great assistance in securing this cooperation, for the measuring stick is based on careful analysis and not preconceived ideas or rule-of-thumb methods. (d) LEVEL OF THE STANDARD. Because one of the primary purposes of a standard is as a control tool—to see that performance is held to what it should be—it is necessary to determine at what level the standard should be set. Just how “tight” should a standard be? Although there is no clear-cut line of demarcation among them, the three following levels may be distinguished: 1. The ideal standard 2. The average of past performance 3. The attainable good performance standard The ideal standard is the one representing the best performance that can be attained under the most favorable conditions possible. It is not a standard that is expected to be attained but rather a goal toward which to strive in an attempt to improve efﬁciency. Hence variances are always unfavorable and represent the inability to reach the ideal level of efﬁciency. The use of an unattainably tight standard confuses the objectives of cost reduction and cost control. Cost reduction involves the ﬁnding of ways and means to achieve a given result through improved design, better methods, new layouts, new equipment, better plant layout, and so forth, and therefore results in the establishment of new standards. If the standards set are more restrictive than currently attainable performance, the lower cost will not necessarily be achieved until cost reduction has found the means by which the standard may be attained. Ideal standards, then, are not highly desirable as a means of cost control. Standards are frequently set on the basis of what was done in the past, without adjustments to reﬂect improved methods or elimination of wastes. A standard set on this basis is likewise a poor measuring stick in that it can be met by poor performance. Hence the very inefﬁciencies that standards should disclose are obscured by the loose standard. A third level at which a standard may be set is the attainable level of good performance. This standard includes waste or spoilage, lost time, and other inefﬁciencies only to the extent that they are considered impractical of elimination. This type of standard can be met or bettered by efﬁcient performance. It is a standard set at a high level but is attainable with reasonably diligent effort. Such a standard would seem to be the most effective for cost control purposes. (e) POINT OF CONTROL. Costs are controlled by individuals, so it follows that the accounting classiﬁcations must reﬂect both standard and actual performance in such a manner that individual performance can be measured. As stated previously, “responsibility accounting” must be adopted. Provision must be made for the accumulation of costs, by cost centers, cost pools, or departments, that follows organizational structure. Furthermore, this cost accumulation must initially reﬂect only those costs that are direct as to the speciﬁc function being measured. Allocations and reallocations may be made for product cost determination and for certain other planning applications, but this is not desirable for cost control. If a great many prorations are made, it is often difﬁcult to determine where the inefﬁciency exists or the extent of it. Therefore, it is desirable from a cost control standpoint to collect the costs at the point of incurrence. If, as in some companies, allocated costs are reﬂected in control reports, it is desirable to separate them from direct expenses or costs. Some companies show allocated costs so that the department manager will be aware of the cost of the facilities or services they use. Discussion of the point of control of costs involves, in addition to placement of responsibility, the matter of timing. Costs must be controlled not only at the point of incurrence but also, preferably, at or before the time of incurrence. Thus, if a department on a budget basis processes a purchase requisition and is advised at that time of the excess cost over budget, perhaps action can be taken then—either delaying the expenditure until the following month or getting a less expensive yet satisfactory substitute. Again, material control is best exercised at the point of issuance. Only

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the standard quantity should be issued. In the case of purchases, the price and type are best controlled at the time of purchase. (f) WHAT COSTS SHOULD HAVE STANDARDS? From the viewpoint of standards for cost control, a question may be raised about the extent to which attempts should be made to set standards. Factors to be considered include the relative amount of cost and the degree of control possible over the cost. It may be stated that standards should be set for all cost items of a signiﬁcant or material amount. In many cases, the more important the cost, the greater is the opportunity or need for cost control. With such items as overhead, it may be necessary to combine certain elements but, so far as practicable, a standard should be set to measure performance. Another factor to be considered is the degree of control possible, needed, or desired over the cost. At ﬁrst, it might appear that little control can be exercised over some types of cost, such as depreciation, salaries of key personnel, or personal property taxes. However, the fact is that most costs can be controlled by someone. The time and place and method of control of costs generally considered as “ﬁxed” may differ from the control of material, direct labor, or variable overhead expense, but a certain degree of control is possible. Control of the ﬁxed charges may be exercised in at least two ways: 1. By limiting the expenditure to a predetermined amount. For example, depreciation charges are controlled through the acquisition of plant and equipment. Any control must be exercised at the time of purchase or construction of the asset. This is usually done by means of an appropriation budget, which is a type of standard. A similar plan can be applied to the group of salaried personnel generally considered as a part of the ﬁxed charges. In many instances, control of this type of expense or expenditure is a top-management decision. It may be observed, however, that control at this high level does exist. 2. By securing the proper utilization of the facilities and organization represented by the ﬁxed charges. The controller can assist in this task by properly isolating the volume costs or cost of idle equipment. An acceptable standard might be the percent of plant utilization as related to “normal.” In the monthly statement of income and expense, the lack of volume costs should be set out as part of the effort to direct management’s attention to the excess costs and to a consideration of ways and means of reducing personnel, if necessary, or increasing volume through other products, intensiﬁed sales activity, and so on.

17.13 PROCEDURE FOR REVISING STANDARDS (a) REVISION OF STANDARDS. Whether standards are used for cost control or the related function of budgetary planning or whether standards are for the purpose of price setting or inventory valuation, they must be kept up to date to be most useful. From a manufacturing operations viewpoint, revision appears desirable when important changes are made in material speciﬁcations or prices, methods of production, or labor efﬁciency or price. Changes in the methods or channels of distribution and basic organizational or functional changes would necessitate standard changes in the selling, research, or administrative activities. Stated in other terms, current standards must be revised when conditions have changed to such an extent that the standard no longer represents a realistic or fair measure of performance. It is obvious that standard revisions should not be made for every change, only the important ones. However, the constant search for better methods and for better measurements of performance subjects every standard to possible revision. The controller constantly must be on the alert about the desirability of adjusting standards to prevent the furnishing of misleading information to management. (b) PROGRAM FOR STANDARD REVISION. The changing of standards is time consuming and may be expensive. For this reason, it should not be treated in a haphazard manner. It is desirable to plan in advance the steps to be taken in revising standards. Through the use of an orderly

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program for constant review and revision of standards, the time and money spent on standard changes can be less and the effort more productive. In planning the program of standard revision, the ramiﬁcations of any changes should be considered. For example, changes in manufacturing standards usually necessitate changes in inventory values. Accordingly, it may appear desirable to review the standards at the end of each ﬁscal year and make the necessary changes. A chemical plant may review material price standards every quarter because the selling price of the ﬁnished product is sympathetic to changes in commodity prices. This frequent revision would result in cost information that is more useful to the sales department. In some companies, a general practice is to change standards whenever basic selling price changes occur. This results in a more constant standard gross proﬁt ﬁgure by which to judge sales performance. In considering frequent changes, however, the expense should be weighed against the beneﬁts. In this connection, the value for cost control should be matched against the lessened degree of comparability of the variances from period to period. Judgment should be exercised about the necessity for, and extent of, changes in the records. For example, general changes in labor rates, raw material costs, standard overhead rates, or product design may dictate a complete revision of product and departmental costs, extending through every stage of manufacture. However, a change in one department, or in one part, or in a small assembly might necessitate the change of only one standard for control purposes. The difference between old and new, with respect to other stages of manufacture, or the ﬁnished product cost, could be temporarily written off as a variance until the time is ripe for a complete product standard revision.

17.14 RECORDING STANDARDS (a) IMPORTANCE OF ADEQUATE RECORDS. If the controller is to serve management most effectively and if the business is to have the advantage of accurate, reliable, and prompt cost information, then an adequate recording of the facts is necessary. This principle is as applicable to recording standards and standard costs as it is to actual costs—perhaps even more so. The degree of intelligence applied to the form and method of recording determines in large measure that: • The data underlying the development and revision of standards will be available as needed. • The facts relating to operating efﬁciency will be ascertainable and accurately analyzed. • The information will be made available on an economical basis. • The records will have the necessary ﬂexibility to meet promptly the needs of the various applications of the standards. (b) TYPES OF RECORDS NECESSARY. In the manufacturing function, the records incident to the establishment and use of standards may be classiﬁed into four basic groups: 1. Physical speciﬁcations that outline the required material and the sequence of manufacturing operations that must be performed 2. Details of standard or budgeted overhead based on normal capacity 3. Standard cost sheets for each product and component part, which indicate standard cost by elements 4. Variance accounts that indicate the type of departure from standard The extent and form of these records depend on the size and characteristics of the business. In an assembly type operation, for example, there would be a product speciﬁcation for each part. These, in turn, would form the basis for cost sheets on subassemblies and assemblies. In most cases this data would be recorded, accumulated, stored, and reported through the integrated computer processing system. This would include information from the production order, standard labor hours for each operation, and the ability to calculate the standard cost of each part and assembly. With the details of standards available, changes are easily made for substitution of parts in determining the standard cost of modiﬁcations of a basic product. Standards are equally applicable to pro-

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cessing operations like the chemical industry—the key is setting fair and reasonable standards for each operation or process and making adjustments for changed conditions. (c) ADMINISTRATIVE CONTROLS. Although the use of standards is not as well developed for administrative functions as for manufacturing operations, yardsticks can be established for such usage in most cases. Some companies collect and analyze statistical data from which some performance measurements can be made. The controller should continue to evaluate these functions to determine the best method or standard against which actual performance can be compared. (d) INCORPORATION OF STANDARD COSTS IN ACCOUNTS. Historically, some companies use standard costs for statistical comparisons only and do not incorporate them into the accounting record system. This is probably more true for administrative-type expenses than for direct manufacturing costs. With the data storage and processing capabilities of computers, it appears essential that the standard cost records be integrated into the accounting system. This will result in better cost control, inventory valuation, budgeting, and pricing.

17.15 APPLICATION OF STANDARD COSTS Even though standard costs are incorporated in the accounts, there is considerable difference about the period in the accounting cycle when the standards should be recorded. Whereas there are several variations in accounting treatment, the distinction may be twofold: 1. Recognition of the standard cost at the time of cost incurrence 2. Recognition of the standard cost at the time of cost completion The ﬁrst method charges work in progress at standard cost, whereas the second method develops the standard cost at the time of transfer to the ﬁnished goods account. Recognition of costs at incurrence would imply a recording of material price variance at the time of purchase and material usage variance at the time of usage or transfer to work in process. However, many ﬁrms record material at actual cost and recognize price variances only as the material is used. This practice permits a write-off of excess costs proportionate to usage so that unit costs tend to approximate the actual cost each month.

17.16 MANAGEMENT USE OF STANDARD COSTS Extensive use of standard cost data can be made by management in directing the activities of the company. Some areas to be considered are: • Planning and forecasting • Motivation of employees • Rewarding employees • Performance measurement • Analyzing alternative courses of action — new products • Pricing decisions • Inventory valuation • Make or buy decisions • Control and cost reduction

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CHAPTER*

18

PLANNING AND CONTROL OF SALES 18.1

INTRODUCTION 330

18.2

SALES MANAGEMENT CONCERNS 330

18.3

CONTROLLER’S ASSISTIVE ROLE IN SALES MANAGEMENT PROBLEMS 331

18.4

CONTROLLER’S INDEPENDENT ROLE IN THE PLANNING AND CONTROL OF SALES 333

18.5

CONTROL OF SALES 334

18.6

SALES ANALYSIS 334 (a) Getting at the Facts 334 (b) Types of Sales Analyses Needed 334 (c) Deductions from Sales 335 (d) Typical Conditions Found by Sales Analysis 335 (e) Illustrative Use of Sales Analysis: Control Application 336 (f) Other Uses of Sales Analysis 337 (g) Sales and Gross Proﬁt Analysis 338 (h) Limitations of Sales Analysis 338

18.7

SALES PLANNING: BASIS OF ALL BUSINESS PLANS 338

18.8

STEPS IN DEVELOPING THE NEAR-TERM SALES PLAN/ BUDGET 339

18.9

CONTROL PHASE 341

18.10 METHODS OF DETERMINING THE SALES LEVEL 341 (a) Mathematical/Statistical Methods 342 (b) Judgmental Methods 342 (c) Other Methods 344 18.11 USEFUL SOURCES OF FORECASTING INFORMATION 344 (a) Some Speciﬁc Sources 345 (b) Validity of Economic Indicators 345 18.12 FORECASTING THE BUSINESS CYCLE 345 (a) Nature of the Business Cycle 345

(b) Impact of the Business Cycle on the Corporation 346 (c) Elements of Business Cycle Forecasting 347 (d) Business Cycle Forecasting at the Corporate Level 349 18.13 SALES STANDARDS 350 (a) Deﬁnition of Sales Standards 350 (b) Purpose of Sales Standards 351 (c) Nature of Sales Standards 351 (d) Illustrations of Sales Standards 351 (e) Developing Sales Standards: Benchmarking 352 (f) Revision of Sales Standards 352 (g) Use of Sales Standards 352 (h) Sales Quotas as Standards 352 (i) Basis of Sales Quotas 353 (j) Method of Expressing Quotas 353 18.14 SALES REPORTS 354 (a) Effecting Sales Control 354 (b) Nature of Sales Reports 354 (c) Content of Sales Reports 354 (d) Illustrative Features in Sales Reports 355 (e) Frequency of Reports 355 18.15 PRODUCT PRICING : POLICY AND PROCEDURE 355 (a) Prices in a Competitive Economy 355 (b) Prices and the Controller 358 (c) Cost Basis for Pricing 362 (d) Elasticity of Demand 363 (e) Total Cost Method 363 (f) Marginal Cost Method 365 (g) Return-on-Assets-Employed Method 366 (h) Applying the Return-on-Assets-Employed Concept 367 (i) Conversion Costs for Pricing Purposes 367

* Section 18.12 adapted with permission from Steven M. Bragg, Financial Analysis: A Controller’s Guide (Hoboken: Wiley, 2000 Chapter 9.)

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18.1 INTRODUCTION Primary responsibility for the planning and control of sales, of course, rests with the chief sales or marketing executive of the company or the business segment. However, the chief accounting ofﬁcer, with the knowledge of costs and cost behavior as well as the familiarity with sales accounting and analysis, is in a position to use these skills to assist the various marketing executives. Some of the areas where the controller might be helpful include: • Selection and application of mathematical/statistical methods to develop or verify sales level trends and relationships • Analysis of internal sales data to reveal trends and relationships • Analysis and assembling of the proposed sales plan/budget • Development and application of sales standards for use by the marketing executive, if applicable • Application of the relevant costs as a factor in setting product sales prices While the controller has a supporting role to the chief sales executive with respect to sales planning and control, there are also some basic independent responsibilities, as a member of the ﬁnancial staff, to see that adequate procedures are followed and that the sales planning and control is sound from a ﬁnancial or economic viewpoint. These subjects and others are discussed in this chapter. First, however, to provide background for the controller or for other readers, a brief review is made of the sales management function and some of its concerns.

18.2 SALES MANAGEMENT CONCERNS The tasks of any management function are many, varied and complex. Sales management is certainly confronted with a broad range of problems. It is a dynamic area, with changing conditions, constantly resulting in new and different problems. The controller can be an important inﬂuence on the resolution of these problems and decisions. An extensive and objective analysis of sales and distribution costs can assist sales executives in making prudent decisions consistent with the shortand long-range goals of the company. One problem area that has a signiﬁcant impact on the planning process of the company is sales forecasting. The accuracy of the sales forecast is essential to good planning. The controller can work with sales management to realistically evaluate the degree to which the actual sales will relate to sales budget or forecast. There are many mathematical techniques available to establish standard deviations or variations that can be expected. Signiﬁcant progress has been made in developing more sophisticated management tools for sales executives. With the utilization of personal computers, management can have available summarized information on sales activity allowing it to make effective decisions in a timely manner. The controller should be an active participant in the development of these information systems and reports. Although there are many types of problems encountered in the sales management function, there may be some that are found in most companies. The following is representative of some of the fundamental questions that are constantly raised: • Product. What product is to be sold and in what quantity? Is it to be the highest quality in its ﬁeld or lower? Is the product to be a specialty or a staple? • Pricing. At what price is the article to be sold? Shall the company follow a policy of meeting any and all price competition? What are the terms of sale to be granted? • Distribution. To whom shall the product be sold; that is, shall the ﬁrm sell directly to the ultimate consumer or through others, such as wholesalers? What channels of distribution should be used? • Method of sale. How shall the goods be sold? Is it to be by personal solicitation, advertising, or direct mail? What sales promotion means shall be used?

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• Organization. How shall salespersons be selected, and how shall they be trained? What is to be the basic organizational setup? Are there to be branch ofﬁces? Will sales supervisors handle all lines of product, or will each specialize? Into what departments shall the sales organization be divided? How many salespersons should be employed? • Planning and control. How are sales territories to be set up? Shall sales standards be used as measuring sticks of performance? How will salespersons be compensated—salary, commission, bonus? What controls will be employed? Questions relating to these six categories are found in every company, regardless of size. The answers to many depend, in large part, on the facts available within each organization.

18.3 CONTROLLER’S ASSISTIVE ROLE IN SALES MANAGEMENT PROBLEMS As stated earlier, the ﬁnal solution to sales management concerns must, of course, rest largely with the chief sales executive. However, an intelligent executive will always seek any assistance available. The controller can help by bringing to bear a scientiﬁc, analytical approach, using judgment as well as imagination. It should be realized that the solution in one ﬁrm may not be the solution in another and that the answers to today’s problems may not be the answer tomorrow. The controller is of value primarily in getting the facts. In presenting the facts, though, it is necessary to merchandise or sell the product; the controller’s approach must be one that invites reception. The degree of assistance the controller can render in solving the previously mentioned sales problems is indicated in the following outline: 1. Problems of product. The initial selection of the product or consideration of changes in the line, sizes, and colors should generally be based on the collective judgment of the marketing considerations by the sales manager, of production problems by the manufacturing executive, and of cost considerations by the controller. Costs are not the only factor in the decision, but they are an important factor. The chief accounting ofﬁcial should be able to indicate the probable margin on the product, as well as the margins on alternative choices. The controller should also be able to indicate the probable effect of volume on the margin or the effect of changes in quality, composition, and manufacturing processes on the cost to make or sell. In the continuous reviews of sales trends, the controller may be able to identify unfavorable trends that might call for redirection of the sales effort or a change in product. 2. Problems of price. In many companies, pricing procedures are not reviewed on a periodic or methodical basis. The pricing procedure may not be responsive to increased costs. Although cost is not the only determining factor, it must be considered in maximizing the return on investment. The controller must be able to provide all the available information. Total costs, marginal or differential costs, out-of-pocket costs, or cost differences must be considered in developing the price structure. This is true for competitive bids or establishing price lists for the usual type of sale. In an analysis of sales volume and related prices, it may be revealed that unfavorable variances often have resulted from salespersons or sales managers having too much authority in setting a selling price. As production costs change, the information should be communicated to the sales executives for consideration of appropriate price changes. Also, assistance should be provided in setting volume price breaks for different sizes of orders. 3. Problems of Distribution. The controller contributes the cost analysis necessary, as well as a review of statistics for unfavorable trends in distribution. Being able to provide indications of the selling cost through the various channels of distribution, the controller should be on the alert for major changes in sales trends through particular channels or margins thereon. Frequently, there are chances to show ingenuity in analysis regarding types and sizes of accounts and orders to be sought. Questions of policy may relate to:

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(a) The minimum order to be accepted (b) Restriction of the sales effort on large volume accounts that purchase only low-margin products or are unproﬁtable because of special laboratory service (c) Desirability of servicing particular types of accounts through jobbers, telephone, mail order, and so forth (d) Discontinuance of aggressive sales effort on accounts where annual sales volume is too low (e) Best location for branch warehouses 4. Problems relating to the method of sale. Many factors will determine the method of sale, and the sales management must make this determination in view of the long-term goals and objectives. The controller can assist by providing information on historical costs and preparing alternative cost estimates for various methods. For example, analyses could be made related to the distribution of samples and the impact on costs and sales trends. Cost data related to advertising programs are useful in making decisions for future media communications. Special cost structures can be developed for market-test situations to determine the cost effectiveness. In the long run, of course, the best method should result in achieving the greatest sales volume with the best return on investment. 5. Problems of organization. Because the sales management function is dynamic, organizational changes are necessary to satisfy the new requirements. In making these changes, information related to potential sales by product or territory may assist in reassigning or hiring new salespersons. Also, comparative cost data on different organizational structures are useful in determining the change. 6. Problems of planning and control. So numerous are the applications where the controller can be of assistance in planning and controlling the sales effort that only a few can be indicated. The controller is able to aid the sales executive in solving some of the previously mentioned problems through special studies, yet in the planning and control ﬁelds many of the controller’s functions are repetitive. The accounting ofﬁcial may contribute in the following ways: (a) Sales budgets and quotas. Detailed records and knowledge about the distribution of sales by territory, product, and customer, coupled with the knowledge of the sales manager on product changes and trends, provide basic information necessary in an intelligent setting of sales budgets, quotas, and standards. The controller also may provide services in connection with forecasting and market studies. (b) Distribution expense budgets and standards. A history of past expenses as recorded in the accounting department provides much needed data in setting budgets and standards for the measurement and control of selling effort. (c) Monthly or periodic income and expense statements: (i) (ii) (iii) (iv) (v) (vi)

By territories By commodities By methods of sale By customers By salespersons By organization or operating divisions

These and other analytical statements can provide a vast amount of useful information. The disclosure of the contribution to the net proﬁt of each territory or some other factor analyzed, over and above the direct expense, may reveal spots of weakness. (d) Special analyses to reveal conditions needing correction or as an audit of performance: (i) Sales incentive plans. The probable cost of various plans as applied to the business and degree to which they are mutually proﬁtable for the company and salesperson.

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18.4 Controller’s Independent Role in the Planning and Control of Sales

333

A determination about whether they direct salespeople’s efforts toward the most proﬁtable products. (ii) Branch ofﬁce and warehouse expense. Periodic reviews of expense, in relationship to sales, growth, and earnings of the activity. (iii) Customer development expense. Analysis of entertainment expense or other business development expense by customer, salesman, or territory, with emphasis on necessity and possible alternatives — all with reference to the related margin or proﬁt. (iv) Salespersons’ compensation and expenses. Review and analysis of salespersons’ salaries, bonuses, and expenses related to budgets, salary structure, and industry.

18.4 CONTROLLER’S INDEPENDENT ROLE IN THE PLANNING AND CONTROL OF SALES As previously stated, the primary responsibility for the development of the sales plan and its subsequent implementation is that of the chief sales executive. But, as just commented on in the preceding section, the controller can be of substantial assistance to the sales executive in supplying analytical and historical data for use in planning and control decisions. However, it should not be assumed that the controller will provide only the data the sales executive wants and that the controllership role is by and large a passive one as to sales activity. Given the analytical background of controllers and their knowledge of the ﬁnancial data concerning the company, they have a series of independent functions to perform in furtherance of a sound business plan and prudent control procedures. Some of their conclusions might not be in agreement with the initial thinking of the sales executive; and some of the procedures they develop might appear redundant to some salespersons. Yet to one sensitive to the need for ﬁnancially sound policies and procedures, and the desirability of proper checks and balances, the role of the controller is indispensable. For most companies, the responsibility of the controller and staff extends to the following outline of functions in the development of a sound annual sales plan (as well as the entire annual business plan) and the related implementation: 1. The planning phase (a) Development, and revision when required, of a practical set of systems and procedures for arriving at a suitable sales plan (and the entire ﬁnancial aspects of the annual plan). This would include: (i) Outlining the steps in the planning procedure (ii) Assigning responsibility for each speciﬁc procedure to speciﬁc executive positions (with the concurrence of executive management) (iii) Providing the format in which the sales plan (quantiﬁed data) must be presented (iv) Examining the economic justiﬁcation for certain decisions (v) Providing the schedule when the data are to be submitted (vi) Ensuring that the cognizant sales executives have the necessary statistical and historical internal sales data required to develop a sound sales plan (b) Supplying the relevant analyses of past sales performance, including the signiﬁcant trends and relationships, for the appropriate executives sales management. (c) Providing for an in-depth ﬁnancial analysis and evaluation of the tentative sales plan, when completed by the marketing executives. The analysis should bring to the attention of the appropriate executive any inconsistencies, questionable assumptions, reasonableness tests, or other matters that warrant discussion. These could include adequacy of margins, comparisons with competitive prices, questions about market growth, economic comparisons of different product sales mixes, etc. (d) When the iteration is complete, preparing the consolidated sales plan with related supplemental adjustments for such matters as returns, allowances, and other sales deductions.

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(e) Incorporating the sales plan into the total business plan for the period involved, including comparative proﬁt data. 2. The control phase (a) Develop and revise (when necessary) appropriate ﬁnancial control systems for the use of the cognizant executive. (b) Provide the useful and timely comparisons of budget and actual sales performance for the sales executive, by appropriate segment, and in an understandable form (by product, by territory, by salesperson, etc.). (c) Provide useful supplemental analytical data such as sales trends, gross margin trends, and relationships, market share information, sales effectiveness, and other control type information. These data can be furnished on a regular basis or when an observed unfavorable condition seems to be arising. These are some of the basic functions performed by many controllers. In each situation, accounting executives will ﬁnd ways in which their analytical capability and business acumen may be put to use.

18.5 CONTROL OF SALES Sales must be controlled to achieve the best or expected return on investment. The optimum net income is realized only when a proper relationship exists among these four factors: (1) investment in working capital and facilities, (2) volume of sales, (3) operating expenses, and (4) gross margins. The accounting control of sales, therefore, relates to the reports analyzing sales activity that bring to light undesirable trends and relationships or departures from goals, budgets, or standards in the manner best calculated to secure corrective action.

18.6 SALES ANALYSIS (a) GETTING AT THE FACTS. The stress sometimes placed on sales volume can be misleading. If a business were to ignore the proﬁt factor, it could probably secure any desired volume. Through the cutting of prices or through the spending of huge amounts on direct selling expense or sales promotion or advertising, volume itself could be secured. Yet what good would result? It is obvious that the implied factor is proﬁtable sales volume. If business is to achieve proﬁtable sales, it must know where the areas of greatest proﬁt are. This means both sales analysis and cost analysis. There is little doubt that the analysis of sales has reached different peaks of achievement in different ﬁrms and industries. Many large companies devote a great deal of time to this phase of marketing control and have well-developed programs. A large number of medium-sized or small ﬁrms have little or none. It is also probably true that the sales executive in consumer goods lines has many more facts than the industrial marketing executive. The evidence is unmistakably clear in any business that overall or average ﬁgures are not sufﬁcient. Such general information is of little value in making key marketing decisions and directing sales efforts. The data must be speciﬁc and related directly to the problem on which a resolution must be achieved. (b) TYPES OF SALES ANALYSES NEEDED. What is needed, then, is detailed analysis to guide sales effort. Some required analysis relates solely to past sales performance as such. Other studies involve the determination of trends by comparison with previous periods. Still other reviews show the relationship to budget or standard, to gross proﬁt, selling expense, or net proﬁt. Analyses may be expressed in physical units, or dollar volume, or both. The types of analyses frequently used are: • Product— type of product sold, colors, sizes, price lines, style, quality (reclaimed material, odd lot, ﬁrst quality)

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• Territory— area used for sales direction — states, cities, counties, other marketing areas • Channel of distribution — wholesalers, retailers, brokers, agents • Method of sale—direct mail, house call, ad or coupon, delivered vs. nondelivered • Customer —domestic vs. foreign, industrial vs. ultimate consumer, private vs. governmental, tabulated according to volume of purchases • Size of order —average size of individual purchase • Terms of sale— cash, cash on delivery (C.O.D.), regular charge account, installment, lay-away • Organization— branches, departments • Salesperson — either individual or groups These analyses may be developed, not merely with regard to sales but through gross proﬁt to proﬁt after direct selling expense or ultimately to the net proﬁt of the segment being measured. Other analyses relating to unrealized sales may also be useful, for example: • Orders received • Unﬁlled orders • Cancellations • Lost sales These studies may be used as an integral part of sales planning or to eliminate reasons for ineffective effort. Analysis of orders may be important where production is made to order. For example, all sales of a given size or type may be summarized to necessitate only one production run in the period. Many subanalyses can be prepared. Thus, management may want to know not merely the overall sales by product but the product sales in each territory. The controller may ﬁnd that the sales manager can use certain of these analyses monthly or periodically — for example, sales by territory, by product lines, or by salesperson. Other analyses may be made only as a special investigation, when it is expected the tabulation will reveal out-of-line conditions. In any event, it is the controller’s responsibility to design and install procedures and records in such a fashion that the maximum information is made available with the minimum of time and effort, both clerical and analytical. It is axiomatic that in many situations the company getting the information most quickly is in a better competitive position. This information will answer the typical questions of an analytical sales executive: What was sold? Where was it sold? Who sold it? What was the proﬁt? (c) DEDUCTIONS FROM SALES. In any analysis of sales the importance of sales deductions should not be overlooked. Although reviews may relate to net sales, the clue to substandard proﬁts may lie in the deductions—high freight cost, special allowances, or discounts. These factors may reveal why unit prices appear low. Useful analyses and reports on sales deductions can be prepared. For example, an informative summary may be compiled to indicate the general types and amounts of sales deductions, namely, returns, freight allowances, price adjustments, or customer sales policy adjustments. It may be helpful, also, to prepare an analysis of deductions by responsibility — the manufacturing division for defective product, the trafﬁc department for erroneous freight allowances, the sales division for allowances to retain customer goodwill. (d) TYPICAL CONDITIONS FOUND BY SALES ANALYSIS. In many businesses, a large proportion of the sales volume is done in a small share of the product line. Likewise, a relatively small proportion of customers will provide the bulk of the volume. Such conditions reﬂect the fact that only a very small part of the selling effort is responsible for most of the business. This information should prove useful to the sales executive. It might permit the concentration of sales effort and the consequent reduction in selling expense. Again, it might mean a change in territorial assignments of sales staff. Where product analysis reveals unsatisfactory conditions, a simpliﬁcation of the product

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line may be indicated. Although the line may not be limited to only volume items, many sales managers are beginning to realize that not all sizes, all colors, and all varieties need be carried. Smart executives will let their competitors have the odd sizes or odd colors and concentrate on the more proﬁtable articles. After all, the economies of production also must be considered in developing the product line. (e) ILLUSTRATIVE USE OF SALES ANALYSIS: CONTROL APPLICATION. Some examples will help in illustrating certain beneﬁts to be gained from sales analysis. Assume a case where the sales executive has just been advised by the accountant that sales for the month then ended total $125,000. Assume further that this is $15,000 lower than the preceding month and that the aggregate volume failed by $25,000 to meet the commitment to the chief executive. What can the sales manager do with merely the information that sales were $125,000? The answer, of course, is not very much. It is the position of a hunter who has a shotgun but needs a high-powered riﬂe. This sales manager’s controller has done a poor job. Now assume that an analysis of sales by territories is made available. The results might be as shown in Exhibit 18.1. This analysis gives the sales executive some useful information. Instead of prodding the managers of all territories, the sales manager can concentrate on the poor performers — B, D, and C, probably in just that order. If more than one salesperson is assigned to a territory, a further analysis of the substandard territories could prove useful. Although territory B, for example, was badly under budget, it could well be that some of the salespersons did a good job. The picture might appear as in Exhibit 18.2. It is evident that something went wrong in the areas covered by Smith, Jones, and Black. Where did they fall down? A subanalysis of the sales by Smith might reveal the data in Exhibit 18.3. Now we are beginning to get at the root of the trouble! Smith has done much better than expected on hard resins and glue, getting what sales management feels is the maximum share of hard resin sales in the territory. While there is still an unrealized share of the potential sales, Smith exceeded Total Sales Territory A B C D E F Total E XHIBIT 18.1

Over (or Under) Budget

Actual

Budget

Value

%

$ 15,000 50,000 10,000 25,000 13,000 12,000 $125,000

$ 12,500 70,000 12,500 37,500 8,500 9,000 $150,000

$ 2,500) (20,000) ( 2,500) (12,500) 4,500) 3,000 $(25,000)

20.00 (28.56) (20.00) (33.33) 52.94 33.33 (16.67)

A NALYSIS

OF

S ALES

BY

T ERRITORIES

T ERRITORY B—A NALYSIS

BY

S ALESPERSON Over (or Under) Budget

Total Sales Salesperson

Actual

Budget

Value

%

Knight Black Smith Jones Nesser Total

$17,000 11,500 8,500 8,000 5,000 $50,000

$14,000 15,000 20,500 16,000 4,500 $70,000

$ 3,000) ( 3,500) (12,000) (8,000) 500 $(20,000)

21.43 (23.33) (58.54) (50.00) 11.11 (28.56)

E XHIBIT 18.2

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OF

S ALES

BY

S ALESPERSON

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337

Over (or Under) Budget

Sales Product

Potential

Actual

Budget

Value

%

Urea molding compound Alkyd molding compound Hard resins Powdered glue Total

$20,000 4,000 1,000 6,000 $31,000

$2,500 500 1,000 4,500 $8,500

$12,000 3,600 900 4,000 $20,500

$( 9,500) ( 3,100) 100 500 $(12,000)

(79.17) (86.11) 11.11 12.50 (58.54)

E XHIBIT 18.3

S UBANALYSIS

OF

S ALESPERSON

BY

P RODUCT

the budget. However, Smith has performed very poorly on molding compound. A review of Smith’s call reports indicates that important users of molding compound have not been called. For example, Smith is completely overlooking the molders of electrical ﬁxtures, yet this is where the greatest potential lies. The sales, as an analysis by customers shows, have been only to molders of bottle caps and the like. Now the sales manager has the facts and can take corrective action, and the controller can feel that the analysis has been useful. (f) OTHER USES OF SALES ANALYSIS. In many businesses, particularly small concerns, budget applications are neither well developed nor applied. Budget information by product or by salesperson is not available. In some instances, the cost of maintaining an elaborate budget system is not cost effective. Sales analyses may be made that are useful but not related to a budget. An analysis by customer by commodity class, indicating sales this month, sales same month last year, sales year to date, and sales last year to date will provide some comparative data as well as trends. If the sales executive has detailed knowledge of each territory and general level of activity by customer, the report can be of use in directing the sales effort. Observations can be made about which customers are growing or declining in sales volume. With knowledge of the margin by commodity class, it can be determined if growth is in the proﬁtable lines or on the low margin products; this may indicate that prices should be reviewed. There are many simple analyses that can be made to guide the sales effort. The controller should continuously work with sales executives to develop those reports that are most useful, like special or one-time reports. The information developed should be interpreted and the important trends or measures should be highlighted. Other uses of sales analyses that may be considered are: • For sales planning and setting of quotas. Past experience is a factor. • For inventory control. To properly plan inventories, a business should be familiar with past sales and probable future trends in terms of seasonal ﬂuctuations and type of product. • For the setting of certain sales standards. Here, also, past experience is a factor. • For the better distribution of sales effort in territories. It may well prove that the business is concentrating its effort in too restrictive an area. Consideration of potential sales, competitive conditions, and cost factors may dictate a wider coverage. Again, analysis might reveal that the territory is not being fully covered. • For better direction of sales effort on products. A study of sales and the potentials may reveal the restriction of sales effort to certain products to the neglect of other and more proﬁtable ones. Also, a comparison of sales by product with previous periods will reveal trends. If the trends are away from the more proﬁtable lines, corrective action may be necessary. • For better direction of sales effort in terms of customers. Analysis by customers should reveal trends about the types of merchandise purchased by each customer. Also, comparison with the sales of a similar period for the previous year will reveal facts on whether the company is making headway in securing the maximum amount of proﬁtable business from the customer. Analysis by customer account, coupled with other information and discussions with the sales

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manager, will show certain accounts that cannot possibly provide a proﬁtable volume, even if developed. This, too, may permit greater utilization of sales effort elsewhere. (g) SALES AND GROSS PROFIT ANALYSIS. Sales efforts, as previously stated, should be directed and focused on proﬁtable volume. To accomplish this, sales executives must be provided with all the facts related to proﬁt. Therefore, analysis of sales must include a detailed analysis of contribution margin and/or gross proﬁt. For example, a sales report by a salesperson should indicate the comparative gross proﬁt by periods as well as sales. Although high gross proﬁt does not necessarily signify a high net proﬁt, since the selling costs may be excessive, it is an indicator. It certainly serves as a guide, however, in determining areas for concentration of the sales effort. One other aspect of gross proﬁt deserves comment. Variations in gross proﬁt may result from changes in the selling price, product sales mixture, returns, or volume (largely controlled by the sales executive) or from changes in manufacturing efﬁciency (controlled by the production executive). These facts should be recognized when reviewing changes in gross proﬁt. The causes should be isolated. If a standard cost system is in operation, this process is simpliﬁed somewhat. In this case, the best measure of sales performance will be standard gross proﬁt. When the standard eliminates the manufacturing efﬁciency factor, then the sales department is generally responsible for the result, as well as the volume variance. (h) LIMITATIONS OF SALES ANALYSIS. Sales analysis is only one management tool used by the sales executive. Such analysis, however, is no substitute for the professional leadership needed to properly direct and manage the sales function. It is obvious that analysis of the actual sales volume must be used in conjunction with other factors like sales potential, plans, budgets, standards, historical performance, industry comparisons, manufacturing costs, and operating expenses. Most important, the sales executive must use the data to make effective decisions. Although sales volume analyses can be used extensively in measuring or studying sales performance, those using the data must recognize that high volume does not mean high proﬁts. Proﬁts will certainly vary, and a business does not earn the same rate of proﬁt on all products. An analysis of sales volume alone will not provide sufﬁcient information to maximize the return on investment on any given product. Many other factors must be considered. Even with some limitations, the analysis of sales is an integral part of any well-managed sales function.

18.7 SALES PLANNING: BASIS OF ALL BUSINESS PLANS Sales analysis is a useful function. As mentioned in the prior section, it may be applied to better direct and control sales effort, and for other related sales control activities. Yet, one of the other principal applications is to sales planning; that is, in helping to determine a proper sales level (by product or territory or salesperson, etc.) for the next year or two of the annual business plan. The application to sales planning is also used in selecting the more proﬁtable sales potential areas for the strategic, or long-range, plan. It will bear mentioning that the sales plan is the foundation for the entire system of plans (see Chapters 12 and 14) including: the production plan, the marketing plan, the research and development plan, the administrative expense plan, the facilities plan, the working capital plan, and the ﬁnancing plan. Thus, the sales plan is so pervasive and fundamental that it is in the interest of the company to develop the best possible plan, using all fairly available information (both internal and external). A reasonable amount of time will be spent in developing the short-term sales plan or budget for the next year in considerable detail. But the chief sales executive has to keep in perspective the relationship of the immediate short-term or tactical plan to the strategic longer-term plan. The ﬂow of products and services in these two plans may be as illustrated in Exhibit 18.4. As a practical matter, the sales manager often will view the marketing task as threefold: 1. Sales of existing products and/or services to existing customers

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18.8 Steps in Developing the Near-Term Sales Plan/Budget

Historical Sales

Annual (Tactical) Plan

339

Strategic Plan Products from Acquisitions

160

New Products

Sales (in millions of dollars)

120

Present Products New Customers 80

40

Present Products Present Customers

0 X0

X1 Years

E XHIBIT 18.4

S TRATEGIC

AND

T ACTICAL S ALES P LAN

2. Sales of existing products/services to new customer 3. Sales of new products to existing, as well as new customers Sales often may be estimated by these segments. These facets of the near- and long-term sales plans, as well as the increase in sales from acquisitions (newly acquired companies or products), are shown in Exhibit 18.4. All these sales targets may be necessary to avoid the natural decline in sales over a period of time and to reach the longterm corporate sales objective.

18.8 STEPS IN DEVELOPING THE NEAR-TERM SALES PLAN/BUDGET Each company has its own way of developing the sales plan or budget, and providing such information to those executives, who, in turn, use it for developing their segment of the total business plan. The planning steps outlined next are somewhat typical when industry estimates of future sales levels are available, or when some useful external data may be secure, and when the involved executives are accustomed to being provided with relevant sales and gross proﬁt analyses.

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1. The chief sales executive who is responsible for preparing the sales plan, also called the sales budget, and meeting it, is given some or all of the following data: (a) Computer sheets or other worksheets in proper format for providing the sales estimate, by month, and by product or salesperson, for the planning year (b) Sales performance for the last year (estimated for the balance of current year) or two by salesperson, and perhaps subanalyzed by territory or customer—in monetary or physical units (c) Industry data on expected next-year total sales (d) Any other analyses based on external information, developed by the market research department or economist or perhaps the controller, giving a clue as to expected sales (correlation techniques, etc.; U.S. government statistics) or business conditions for the coming plan year (e) Any other data the sales manager or salespersons reasonably request as helpful in developing sales estimates (f) Analyses, if available, giving the estimated sales impact of planned sales promotions, and reasons for the cause or precise location of below-plan performance in the sales area (current year) (g) Any guidance, or expected sales levels that the CEO or other inﬂuential executives (e.g., manufacturing executives as to new production capacity) may wish to provide 2. The sales executive provides an estimate of sales for the planning year in appropriate detail (by product, salesperson, or territory). While the sales executive may prepare such an estimate unaided, it is preferable to ask each salesperson (through appropriate organization channels) to make an estimate of sales for that person’s assigned area or product, in appropriate detail, by month or other time period, for the coming year. The chief sales executive, directly or acting through territorial or product sales managers, will provide guidance to the sales staff on such subjects as: Percent sales increase expected Estimated impact of planned promotional programs Competitive actions and the like

Assuming each salesperson prepares their own estimate (by customer, product, etc.), as the plan is forwarded up the organization structure to the chief sales executive, it may be modiﬁed by the intervening sales executives — each giving reasons for the changes. 3. Finally, at the top executive level, the estimates are consolidated (probably by the controller’s staff) and company totals determined. The summarized sales plan, following the territorial organization structure is illustrated in Exhibit 18.5. Supporting territorial budgets for each territory sales manager, by salesperson, would be available from the database. Other analyses, such as by product, could be prepared. 4. Each proposed sales level is discussed by executive management as to acceptability, reasonableness, etc. 5. When the sales budget is tentatively approved (an iterative process) then other functional executives who need the data are provided with it so they can develop their segments of the annual plan (the marketing plan, production plan, research and development plan). Several iterations can take place (adjusting for capacity, competitive actions, probable lack of raw material, etc.) until an operating plan is agreed upon. 6. The operating budget and capital budget, together with the related ﬁnancial statements, are consolidated and tested for ﬁnancial acceptability, and so on. Through iteration a ﬁnal plan is arrived at. 7. When the board of directors approves the plan, each segment becomes a commitment for the plan period by the relevant or responsible executive.

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T HE I LLUSTRATIVE C OMPANY S ALES P LAN BY T ERRITORY F OR THE Y EAR 20XX ( DOLLARS IN THOUSANDS ) Plan Quarter

Territory

Sales This Year

Total

1

2

3

4

West Rockies Southwest Central Plains Midwest Southeast Total

$212,400 75,000 134,600 53,400 171,300 91,400 $738,100

$230,000 78,750 150,750 56,100 186,700 95,100 $797,400

$ 46,000 15,750 37,690 14,000 33,600 19,000 $166,040

$ 63,720 23,620 45,200 16,900 65,300 28,500 $243,240

$ 79,040 31,500 45,200 16,900 50,000 21,000 $243,640

$ 41,240 7,880 22,660 8,300 37,800 26,600 $144,480

E XHIBIT 18.5

S ALES P LAN

BY

T ERRITORY

18.9 CONTROL PHASE In the context of the budgeting process (a two-pronged device consisting of the planning phase and the control phase) the steps discussed in Section 18.8 complete the planning phase when the sales plan is approved by the board of directors. Then, the task consists of, among other things, monitoring actual sales results and directing the sales effort so that the plan is achieved. This is generally identiﬁed as the control phase. The implementing steps are essentially as: • Actual performance is compared with plan (or quota), for each salesperson involved in the sales effort, for the appropriate time period, which may be the day (cumulative), week, or month. • The data are analyzed, much as described earlier, to determine the cause of the subperformance. • Corrective action, if needed, is taken by the sales executive to get sales “on plan.” This might include special sales promotion, etc., especially if the cause of under-plan sales is a general condition, that is, not one induced by the lack of effort of a salesperson. • Aside from analysis of actual and planned sales, a review of some selected statistical performance measures may provide clues on how sales could be improved (e.g., conversion rate of prospects to customers). See the sections on standards and benchmarking.

18.10 METHODS OF DETERMINING THE SALES LEVEL The development of a sound sales plan, together with the program for directing the sales effort, ultimately must rest largely on the judgment of the cognizant sales executive. The means used to arrive at a decision obviously may inﬂuence its quality. Ordinarily, weight must be given to both external and internal factors. External factors (including such elements as general economic conditions, industry trends, total market potential, and competitive actions or reactions) are beyond the control of the individual company, but nevertheless may largely prescribe the sales potential. Internal factors relate to conditions within the entity and are composed of matters such as production capacity, product quality, sales experience, history, special advertising and sales promotion programs, pricing policy, and sales method changes. In this section, some of the more commonly used methods of estimating sales levels, to help the sales executive reach decisions or judgments, are discussed. What system will be used may depend on several related attributes: • Time. The time span available, the frequency of the data • Resources needed or available. Manpower, computers, ﬁnancial sophistication, cost

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• Data input. What is needed, consistency, availability, variability • Output. Reliability, extent of detail, capability of detecting trend changes, capability of revealing direction changes that have taken place For the knowledge of the controller, the more or less proven techniques of forecasting sales demand may be categorized in these three groups: 1. Mathematical/statistical methods Time series analysis Correlation 2. Judgmental methods (nonstatistical) Estimates of salespersons Customer surveys Executive opinion composites 3. Other methods Share of market End-use analysis Product line analysis Market simulation Combinations of methods (a) MATHEMATICAL/STATISTICAL METHODS. The various mathematical/statistical methods usually require the services of a person or persons skilled in the techniques (statisticians, economists, and perhaps accountants). Basically, a statistical technique is applied to a series of relevant numbers to arrive at a forecast of sales for the industry or company. Then, this forecast is modiﬁed by the expected impact of sales efforts, promotional campaigns, and so forth, to arrive at a sales plan for the company. Two types of mathematical applications are addressed here. (i) Time Series Analysis. With the use of a model already programmed in the computer, or by the application of the well-known least squares method, an existing series of values is converted into a trend, and extrapolated for a future time period. Basically, the existing series of values is isolated into its statistical components: • Secular or long-term trend • Cyclical movements • Seasonal patterns • The remaining random ﬂuctuations The long-term trend is projected to estimate the future sales for the planning periods. (ii) Correlation Analysis. As the name implies, a series is located with which the company sales, or sales of a particular product line, seem to correlate or move sympathetically. Presumably, the data are readily and timely available, are reliable, and are those that lead the company sales. The annual product sales are plotted against the index and, based on the leading factor, calculated for the planning period. Some illustrative correlation bases could be the U.S. Department of Commerce composite index of leading indicators (discussed later) or Series No. 20, contracts and orders for plant and equipment, also issued by the U.S. Department of Commerce, or the Federal Reserve Index of Industrial Production. Other statistical methods, such as the Box-Jenkins computer-based iterative procedure, or use of moving averages, can be employed. (b) JUDGMENTAL METHODS. Another popular method is the gathering of opinions or estimates from several groups. Some common variations of this method are discussed.

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(i) Estimates of Salespersons. In using the estimates of salespeople, one method involves securing the estimates of the sales staff itself. Each salesperson is provided with a record of his or her sales, by month, for the past year or two. With this data and that person’s knowledge of the sales territory and customer, an estimate by product and/or customer is obtained from the person who will be responsible for securing the sale. A variation of this procedure is to have the sales manager to whom the salesperson reports and the salesperson jointly arrive at a sales estimate. Another procedure involving the sales department personnel is to secure the opinions of the various sales managers — the product sales managers, division sales managers, or territory sales managers, together with the general sales manager. Through discussions and cross-checking, and considering the impact of sales programs, many believe a reliable estimate can be secured. Of course, the extent of knowledge of the sales manager level must be considered. Hopefully, they are close enough to the ﬁring line to know the sales conditions, products, and customers. The use of only sales department personnel has both advantages and disadvantages: • Advantages The knowledge of the persons closest to the sales picture is used. Those who must meet plan have a voice in setting it. • Disadvantages The level may be biased in that sales personnel often tend to provide optimistic estimates when the business level is high, and too low estimates when the level is poor. The participants may not give proper weight to broad economic trends that the sales force or managers either do not recognize or fail to properly evaluate. If compensation levels depend on meeting the sales plan, a deliberate effort might be made to keep the estimate on the low side so that enhanced remuneration is more likely. Care must be taken (by the CEO, other top executives, or the controller) in weighing the sales personnel opinions. (ii) Customer Surveys. The practice of asking customers for their estimate of purchases for the coming year often is used when there is no other source of reliable and speciﬁc data to make a sales estimate. It may be employed when there is a good relationship between the salesperson and the customer, and when the customers tend to be very large and limited in number. An example is the glass companies who make the windshields and glass windows used by automobile manufacturers. The disadvantages include the facts that: • The user may be ill-informed or uncooperative in such sensitive matters. • It is time consuming if many customers must be contacted. The possible advantages are: • It may be the only suitable manner of preparing a sales plan. • It gives the questioner an opportunity to delve into the thinking of the customers about the business outlook. • It is an opportunity to secure information directly from those who will be using the product. (iii) Executive Opinion Composites. Another commonly used and convenient method of estimating future sales volume is by securing opinions from a group of top and middle management executives who have reason to be familiar with the industry and company sales picture. The method involves simply securing the estimates from a group of executives, perhaps weighting them, and then combining the opinions. Thus, the CEO and sales, production, research, and ﬁnancial executives may be contacted, and weightings given to their opinions, depending on their knowledge of the market and perhaps on the accuracy of their past estimates. Each executive may determine his expectation based on his own methods; and the groups may meet to discuss the levels and the basis for the opinion.

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While this method may provide a broader base than from sales personnel only, and be more convenient, if the executives don’t really know the market, then the opinion may be one big guess, based on few facts. (c) OTHER METHODS. There are numerous other methods for developing sales forecasts or plans, some of which may be used alone or in combination with other procedures. A few brief comments follow. (i) Share of Market. For some types of products the total market is well known. In addition to the industry total unit volume and/or dollar volume, the rate of growth has been calculated, and often the estimated sales for the next year or two have been determined — perhaps by the industry association. In any event, the planner knows what share of the market the company has secured in the past. This market share, say 27 percent, adjusted for the estimated impact of special sales promotions, or guessed competitive activity is applied to the projected total market to arrive at the company segment of, for example, 29 percent of the estimated industry sales for the coming year. (ii) End-Use Analysis. This technique depends on having a sound estimate of the total end-use market for which products the company’s articles serve as component parts or elements. Again, to use the automotive industry as an example, if the expected unit sales of automobiles are known or have been estimated, then the supplier company can estimate its probable sales for the planning period for its product, the new car business. This market, plus the estimated replacement business, or other business, can be combined to arrive at sales expectations. This method bears a close relationship, in some cases, to the customer survey procedure. (iii) Product Line Analysis. Quite often major products are sold through different channels of distribution or methods of sales than other products, and the sales and sales effort may be managed by product line. Under these circumstances, a company’s internal sales (and gross proﬁt) analyses by product, subanalyzed by territory, and so on (as discussed earlier in Section 18.6) may be the starting point of determining the sales estimate, supplemented by some of the other techniques to arrive at the sales plan. (iv) Market Simulation. This technique ordinarily involves the use of a computer, and the construction of a mathematical model of the market. Modifying input for the different factors that inﬂuence the market permits the calculation of various sales estimates. This is another helpful tool, often developed by the market research organization, that can assist in arriving at a realistic sales plan. It should be understood that, whatever estimating technique is used: • Even a good forecast reduces only some of the risk that confronts sales management. • It is often helpful to compare the results of several forecasting methods. • Some of the simplest methods work best, because they are more easily understood; the heart of good forecasting probably often is intelligently based intuition on the part of sales management.

18.11 USEFUL SOURCES OF FORECASTING INFORMATION Business executives long have been intrigued by the promise of a practical indicator of business trends that could be useful in their business forecasting. Some have found broad economic measures helpful, such as gross national product (GNP), new car sales in a given territory, etc. But for many, no practical guide has been located either for the business as a whole or for major lines. Many of the broad indicators have suffered from late availability, signiﬁcant revisions, inaccuracies in compilation, and components out of touch with the market, to name a few. These executives, therefore, have encouraged their staffs to develop in-house models, perhaps based on some readily available indicators. Sometimes these models have been built from data furnished by commercial banks, or in other instances developed from a factor, such as regional car sales, that an

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executive has noticed appears to correlate quite closely with the company’s sales experience on certain products. Given the conﬂicting or indecisive signals put out by some indicators and the inability to ﬁnd a suitable one, sometimes the intuition of the chief executive or chief sales executive is one of the best guides. The controller should be aware of external sources of sales forecasting data just in case the present sales estimating techniques could stand some testing or improvement. (a) SOME SPECIFIC SOURCES. There are numerous sources, ranging from the federal government to selected ﬁnancial services, such as Standard & Poor’s (S&P) and Moody’s, that supply information which may be useful in sales forecasting. Market planners, market research analysts, and many ﬁnancial executives often are familiar with them. Of course, libraries may provide assistance on this subject. The secret is to ﬁnd an index or economic data useful in a particular business. A partial outline of some sources follows: 1. U.S. government Department of Commerce (a) Bureau of Economic Analysis (BEA) Includes cyclical indicators and economic measures published in the Survey of Current Business (b) Department of Labor Bureau of Labor Statistics (c) Department of Agriculture (d) Bureau of Mines (e) U.S. Government Printing Ofﬁce 2. Commercial banks1 3. Other sources (a) Trade associations (b) State governments (c) Federal Reserve Board (d) Universities (economics departments and schools of business, etc.) (e) Financial services providing economic data for pay (f) Numerous business magazines, such as: (i) Survey of Current Business (ii) Business Week, with its weekly “Business Week Leading Index” (iii) Fortune magazine (its “Forecast”) (g) Libraries (b) VALIDITY OF ECONOMIC INDICATORS. While the wealth of economic data provided by Washington is useful, the data need careful interpretation by those who know what to look for.

18.12 FORECASTING THE BUSINESS CYCLE (a) NATURE OF THE BUSINESS CYCLE. A business cycle is a recurring series of expansions and contractions, involving and driven by a vast number of economic variables, that manifests itself as changes in the level of income, production, and employment. As will be described in the next

1. The controller can check through the appropriate company channel or directly from its commercial bankers as to data available.

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section, these swings can have a profound impact on a company. A business cycle tends to be longterm in nature, and is very difﬁcult to predict in terms of length or intensity. It is driven by so many variables, most of which interact with each other, that it is excruciatingly difﬁcult to determine the exact causes of previous cycles and the timing of the next one based on those variables. Though the exact causes of the business cycle are difﬁcult to discern, there are essentially two types of variables that cause business cycle changes to occur. The ﬁrst is an exogenous variable. This is a variable that impacts the economic system, though it is not an integral component of the system. For example, a bad rainy season will impact the crop yields in the farming community, which in turn reduces the amount of purchases by farmers for the next season’s crop, which in turn impacts the activity of the suppliers of those purchases, and so on. Another exogenous variable is a war, which can wreak enough destruction to entirely shatter an economy. These types of variables can, to some extent, be called “acts of God.” The other type of variable is the endogenous variable. This is a variable that impacts an economic system from within. For example, overcapacity in the resin-production industry causes suppliers to reduce their resin prices to plastic molding companies, which in turn can now reduce the prices of their products, which creates an increase in sales, and contributes to an increase in the level of economic activity. Other examples of this type include the demand for products, and pricing changes. The typical company operates within a single sector of the economy, where a single major shock, either of the endogenous or exogenous variety, can cause immediate and massive changes, since individual sectors are much smaller than the national economy, and so can be severely impacted by smaller events. For example, an increase in the price of aviation jet fuel will cause the airlines to increase their prices, which reduces the number of seats ﬁlled, which drives down airline proﬁts and forces them to postpone orders for new jets, which in turn harms the airline manufacturing companies and their supporting groups of suppliers — all due to an increase in the price of jet fuel, which is just a single variable. Consequently, a controller may not be overwhelmingly concerned with the operations of the entire national or international economy, since the typical economic contraction corresponds to a drop in GNP of only a few percentage points. However, industry-speciﬁc changes within that larger economy can be truly catastrophic, and it is within this smaller economic environment that a company operates and must make management changes. This leads us to the next section, which covers the speciﬁc problems a company faces as a result of changes in the business cycle. (b) IMPACT OF THE BUSINESS CYCLE ON THE CORPORATION. What happens to a company when the business cycle changes to a new phase, either upward or downward? We will begin with the impact of an economic contraction. When management realizes that sales have declined, it must contract the business. One of the ﬁrst steps taken is to reduce inventories, so that the company is not stuck with a large investment of products that will be at risk of becoming obsolete before they can be sold. One way to reduce inventories is to sell them off at reduced prices, but this cuts into gross margins and also ﬁlls the distribution pipeline, so that no additional sales can be made until the pipeline clears. The more common approach is to reduce the production staff and all related overhead staff with a layoff, the extent of which will be driven by management’s perception of the depth of the upcoming cyclical decline. Management will also likely curtail capital expenditures and increase controls over incidental expenses. Further, the controller will be called on to tighten credit to customers and heighten collection activities to ensure that accounts receivable do not include any bad debts, and that collections are made as soon as possible. If there are excess funds available, management will likely use them to pay down debt, so that ﬁxed costs are reduced to the bare minimum in anticipation of poor sales conditions at the bottom of the economic cycle. Also during business downturns, there will be a few adventurous companies that will buck the industry trend and expand. They do this because they anticipate a short downturn in the economy, and they want to pick up new business, either by undercutting competitors or (more commonly) by waiting until ﬁnancially weaker companies begin to fail, and then buying them. They may also take advantage of lower real estate and equipment costs during these periods to add to their capacity with inexpensive new production facilities. This strategy is possible only if a company has sub-

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stantial cash reserves or available debt, and has an aggressive management team that is willing to take chances. When the economy begins to turn in an upward direction, management must make several contrary decisions. The ﬁrst one is to ramp up existing production capacity, which may have been shuttered, and now requires refurbishment before production can begin. Then management must determine the extent to which it wants to rebuild its inventory levels to anticipate renewed sales. This is a critical decision, for overproduction in a weakly rebounding economy will create more inventory than is needed, whereas producing too little in the midst of a strong economic rebound will result in sales being lost to more aggressive competitors. If the rebound is sudden, the company must spend more money on staff overtime and rush equipment deliveries to bring production back up to speed as soon as possible. Credit policies likely will be loosened in order to bring in new business, and management must decide on how much new capital equipment to purchase, and the most appropriate time for when to acquire it. All of the changes noted here, for either an increase or decrease in the business cycle, call for changes in a company’s operations that will certainly have some impact on proﬁts, but even more so on the level of working capital and ﬁxed assets. For example, waiting too long to cut back production will result in an excess investment in inventory, as well as any new capital projects that were not curtailed in time. The reverse problem arises during an economic upswing, when reacting too slowly will result in a cash inﬂow from the sale of all inventory, followed by the loss of additional proﬁts because all of the inventory has been sold, and there is none left to sell. Thus proper management of working capital and ﬁxed assets lies at the heart of management’s decisions regarding how to deal with changes in the business cycle. (c) ELEMENTS OF BUSINESS CYCLE FORECASTING. In this section, we will review who does forecasting, what information they forecast, and the methods they use for doing so. Forecasting is conducted not only by various branches of the federal government, such as the Department of Commerce and the Federal Reserve Board, but also by a number of universities and private institutions. The governments and schools do so as a public service, but the private groups do so for an entirely different reason — they create tailored forecasts that churn out estimates on very speciﬁc items, such as stock prices or exchange rates, that are requested by top-paying clients. These forecasts commonly cover a series of quarterly periods, which, due to the short time frames involved, are much more difﬁcult to predict with any degree of reliability than the annual forecasts that were more common in the last few decades. The governments and universities focus on such macro issues as the Gross National Product or the rate of inﬂation. The trade group to which most of these organizations belong is the National Association of Business Economists. There are four primary methods used to arrive at forecasts. Since each one is based on different information and may arrive at somewhat different results, it is common for forecasters to blend the results of two or more methods to arrive at their estimates of future conditions. The methods are: • Anticipation surveys. These are surveys of key people in the business community. The purpose of these surveys is to collect information about the intentions of the survey participants to engage in capital purchases, acquisitions, changes in headcount, or any other steps that may impact the economy, and then aggregate this information to arrive at general estimates of trends. • Time series models. These are trend lines that are based on historical information. For a forecast, one ﬁnds the trend line that ﬁts a similar set of previous conditions, and ﬁts it to the current conditions to arrive at a trend line of future expectations. These can be relatively accurate in the short run, but do not generate good results very far into the future. • Econometric models. These are highly complex and iterative models that simulate the real economy, and are frequently composed of hundreds of variables that interact with each other. These can yield good results over periods longer than those predicted by time series models. However, changes in the results of the models are difﬁcult to explain, given the complexity of the underlying formulas. • Cyclical indicators. These are the leading, coincident, and lagging indicators that foretell changes in the economy. This method is a good way to conﬁrm the existence of business cycle

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changes that have been predicted by other forecasting methods. A leading indicator is something that changes in advance of an alteration in a business cycle, such as the number of new business formations, new capital expenditure requests, construction contracts, the length of the average work week, layoff rate, unemployment insurance claims, proﬁt margins, new orders, investments in residential structures, capacity utilization, and new bond or equity issues. These can change anywhere from a few months to over a year in advance of a related change in the phase of the business cycle. A lagging indicator is something that changes after an alteration in the business cycle has occurred, and is used by forecasters to conﬁrm the business cycle change that was indicated by leading indicators. Examples of lagging indicators are investments in nonresidential structures, unit labor costs, and the amount of consumer credit outstanding. The exact forecasting method used depends on the person doing the forecasting, and is largely inﬂuenced by judgment. The reason why judgment is such a necessary factor in forecasting is that all of the forecasting methods, with the exception of anticipation surveys, are based on the interpretation of historical economic data, which may no longer impact the economy in the same manner as it did when the various models were constructed. Thus, having an in-depth knowledge of the current economic situation, and using their information to adjust the results of quantitatively derived forecasts is the key difference between a quantitative analyst who does nothing but tweak the numbers, and a great forecaster who consistently outperforms the outcomes predicted by the various models. In addition to judgment, forecasters will use numeric weighting schemes, where they give greater value to the results of certain forecasting models or speciﬁc variables, depending on their experience of past forecasting results, or their guesses regarding changes in the economy for the period being predicted. Some forecasters will even combine and average out the predictions of groups of other forecasters, on the grounds that this will create a consensus opinion that has a better chance of being accurate. However, there may be a wide dispersion in the various forecasts being predicted, which makes it difﬁcult to arrive at a time period for forecasted changes in the business cycle based on this approach. Once the forecasters make their predictions, they also compare their forecasts to the actual results as that information arrives. They will then spend a great deal of time modifying their forecasting methods to make their next set of forecasts more closely match the future results. This is an ongoing process that never ends, because the underlying variables that drive business cycles are constantly altering the degrees of force with which they impact the economy. Also, old variables may eventually have so little impact on business cycles that they are dropped entirely from the forecasting systems, while new variables must be researched and inserted into the models. Thus, the after-the-fact review of forecasting models and their component parts is a major forecasting task. When reviewing the effectiveness of the variables that comprise a forecast, there are several factors to consider. One is that a small pool of variables may result in an incorrect forecast, because each of them may be adversely impacted by exogenous variables that yield results not truly representing their impact on the business cycle as a whole. However, by using a large number of variables in a forecasting model, one can tolerate a minority of variables that yield incorrect results, while still arriving at an overall forecast that is made accurate by the sheer volume of variables included in the model. Another item to review is the number of months by which leading indicators presage a change in the business cycle. Though there may be historical justiﬁcation for using a certain number of months in a forecasting model, these periods can change, sometimes to the extent of having a leading indicator turn into a lagging indicator. Also, the selection process for variables needs to be very in-depth before they are added to a forecasting model. For example, a new variable should be thoroughly researched to determine the extent of its linkage to a business cycle, how well it predicts business cycle behavior, how consistently it does so, and also how frequently information about the variable is reported (so that it can be included in the forecast in a timely manner). Only if all these questions receive favorable answers should a new variable be included in a forecasting model. Having brieﬂy described who creates forecasts, what information they issue, and how they arrive at these forecasts, we now turn to the role of the controller in creating forecasts that are tailored for the use of company management.

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(d) BUSINESS CYCLE FORECASTING AT THE CORPORATE LEVEL. What can a controller do in his or her role as a ﬁnancial analyst to provide business cycle predictions to the management team? There are several possible routes to take. The main factor a controller must decide on is balancing the time needed for forecasting against the perceived value of the information. For example, if a company has a stable sales base that rarely varies, irrespective of what stage the business cycle is currently in, then there is no reason to track cycles very carefully. Also, if the accounting function is understaffed, the needs of day-to-day activities will probably supersede any demands for forecasting. However, if a controller can prove that the deleterious effects of not tracking business cycle conditions will lead to company losses that signiﬁcantly exceed the cost of having extra staff on hand to perform the analysis, then this second factor disappears. Let us assume that there is some time available for forecasting work, and that business cycles have a sufﬁcient impact on company conditions to be worthy of review. If so, here are some possible actions to take to obtain, analyze, and report on business cycle forecasts. They are listed in ascending order of difﬁculty: • Report on published forecasts. There are forecasts published by nearly every major business magazine for the economy at large, which can be easily extracted, reformatted into an internal report, and presented to management, perhaps as part of the monthly ﬁnancial statements. Several key advantages are that the information is fairly accurate for the entire economy, it is prepared by professional forecasters, and it is essentially free. The problem is that each company operates in a smaller industry within the national economy, and as such is subject to mini-business cycles that may not move in lockstep with that of the national economy. For this reason, the reported information may be only generally relevant to a company’s speciﬁc situation. • Subscribe to a forecasting service. A company can pay a signiﬁcant fee, probably in the ﬁveto six-ﬁgure range, to a forecasting service for more speciﬁc reports that relate to the industry in which it operates. This is a good approach for those organizations that do not have the resources to gather, summarize, and interpret economic data by themselves. However, some industries are too small to be serviced by a specialized forecasting service, or the fee charged is considered too high in comparison to the value of the information received. • Develop an in-house forecasting model. In cases where a company either wants to run its own forecasting model, or there are no forecasting services available that can provide the information, and it is deemed relevant, it is time to try some in-house forecasting. This effort can range from a minimalist approach to a comprehensive one, with each level of effort yielding better results. The ﬁrst step is to go through the steps noted in the preceding section to ﬁnd the right kinds of data to accumulate, followed by implementing a data-gathering method that yields reliable data in a timely manner. Then, one must work with management to determine what resulting information is desired (usually a sales estimate). Then the controller must arrive at a methodology for translating the underlying data into a forecast. Then the controller should develop a standard reporting format that imparts the results to management. This report should include the underlying assumptions and data used to arrive at the forecast, so that any changes in the assumptions are clearly laid out. Finally, there should be a methodology for comparing the results against actual data, and adjusting the forecasting methodology based on that information. Though this approach is a time-consuming one, it can yield the best results if a carefully developed forecasting system is used. For example, let us assume that a controller of a sport rack company has elected to use the last of the above options for creating forecasting information. Sport racks is a very small niche market that creates and sells racks for skis, snowboards, bicycles, and kayaks that can be attached to the tops of most kinds of automobiles. The controller wants to derive a forecasting system that will give management an estimate of the amount by which projected sales can be expected to vary. She decides to subdivide the market into four categories, one each for skis, snowboards, bicycles, and kayaks. Based on a historical analysis, she ﬁnds that 25 percent of ski purchasers, 35 percent of

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snowboard purchasers, 75 percent of bicycle purchasers, and 30 percent of kayak purchasers will purchase a car-top rack system to hold their new equipment. The typical delay in these purchases from the time when they bought their sports equipment to the time they bought sport racks was six months. The controller ﬁnds that she can obtain new sports equipment sales data from industry trade groups every three months. Given the lag time before users purchase car-top racks, this means that she can accumulate the underlying data that predict sport rack sales and disseminate them to management with three months to go before the resulting sport rack sales will occur. Thus, she concludes that these are usable data. The next task is to determine the company’s share of the sport rack market, which is readily obtainable from the industry trade group for sport racks, though this information is at least one year old. Given the stability of sales within the industry, she feels that this information is still accurate. She then prepares the report shown in Exhibit 18.6. It shows total sports equipment sales for the last quarter, uses historical percentages to arrive at the amount of resulting sport rack sales, and then factors in the company’s market share percentage to determine the forecasted sales of each type of sport rack. By comparing this information to the previously forecasted sales information, the report reveals that the company should signiﬁcantly ramp up its production of snowboard sport racks as soon as possible. The example used was for an extremely limited niche market, but it does point out that a modest amount of forecasting work can yield excellent results that are much more company-speciﬁc than would be the case if a company relied solely on the forecasts of experts who were concerned only with general national trends. For most companies, there will be a number of additional underlying indicators that should be factored into the forecasting model; however, the work associated with tracking these added data must be compared to the beneﬁt of more accurate results, so that a controller arrives at a reasonable cost-beneﬁt compromise.

18.13 SALES STANDARDS (a) DEFINITION OF SALES STANDARDS. A standard has been deﬁned as a scientiﬁcally developed measure of performance. It was further noted that standards can be adapted to the measurement of sales performance in somewhat the same way they have been used to judge performance in the factory. The primary requirements in developing tools for the sales executive are threefold: 1. Sales standards are the result of careful investigation and analysis of past performance, taking into consideration expected future conditions. Sales standards represent the opinion of those best qualiﬁed to judge what constitutes satisfactory performance. Judgment about detailed operations must rest largely with the sales executives. Opinions about expected general business conditions and market potentials should represent the combined judgment of the executive staff, including the chief executive, the sales manager, and the controller. 2. Sales standards must be fair and reasonable measures of performance. Nothing will be so destructive of morale as a sales quota, or any other standard, set much too high. Experience shows that such standards will be ignored. The standards must be attainable by the caliber of salesman the company expects to be representative of its selling staff. 3. Sales standards will need review and revision from time to time. As sales conditions change frequently, so the measuring stick must change.

Description

Sports Equipment Unit Sales

% Buying Sport Racks

Company Market Share

Forecasted Company Unit Sales

Original Company Forecast

Variance

Ski Snowboard Bicycle Kayak

3,200,000 2,700,000 2,500,000 450,000

25% 35% 75% 30%

40% 40% 30% 30%

320,000 378,000 562,500 40,500

300,000 300,000 550,000 45,000

20,000 78,000 16,500 4,500

E XHIBIT 18.6

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351

(b) PURPOSE OF SALES STANDARDS. Sales managers are sometimes of the opinion that sales standards are not welcome. Some sales executives feel that sales standards are an attempt to substitute impersonal statistics for sales leadership. There is no substitute for dynamic and farsighted sales executives; there is no intent that sales standards in any way replace personal guidance. But sales standards do provide management with an important tool of sales control, a basis for fairly rewarding merit, and a stimulating device under many circumstances, but not all. As a tool of control they reveal weaknesses in performance that, if properly analyzed in terms of causes, open the way for correction and strengthening. As a basis for rewarding merit they result in a fairer and more accurate relationship between compensation and performance. As a stimulating device they provide each salesperson and executive with a goal of accomplishment and with assurance of fair reward. (c) NATURE OF SALES STANDARDS. The sales standards may be expressed in terms of effort, results, or the relation of effort to result. For example, a salesperson may be required to make three calls a day or ﬁfteen calls per week. Making this number of calls meets this particular standard of effort. As a result of these calls, the expectations may be to secure ten orders for every ﬁfteen calls or a certain dollar volume per call. Doing this meets this particular relationship standard. Securing a certain dollar volume from a given territory, regardless of the number of calls made or the orders and sales per call, meets another particular standard of results. Again, the standards may involve a relationship between selling cost and sales results. For example, in a retail furniture store, the standard may require that one prospective customer be attracted to the store for every $2 expended in advertising or that $1 of sales be secured for every $0.07 expended for advertising. If these goals are achieved, those responsible for the advertising expenditures are meeting the standards of advertising results. (d) ILLUSTRATIONS OF SALES STANDARDS. Although the applicability of sales standards to various industries and types of trading concerns may differ, suggestive standards the controller may consider discussing with the sales manager are: 1. Standards of effort Number of calls to be made per period Number of calls to be made on prospective customers Number of dealers and agencies to be established Number of units of sales promotional effort to be used (e.g., demonstrations or pieces of direct mail sent) 2. Standards of results Percentage of prospects to whom sales are to be made Number of customers to whom new articles are to be introduced or sold Number of new customers to be secured Amount of dollar volume to be secured Number of physical units to be sold Amount of gross proﬁt to be secured Amount of proﬁt to be secured (here proﬁt is frequently considered as the excess of gross proﬁt over the expenses that are subject to the control of the salesperson or executive to whom the standard is to apply) Amounts to be sold to individual customers (especially larger customers) Dollar or physical volume of individual products or product classes to be sold Percentage of gross proﬁt to be returned (where there is a varied line or where the salesperson has price latitude) Average size of order to be secured Relation of sales deductions to gross sales

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3. Standards expressing relationship of effort and result Number of orders to be received per call made Number of new customers to be secured per call made on prospects Number of inquiries or orders to be received per unit or per dollar of sales promotional

effort expended Relation of individual direct selling expense items to volume or gross proﬁt Relation of sales administration or supervision costs to volume or gross proﬁt

(e) DEVELOPING SALES STANDARDS: BENCHMARKING. Now that sales standards have been deﬁned, their purpose and nature explained, and illustrations provided, the question arises as to how sales standards are and should be developed. To be effective, the standards must be accepted by those who use them as fair and reasonable, not the product of the whim of some overzealous bean counter. Benchmarking is used by a company to measure its products, services, and business practices against the toughest competitor, or those companies best in its class, or other comparisons. Brief commentary on this process and results are presented in Section 17.9. (f) REVISION OF SALES STANDARDS. Some standards of sales performance can be set with a high degree of exactness. The number of calls a salesperson should make, the percentage of prospects to whom sales should be made, and the physical units that should be sold to each customer are illustrative of performances that frequently lend themselves to accurate measurements. On the other hand, there are many factors in sales performance that are so governed by conditions beyond the control of the salespeople that the standards must be promptly revised to meet important changes in such conditions. Where a salesperson is given some latitude in price setting, the gross proﬁt percentage may vary with competitive conditions beyond the salesperson’s control. Strikes, droughts, and ﬂoods may suddenly affect the sales possibilities in a particular territory. If the sales standards are to be effective measures of sales performance, they must be promptly revised as conditions change. Careless measurement of performance soon leads to discouragement, resentment, and disinterest in the task. (g) USE OF SALES STANDARDS. As stated previously, the purposes of sales standards are to control sales operations, to reward merit, and to stimulate sales effort. The standards in themselves are of limited value, except as they are made effective in the accomplishment of such purposes. To make the standards effective requires the following be done: • The variations between actual and standard performance be promptly determined • The causes of such variations be investigated and explained • The responsibility for the variations be deﬁnitely ﬁxed • The individuals held responsible be given full opportunity to present their explanations • Prompt action be taken to correct any weaknesses revealed • The method of compensation shall provide a fair and accurate reward for performance (h) SALES QUOTAS AS STANDARDS. The most widely used sales standard is the sales quota. As usually constituted, the sales quota is the dollar amount of of physical volume of sales assigned to a particular salesperson, department, branch, territory, or other division as a measure of satisfactory performance. The quota may, however, involve other considerations, such as gross proﬁt, new customers, collections, or traveling expense, thereby representing something of a composite or collective standard of performance. The quota does not differ in its purpose and use from other sales standards as discussed earlier. The applicability of the quota to various types of concerns depends largely on the extent to which sales and other results are actually affected by the direct efforts of the salespeople involved and the extent to which such results are affected by other factors, such as expenditures for advertising,

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special sales promotion, styles, and acceptability of products. Where the former is the dominant factor, sales quotas constitute a valuable type of sales standard. (i) BASIS OF SALES QUOTAS. Generally speaking, sales quotas are of value only to the extent that they are based on known facts relative to sales possibilities. They must not be based on the greed of the company or fanciful ideas of what might be done but on actual facts relating to past sales, sales in allied industries, population, buying power, or territorial conditions. The sales representative should be thoroughly informed about the method of arriving at the quota and convinced that the amount of sales assigned is entirely justiﬁed according to the existing conditions. Then, and only then, will the salesperson exert full effort in meeting the quota. The quota should not be thought of primarily as a basis for contests. The salesperson should consider the quota as representing a careful measurement of the task rather than a temporary target at which to shoot. Actual experience with sales quotas, as with all standards, will reveal that sales representatives react to them somewhat differently, particularly at ﬁrst. Some are stimulated to their highest efﬁciency, whereas others are discouraged. Some sales executives place considerable emphasis on this human element in setting their quotas. In general, however, good salespeople will, in the long run, respond favorably to intelligently devised quotas, particularly when compensation is fairly adjusted to performance. The objection sometimes raised, that efforts are lessened after quotas are reached, is seldom valid if performance is properly rewarded. The chief difﬁculty arises when quotas are exceeded as a result of some fortuitous circumstance in which the sales representative has had no part or for which the share of the credit is uncertain. The solution here usually rests with extreme fairness in handling individual cases and with the development of conﬁdence in the knowledge and integrity of sales executives. The method of establishing sales quotas is still unsatisfactory in many concerns. The matter is frequently given insufﬁcient study, and the results are ineffective. There has, however, been a vast improvement in such methods in recent years, and alert controllers have made a substantial contribution to this improvement. Past performance is greatly inﬂuenced by conditions beyond the control of the individual salesperson. Hence a quota set when business is poor is likely to result in undue reward to the salesperson. Conversely, one set when business is good is likely to prove too high to serve as an effective incentive, or even provide fair compensation. (j) METHOD OF EXPRESSING QUOTAS. Insofar as practicable, quotas should be broken down into their detailed elements. This helps to show the sales representative where, how, and to whom the goods should be sold. To illustrate, a certain company gives each of its sales representatives the following details relative to the sales quota: • The proportion of the quota assigned to each product line • The part of the quota that represents an expected increase in business from new customers • The part of the quota that represents an expected increase in business among old customers • The part of the quota to be secured in cities of various sizes • The part of the quota assigned to particular kinds of outlets or classes of customers • The part of the quota to be secured from special or exceptional sources • The distribution of the quota by months Although such a plan entails considerable work, it tends to balance the sales effort and to assist the sales representative in directing work most effectively. It should be realized that such details require the necessary detailed analysis of past performance by the controller’s staff. Furthermore, such detail is indicative of a well-developed program. Many ﬁrms, particularly the small and medium sized, will express quotas in general terms only— so many dollars of sales or so many overall units. Where quotas are relatively new, the controller

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should proceed cautiously and develop the details gradually so that the sales executives can be guided step by step. Only when the data are available and the sales staff realizes the advantages of detailed planning can the quota type of standard serve most usefully. It frequently happens that the quota cannot be fairly expressed directly in money or physical volume. For example, a sale of $100 of class A goods may deserve more credit than a like amount of class B goods, or a sale to a new customer may deserve more credit than a similar sale to an old customer. In such cases, the quota may be expressed in points that give effect to a weighting for different types of sales performance. Thus a sale of $100 class A goods may be counted as 10 points, whereas $100 of class B goods would be counted as only 5 points. The “point” system may likewise be extended to include other types of service, such as calls on new prospects, demonstrations, or collections. The ﬁnal requirement for effective standards is an adequate method of compensation as a reward for good performance.

18.14 SALES REPORTS (a) EFFECTING SALES CONTROL. Fundamentally, control is the prompt follow-up of unfavorable trends or conditions before they develop into large losses. In the small business, the owner or manager can exercise current control of sales through a review of orders received and so forth. In the larger businesses, however, such personal contact must be supplemented by reports that indicate current conditions and trends as well as current performance. It is the function of the controller, of course, to furnish the sales executives with the sales facts. However, it is one thing to furnish the information; it is quite another thing to see that it is understood and acted on. To assure the necessary understanding, the controller must adapt the report to the reader. Information for the needs of the chief executive will be different from that for the sales manager, and reports for subordinate sales executives will differ even more. The extent of the information required and the form of presentation will depend on the capabilities of the individual, the type of organization, the responsibilities of the vender, and the philosophy of sales management. (b) NATURE OF SALES REPORTS. Sales executives have many management styles and backgrounds. Some sales managers can effectively use vast amounts of statistical data, whereas others prefer summarizations. Accordingly, the controller should offer to develop reports to meet the requirement. The use of charts, graphs, and summaries will greatly enhance the communication of the sales data to sales management. In many instances, a narrative report citing the signiﬁcant issues or problems is the most effective tool. Depending on the seriousness of the problem, or where major actions are being recommended, a meeting may be in order. It is up to the controller to ensure that the information provided is understood and can be properly used. (c) CONTENT OF SALES REPORTS. The matters that may be included in a sales report cover a broad front. Such reports might contain: • Actual sales performance, with month- or year-to-date ﬁgures • Budgeted sales for both the period and year to date • Comparison of actual sales by ﬁrm with industry ﬁgures, including percentages of total • Analysis of variances between budgeted and actual sales and reasons for differences • Sale – cost relationships, such as cost per order received • Sales standards—comparison of actual and quota sales by salesperson • Unit sales price data • Gross proﬁt data These data often may be expressed in physical units or in dollars. Aside from actual or standard sales performance, some may relate to orders, cancellations, returns or allowances, or lost sales.

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355

(d) ILLUSTRATIVE FEATURES IN SALES REPORTS. As stated previously, the content of sales reports must be varied to suit the needs and personality of the user. Reports to the chief executive and top sales executive, for example, should present the overall view in summary fashion. A simple comparison of actual and planned sales by major product line or territory, as shown in Exhibit 18.7, summarizes the sales in a brief but informative manner. Summary information is also presented comparing the company performance against industry by months (or years) in Exhibit 18.8. A graphic comparison of actual with planned sales as illustrated in Exhibit 18.9 is also useful. Sales executives also ﬁnd trend reports on product lines to be of value. A percentage bar chart, illustrated in Exhibit 18.10, would be particularly signiﬁcant if the proﬁt by product group is greatly different. Trends in sales volume are easily shown by vertical bar charts similar to that pictured in Exhibit 18.10. Sales managers typically need information on the probable future course of sales. For this purpose, timely reports summarizing the orders-on-hand picture are helpful. Such a report, which may be desired daily, weekly, or monthly, is illustrated in Exhibit 18.11. The graphs and reports presented thus far have been rather simple in nature. Whereas reports always should be understood, in many cases, particularly in larger companies, they must be more analytical or detailed in nature. Moreover, for control purposes and adopting the concept of “responsibility reporting,” the performance of each segment of the sales organization should be made known to the supervisor responsible. It follows, therefore, that reporting must be available for each division, district, area, branch, or salesperson. A typical branch report is illustrated in Exhibit 18.12 and is very brief. However, as reports relate to increasingly lower levels of management, such information can become massive in extent. Therefore, although data may be periodically prepared on each segment of the organization, it has been found practical to apply the “exceptional principle” in a great many cases. This method eliminates data where performance was satisfactory and details only that which did not reach acceptable levels. An example is Exhibit 18.13, indicating only those salespersons who were 5 percent or more under budget. Another report prepared on only out-of-line performance is that shown in Exhibit 18.14. Only customers on which a loss was realized are listed. It is to be noted that two proﬁt or loss computations are made: 1. Actual out-of-pocket losses, using the direct costing concept 2. Gross loss, wherein all ﬁxed and allocated charges are considered (e) FREQUENCY OF REPORTS. The frequency of any report will depend on the individual requirements of each executive or staff member and may be daily, weekly, monthly, or quarterly. For example, the top executive and general sales manager may want a daily report on sales, orders received, and orders on hand; a weekly report may sufﬁce; or a report may be wanted daily during a critical period and less frequently thereafter. In those cases where sales data are collected by use of data input devices from remote locations and stored in the computer, reports and data can be provided on a visual display unit on a real-time basis.

18.15 PRODUCT PRICING : POLICY AND PROCEDURE (a) PRICES IN A COMPETITIVE ECONOMY. From the economic viewpoint, prices are the regulator of our economy in that they determine the distribution of goods and services. Over the long run, when prices in a given industry are insufﬁcient to provide an adequate return, capital and labor tend to shift to more attractive ﬁelds. In the individual business, also, skill in setting prices has a tremendous impact on the proﬁtability of the operation and therefore on its economic life. Product pricing is a difﬁcult area in which to make decisions because of the many forces at play. It is so complex a subject that it is not ordinarily a one-man job or one-activity job. Rather the combined talents of marketer, accountant, engineer, and economist may be needed. It might be said that pricing is one-third computation and two-thirds judgment. From the accounting viewpoint, however, the one-third computation is an essential aid to the judgment factor. Factors that inﬂuence prices include market conditions, costs of manufacturing and distribution, plant capacity, competitive activity, capital investments, ﬁnancial liquidity, government pressures, and a multitude

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E XHIBIT 18.7

C OMPARISON

Comments (to be coded to ﬁgures) *Signiﬁcance variance. (1) Action assigned to. (2) Strike. (3) Other —(explain).

Product line “B” Item 1 Item 2 Item 3 Item 4 Total Total

Product line “A” Item 1 Item 2 Item 3 Item 4 Total

OF

A CTUAL

Actual

TO

Over (under) Plan

Month

P LANNED S ALES

Plan

Ch. 18 Planning and Control of Sales

Product or Territory

356

Last Year Actual Actual

Plan

Over (under) Plan

Year to Date

ABC M ANUFACTURING C OMPANY C OMPARATIVE S TATEMENT OF S ALES M ONTH OF _________________ 200X

Last Year Actual Indicated Final

Plan

Total Year Over (under) Plan

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18.15 Product Pricing : Policy and Procedure

ABC M ANUFACTURING C OMPANY C OMPARISON OF C OMPANY AND I NDUSTRY S ALES

E XHIBIT 18.8

G RAPHIC C OMPARISON

OF

C OMPANY

VS . I NDUSTRY

ABC M ANUFACTURING C OMPANY P RODUCT A S ALES

E XHIBIT 18.9

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A CTUAL

AND

P LANNED S ALES ; S ALES T REND

S ALES

357

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Ch. 18 Planning and Control of Sales

ABC M ANUFACTURING C OMPANY S ALES OF P RODUCT L INES , BY M ONTHS

E XHIBIT 18.10

P ERCENTAGE

OF

S ALES

BY

P RODUCT L INES

ABC M ANUFACTURING C OMPANY S UMMARY OF O RDERS ON H AND

Description Vehicles Type A Type B Type C Type D E XHIBIT 18.11

Orders on Hand July 31, 20XX

Orders on Hand June 30, 20XX

Orders Received

Orders Canceled

Orders Delivered

Units

Sales Value ($ in thousands)

50 100 150 60

25 — 50 10

5 5 — —

10 20 5 5

60 75 195 65

120.0 262.5 838.5 97.5

R EPORT

ON

S ALES O RDER A CTIVITY

of others. It is therefore understandable that there exists a diversity of approaches to the problem. But this situation presents an equally valid reason to attempt to set out some guiding principles. (b) PRICES AND THE CONTROLLER. The accountant’s contribution to the accounting control of sales is in most cases largely after the fact. That is, comparisons of actual performance are made with budget, forecast, or standard; or sales data are analyzed to reveal unfavorable trends and relationships. In the ﬁeld of product pricing, however, the controller may be able to exert “preventive” accounting control before the occurrence by bringing facts to bear on the problem before unwise decisions are made. This activity is closely related to proﬁt planning as well as control. The inﬂuence of prices on company proﬁts is obvious, and the ﬁnest controls on costs and expenses will not succeed in producing a proﬁt if selling prices are incorrectly set. If the controller is charged with a responsibility for protecting the assets of the company, or of exercising the control function on costs and expenses or capital expenditures, then an important role should also be played in price determination.

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E XHIBIT 18.12

C OMPARISON OF

B UDGETED AND

A CTUAL S ALES

BY

B RANCH

18.15

Product Pricing: Policy and Procedure

359

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E XHIBIT 18.13

2609 2671 2685 2716 2804 2827 2982 3007 5066

32,016 17,433 19,811 24,033 8,995 27,666 4,277 39,474 43,189 216,894 $1,044,326

$ 827,432 1,760 1,390 1,320 1,470 480 1,820 600 3,800 4,400 17,040 $ 95,570*

$112,610*

Amount

Under Budget

Current Month

5.2 7.4 6.2 5.8 5.1 6.2 12.3 8.8 9.6 7.3 10.1*

15.8*

%

TO

102,600 61,080 70,100 84,390 31,600 97,010 15,020 138,400 151,800 752,000 $5,375,096

$4,623,096

Actual Sales

ABC M ANUFACTURING C OMPANY S ALESPERSON —U NDER B UDGET 5% OR M ORE —Y EAR D ISTRICT P ITTSBURGH A PRIL 20XX AND Y EAR TO D ATE

Actual Sales

BY

E XCEPTION R EPORTING —S ALESPERSON P ERFORMANCE

*Better than budget.

Performance Satisfactory: Under Budget Performance: Abernathy Bristol Caldwell Fischer Gorder Inch Long Mather Owens Subtotal District Total

Salesperson No.

S ALES A NALYSIS

Ch. 18 Planning and Control of Sales

Description

360

6,300 4,270 4,600 5,090 1,810 5,930 900 8,540 9,080 46,520 $451,310*

$497,830*

Amount

%

5.8 6.5 6.2 5.7 5.4 5.8 5.7 5.8 5.6 5.8 9.2*

12.1*

Under Budget

Year to Date

D ATE

$ 1,520 1,080 1,150 1,270 450 1,480 230 2,150 2,270 $11,600

“Lost Gross”

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C USTOMERS —E XCEPTION B ASIS

S ALES A NALYSIS

E XHIBIT 18.14

127 243 182 24 281 19 76 32 984 $225,374

839 876 11314 207 436 920 800 392

$224,390

Net Sales

Margins satisfactory Gross losses year to date: American Steel Co. Barrett Machine Corp. Benson Mfg. Co. Central Heating Co. Fagan Steel, Inc. Jones Iron Co. Luckey Bridge Corp. Oppowa Metals Co. Subtotal District total

Customer

Customer No.

94 246 189 20 307 22 70 43 991 $157,421

$156,430

Direct Costs

33 3 7 4 26 3 6 11 7 $67,953

$67,960

Amount

18.15

13 62 23 12 56 9 6 20 201 $37,100

$37,301

Amount

10.2 25.5 12.6 50.0 19.9 47.4 7.9 62.5 20.4 16.5

16.6

361

% Net Sales

Gross Margin or Loss

Product Pricing: Policy and Procedure

25.9 1.2 3.8 16.7 9.3 15.8 7.9 34.4 .7 30.2

30.3

% Net Sales

Gain or Loss over Direct Costs

ABC M ANUFACTURING C OMPANY S ALES A NALYSIS BY C USTOMER —G ROSS L OSSES O NLY D ISTRICT C ALIFORNIA Y EAR TO D ATE THROUGH J UNE 30, 20XX ( DOLLARS IN THOUSANDS )

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And just what should the function be in price determination and related accounting control? It is hoped that it will not be merely as a source of information, providing data only when requested, and even then in the form and of the content speciﬁed. In many companies, it is questionable whether the pricing ofﬁcials are fully aware of the kinds of facts required. Therefore, the controller should be expected to show some initiative and supply intelligent information from the legitimate sphere of activity. More speciﬁcally, the chief accounting ofﬁcial ordinarily can be of assistance by performing the following functions: • Help establish a pricing policy that will be consistent with the corporate objectives—for example, earning the desired return on investment. • Provide unit cost analysis, in proper form, as one factor in price setting. • Project the effect on earnings of proposed price changes and alternatives. • To the extent necessary or practicable, gather pertinent information on competitive price activity (this may be the function of the market research group or economics department in some companies). • Analyze the historical data on prices and volumes to substantiate probable trends as they may inﬂuence proposed price changes. • Determine for management, on a regular basis (such as the monthly operations report) the inﬂuence on proﬁt of changes in price, product mix, sales volume, etc.; in other words, focus attention on the price problem where such action may bring about intelligent direction. Some of these procedures are reviewed in the sections that follow. (c) COST BASIS FOR PRICING. There is a great tendency to either underrate or overrate costs as a factor in setting prices. Frequently, the statement is heard that “prices are based on competition.” Less often, the statement is made that “prices are based on costs.” There are certainly circumstances where these comments apply. Rarely, however, can costs be ignored entirely. Over any extended period, no business can consistently sell all or most products at less than cost, cost that results from production and distribution functions and the related service activities. It is further recognized as a highly desirable condition that a proﬁt be made on every product, in every territory, with every customer. Although this may not always be practicable, the closer such conditions are approached, the more certain or assured is the net proﬁt. Hence, it is apparent that adequate cost information is absolutely indispensable. In summary, costs may be viewed as the point of departure or starting place in product pricing. And the role to be played by the cost factor depends on the circumstances. If the product is built to customer order, and is not a stock item, costs will be more important. Further, if competition is weak or if the company is a price leader, cost information will play a larger part than if the opposite situations exist. Also, elasticity of demand inﬂuences the weighting of costs in that an inelastic demand probably will cause costs to be a greater factor and costs at various volume levels must be studied to maximize earnings. The question then arises, “What kinds of costs are required?” For different purposes, different types of costs may be desirable. One type of cost may be suitable for a short-range decision and quite another type for longer-term purposes. Moreover, for pricing, the usual historical cost approach may not meet the requirement. In summary, then, the controller is expected to be aware of the several costing methods and the limitations of each and to select that concept most suited to the purpose at hand. Before reviewing several alternative costing techniques, some general observations are desirable. First, prices relate to the future. Therefore, costs to be used in determining prices must be prospective. Recognition should be given to cost levels expected to prevail in the period under review. Probable raw material and labor costs should be considered. Prospective changes in process ought to be reﬂected in the cost estimates. Inﬂation must be considered, and the best available information should be obtained to recognize what future rates of inﬂation can be expected. In this forecasting or projecting, the modern

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scientiﬁc tools should be utilized to the extent practicable, such as statistical sampling, sound economic principles, simulation methods, decision analysis techniques, price level analysis. Consideration should also be given to replacement cost of the productive capacity or capital assets. Prices must provide for the future replacement of these productive assets at the projected costs. Finally, it should be obvious that all costs related to a product should be considered and not merely the cost to manufacture. It defeats the purpose if manufacturing costs are carefully calculated but selling or other expenses are applied as an overall percent without regard to the direct expense and effort speciﬁcally applicable to the product. Although many costing methods or variations are in use, there are three basic approaches that warrant discussion: 1. Total cost method 2. Marginal or direct cost method 3. Return on assets method As a prelude to reviewing costing methods, it seems desirable ﬁrst to review an example of the inﬂuence of costs on proﬁt at differing volume levels. Further, the role of competitive conditions and demand in relation to costs needs to be understood. (d) ELASTICITY OF DEMAND. In exercising judgment on prices, elasticity of demand should be given proper weighting in any cost–proﬁt–volume calculations. Normally, the pricing executives will have some general knowledge of the extent to which demand will react to changes in price. However, to provide supplemental assurance, perhaps controlled experimentation will be helpful in gauging this factor. If demand is relatively inelastic, and competitive conditions permit, then it may be possible to pass cost increases on to the customers. Under such circumstances, the controller can show the effect of cost changes on proﬁts and the desirability of effecting price changes. If demand is highly elastic, and the market is somewhat noncompetitive, unit costs can be employed to determine the optimum price with which to produce the optimum proﬁt. Under such circumstances, it is desirable to determine the sales price that will produce the greatest net proﬁt over a long period of time. Too high a proﬁt over a short term might invite competition or governmental regulation. Where conditions approach monopoly, it is perhaps of interest to review a typical procedure in setting selling prices. Basically, an estimate is secured from the sales manager about the probable number of units that can be sold at various price levels. Then the unit cost and total cost at the corresponding production level are calculated. That volume at which the greatest total proﬁt is secured can then be determined. Exhibit 18.15 illustrates the application of this procedure. Here, it is suggested that the unit selling price may be set at $12, $10, $8, $6, $4, or $2. Estimates are then made about the number of units that can be sold at each price. These are indicated by the sales line. Thus it is estimated that 1,600 units can be sold at a price of $10 per unit, whereas 4,000 units can be sold at a price of $4. Likewise, the cost line shows the estimated total unit cost (including interest on investment) at each volume level. Thus it is estimated that the unit cost will be $5 when volume reaches 2,400 units. The spread between selling price and costs constitutes the unit proﬁt that, multiplied by the number of units, gives the total proﬁt at various price levels. At a price of $10, the proﬁt will be $2 per unit, the volume 1,600 units, and the total proﬁt $3,200. At a price of $8, the total proﬁt will be $7,200. At a price of $6, the total proﬁt will be $6,400. It is apparent here that the greatest proﬁt will be made at a unit price of $8. (e) TOTAL COST METHOD. Now let us consider the three important costing techniques, the ﬁrst of which is the “total cost” or “full cost” method. Under this concept, the cost of the individual product is determined, and to this ﬁgure is added the desired proﬁt margin. Such a margin is usually expressed as a percentage of either cost or the selling price. As an example, the proposed selling price might be calculated as shown in Exhibit 18.16.

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Ch. 18 Planning and Control of Sales

$12

2 s le Sa

8

3 6

Co st

Selling Price and Unit Cost

10

5

2

4 1 2 *Denotes red 0 0

800

0

3200*

E XHIBIT 18.15

1600 2400 3200 4000 Quantity which will be taken 3200

7200 Profit

6400

4000

4800 3600*

M ETHODS OF S ETTING S ELLING P RICE C ONTROLLED M ARKET

IN A

Unit Cost and Selling Price

Cost and expenses Raw material (quantity expected purchase cost) Direct labor (hours expected hourly rate) Manufacturing overhead (150% of direct labor) Total manufacturing cost Research and development expense (10% of manufacturing cost) Selling and advertising expense (20% of manufacturing cost) General and administrative expense (10% of manufacturing overhead) Total cost Desired proﬁt margin (25% of total cost) Proposed selling price E XHIBIT 18.16

Product A

Product B

$10.00 4.00 6.00 20.00 2.00 4.00 .60 26.60 6.65 $33.25

$ 3.00 8.00 12.00 23.00 2.30 4.60 1.20 31.10 7.78 $38.88

T OTAL C OST M ETHOD

In Exhibit 18.16, costs were used as the basis for determination of the markup, as well as the charge for each of the nonmanufacturing expense levels. As an alternative, each cost element could have been calculated in relation to the proposed selling price. Thus the proﬁt margin might have been expressed in the formulas as 20 percent of the selling price, and expenses might have been treated in the same manner.

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Such a method has at least two advantages: (1) it is simple in application, and (2) it bases selling prices on all costs expected to be incurred — thus tending to assure full cost recovery, if the product sells and if the costs are generally as estimated. Over the longer run, all costs must be recovered. From the cost viewpoint, at least four disadvantages exist in using such a method exclusively: 1. It fails to distinguish between out-of-pocket costs and total costs. In the short run and with available plant capacity, there will be circumstances when business should be accepted on something less than a total cost basis. 2. It does not recognize the inability of all products to return the same rate of proﬁt. Moreover, it fails to distinguish the elements of cost creating the proﬁt, some of which cannot be expected logically to generate the same rate of income. For example, a product that is largely purchased materials may not reasonably return the same percentage of proﬁt on total cost as one constituted mainly of labor and a consequent higher relative share of factory overhead and management talent. 3. The method does not recognize the optimum proﬁt potential. The effect of elasticity in demand and the consequent point of greatest return are ignored. 4. This method of calculating tends to encourage a constant overhead application percent to the exclusion of volume factor likely to be applicable. The cost calculations can be modiﬁed to overcome the second objection. Then, too, several computations can be made to compensate partially for differing volumes. (f) MARGINAL COST METHOD. The marginal cost approach to prices gives recognition to the “incremental” or “marginal” costs of the product. These are costs directly associated with the product that would not be incurred if the product were not manufactured or sold. Any selling price received above this ﬂoor represents a contribution to ﬁxed expenses and/or proﬁt. The application of this principle to products A and B described in the full cost method might produce a picture as shown in Exhibit 18.17. In Exhibit 18.17, incremental costs have been segregated from direct expenses of a ﬁxed nature applicable to the product, and these direct costs have been identiﬁed separately from the allocated costs of a ﬁxed nature. If the product must be sold for the incremental costs or less, then the company would earn no less a proﬁt, or possibly even a higher proﬁt, by not manufacturing and selling such product. Full consideration must be given, of course, to related proﬁt results, namely, sales of other products to the customers, and so on, if the withdrawal of a given product would in fact cause loss of the other business. From the longer-range viewpoint, the minimum price to be charged would be that covering all direct costs, and for the company to continue in business over the longer term, all costs must be recouped. Unit Cost

Raw materials Direct labor Variable manufacturing expense Variable selling expense Variable administrative expense Total variable or incremental cost Fixed expense directly applicable to product Total direct costs E XHIBIT 18.17

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M ARGINAL C OST M ETHOD

Product A

Product B

$10.00 4.00 1.50 1.50 .30 17.30 2.50 $19.80

$ 3.00 8.00 2.00 1.90 .40 15.30 3.10 $18.40

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Ch. 18 Planning and Control of Sales

It can be appreciated that marginal and direct cost data — before allocated continuing costs — are of value in any one of several situations: • Where additional sales may be made at reduced prices, over and above direct costs, to another class of customer, namely, private brand business, or under another trade name and so forth. • Where idle plant capacity can be utilized only at reduced prices and in other than regular sales outlets • Under circumstances where these added sales at reduced prices do not create problems in the regular marketplace The use of marginal costs is for short-term decisions only. The great danger is the tendency to secure a larger and larger volume of sales on an incremental basis, with an ultimate deteriorating effect in the market and a large share of business that does not return its full and proper share of all costs. Furthermore, under such conditions there is no return on assets employed from the products priced at not more than total costs. (g) RETURN-ON-ASSETS-EMPLOYED METHOD. From the proﬁt viewpoint, the most desirable costing method is that which maximizes the return on total assets employed. This is the approach that has been given more attention in recent years. It is to be noted that under the two costing procedures just reviewed, no consideration has been given, for example, to the capital invested in manufacturing or sales facilities or in working capital. Yet, as discussed in Chapter 6, the real test of business efﬁciency is the rate of return on total assets employed. Growth generally takes place only when the product yields a reasonable return on the funds devoted to it. If the business objective is to maximize return on capital, then, as a starting point at least, the price of each product required to achieve the desired rate of return should be known. This method of determining markup over total costs for the desired percent return on assets rather than markup for a percent return on costs (or percent of net sales) has considerable merit in the opinion of the authors. Some of the assets employed are ﬁxed in nature, such as plant and equipment. But a share of the investment—primarily current assets—is a variable of volume and prices. For example, accounts receivable will be higher as sales volume and sales prices are higher. Investment in inventory will increase or decrease as volume changes and as manufacturing costs and raw material prices ﬂuctuate. In view of the variables, a formula may be employed to calculate the sales price required to produce a planned return on assets employed: Cost (Desired % return fixed assets) --------------------------------------------------------------------------------------------------Annual sales volume in units Unit price ---------------------------------------------------------------------------------------------------------Desired %  Variable assets expressed  1 ------------------------- ------------------------------------------------------------ return   as % of sales volume  In the formula: Cost represents total cost of manufacturing, selling, administrative, research, etc. % return represents that rate desired on assets employed (before income taxes). The ﬁxed assets represent plant and equipment, although some of the current assets might be placed in this category. The variable assets represent the current assets that are a function of volume and prices. Applying some assumptions, a unit price on product A may be calculated as: $2,660,000 (.20 $300,000) ----------------------------------------------------------------------------100,000 ----------------------------------------------------------------------------1 (.20 .30) $2,720,000/100,000 units ------------------------------------------------------------1 .06

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 27.20 - $28.936  -----------.94 The proof is computed in this manner: Income and costs Sales (100,000 units at $28.936) Costs Income before taxes Assets employed Variable (30% of $2,893,600) Fixed Total assets employed 20% Return on assets employed of $1,168,080 (fractions ignored)

$2,893,600 2,660,000 $ 233,600 $ 868,080 300,000 $1,168,080 $ 233,600

The foregoing is intended to show the method of determining unit sales prices to provide a target or planned return on investment. Although applied to a single product, the percentages used were those of the product class or group of which product A is one segment. (h) APPLYING THE RETURN-ON-ASSETS-EMPLOYED CONCEPT. The simple example just cited purposely avoided some of the controversial or problem areas in using the return-on-assetsemployed concept. Some brief observations on the subject may prove helpful. Under this procedure, total assets employed is considered to include all assets used in manufacturing and selling the product (including related services). It is immaterial how the funds were provided — whether by debt or equity. The management of a company should effectively use all assets, whether owner supplied or creditor supplied. Another question often raised is the basis of valuation of assets. Should replacement value be considered? Should ﬁxed assets be included on a gross or depreciated basis? Essentially, policies of valuation will have no appreciable effect on price determination. Recognition can be provided directly or indirectly in the rate of return objective. Consistency is the important consideration. In a multiproduct company, a problem to be solved is the allocation of capital employed to the various product lines. On reﬂection, this need not be a major stumbling block. Just as controllers have been allocating costs to products for years, so also they can allocate assets on a reasonable basis consistent with the facts of the particular business. Some suggested methods of prorating assets to product lines are: Item Cash Accounts receivable Raw material Work in process Finished goods Fixed assets

Possible Bases In ratio to total product cost In ratio to sales, adjusted for signiﬁcant differences in terms of sale In ratio to actual or expected usage In ratio to actual or expected usage In ratio to cost of manufacture In ratio to conversion costs (labor and variable manufacturing overhead) or labor hours—either actual, normal, or standard

(i) CONVERSION COSTS FOR PRICING PURPOSES. Still another economic concept useful in pricing is termed the “conversion cost theory of value.” In essence, this view holds that proﬁts are, or should be, earned commensurate with the effort and risk inherent in converting raw materials into ﬁnished products. This approach has merit, particularly in situations where relative material content varies widely by product. For example, if one product is largely an assembly of purchased

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parts and another requires extensive processing in expensive facilities, application of the same markup to each probably would result in a price too high on the assembly item and too low on the fabricated product. Differences in types of costs may therefore need to be recognized. A combined use of the return-on-assets concept and direct costs may be illustrative. Assume the following is a typical pricing and proﬁt-planning problem: • A given product line R is made up of products of varying material content. • $24,000,000 are the gross assets employed for the line. • Management desires a 20% return (before taxes) on the assets employed. • The pertinent proﬁt data are: Period (ﬁxed or continuing) expenses are $6,000,000. The proﬁt to volume or contribution margin (P/V) ratio is 30%. Direct materials and conversion expenses are, on the average, in a 4 to 3 ratio. Material turnover is twice a year. With these premises, it is necessary to calculate the following: • The sales volume needed to produce the desired rate of return • The markup to be applied on each of the direct cost factors in the product line Net sales and aggregate costs by element may be determined in this manner: Required operating proﬁt (20% of $24,000,000) Add: Continuing or period expenses Required margin over direct costs Required sales [$10,800,000 30% (P/V ratio)] Deduct: Margin Direct costs Segregated on a 4 to 3 ratio as: Direct material Conversion

$ 4,800,000 6,000,000 10,800,000 36,000,000 10,800,000 25,200,000 $14,400,000 10,800,000

$25,200,000

Inasmuch as the material turnover is two times per year, the investment is $7,200,000 ($14,400,000 2). Twenty percent of this ﬁgure is $1,440,000. Consequently, the additive factor is 10% ($1,440,000 $14,400,000), and the portion of sales revenue needed to provide a 20% return is $15,840,000 ($14,400,000 $1,440,000). The additive factor on conversion costs may be determined by the difference method as: Total required income (sales) Less: Direct material and related proﬁt additive Balance attributable to conversion factor

$36,000,000 15,840,000 $20,160,000

Thus, the conversion markup is 1.867 ($20,160,000 $10,800,000). If the direct costs of product R162 in the line are known, the target or “ideal” selling price is then determined in this fashion: Unit Direct Cost Direct material Conversion Total

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$16.10 20.30 $36.40

Factor 1.100 2.867

Unit Selling Price $17.71 58.20 $75.91

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Such proposed prices are only a starting point — they must be considered in relationship to competitive prices. The setting of product prices is complex and includes the evaluation of many variables. It is the task of the controller to provide for management’s judgment all pertinent facts. The various costing methods must be considered and the most appropriate applied in the particular company set of circumstances. In addition to the applicable costs, other factors in setting product prices to be summarized for management’s review are: • Return on invested capital or assets employed • Assets employed and turnover • Percentage of plant capacity utilized • Percentage of product line for each product • Percentage of market • Competition pricing and percentage of market • Margin over direct costs Recognizing the numerous “what-if” situations in setting prices, the controller should be familiar with the many computer models available for evaluating such business decision as price formulation. The variable inputs can be provided to the system, and when combined with the stored data, the alternatives can be quickly and easily evaluated. From a control viewpoint, a key responsibility for the controller is to participate actively in the costing and pricing function.

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CHAPTER

19

PLANNING AND CONTROL OF MARKETING EXPENSES 19.1

INTRODUCTION 371

19.2

DEFINITION 371

19.3

SIGNIFICANCE 372

19.4

FACTORS INCREASING THE DIFFICULTY OF COST CONTROL 372

19.5

SALES MANAGER AND MARKETING EXPENSES 373

19.6

BASIC APPROACH IN THE PLANNING AND CONTROL OF MARKETING EXPENSES 373

19.7

MARKETING EXPENSE ANALYSIS 373

19.8

TYPES OF ANALYSES 374 (a) Analysis by Nature of Expense 374 (b) Analysis by Functional Operations 374 (c) Analysis by Manner of Application 375 (d) Contribution Margin Approach 376 (e) Technique of Analysis by Manner of Application 377 (f) Analysis by Territory 377 (g) Analysis by Product 378 (h) Analysis by Customer 380 (i) Analysis by Size of Order 382 (j) Other Analyses 384 (k) Using Mathematical Techniques 385

(l) Interpreting the Results of Analysis 385 19.9

PLANNING MARKETING EXPENSES 386 (a) Administrative-Type Budget 386 (b) Project-Type Budget 387 (c) Variable Volume Budget 388 (d) Competitive Service Budget 392 (e) Summarized Marketing Expense Budget 392

19.10 SPECIAL COMMENTS ON ADVERTISING AND SALES PROMOTION EXPENSE 392 19.11 CONTROL OF MARKETING EXPENSES 397 19.12 MARKETING EXPENSE STANDARDS 397 (a) Standards and Control 397 (b) Can Standards Be Established for Marketing Activity? 397 (c) Types of Marketing Expense Standards 398 (d) Other Considerations in Setting Marketing expense Standards 399 (e) How to Set Marketing Expense Standards: Benchmarking 399 (f) Additional Information Needed 400 (g) Use of Standards for Control 402

19.1 INTRODUCTION The planning and control of sales are discussed in the preceding chapter. But the relationship between sales and the effort (the marketing effort) to achieve the sales plan is so close, that it is practical to now review the planning and control of marketing expenses.

19.2 DEFINITION In a broad sense, marketing expenses may be deﬁned as the costs relative to all activities from the time goods are produced/manufactured or from the time of purchase in a nonmanufacturing company until the products reach the customer — the cost of marketing or selling. This would include the 371

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Ch. 19 Planning and Control of Marketing Expenses

applicable portion of all costs, including general, administrative, and ﬁnancial expenses. For our purposes here, however, the discussion is limited to those expenses, exclusive of general, administrative, and ﬁnancial expenses, that are normally under the control of the marketing or sales executive. They may include, but are not limited to, the following general classiﬁcations: • Direct selling expense. All the direct expense of order-getting costs, including direct expenses of salespersons, sales management and supervision, branch sales ofﬁces, and sales service (the expenses generally incident to the solicitation of orders). • Advertising and sales promotion expense. All media advertising expenditures, expenses relating to various types of sales promotions, market development, and publicity. • Transportation expense. All transportation charges on outbound goods to customers and returned sales and costs of managing and maintaining the operation of outbound transportation facilities. • Warehousing and storage expense. Includes all costs of warehousing, storing, inventory handling, order-ﬁlling, packaging, and preparation for shipment. • Market research expense. The expenses of the various project studies, including the expenses of administering the department activity, undertaken to test or obtain information on the various products, markets, channels of distribution, or other distribution segments. • General distribution expense. All other expenses related to distribution functions under sales management that are not included in the foregoing items. They may include general sales management expenses, recruitment and training, and staff functions such as accounting, if applicable.

19.3 SIGNIFICANCE The costs of getting the manufactured products to the customer, consumer, or user have become increasingly more signiﬁcant in recent years. In fact, for many companies the total costs of distribution of the products are in excess of the production or procurement costs. In general, it may be stated that the manufacturing costs have been decreasing, whereas the costs of selling and distributing the product have been increasing. To some degree, the increase in selling expense that results in increased sales volume has enabled companies to achieve greater efﬁciency in the manufacturing process. In most companies, more effort has been directed toward analysis and control of production costs, and the costs of marketing have either not been available in usable form or not communicated to responsible marketing management for decision making. Executives responsible for the selling and distribution of the products must be made aware of the cost components to effectively plan and carry out a proper distribution system effort. The controller must develop the control mechanisms, secure the facts and interpret them, and communicate the information to the marketing executives. To be effective, the marketing executive must understand the accounting control information and use it in developing his marketing plans and resolving any problems that may develop. The increasing costs of marketing can be effectively controlled and even reduced if the controller works with the sales and marketing management to develop the necessary control techniques and thus obviously have a positive impact on the bottom line — net proﬁt.

19.4 FACTORS INCREASING THE DIFFICULTY OF COST CONTROL Any controller who tackles the matter of marketing expenses control will ﬁnd that the problems usually are much more complex than those relating to production costs. First, the psychological factors require more consideration. In selling, the attitude of the buyer as well as the salesman is variable, and competitive reaction cannot be overlooked. This is in sharp contrast to production where the worker is generally the only human element. Moreover, in marketing activities the methods are more ﬂexible and more numerous than in production, and several agencies or channels of distribution may be used. Such conditions make the activities more difﬁcult to standardize than production activities. Also, the constant changes or switches in method of sale or channel of distribution are factors that make it harder to secure basic information. Even when the information

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is secured, great care must be used in interpretation. Finally, the nature of the activities requires different types of costs than might be needed in production. Where the indirect or allocated costs are signiﬁcant, the analyses may require a more relative marginal or incremental cost approach under various circumstances. Such conditions create problems that may test the ingenuity of the controller.

19.5 SALES MANAGER AND MARKETING EXPENSES The sales manager is responsible for two primary functions in a business: (1) the requisite sales volume of the right products, and (2) the planning and control of marketing expenses. These may seem like two diametrically opposed objectives. However, the situation may be described as a problem of balance: If more money is spent for the distribution effort, what does the business receive in return? Usually, the sales manager will be under continuous pressure to increase sales and yet reduce selling expenses. It is obvious, then, that the sales manager must be in a position to know whether marketing expenses really are too high, and if they are too high, just where—what salesperson? what territory? what expense? The sales effort must be wisely guided, and if this is to be done the controller must provide the necessary ﬁnancial facts. The sales manager must have an intelligent analysis of distribution costs as a basis on which to work. Marketing decisions must be based on adequate knowledge.

19.6 BASIC APPROACH IN THE PLANNING AND CONTROL OF MARKETING EXPENSES The many variables already mentioned in connection with marketing costs should make it fairly obvious that the problem of control is complex and difﬁcult. In production cost control, a usual procedure is to compare actual and standard or budgeted expenses and exert continuous pressure on actual expenses until they are brought in line with the standard or budget. To an extent this can be done with respect to marketing costs, particularly those of a routine, repetitive, and nonselling nature, such as order handling or warehousing. But by and large, a more positive approach is necessary to avoid an injurious curtailment of necessary distribution services. That approach consists in securing the greatest possible effectiveness in the selling or marketing operations. As a matter of experience, any controller will ﬁnd many occasions when suggestions that selling costs be reduced will arouse resentment on the part of the sales force. But almost any sales manager will listen when the approach is that of getting more distribution effort and results for the same money. Unit selling costs can be effectively reduced by getting greater volume from the same sales force, whether by securing larger orders, more customers, or otherwise. This does not obviate the fact that there will be many instances where costs must and will be reduced, but it does emphasize the consideration necessary about the effect on sales volume of reduced marketing expenses. Since emphasis in the marketing operations is in large measure directed to securing more effective results (more earnings per dollar of distribution cost) it can be seen that much of the study and effort will be applied in a preventive way. Comparative margins and distribution costs may be used in setting future action, in changing plans to secure improved results.

19.7 MARKETING EXPENSE ANALYSIS Marketing costs are analyzed for three primary purposes: 1. Cost determination 2. Cost control 3. Planning and direction of the selling and distribution effort Perhaps the least important of these is cost determination. Yet costs must be ascertained to establish selling prices, formulate distribution policies, and prepare various operating statements. However, the most important purpose is to supply the marketing executives with the necessary information in the planning, direction, and control of the marketing effort. Sales plans must be

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Ch. 19 Planning and Control of Marketing Expenses

developed on the basis of those programs or projects that seem to offer a reasonable return. The sales effort must be directed along the most proﬁtable channels, and inefﬁciencies eliminated. The what, when, and where questions of sales direction must be answered. An analysis of marketing expenses will not provide all the answers to all the sales manager’s problems, but it can play an important part in making decisions. Therefore, since marketing cost analysis is useful in the early stages of both the planning and control of costs, it seems logical to review this function before proceeding to the detailed planning and control procedures.

19.8 TYPES OF ANALYSES There are three basic methods of analyzing marketing expenses: 1. By nature of the expense or object of expenditure 2. By functions or functional operations performed 3. By the manner of application of the distribution effort The effective direction and control of sales effort usually require all these various types of analyses if the sales manager is to be furnished with the necessary information. (a) ANALYSIS BY NATURE OF EXPENSE. Generally, the ledger accounts in even the smallest companies provide for a recording of marketing expenses by nature of expense or object of expenditure. For example, salaries, payroll taxes, supplies, rent, traveling expense, and advertising space are usually set out in separate accounts. This is often the ﬁrst, and sometimes the only, analysis made of marketing expenses. Such an analysis does provide some information for cost control purposes, general though it may be. With the type of expense segregated month by month, it is possible to follow trends and compare the expense with the previous month and with the same month last year. The ratio of the expense to net sales can also be determined. But a comparison with other periods serves to perpetuate inefﬁciency, and weaknesses will be revealed only in extreme instances. It should be clear that an analysis by nature of the expense is of limited value. The cost of marketing generally is known. Yet the controller cannot tell the sales manager the traveling expense is too high or that too much is being spent on advertising. It must be known whose selling expenses are too high and how it is known they are too high. The points of high cost must be clearly deﬁned and responsibility placed, and possibly even the solution suggested. The controller cannot expect cooperation from the sales manager or chief executive on the basis of generalities. The excess cost of speciﬁc operations or the excess cost of securing particular results must be set out if an intelligent effort is to be made in reducing the cost or improving the effectiveness of the effort. The limitation of analysis by the nature of the expense, from a control standpoint, is obvious. And since the information provided is very general, it serves little useful purpose for the direction of the sales effort. (b) ANALYSIS BY FUNCTIONAL OPERATIONS. An analysis that has been found useful, particularly for the control of marketing expenses, is that by functions or functional operations. It is of assistance in measuring the performance by individual responsibility, especially in those applications where the organization is complex or large. The approach is substantially similar to that used in analyzing production costs and may be outlined as: 1. Establish the functional operations to be measured, taking care to see that the functions are properly segregated in terms of individual responsibility. Some illustrative functional operations are: (a) Salesperson’s calls on prospects or customers (b) Shipments from warehouse (c) Circular mailing

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2. Provide for a cost segregation of these functions. In this connection the classiﬁcation should provide for those costs that are direct in regard to the function. For cost determination, perhaps cost allocations should be made. Generally, however, for cost control, emphasis must be on the direct expenses only. Thus in a small branch warehouse such expenses as the indirect labor, supervisory salaries, and fuel should be known, but these costs should be distinct from the allocated share of the regional sales ofﬁce expense. 3. Establish units of measurement of functional service to the extent practicable. For example, the pounds of shipments might be the measure of the shipping expense, or the number of salesperson’s calls might serve as one measurement of direct ﬁeld selling expense. 4. Calculate a unit cost of operation by dividing the total controllable functional cost by the number of units. 5. Take corrective action if out-of-line conditions appear. This situation may become more readily apparent if standards are established and actual performance is measured against them. It will be appreciated that this method cannot be applied to all marketing costs, but it may extend to a considerable portion. The functional approach is useful in control and also in analysis by manner of application. For example, if an analysis is being made by territories, it is necessary to record the number of functional units of the particular activity used in that territory and then simply multiply this number by the unit cost to arrive at a fair cost of the function for each territory. A speciﬁc application of the functional analysis in controlling costs is discussed in Section 19.12. (c) ANALYSIS BY MANNER OF APPLICATION. It is one thing to have an efﬁcient organization from the standpoint of performance of the individual functions and quite another thing to see that the performance is so directed and coordinated that it is productive of the most fruitful results. For example, the controller might well show the sales manager that the cost per call is very reasonable or that the cost per hundredweight of handling material in the New York warehouse is below standard. Yet the controller must go much further in his analysis. It is as important, perhaps even more important, that the controller provide information about income or results achieved in relation to the effort or cost expended. Sales effort must relate to sales possibilities, and these factors must be brought into proper balance. Analysis by manner of application is primarily for the purpose of providing information in the direction of sales effort. The income from a particular factor is being measured against the cost applied against that factor. This type of analysis indicates the distribution cost of different territories, products, customers, channels of distribution, methods of sale, or salespeople. Depending on the problem, the controller must counsel with the sales manager and decide which ones are most useful. These analyses probably will extend to various subanalyses. For example, the breakdown of territorial costs among different products distributed or expected to be distributed might be necessary. In making any analysis by manner of application, an important consideration is the proper segregation of costs. The value of the cost study will depend in large part on this factor. For this type of analysis, marketing expenses may be divided into three main groups: direct costs, semidirect costs, and indirect costs. As the name implies, direct costs are those immediately identiﬁed with a segment and need no allocation. For example, in an analysis by salesperson, the ﬁeld expense of salary, traveling expense, and entertainment incurred by that salesperson is direct. However, in an analysis by product these expenses might be semidirect or indirect. Expenses that are direct in one application are usually not in another. Ordinarily, the classiﬁcation of accounts is such that one application is direct for many of the expenses. Semidirect costs are those related in some measurable way with the particular segments under study. The variability factor responsible for the amount of the expense is known and recorded quantitatively, and the costs may be distributed in accordance with the service required. Thus, the cost factor of the warehousing function might be pounds handled. The order-handling costs might relate to the number of item lines. Stated in other terms, the basis of allocation is less arbitrary than a basis selected at random, such as net sales; and the cost results are therefore of more signiﬁ-

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cance. This might be said to be the distinction between the semidirect costs and those other common or joint costs here designated as indirect. Indirect expenses are a general charge against the business and must be allocated on a more or less arbitrary basis. No simple measure is available to identify the expense with one territory or product, as distinguished from any other. In practice this may be found to be due as much to records kept as to the nature of the expense. Common examples are institutional advertising or the salaries of general sales executives. There perhaps is little relationship between institutional advertising and the sales in the Western territory as contrasted with the Middle Atlantic territory. There might be little relationship between the costs of general sales administration and sales of product X as compared with product Y. Where it is practical for the general sales executive to keep a time record, the allocation of the expense may be less arbitrary and of more signiﬁcance. For marketing expense analysis, as for any intelligent analysis, the type of costs most suitable will depend on the purpose of the study. For long-term decisions, total costs should be known; hence allocated costs need to be identiﬁed. If, however, decisions are of limited scope and for a short period, such as the sale to a private brand customer for the next year, then perhaps only direct expenses ought to be considered. The advisability of making arbitrary allocations of indirect costs may be questioned. It is most important, however, that those who use the ﬁgures are knowledgeable about limitations. (d) CONTRIBUTION MARGIN APPROACH. In making a choice between alternative business decisions, usually some costs are unaffected regardless of the conclusions reached. For this reason, among others, it has been found practical to isolate and identify those costs that do change to the exclusion of those costs that do not. The contribution margin approach adopts this concept, although such a segregation may be made in a total cost study as well. The “contribution margin” is calculated by deducting from sales income those costs incurred in obtaining that segment of the sales income being analyzed. It may be the sales and costs of a given territory or product or customer and need not relate to the company’s entire sales of the period. These costs may be described as costs that would not be incurred if the segment being reported on were not present. Such costs are sometimes known also as “variable costs” or as “direct costs.” As costs are deﬁned in the preceding section, the costs deducted would include all direct costs, plus, in some instances, the semidirect costs. The inclusion of the latter would depend on the extent to which some of the content is ﬁxed or continuing in nature. As an example, if the bulk of warehousing expense is variable, the period expense content, such as the foreman’s salary, might be ignored. In such a case, the entire semidirect costs for the warehousing function might be included. (As a practical matter, the authors assume in all illustrations of semidirect costs that such costs relate basically to an activity factor and would be reduced generally in proportion to volume.) The costs and expenses not deducted from sales income in computing contribution margins are those not changed in the total amount by the decision under review. The contribution margin, therefore, is the contribution that the activity under question makes toward meeting the ﬁxed or continuing expenses and proﬁt. The use of such an approach does not ignore the period costs. Rather it recognizes that the separation of the common expenses in relation to the business decision at hand serves little useful purpose and emphasis should be placed on the “contribution” or provision made by the segment toward the joint expenses and proﬁt. The contribution margin approach and the related “direct costing” have these advantages: • Measurement of the immediate gain to the company’s overall proﬁt by the transaction or segment under review. • Facilitation of management’s decision because those costs to be changed are already separated from costs not affected. • Avoidance of errors and controversy that arise by reason of cost allocations and allocation methods. • Simplicity of application, since direct costs usually are identiﬁable more readily than total costs, including the necessary allocations. • Data can be secured much more quickly and with less effort.

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In practice, marginal costs are used for short-term tactical decisions and their value can be appreciated. However, over the longer term, a business must recover total costs and a reasonable proﬁt if it is to survive. Under the circumstances, there is no good reason why the total cost method and contribution margin approach cannot be used jointly. Such a statement would indicate the immediate proﬁt effect of the business decision and, by inclusion of the joint or pooled costs, can reveal the operating income picture. Management's needs and the judgment of the controller will ordinarily dictate the type of costing most adaptable. For reasons of prudence, sometimes distribution costs will be segregated on a contribution basis, whereas manufacturing costs will be shown in total. An example of such a situation would be in circumstances where top management adopts the viewpoint that a sale must always recoup all manufacturing expenses, plus, at a minimum, the direct selling expenses. (e) TECHNIQUE OF ANALYSIS BY MANNER OF APPLICATION. There has been sufﬁcient experience with marketing expense analysis by manner of application to prove the value of the technique. Although the degree of reﬁnement may vary in different companies, the general approach may be outlined as: 1. Determine which analysis (or analyses) needs to be made. Determine which might be required in a particular application, such as an analysis by method of delivery. Again, some may be recurring and others may be made only as weaknesses are indicated. 2. Classify marketing expense according to those that are direct, semidirect, and indirect. 3. Select and apply the allocation bases to the semidirect and indirect expenses. This includes a segregation and proper treatment of variable, as contrasted with ﬁxed, costs where such a segregation is a factor. 4. Prepare the analysis and commentary for the use of the proper executive. This will involve the following steps in arriving at signiﬁcant cost and proﬁt relationships: (a) Determine the gross proﬁt by segment (e.g., territory, product, size of order). (b) Accumulate the direct expense by segment, and deduct this from gross proﬁt to arrive at proﬁt after direct expense. (c) Distribute the semidirect expenses, and deduct these to arrive at proﬁt after semidirect expense. (d) Prorate the indirect expense to arrive at the ﬁnal net proﬁt (in some instances steps c and d will be combined). (e) Prepare the necessary subanalyses to pinpoint the conditions needing correction. These comments should indicate the principles and technique involved so that any controller can proceed to prepare the facts necessary in his particular situation. Comments on the need and use of certain analyses by manner of application are made hereafter. (f) ANALYSIS BY TERRITORY. A territory may be deﬁned, for this purpose, as any geographical area, whether city, trading area, county, state, or sales district, used by a company for sales planning, direction, or analysis. Where, or in which territory, goods are sold has a great effect on the net proﬁt. There are striking variations between territories in terms of sales potentials, net proﬁt, and gross margins. If goods are sold free on board (F.O.B.) a central point and at the same price, the gross proﬁt, of course, is unchanged. But if the product is sold on a delivered price basis, the gross margin is different because of transportation charges. In different areas the consumers' wants and needs are different, and this factor affects the total gross margins. Even aside from these considerations, experience has shown that the costs to sell and distribute are different in different territories. The cost to sell in densely populated New York is much different from the cost to sell in Western Texas. Because of all these dissimilar conditions, executives must have an analysis of distribution costs by territory. Such information permits the sales manager to rearrange sales effort where necessary and direct sales effort into the most proﬁtable areas. Control of marketing costs is

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Ch. 19 Planning and Control of Marketing Expenses

facilitated through this same analysis, perhaps with the aid of cost standards. Sales planning, of course, with respect to new territories and new markets is affected by distribution cost considerations. Not every concern will ﬁnd analysis by territory necessary. Such an analysis applies largely in those instances where a large geographical area is covered. Thus a manufacturer covering a national market would greatly beneﬁt from such an analysis, whereas a retail store probably would not. Exactly what type of territorial analysis needs to be made depends on the problem and type of organization. If a territorial sales executive is largely responsible for costs and results, a complete analysis by this responsibility area is desirable. Or if the problem is one of costs to sell in small towns versus cities, such a segregation is to be made. A statement of income and expense by territory is shown in Exhibit 19.1. Once the points of weakness are discovered through analysis, corrective action needs to be taken. Some of the possibilities for such are: • Reorganization of territories to permit effort more nearly in line with potentials • Rearrangement of territorial boundaries to reduce selling expense, secure better coverage, and so forth • Shifting of salespersons • Increased emphasis on neglected lines or customers in territory • Change in method of sale or channel of distribution (shift from salesperson to agent, etc.) • Changes in physical facilities (warehouses, etc.) in territory • Elimination of unproﬁtable territories (potentials of area and out-of-pocket costs vs. allocated costs considered) • Change in advertising policy or expenditure in territory (g) ANALYSIS BY PRODUCT. In our dynamic and competitive economy, the design or style or type of product a ﬁrm sells may change constantly. The tremendous strides of research, among other factors, are repeatedly bringing new products into the market. Hence, every company is sooner or later faced with the problem of what products it should sell. Will the ﬁrm sell the best or the cheapest line? Will it promote the use of a new plastic? Should it introduce a silent airplane motor? The answer to questions like these are twofold. First, through market analysis a determination must be made about what the consumers want and what price they will pay. Then, through cost analysis it must be determined whether the company can make and sell the article at a proﬁt. Therefore, an analysis by products is desirable. Many ﬁrms, in their urge to increase sales volume to better utilize facilities and personnel, often add new products to the line. Sometimes these new products “ﬁt” into the line and permit certain economies. Often, however, the different products require services in varying degree. For this reason, too, an analysis by product is necessary to determine the cost to sell, as well as the net proﬁt. Generally speaking, sales effort should be directed toward those products with the greatest net proﬁt possibilities, and cost analysis is necessary to know just which products these are. This is not to say that a company should drop a low-margin item; it may be contributing more than out-of-pocket costs, or it may be necessary for customer convenience. Furthermore, there may be little possibility of selling a high-margin item to a customer. For example, there may be no chance of selling to a paint manufacturer any quantity of a high-proﬁt glue instead of a low-margin paint vehicle. There are more factors than merely cost considerations in selling. But such conditions must be watched and held within reasonable limits. Marketing expense analyses by commodity, then, are of use in the direction of the sales effort. Many controllers may ﬁnd, in making product cost analyses, that the net proﬁt on an entire line of products is not great enough or even that losses are being sustained. When such conditions are revealed, steps are usually taken to increase that margin because the ﬁrm may not be in a position to drop an entire line. This is but another way of saying that analysis is a means of controlling costs, because the manufacturing costs or marketing costs may be too high.

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Black process 45.0° 133.0 LPI OF I NCOME AND

E XPENSE BY

2.00 20.23

15,780 $159,662

S TATEMENT

24.49 2.26 22.23

193,296 17,854 175,442

E XHIBIT 19.1

100.00 69.73 30.27 5.78

36,692 $850,000 92.8

4,200 750 670 5,620 44,380 31,066 13,314 2,219

35,359 5,000 10,650 51,009 788,991 550,127 238,864 45,568

T ERRITORY

2,000 $85,000 52.2

888 $ 9,207

11,095 1,000 10,095

$50,000

$840,000

Amount

Gross sales Less: Freight Returns Allowances Total sales deductions Net sales Cost of sales Gross proﬁt Direct selling expenses Proﬁt after direct selling expenses Semidirect expenses Proﬁt after semidirect expenses Allocated share of general expenses Proﬁt before income taxes Other Data Units sold Sales potential % of potential

% of Net Sales

Amount

Description

Total

2.00 20.75

25.00 2.25 22.75

100.00 70.00 30.00 5.00

% of Net Sales

West

17,333 $400,000 92.9

7,431 $ 98,095

113,326 7,800 105,526

13,500 1,050 3,890 18,440 371,560 241,514 130,046 16,720

$390,000

Amount

2.00 26.40

30.50 2.10 28.40

100.00 65.00 35.00 4.50

10,550 $225,000 99.4

4,473 $ 24,983

35,786 6,330 29,456

10,750 1,840 3,750 16,340 223,660 167,745 55,915 20,129

$240,000

19.8

2.00 11.17

16.00 2.83 13.17

100.00 75.00 25.00 9.00

% of Net Sales

Middle Atlantic Amount

Territory

% of Net Sales

Middle West

T HE P C OMPANY S TATEMENT OF I NCOME AND E XPENSE BY T ERRITORY F OR THE M ONTH E NDED J ANUARY 31, 20XX

379

2.00 18.33

22.15 1.82 20.33

100.00 73.50 26.50 4.35

% of Net Sales

Types of Analyses

6,809 $140,000 106.7

2,988 $ 27,377

33,089 2,724 30,365

6,909 1,360 2,340 10,609 149,391 109,802 39,589 6,500

$160,000

Amount

New England

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Ch. 19 Planning and Control of Marketing Expenses

Finally, product cost analyses are helpful in setting selling prices when the company is in a position to use costs as a major guide. Such analyses are desirable in conjunction with determining maximum price differentials to particular customers. It is probably self-evident to most controllers or accountants that a product analysis of distribution costs should be made when the characteristics of the commodity or their methods of marketing are such that a uniform basis of allocation is not indicative of the effort or cost to sell. Thus, pounds or units of sale or sales dollars may be a fair measure of selling expense. There are numerous circumstances when such an apportionment is inaccurate or misleading: • If there are differences in the time or amount of sales effort required. Thus product A that sells at $0.60 each may require about three times the effort of product V which sells at $0.30 each. Neither sales dollar nor units would be a fair basis. Perhaps one product would require a high degree of technical assistance with frequent callbacks as compared with another. Again, specialty salespeople may merchandise one product, and a general-line salesperson may handle another. All such circumstances result in different costs to sell, and should be so reﬂected in the analyses. • If there are differences in the method of sale. Obviously, if one product is sold exclusively by mail order and another by salespeople, the selling cost cannot be prorated on a sales dollar or unit basis. • If there are differences in the size of the order. When one product is sold in 10-pound lots and another is sold in tank cars, many of the distribution costs can be different. • If there are differences in channels of distribution. One product may be sold directly to retailers, whereas another is distributed through wholesalers. Here, also, there is a difference in distribution cost. The analysis by product ordinarily will reveal areas of weakness about which corrective action can be taken in some degree, such as: • Shifting emphasis of the sales effort to more proﬁtable lines or bringing effort in line with sales potential • Adjusting sales prices • Eliminating certain unproﬁtable lines, package sizes, colors, and so forth • Adding product lines related to the “family,” with consequent sharing of ﬁxed distribution expense • Changing the method of sale or channel of distribution • Changing the type, amount, and emphasis of advertising • Revising packages, design, quality, and the like A statement of income and expense that incorporates the contribution margin concept by products is shown in Exhibit 19.2. (h) ANALYSIS BY CUSTOMER. It is no secret that many manufacturers or distributors carry unproﬁtable accounts or customers. Such a condition may result from a philosophy of “get the volume,” or from insufﬁcient effort to do something about the status quo, or probably because the sales executive just does not have sufﬁcient knowledge about marketing costs. Yet it costs more to sell to some types of customers than to others and more to one customer within a type than another. Some customers require more services than others, such as warehousing, delivery, or ﬁnancing. Some customers insist on different prices, particularly where different size orders or annual purchases are factors. Again, the types of products sold to some classes differ from others. All these are reasons why analyses by customers are necessary to measure the difference in net proﬁt. Aside from use in the direction of sales effort, these analyses serve in setting prices and controlling distribution costs.

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E XHIBIT 19.2

S TATEMENT

OF I NCOME AND

Hundredweight Sold Average Sale per Call (when sold) Number of “No Sale” Calls Lack of Volume Manufacturing Costs

Other Data

Less: Sales Deductions Net Sales Variable Cost of Sales Proﬁt After Direct Mfg. Costs Direct Marketing Expense Semidirect Distribution Expense (Variable) Contribution Margin Fixed Expenses Manufacturing Marketing Total Proﬁt (or Loss) Before Income Tax

Gross Sales

Description

18.4 4.4 22.8 29.4

4,900 1,170 6,070 $ 7,815

E XPENSE BY

P RODUCT

100.0 30.5 69.5 4.7 12.6 52.2

$27,890 1,295 26,595 8,100 18,495 1,255 3,355 13,885

1,950 $348.63 20 $ 2,800

% of Net Sales

Amount

All Products

1,000 $486.67 10 $ 600

3,000 600 3,600 $ 4,100

$14,600 600 14,000 5,000 9,000 500 800 7,700

Amount

A

3.00 .60 3.60 $ 4.10

$14.60 .60 14.00 5.00 9.00 .50 .80 7.70

Per Cwt.

100 30 130 (45)

620 25 595 300 295 25 185 85

50 $124.00 3 $ 500

$

$

Amount

B

T HE B EST C OMPANY S TATEMENT OF I NCOME AND E XPENSE BY P RODUCT F OR THE M ONTH E NDED J UNE 30, 20XX

2.00 .60 2.60 $( .90)

$12.40) .50 11.90 6.00 5.90 .50 3.70 1.70

Per Cwt

Product

800 $736.00 4 $ 1,400

1,600 480 2,090 $ 3,440

$11,040 640 10,400 2,400 8,000 640 1,840 5,520

Amount

C

19.8

100 $54.33 3 $ 300

200 60 260 $ 320

$1,630 30 1,600 400 1,200 90 530 580

Amount

Types of Analyses

2.00 .60 2.60 $ 4.30

$13.80 .80 13.00 3.00 10.00 .80 2.30 6.90

Per Cwt.

D

381

2.00 .60 2.60 $ 3.20

$16.30 .30 16.00 4.00 12.00 .90 5.30 5.80

Per Cwt.

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Ch. 19 Planning and Control of Marketing Expenses

In most ﬁrms, the analyses by customers will not be continuous. Perhaps the sales manager will be interested in whether money is being made on a particular account, or changes may be contemplated only on certain groups of accounts. On these occasions special analyses can be made. Although analyses may be made by individual customers, particularly when there are a few high-volume accounts, by and large the analyses will relate to certain groups or categories. The two basic factors in selecting the classiﬁcation to be used are the amount of marketing services required, for this is the primary reason for differences in marketing costs, and the practicability of segregating the marketing costs. Classiﬁcations that have proved useful are: • Amount of annual purchases • Size of orders • Location • Frequency of salespersons' calls • Type of agent (retailer, wholesaler, or jobber) • Credit rating of customers In making an analysis by classiﬁcation of customer, one approach is to segregate all customers in the applicable group and determine total costs for each group. This may often be time consuming. Another method involves a sampling procedure, wherein representative customers in each category are selected and the cost of servicing them is determined. A modiﬁcation of this approach is to make a thoroughly detailed analysis in some areas and a sample run in other areas. It will be appreciated that relatively few marketing expense items can be charged directly to customers and that allocations must be made. Statistical data from various reports will be found necessary, namely, the number of calls made to customers or customer classes and the time spent with customers or the number of orders. Presentation of the analysis by customers may take the form of an income and expense statement as shown in Exhibit 19.3. This example classiﬁes customers according to type, but a similar analysis could be made by annual volume of sales. Occasions will arise when a decision must be made about whether the business with a speciﬁc customer should be continued or whether the method of sale ought to be changed. The use of unit analysis of individual customers, the contribution margin concept, and an alternative method of sale for small customers are illustrated in Exhibit 19.4. In this instance, changing the selling method from ﬁeld calls to a phone basis resulted in the retention of valuable business and securing a contribution margin in line with normal operating requirements. Other data may be presented in graphic form, as in Exhibit 19.5. An analysis by customers will provide information of great value to the sales manager. It will give a clear view of the number of accounts in various volume brackets and the average value of orders. In using this information for corrective action, consideration must be given to potential volume and the absorption of ﬁxed production costs. But it will furnish facts for executive discussion regarding: • Discontinuance of certain customer groups • Price adjustments • The need for higher margin for certain groups • Change in method of sale (i) ANALYSIS BY SIZE OF ORDER. Another analysis that may be made advantageously in many business concerns is that by size of orders. It has been recognized for some time that one of the causes of both high marketing expense and unproﬁtable sales is the small order — generally not because it is small in itself but because the prices arenot high enough to cover the costs and leave a proﬁt. There are many instances where small orders cannot be discontinued. But again, the problem can be solved. Corrective action can be taken; it can be brought under control. Obviously, the ﬁrst step a controller must take is to get the facts through an analysis of marketing costs by size of order.

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E XHIBIT 19.3

S TATEMENT

E XPENSE

67,700 BY

C USTOMER C LASS

5.7

100.0 80.7 19.3 9.1 10.2 4.5

$1,220,000 33,000 1,187,000 957,600 229,400 108,300 121,100 53,400 $

% of Net Sales

Amount

OF I NCOME AND

Less: Sales deductions Net sales Cost of goods sold Gross proﬁt Direct customer marketing costs Proﬁt remaining after direct costs Indirect customer marketing costs Proﬁt (or loss) after marketing costs (and before income taxes)

Gross Sales

Description

Total

42,900

$690,000 20,000 670,000 503,800 166,200 82,400 83,800 40,900

Amount

6.4

100.0 75.2 24.8 12.3 12.5 6.1

% of Net Sales

Retailers

$(

Jobbers

400)

$220,000 3,000 217,000 187,700 29,300 20,800 8,500 8,900

Amount

T HE B EST C OMPANY S TATEMENT OF I NCOME AND E XPENSE BY C USTOMER C LASS F OR THE M ONTH E NDED A PRIL 30, 20XX

(

.2)

100.0 86.5 13.5 9.6 3.9 4.1

% of Net Sales

19.8

383

8.4

100.0 88.7 11.3 1.7 9.6 1.2

% of Net Sales

Types of Analyses

$ 25,200

$310,000 10,000 300,000 266,100 33,900 5,100 28,800 3,600

Amount

Mail Order Houses

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T HE R OTH C OMPANY S ELECTED C USTOMER A NALYSIS ON A S ALES U NIT B ASIS F OR THE S IX M ONTHS E NDED J UNE 30, 20XX Proposed Centralized Phone Order Desk

By Calls of Field Force

Net sales Direct costs Manufacturing Transportation Warehousing Selling Total Contribution margin Units sold Aggregate contribution E XHIBIT 19.4

Customer W

Customer X

Customer Y

Customer Z

$10.09

$10.16

$10.13

$10.21

$10.21

8.07 .11 .02 .09 8.29 $ 1.80 1,200 $2,160

8.09 .12 .02 .10 8.33 $ 1.83 1,090 $1,995

8.08 .14 .02 .09 8.33 $ 1.80 800 $1,440

8.08 .18 .04 .22 8.52 $ 1.69 390 $ 559

8.08 .18 .04 .09 8.39 $ 1.82 390 $ 710

C USTOMER A NALYSIS

ON

Customer Z

C ONTRIBUTION M ARGIN B ASIS

The problem is naturally more important in some concerns than in others, particularly where the order-handling costs are relatively large or ﬁxed. By and large, the procedure for analyzing marketing expense by size of order is similar to that for other analyses. It involves segregating costs by factor of variability and applying the factors. In this case, certain costs will be recognized as ﬁxed for all sizes or orders, others will vary with the money volume, and still others will vary with physical volume. By way of general suggestion, the steps to be followed might be: 1. Determine the size of the order groups to be studied (e.g., below $25, $25 to $50). 2. Classify the costs according to (a) those that vary with the size of the order (e.g., packing); (b) those uniform for orders of all sizes (e.g., accounts receivable bookkeeping); and (c) those that must be considered as general overhead with no direct relation to orders (e.g., certain advertising and supervision costs). 3. Identify the factors that appear to govern the amount of the variable expense (expense that varies with the size of the order) applicable to orders of different sizes (e.g., dollar value, weight, or handling time). 4. Apply the factors of variability to the variable expenses and add the uniform costs, thereby arriving at a direct cost of orders by sizes. 5. Apply the overhead costs by some suitable factor, such as hundredweight or dollar value, to arrive at the total order cost. (j) OTHER ANALYSES. for example:

There are other analyses that may prove useful in a particular concern,

• By channel of distribution. Useful where a choice in channel of distribution may be made in order to direct sales into the most proﬁtable channel. The analysis needs to be made from time to time as cost trends change. • By method of sale. The same comments are applicable as in the case of analysis by channels of distribution.

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19.8 Types of Analyses

385

C OMPARISON OF P ROFITABLE AND U NPROFITABLE C USTOMERS N UMBER OF C ASES , N UMBER OF C USTOMERS , S ALES V OLUME , G ROSS M ARGIN AND S ELLING E XPENSE B ASED ON A NNUAL S ALES V OLUME % of Total 130

100

9%

18% 80

58% 130%

60

40

89%

88%

91%

82%

42%

20 11%

0 Profitable Customers

12%

Unprofitable Customers (Less than $200 Annual Sales)

30%

–30 Number of Calls

E XHIBIT 19.5

Number of Customers

Sales Volume

C OMPARATIVE D ATA

ON

Gross Profit

P ROFITABLE

AND

Selling Expense

Net Profit

U NPROFITABLE A CCOUNTS

• By salesperson. For the purpose of measuring the salesperson's performance in terms of proﬁt and to better direct salespeople in their activity. • By organization or operating division. Useful where there are separate and distinct selling divisions. Such an analysis is used to measure performance of the divisional executive. Examples are analyses by departments in a department store, by stores in a retail chain store company, or by branches in a manufacturing organization. (k) USING MATHEMATICAL TECHNIQUES. The analyses indicated herein are only illustrative. The many variables and alternatives in the distribution or marketing function can indeed make the task of analyzing seem overwhelming. Problems to be solved include warehouse locations, transportation routes, most economical shipment patterns, and a host of others. To perform the needed review, and to effect economies in these functions, use of mathematical formulas or “models” in conjunction with a personal computer can be most helpful. By using mathematical symbolization and techniques, the many relationships and quantities can be expressed and dealt with. (See Chapter 34.) (l) INTERPRETING THE RESULTS OF ANALYSIS. It has already been stated that the primary purpose of distribution cost analysis is to supply the marketing executives with the necessary information for the planning, direction, and control of marketing effort. The preceding section has suggested the technique and purpose or use of various analyses. It is clear, however, that these methods and studies will be varied as the controller ﬁnds necessary. The controller must be alert to the pitfalls or limitations of any ﬁgures prepared. Perhaps the problem will be attacked from several sides. In some cases only the variable marketing expenses (or even production costs) will be used, whereas in others both the ﬁxed and variable will be included.

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Ch. 19 Planning and Control of Marketing Expenses

Again, in making recommendations based on the marketing expense analysis, the decisions reached must consider every possible effect on every activity of the business. For example, the conclusion that a certain territory must be dropped must consider the net effect on proﬁt — the change in factory volume with the same ﬁxed expense and resulting differences in unit costs.

19.9 PLANNING MARKETING EXPENSES Just as sales must be planned in attempting to reach the annual proﬁt objective, so also must marketing expenses. It is usually the task of the controller or the budget director to develop the procedures for estimating the expense levels, and to provide the proper format and supporting data so that the chief marketing executive can furnish the ﬁnancial data for consolidating the annual business plan. But marketing costs differ in nature especially as to how the costs vary, or should vary, with volume and how they are best planned and controlled. Depending on industry practice and company experience, budgetary control of distribution costs may be achieved through one of these types of budgets: • Administrative • Project • Volume—variable • Competitive service (a) ADMINISTRATIVE-TYPE BUDGET. Probably the most commonly used budget for planning and controlling marketing expenses is what is described here as an “administrative-type” budget. The circumstances when this kind of planning and control device is most applicable include: • The expense level is not, and should not be, inﬂuenced by the day-to-day variations in the sales level. To be sure, expenses must bear a certain relationship to sales, but this is accomplished over a longer time span, say from year to year. • The output is not necessarily or easily quantiﬁed over very short periods, but rather over months — if then. Moreover, often the function is subjective in nature and relates to planning and controlling sales or to some other distribution effort. • The number of routine and recurring functions is limited. • Most of the expense is in the form of “people costs,” represented largely by the expense of salaries, fringe beneﬁts, occupancy, and travel and entertainment. • The function is such that it cannot be planned and controlled on a project or program basis (as discussed in the next section). Typical departments whose expenses usually are managed by an administrative budget include direct selling, ﬁeld sales ofﬁces, general and territorial or product sales management units, and possibly the order department. A typical procedure for developing an administrative-type planning budget is (see also Chapter 24): 1. The controller or budget administrator provides each marketing department manager (who will use this kind of budget) with last year's budget, and with the current head count and year-to-date expenses (by type of expense). This may be furnished through computer access or by worksheet. 2. The department manager estimates expenses for the remaining period of the current year (as in Exhibit 19.6), thus having two years of cost experience as a guide. 3. The sales executive estimates the departmental expenses by type of expenses and by month or quarter for the coming year. The sales executive takes into account the activity level expected, special tasks to be performed, general pay increases, and any other expected change in the function. Of course, the controller provides the sales executive with appropriate guidelines, such as fringe beneﬁt rates, and other needed data. If traveling expenses are

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19.9 Planning Marketing Expenses

387

T HE I LLUSTRATIVE C OMPANY A NNUAL B UDGET S ALES A DMINISTRATION D EPARTMENT ( DOLLARS IN THOUSANDS ) Current Year Prior Year

Item No. of staff Expenses Salaries and wages Fringe beneﬁt costs (40%) Travel Entertainment Communication Occupancy Supplies Depreciation Insurance Dues and subscriptions Miscellaneous Total E XHIBIT 19.6

4. 5.

6. 7.

Actual (9 mos)

Estimated (3 mos)

Total

Plan Year Total

Increase (Decrease)

6

8

8

8

10

2

$209 84 110 49 8 25 12 8 6 5 1 $517

$194 78 90 40 7 19 12 6 6 5 1 $458

$ 65 26 32 13 2 7 2 2 1 — — $150

$259 104 122 53 9 26 14 8 7 5 1 $608

$306 123 133 60 10 28 16 8 8 6 1 $699

$47 19 11 7 1 2 2 — 1 1 — $91

A DMINISTRATIVE- T YPE B UDGET

applicable, the marketing executive must estimate them, based on the number and types of trips to be made, etc. The completed estimate is forwarded by the marketing manager through organization channels for review and approval, before reaching the ﬁnancial representative. The controller or budget ofﬁcer reviews the departmental estimates for completeness and reasonableness. When the data seem in order, they are summarized for the marketing function. An administrative-type departmental marketing budget might appear as in Exhibit 19.6. When the business plan is completed and approved, the departmental executive is so informed. (Of course, there may be iterative changes.) After the planning period has commenced, the marketing executive is provided periodically (usually monthly) a comparison of actual and budgeted expenses for information and for corrective action, if warranted. (See Exhibit 19.7.)

(b) PROJECT-TYPE BUDGET. Probably the second most widely used budget in the planning and control of marketing expenses is the project type. This is so designated because many of the cost elements are best. planned on a project basis; that is, certain tasks or programs or projects are planned, then executed, and then the results are measured sometime in the future. The level of planned expense is not directly related to the immediate sales, but rather future sales over perhaps a year or two. The project is completed and the expense largely stops until another project is undertaken. The expense level bears a necessary relationship to sales, but only indirectly and over a period of time. Emphasis is on getting a certain task done within a certain time and within cost constraints. Typical activities handled largely on a project basis are advertising and sales promotion expense or market research. The budgetary procedure for a project type budget is essentially: 1. The marketing executives agree or decide what projects of a given departmental type are necessary to attain the planned sales objective or are otherwise desirable.

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Ch. 19 Planning and Control of Marketing Expenses

T HE I LLUSTRATIVE C OMPANY B UDGET R EPORT S ALES A DMINISTRATION D EPARTMENT ( DOLLARS IN THOUSANDS )

Month: June

Current Month

Item No. of staff Expenses Salaries and wages Fringe beneﬁt costs (40%) Travel Entertainment Communications Occupancy Supplies Depreciation Insurance Dues and subscriptions Miscellaneous Total

Actual

Budget

9

10

$23 10 14 4 1 3 2 .5 .7 .5 .1 $58.8

$25 10 11 5 1 3 1 .5 .7 .5 .1 $57.8

Year to Date (Over) Under Budget 1 (a) $2 — (3)(b) 1 — (1) — — — — $(1)

Actual

Budget

9

10

$138 55.2 75 29 5 14 8 4 4 3 .5 $335.7

$150 60.0 67 30 5 14 8 4 4 3 .5 $345.5

(Over) Under Budget 1 $12. 4.8 (8.0)(b) 1 — — — — — — — $ 9.8

Notes: (a) Market analyst not yet located. (b) No provision made for London trips.

E XHIBIT 19.7

B UDGET R EPORT —A S ALES D EPARTMENT

2. The department manager (e.g., advertising or market research) estimates the cost for each project by type of expense, if applicable—usually in a format suggested by the controller. In some instances, budget limits are set based on estimated unit sales, or as related to prior year expenses (e.g., advertising). 3. The various projects are summarized and included in the departmental budget for the planning period. (See Exhibit 19.8.) 4. After appropriate review and change, if necessary, the budget is approved as part of the annual plan. (In many companies the advertising budget is approved by the board of directors as a special budget.) 5. Periodically, perhaps monthly, the actual expenses and commitments are updated and compared with the project budget and corrective action taken if necessary or possible. (See Exhibit 19.9.) (c) VARIABLE VOLUME BUDGET. A limited number of distribution activities are highvolume repetitive tasks that probably can be directly related to the immediate physical volume handled. The loading and unloading of trucks, freight cars, or packaging products are examples. Giving recognition to the need to have an adequate number of workers available, even when the volume ﬂuctuates greatly, these activities can be planned, measured, and controlled much like some factory operations.) The steps involved in this type of variable budget are (see also Chapter 21): 1. For each department or activity grouping, expenses are identiﬁed by type (salaries and wages, fringe beneﬁts, supplies, etc.).

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19.9 Planning Marketing Expenses

389

T HE I LLUSTRATIVE C OMPANY , I NC . A DVERTISING AND S ALES P ROMOTION B UDGET ( DOLLARS IN THOUSANDS ) Current Year Project Budget

Category

Plan Year Requested Budget

(Increase) Decrease over Current Year

Comments

Broadcast media

Radio —local Television

$

525

$( 25)

1,300

1,400

(100)

2,500 3,800 4,300

2,625 4,025 4,550

(125) (225) (250)

400 700

420 700

( 20) —

Price increase

1,200 2,300 900 350 1,900 5,450 9,750

1,100 2,220 900 300 2,000 5,420 9,970

100 80 — 50 (100) 30 (220)

Elimination of Oregon

400 160 140 100

420 168 120 90

( 20) ( 8) 20 10

General wage increase o f 5%

All other Total administration Grand total Percentage of sales

90 890 $10,640 8.0%

90 888 $10,858 7.4%

— 2 $(218)

E XHIBIT 19.8

AND

Regional Local spots Total Total broadcast media

500

$

Price increase Price increase ($65,000) Expanded coverage 5% price increase

Print media

Local newspapers Business publications General public magazines Subtotal Catalogs Newspaper stuffers Direct mail Total print media Total media Advertising administration

Salaries and wages Fringe beneﬁts Travel Communications

A DVERTISING

No foreign trips Negotiation Pac Bell and AT&T

S ALES P ROMOTION B UDGET

2. Such expenses are segregated into their ﬁxed and variable components for the planning period. Recognition must be given to the true cost drivers, as in activity-based costing. (See Chapters 5 and 21.) 3. For the planning budget, the estimated expenses are determined for each applicable time period (monthly or quarterly) by applying the estimated units to be handled to the unit variable expense rate, and adding the ﬁxed components. (See Exhibit 19.10, which is expanded to show budget structure.) This planning budget is approved by the supervisor, when in order, and consolidated with the other distribution cost budgets to arrive at the total marketing department budget.

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E XHIBIT 19.9

$ 220 600 1,125 1,725 1,945 140 450 510 1,100 400 100 1,300 2,900 4,845 210 84 50 40 50 434 $5,279

525 1,400 2,625 4,025 4,550 420 700 1,100 2,220 900 300 2,000 5,420 9,970

420 168 120 90 90 888 $10,858 7.4%

$

60

— — — — — — $3,120

60 150 400 610 300 50 900 1,860 3,120

700 500 1,200 1,260

$

Commitments

Actual to 6/30/XX

210 84 50 40 50 434 $8,399

200 600 910 1,710 700 150 2,200 4,760 7,965

1,300 1,625 2,925 3,205

$ 280

Total

T HE I LLUSTRATIVE C OMPANY , I NC . A DVERTISING AND S ALES P ROMOTION B UDGET S TATUS R EPORT AS AT J UNE 30, 20XX ( DOLLARS IN THOUSANDS )

Expenditures

A DVERTISING B UDGET —S TATUS R EPORT

Broadcast media Radio —local Television Regional Local spots Total Total broadcast media Print media Local newspapers Business publications General public magazines Subtotal Catalogs Newspaper stuffers Direct mail Total print media Total media Advertising administration Salaries and wages Fringe beneﬁts Travel Communications All other costs Total administration Grand total Percentage of sales

Project Budget

Ch. 19 Planning and Control of Marketing Expenses

Category

390

210 84 60 50 40 444 $2,589

200 150 200 550 200 150 — 900 2,145

200 800 1,000 1,245

$ 245

Estimated Cost to Complete

1,500 2,425 3,925 4,450

525

420 168 110 90 90 878 $10,988 7.5%

400 750 1,110 2,260 900 300 2,200 5,660 10,110

$

Indicated Total Cost

— — 10 — — 10 $(130)

— (200) (240) (140)

20 ( 50) ( 10) ( 40)

(100) 200 100 100

$ —

(Over) Under Budget

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700 2,500 100 $43,190

— .70 — .07

$15,000 6,000 1,500 600 23,100 9,240 1,000 1,000 400 500 1,000 3,000 650 — — .05

.10 .30 .10 .20 .03 — .15

Variable

Fixed

8,400 30,000 1,200 $518,280

V ARIABLE V OLUME B UDGET

8,400 30,000 17,200 $1,241,160

$ 180,000 324,000 18,000 32,400 554,400 221,760 48,000 120,000 40,800 78,000 22,800 36,000 61,800

Total

8,400 30,000 1,200 $537,684

$189,000 75,600 18,900 7,560 291,060 116,424 12,000 12,000 4,800 6,000 12,000 36,000 7,800

Fixed

— — 21,000 $886,578

— $323,400 — 30,870 354,270 141,708 42,000 126,000 42,000 84,000 12,600 — 63,000

Variable

Estimated Budget—200X

8,400 30,000 22,200 $1,424,262

$ 189,000 399,000 18,900 38,430 645,330 258,132 54,000 138,000 46,800 90,000 24,600 36,000 70,800

Total

Estimated Units —200W 360,000 200X 420,000

19.9

Planning Marketing Expenses

391

4. When approved, and when the year is underway, actual costs are measured monthly against the budgeted expense (ﬁxed costs plus unit variable expense multiplied by the units handled) and corrective action taken if necessary. (See Exhibit 19.11.)

E XHIBIT 19.10

— — 18,000 $722,880

— $252,000 — 25,200 277,200 110,880 36,000 108,000 36,000 72,000 10,800 — 54,000

Variable

Est. Budget—Current Year 200X

$180,000 72,000 18,000 7,200 277,200 110,880 12,000 12,000 4,800 6,000 12,000 36,000 7,800

Fixed

Notes: Increases requested: 5% on all salaries and wages and incentive pay. No other changes.

Salaries Hourly wages Incentive pay —M Incentive pay—H Subtotal Fringe beneﬁts Supplies Gas and oil Repairs —regular Repairs—special Communications Occupancy Utilities Property taxes and insurance Depreciation Miscellaneous Total

Item

Mo. Budget Structure

A NNUAL

T HE I LLUSTRATIVE C OMPANY L OS A NGELES T ERMINAL P LANNING B UDGET FOR THE Y EAR 200X

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Ch. 19 Planning and Control of Marketing Expenses

(d) COMPETITIVE SERVICE BUDGET. In a limited number of cases, the competitive servicetype budget, or proﬁt or loss-type budget, may be useful. Basically, it can be applied when the costs of a distribution operation can be readily compared with an independent and similar service activity. Examples include building maintenance or warehousing activities. The procedure is closely related to the variable budget system just reviewed, combined with an in-house billing rate based on competitive prices. Steps in the process are: 1. The competitive price to be charged for each type of service is determined based on the area prevailing practice. 2. Expenses are accumulated on a responsibility accounting basis for the department. 3. Expenses are analyzed or identiﬁed into their ﬁxed and variable components. 4. For the planning budget, the expected unit volumes are estimated and applied to the budget structure of ﬁxed and variable elements: (a) To the competitive unit service prices to arrive at the net billings. (See Exhibit 19.12.) (b) To unit variable cost rates to arrive at the variable budget. This is added to the ﬁxed expense budget, by type of expense, to arrive at the budget level for each type of expense. (c) As to “billings,” these should be properly handled in the distribution budget consolidation (i.e., eliminated in most cases). 5. For control purposes, the unit budget times the actual volume handled, plus the budgeted ﬁxed costs, is compared to actual expense to determine budget performance. (See Exhibit 19.12.) 6. Corrective action is taken as required. (e) SUMMARIZED MARKETING EXPENSE BUDGET. When the individual department planning budgets are approved, they are summarized by the controller's staff to arrive at the tentative marketing expense budget as in Exhibit 19.13. For illustrative purposes only, this summary budget identiﬁes the supporting types of budgets in the marketing function. When the complete annual plan is approved, the chief sales executive is advised by the chief executive ofﬁcer (CEO) of the approved budget. This becomes a commitment by the CEO as to expense levels for the year.

19.10 SPECIAL COMMENTS ON ADVERTISING AND SALES PROMOTION EXPENSE In discussing marketing expenses, the example selected for a project-type budget (see Exhibit 19.8) was advertising and sales promotion expense. This expense, as well as market research expense, often is planned and controlled on a project basis. Planning and controlling advertising and sales promotion expense is the responsibility of the chief sales executive, and such expenses are included in the marketing expense budget for internal administration purposes. However, the approval process at the board-of-director level often considers this kind of expense in a separate budget review. For this reason, among others, some special comments appear appropriate. First, it may be well to deﬁne advertising as any paid form of nonpersonal presentation and promotion of ideas, goods, and services by an identiﬁed sponsor. Inherent in this and similar deﬁnitions is the fact that presentations are nonpersonal, that is, there is no face-to-face personal selling to the customer. It is a controlled, paid-for service, not free publicity. Sales promotion ims more difﬁcult to describe. It may be supplementary to either advertising or personal selling. Typically, it takes the form of a special effort, usually for a limited time only, of inducements such as price reductions, cents-off coupons, cash refunds, or contests or prizes, to induce the purchase of the goods or service. The campaign may be directed to consumers, or salespeople, or other intermediaries.

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— $26,460 — 2,646 29,106 11,642 3,600 10,800 3,600 7,200 1,080 — 5,400 — — 1,800 $74,228

700 2,500 100 $44,807

Variable

$15,750 6,300 1,575 630 24,255 9,702 1,000 1,000 400 500 1,000 3,000 650

Fixed

700 2,500 1,900 $119,035

$ 15,750 32,760 1,575 3,276 53,361 21,344 4,600 11,800 4,000 7,700 2,080 3,000 6,050

Total

March

700 2,500 1,300 $117,975

$ 15,750 32,500 1,575 3,250 53,075 21,230 4,300 12,120 4,600 7,200 2,000 3,000 5,950

Actual

— — 600 $1,060

— $ 260 — 26 286 114 300 (320) (600) 500 80 — 100

(Over) Under Budget

2,100 7,500 5,700 $357,105

$ 47,250 98,280 4,725 9,828 160,083 64,032 13,800 35,400 12,000 23,100 6,240 9,000 18,150

Budget

2,100 7,500 5,900 $354,225

$ 47,250 98,000 4,725 9,800 159,775 63,910 13,900 35,000 12,000 21,100 6,040 9,000 18,000

Actual

Year to Date

Supervisor Units Handled

E XHIBIT 19.11

V ARIABLE B UDGET C ONTROL R EPORT

19.10

— 280 — 28 308 122 (100) 400 — 2,000 200 — 150

Special Comments on Advertising and Sales Promotion Expense

393

— — (200) $2,880

$

(Over) Under Budget

Johnsen 36,000

Notes: Telephone companies have announced an 8% increase in the tariff. Since no budget was provided for such an increase, Johnsen is requesting a budget adjustment.

Salaries Hourly wages Incentive pay —M Incentive pay—H Subtotal Fringe beneﬁts (40%) Supplies Gas and oil Repairs —regular Repairs—special Communications Occupancy Utilities Property taxes and insurance Depreciation Miscellaneous Total

Item

Budget

T HE I LLUSTRATIVE C OMPANY L OS A NGELES T ERMINAL B UDGET —R EPORT — MONTH OF M ARCH

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T HE I LLUSTRATIVE C OMPANY O REGON D ISTRIBUTION C ENTER B UDGET R EPORT

Item Net billings to using activities Operating Expenses Salaries and wages Supplies Vehicle maintenance Repairs Occupancy charges Depreciation Property taxes Miscellaneous Total Operating proﬁt (or loss) E XHIBIT 19.12

Month of Units handled

January 200,000

Budget

Actual

Favorable (Unfavorable) Variance

$242,330

$201,100

$(41,230)

162,500 4,900 18,760 5,800 25,000 10,000 3,000 300 $230,260 $ 12,070

164,100 4,810 16,440 5,900 25,000 10,000 3,000 310 $229,560 $(28.460)

( 1,600) 90 2,320 ( 100) — — — ( 10) $ 700 $(40,530)

C OMPETITIVE S ERVICE B UDGET R EPORT

Second, the reasons for often separate consideration or approval by a board of directors (or internal management) include these factors: • For many companies, such as retail stores or consumer goods producers (e.g., Procter & Gamble, Kimberly-Clark, or Coca-Cola, Inc.), it is a major expenditure. • It is difﬁcult to measure the effectiveness of advertising or sales promotion programs. • Closely related to the difﬁculty of measurement is the fact that the results of the program may be less immediate and less direct than some other type of marketing effort, such as direct selling. • Finally, advertising and sales promotion effort is usually organized as a separate department or as an outside agency, as compared with other selling efforts. All of these factors are among the reasons for separate budgetary treatment. Third, the type of expenses involved here differ somewhat from other marketing expenses. A large portion will represent media costs, whether for television or radio broadcasts, for printed media (such as newspapers and/or magazines), or for direct mail costs, or other public media costs (such as outdoor advertising). Associated with the media costs are the usual administrative expenses: salaries and wages, fringe beneﬁts, travel, occupancy costs, automobile maintenance, and so on. Fourth, the purpose of advertising will vary in differing circumstances. While the general purpose is to support the broad marketing objectives, more speciﬁc goals may include: • Educate consumers in the use of the product or service. • Reduce the cost of other selling effort. • Increase sales. • Establish or maintain trademarks or brand names. • Develop new markets. • Meet or outdo competition.

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Variable Variable Variable Variable

E XHIBIT 19.13

S UMMARY M ARKETING E XPENSE B UDGET

Grand total—division

Project

Warehousing Portland Denver Chicago New Orleans Total

Administrative Administrative Administrative Administrative Administrative

Administrative Administrative Administrative

Administrative Administrative Project

Advertising and sales promotion

West Rocky Mountains Great Plains Southwest Middle West Total

Direct selling

San Francisco Chicago New Orleans Total

Branch ofﬁces

V.P. sales Customer relations Market research Total

General and administrative

Department

Type of Budget

2,960 1,840 3,480 1,710 9,990 $65,390

10,470

8,310 6,120 5,870 7,960 9,540 37,800

410 620 360 1,390

$ 3,840 780 1,120 5,740

Prior Year Actual

F OR

3,170 1,990 3,495 1,725 10,380 $67,760

10,560

9,120 6,230 6,040 8,170 9,980 39,540

415 630 365 1,410

$ 3,910 820 1,140 5,870

Total

19.10

2,220

2,270 1,550 1,510 2,020 2,470 9,820

104 158 91 353

950 205 280 1,435

2,610

2,290 1,570 1,510 2,050 2,510 9,930

103 157 91 351

990 205 290 1,485

780 500 870 430 2,580 $16,956

$

2

Quarter

Plan Year

810 510 865 460 2,645 $16,641

2,140

2,310 1,590 1,530 2,070 2,500 10,000

105 159 92 356

$ 1,010 205 285 1,500

3

3,590

2,250 1,520 1,490 2,030 2,500 9,790

103 156 91 350

960 205 285 1,450

790 500 900 415 2,605 $17,785

$

4

5 10 5 20

70 40 20 130

395

210 150 15 15 390 $2,370

90

810 110 170 210 440 1,740

$

Annual Budget (Increase) Decrease

Special Comments on Advertising and Sales Promotion Expense

790 480 860 420 2,550 $16,378

$

1

T HE J OHNSON C OMPANY , I NC . S UMMARY M ARKETING D IVISION B UDGET THE P LAN Y EAR E NDING D ECEMBER 31, 20XX ( DOLLARS IN THOUSANDS )

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• Maintain prices. • Introduce new products or services. • Create favorable public opinion. • Avoid unfavorable legislation. Fifth, two basic ways are currently in use of establishing an advertising and sales promotion budget: the lump-sum appropriation method estimating the amount required to attain certain objectives. Comments on each follow. The simple lump-sum appropriation method consists of authorizing the expenditure for advertising and sales promotions related to some factor. Under this plan the total amount to be spent could be based on: • A percentage of planned or budgeted sales • A percentage of the prior year sales or perhaps of an average of several past years • A ﬁxed amount per unit of product expected to be sold (the units are obtained from the sales plan) • An arbitrary percentage increase over the prior year's expenditure • A percent of gross proﬁt on the product for the prior year or the planning year • A percentage of net income of the prior year or the planning year The advantage of the lump-sum appropriation method is sheer simplicity. Basically it seems to lack any scientiﬁc basis, although there may be a perceived long-term relationship between advertising expenditures and level of sales. The estimated “cost of attaining the objective” procedure seems a more logical process: Objectives are set; the detailed steps to reach the objective are decided upon; the relevant costs for each such program are estimated and are summarized to arrive at the total cost for the planning year. This estimating process may be performed by the advertising department, perhaps assisted by an outside advertising agency, or sometimes it is done by the agency itself. Obviously, a skilled ﬁnancial analyst should review such costs for any evidence of waste. Moreover, in some cases the marginal or gross proﬁt from the additional units estimated to be sold can be compared with the advertising expense to determine if the project seems to make ﬁnancial sense. This can be done on an incremental advertising expense and quantity basis to ascertain at which point, if any, the incremental unit advertising cost exceeds the incremental marginal proﬁt all direct expenses.

Incremental Block 1 2 3 4 5 6 7 8 9

Incremental Advertising Expense $ –0– 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000

Additional Units Estimated to Be Sold 20,000 30,000 70,000 50,000 50,000 30,000 30,000 20,000 10,000

Estimated Marginal Unit Income* $1.00 1.20 1.30 .90 .80 .70 .60 .50 .40

Incremental Unit Advertising Cost $ — .83 .36 .50 .50 .83 .83 1.25 2.50

Unit Increment or (Decrement) Margin (1.00) .37 .94 .40 .30 ( .13) ( .23) ( .75) (2.10)

Total Margin $ 20,000 11,100 65,800 20,000 15,000 ( 3,900) ( 6,900) (15,000) (21,000)

*After all direct costs and before advertising cost.

E XHIBIT 19.14

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I NCREMENTAL A DVERTISING E XPENSE C OMPARED

TO I NCREMENTAL

P ROFIT M ARGIN

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397

A simple example is shown in the matrix illustrated in Exhibit 19.14. If these estimates are valid, then not more than $100,000 (incremental block 5) should be spent in advertising Product 10. Financial analysis would sometimes identify some possibly uneconomic programs. It is beyond the scope of this section to review the many facets of advertising and sales promotion that might interest the controller or staff in attempting to ﬁnancially appraise the advertising and sales promotion budget. Books on advertising and sales promotion are worth perusing for more detailed information.

19.11 CONTROL OF MARKETING EXPENSES As already explained, the budgetary control process involves comparing the actual expenses with the budgeted expenses (or the budgeted rates time the actual volume handled for variable expenses) and taking corrective action. Where budgets are not used, actual expenses may be compared with the unit standards and actual unit volumes, as reviewed in the next section.

19.12 MARKETING EXPENSE STANDARDS (a) STANDARDS AND CONTROL. The very foundation of marketing cost control lies in the correlation of sales effort with the potential and the use of analysis to avoid misdirection. Although this may be done, and although the income and expense statement may reveal a satisfactory result for a time, still this is not enough. It must be known that the business is being operated efﬁciently, and this requires measuring sticks — standards. A complete analysis of past operations must be taken as a starting point. By this it may be determined that 1,000 calls have been made by salespeople in a given territory, at a cost of $5 per call, and with certain sales results. But the questions are left unanswered about how many calls should have been made by the salespeople and what the cost per call should have been. These also must be ascertained if effective control of sales effort is to be exercised. It may be known that 1,000 orders have been handled at a clerical cost of $0.50 per order, but it needs to be known also what the cost would have been if the clerical work had been efﬁciently directed. In brief, standards are needed by which to judge the distribution performance and signal its weaknesses. Knowing in detail what it has been is not enough; it needs also to be known in detail what it should be in the immediate future. (b) CAN STANDARDS BE ESTABLISHED FOR MARKETING ACTIVITY? It would be foolish to contend that all distribution activity can be highly standardized. In fact, it is never possible completely to standardize production activities. The answer to just exactly what results should be obtained from a dollar expended for advertising or direct sales effort when developing a new territory or a new product or just what costs will be necessary to accomplish certain deﬁnite ends pertaining to customer goodwill is frequently problematic. But it would be equally foolish, and a fatal management error, to evade the fact that standards can be successfully applied to a vast amount of the distribution activity. If no one is competent to judge what distribution effort is necessary to secure certain results and what it will cost to do it, then management must indeed be in a helpless position. Although a new venture may be undertaken here and there on something of an experimental basis, the entire distribution effort will scarcely be directed along such lines continuously. It is hardly to be expected that an intelligent executive will direct $1 million into the distribution effort in the vain hope that proﬁt will result at the end of the year. Rather the executive may be expected to provide for the continuous measurement of individual and group performance as expressed in costs and results. Knowledge is needed of when billing clerks are wasting time, when automotive equipment is too costly, when direct mail prices fail to “pull,” when bad debt losses are excessive, when warehouse labor hours are too high, when long-distance telephone costs are exorbitant, and

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when salespeople produce insufﬁcient orders. If these costs and performance factors are not under constant control, the executive's proﬁt goal is almost certain to be unmet. But such control implies standards and depends entirely on the establishment and use of standards. Warehouse labor hours never appear too high in the absolute. They become too high only when measured against what they should be under the circumstances—only when a standard is applied. Although it must be admitted that it is difﬁcult to establish standards for some marketing activities; that psychological factors are relatively more, and physical and mechanical factors relatively less, inﬂuential than in production; that relatively more depends on the judgment of executives and relatively less on objective measurements; and that a somewhat greater tolerance must be allowed in the consideration of variances, it should be understood that this applies only to a part of the marketing activity. Much of the marketing activity is fully as measurable as production. There is no important difference, for example, between the method of establishing standards for order handling, warehousing, shipping, delivery, and clerical work and the methods employed in production. Even those distribution activities that are largely affected by psychological factors, such as advertising and personal selling, are usually capable of reasonably accurate measurement when the activities are continuous or repetitive. The types of standards needed, as well as the techniques used for their establishment, change as circumstances change, such as increased globalization. Whereas at one time much attention was focused on internal unit cost standards and unit revenue standards, now other facets are involved. While internal comparisons of internal trends and relationships are still made, there is a movement to measure against external standards. Moreover, some standards are now time related, such as the time required to develop a new product. Standards might relate to customer satisfaction, such as number of prospects converted to customer status. Some of the newer standards, some of which are applicable to marketing efforts, are reviewed in Chapter 17. (c) TYPES OF MARKETING EXPENSE STANDARDS. Marketing expense standards may be either (1) of a very general nature, and applicable to distribution functions as a whole, or by major divisions, or (2) units that measure individual performance. Illustrative of the former are: • Selling cost as a percentage of net sales • Cost per dollar of gross proﬁt • Cost per unit sold • Cost per sales transaction • Cost per order received • Cost per customer account Standards such as these are useful indicators of trends for the entire distribution effort. Furthermore, such standards can be applied to individual products, territories, branches, or departments. However, these general standards do not necessarily indicate points of weaknesses in terms of individual responsibility. If costs are to be controlled, the performance of the individual must be measured. Hence it is necessary to set standards for controllable costs of individual cost items or functions. In warehousing, for example, standards might be set for direct labor as: • Cost per item handled • Cost per pound handled • Cost per shipment • Cost per order ﬁlled Similar standards might be set for shipping supplies or delivery and truck expense. In the direct sales ﬁeld, standards might be set for a salesperson's automobile expense in terms of the following: • Cost per mile traveled • Cost per day • Cost per month

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399

Again, entertainment expense standards might relate to cost per customer or cost per dollar of net sales. (d) OTHER CONSIDERATIONS IN SETTING MARKETING EXPENSE STANDARDS. The controller has a joint responsibility with the sales executives in setting marketing expense standards. In fulﬁlling this responsibility, it is well to keep in mind the complications. For example, in manufacturing there is usually only one standard cost for the product. There are, however, many standard costs for distribution of the same article. Thus, the cost per call may be different in every territory or sales district. Even in the same territory the standard cost to sell to different classes of customers may vary. By and large, the same principles applicable to manufacturing expense standards apply to distribution costs. Thus, standards will require revision when operating conditions change materially. Also, where ﬁxed elements of cost are included in the standards, the effect of volume must be recognized. (e) HOW TO SET MARKETING EXPENSE STANDARDS: BENCHMARKING. The methods of establishing standards vary depending on whether external or only internal standards are the objective. A procedure of measuring products, or services, or business practice against the toughest competitor, or the companies best in their class, or other measures — benchmarking — is discussed in Section 17.9. Another method that may be somewhat more internally oriented, but also involves an analytical approach is reviewed next. When the need for standards has been agreed to with the sales executive, the detailed work of setting standards can proceed. The ﬁrst step in setting the marketing expense standards is to classify the costs according to functions and activities expressive of individual responsibility. How far such classiﬁcation can and should be carried depends, of course, on the nature of the business, its size, methods of operation, and internal organization. The cost of such major functions as direct selling, advertising, transportation, warehousing, credit and collection, and ﬁnancing can be separated in most businesses and subjected to individual study and control. Even such a general classiﬁcation as this is not universal. For example, in a concern doing a house-to-house business, the functions of direct selling and credit and collection are merged, since the work is done by the same people under the same supervision. The costs of the major functions should be further classiﬁed by individual activities that make up the functional service. For example, the credit and collection costs may be separated into credit approvals, posting charges, posting credits, preparing customers' monthly statements, writing collection letters, and so on. The second step is to select units or bases of measurement through which the standards can be expressed. Such units or bases will vary with the type of measurement to be applied; thus the measurement may apply to effort used, to cost, to results achieved, or to the relationship of these factors. To illustrate, a salesperson may be expected to make a given number of calls per day. This constitutes a measure of effort used and the unit of measure is the call. The cost of writing orders in the order department may be measured in terms of the number of orders or order lines1 written. This is a measure of costs, and the unit of measurement is the order or order line. Salespeople may each be expected to produce a certain number of orders or to secure a certain number of new accounts. This is a measure of results, and the units of measurement are orders and new accounts. Finally, salespeople may be required to hold their direct costs within 8 percent of their sales volume. Here, the measurement is in terms of the relationship of particular costs to the results in the sales volumes and the basis of measurement is the ratio of one to the other.

1 Order line here means the writing of one line on a sales order (e.g., “200 1/2” Malleable Iron Nipples No. 682 at $8.00 = $16.00).

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Although such speciﬁc units of measurement are not available for all distribution activities, some basis must be selected before the standards can be applied. Where speciﬁc units are not available, more inclusive or composite bases must be used. For example, the entire credit and collection cost may be measured by the number of accounts carried, or the entire advertising cost may be measured by its ratio to dollar sales volume. The third step is to analyze past experience relative to the cost of the functions and speciﬁc activities involved with a view to selecting the best experience and indications about the best procedure. This may involve intensive study of individual methods of procedure and operation similar to that employed in the development of production standards. The fourth step is to consider the effect on costs of expected changes in external conditions and of the sales program as planned. If increased sales resistance is expected, an estimate must be made about its effect on such costs as advertising and direct selling. If the program calls for a lengthening of the installment credit period, the effect on the ﬁnancing cost must be estimated. The ﬁnal step is to summarize the judgment of those executives, division heads, department heads, and salespersons whose experience and training qualify them to judge the measures of satisfactory performance. The standards set must be the ﬁnal expression of such judgment, based on an intelligent study of past experience and future outlook. Standards as ﬁnally set will result in much overlapping. Thus a standard cost may be applied to the warehousing function as a whole. Within this general function, many individual cost standards may be applied that relate to speciﬁc activities such as clerical costs of order handling and physical assembling. Finally, different standards must frequently be set for different territories, products, channels of distribution, classes of customers, departments, and so forth, wherein different conditions prevail. (f) ADDITIONAL INFORMATION NEEDED. To establish and use marketing expense standards successfully, a concern must accumulate and have available a considerable amount of information relative to marketing activities and the cost factors pertaining to such activities. This includes a considerable body of information not available in the regular accounting records. Permanent records must be designed for regularly recording and accumulating these data in readily usable form. Just as it is now the custom to record regularly such production factors as labor hours, chargeable hours, idle hours, machine hours, power loads, and number of operations, records must likewise be made of the marketing factors. Illustrative of such data are: • Analyses of sales in physical units • Number of sales transactions classiﬁed in terms of size, hour of day, and so on • Number of quotations made • Number of orders classiﬁed in terms of size, period in which received, and the like • Number of order lines written • Average number of salespersons • Number of salesperson days • Number of calls on old and new customers • Number of days of salespersons' travel • Number of miles of salespersons' travel • Average number of customers classiﬁed with regard to location, annual volume, and so forth • Number of labor hours of salespeople advertising and display people, warehouse workers, truck drivers, delivery people, maintenance workers, clerical workers, and so on • Number of returns and allowances classiﬁed in terms of cause • Number of units of advertising space or time used in the various advertising media • Number of advertising pieces mailed: letters, circulars, folders, calendars, and so on

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401

• Number of pieces of advertising material distributed: window cards, store displays, inserts, and the like • Number of samples distributed • Number of demonstrations made • Number of inquiries received • Number of new customers secured • Number of shipments • Analyses of shipments in physical units • Dollar value of shipments • Number of ton-mile units of shipping • Number of deliveries • Number of parcels delivered • Number of miles of truck operation • Number of shipping claims handled • Physical volume of goods handled in warehouses • Average size of physical inventory carried • Rates of turnover in dollars and physical units • Average number of accounts carried • Number of invoices • Number of invoice lines • Number of remittances received • Number of credit letters sent • Average number of days accounts are outstanding • Average amount of receivables carried • Number of mail pieces handled • Number of postings • Number of letters written — distribution sections • Number of units ﬁled • Percentage of sales from new products • Percentage of on-time customer deliveries • Number of customers for which company is sole supplier Many of the foregoing items must be further classiﬁed by territories, commodities, and departments to supply the full information needed. Such information will be found useful for many purposes in the direction of distribution activity but is essential to a program of standards. Many concerns have in the past neglected to accumulate and use such information. It is not uncommon to ﬁnd a concern that has the most exacting records of a production machine (the date of its purchase, full detail about its cost, working hours, number and cause of idle hours, and cost of maintenance) almost to the point of a complete diary of the machine's daily routine over a long period of years. During the same time, the concern may have been employing a salesperson whose total cost through the years has greatly exceeded the cost and maintenance of the machine, but little detailed record of activities has been kept. How the salesperson has spent time, the number of calls made, the number of prospects interviewed, orders received, gross proﬁt, and even the type of goods sold has not always been recorded. The salesperson's activity report can provide some of these data. With many concerns the distribution information is entirely too meager. More information must be collected if the distribution program is to be wisely directed.

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(g) USE OF STANDARDS FOR CONTROL. The essence of control is the prompt follow-up of unfavorable trends before they develop into large losses. Once the standards are determined, the stage is set for action. The controller compares actual and standard performance and reports the results to the sales executive.

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CHAPTER

20

PLANNING AND CONTROL OF MANUFACTURING COSTS: DIRECT MATERIAL AND DIRECT LABOR 20.1

GENERAL ASPECTS OF MANUFACTURING 403 (a) Responsibilities of the Manufacturing Executive 403 (b) Objectives of Manufacturing Cost Accounting 404 (c) Controller and Manufacturing Management Problems 405 (d) Types of Manufacturing Cost Analyses 406 (e) Types of Cost Systems 407 (f) Factory Accounts and General Accounts 407

20.2

(h) Using Quantity Standards for Cost Control 412 (i) Limited Usefulness of Material Price Standards 414 (j) Setting Material Price Standards 414 (k) Other Applications of Material Control 414 20.3

DIRECT MATERIAL COSTS: PLANNING AND CONTROL 408 (a) Scope of Direct Material Involvement 408 (b) Beneﬁts from Proper Material Planning and Control 408 (c) Deﬁning and Measuring Direct Material Costs 408 (d) Planning for Direct Material 409 (e) Basic Approach to Direct Material Cost Control 411 (f) Setting Material Quantity Standards 412 (g) Revision of Material Quantity Standards 412

LABOR COSTS: PLANNING AND CONTROL 416 (a) Labor Accounting under Private Enterprise 416 (b) Classiﬁcation of Labor Costs 416 (c) Expanded Deﬁnition of Direct Labor 416 (d) Planning of Labor Costs 417 (e) Controller’s Contribution to Control 417 (f) Setting Labor Performance Standards 418 (g) Revision of Labor Performance Standards 419 (h) Operating under Performance Standards 419 (i) Use of Labor Rate Standards 420 (j) Control through Preplanning 420 (k) Labor Accounting and Statutory Requirements 422 (l) Wage Incentive Plans: Relationship to Cost Standards 422

20.1 GENERAL ASPECTS OF MANUFACTURING (a) RESPONSIBILITIES OF THE MANUFACTURING EXECUTIVE. To those not familiar with the intricacies of the modern manufacturing processes, it might seem that once a determination has been made of the products to be manufactured and sold, and of the quantities required, then the remaining task is simple: proceed to manufacture the articles. As compared with the task of the sales executive, many of the variables in manufacturing are more subject to the control of the executive than they are in selling, many are more easily measured, and the psychological factors may be less 403

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Ch. 20 Planning and Control of Manufacturing Costs: Direct Material and Direct Labor

pronounced. But the job is by no means an easy one, and many difﬁculties plague the manufacturing manager who is attempting to deliver a quality product, within cost, and on schedule. Consider some of the numerous decisions the manufacturing executive is called upon to make— in many of which the controller is not involved at all, others with which he may be only tangentially concerned, and yet others where he may be, or should be, of assistance to the production executive. While any number of classiﬁcations may be used, these groupings of the duties seem practical: • Physical Facilities Acquisition of plant and equipment Proper layout of machinery and equipment, storage facilities, and so on Adequate maintenance of plant and equipment Proper safeguarding of the physical assets (security)

• Product and Production Planning Product design Decisions on product speciﬁcations Determination of material requirements — speciﬁcations and quantities Selection of manufacturing processes Planning the production schedule Decisions on manufacturing or purchasing the components—“make-or-buy” decisions Material purchases Labor-requirements—skill needs, employment, training, and job assignment and transfer Inventory levels required Preparing the production and manufacturing plans—short and long term

• Manufacturing Process Planning and controlling labor Receiving, handling, routing, and processing raw materials and work-in-process in an eco-

nomical manner Controlling quality Coordinating manufacturing with sales Planning and controlling all manufacturing costs—direct and indirect

And the list could go on. For some phases, the controller may coordinate procedures and see that adequate internal controls exist, that needed economic analysis is made, as in acquisition of plant and equipment or as part of the annual planning process. But perhaps the biggest contribution of the controller is the development and maintenance of a general accounting and cost system that will assist the manufacturing executive, and that will provide the necessary information for the planning and control of the business. (b) OBJECTIVES OF MANUFACTURING COST ACCOUNTING. A manufacturing cost accounting system is an integral part of the total management information system. In analyzing costing systems for control, the controller must recognize the purpose of the manufacturing cost accounting system and relate it to the production or operating management problems. The objectives must be clearly deﬁned if the system is to be effectively utilized. There are four fundamental purposes of a cost system that may vary in importance from one organization to another: 1. Control of costs 2. Planning and performance measurement

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405

3. Inventory valuation 4. Deriving anticipated prices Control of costs is a primary function of manufacturing cost accounting and cost analysis. The major elements of costs — labor, material, and manufacturing expenses — must be segregated by product, by type of cost, and by responsibility. For example, the actual number of parts used in the assembly of an airplane section, such as a wing, may be compared to the bill of materials and corrective action taken when appropriate. Closely related to cost control is the use of cost data for effective planning and performance measurement. Some of the same information used for cost control purposes may be used for the planning of manufacturing operations. For example, the standards used for cost control of manufacturing expenses can be used to plan these expenses for future periods with due consideration to past experience relative to the established standards. Cost analysis can be utilized, as part of the planning process, to determine the probable effect of different courses of action. Again, a comparison of manufacturing costs versus purchasing a particular part or component can be made in making the determination in make-or-buy decisions. The use of costs and analysis would extend to many facets of the total planning process. One of the key objectives of a costing system is the determination of product unit cost and the valuation of inventories. This is also a prerequisite to an accurate determination of the cost of goods sold in the statement of income and expense. The manufacturing cost system should recognize this fact and include sufﬁcient cost details, such as layering part costs and quantities for items in inventory, to accomplish this purpose. A critical purpose of cost data is for establishing selling prices. The manufactured cost of a product is not necessarily the sole determinant in setting prices, since the desired gross margin and the price acceptable to the market are also signiﬁcant factors. As more companies realize that direct labor and materials are relatively ﬁxed costs, management will concentrate on designing the product to ﬁt a speciﬁc price, cost, and gross margin; the controller should be included in this process to advise management about indirect and direct costs. (c) CONTROLLER AND MANUFACTURING MANAGEMENT PROBLEMS. A fundamental responsibility of the controller is to ensure that the manufacturing cost systems have been established to serve the needs and requirements of production executives. The controller is the fact ﬁnder regarding costs and is responsible for furnishing factory management with sufﬁcient cost information on a timely basis and in a proper format to effect proper control and planning. Unfortunately, under a just-in-time (JIT) system, manufacturing managers need feedback regarding costs far more frequently than on a monthly basis. JIT products are manufactured with little or no wait time, and consequently can be produced in periods far less than was the case under the line manufacturing concept. Therefore, if a cost problem occurred, such as too many direct labor hours required to ﬁnish a part, the formal accounting system would not tell the line managers until well after the problem had happened. Fortunately, JIT principles stress the need to shrink inventories and streamline processes, thereby making manufacturing problems highly visible without any product costing reports. A subset of JIT is cellular (i.e., group) manufacturing, in which equipment is generally arranged in a horseshoe shape, and one employee uses those machines to make one part, taking the piece from machine to machine. Consequently, there is little or no work-in-process (WIP) to track, and any scrapped parts are immediately visible to management. Based on this kind of manufacturing concept, line managers can do without reports, with the exception of daily production quantities versus budgeted quantities that meet quality standards. Just-in-time manufacturing places the controller in the unique position of looking for something to report on. Since direct labor and materials costs are now largely ﬁxed, the controller’s time emphasis should switch to planning the costs of new products, and tracking planned costs versus actual costs. Because the JIT manufacturing environment tends to have small cost variances, the controller should seriously question the amount of effort to be invested in tracking direct labor and materials variances versus the beneﬁt of collecting the data.

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Another area in which the controller can proﬁtably invest time tracking information is the number of items that increase a product’s cycle time or the non–value-added cost of producing a product. Management can then work to reduce the frequency of these items, thereby reducing the costs associated with them. Here is a partial list of such items: • Number of material moves • Number of part numbers used by the company • Number of setups required to build a product • Number of products sold by the company, including the number of options offered • Number of product distribution locations used • Number of engineering change notices • Number of parts reworked If a process is value-added, the controller can initiate an operational audit to ﬁnd any bottlenecks in the process, thereby improving the capacity of the process. For example, engineering a custom product is clearly value-added; internal auditors could recommend new hardware or software for designing the product to allow the engineering department to design twice as many products with the same number of staff. Under JIT, there are several traditional performance measures that the controller should be careful not to report: • If the report is on machine efﬁciency, then line managers will have an incentive to create an excessive amount of WIP in order to keep their machines running at maximum utilization. • If the report is on purchase price variances, the materials staff will have an incentive to purchase large quantities of raw materials in order to get volume discounts. • If the report is on headcount, the manufacturing manager will have an incentive to hire untrained contract workers, who may produce more scrap than full-time, better-trained employees. • If you include a scrap factor into a product’s standard cost, then line managers will take no corrective action unless scrap exceeds the budgeted level, thereby incorporating scrap into the production process. • If the report is on labor variances, then the accountants will expend considerable labor in an area that has relatively ﬁxed costs and not put time into areas that require more analysis. • If the report is on standard cost overhead absorption, then management will have an incentive to overproduce to absorb more overhead than was actually expended, thereby increasing proﬁts, increasing inventory, and reducing available cash. (d) TYPES OF MANUFACTURING COST ANALYSES. The question will arise often about what type of cost data should be presented. Just how should production costs be analyzed? This will depend on the purpose for which the costs are to be used, as well as the cost experience of those who use the information. Unit costs or total costs may be accumulated in an inﬁnite variety of ways. The primary segregation may be by any one of the following: Product or class of product Operation Department Machine or machine center

Process Customer order Worker responsible Cost element

Each of the primary segregations may be subdivided a number of ways. For example, the out-of-pocket costs may be separated from the “continuing costs,” those that would be incurred whether a particular order or run was made. Again, production costs might be segregated between those which are direct or indirect; that is, those attributable directly to the operation and those prorated. Thus the material used to fashion a cup might be direct, whereas the power used to operate

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the press would be indirect. Sometimes the analysis of costs will differentiate between those that vary with production volume and those which are constant within the range of production usually experienced. For example, the direct labor consumed may relate directly to volume, whereas depreciation remains unchanged. The controller must use judgment and experience in deciding what type of analysis is necessary to present the essential facts. The mix of product-cost components has shifted away from direct labor and material dominance to overhead (such as depreciation, materials management, and engineering time). Overhead takes up a greater proportion of a typical product’s cost. Because of this change in mix, the controller will ﬁnd that product cost analyses will depend heavily on how to assign overhead costs to a product. Activity-based costing (ABC) is of considerable use in this area. For more information about ABC, refer to Chapter 21. (e) TYPES OF COST SYSTEMS. Experience in cost determination in various industries and speciﬁc companies has given rise to several types of cost systems that best suit the kinds of manufacturing activities. A traditional costing system known as a “job order cost system” is normally used for manufacturing products to a speciﬁc customer order or unique product. For example, the assembly or fabrication operations of a particular job or contract are collected in a separate job order number. Another widely used costing system is known as a “process cost system.” This system assigns costs to a cost center rather than to a particular job. All the production costs of a department are collected, and the departmental cost per unit is determined by dividing the total departmental costs by the number of units processed through the department. Process cost systems are more commonly used in food processing, oil reﬁning, ﬂour milling, paint manufacturing, and so forth. No two cost accounting systems are identical. There are many factors that determine the kind of system to use, such as product mix, plant location, product diversity, number of speciﬁc customer orders, and complexity of the manufacturing process. It may be advisable to combine certain characteristics of both types of systems in certain situations. For example, in a steel mill the primary system may be a process cost system; however, minor activities such as maintenance may be on a job cost basis. The controller should thoroughly analyze all operations to determine the system that best satisﬁes all needs. There are two issues currently affecting the job order and process costing systems of which the controller should be aware: 1. JIT manufacturing systems allow the controller to reduce or eliminate the recordkeeping needed for job cost reporting. Since JIT tends to eliminate variances on the shop ﬂoor by eliminating the WIP that used to mask problems, there are few cost variances for the cost accountant to accumulate in a job cost report. Therefore, the time needed to accumulate information for job costing may no longer be worth the increase in accuracy derived from it, and the controller should consider using the initial planned job cost as the actual job cost. 2. One of the primary differences between process and job-shop costing systems is the presence (job shop) or absence (process ﬂow) of WIP. Since installing a JIT manufacturing system inherently implies reducing or eliminating WIP, a JIT job-shop costing system may not vary that much from a process costing system. (f) FACTORY ACCOUNTS AND GENERAL ACCOUNTS. The selection of the manufacturing cost accounting system should recognize the relationship of the factory cost accounts to the general accounts. Normally, the factory accounts should be tied into the general accounts for control purposes. It should enhance the accuracy of the cost information included in the top-level manufacturing cost reports as well as the proﬁt or loss statements and balance sheet. Periodic review and reconciliation of the accounts will also minimize unexpected or year-end adjustments. This integration of the cost accounts is extremely important as the company expands and the operations are more complex. Although there are situations where the factory and general accounts are not coordinated, it is not recommended. If such a system is used additional effort is required to ensure the accuracy and preclude misstatement of cost information. Such a procedure requires extreme care in cutoffs for liabilities and the taking of physical inventories as well as analyzing inventory differences.

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Ch. 20 Planning and Control of Manufacturing Costs: Direct Material and Direct Labor

20.2 DIRECT MATERIAL COSTS: PLANNING AND CONTROL (a) SCOPE OF DIRECT MATERIAL INVOLVEMENT. Direct material, as the term is used by cost accountants, refers to material that can be deﬁnitely or speciﬁcally charged to a particular product, process, or job, and that becomes a component part of the ﬁnished product. The deﬁnition must be applied in a practical way, for if the material cannot be conveniently charged as direct or if it is an insigniﬁcant item of cost, then it would probably be classiﬁed as indirect material and allocated with other manufacturing expenses to the product on some logical basis. Although this section deals primarily with direct material, certain of the phases relate also to indirect material. In its broadest phase, material planning and control is simply the providing of the required quantity and quality of material at the required time and place in the manufacturing process. By implication, the material secured must not be excessive in amount, and it must be fully accounted for and used as intended. The extent of material planning and control is broad and should cover many phases or areas, such as plans and speciﬁcations; purchasing; receiving and handling; inventories; usage; and scrap, waste, and salvage. In each of these phases, the controller has certain responsibilities and can make contributions toward an efﬁcient operation. (b) BENEFITS FROM PROPER MATERIAL PLANNING AND CONTROL. Because material is such a large cost item in most manufacturing concerns, effective utilization is an important factor in the ﬁnancial success or failure of the business. Proper planning and control of materials with the related adequate accounting has the following ten advantages: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Reduces inefﬁcient use or waste of materials Reduces or prevents production delays by reason of lack of materials Reduces the risk from theft or fraud Reduces the investment in inventorie May reduce the required investment in storage facilities Provides more accurate interim ﬁnancial statements Assists buyers through a better coordinated buying program Provides a basis for proper product pricing Provides more accurate inventory values Reduces the cost of insurance for inventory

(c) DEFINING AND MEASURING DIRECT MATERIAL COSTS. There is some confusion regarding what costs can be itemized as direct materials. This section deﬁnes the various cost elements and explains why some costs are categorized as direct materials and others are not. It is common to charge any material that is listed on a product’s bill of materials (BOM) to that product as a direct material cost. If there is no BOM, then it may be necessary to physically break down a product to determine the types and quantities of its component parts. Though this deﬁnition seems simple enough, there are a variety of peripheral costs to consider: • Discounts. It is reasonable to deduct discounts from suppliers from the cost of direct materials, because there is a direct and clearly identiﬁable relationship between the discount and the payment for the materials. • Estimates. It is reasonable to credit or debit material costs if the estimates are based on calculations that can be easily proved through an audit. For example, it may be easier to allocated purchase discounts to speciﬁc materials than to credit them individually; if so, there should be a calculation that bases the estimated credit on past discounts for speciﬁc materials. • Freight. It is reasonable to include the freight cost of bringing materials to the production facility, because this cost is directly related to the materials themselves. However, outbound freight costs should not be included in direct materials, because this cost is more directly related to sales or logistics than to manufacturing.

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• Packaging costs. It is reasonable to include packaging costs in direct materials if the packaging is a major component of the ﬁnal product. For example, perfume requires a glass container before it is sold, so the glass container should be included in the direct materials cost. This should also include packing supplies. • Samples and tests. It is reasonable to include the cost of routine samples and tests in direct materials. For example, the quality assurance staff may pull a speciﬁc number of products from the production line for destructive testing; this is a standard part of the production process, so the materials lost should still be recorded as direct materials. • Scrap. It is reasonable to include the cost of scrap in direct materials if it is an ongoing and fairly predictable expense. For example, there is a standard amount of liquid evaporation to be expected during the processing of some products, while other products will require a percentage of scrap when raw materials are used to create the ﬁnished product. However, an inordinate level of scrap that is above usual expectations should be expensed off separately and immediately as scrap, since it is not an ongoing part of the production process. If there is some salvage value to scrapped materials, this amount should be an offset to the direct materials cost. • Indirect materials costs. There are a number of costs that are somewhat related to materials costs, but which cannot be charged straight to direct materials because of accounting rules. These costs include the cost of warehousing, purchasing, and distribution. Instead, these costs can be combined into one or more cost pools and allocated to products based on the proportion of usage of the expenses in those cost pools. (d) PLANNING FOR DIRECT MATERIAL. phases, budgets, or plans:

The planning aspect of direct material relates to four

1. Material usage budget. This budget involves determining the quantities and related cost of the raw materials and purchased parts needed to meet the production budget (quantities of product to be manufactured) on a time-phased basis. Basically it is a matter of multiplying the volume of ﬁnished articles to be produced times the number of individual components needed for its manufacture. This determination is the responsibility of the manufacturing executive. However, the aggregate costs must be provided to the controller in an appropriate format. In most instances, it will be under the direction of the controller that the planning procedure and format of exhibits required will be established. The controller requires the total cost, by time period, to provide for the charge to work-in-process inventory and for relief of raw materials and purchased parts inventory in the ﬁnancial planning process of preparing the business plan for the year or for other planning periods. Obviously, the material usage budget must be known so that the required purchases can be made and the required inventory level maintained. The determination of the material usage budget is described in more detail in Chapter 28 on inventory planning and control. The material usage budget generally will be summarized by physical quantities of significant items for use by manufacturing personnel. A cost summary is needed by the controller for preparing the plan in monetary terms. The usage budget may be presented in any one of several ways. A time-phased summary by major category of raw material for a small aircraft manufacturer is illustrated in Exhibit 20.1. 2. Material purchases budget. When the material usage budget is known, the purchases budget can be determined (by the purchasing department), taking into account the required inventory levels. The time-phased material purchases budget is provided by the purchasing director (usually reporting to the manufacturing executive) to the controller for use in planning cash disbursements, and additions to the raw materials and purchased parts inventories—as part of the annual planning process (or planning for any other period). A highly condensed raw material purchases budget for the annual plan is illustrated in Exhibit 20.2.

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T HE A IRCRAFT C OMPANY S UMMARIZED M ATERIAL U SAGE B UDGET F OR THE P LAN Y EAR 20XX ( DOLLARS IN THOUSANDS ) Material Category Month

Engine

Aluminum

Electrical

January February March April May June July August September October November December Total

$ 7,500 5,500 8,000 8,500 9,000 10,000 9,000 8,000 7,000 6,000 5,000 6,000 $89,500

$ 1,500 1,000 1,600 1,800 1,800 2,000 1,800 1,600 1,400 1,200 1,000 1,200 $17,900

E XHIBIT 20.1

S UMMARIZED M ATERIAL U SAGE B UDGET

Purchased Assemblies

All Other

Total

$ 790 530 840 960 960 1,060 960 840 740 630 530 630 $9,470

$ 200 130 210 240 240 260 240 210 190 160 130 160 $2,370

$ 10,980 7,820 11,700 12,700 13,200 14,640 13,200 11,700 10,250 8,780 7,320 8,780 $131,070

$

990 660 1,050 1,200 1,200 1,320 1,200 1,050 920 790 660 790 $11,830

3. Finished production budget. This represents the quantities of ﬁnished product to be manufactured in the planning period. Such estimates are provided by the manufacturing executive to the controller for determining the additions to the ﬁnished goods inventory and the relief to the work-in-process inventory. The quantities of production usually are costed by the cost department under the supervision of the controller. T HE I LLUSTRATIVE C OMPANY S UMMARIZED R AW M ATERIAL P URCHASES B UDGET F OR THE P LAN Y EAR 20XX ( DOLLARS IN HUNDREDS ) Material Category Quarter/Month Quarter 1 January February March Subtotal Quarter 2 Quarter 3 Quarter 4 Total

A

B

C

D

Total

$ 40,000 35,000 50,000 125,000 150,000 116,000 103,000 $514,000

$ 20,000 17,000 25,000 62,000 70,000 60,000 50,000 $242,000

$ 50,000 45,000 60,000 155,000 165,000 150,000 160,000 $630,000

$ 10,000 8,000 12,000 30,000 40,000 20,000 25,000 $115,000

$ 120,000 105,000 147,000 372,000 425,000 346,000 358,000 $1,501,000

Note: A 5% price increase is assumed for the last two quarters.

E XHIBIT 20.2

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S UMMARIZED R AW M ATERIAL P URCHASE B UDGET

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4. Inventories budgets. The three preceding budgets, plus the cost-of-goods-sold budget, determine the inventory budgets for the planning period. In the annual planning process, the inventory costs usually are determined monthly. Inventory budgets, together with the related purchases, usage, and completed product, are shown in Chapter 28 on planning and control of inventories. While the raw materials, purchased parts, and work-in-process budgets usually are the responsibility of the manufacturing executive, and the ﬁnished goods budget is the responsibility of either the manufacturing executive or the sales executive, the controller has certain reporting functions (see Chapter 28) as to planned versus actual inventory levels and turnover rates, as well as responsibility for the adequacy of the internal control system. To summarize, any planning responsibilities for direct materials rest with other line executives, although the controller will use these related data in the ﬁnancial planning process—in preparing the statement of estimated income and expense, the statement of estimated ﬁnancial condition, and statement of estimated cash ﬂows. Also, the controller will often test-check or audit the information furnished by the manufacturing executive for completeness, reasonableness, and compatibility with other plans. On occasion, the chief manufacturing executive will request the controller and staff to assemble the needed ﬁgures, with the help of the production staff. The various budgets related to materials generally will be developed following a procedure and format coordinated (and sometimes developed by) the controller. Those interested in a more detailed explanation of developing the plans or budgets for raw material usage and purchases may wish to check some of the current literature. (e) BASIC APPROACH TO DIRECT MATERIAL COST CONTROL. With an overview of the planning function behind us, we can now review the control function. With respect to materials, as with other costs, control in its simplest form involves the comparison of actual performance with a measuring stick—standard performance—and the prompt follow-up of adverse trends. However, it is not simply a matter of saying “350 yards of material were used, and the standard quantity is only 325” or “The standard price is $10.25 but the actual cost to the company was $13.60 each.” Many other reﬁnements or applications are involved. The standards must be reviewed and better methods found. Or checks and controls must be exercised before the cost is incurred. The central theme, however, is still the use of a standard as a point of measurement. Although the applications will vary in different concerns, some of the problems or considerations that must be handled by the controller are: • Purchasing and receiving Establishment and maintenance of internal checks to assure that materials paid for are received and used for the purpose intended. Since some purchases are now received on a just-in-time basis, the controller may ﬁnd that materials are now paid for based on the amount of product manufactured by the company in a given period, instead of on a large quantity of paperwork associated with a large number of small-quantity receipts. Audit of purchasing procedures to ascertain that bids are received where applicable. A JIT manufacturing system uses a small number of long-term suppliers, however, so the controller may ﬁnd that bids are restricted to providers of services such as janitorial duties and maintenance activities. Comparative studies of prices paid for commodities with industry prices or indexes. Measurement of price trends on raw materials. Many JIT supplier contracts call for price decreases by suppliers at set intervals; the controller should be aware of the terms of these contracts and audit the timing and amount of the changes. Determination of price variance on current purchases through comparison of actual and standard costs. This may relate to purchases at the time of ordering or at time of receipt. The same approach may be used in a review of current purchase orders to advise management in advance about the effect on standard costs. In a JIT environment, most part costs

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would be contractually set with a small number of suppliers, so the controller would examine prices charged for any variations from the agreed-upon rates. • Usage Comparison of actual and standard quantities used in production. A variance may indicate an incorrect quantity on the product’s bill of materials, misplaced parts, pilferage, or incorrect part quantities recorded in inventory. Preparation of standard cost formulas (to emphasize major cost items and as part of a cost reduction program). Preparation of reports on spoilage, scrap, and waste as compared with standard. In a JIT environment, no scrap is allowed for and therefore is not included in the budget as a standard. Calculation of costs to make versus costs to buy. This list suggests only some of the methods available to the controller in dealing with material cost control. (f) SETTING MATERIAL QUANTITY STANDARDS. Because an important phase of material control is the comparison of actual usage with standard, the controller is interested in the method of setting these quantitative standards. First, assistance can be rendered by contributing information about past experience. Second, the controller should act as a check in seeing that the standards are not so loose that they bury poor performance, on the one hand, and represent realistic but attainable performance, on the other. Standards of material usage may be established by at least three procedures: 1. By engineering studies to determine the best kind and quality of material, taking into account the product design requirements and production methods 2. By an analysis of past experience for the same or similar operations 3. By making test runs under controlled conditions Although a combination of these methods may be used, best practice usually dictates that engineering studies be made. To the theoretical loss must be added a provision for those other unavoidable losses that it is impractical to eliminate. In this decision, past experience will play a part. Past performance alone, of course, is not desirable in that certain known wastes may be perpetuated. This engineering study, combined with a few test runs, should give fairly reliable standards. (g) REVISION OF MATERIAL QUANTITY STANDARDS. Standards are based on certain production methods and product speciﬁcations. It would be expected, therefore, that these standards should be modiﬁed as these other factors change, if such changes affect material usage. For the measuring stick to be an effective control tool, it must relate to the function being measured. However, the adjustment need not be carried through as a change in inventory value, unless it is signiﬁcant. (h) USING QUANTITY STANDARDS FOR COST CONTROL. The key to material quantity control is to know in advance how much material should be used on the job, frequently to secure information about how actual performance compares with standard during the progress of the work, and to take corrective action where necessary. The supervisor responsible for the use of materials, as well as the superior, should be aware of these facts. At the lowest supervisory level, details of each operation and process should be in the hands of those who can control usage. At higher levels, only overall results need be known. The method to be used in comparing the actual and standard usage will differ in each company, depending on several conditions. Some of the more important factors that will inﬂuence the controller in applying control procedures about material usage are: • The production method in use • The type and value of the materials • The degree to which cost reports are utilized by management for cost control purposes

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A simple excess material report that is issued daily is shown in Exhibit 20.3. It shows not only the type of material involved as excess usage, but also the cause of the condition. This report could be available on a real-time basis, with the use of a computer, and could be summarized daily for the plant manager. One of the most important considerations is the nature of the production process. In a job order or lot system, such as an assembly operation in an aircraft plant, where a deﬁnite quantity is to be produced, the procedure is quite simple. A production order is issued, and a bill of material or “standard requisition” states the exact quantity of material needed to complete the order. If parts are spoiled or lost, it then becomes necessary to secure replacements by means of a nonstandard or excess usage requisition. Usually, the foreman must approve this request, and, consequently, the excess usage can be identiﬁed immediately. A special color (red) requisition may be used, and a summary report issued at certain intervals for the use of the production executives responsible. If production is on a continuous process basis, then periodically a comparison can be made of material used in relation to the ﬁnished product. Corrective action may not be as quick here, but measures can be taken to avoid future losses. Just as the production process is a vital factor in determining the cost accounting plan, so also it is a consideration in the method of detecting material losses. If losses are to be localized, then inspections must be made at selected points in the process of manufacture. At these various stations, the rejected material can be counted or weighed and costed if necessary. When there are several distinct steps in the manufacturing process, the controller may have to persuade the production group of the need and desirability of establishing count stations for control purposes. Once these stations are established, the chief contribution of the accountant is to summarize and report the losses over standard. The process can be adopted to the use of personal computers and provision of control information on a real-time basis. Another obvious factor in the method of reporting material usage is the type and value of the item itself. A cardinal principle in cost control is to place primary emphasis on high-value items. Hence, valuable airplane motors, for example, would be identiﬁed by serial number and otherwise accurately accounted for. Items with less unit value, or not readily segregated, might be controlled through less accurate periodic reporting. An example might be lumber. The nature and value of the materials determine whether the time factor or the unit factor would be predominant in usage reporting.

T HE C OMPUTER C HIP C OMPANY D AILY E XCESS M ATERIAL U SAGE (D ATE ) Material Used

Amount of Finished Product

Standard Usage (Units)

Actual Usage (Units)

Excess Usage (Units)

Unit Cost

3,960 7,920 1,980 3,960 15,840

3,960 15,840 3,960 3,960 15,840

4,110 15,960 4,000 3,970 15,920

150 120 40 10 80

$ 4.75 2.00 21.50 65.40 3.25

A B C D E Total

Comments: (a) Parts defective (Vendor Bush). (b) Careless workmanship. (c) Power down. (d) Wrong speed drilling. (e) Maintenance technician dropped case.

E XHIBIT 20.3

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D AILY E XCESS M ATERIAL U SAGE R EPORT

Dept. No. Foreperson: Total Excess Cost $ 712.50 240.00 860.00 654.00 260.00 $2,726.50

42 Magraudy

Comments (a) (b) (c) (d) (e)

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Ch. 20 Planning and Control of Manufacturing Costs: Direct Material and Direct Labor

Management is often not directly interested in dollar cost for control purposes but rather only in units. There is no difference in the principle involved but merely in the application. Under these conditions, the controller should see that management is informed of losses in terms of physical units — something it understands. In this case, the cost report would be merely a summary of the losses. Experience will often show, however, that as the controller gives an accounting in dollars, the other members of management will become more cost conscious. The essence of any control program, regardless of the method of reporting, however, is to follow up on substandard performance and take corrective action. A variation on using quantity standards and materials variation reporting is JIT variance reporting. One of the cornerstones of the JIT concept is that you order only what you need. That means you won’t waste what you use and that there should be no materials variances. Of course, even at world-class JIT practitioners such as Motorola and Toyota, there is scrap; however, there is much less than will be found at a non-JIT company. Consequently, the controller must examine the cost of collecting the variance information against its value in correcting the amount of scrap accumulation. The conclusion may be that JIT does not require much materials variance reporting, if any. (i) LIMITED USEFULNESS OF MATERIAL PRICE STANDARDS. In comparing actual and standard material costs, the use of price standards permits the segregation of variances as a result of excess usage from those incurred by reason of price changes. By and large, however, the material price standards used for inventory valuation cannot be considered as a satisfactory guide in measuring the performance of the purchasing department. Prices of materials are affected by so many factors outside the business that the standards represent merely a measure of what prices are being paid as compared with what was expected to be paid. A review of price variances may, however, reveal some informative data. Exceedingly high prices may reveal special purchases for quick delivery because someone had not properly scheduled purchases. Or higher prices may reveal shipment via express when freight shipments would have been satisfactory. Again, the lowest cost supplier may not be utilized because of the advantages of excellent quality control methods in place at a competitive shop. The total cost of production and impact on the marketplace needs to be considered — not merely the purchase price of the speciﬁc item. To generalize, the exact cause for any price variance must be ascertained before valid conclusions can be drawn. Some companies have found it advisable to establish two standards — one for inventory valuation and quite another to be used by the purchasing department as a goal to be attained. One negative result of recording a purchase price variance is that the purchasing department may give up close supplier relationships in order to get the lowest part cost through the bidding process. Part bidding is the nemesis of close supplier parings (a cornerstone of JIT), since suppliers know they will be kicked off the supplier list, no matter how good their delivery or quality, unless they bid the lowest cost. (j) SETTING MATERIAL PRICE STANDARDS. Practice varies somewhat about the responsibility for setting price standards. Sometimes the cost department assumes this responsibility on the basis of a review of past prices. In other cases, the purchasing staff gives its estimate of expected prices that is subject to a thorough and analytical check by the accounting staff. Probably, the most satisfactory setup is through the combined effort of these two departments. (k) OTHER APPLICATIONS OF MATERIAL CONTROL. By using a little imagination, every controller will be able to devise simple reports that will be of great value in material control — whether in merely making the production staff aware of the high-cost items of the product or in stimulating a program of cost reduction. For example, in a chemical processing plant, a simple report detailing the material components cost of a formulation could be used to advantage. Another report is illustrated in Exhibit 20.4, wherein the standard material cost of an assembly-type operation, in this case a self-guided small plane, is given Where the products are costly, and relatively few in number, it may be useful to provide management periodically with the changes in contracted prices, as well as an indication about the effect of price changes on the planned cost of the product. Such statements may stimulate thinking about material substitutions or changes in processes or speciﬁcations.

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Black process 45.0° 133.0 LPI OF , AND

C HANGES

IN ,

$30.00 — — — — — — — — — — — — — — — — — — — $30.00

Increases

Changes

S TANDARD M ATERIAL C OSTS

Power unit Raw stock aluminum Fabric Paint Steel tubing Stabilizer Instruments Hardware Radio equipment Exhaust stock Steel small parts Synthetic small parts Plastic Rubber Aluminum forging Raw stock steel Directional control component Battery Cushion Miscellaneous trim parts Total

D ETAIL

$ 820.00 277.40 142.60 127.54 117.50 106.22 93.14 92.20 91.20 34.17 76.16 14.20 19.06 12.00 32.14 43.15 39.15 18.00 14.70 22.13 $2,192.66

Description

E XHIBIT 20.4

Standard Cost 5/31/XX — — — 22.54 — — 1.14 — — — — — .06 — 2.00 — — — — — $25.74

$

Decreases

20.2

Substitute “R” forging

New altimeter

Installation of electric equipment

Price increased by manufacturer

Remarks

Direct Material Costs: Planning and Control

$ 850.00 277.40 142.60 105.00 117.50 106.22 92.00 92.20 91.20 34.17 76.16 14.20 19.00 12.00 30.14 43.15 39.15 18.00 14.70 22.13 $2,196.92

Standard Cost 6/30/XX

T HE S MALL P LANE M ANUFACTURING C OMPANY S TATEMENT ON U NIT S TANDARD M ATERIAL C OSTS F OR THE M ONTH OF J UNE 20XX

415

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Ch. 20 Planning and Control of Manufacturing Costs: Direct Material and Direct Labor

20.3 LABOR COSTS: PLANNING AND CONTROL (a) LABOR ACCOUNTING UNDER PRIVATE ENTERPRISE. One of the most important factors in the success of a business is the maintenance of a satisfactory relationship between management and employees. Controllers as well as their staff can do much to encourage and promote such a relationship, whether it is such a simple matter as seeing that the payroll checks are ready on time or whether it extends to the development of a wage system that rewards meritorious performance. Aside from this fact, labor accounting and control are important. As automation and the use of robots and computers become even more prevalent, what was once called direct labor may not any longer increase in relative importance. But labor is still a signiﬁcant cost. Likewise, those costs usually closely related to labor costs have grown by leaps and bounds—costs for longer vacations, more adequate health and welfare plans, pension plans, and increased Social Security taxes. These fringe beneﬁt costs are 50% or more of many payrolls. For all these reasons, the cost of labor is an important cost factor. The three objectives of labor accounting are outlined as: 1. A prompt and accurate determination of the amount of wages due the employee. 2. The analysis and determination of labor costs in such a manner as may be needed by management (e.g., by product, operation, department, or category of labor) for planning and control purposes. 3. The advent of JIT manufacturing systems has called into question the need for reporting the direct labor utilization variance. This variance revolves around the amount of a product that is produced with a given amount of labor; thus, a positive labor utilization variance can be achieved by producing more product than may be needed. An underlying principle of JIT is to produce only as much as is needed to produce, so JIT and labor utilization variance reporting are inherently at odds with each other. If JIT has been installed, then the controller should consider eliminating this type of variance reporting. (b) CLASSIFICATION OF LABOR COSTS. With the increasing trends to automation, to continuous process type of manufacturing, and to integrated machine operations under which individual hand operations are replaced, the traditional accounting deﬁnition of direct labor must be modernized. As a practical matter, where labor is charged to a cost center and is directly related to the main function of that center, whether it is direct or indirect labor is of no consequence. Rather, attention must be directed to labor costs. Perhaps the primary considerations are measurability and materiality rather than physical association with the product. For planning and control purposes, any factory wages or salaries that are identiﬁable with a directly productive department as contrasted with a service department and are of signiﬁcance in that department are deﬁned as manufacturing labor. All other labor will be deﬁned as indirect labor, treated as overhead expense, and discussed under manufacturing expenses. (c) EXPANDED DEFINITION OF DIRECT LABOR. Direct labor is that labor which is traceable to the manufacturing of products or the provision of services for consumption by a customer. This cost includes incidental time that is part of a typical working day, such as break time, but does not include protracted down time for nonrecurring activities, such as training or downtime caused by machine failures. Direct labor should also include those beneﬁts costs that are “part and parcel” of the direct labor worker, such as medical and dental insurance costs, production-related bonuses, FICA, cost of living allowances, workers’ compensation insurance, vacation and holiday pay, unemployment compensation insurance, and pension costs. Overtime bonuses should also be included in direct labor costs. It is also acceptable to track labor costs as standard costs, as long as one periodically writes off the difference between standard and actual direct labor costs, so that there is no long-term difference between the two types of labor costs. These are the components of direct labor. Direct labor is only that labor that adds value to the product or service. However, there are many activities in the manufacturing or service areas, not all of which add value to the ﬁnal product,

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20.3 Labor Costs: Planning and Control

417

so one must be careful to segregate costs into the direct labor and indirect labor categories. Direct labor is typically incurred during the fabrication, processing, assembly, or packaging of a product or service. Alternatively, any labor incurred to maintain or supervise the production or service facility is categorized as indirect labor. There are several costs that should not be included in direct labor. These are excluded because they do not directly trace back to work on products or services, nor are they a standard part of a direct labor worker’s beneﬁts package. These costs include the maintenance of recreational facilities for employees, any company-sponsored meal plans, membership dues in outside organizations, separation allowances, and safety-related expenses. These costs are typically either charged off to current expenses, or else rolled into overhead costs. (d) PLANNING OF LABOR COSTS. Planning labor costs might be described as planning or estimating the required manpower and costs associated with direct manufacturing departments (not indirect) for the annual plan or some other relevant planning period. It consists of determining the labor planning budget. The process, which is essentially the responsibility of the manufacturing executive, consists of extrapolating the planned production of units times the standard labor content, plus an allowance for variances, to arrive at the labor hours required. This is a tedious job, but the computer as applied to the standard labor hour content of expected production makes it much easier. Essentially, this process has several purposes, such as: • Ascertaining by department, by skill, and by time period the number and type of workers needed to carry out the production program for the planning horizon • Determining the labor cost for the production program, including: labor input, labor content of completed product, and labor content of work-in-process. These data may then be used by the controller for determining the transfers to/from work- in-process and ﬁnished goods — in the same manner material costs were accounted for. • Determining the estimated cost (payroll) requirements of the time-phased manufacturing labor budget for the planning period • Determining the unit labor content of each product so that the inventory values, cost of manufacturer, and cost of sales can be calculated for use in the statements of planned income and expense, planned ﬁnancial condition, and planned cash ﬂows • Seeing that the planned funds are available to meet the payroll A summarized direct labor budget for annual planning purposes, based on the underlying required labor hours by department, by product, and time-phased, might appear as in Exhibit 20.5. A JIT manufacturing environment creates signiﬁcant changes in direct labor costs that the controller should be aware of. When a manufacturing facility changes from an assembly line to manufacturing cells, the labor efﬁciency level drops, because machine setups become more frequent. A major JIT technique is to reduce setup times to minimal levels, but nonetheless, even the small setup times required for cellular manufacturing require more labor time than the zero setup times used in long assembly line production runs. Consequently, if management is contemplating switching to cellular manufacturing, the controller should expect an increase in the labor hours budget. Also, if the labor cost does not increase, the controller should see if the engineering staff has changed the labor routings to increase the number of expected setup times. To the extent more information is desired on the planning aspects of direct labor, the reader may wish to consult some of the books on the subject.1 (e) CONTROLLER’S CONTRIBUTION TO CONTROL. In controlling direct labor costs, as with most manufacturing costs, the ultimate responsibility must rest with the line supervision. Yet this group must be given assistance in measuring performance, and certain other policing or restrain1. See, for example, James D. Willson, Budgeting and Proﬁt Planning Manual, 3rd ed. (Boston: Warren, Gorham & Lamont, 1994). Chap. B3.

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Ch. 20 Planning and Control of Manufacturing Costs: Direct Material and Direct Labor

T HE G IDGET C OMPANY S UMMARIZED D IRECT L ABOR B UDGET F OR P LAN Y EAR 20XX Direct Labor Hours

Month/Quarter

Standard

Provision for Variances

First Quarter January February March Total Second Quarter Third Quarter Fourth Quarter Total

222,500 204,300 223,400 650,200 712,000 725,700 719,300 2,807,200

4,450 4,100 4,500 13,050 14,240 10,890 11,510 49,690

Gross Cost

Total 226,950 208,400 227,900 663,250 726,240 736,590 730,810 2,856,890

Standard

Provision for Variances

Total

$ 3,337,500 3,064,500 3,351,000 9,753,000 10,680,000 11,429,775 11,328,975 $43,191,750

$ 66,750 61,500 67,500 195,750 213,600 171,518 181,283 $762,151

$ 3,404,250 3,126,000 3,418,500 9,948,750 10,893,600 11,601,293 11,510,258 $43,953,901

Note: Present wage rates used through second quarter. Balance of year assumes a 5% wage increase.

E XHIBIT 20.5

S UMMARIZED D IRECT L ABOR B UDGET

ing functions must be exercised. Herein lie the primary duties of the controller’s organization. Among the means at the disposal of the chief accounting executive for labor control are the following seven:2 1. Institute procedures to limit the number of employees placed on the payroll to that called for by the production plan. 2. Provide preplanning information for use in determining standard labor crews by calculating required standard labor-hours for the production program. 3. Report hourly, daily, or weekly standard and actual labor performance. 4. Institute procedures for accurate distribution of actual labor costs, including signiﬁcant labor classiﬁcations to provide informative labor cost analyses. 5. Provide data on past experience with respect to the establishment of standards. 6. Keep adequate records on labor standards and be on the alert for necessary revisions. 7. Furnish other supplementary labor data reports, such as: (a) Hours and cost of overtime premium, for control of overtime (b) Cost of call-in pay for time not worked to measure efﬁciency of those responsible for call-in by union seniority (c) Comparative contract costs, that is, old and new union contracts (d) Average hours worked per week, average take-home pay, and similar data for labor negotiations (e) Detailed analysis of labor costs over or under standard (f) Statistical data on labor turnover, length of service, training costs (g) Union time—cost of time spent on union business (f) SETTING LABOR PERFORMANCE STANDARDS. The improvement of labor performance and the parallel reduction and control of costs require labor standards—operating time standards and the related cost standards. Setting labor performance standards is a highly analytical job that 2.

In a JIT environment, this reporting would not be necessary in items 3, 4, 5, and 7e.

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20.3 Labor Costs: Planning and Control

419

requires a technical background of the production processes as well as a knowledge of time study methods. This may be the responsibility of a standards department, industrial engineering department, or cost control department. Occasionally, although rarely, it is under the jurisdiction of the controller. Establishment of the standard operation time requires a determination of the time needed to complete each operation when working under standard conditions. Hence this study embodies working conditions, including the material control plan, the production planning and scheduling procedure, and layout of equipment and facilities. After all these factors are considered, a standard can be set by the engineers. In using time standards for measuring labor performance the accounting staff must work closely with the industrial engineers or those responsible for setting the standards. The related cost standards must be consistent; the accumulation of cost information must consider how the standards were set and how the variances are analyzed. The following discussion on labor standards does not apply to a JIT manufacturing environment, especially one that uses cellular (i.e., group) manufacturing layouts. Labor utilization standards can be improved by increasing the amount of production for a set level of labor, and this is considered to be good in an assembly line environment. Under JIT, however, producing large quantities of parts is not considered acceptable; under JIT, good performance is producing the exact quantity of parts that are needed, and doing so with quality that is within preset tolerance levels. Once the correct quantity of parts are produced, the direct labor staff stops production; this creates unfavorable labor utilization variances. Therefore, measuring a JIT production facility with a labor utilization variance would work against the intent of JIT, since the production manager would have an incentive to produce more parts than needed, and would not be mindful of the part quality. (g) REVISION OF LABOR PERFORMANCE STANDARDS. Generally, performance standards are not revised until a change of method or process occurs. Since standards serve as the basis of control, the accounting staff should be on the alert for changes put into effect in the factory but not reported for standard revision. If the revised process requires more time, the production staff will usually make quite certain that their measuring stick is modiﬁed. However, if the new process requires less time, it is understandable that the change might not be reported promptly. Each supervisor naturally desires to make the best possible showing. The prompt reporting of time reductions might be stimulated through periodic review of changes in standard labor hours or costs. In other words, the current labor performance of actual hours compared to standard should be but one measure of performance; another is standard time reductions, also measured against a goal for the year. It should be the responsibility of the controller to see that the standards are changed as the process changes to report true performance. If a wage incentive system is related to these standards, the need for adjusting process changes is emphasized. An analysis of variances, whether favorable or unfavorable, will often serve to indicate revisions not yet reported. Although standard revisions will often be made for control purposes, it may not be practical or desirable to change product cost standards. The differences may be treated as cost variances until they are of sufﬁcient magnitude to warrant a cost revision. (h) OPERATING UNDER PERFORMANCE STANDARDS. Effective labor control through the use of standards requires frequent reporting of actual and standard performance. Furthermore, the variance report must be by responsibility. For this reason the report on performance is prepared for each foreman as well as the plant superintendent. The report may or may not be expressed in terms of dollars. It may compare labor-hours or units of production instead of monetary units. But it does compare actual and standard performance. Some operations lend themselves to daily reporting. Through the use of computer equipment or other means, daily production may be evaluated and promptly reported on. A simple form of daily report, available to the plant superintendent by 8:00 A.M. for the preceding day’s operations, is shown in Exhibit 20.6. With the use of computers, this data can be made available, essentially on a real-time basis.

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Ch. 20 Planning and Control of Manufacturing Costs: Direct Material and Direct Labor

F OR D AY

P LANT D AILY L ABOR R EPORT E NDING AT 4:00 P . M . ON (D ATE ) Man-Hours

Department

Actual

Standard

% Standard to Actual

51 52 53 54 55 56

2,322 1,846 492 3,960 2,120 970 11,170

2,360 1,821 500 4,110 2,060 1,320 12,171

101.6 98.6 101.6 103.8 97.2 136.1 103.9

Fabricating Subassembly Painting Assembly Polishing Packing Total

E XHIBIT 20.6

S AMPLE D AILY R EPORT

If required, the detail of this summary report can be made available to indicate on what classiﬁcation and shift the substandard operations were performed. Another report, issued weekly, that details the general reason for excess labor hours is illustrated in Exhibit 20.7. In a JIT environment, the manufacturing departments are tightly interlocked with minimal WIP between each department to cover for reduced staff problems. In other words, if an area is understaffed, then downstream work stations will quickly run short of work. Consequently, the most critical direct labor measure in a JIT environment is a report of absent personnel, delivered promptly to the production managers at the start of the work day, so they can reshufﬂe the staff to cover all departments, and contact the missing personnel. (i) USE OF LABOR RATE STANDARDS. Generally speaking, labor rates paid by a company are determined by external factors. The rate standard used is usually that normally paid for the job or classiﬁcation as set by collective bargaining. If standards are set under this policy, no signiﬁcant variances should develop because of base rates paid. There are, however, some rate variances that may be created and are controllable by management. Some of these reasons, which should be set out for corrective action, include: • Overtime in excess of that provided in the standard • Use of higher-rated classiﬁcations on the job • Failure to place staff on incentive • Use of crew mixture different from standard (more higher classiﬁcations and fewer of the lower) The application of the standard labor rate to the job poses no great problem. Usually, this is performed by the accounting department after securing the rates from the personnel department. Where overtime is contemplated in the standard, it is necessary, of course, to consult with production to determine the probable extent of overtime for the capacity at which the standard is set. It should be mentioned that the basic design of the product will play a part in control of costs by establishing the skill necessary and therefore the job classiﬁcation required to do the work. (j) CONTROL THROUGH PREPLANNING. The use of the control tools previously discussed serves to point out labor inefﬁciencies after they have happened. Another type of control requires a determination about what should happen and makes plans to assure, to the extent possible, that it does happen. It is forward looking and preventive. This approach embodies budgetary control and can be applied to the control of labor costs. For example, if the staff requirements for the production program one month hence can be determined, then steps can be taken to make certain that excess labor costs do not arise because too many people are on the payroll. This factor can be controlled;

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Stamping (b) Foundry (b) Paint Subassembly A Final assembly Receiving and shipping Total

16,320 4,390 12,800 18,920 17,777 44,310

Units Reported (a)

E XHIBIT 20.7

W EEKLY L ABOR R EPORT

Issued by Cost Department— December 29, 20XX

Notes: (a) Equivalent units per 6/12/XX letter. (b) Standards for Departments 25 and 26 are in process of review.

Percentage (Over) or under standard

25 26 27 41 42 44

Department 153 56 30 366 106 323 1,034

Actual Hours 194 103 25 384 120 271 1,097

Standard Hours

5.7

41 47 ( 5) 18 14 (52) 63

(Over) or Under Standard

J OHNSON M ANUFACTURING C OMPANY W EEKLY L ABOR R EPORT W EEK E NDED D ECEMBER 28, 20XX

(1.9)

— — — ( 5) — (16) (21)

Training

20.3

8.8

41 47 — 25 20 (36) 97

Low Production

421

Distribution: J.R.M. J.A.M. (2) L.L.B. (6) R.E.H. File

(.5)

— — (5) — — — (5)

Machine Breakdown

Labor Costs: Planning and Control

(.7)

— — — ( 2) ( 6) — (8)

Lack of Material

(Over) or Under Standard Due to

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Ch. 20 Planning and Control of Manufacturing Costs: Direct Material and Direct Labor

thus the remaining factors are rate and quality of production and overtime. Overtime costs can be held within limits through the use of authorization slips. The degree to which this preplanning can take place depends on the industry and particular conditions within the individual business ﬁrm. Are business conditions sufﬁciently stable so that some reasonably accurate planning can be done? Can the sales department indicate with reasonable accuracy what the requirements will be over the short run? An application might be in a machine shop where thousands of parts are made. If production requirements are known, the standard labor hours necessary can be calculated and converted to staff hours. The standard labor hours may be stored in a computer by skills required and by department. After evaluating the particular production job, an experienced efﬁciency factor may be determined. Thus, if 12,320 standard labor hours are needed for the planned production but an efﬁciency rate of only 80% is expected, then 15,400 actual labor hours must be scheduled. This requires a crew of 385 people (40 hours per week). This can be further reﬁned by skills or an analysis made of the economics of some overtime. Steps should be taken to assure that only the required number is authorized on the payroll for this production. As the requirements change, the standard labor hours should be reevaluated. In an Manufacturing Resource Planning II environment, labor routings must be at least 95% accurate, and the ﬁrm must strictly adhere to a master production schedule. If the controller works in such an environment, then labor requirements can easily be predicted by multiplying the related labor routings by the unit types and quantities shown on the master schedule. There are many computer-based labor control systems available for adoption to particular or speciﬁc needs. The controller or accounting staff should be familiar with the various systems so that labor costs are controlled and performance reported in a timely and accurate manner. (k) LABOR ACCOUNTING AND STATUTORY REQUIREMENTS. One of the functions of a controller is to ensure that the company maintains the various payroll and other records required by various federal and state government agencies, including the IRS. It is mandatory that the employee’s earning records be properly and accurately maintained, including all deductions from gross pay. The required reports must be submitted, and withheld amounts transmitted to the appropriate agencies. It is not the purpose of this book to discuss in detail these reporting requirements, since many publications are available to the controller on this subject. (l) WAGE INCENTIVE PLANS: RELATIONSHIP TO COST STANDARDS. In an effort to increase efﬁciency, a number of companies have introduced wage incentive plans—with good results. The controller is involved through the payroll department, which must calculate the amount. The controller’s responsibilities for the system are best left to authorities on the subject. One facet, however, is germane to the costing process and should be discussed. When an incentive wage plan is introduced into an operation already on a standard cost basis, a problem arises about the relationship between the standard level at which incentive earnings commence and the standard level used for costing purposes. Moreover, what effect should the wage incentive plan have on the standard labor cost and standard manufacturing expense of the product? To cite a speciﬁc situation, a company may be willing to pay an incentive to labor for performance that is lower than that assumed in the cost standard (but much higher than actual experience). If such a bonus is excluded from the cost standard, the labor cost at the cost standard level will be understated. Further, there may be no offsetting savings in manufacturing expenses since the costs are incurred to secure performance at a lower level than the cost standard. These statements assume that the existing cost standard represents efﬁcient performance even under incentive conditions. However, if the effect of the incentive plan is to increase sustained production levels well above those contemplated in the cost standards, it may be that the product will be overcosted by using present cost standards and that these standards are no longer applicable. How should the cost standards be set in relation to the incentive plan? In reviewing the problem, several generalizations may be made. First, there is no necessary relationship between standards for incentive purposes and standards for costing purposes. The former are intended to stimulate effort, whereas the latter are used to determine what the labor cost of the product should be. One is a problem in personnel management, whereas the other is strictly

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an accounting problem. With such dissimilar objectives, the levels of performance could logically be quite different. Then, too, the matter of labor costing for statement purposes should be differentiated from labor control. As we have seen, labor control may involve nonﬁnancial terms—pieces per hour, pounds per labor hour, and so on. Labor control can be accomplished through the use of quantitative standards. Even if costs are used, the measuring stick for control need not be the same as for product costing. Control is centered on variations from performance standards and not on product cost variations. A thorough consideration of the problem results in the conclusion that labor standards for costing purposes should be based on normal expectations from the operation of a wage incentive system under standard operating conditions. The expected earnings under the bonus plan should be reﬂected in the standard unit cost of the product. It does not necessarily follow that the product standard cost will be higher than that used before introduction of the incentive plan. It may mean, however, that the direct labor cost will be higher by reason of bonus payments. Yet, because of increased production and material savings, the total unit standard manufacturing cost should be lower.

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CHAPTER

21

PLANNING AND CONTROL OF MANUFACTURING COSTS: MANUFACTURING EXPENSES 21.1

NATURE OF MANUFACTURING EXPENSES 425

21.2

RESPONSIBILITY FOR PLANNING AND CONTROL OF MANUFACTURING EXPENSES 426

21.3

APPROACH IN CONTROL OF MANUFACTURING EXPENSES 427

21.4

PROPER DEPARTMENTALIZATION OF EXPENSES 427

21.5

VARIATIONS IN COST BASED ON FIXED AND VARIABLE COSTS 428

21.6

VARIATIONS IN COST BASED ON DIRECT LABOR 429

21.7

VARIATIONS IN COST BASED ON BATCH SIZE 431

21.8

VARIATIONS IN COST BASED ON OVERHEAD 433

21.9

VARIATIONS IN COST BASED ON TIME 435

21.10 COST ESTIMATION METHODS 436 21.11 NORMAL ACTIVITY 439 21.12 ALLOCATION OF INDIRECT PRODUCTION COSTS 440 21.13 BUDGETARY PLANNING AND CONTROL OF MANUFACTURING EXPENSES 442

(a) (b) (c) (d)

Fixed-Type Budget 442 Flexible Budget 442 Step-Type Budget 446 Summarized Manufacturing Expense Planning Budget 446

21.14 REVISION OF MANUFACTURING EXPENSE BUDGETS 446 21.15 SECURING CONTROL OF OVERHEAD 449 (a) Analysis of Expense Variances 449 (b) Incentives to Reduce Costs 450 21.16 INDIRECT LABOR: A MORE PRECISE TECHNIQUE 451 21.17 OTHER ASPECTS OF APPLYING BUDGETARY CONTROL 451 21.18 OTHER CONTROL PROCEDURES 453 21.19 ROLE OF THE CONTROLLER 454 21.20 REPORTS FOR MANUFACTURING EXECUTIVES 455 (a) Scope of Coverage 455 (b) Types of Reports on Actual Performance 455 (c) Presentation of Data 456 (d) Illustrative Reports 456

21.1 NATURE OF MANUFACTURING EXPENSES The indirect manufacturing expenses or overhead costs of a manufacturing operation have increased signiﬁcantly as business has become more complex, and the utilization of more sophisticated machinery and equipment is more prevalent. As the investment in computer-controlled machinery has increased, improving productivity and reducing direct labor hours, the control of depreciation expense, power costs, machinery repairs and maintenance, and similar items has received a greater emphasis by management. 425

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Ch. 21 Planning and Control of Manufacturing Costs: Manufacturing Expenses

Manufacturing overhead has several distinguishing characteristics as compared with the direct manufacturing costs of material and labor. It includes a wide variety of expenses, such as depreciation, property taxes, insurance, fringe beneﬁt costs, indirect labor, supplies, power and other utilities, clerical costs, maintenance and repairs, and other costs that cannot be directly identiﬁed to a product, process, or job. These types of costs behave differently from direct costs, as the volume of production varies. Some will ﬂuctuate proportionately as production increases or decreases, and some will remain constant or ﬁxed and will not be sensitive to the change in the number of units produced. Some costs are semivariable and for a particular volume level are ﬁxed; however, they may vary with volume but less proportionately and probably can be segregated into their ﬁxed and variable components. The control of overhead costs rests with many individuals involved in the manufacturing process. Certain costs such as repairs and maintenance are controlled by the head of the maintenance department. Manufacturing supplies may be controlled by each department head who uses the supplies in carrying out his function. Other costs may be decided by management and assigned to a particular manager for control — for example, depreciation, taxes, insurance. Accounting planning and control of manufacturing indirect expenses is diverse and a challenging opportunity for the controller.

21.2 RESPONSIBILITY FOR PLANNING AND CONTROL OF MANUFACTURING EXPENSES Responsibility for the planning and control of manufacturing expenses is clearly that of the manufacturing or production executive. However, this executive will be working through a ﬁnancial information system largely designed by the chief accounting ofﬁcial or his staff — although there should be full participation by the production staff on many aspects of the system development. In formulating the expense account structure under which expenses will be planned and actual expenses matched against the budget or other standards, the controller should heed these common sense suggestions to make the reports more useful to the manufacturing executive: • The budget (or other standard) should be based on technical data that are sound from a manufacturing viewpoint. Among other things, this will call for cooperation with the industrial engineers or process engineers who will supply the technical data required in developing the budget and/or standards. As manufacturing processes change, the standards must change. Adoption of just-in- time (JIT) techniques may require, for example, a different alignment of cost centers. Further, with the increased use of robots or other types of mechanization, direct labor will play a less important role, while manufacturing expense (through higher depreciation charges, perhaps more indirect labor, higher repairs and maintenance, and power) will become relatively more signiﬁcant. • The manufacturing department supervisors, who will do the actual planning and control of expenses, must be given the opportunity to fully understand the system, including the manner in which the budget expense structure is developed, and to generally concur in the fairness of the system. • The account classiﬁcations must be practical, the cost departments should follow the manufacturing organization structure (responsibility accounting and reporting), and the allocation methods must permit the proper valuation of inventories (usually under general accepted accounting principles), as well as proper control of expense. • The manufacturing costs must be allocated as accurately as possible, so the manufacturing executive can determine the expense of various products and processes. This topic is covered in more detail later in this chapter, under activity-based costing. Also, industrial engineers will provide the technical data required for the development of standards, such as manpower needs, power requirements, expected downtime, and maintenance requirements. Finally, if an activity-based costing (ABC) system is in place, then the manufacturing executive should work with the controller to develop information collection procedures for resource drivers.

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21.3 APPROACH IN CONTROL OF MANUFACTURING EXPENSES The diverse types of expenses in overhead and the divided responsibility may contribute to the incurrence of excessive costs. Furthermore, the fact that many cost elements seem to be quite small and insigniﬁcant in terms of consumption or cost per unit often encourages neglect of proper control. For example, it is natural to increase clerical help as required when volume increases to higher levels, but there is a reluctance and usually a delay from a timing viewpoint in eliminating such help when no longer needed. The reduced requirement must be forecasted and anticipated and appropriate actions taken in a timely manner. There are numerous expenses of small unit-cost items that may be insigniﬁcant but in the aggregate can make the company less competitive. Some examples are excessive labor hours for maintenance, use of special forms or supplies when standard items would be sufﬁcient, personal use of supplies, and indiscriminate use of communication and reproduction facilities. All types of overhead expenses must be evaluated and controls established to achieve cost reduction wherever possible. Although these factors may complicate somewhat the control of manufacturing overhead, the basic approach to this control is fundamentally the same as that applying to direct costs: the setting of budgets or standards, the measurement of actual performance against these standards, and the taking of corrective action when those responsible for meeting budgets or standards repeatedly fail to reach the goal. Standards may change at different volume levels; or stated in other terms, they must have sufﬁcient ﬂexibility to adjust to the level of operations under which the supervisor is working. To this extent the setting and application of overhead standards may differ from the procedure used in the control of direct material and direct labor. The degree of reﬁnement and extent of application will vary with the cost involved. The controller should make every attempt to apply fair and meaningful standards, not thinking that little is needed or that nothing can be accomplished. Also, the controller can use ABC to assign costs to products (or other entities, such as production departments or customers). This approach is better than the traditional method of assigning a uniform overhead rate to all production, since it assigns overhead costs to speciﬁc products based on their use of various activities, resulting in more accurate product costs.

21.4 PROPER DEPARTMENTALIZATION OF EXPENSES One of the most essential requirements for either adequate cost control or accurate cost determination is the proper classiﬁcation of accounts. Control must be exercised at the source, and since costs are controlled by individuals, the primary classiﬁcation of accounts must be by individual responsibility — “ responsibility accounting.” This generally requires a breakdown of expenses by factory departments that may be either productive departments or service departments, such as maintenance, power, or tool crib. Sometimes, however, it becomes necessary to divide the expense classiﬁcation more ﬁnely to secure a proper control or costing of products — to determine actual expenses and expense standards by cost center. This decision about the degree of reﬁnement will depend largely on whether improved product costs result or whether better expense control can be achieved. A cost center, which is ordinarily the most minute division of costs, is determined on one of the following bases: • One or more similar or identical machines • The performance of a single operation or group of similar or related operations in the manufacturing process The separation of operations or functions is essential because a foreman may have more than one type of machine or operation in his department—all of which affect costs. One product may require the use of expensive machinery in a department, and another may need only some simple hand operations. The segregation by cost center will reveal this cost difference. Different overhead rates are needed to reﬂect differences in services or machines required. If the controller chooses to install an ABC system, a very different kind of cost breakdown will be required. The ABC method collects costs by activities, rather than by department; for example, information might be collected about the costs associated with engineering change orders, rather

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Ch. 21 Planning and Control of Manufacturing Costs: Manufacturing Expenses

than the cost of the entire engineering department. If management decides that it wants both ABC and departmental cost information, then the controller must record the information twice — once by department and again by activity.

21.5 VARIATIONS IN COST BASED ON FIXED AND VARIABLE COSTS * One factor that can cause costs to vary is that they contain both variable and ﬁxed elements. The cost of most products is itemized in a bill of materials (BOM) that itemizes all the components that are assembled into it. An example of a bill of materials for a desk light is shown in Exhibit 21.1. Each of the line items in this BOM are variable costs, for each one will be incurred only if a desk light is created — that is, the costs vary directly with unit volume. In its current format, the BOM is very simple; we see a quantity for each component, a cost per component, and a total cost for each component that is derived by multiplying the number of units by the cost per unit. The only line item in this BOM that does not include a cost per unit or number of units is the overhead cost, which is situated near the bottom. This line item represents a variety of costs that are being allocated to each desk lamp produced. The costs included in this line item represent the ﬁxed costs associated with lamp production. For example, there may be a legal cost associated with a patent that covers some feature of the desk lamp, the cost of a production supervisor who runs the desk lamp assembly line, a buyer who purchases components, the depreciation on any equipment used in the production process—the list of possible costs is lengthy. The key factor that brings together these ﬁxed costs is that they are associated with the production of desk lamps, but they do not vary directly with the production of each incremental lamp. For example, if one more desk lamp is produced, there will be no corresponding increase in the legal fees needed to apply for or protect the patent that applies to the lamp. This splitting of costs between variable and ﬁxed costs can occupy the extremes of entirely ﬁxed costs or entirely variable ones, with the most likely case being a mix of the two. For example, a software company that downloads its products over the Internet has entirely ﬁxed costs; it incurs substantial costs to develop the software and set up a web site for downloading purposes, but then incurs zero costs when a customer downloads the software from the web site (though even in this case, there will be a small credit card processing fee charged on each transaction). Alternatively, a custom programming company will charge customers directly for every hour of time its programmers spend on software development, so that all programming costs are variable Component Description Base Switch Spring Extension arm, lower Extension arm, upper Adjustment knob Bulb holder Bulb Bulb lens Overhead costs Total cost E XHIBIT 21.1

B ILL

OF

Quantity

Cost/ Each

Total Cost

1 1 4 1 1 2 1 1 1 — —

$17.00 .75 .25 3.75 4.25 .75 .30 2.15 1.50 6.20 —

$17.00 .75 1.00 3.75 4.25 1.50 .30 2.15 1.50 6.20 $ 38.40

M ATERIALS

* Summarized with permission from Chapter 29 of Steven M. Bragg, Cost Accounting (Wiley, Hoboken, NJ: 2001).

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(though any administrative costs still will be ﬁxed). To use a variation on the software example, a software developer that sells its products by storing the information on CDs or diskettes, printing instruction manuals, and mailing the resulting packages to customers will incur variable costs associated with the mailed packages, and ﬁxed costs associated with the initial software development. All three variations on the variable-ﬁxed cost mix are shown in Exhibit 21.2. In the exhibit, the ﬁrst graph shows a straight horizontal line, indicating that there is no incremental cost associated with each additional unit sold. The second graph shows a steeply sloped line that begins at the X-Y intercept, which indicates that all costs are incurred as the result of incremental unit increases in sales. Finally, the third graph shows the sloped line beginning partway up the left side of the graph, which indicates that some (ﬁxed) costs will be incurred even if no sales occur. To return to the BOM listed earlier in Exhibit 21.1, the format does a good job of itemizing the variable costs associated with the desk lamp, but a poor one of describing the ﬁxed costs associated with the product; there is only a single line item for $6.20 that does not indicate what costs are included in the overhead charge, nor how it was calculated. In most cases, the number was derived by summarizing all overhead into a single massive overhead cost pool for the entire production facility, which is then allocated out to the various products based on the proportion of direct labor that was charged to each product. However, many of the costs in the overhead pool may not be related in any way to the production of desk lamps, nor may the use of direct labor hours be an appropriate way in which to allocate the ﬁxed costs. This is a key area in which the costing information provided by controllers can result in incorrect management decisions of various kinds. For example, if the purpose of a costing inquiry by management is to add a standard margin to a cost and use the result as a product’s new price, then the addition of a ﬁxed cost that includes nonrelevant costs will result in a price that is too high. Similarly, using the same information but without any ﬁxed cost may result in a price that is too low to ever cover all related ﬁxed costs unless enormous sales volumes can be achieved. One of the best ways to avoid this problem with the proper reporting of ﬁxed costs is to split the variable and ﬁxed cost portions of a product’s cost into two separate pieces, and then report them as two separate line items to the person requesting the information. The variable cost element is reported as the cost per unit, while the ﬁxed cost element is reported as the entire ﬁxed cost pool, as well as the assumed number of units over which the cost pool is being spread. To use the desk lamp example, the report could look like this: In response to your inquiry regarding the cost of a desk lamp, the variable cost per unit is $32.20, and the ﬁxed cost is $6.20. The ﬁxed cost pool upon which the ﬁxed cost per unit is based is $186,000, and is divided by an assumed annual sales volume of 30,000 desk lamps to arrive at the ﬁxed cost of $6.20 per unit. I would be happy to assist you in discussing this information further.

We do not know the precise use to which our costing information will be put by the person requesting the preceding information, so we are giving her the key details regarding the ﬁxed and variable cost elements of the desk lamp, from which she can make better decisions than would be the case if she received only the total cost of the desk lamp. This approach yields better management information, but, as we will see in the following sections, there are many other issues that can also impact a product’s cost and that a controller should be aware of before issuing costing information to the rest of the organization.

21.6 VARIATIONS IN COST BASED ON DIRECT LABOR One of the larger variable costs noted in a product’s bill of materials is direct labor. This is the cost of all labor that is directly associated with the manufacture of a product. For example, it includes the cost of an assembly person who creates a product, or the machine operator whose equipment stamps out the parts that are later used in a product. However, it does not include a wide range of supporting activities, such as machine maintenance, janitorial services, production scheduling, or management, for these activities cannot be quite so obviously associated with a particular product. Consequently, direct labor is itemized separately on the BOM (as noted in Exhibit 21.3), while all

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Ch. 21 Planning and Control of Manufacturing Costs: Manufacturing Expenses

Cost

Graph of Purely Fixed Costs

Fixed Costs

Volume

Cost

Graph of Purely Variable Costs

Variable Costs

Volume

Cost

Graph of Mixed Fixed and Variable Costs

Variable Costs Fixed Costs

Volume

E XHIBIT 21.2

G RAPHS

OF

F IXED C OSTS , V ARIABLE C OSTS ,

AND

M IXED C OSTS

other indirect labor elements are lumped into the ﬁxed cost line item. In the exhibit, we have now switched from just one type of unit-based cost, as was noted in Exhibit 21.1, to two types of costs; one is still based on a cost per unit, but now we have included direct labor, which is based on a cost per hour. Accordingly, there is now a “unit of measure” column in the BOM that identiﬁes each type of cost. The two types of direct labor itemized in the BOM are listed as a cost per hour, along with the fraction of an hour that is required to manufacture the desk lamp.

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The trouble with listing direct labor as a separate variable product cost is that it is not really a variable cost in many situations. Companies are not normally in the habit of laying off their production workers when there is a modest reduction in production volume, and will sometimes retain many key employees even when there is no production to be completed at all. This is hardly the sort of behavior that will lead a controller to treat a cost as variable. The reason why companies retain their production employees, irrespective of manufacturing volume, is that the skills needed to operate machinery or assembly products are so valuable that a well-trained production person can achieve much higher levels of productivity than an untrained one. Accordingly, companies are very reluctant to release production employees with proven skills. While this issue may simply result in the layoff of the least trained employees, while retaining the most experienced personnel at all times, the more common result is a strong reluctance by managers to lay off anyone; the level of experience that is lost with even a junior employee is too difﬁcult to replace, especially in a tight job market where the pool of applicants does not contain a high level of quality. Direct labor also can be forced into the ﬁxed cost category if there is a collective bargaining agreement that severely restricts the ability of management to lay off workers or shut down production facilities. This issue is exacerbated by some national laws, such as those of Germany, that lay signiﬁcant restrictions on the closure of production facilities. Managers are also forced by the unemployment tax system to avoid layoffs. The unemployment tax is based on the number of employees from a speciﬁc company who applied to the government for unemployment beneﬁts in the preceding year. If there was a large layoff, then the unemployment tax will rise. Managers who are cognizant of this problem will do their best to avoid layoffs in order to avoid the unemployment tax increase, though layoffs are still the most rational approach for a company that faces massive overstafﬁng with no near-term increase in production foreseen. In this instance, the cost of the unemployment insurance increase is still cheaper than the cost of keeping extra workers on the payroll. The primary impact of these issues on the bill of materials is that the BOM identiﬁes direct labor as a variable cost, when in reality it is a ﬁxed one in many situations. Accordingly, it may be best for a controller to itemize this cost as ﬁxed if there is no evidence of change in stafﬁng levels as production volumes vary.

21.7 VARIATIONS IN COST BASED ON BATCH SIZE A major issue that can signiﬁcantly affect a product’s cost is the size of the batches in which parts are purchased, as well as manufactured. For example, if the purchasing department buys a trailerload of switches for the desk lamp in our ongoing example, then the per-unit cost will be very low, Component Description

Unit of Measure

Quantity

Cost/Each

Total Cost

Ea Ea Ea Ea Ea Ea Ea Ea Ea Hr Hr —

1.0 1.0 4.0 1.0 1.0 2.0 1.0 1.0 1.0 2.5 2.0 —

$17.00 .75 .25 3.75 4.25 .75 .30 2.15 1.50 18.00 12.50 6.20

—

—

$ 17.00 .75 1.00 3.75 4.25 1.50 .30 2.15 1.50 45.00 25.00 6.20 $ 108.40

Base Switch Spring Extension arm, lower Extension arm, upper Adjustment knob Bulb holder Bulb Bulb lens Fabrication labor Assembly labor Overhead costs Total cost E XHIBIT 21.3

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B ILL

OF

M ATERIALS

WITH

D IRECT L ABOR C OMPONENT

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432

Ch. 21 Planning and Control of Manufacturing Costs: Manufacturing Expenses

since the switch manufacturer can produce a lengthy production run of switches, with minimal setup costs. The per-unit cost will also be lowered due to the reduced cost of packaging and transportation, given the beneﬁts of bulk shipping. However, if the purchasing staff buys only one switch, then the manufacturer will charge a premium amount for it, either because a single production run must be set up for the single unit of output, or (if the item is already stored in the manufacturer’s warehouse) because the switch must be pulled from stock, individually packaged, and shipped. All of these manufacturing, shipping, and handling costs cannot be spread over many switches, since only one unit has been ordered. Accordingly, the per-unit cost is much higher when ordering in smaller volumes. This is a particular problem when a company orders in odd-lot volumes. When this happens, the manufacturer of the part must repackage the items ordered into a new shipping conﬁguration, possibly having to recreate the correct-size shipping containers, just to satisfy the company’s order size. Another way of looking at the volume-related cost issue is that the proportion of ﬁxed costs to variable costs within a product increases as the production volume drops. For example, if a product has $10 of variable costs and a onetime machinery setup cost of $4,500, then the proportion of variable to ﬁxed costs will change with production volumes as noted in Exhibit 21.4. A controller must be cognizant of the proportional increase in ﬁxed cost as volume drops, since this means that the full cost per unit will increase as volume declines. To use the example in Exhibit 21.4, at the volume level of 2,000 units produced, the full cost per unit is $12.25, but this cost per unit increases to $19.00 as volume drops to 500 units. To ensure that the most accurate possible information is assembled regarding order sizes, it is best to specify a volume range in the BOM within which the per-unit costs are accurate. An example of this format is shown in Exhibit 21.5, where we have included an extra column denoting the batch range for each line item. This range is also useful for labor, since there is a learning curve (covered in a later section) associated with longer production runs that results in greater labor efﬁciency.

Volume

Total Variable Cost

Total Fixed Cost

Percentage of Fixed Cost

$20,000 $10,000 $ 5,000

$4,500 $4,500 $4,500

18% 31% 47%

2,000 units 1,000 units 500 units E XHIBIT 21.4

Component Description Base Switch Spring Extension arm, lower Extension arm, upper Adjustment knob Bulb holder Bulb Bulb lens Fabrication labor Assembly labor Overhead costs

P ROPORTION OF F IXED V OLUME C HANGES

TO

T OTAL C OSTS

Unit of Measure

Batch Range

Quantity

Cost/Each

Total Cost

Ea Ea Ea Ea Ea Ea Ea Ea Ea Hr Hr —

500–1,000 1,000 –2,000 5,000 –8,000 250 –500 250 –500 400 –800 1,000 –5,000 2,000 –2,500 500–1,000 250 –500 Units 250 –500 Units —

1.5 1.5 4.5 1.5 1.5 2.5 1.5 1.5 1.5 2.5 2.0 —

$17.00 .75 .25 3.75 4.25 .75 .30 2.15 1.50 18.00 12.50 6.20

—

—

$ 17.00 .75 1.00 3.75 4.25 1.50 .30 2.15 1.50 45.00 25.00 6.20 $ 108.40

Total cost E XHIBIT 21.5

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B ILL

OF

AS

M ATERIALS

WITH

B ATCH R ANGE

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21.8 Variations in Cost Based on Overhead

433

The controller may need to supply a copy of the BOM with any reports that itemize batch sizes, since the reader may need to know the speciﬁc volumes within which the costs of certain line items will be valid. An additional problem related to batch size is sudden jumps in costs that are incurred when production volumes surpass a speciﬁc level; these are known as step costs. An example of a step cost is the purchase of a new machine to relieve a production bottleneck. If the machine were not obtained, there would be no way to increase production capacity. The machine must be purchased in order to increase production volume by just one additional unit, so this constitutes a considerable incremental cost if the unit volume is to be increased by only a small amount. This concept is particularly important if a company is operating at production levels that are close to the maximum possible with existing equipment and personnel, for nearly any subsequent decision to increase production may result in the incurrence of a step cost. Other types of step costs are the addition of a supervisor if a new shift is opened up, or a new building if a production line must be built elsewhere, or a new warehouse to store the additional volumes of material needed for a new production line. A controller must be particularly cognizant of this volume-driven issue, since the costing information he issues may be relied upon to increase production to levels where new step costs will take effect, thereby rendering the initial cost report irrelevant. A good way to ensure that a cost report is used correctly is to list on it the volume range within which the stated costs are accurate, and to further note that the controller should be consulted if volumes are expected to vary beyond this range. An excellent competitive tool for companies that want to adjust their prices to match different production volumes is to maintain a separate database of unit costs for a wide range of production and purchasing volumes. The marketing staff can use this information to conduct what-if analyses for a speciﬁc level of sales volume, so that it can estimate, with a fair degree of precision, the profits to be expected at each volume level. Unfortunately, such a database is usually custom-designed, and requires a great deal of research to assemble the data for all relevant volume ranges. Some Japanese companies have taken over a decade to create such systems.

21.8 VARIATIONS IN COST BASED ON OVERHEAD The line item in a BOM that continually raises the most questions from the recipients of cost reports is for overhead cost. They ask if this cost is relevant, what makes up the number, and how it is allocated. The relevance of overhead costs is entirely dependent on the use to which the cost information will be put. If the report recipient is concerned only with pricing a product to a level near its variable cost, then there is certainly no need for the overhead cost, which can be ignored. However, if the issue is what price to set over the long term in order to cover all ﬁxed costs, then the overhead ﬁgure must be included in the calculation. If the latter reasoning is used, then the controller must delve deeper into the manner in which overhead costs are calculated and allocated, to ensure that only relevant overhead costs are charged on the BOM. There are two factors that go into the production of the overhead number. One is the compilation of the overhead pool, which yields the grand total of all overhead costs that subsequently will be allocated to each product. The second factor is the allocation method that is used to determine how much of the ﬁxed cost is allocated to each unit. The overhead cost pool can contain a wide array of costs that are related to the production of a speciﬁc product in varying degrees. For example, there may be machine-speciﬁc costs, such as setup, depreciation, maintenance, and repairs, that have some reasonably traceable connection to a speciﬁc product at the batch level. Other overhead costs, such as building maintenance or insurance, are related more closely to the building in which the production operation is housed, and have a much looser connection to a speciﬁc product. The overhead cost pool may also contain costs for the management or production scheduling of an entire production line, as well as the costs of distributing product to customers. Given the wide-ranging nature of these costs, it is evident that a hodgepodge of costs are being accumulated into a single cost pool, which almost certainly will result in very inaccurate allocations to individual products.

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Ch. 21 Planning and Control of Manufacturing Costs: Manufacturing Expenses

The allocation method is the other factor that impacts the cost of overhead. Far and away the most common method of allocation is based on the amount of direct labor dollars used to create a product. This method can cause considerable cost misallocations, because the amount of labor in a product may be so much smaller than the quantity of overhead cost to be allocated that anywhere from $1 to $4 may be allocated to a product for every $1 of direct labor cost in it. Given the high ratio of overhead to direct labor, it is very easy for the amount of overhead charged to a product to swing drastically in response to a relatively minor shift in direct labor costs. A classic example of this problem is what happens when a company decides to automate a product line. When it does so, it incurs extra costs associated with new machinery, which adds to the overhead cost pool. Meanwhile, the amount of direct labor in the product plummets, due to the increased level of automation. Consequently, the increased amount of overhead—which is directly associated with the newly automated production line—is allocated to other products whose production has not yet been automated. This means that a product that is created by an automated production line does not have enough overhead cost allocated to it, while the overhead costs assigned to more laborintensive products is too high. There are solutions to the problems of excessively congregated cost pools, as well as allocations based on direct labor. One is to split the single overhead allocation pool into a small number of overhead cost pools. Each of these pools should contain costs that are closely related to each other. For example, there may be an assembly overhead cost pool (as noted in Exhibit 21.6) that contains only those overhead costs associated with the assembly operation, such as janitorial costs, the depreciation and maintenance on assembly equipment, and the supervision costs of that area. Similarly, there can be another cost pool (as also noted in Exhibit 21.6) that summarizes all fabrication costs. This pool may contain all costs associated with the manufacture and procurement of Component Description Base Switch Spring Extension arm, lower Extension arm, upper Adjustment knob Bulb holder Bulb Bulb lens Fabrication labor Assembly labor Assembly overhead Fabrication overhead Plant overhead

Unit of Measure

Batch Range

Scrap Percentage

Quantity

Cost/Each

Total Cost

Ea Ea Ea

500–1,000 1,000 –2,000 5,000 –8,000

— — —

1.00 1.00 4.00

$17.00 .75 .25

$ 17.00 .75 1.00

Ea

250 –500

8%

1.00

3.75

4.05

Ea

250 –500

8%

1.00

4.25

4.59

Ea Ea Ea Ea

400 –800 1,000 –5,000 2,000 –2,500 500–1,000

5% — 1% 2%

2.00 1.00 1.00 1.00

.75 .30 2.15 1.50

1.58 .30 2.17 1.53

Hr

250 –500 units

—

2.5

18.00

45.00

Hr Assembly labor hour Fabrication machine hour Square footage

250 –500 units

—

2.0

12.50

25.00

500–1,000 hours

—

2.0

3.25

6.50

625–1,250 hours

—

2.5

1.20

3.00

5,000 square feet

—

1.5

1.75

1.75

—

—

$ 114.22

Total cost E XHIBIT 21.6

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B ILL

OF

M ATERIALS

WITH

M ULTIPLE O VERHEAD C OSTS

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21.9 Variations in Cost Based on Time

435

all component parts, which includes the costs of machinery setup, depreciation, and maintenance, as well as purchasing salaries. Finally, there can be an overall plant overhead cost pool that includes the costs of building maintenance, supervision, taxes, and insurance. It may not be useful to exceed this relatively limited number of cost pools, for the complexity of cost tracking can become excessive. The result of this process is a much better summarization of costs. Each of the newly created cost pools then can be assigned a separate cost allocation method that has a direct relationship between the cost pool and the product being created. For example, the principal activity in the assembly operation is direct labor, so this time-honored allocation method can be retained when allocating the costs of the assembly overhead cost pool to products. However, the principle activity in the fabrication area is machine hours, so this becomes the basis of allocation for fabrication overhead costs. Finally, all building-related costs are best apportioned through the total square footage of all machinery, inventory, and related operations used by each product, so square footage becomes the basis of allocation for this cost pool. The result of these changes, as noted in Exhibit 21.6, is an altered BOM that replaces a single overhead cost line item with three different overhead costs, each one being allocated based on the most logical allocation measure. A ﬁnal issue related to overhead is the frequency with which the overhead cost per unit is calculated. When the controller adds the overhead cost to a BOM, the typical process is to calculate the overhead cost pool, apply an allocation formula, and enter the cost—and not update the resulting ﬁgure again for a long time. The updating process can be as laborious as manually accessing each BOM to make an update, or else entering a dollar cost for each unit of allocation (such as per dollar of direct labor, hour of machine time, etc.) into a central computer screen, which the computer system then uses to automatically update all BOMs. In either case, the overhead cost in each BOM will not be updated unless speciﬁc action is taken by the controller to update the overhead ﬁgures. Consequently, the overhead cost in a BOM must be regularly updated to ensure its accuracy. By using this more reﬁned set of overhead allocation methods, the accuracy of cost reports can be increased. In particular, it tells managers which cost pools are responsible for the bulk of overhead costs being assigned to speciﬁc products. This is information they can use to target reductions in these cost pools, thereby reducing overhead charges.

21.9 VARIATIONS IN COST BASED ON TIME The old adage points out that in the long run, nothing is certain except for death and taxes. This is not precisely true. Also, virtually all costs are variable in the long run. Accountants are good at classifying costs as ﬁxed or variable, but they must remember that any cost can be eliminated if enough time goes by in which to effect a change. For example, a production facility can be eliminated, as can the taxes being paid on it, as well as all of the machinery in it and the people employed there. Though these items may all seem immovable and utterly ﬁxed in the short run, a determined manager with a long-term view of changing an organization can eliminate or alter them all. Some ﬁxed costs can be converted into variable costs more easily than others. There are three main categories into which ﬁxed costs can fall: 1. Programmable costs. These are costs that are generally considered to be ﬁxed but that can be eliminated relatively easily and without the passage of much time, while also not having an immediate impact on a company’s daily operations. An example of such a cost is machine maintenance. If a manager needs to hold down costs for a short period, such as a few weeks, eliminating machine maintenance should not have much of an impact on operations (unless the equipment is subject to continual breakdown!). 2. Discretionary costs. These are costs that are not considered to vary with production volume and that frequently are itemized as administrative overhead costs. Again, these are costs that can be eliminated in the short run without causing a signiﬁcant impact on operational efﬁciencies. Examples of discretionary costs are advertising costs and training expenses. 3. Committed costs. These are costs to which a company is committed over a relatively long period, such as major capital projects. Due to the amount of funding involved, the amount of

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Ch. 21 Planning and Control of Manufacturing Costs: Manufacturing Expenses

sunk costs, and the impact on production capabilities, these are costs that can be quite difﬁcult to eliminate. A manager who is looking into a short-term reduction in costs will focus his or her attention most proﬁtably on the reduction of programmable and discretionary costs, since they are relatively easy to cut. If the intention is a long-term reduction, and especially if the size of reduction contemplated is large, then the best type of ﬁxed cost to target is committed costs. If the manager requesting costing information is undertaking a long-term cost-reduction effort, the controller should go to great lengths to identify the exact nature of all ﬁxed costs in the costing analysis, so that the recipient can determine whether these costs can be converted to variable costs over the long term, or even completely eliminate them.

21.10 COST ESTIMATION METHODS We have covered a number of issues that impact cost. After reviewing the preceding list, one might wonder how anyone ever estimates a cost with any degree of accuracy, given the number of issues that can impact it. In this section, we cover a number of methods, with varying degrees of accuracy and difﬁculty of use, that can be used to derive costs at different levels of unit volume. These methods are of most use in situations where the costs listed in a BOM are not reliable, due to the impact of outside variables (as noted in the preceding sections) that have caused costs to vary to an excessive degree. The ﬁrst and most popular method by far is to have very experienced employees make a judgment call regarding whether or not a cost is ﬁxed or variable, and how much it will change under certain circumstances. For example, a plant manager may decide that the cost of utilities is half ﬁxed and half based on the number of hours that machines are operated in the facility, with this number becoming totally ﬁxed when the facility is not running at all. This approach is heavily used because it is easy to make a determination, and because in many situations the result is reasonably accurate — after all, there is something to be said for lengthy experience! However, costs may be much more or less variable than an expert estimates, resulting in inaccurate costs. Also, experts tend to assign costs to either the ﬁxed or variable categories, without considering that they really might be mixed costs (as in the last example) that have both ﬁxed and variable portions. The problem can be resolved to some degree by pooling the estimates of a number of experts, or by combining this method with the results obtained from one of the more quantitative approaches to be covered shortly in this section. A more scientiﬁc approach is the engineering method. This involves having a qualiﬁed industrial engineer team with a controller to conduct exact measurements of how costs relate to speciﬁc measurements. For example, this approach may use time-and-motion studies to determine the exact amount of direct labor that is required to produce one unit of ﬁnished goods. The result is precise information about the relationship between a cost and a speciﬁc activity measure. However, this approach is extremely time consuming, and so is difﬁcult to conduct when there are many costs and activities to compare. Also, the cost levels examined will be accurate only for the speciﬁc volume range being used at the time of the engineering study. If the study were to be conducted at a different volume of production, the original costing information per unit produced may no longer be accurate. However, since many businesses operate only within relatively narrow bands of production capacity, this latter issue may not be a problem. A ﬁnal issue with the engineering method is that it cannot be used to determine the per-unit cost of many costs for which there is no direct relationship to a given activity. For example, there is only a tenuous linkage in the short run between the amount of money spent on advertising and the number of units sold, so the engineering method will be of little use in uncovering per-unit advertising costs. Despite these problems, the engineering method can be a reasonable alternative if conﬁned to those costs that bear a clear relationship to speciﬁc activities, and for which there are not signiﬁcant changes in the level of activity from period to period. An alternative approach that avoids an intensive engineering review is the scattergraph method. Under this approach, the cost accounting staff compiles activity data for a given period, and then

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437

plots it on a chart in relation to the costs that were incurred in the same period. An example of a scattergraph is shown in Exhibit 21.7. In the exhibit, we plot the relationship between the number of units produced and the total variable material cost for the period. The total material cost is noted on the Y axis and the number of units on the X axis. Though there is some variability in the positioning of costs per unit at different volume levels, it is clear that there is a signiﬁcant relationship between the number of units produced and the total variable material cost. After completing the scattergraph, the controller then manually ﬁts a line to the data (as also noted in the exhibit). Then, by measuring the slope of the line and the point where the line intercepts the Y axis, one can determine not only the variable cost per unit of production, but also the amount of ﬁxed costs that will be incurred, irrespective of the level of production. This is a good quantitative way to assemble relevant data into a coherent structure from which costing information can be derived, but suffers from the possible inaccuracy of the user’s interpretation of where the average slope and placement of the line should be within the graph. If the user creates an incorrect Y intercept or slope angle, then the resulting information pertaining to ﬁxed and variable costs will be inaccurate. However, this approach gives the user an immediate visual overview of any data items that are clearly far outside the normal cluster of data, which allows her to investigate and correct these outlying data points, or to at least exclude them from any further calculations on the grounds that they are extraneous. Further, the scattergraph method may result in a shapeless blob of data elements that clearly contain no linearities, which tells the controller that there is no relationship between the costs and activity measures being reviewed, which means that some other relationship must be found. There are two ways to create a more precise determination of the linearity of this information — the high/ low method and the regression calculation. Since the manual plotting of a “best-ﬁt” line through a scattergraph can be quite inaccurate, a better approach is to use a mathematical formula that derives the best-ﬁt line without the risk of operator error. One such method is the high/low method. To conduct this calculation, take only the highest and lowest values from the data used in the scattergram and determine the difference between them. If we use the same data noted in the scattergraph in Exhibit 21.7, the calculation of the differential would be: Total Variable Material Cost

Units Produced

$40,000 $ 8,000 $32,000

4,250 1,000 3,250

Highest value in data set Lowest value in data set Difference

Total Variable Material Cost

The calculation of the cost per unit produced is $32,000 divided by 3,250, which is the net change in cost divided by the net change in activity. The result is $9.85 in material costs per unit produced.

$50,000 $40,000 $30,000 $20,000 $10,000 $0 0

1,000

2,000

3,000

Units Produced E XHIBIT 21.7

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A S CATTERGRAPH C HART

4,000

5,000

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Ch. 21 Planning and Control of Manufacturing Costs: Manufacturing Expenses

There may also be a ﬁxed cost component to the trend line, indicating the existence of costs that will be present even if no activities occur. This is not the case in the example, since we are focusing on variable material costs. However, it may very well be the case in many other situations. For example, if the preceding trend line were the result of an analysis of machine costs to units produced, we would intuitively know that some machine costs will still occur even if there are no units produced. These costs can include the depreciation on equipment, preventive maintenance, and personal property taxes. We can still use the high/low method to determine the amount of these ﬁxed costs. To do so, we will continue to use the $9.85 per unit in variable costs that we derived in the last example, but we will increase the cost for the lowest data value observed to $11,000. We then multiply the variable cost per unit of $9.85 times the total number of units produced at the lowest observed level, which is 1,000 units, which gives us a total variable cost of $9,850. However, the total cost at the lowest observed activity level is $11,000, which exceeds the calculated variable cost of $9,850 by $1,150. This excess amount of cost represents the ﬁxed costs that will be incurred, irrespective of the level of activity. This information can be summarized into a formula that describes the line: Y intercept $1,150 Slope of line $9.85 number of units produced or, Y $1,150 ($9.85 number of units produced)

Total Variable Material Cost

The obvious problem with the high/low method is that it uses only two values out of the entire available set of data, which may result in a less accurate best-ﬁt line than would be the case if all scattergram data were to be included in the calculation. The problem is particularly acute if one of the high or low values is a stray ﬁgure that is caused by incorrect data, and is therefore so far outside of the normal range of data that the resulting high/low calculation will be signiﬁcantly skewed. This problem can be avoided to some extent if the high and low values are averaged over a cluster of values at the high and low ends of the data range, or if the data are visually examined prior to making the calculation, and clearly inaccurate data are either thrown out or corrected. A formulation that avoids the high/low calculation’s problem of using too few data items is called linear regression. It uses every data item in a data set to calculate the variable and ﬁxed cost components of an activity within a speciﬁc activity range. This calculation is best derived on an electronic spreadsheet, which can quickly determine the best-ﬁt line on the scattergram that comes the closest to all data points. It does so by calculating the line for which the sum of all squared deviations between the line and all data elements results in the smallest possible ﬁgure. The result is shown in Exhibit 21.8, where a line has been plotted through the scattergram by the computer. A variation on the process is shown in the same graph, which includes a curvilinear regression line that matches the data more closely. The curvilinear approach does not force the computer program to determine a $50,000 $40,000 $30,000 $20,000 $10,000 $0 0

1,000

2,000

3,000

4,000

Units Produced E XHIBIT 21.8

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L INEAR

AND

C URVILINEAR R EGRESSION A NALYSIS

5,000

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21.11 Normal Activity

439

straight line from the available data, thereby revealing trends in the data that may not otherwise be immediately apparent, such as higher or lower variable costs per unit at different volume levels. The regression calculation method is the most accurate of all the cost prediction models, but suffers from several issues that one must be aware of when creating regression calculations. They are: • Verify a valid cause-and-effect relationship. Even though the regression analysis may appear to have found a solid relationship between an activity and a cost, be sure to give the relationship a reality test to ensure that it is valid. For example, there is a long-running and completely irrelevant relationship between the length of women’s skirts and variations in the stock market. Even though there may be a statistically valid relationship, there is no reason in fact for the relationship to exist, and so there is no reason for changes in the activity to accurately predict stock market volatility in the future. Similarly, make sure that the activity measure being included in a regression analysis bears some reasonable relationship to the cost being reviewed. • Pick a cost driver with a statistically strong relationship to the activity being measured. No matter how obviously a cost driver appears to relate to an activity from the standpoint of common sense, it may not be suitable if the measured data do not support the relationship. Evidence of a tight relationship is one where the trend line in the regression analysis has a steep slope, and about which the data points are tightly clustered. If this is not the case, another cost driver should be found that results in a better statistical relationship. • Verify the accuracy of data collection methods. A regression analysis may result in a weak correlation between a cost driver and an activity—not because there is in fact a weak correlation, but because the data collection system that compiles the activity data is not functioning properly. To correct this problem, one should examine the procedures, forms, training, and data entry methods used to accumulate all activity data, and have the system periodically audited to ensure that the correct information is being reported. • Include all relevant costs. When comparing an activity to a cost, a common problem is to not include costs because they are recorded either in the wrong account or in the wrong time period. In the ﬁrst case, this requires better attention to how costs are compiled and stored in the accounting system. In the latter case, the easiest way to ensure that costs are included in the correct time period is to lengthen the time period used for the study — for example, from a month to a quarter. By doing so, inter-period changes in costs are eliminated, and the sample size is so much larger that any remaining problems with the timing of costs are rendered statistically insigniﬁcant. • Ensure that the time required is worth the effort. A regression analysis involves the determination of a cost driver, data collection, plotting on a scattergraph to ﬁnd and correct outlying data items, and then (ﬁnally) the actual regression calculation. If the beneﬁt of obtaining this information is less than the not-inconsiderable cost of the effort required to obtain it, then switch to a less accurate and less expensive prediction method that will yield a more favorable cost/beneﬁt ratio. No matter which of the preceding methods are used, there still will be the potential for errors in costing predictions, given the various problems inherent with each method. To counteract some of these problems, it is useful to combine methods. For example, the linear regression method can derive an accurate formulation of ﬁxed costs and variable costs per unit, but only if the data being used are accurate; by preceding the regression analysis with a review of the data by an expert who can throw out or adjust inaccurate data, the resulting regression analysis will be signiﬁcantly improved. This same principle can be applied to any of the quantitative measures noted here: Have the underlying data reviewed by experienced personnel prior to running the calculations, and the results will be improved.

21.11 NORMAL ACTIVITY A signiﬁcant consideration in the control of manufacturing overhead expense through the analysis of variances is the level of activity selected in setting the standard costs. While it has no direct

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Ch. 21 Planning and Control of Manufacturing Costs: Manufacturing Expenses

bearing on the planning and control of the manufacturing expenses of each individual department, it does have an impact on the statement of income and expenses (both planned and actual) as well as on the statement of ﬁnancial position. As to the income statement, it is desirable to identify the amount of manufacturing expense “absorbed” by or allocated to the manufactured product, with the excess expense identiﬁed as variance from the standard cost. This variance or excess cost ordinarily should be classiﬁed as to cause. As to the statement of ﬁnancial position, the normal activity level has a direct impact on inventory valuation and, consequently, on the cost-of-goods-sold element of the income statement, in that it helps determine the standard product cost. It should be obvious that the ﬁxed element of unit product costs is greatly inﬂuenced by the total quantity of production assumed. Of equal importance is the necessity of a clear understanding by management of the signiﬁcance of the level selected, because in large part it determines the “volume” variance. Generally speaking, there are three levels on which ﬁxed standard manufacturing overhead may be set: 1. The expected sales volume for the year, or other period, when the standards are to be applied 2. Practical plant capacity, representing the volume at which a plant could produce if there were no lack of orders 3. The normal or average sales volume, here deﬁned as normal capacity Some general comments may be made about each of these three levels. If expected sales volume is used, all costs are adjusted from year to year. Consequently, certain cost comparisons are difﬁcult to make. Furthermore, the resulting statements fail to give management what may be considered the most useful information about volume costs. Standard costs would be higher in low-volume years, when lower prices might be needed to get more business, and lower in high-volume years, when the increased demand presumably would tend toward higher prices. Another weakness is that the estimate of sales used as a basis would not be too accurate in many cases. Practical plant capacity as a basis tends to give the lowest cost. This can be misleading because sales volume will not average this level. Generally, there will always be large unfavorable variances, the unabsorbed expense. Normal sales volume or activity has been deﬁned as the utilization of the plant that is necessary to meet the average sales demand over the period of a business cycle or at least long enough to level out cyclical and seasonal inﬂuences. This base permits a certain stabilization of costs and the recognition of long-term trends in sales. Each basis has its advantages and disadvantages, but normal capacity would seem to be the most desirable under ordinary circumstances. Where one product is manufactured, normal capacity can be stated in the quantity of this unit. In those cases where many products are made, it is usually necessary to select a common unit for the denominator. Productive hours are a practical measure. If the normal productive hours for all departments or cost centers are known, the sum of these will represent the total for the plant. The total ﬁxed costs divided by the productive hours at normal capacity results in the standard ﬁxed cost per productive hour. Volume variances can also cause costing problems in an ABC environment. Activity costs are derived by dividing estimated volumes of activity drivers into activity cost pools to derive costs for individual activities. If the estimated volume of an activity driver deviates excessively from the actual amount, then the activity cost applied to a product may signiﬁcantly alter the product’s ABC cost. For example, there are estimated to be 1,000 material moves associated with a product in a month, and the total cost of those moves in a month is $10,000, which is $10 per move. If the actual number of moves associated with the product is 2,000, then the cost per move that is applied to product costs is off by $5 per move. However, if the ABC system collects activity driver volume information for every accounting period, then the volume variance will not occur.

21.12 ALLOCATION OF INDIRECT PRODUCTION COSTS This section discusses the methods for storing and allocating costs in a typical cost accounting system, as well as the types of costs that are typically found in an indirect production cost pool. The

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discussion is designed to leave the reader with a good understanding of how to organize costs into an adequate cost allocation system. It is common for a company to have a large amount of overhead costs that are not readily identiﬁable to a speciﬁc product or service. These costs can include engineering, ﬁxed asset charges, general supervision, and quality-related costs. Though it is possible to simply lump these costs into a massive overhead account,” it is irresponsible to do so, because this means that there is minimal identiﬁcation of or control over what may very well be the largest expense in the company. To attain greater control over these costs, it is best to ﬁrst group costs into cost pools, from which they can be allocated to various activities. Most companies still use just one cost pool to allocate costs to activities. This single overhead cost pool is frequently allocated to products based on the labor that goes into making them. For example, if all overhead costs during the period equal $1 million and the total direct labor incurred during that period equals $100,000, then a controller is theoretically justiﬁed in charging $10 to a product for every dollar of direct labor cost that it has absorbed. The problems with this allocation approach are that the costs contained in the single cost pool may not directly relate to the product, while the direct labor rate may not be the best way to allocate costs to the product. A better approach is to group costs into different cost pools related to speciﬁc activities, and then allocate those costs based better allocation measures. Examples of cost pools are: • Employee-related costs. These costs can include beneﬁts, the cost of payroll systems, and the entire cost of the human resources and payroll departments. This cost pool should be allocated out to activities based on their use of employees — for example, an activity like production, that normally uses a large proportion of a company’s employees, should be charged with a large proportion of this cost pool. • Equipment-related costs. Many costs directly relate to speciﬁc machines or groups of machines, such as depreciation, maintenance, and repairs. These costs can easily be charged back to the machines based on the amount of machine usage. It is common for each machine to have its own cost pool, which can then be charged out to production jobs based on the machine hours used by each job. • Materials-related costs. There are signiﬁcant costs associated with storing and moving materials, such as taxes insurance, a warehouse staff, and materials handling equipment. These costs can be charged to speciﬁc products based on the square footage occupied by ﬁnished goods, as well as by the space taken up by component parts. • Occupancy-related costs. A building requires expenditures for utilities, repairs, insurance, and a maintenance staff, all of which can be stored in a cost pool and charged out to various activities based on the square footage they require. • Transaction-related costs. Some activities require a considerable usage of transaction processing expenses, such as order entry time, the time to issue an invoice and collect on it, and procure materials for an order. There are signiﬁcant staff expenses attached to these activities, which can be charged out based on order size or frequency, or even the number of invoices issued. All of these cost pools have a different allocation method, because company activities use the costs in different ways. For example, a production job should be charged for the machine hours it uses on a speciﬁc machine, rather than direct labor hours, because the machine usage more correctly reﬂects the job’s use of a company asset. Though this may seem like a relatively simple and accurate approach to allocating costs, there are a variety of problems to be aware of: • New cost-tracking systems needed. A traditional cost allocation system uses only one cost pool, so this revised approach, with multiple pools, requires a different cost roll-up methodology in the general ledger, as well as the storage of information about the different allocation methods to be used. For example, the existing system may not track the usage of a speciﬁc machine by all production jobs, which is needed to properly allocate costs from the cost pool. • Multilevel allocations are probable. Not all cost pools can be charged straight to an activity or customer, because there is no direct relationship. Instead, one cost pool may have to be

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Ch. 21 Planning and Control of Manufacturing Costs: Manufacturing Expenses

charged to another cost pool, which in turn is charged to the ﬁnal activity. For example, the cost pool for occupancy-related costs must ﬁrst be charged (at least in part) to the machine cost pool, since each machine uses up some building space (which is the usual allocation method for occupancy costs); the enlarged machine cost pool is then charged to an activity. • Some costs do not ﬁt into any cost pools. There will always be some costs, such as the receptionist’s salary or subscriptions, that do not easily fall into the usual cost pools, and which could not justiﬁably be charged to an activity in any event. These costs should be segregated and tracked; if the total of these costs becomes excessive, there should be a review to determine which costs actually can be shifted to a cost pool—an excessive amount of unallocatable costs leads one to conclude that there are too many costs that are probably not justiﬁed in order to run a company. This section described the most common cost pools used to allocate indirect costs, as well as the allocation methods used to charge the pooled costs out to activities. Though presented in a simpliﬁed manner, this should be sufﬁcient information for a controller to construct a simple indirect cost allocation system.

21.13 BUDGETARY PLANNING AND CONTROL OF MANUFACTURING EXPENSES Having discussed those special factors that are important in the proper planning and control of manufacturing expense, we will now review some of the budgetary methods. It should be understood that manufacturing expenses can be controlled through the use of unit standards applied to the expense type or department under consideration. Probably budgetary control is the technique more useful in the overall planning of expense levels, as well as the control phase. Three types of budgets might be applied in the manufacturing expense area: 1. A ﬁxed- or administrative-type budget 2. A ﬂexible budget, wherein certain expenses should vary with volume handled 3. A step-type budget (a) FIXED-TYPE BUDGET. The ﬁxed-type budget is, as the name implies, more or less constant in the amount of budgeted or allowed expenses for each month. The permitted expense level does change somewhat to reﬂect a differing volume of manufacturing. Basically, the planning procedure is one wherein the department manager estimates the level of expenses, by account, for each month of the planning period, with some recognition given to expected differing amounts of production. These monthly estimates are subject to review by a superior (with the advice in some instances of the controller or budget director). The control phase consists in comparing actual expense incurred with the predetermined estimate. An example of a summary planning budget of the ﬁxed type for the manufacturing department is illustrated in Exhibit 21.9. While the budget estimate in this exhibit reﬂects only the annual and quarterly amounts, in practice the estimate is prepared on a monthly basis. This ﬁxed type of budget has the advantage of simplicity, and some recognition is given to the small changes in production level. Where production volume is nearly constant, perhaps the method is satisfactory. If the monthly budget in the example is predicated on a volume of 43,333 machine hours (1/3 of 130,000) and the actual level turns out to be 51,000, can the resulting budget comparison be deemed a good control tool? For expenses that are truly ﬁxed, it would be satisfactory. For expenses that should vary by production volume, the “allowed” budget may be inadequate— if such a wide variance happens frequently. (b) FLEXIBLE BUDGET. The ﬂexible or variable budget recognizes that some expense levels should change as the volume of production varies, and it is the type suggested for proper planning and control of manufacturing expenses in many instances. An illustrative annual planning budget is shown in Exhibit 21.10. An example of a related budgetary control report is presented in Exhibit 21.11.

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E XHIBIT 21.9

$ 170,000 66,000 742,000 978,000 391,200 243,100 191,300 71,000 129,500 62,000 98,700 10,200 $2,175,000

412,000 $ 178,500 70,000 786,500 1,035,020 414,000 267,400 200,860 72,000 129,500 63,000 98,700 9,000 $2,289,480

440,000

Total

M ANUFACTURING E XPENSE —F IXED -T YPE B UDGET

Expenses Supervisory salaries Other salaries Indirect wages Subtotal Fringe beneﬁts (40%) Repairs and maintenance Power Supplies Depreciation Communications Occupancy Other Total

Planned production (machine hours)

Item/Expense

Present Year Indicated Final

$ 44,625 17,500 200,000 262,125 104,850 67,100 50,600 18,000 32,375 15,400 24,675 2,000 $577,125

110,000

1

21.13

Quarter

$ 44,625 17,500 180,000 242,125 96,850 60,000 46,000 18,000 32,375 15,400 24,675 2,000 $537,425

100,000

3

$ 44,625 17,500 180,000 242,125 96,850 57,900 44,460 18,000 32,375 14,000 24,675 2,000 $532,385

100,000

4

443

8,500 4,000 44,520 57,020 22,800 24,300 9,560 1,000 — 1,000 — ( 1,200) $114,480

$

28,000

Increase (Decrease) over Present Year

Budgetary Planning and Control of Manufacturing Expenses

$ 44,625 17,500 226,520 288,645 115,450 82,400 59,800 18,000 32,375 18,200 24,675 3,000 $642,545

130,000

2

Plan Year

T HE J OHNSON C ONTROLS C O . M ANUFACTURING D IVISION —A NNUAL B UDGET M ANUFACTURING E XPENSE

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7,310 4,340 24,900 36,550 14,620 6,000 10,000 2,000 30,000 3,000 40,000 $142,170

$

$ — .10 .50 .60 .24 .11 .23 .10 — .05 — $1.33

Variable Rate per Hour

82,000 112,000 493,400 687,400 274,960 142,800 246,100 81,100 334,800 61,400 420,000 $2,248,560

$

598,000

Estimated Final–Current Year

E XHIBIT 21.10

M ANUFACTURING E XPENSE —F LEXIBLE B UDGET

Note: (a) Adjusted to reﬂect new expense levels (inﬂation, cost reduction, and restructuring).

Expenses Supervisory salaries Other salaries Indirect wages Subtotal Fringe beneﬁts (40%) Repairs and maintenance Power Communications Occupancy Supplies Depreciation Total

Machine hours

Item/Expense

Budget Fixed per Month

Budget Structure (a)

87,720 116,080 618,800 822,600 329,040 142,400 267,200 88,000 360,000 68,000 480,000 $2,557,240

$

740,000

Total

T HE A DAMSON C ONTROLS C O . M ANUFACTURING E XPENSE —A NNUAL B UDGET F LEXIBLE T YPE P LANNED A CTIVITY L EVEL

87,720 52,080 298,800 438,600 175,440 72,000 120,000 24,000 360,000 36,000 480,000 $1,706,040

$

Fixed

Planning Year

— 64,000 320,000 384,000 153,600 70,400 147,200 64,000 — 32,000 — $851,200

$

Variable

Department Machine Hours

5,720 4,000 125,400 135,200 54,080 (400) 21,100 6,900 35,200 6,600 60,000 $308,680

$

142,000

Increase (Decrease) Annual

62 640,000

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$

$211,463(a)

Total

— 330 (1,150) ( 820) ( 328) (1,670) 1,971 300 — 5 — $( 542)

$

(Over)/under Budget

$ 21,930 29,000 156,700 207,630 83,052 33,620 63,260 22,000 90,000 16,900 120,000 $636,462

162,000

Actual

$641,970

215,460

$426,510

$ 21,930 29,220 155,700 206,850 82,740 35,820 67,260 22,200 90,000 17,100 120,000 $641,970

Budget

E XHIBIT 21.11

D EPARTMENTAL B UDGET R EPORT

21.13

Budgetary Planning and Control of Manufacturing Expenses

— 222 (1,000) ( 780) ( 312) 2,200 4,000 200 — 200 — $ 5,508

$

(Over)/under Budget

52,100 Machine Hours

Year to Date

Activity Level

(b) Despite the disruptions to his operations from ongoing construction, Foreman Johnson has done an excellent job controlling costs.

69,293(a)

$142,170(a)

7,310(a) 9,550(a) 50,950(a) 67,810(a) 27,124(a) 11,731(a) 21,983(a) 7,210(a) 30,000(a) 5,605(a) 40,000(a) $211,463(a)

$

Budget

(a) Budget — Variable

(a) Budget— Fixed

Notes: (Over)/under budget— not signiﬁcant.

7,310 9,220 52,100 68,630 27,452 13,401 20,012 6,910 30,000 5,600 40,000 $212,005

52,100

Machine hours

Expenses Supervisory salaries Other salaries Indirect wages Subtotal Fringe beneﬁts (40%) Repairs and maintenance Power Communications Occupancy Supplies Depreciation Total

Actual

Item/Expense

Month

T HE A DAMSON C ONTROLS C O . B UDGET R EPORT —D EPT . 62( B ) M ONTH OF M ARCH , 20XX

445

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Ch. 21 Planning and Control of Manufacturing Costs: Manufacturing Expenses

Basically, the budgetary procedure is: • By an examination and analysis of the expenses in each department, for each type of expense the budget structure of a ﬁxed amount and a variable rate per factor of variability is determined. For an illustrative structure, see Exhibit 21.10. • The department manager, when the planned production level is known, applies the budget structure to the planned volume level, probably by month, and arrives at the annual budget. (See Exhibit 21.10). • The planned budget is reviewed by the manager’s supervisors, etc.; after the iterative process is complete, the approved budget becomes part of the manufacturing division budget. • This budget is incorporated in the company/division annual plan. • Each month the actual expenses are compared to the ﬂexible budget as applied to the actual volume level experienced. (See Exhibit 21.11). • Corrective action, if necessary, is taken by the department manager. For most applications this ﬂexible-type budget probably is the more suitable. (c) STEP-TYPE BUDGET. Some companies desire budgets that more or less reﬂect what expenses should be at particular levels, but wish to avoid a monthly calculation of the allowable budget based on the ﬁxed amount and variable unit rate as in the ﬂexible budget. Rather, the management prefers to establish a budget for each level of activity within a range of possible activity levels. Such a budget is illustrated in Exhibit 21.12. Budgetary control consists of comparing actual expenses, by account, with the budget level closest to the activity level experienced. Some applications provide for interpolating between budget levels for the allowed budget. (d) SUMMARIZED MANUFACTURING EXPENSE PLANNING BUDGET. In the context of planning, the annual planning budget should be prepared for each department in the manufacturing department, on a responsibility basis. Whatever type of budget is to be used — whether ﬁxed or variable—the department budgets for the expected production level for the plan year should be summarized as part of the annual planning process. (See Chapter 14). A summarized manufacturing expense budget, after completion of the iterative process and approval by the chief production executive, could be in the format reﬂected in Exhibit 21.13. This planning budget is then used in the process of determining the total cost of goods manufactured. While the illustrated budget is presented on an annual basis only, in fact the budget is prepared to show monthly data. From a control viewpoint, each month the actual departmental expenses, by type of expense, under the control of the department manager, are compared with the monthly budget, reasons for variance are established, and corrective action taken. A representative departmental control report is shown in Exhibit 21.11, as already commented upon.

21.14 REVISION OF MANUFACTURING EXPENSE BUDGETS It is intended that any budget procedure be a useful function. Since the budget structure is founded on certain assumptions, standards, and criteria, these need to be periodically checked. Normally, the expense structure does not change very often, but there will be occasions when the data should be updated, such as when: • There are major changes in the manufacturing process (e.g., introduction of JIT techniques) such as cellular manufacturing or departmental functions. • Major changes take place in the salary, wage, or employee fringe beneﬁts package. • Major organizational changes take place (new departmental structure). • Major inﬂationary or other external price changes occur in commodities or services purchased and so forth.

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E XHIBIT 21.12

8,000 17,000 1,500 20,000 46,500 18,600 19,000 38,000 8,000 6,000 8,000 1,600 145,700 40,000 5,000 3,000 $193,700

$

60% 8,000 19,000 1,500 22,000 50,500 20,200 21,000 39,000 8,000 7,000 8,000 1,700 155,400 40,000 5,000 3,000 $203,400

$

70%

M ANUFACTURING E XPENSE B UDGET : S TEP T YPE

Salaries and wages General foreperson Foreperson Clerical Indirect labor Subtotal Fringe beneﬁts (40%) Maintenance and repairs Power Traveling Communications Supplies All other controllable Subtotal Depreciation Property taxes Insurance Total

Department Fabrication Department Head Ship

8,000 21,000 2,000 25,000 56,000 22,400 24,000 41,000 10,000 7,000 9,000 1,800 171,200 40,000 5,000 3,000 $219,200

$

80% 8,000 24,000 2,000 30,000 64,000 25,600 29,000 43,000 10,000 8,000 9,000 2,000 190,600 40,000 5,000 3,000 $238,600

$

90%

21.14

8,000 24,000 2,000 30,000 64,000 25,600 30,000 45,000 12,000 8,000 10,000 2,000 196,600 40,000 5,000 3,000 $244,600

$

100% (N.A.)

Percent of Normal Activity (N.A.)

T HE G ENERAL C ORPORATION H EATER D IVISION M ONTHLY M ANUFACTURING E XPENSE B UDGET

8,000 27,000 2,500 32,000 69,500 27,800 37,000 50,000 12,000 9,000 12,000 2,500 219,800 40,000 5,000 3,000 $267,800

$

120%

447

8,000 27,000 2,500 34,000 71,500 28,600 39,000 52,000 12,000 9,000 12,000 3,000 227,100 40,000 5,000 3,000 $275,100

$

130%

Revision of Manufacturing Expense Budgets

8,000 24,000 2,000 30,000 64,000 25,600 34,000 47,000 12,000 8,000 11,000 2,000 203,600 40,000 5,000 3,000 $251,600

$

110%

Year 20XX Normal Activity (month) 85,000 Base Standard Machine Hours

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11,780 212.1 2,316.4 2,721.3 2,016.9 472.5 389.2 140.0 89.7 167.6 212.4 1,014.1 687.3 (1,624.3) $ 8,815.2 $

12,500 225.0 2,480.0 2,850.0 2,160.0 505.0 410.0 150.0 112.1 170.2 225.3 1,080.4 730.2 ( 1,922.7) $ 9,175.5 $

Annual Plan

E XHIBIT 21.13

S UMMARIZED M ANUFACTURING E XPENSE B UDGET ,

BY

D EPARTMENT

Note: (a) Represents allocation from tooling, power, and maintenance departments.

Manufacturing administration Fabrication Subassembly Final assembly Production control Industrial engineering Quality control Tooling Purchasing Shipping Power Maintenance Less: Interdepartmental transfers(a) Total

Standard machine hours (000)

Department

Indicated Final Current Year 3,125 56.25 620.00 712.50 540.00 126.25 102.50 37.50 28.03 42.55 56.00 270.10 182.55 ( 480.68) $2,293.55 $

1

T HE A DAMSON C ONTROLS C O . S UMMARY M ANUFACTURING E XPENSE B UDGET F OR THE P LANNING Y EAR 20XX ( DOLLARS IN THOUSANDS )

3,500 56.25 670.00 790.00 604.80 141.40 102.50 42.50 30.03 44.55 60.10 300.50 184.55 ( 515.08) $2,512.10 $

2

Quarter

Plan Year 20XX

2,700 56.25 535.70 627.00 470.20 110.10 102.50 32.50 26.01 40.55 52.50 237.70 180.55 ( 444.20) $2,027.30 $

3

3,175 56.25 654.30 720.50 545.00 127.25 102.50 37.50 28.03 42.55 56.70 272.10 182.55 ( 482.68) $2,342.55 $

4

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21.15 Securing Control of Overhead

449

Many of these adjustments can be made in connection with the annual planning cycle. During the interim period, small cost level advances probably can be ignored, but major increases need to be instituted on a timely basis.

21.15 SECURING CONTROL OF OVERHEAD As previously stated, the basic approach in controlling factory overhead is to set standards of performance and operate within the limits of these standards. Two avenues may be followed to accomplish this objective: one involves the preplanning or preventive approach; the other, the after-the-fact approach of reporting unfavorable trends and performance. Preplanning can be accomplished on many items of manufacturing overhead expense in somewhat the same fashion as discussed in connection with direct labor. For example, the crews for indirect labor can be planned just as well as the crews for direct labor. The preplanning approach will be found useful where a substantial dollar cost is involved for purchase of supplies or repair materials. It may be found desirable to maintain a record of purchase commitments, by responsibility, for these accounts. Each purchase requisition, for example, might require the approval of the budget department. When the budget limit is reached, then no further purchases would be permitted except with the approval of much higher authority. Again, where stores or stock requisitions are the sources of charges, the department manager may be kept informed periodically of the cumulative monthly cost, and steps may be taken to stop further issues, except in emergencies, as the budget limit is approached. The controller will be able to ﬁnd ways and means of assisting the department operating executives to keep within budget limits by providing this kind of information. The other policing function of control is the reporting of unfavorable trends and performance. This involves an analysis of expense variances. Here the problem is somewhat different as compared with direct labor or material because of the factor of different levels of activity. Overhead variances may be grouped into the following classiﬁcations: • Controllable by departmental supervision Rate or spending variance Efﬁciency variance • Responsibility of top management Volume variance It is important to recognize the cause of variances if corrective action is to be taken. For this reason, the variance due to business volume must be isolated from that controllable by the departmental supervisors. Activity-based costing is rarely used for budgeting, but if the controller wishes to use it, then bills of activity and bills of material should be used as the foundation data for standard costs. Multiplying the planned production quantities by the activity costs found in the bills of activity and direct costs found in the bills of lading will yield the bulk of all anticipated manufacturing costs for the budget period. The appropriate management use of budgeted activity costs is to target reductions in the use of activities by various products, as well as to reduce the cost of those activities. For example, the cost of paying a supplier invoice for a part used by the company’s product can be reduced by either automating the activity to reduce its cost, or to reduce the product’s use of the activity, such as by reducing the number of suppliers, reducing the number of parts used in the product, or grouping invoices and only paying the supplier on a monthly basis. (a) ANALYSIS OF EXPENSE VARIANCES. The exact method and degree of reﬁnement in analyzing variances will depend on the desires of management and the opinion of the controller about requirements. However, the volume variance, regardless of cause, must be segregated from the controllable variances. Volume variance may be deﬁned, simply, as the difference between budgeted expense for current activity and the standard cost for the same level. It arises because production is above or below normal activity and relates primarily to the ﬁxed costs of the business. The variance

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Ch. 21 Planning and Control of Manufacturing Costs: Manufacturing Expenses

can be analyzed in more detail about whether it is due to seasonal causes, the number of calendar days in the month, or other causes. The controllable variances may be deﬁned as the difference between the budget at the current activity level and actual expenses. They must be set out for each cost center and analyzed in such detail that the supervisor knows exactly what caused the condition. At least two general categories can be recognized. The ﬁrst is the rate of spending variance. Simply stated, this variance arises because more or less than standard was spent for each machine hour, operating hour, or standard labor hour. This variance must be isolated for each cost element of production expense. An analysis of the variance on indirect labor, for example, may indicate what share of the excess cost is due to: (1) overtime, (2) an excess number of workers, or (3) use of higher-rated workers than standard. The analysis may be detailed to show the excess by craft and by shift. As another example, supplies may be analyzed to show the cause of variance as: (1) too large a quantity of certain items, (2) a different material or quality being used, or (3) higher prices than anticipated. Another general type of controllable variance is the “production” or “efﬁciency” variance. This variance represents the difference between actual hours used in production and the standard hours allowed for the same volume. Such a loss involves all elements of overhead. Here, too, the controller should analyze the causes, usually with the assistance of production personnel. The lost production might be due to mechanical failure, poor material, inefﬁcient labor, or lack of material. Such an analysis points out weaknesses and paves the way to corrective action by the line executives. The accounting staff must be prepared to analyze overhead variances quickly and accurately to keep the manufacturing supervision and management informed. The variance analysis should relate to overhead losses or gains for which unit supervision is responsible and include such features as: • The expenditure or rate variance for each cost element as an over or under the budget condition for the reporting period and year to date. The budgeted amount for controllable expenses may be calculated by multiplying the operating hours by the standard rate per cost element and compared to actual. • The departmental variance related to the level of production. • The amount of ﬁxed costs, even though the particular supervisor may not be responsible for the incurrence. • Interpretative comments as to areas for corrective action, trends, and reasons for any negative variances. It is not sufﬁcient just to render a budget report to the manufacturing supervision; this group must be informed about the reasons for variances. The information must be communicated and a continuous follow-up must be undertaken to see that any unfavorable conditions are corrected. This may take the form of reviewing and analyzing weekly or even daily reports. Abnormal conditions such as excess training, overtime, absenteeism, and excessive usage of supplies must be isolated and brought to the attention of the responsible individuals who can take remedial action. There also may be other data available such as repair records, material and supplies usage reports, personnel statistics — including turnover and attendance records that are useful. Responsibility must be established for all signiﬁcant variances in a timely manner so that appropriate corrective action is taken. (b) INCENTIVES TO REDUCE COSTS. It has been stated repeatedly that costs are controlled by individuals. In the control of manufacturing expenses, as in the case of direct labor and material, a most important factor is the ﬁrst-line supervision. As representatives of management who are on the scene observing production the ﬁrst-line supervisors can detect immediately deﬁcient conditions and take action or inﬂuence the utilization of resources. Reports showing the performance of this group are of great assistance. However, the experience of many companies has shown that standard costs or budgets covering indirect costs are a more effective management tool when related to some type of incentive or ﬁnancial reward. Usually, this incentive takes the form of a percentage of the savings or is based on achieving a performance realization above some predetermined norm. If a supervisor participates in the savings from being under the budget it is a powerful

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21.17 Other Aspects of Applying Budgetary Control

451

force in obtaining maximum efﬁciency. Since variances will ﬂuctuate from month to month, it is advisable to consider an incentive plan for supervision on a cumulative performance basis — a quarter or a year.

21.16 INDIRECT LABOR: A MORE PRECISE TECHNIQUE Indirect labor often is one of the largest controllable elements of manufacturing expense and therefore may warrant a special review. In the examples provided earlier in this chapter, an acceptable cost level for this type of expense was determined by measuring the historical cost against a factor of variability such as standard machine hours or direct labor hours. Sometimes the correlation may not be as close as desired and a more analytical technique may be necessary—which involves the aid of industrial or process engineers. The method, which closely resembles the calculation of the required direct labor for any given manufacturing operation, essentially is: • The engineers study the speciﬁc function to be performed by the departmental indirect labor crew, including the exact labor hours required at differing activity levels. • An activity base is selected, such as standard machine hours, that would be a fair and easily determinable measure of just what labor hours are needed for each function of the indirect labor crew. • Estimates are made as to just what portion of the crew is ﬁxed, and what portion can be treated as variable (perhaps by performing other functions), and the related labor hours are determined. • The hours data are costed (by the cost accountants), the ﬁxed budget allowance determined, and the variable rate calculated per unit of activity. The process is summarized on the cost worksheet in Exhibit 21.14. First, the technical data are summarized, and then the cost bases are calculated. Where deemed appropriate, this more exact method can be used in arriving at the ﬂexible budget base.

21.17 OTHER ASPECTS OF APPLYING BUDGETARY CONTROL In applying budgetary control to manufacturing expenses, an alert controller will generate ideas of how to make the budget report more usable to those managers who use it. There are many techniques that can be found; however, in any case it takes good communication. Normally, accountants will develop budgets in terms of dollars or value. Sometimes, production managers cannot relate their operations to monetary units. In most cases they think and manage in terms of labor hours. If this is more understandable, the budget can easily be stated in terms of labor hours per standard labor hours or some other factor. The budgeted allowances of other expenses may be expressed in units of consumption — kilowatt hours of power, gallons of fuel, tons of coal, pounds of grease, and so on. One of the purposes of budgetary control is to maintain expenses within the limits of income. To this end, common factors of variability are standard labor hours or standard machine hours— bases affected by the quantity of approved production. If manufacturing difﬁculties are encountered, the budget allowance of all departments on such a base would be reduced. The controller might hear many vehement arguments by the maintenance foreperson, for example, that the budget should not be penalized because production was inefﬁcient or that plans once set cannot be changed constantly because production does not come up to expectations. Such a situation may be resolved in one of at least two ways: (1) the forecast standard hours could be used as the basis for the variable allowance, or (2) the maintenance foreperson could be informed regularly if production, and therefore the standard budget allowance, will be under that anticipated. The ﬁrst suggestion departs somewhat from the income-producing sources but does permit a budget allowance within the limits of income and does not require constant changes of labor force over a very short period. The second suggestion makes for more coordination between departments although it injects the element of instability to a slight degree.

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Janitorial Moving Testing Preparation Inspection All other

601 602 603 604 605 485

86 344 172 86 344 38 1,070

70% 86 430 172 86 430 40 1,244

80% 86 516 258 172 516 42 1,590

100% $15.00 16.50 18.50 20.00 22.50 17.00

Rate per Hour

.5 2.0 1.0 .5 2.0 6.0

70%

Fixed

86 — — 86 — 30 202

Man-hours

C OST D ATA

.3 2.5 1.0 .7 2.5 7.0

80% .5 — — .5 — 1.0

$1,290 — — 1,720 — 510 $3,520

Amount

— 516 258 86 516 12 1,388

Man-hours

Variable

— 8,514 4,773 1,720 11,610 510 $27,127

$

Amount

— 3.0 1.5 .5 3.0 8.0

Variable

— 75.00 37.50 12.50 16.15 .38 141.53

Man-hours

$1,237.50 693.75 250.00 1,687.50 74.12 $3,942.88

Amount

Variable Rate per M Units

Plant Sylvan Dept. Machine Shop Year 20XX Activity base Standard Hours Activity units at capacity 6,880

Data at 100% Level Fixed

100% Activity Level

.5 3.0 1.5 1.0 3.0 9.0

100%

Requirement at Activity Level

T ECHNICAL D ATA ( WORKERS PER SHIFT )

Normal Work Week: Shifts per day 1 Hours per shift 8 Days per week Operating Range 70%–100%

E XHIBIT 21.14

E NGINEERING -B ASED I NDIRECT L ABOR B UDGET S TRUCTURE

Supplementary Data and Comments: 1. Calculation of hours at capacity: a 40 machines per shift, b 8 hours per shift, c 5 days per week, d 4.3 weeks per month a b c d 40 8 5 4.3 6,880 hours. 2. At a 100% operation, one tester will spend one-half of time on janitorial. At the 70% operation, preparation man will spend alternate days on janitorial. 3. Time for 80– 90 codes will be offset by overtime if needed. 4. All other consists of union meetings, training, and physical inventory.

Description

Job Code

Janitorial Moving Testing Preparation Inspection

601 602 603 604 605 Total

Requirement at Activity Level

Description

Job Code

Account Name Indirect Labor Account No. 6201 Length of Period Month

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21.18 Other Control Procedures

453

Extraordinary or unanticipated expenditures of a manufacturing expense nature must frequently be made. These may fall well without the scope of the usual budget, even when the cumulative yearly condition is considered. In such instances, and if the expenditure is considered necessary and advisable, a special budget allowance will be made over and above the usual budget — something superimposed on the regular ﬂexible budget structure. Another point should not be overlooked by the accounting staff: The important consideration is not how ﬂexibility is introduced into the standard or budget but rather that it is injected. Whether charts or tables are used to determine the allowable budget on a more or less automatic basis or whether the budget is adjusted monthly or quarterly on the basis of special review in relation to business volume is not too essential, because either method can be successfully employed. The major consideration is that of securing an adequate measuring stick that also keeps expenses at the proper level in relation to activity or income.

21.18 OTHER CONTROL PROCEDURES The budgetary process has been emphasized for control of manufacturing overhead expenses in this chapter for these reasons: • It more closely recognizes the cost behavior of the speciﬁc types of expense through its ﬁxed and variable expense structure determination. • It not only addresses the control process, but also is a planning device. • It tends to promote coordination among functions. There will be occasions when, for whatever reason, the top management and/or functional management does not wish to adopt budgetary procedures. Under these circumstances, in some departments other standards may be employed. In other instances, selected standards may supplement the budget standards. In fact, it is in the manufacturing function that standards were ﬁrst employed in the control of not only direct labor and direct material, but also many of the indirect expenses. Such a system involves the establishment of standards (see Chapter 18) and the comparison of actual expenses — either individual accounts, or departmental totals — against such standards, and the taking of corrective action where appropriate. Many manufacturing executives in particular industries know from observation that certain expense relationships are the key to a proﬁtable operation. Their experience has led to the use of a number of standards or standard relationships for manufacturing expenses. These ratios are usually collected and distributed by industry trade associations or magazines devoted to the affairs of speciﬁc industries. Some comparisons often used, or trends followed, are shown in Exhibit 21.15.

Item

As Related to

Total manufacturing expenses (or selected departments) Indirect labor expense

Total direct labor costs Total direct costs Total standard direct labor Per direct labor hour Per actual direct labor hour Per machine hour Total manufacturing expense Per machine hour Per operating hour Per labor hour Per ton handled Per operating hour

Repair and maintenance expense Power Supplies Shipping and receiving Downtime expense E XHIBIT 21.15

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S AMPLE E XPENSE C OMPARISONS

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Ch. 21 Planning and Control of Manufacturing Costs: Manufacturing Expenses

For any signiﬁcant expenses, trends can often be observed in the absolute and in relationship to selected or total manufacturing expenses.

21.19 ROLE OF THE CONTROLLER Much has been said about the technique of setting manufacturing expense budgets or standards, but little mention has been made about who prepares the budgets and applies them. This duty is usually delegated to the controller and staff and understandably so. Past experience is an important factor in setting expense budgets. An analysis of expenses and their behavior in relation to volume is required, and the principal source of information is the accounting records. The accountants are the best qualiﬁed to make these analyses of the historical information. Then, too, the accounting staff usually possesses the necessary technical qualiﬁcations for organizing the data into the desired shape. Furthermore, the approach must be objective, and the independent position of the accounting department makes it suitable for the setting of fair standards or budgets. Although the controller “carries the ball” in preparing the budgets, he is only part of the team. Successful control of manufacturing expenses requires the cooperation of the operating departments’ supervisors who are charged with the responsibility of meeting their budgets. For this reason, among others, each supervisor should agree to the budget before it is put into effect. Moreover, each supervisor’s experience and knowledge of operating conditions must be utilized in the preparation of the budget. The controller and staff act as coordinators in seeing that the job gets done reasonably well and that it is accomplished on time. The role of the controller and staff in the accounting for, and planning and control of, manufacturing expenses may be summarized in this fashion. The controller should: • Provide that expenses are accumulated in such account categories that control is reasonably simple; that is, the natural expense groupings should originate from the same sources, or a comparable method of control or time or point of control should be employed. Thus, repairs done by outside sources and controlled on a purchase order basis, perhaps should be isolated from in-house repairs that are controlled by requisition. • Arrange the departmental accounts on a responsibility basis, by natural expense classiﬁcations, so that costs are accumulated according to the authority delegated to plan and control the expenses. This categorization also should permit the accumulation of product costs in a suitable manner. • Where a budgetary process is in effect, arrange that the procedure facilitates the preparation of the planning budget in an effective and timely manner (by provision of adequate instructions, forms, schedules, etc.); and that the control procedure provides a timely accumulation of actual expenses, compared with budget, together with reasons for any signiﬁcant departure from plan, if known. • Provide reasonable assistance to department managers in their preparation of the annual plan or budget (including requested analyses), and in searching out causes of standard deviation and perhaps methods of correction. • Where ﬂexible budgets are in use, either identify, or assist in the identiﬁcation of, the ﬁxed and variable portions. • Where budget structures need revision by reason of changed expense levels (inﬂation, etc.) or new manufacturing processes, see that timely revisions are made to the end that the budgets are useful and not outdated. • Evaluate the planned level of manufacturing expenses in the process of consolidating and testing the annual plan. • If budgetary procedures, for whatever reason, are not used, see if some other sort of standard application may be of value in planning and controlling the manufacturing expenses. • Determine that the costing methods provide reliable and acceptable accumulation and allocation by cost object—product, department (as to service operations), and so forth—and that variances are properly analyzed.

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21.20 Reports for Manufacturing Executives

455

21.20 REPORTS FOR MANUFACTURING EXECUTIVES (a) SCOPE OF COVERAGE. The supervisory staff of the production organization extends over several levels of authority and responsibility from the assistant foreperson, foreperson, general foreperson, division head, plant superintendent, and so on, up to the works manager. Likewise, the matters the supervisory staff controls relate to materials, labor, and overhead, and each of these subjects has special aspects to be reported on. Production reports must cover a wide ﬁeld of both reader and subject matter. Effective production control is possible only when the production executives are aware of the necessary facts related to the plant operations, and the higher the executive the more reliance on reports instead of personal contacts and observations. As a result, a system of reports has been developed in most industrial organizations for presenting the pertinent facts on the production activities. It will bear mentioning that the recent developments in computer hardware and software (programs) permit an improved monitoring of operations. Information on some activities must be, and is, available on a real-time basis. With the advent of personal computers, interesting combination reports consisting of commentary, tabulations, and graphs in an inviting appearance are now possible. The number of variance reports that are used by manufacturing management will decline as cellular manufacturing becomes the standard form of production. Since cellular manufacturing uses minimal work-in-process (WIP), month-end variance reports from the accounting department will arrive far too late for the information to be useful. For example, if a machine produces a part out of speciﬁcation, then a cellular layout will immediately detect the problem, because the part will not be hidden in a pile of WIP. Consequently, management can detect and correct the problem immediately without the need for a report. (b) TYPES OF REPORTS ON ACTUAL PERFORMANCE. The reports will differ from industry to industry from company to company so that no standardized reports can be set for business generally. However, they may be divided into two general categories according to their purpose. These may be classiﬁed as (1) control reports and (2) summary reports. As the name implies, control reports are issued primarily to highlight substandard performance so that corrective action may be taken promptly. These reports deal with performance at the occurrence level and are therefore usually detailed in nature and frequent in issuance. On the other hand, summary reports show the results of performance over a longer period of time, such as a month, and are an overall recapitulation of performance. They serve to keep the general executives aware of factory performance and are, in effect, a summary of the control reports. Indicative of the subjects the reports to production executives may cover, including direct and indirect costs for which the executive may be responsible, are: • Material Inventories Spoilage and waste Unit standard costs Material consumed Actual versus standard usage

• Labor Total payroll Unit output per labor hour Total production in units Average hourly labor rates Overtime hours and costs

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Ch. 21 Planning and Control of Manufacturing Costs: Manufacturing Expenses Bonus costs Turnover Relationship of supervisory personnel to direct labor Actual and standard unit and total labor costs

• Overhead Actual versus budgeted costs Idle facilities Maintenance costs Supplies used Cost of union business Subcontracted repairs Ratio of indirect to direct labor

In a production environment that has adopted just-in-time (JIT) manufacturing systems, reports will no longer include standards, because JIT assumes that most cost improvements can be managed in the design phase, not in the production phase, and that collecting variance information costs more in effort than is gained in tangible results. A set of JIT reports would include: • Inventory turnover • Unit output per labor hour • Total production in units • Staff turnover • Actual purchased costs versus planned costs • Inventory accuracy • Bill of material accuracy • Bill of activities accuracy (c) PRESENTATION OF DATA. Most production executives will make good use of data bearing on their operations provided three fundamental rules are followed: 1. The reports should be expressed in the language of the executive who is to use them and in the form preferred by him. 2. Reports should be submitted promptly enough to serve the purpose intended. Control reports are of little value if issued too late to take corrective action. 3. The form and content of the report should be in keeping with the responsibility of the executive receiving it. Minor executives are interested in details, whereas higher executives are interested in departmental summaries, trends, and relationships. Some of the reports prepared by the accounting department will be on costs, and others will be expressed in nonﬁnancial terms. Some may be narrative; others will be in tabular or graphic form. But all should follow the principles just set forth. (d) ILLUSTRATIVE REPORTS. As indicated previously, indirect manufacturing costs have increased signiﬁcantly, resulting in the need for better visibility and control of these expenses. Exhibits 21.16 through 21.18 are examples of reports that may be adapted to a particular company or type of manufacturing operation.

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E XHIBIT 21.16

Total Ops Payroll

112 $ 7,958

$ 7,965

152 40

280 689 2,885

263 511 2,439

510 2,196

131 1,928 409

22

69

248

$ 459 418 19 504 105 159

$ 574 341 32 463 105 213

L ABOR A NALYSIS R EPORT

Time Card Var Suspense/ Correct Vac Advances Edit Rejects Total Adjustments

Adjustments

Vacation Taken Holiday Paid Absence Total Fringe Sub Total

Fringe

Burden Supervisor Clerical V C Burden Staff & Tech Ops Lead Key Lead Comm Act Miscellaneous Idle-Equip Fail Conference Training Premium Pay Total Burden

Operations Section

Report No. 97

Weekly Plan Actual

$ 109,363

3,423 3,112 3,488 10,023 36,175

1,698 26,152

920

$ 7,860 4,517 445 6,339 1,442 2,931

Plan

Hours

$ 106,055

152 160 40 32

3,152 2,877 3,445 9,474 38,853

445 22 16 4,675 29,379

$ 6,946 6,096 238 6,291 1,566 3,084

Year to Date Actual

$ 3,308

152 160 40 32

271 235 43 549 2,678

475 22 16 2,977 3,227

$ 914 1,579 207 48 124 153

Var

O PERATIONS L ABOR A NALYSIS NDPIM-01

$ 69,67l

2,262 4,390 26,514

2,128

1,076 1,139 22,124

493

$ 8,437 2,244 227 5,651 1,061 1,776

21.20

$ 68,640

$ 964,202

29,547 26,898 30,096 86,543 393,178

13,962 21,143 306,635

6,578

$ 115,471 29,722 3,125 77,352 14,869 249,413

Plan

Dollars

$ 931,627

1,079 716 320 681

26,203 24,573 27,812 78,586 410,025

2,987 153 244 32,610 31,732 331,437

$ 103,099 41,778 2,026 75,040 16,090 25,676

Year to Date Actual

457

$ 32,575

1,079 716 320 681

3,344 2,325 2,286 7,955 16,847

3,591 153 244 18,648 10,589 24,802

$ 12,372 12,056 1,099 2,312 1,221 1,265

Var

Reports for Manufacturing Executives

1,079 402 5 682

2,026 5,600 29,756

3,574

3,421 2,338 24,156

157

$ 6,822 2,814 157 6,017 1,002 1,348

Weekly Plan Actual

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C24.206

Bus. Conf. O/T Meals

Telephone Depr Other Due Non Memr Sci Tech

Emp Rel Misc Gen Ins Consultants Rent-Off. Eq Maint-Off Eq

028-01 028-02

030-01 033-02 035-01 035-02

041-01 015-01 057-03 062-08 065-07

Account Total

Account Total

Account Total

Account Total

Account Total

F ACTORY O VERHEAD B UDGET R EPORT

Mileage Co. Vehicles

024-01 024-02

E XHIBIT 21.17

Adv Per Proc Agency Fees

020-01 020-02

Other Expenses 014-02 Training 014-03 Medical 014-07 Moving Exp

Account

Report No.

A CCOUNTS

1,225 71

1,225 4,708

12,512 333 2,104 14,949 1,362 2,268 3,630 333 125 208 128 25 103 15,847 87 3,750 2,162 5,912

Variance

1,042

4,636

270 270

128 13 10,535

750 128

104 4,025 9,695 6,435 16,130 750

4,130

Actual

Month

OF

1,142

25 25 15,834 10,623 3,750 2,432 6,182

16,642 333 2,000 18,975 8,333 4,167 12,500 417 125 542

Budget

S UMMARY

3,675 17,624

3,126

30,421 999 6,000 37,420 24,999 12,501 37,500 1,251 375 1,626 100 25 125 47,502 31,961 17,250 5,366 22,616

Budget

848 1,569 2,212 23,533

310 30,171 31,699 17,755 3,340 21,095

14,420 603 13,879 28,902 28,723 15,435 44,158 2,394 338 2,732 310

Actual

Year To Date

2,277 1,569 1,462 5,909

l6,000 396 7,879 8,517 3,724 2,934 6,658 1,143 36 1,106 210 25 185 17,330 261 505 2,026 1,521

Variance

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C24.206

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E XHIBIT 21.17

Account Total Sub Group Total Group Total

Account Total Sub Group Total

Account Total Sub Group Total Group Total

A CCOUNTS

3,175 12,500 15,675 15,675 190,285

174,610 174,610

3,887 3,100 2,583 3,975 101,529 7,826 38,472 13,238

342,404 342,404 456,938

3,087 622 3,709 3,709 67,249

11,361 1,931 2,560 2,954 111,349 15,027 87,904 6,494 236 63,539 63,539

358,783 358,783 421,641

211,637 11,541

162,416 4,833

Month

OF

Actual

S UMMARY

Budget

F ACTORY O VERHEAD B UDGET R EPORT (C ONTINUED )

Other Supplies 071-01 Ofﬁce 071-03 M Eq Non Dp

Supplies DP Supplies 071-20 Misc. 071-21 Mag. Tape 071-22 Paper Tape 071-23 Cards 071-24 Paper 071-25 Ribbon 071-27 Form Paper 071-28 Microﬁlm Su 071-29 Fiche Supp.

Account Purchased Services Offsite 067-13 Pur Systems 067-14 Pur Prg Labr 067-19 Misc.

Report No.

87 11,877 11,965 11,965 123,035

7,474 1,168 22 1,020 9,820 7,201 126,376 6,743 236 111,070 111,070

16,379 16,379 35,296

49,221 6,708

Variance

21.20

8,375 13,237 21,613 21,613 458,897

39,188 3,863 5,507 11,963 321,759 29,039 11,507 37,706 236 437,284 437,284

1,204,229 1,204,229 1,514,544

720,935 17,241

Actual

459

1,149 24,262 25,411 25,411 105,052

29,393 5,436 1,241 38 5,215 4,717 106,887 5,203 236 79,640 79,640

106,716 106,116 70,680

232,212 14,257

Variance

Reports for Manufacturing Executives

9,525 37,500 47,025 47,025 563,950

516,925 516,925

9,795 9,300 6,749 11,925 316,544 24,322 95,380 42,910

1,097,513 1,097,513 1,443,864

488,723 31,499

Budget

Year To Date

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Ch. 21 Planning and Control of Manufacturing Costs: Manufacturing Expenses

5

Year

4

3 Other Labor

2

Equipment 1

0%

10%

20%

30%

40%

50%

60%

Percent

E XHIBIT 21.18

C OMPARATIVE C OST H ISTORY C HART

Exhibit 21.19 provides an analysis of weekly and year-to-date hours and costs of the indirect labor and related fringe costs of a manufacturing department. Exhibit 21.20 is a summary and analysis of the monthly and year-to-date expenses for the activity of three manufacturing expense accounts being monitored: supplies, purchased services, and “other” expenses.

PURCHASED SERVICES

MONTHLY $ (THOUSANDS) 80

80

70

70

60

60

50

50

40

40

30

30

MONTHLY AVERAGE

20

20

10

10

0

J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A S O N D

20X8

E XHIBIT 21.19

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T REND A NALYSIS C HART

20X9

20XX

0

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21.20 Reports for Manufacturing Executives

461

PERSONNEL & LABOR RATES TOTAL SECTION HEADCOUNT

PERSONNEL

ADMINISTRATIVE OPERATIONS PROG. & INFO. SYSTEMS

27 28 27 28 28 29 29 29 29 40 40 40 42 43 45 48 168 156 159 159 157 159 166 165 160 193 193 190 190 192 197 199

WAGE RATE

206 202 202 196 198 198 221 224 224 311 313 318 318 306 297 309

650

11.50

600

11.00 NCP/IS MERGER

550

10.50

500

10.00 RATE

450

9.50 PERSONNEL

400

9.00

350 300

8.50

J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A S O N D

20X8

E XHIBIT 21.20

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T REND A NALYSIS C HART

20X9

20XX

8.00

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CHAPTER

22

PLANNING AND CONTROL OF RESEARCH AND DEVELOPMENT EXPENSES 22.1

RESEARCH AND DEVELOPMENT ACTIVITIES 463

22.9

22.2

IMPACT OF R&D ACTIVITIES ON CORPORATE EARNINGS 464

22.10 DETERMINING THE TOTAL R&D BUDGET 470

22.3

R&D ACTIVITIES IN RELATION TO CORPORATE OBJECTIVES 464

22.11 INFORMATION SOURCES ON R&D SPENDING 471

22.4

INTEGRATION OF R&D WITH OTHER FUNCTIONS 465

22.5

ORGANIZATION FOR THE R&D FINANCIAL FUNCTIONS 466

22.6

ACCOUNTING TREATMENT OF R&D IN FINANCIAL STATEMENTS 466

22.12 ESTABLISHING THE R&D OPERATING BUDGETS 472 (a) Project Selection 472 (b) Some Quantitative Techniques in Evaluating R&D Expenditures 473 (c) Project Risk 475

22.7

ELEMENTS OF R&D COSTS 468

22.8

ROLE OF THE FINANCIAL EXECUTIVE IN R&D 469

GENERAL BUDGETARY PROCEDURE 470

22.13 DETAILED BUDGETING PROCEDURE 476 22.14 OTHER CONTROL METHODS 477 22.15 EFFECTIVENESS OF R&D EFFORT 481

22.1 RESEARCH AND DEVELOPMENT ACTIVITIES The terms research and development are often used imprecisely. Each may have a myriad of connotations, and even though these two words often are used together, each represents a different process with differing implications in terms of planning and control. Research as used herein relates to those activities in a business enterprise that are directed to a search for new facts, or new applications of accepted facts, or possibly new interpretations of available information, primarily as related to the physical sciences. It is the activities or functions undertaken, often in the laboratory, to discover new products or processes. Development, however, as discussed herein, denotes those activities that attempt to place on a commercial basis that knowledge gained from research. In another sense, the efforts discussed in this chapter are those that normally would be managed by the vice president or director of research and development (R&D). Although R&D activities may be grouped in any number of ways—and proper classiﬁcation is important in the planning and control function—this segregation is often used internally by those entities that do extensive work in these three areas: 1. Basic or fundamental research. This may be deﬁned as investigation for the advancement of scientiﬁc knowledge that does not have any speciﬁc commercial objective. It may or may not be, in ﬁelds of present, or of possible, interest to a company or a customer. 463

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Ch. 22 Planning and Control of Research and Development Expenses

2. Applied research. Activity in this area would relate to the practical application of new scientiﬁc knowledge to products or processes in which the company has an interest. 3. Development. Functions under this classiﬁcation would include those efforts or studies to get the product or process into full-scale commercial production. For those ﬁnancial executives who deal with budgeting efforts in the R&D area, and who are desirous of having the activity deﬁned, here are separate deﬁnitions for “research” and “development.” • Research is an organized search for new knowledge that may lead to the creation of an entirely new product, or that will lead to the development of a new process, or which will substantially improve an existing product or process. • Development involves the systematic translation of new knowledge into the designs, tests, prototypes, and pilot production of new products or processes. It does not involve minor enhancements to existing products or processes.

22.2 IMPACT OF R&D ACTIVITIES ON CORPORATE EARNINGS The most effective assistance of the ﬁnancial discipline in respect to the planning and control of R&D expenses probably must recognize the role these expenditures can and should play in the economy as well as in a given business. R&D in the United States is conducted by a diverse number of institutions: the federal government and other governments; industry; universities and colleges; nonproﬁt types of organizations; and professional ﬁrms that conduct research for others. Although the efforts of these groups have resulted in the technological superiority of the United States in the mid-twentieth century, now it has become evident that reduced expenditures at the federal level and a hostile climate for new ideas and products are threatening this position. Whether it be because of uncertain business conditions, shortsighted corporate management, lack of adequate incentive, unacceptable governmental regulation or procedures, the fact remains that such a trend may well have adverse implications for the U.S. economy. There is evidence, in an aggregate sense, of the relationship between technical innovation and the stimulation of economic development. Within a given manufacturing company, in terms of a particular project or projects, perhaps no simple cause-and-effect relationship between R&D expenditures and net income can be found. However, statistical correlation suggests a tendency for earnings to increase, over a period of time, with an increase in research spending. Empirical data tend to show that under the private enterprise system, industrial ﬁrms grow and prosper by developing, or investing in new products or processes, or improving existing ones. It simply is not enough to do reasonably well that which is being done, for competitors will pass by such a business. Innovation or improvement and management of change are the intangible attributes that distinguish the progressive company from one on the road to decline. And the wise planning and control of research and development costs should recognize this relationship. In a very real sense, the funds spent on R&D are quite different from many other expenses. They are an investment in the regeneration, growth, and continued existence of the business and should be evaluated, insofar as possible, as an investment.

22.3 R&D ACTIVITIES IN RELATION TO CORPORATE OBJECTIVES From the strategic and long-range viewpoint, the important corporate activities should support the corporate goals and objectives. Certainly research and development efforts should ﬁt this category. For example, if an entity is planning substantial growth in the compact disc ﬁeld, then research and development in this area should be considered. Conversely, if strategic plans call for divestiture of a television operation, then it makes little sense to expend sizable sums on R&D in this ﬁeld. Moreover, R&D input regarding acquisition targets, competitive R&D activity, or the state of the art should be helpful in strategic planning. Further, strategic planning should consider the alternative of performing research in-house or of purchasing an entity already active in the product line.

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22.4 Integration of R&D with Other Functions

465

This preferred relationship between corporate objectives and the R&D plan is shown in Exhibit 22.1.

22.4 INTEGRATION OF R&D WITH OTHER FUNCTIONS Aside from understanding the proper relationship of R&D to corporate objectives, the increased competition, the often critical time factor in developing new products, and perhaps greater wisdom about the nature of R&D, is forcing a new approach in many complex R&D situations. This viewpoint has been denoted as system focus by one author.1 System focus is a philosophy which emphasizes the importance of technology integration early in the process: the mutual adaptation of new technology, product design, the manufacturing process, and user needs. The traditional approach to R&D might be regarded as one group of executives after another adding its contribution to the developing product and then passing the task later to others down the line—in the engineering department and then in the manufacturing process and ﬁnally in marketing. This transfer of knowledge is mostly downstream. Often there is little incentive or no mechanism for sending knowledge back upstream so it can improve the technology in the next go-around. In the systems-focused organization, the goal of new product development shifts from a compartmentalized sequential approach to optimizing the whole system. Under such circumstances, the company early in the R&D process forms an integration team composed of a core group of managers,

E XHIBIT 22.1

I NTERRELATIONSHIP THE R&D P LAN

OF

C ORPORATE G OALS

AND

O BJECTIVES

WITH

1. Marco Iansiti, “Real-World R&D: Jumping the Product Generation Gap,” Harvard Business Review, May/ June 1993, pp. 138 –147.

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Ch. 22 Planning and Control of Research and Development Expenses

scientists, and engineers. This team investigates the impact of various technical choices on the design of the product and the manufacturing system. The purpose of this brief section is to alert the controller to the time and cost savings inherent in this systems integration. The controller should be aware of the potential in any relevant discussions with the R&D manager, and in the formulation of the planning and control system.

22.5 ORGANIZATION FOR THE R&D FINANCIAL FUNCTIONS Another relevant background matter is organization. The importance of the R&D function in many companies has led to the establishment of separate organizational units, such as a division or subsidiary. Although the size of the company, scope of the research function, management philosophy, and type of research may inﬂuence the organization structure, a pattern is discernible in a review of different corporations. A self-contained unit is illustrated in Exhibit 22.2. The ﬁnancial ofﬁcer handling the ﬁnancial aspects of R&D activity reports to the vice president of Research and Development, and provides the necessary ﬁnancial analysis, accounting and reporting services, and coordination with the corporate ﬁnance group. In this instance, a “dotted line” relationship is maintained with the corporate vice president and controller. The precise manner in which the R&D function is organized directly affects the accounting for the activity. The organization responsibilities, as deﬁned by the functional outline or charter, provide the basis for budgeting and controlling the costs. The reporting and measurement of expenses must be guided by the organization plan; it must parallel the responsibilities of each organizational unit.

22.6 ACCOUNTING TREATMENT OF R&D IN FINANCIAL STATEMENTS In public corporations, prior to the mid-1970s, there existed a wide difference in the balance sheet treatment of R&D costs. Given the tendency or desire in some quarters to report the highest possible earnings, as well as the high degree of uncertainty about the future economic beneﬁts of individual R&D projects, such variations are understandable. Therefore, because of this reason, among others, and before deciding on the preferred accounting treatment of R&D costs, the Financial Accounting Standards Board (FASB) in 1973 considered four alternative methods of accounting for such costs as incurred: 1. Charge all costs to expense as incurred. 2. Capitalize all costs as incurred. 3. Capitalize costs when incurred, if speciﬁed conditions are fulﬁlled, and charge all other costs to expense. 4. Accumulate all costs in a special category until the existence of future beneﬁts could be determined. The FASB concluded that all R&D costs (except those covered by contract) should be charged to expense when incurred. This treatment was to be effective for ﬁscal years beginning on or after January 1, 1975. The above comments relate to R&D costs exclusive of costs of developing of software. U.S. ﬁrms may account for the costs of development of similar software products in different ways. Some costs of development of software to be sold, leased, or otherwise marketed, may be capitalized. All the costs of development of similar software created for internal use may be expensed by some ﬁrms and capitalized by others. There seem to be differences of opinion between the Institute of Management Accounting (IMA) and the FASB. The results of a survey by Kirsch and Sakthivel published in January 1993, cover-

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E XHIBIT 22.2

O RGANIZATION C HART FOR

Project C

Project B

Project A

Product development

Basic research

Director, laboratories

R&D A CTIVITIES

Support services

Vice president and controller

Accounting Treatment of R&D in Financial Statements

Legal

Organization and personnel

The Jones Company ORGANIZATION CHART Vice President, Research and Development

Business administration and control

Vice-president Research and development

Chief executive officer

467

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468

Ch. 22 Planning and Control of Research and Development Expenses

ing 139 completed questionnaires mailed to 417 of the Fortune 500 companies showed this treatment of software development costs: Systems Software Expense Capitalize Expense and capitalize

Application Software 84% 9 7 100%

78% 10 12 100%

Readers, if interested, can keep updated on the directives concerning accounting for software development costs.

22.7 ELEMENTS OF R&D COSTS The Statement of Financial Accounting Standards No. 2 does not apply to the costs of R&D conducted for others under a contractual arrangement; this is covered by statements relating to accounting for contracts in general. It does apply to the types of costs discussed in this chapter but not incurred under a contract to outside parties. Elements of costs identiﬁed with R&D activities would include costs of (a) materials, equipment, and special facilities, (b) personnel, (c) intangibles purchased from others, (d) contract services, and (e) indirect costs. Illustrative activities, the costs of which typically would be included in R&D and would be expensed unless conducted for others under a contractual arrangement as outlined in the FASB’s Statement No. 2, include: • Basic research related to the discovery of entirely new uses or applications • Applied research that attempts to adapt existing discoveries to speciﬁc applications • Testing of new concepts or adaptations of new concepts to determine operating parameters • Design, construction, and testing of prototypes • Design, construction, and testing tools, molds, and dies involving new technological applications • Design, construction, and testing of pilot production facilities that are strictly for the testing of new production concepts, and not for ongoing production for sale to customers If an activity ﬁts into one of the above categories, then a controller should categorize any related expenses into a format that clearly breaks down expenditures for each R&D activity. Before going into the details of this breakdown, however, it is reasonable for a controller to determine the size of expected R&D expenditures. If they are comparatively small, it may be easier to roll the R&D costs into overall engineering expenses and not go to the expense of creating a separate categorization. However, if the costs are signiﬁcant, costs should be grouped into the following ﬁve categories for reporting purposes, or some similar format: 1. Cost of materials, equipment, and special facilities: Building rental or lease fees Building occupancy costs Equipment capital costs Equipment maintenance costs Equipment operating costs Equipment depreciation costs Laboratory supplies

2. Personnel: Department supervisory staff

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22.8 Role of the Financial Executive in R&D

469

Professional staff Clerical and other personnel

3. Intangibles purchased from others: Scholarly subscriptions Outside services such as document reproduction Legal fees for the ﬁling and maintenance of patents 4. Contract services: Any purchased service directly related to R&D, such as testing or analysis services 5. Indirect costs: Allocated corporate or local overhead costs Though it is important to group expenses into the proper R&D categories, it is equally important to exclude some expenses, primarily those that are no longer strictly concerned with R&D activities, but rather with commercial production. These excludable expenses are: • Correction of production or engineering problems after a product has been released to the production department • Ongoing efforts to improve existing product quality • Slight product alterations • Routine changes to molds, tools, or dies • Any work related to full-scale commercial production facilities (as opposed to pilot plants)

22.8 ROLE OF THE FINANCIAL EXECUTIVE IN R&D Now that much of the background information has been brieﬂy reviewed, it might be useful to discuss some of the areas where the knowledge of the ﬁnancial executive should be helpful to the research director before talking about the technical ﬁnancial aspects relating to planning and control of R&D costs. Primary responsibility for the R&D activities rests with the ofﬁcer in charge of the function. However, the corporate controller and the cognizant ﬁnancial executive assigned to the R&D ﬁnancial duties should be knowledgeable and exercise leadership in these areas (not necessarily in the order of importance): • Provide the necessary accounting accumulation and reporting of the costs and expenses, and assets and liabilities, of the R&D activities in an economical way, and in a manner that provides useful ﬁnancial data to the R&D executives. As to expenses, this will include accumulation by type of expense, by department, and, where appropriate, by project. • Establish and maintain proper internal controls. • In conjunction with the headquarters controller, if applicable, and the R&D executives and managers, establish and maintain an adequate budgetary planning and control system. • Assist in developing guidelines for the total amount to be spent on R&D activities (for the annual plan and/or strategic planning). • Where applicable, and where quantitative analysis may be helpful, and in those instances where an economic/business viewpoint is needed, provide data to guide in establishing budgets and cost/beneﬁt and relative risk comparisons, for R&D projects. (See the discussion of “stage-gate systems” at the end of Section 22.15, Effectiveness of R&D Effort.) • Assist the R&D managers in developing the planning budgets for which each is responsible. • Assist in preparing the annual capital budget (discussed in Chapter 31). • Provide acceptable, practical expense control reports — either budgetary or otherwise (standards).

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470

Ch. 22 Planning and Control of Research and Development Expenses

The remainder of this chapter relates to speciﬁc questions or tasks in the planning and control of R&D expenses.

22.9 GENERAL BUDGETARY PROCEDURE By and large the planning and control of R&D expenses in the United States are handled through a budgetary process. The seven principal steps are: 1. Determine the total amount to be spent on R&D activities for the planning period. 2. Establish the individual project budgets and, where appropriate, provide related risks and costs/beneﬁts information. 3. Where applicable, as in the overall administrative function, establish the individual departmental budgets. 4. After appraisal and consolidation, secure approval of the budget. 5. Provide the periodic comparisons of actual versus planned expenses and the cost to completion of project budgets. 6. Where needed, provide data on a standards basis—actual versus standard performance. 7. Where feasible, provide measures on the effectiveness of R&D activity.

22.10 DETERMINING THE TOTAL R&D BUDGET “How much should the company spend on R&D this year?” A great many managers ask this question. And since expenditures should give weight to the long term, the query is really a multiyear one. There are innumerable projects which innovative R&D executives can conjure up; but there are limits on what a company should spend. Many constraints must be considered, including these, in determining the total R&D budget for any given time period: • Funds available. Most entities have ﬁnancial limitations; and the funds must be within reach, not merely in the one year, but perhaps extending over several years—depending on the projects. • Availability of manpower. In the United States, companies often are unable to secure the needed professional or technical talent for a given project. • Competitive actions. What the competitors are doing in R&D, or not doing, usually is a factor that management must weigh. The ﬁrm should be reasonably up to date on its R&D efforts. • Amount required to make the effort effective. If the company embarks on some speciﬁc programs, sufﬁcient amounts must be spent. It may be foolish to spend too little; better not to attempt the project. • The strategic plans. Future needs over the longer term to meet the strategic plan may eliminate some proposed new projects. • General economic and company outlook. Is the company about to enter a cyclical downturn? What is the expected trend in earnings? These factors may deter new projects if the outlook seems downbeat for a time. So, if the constraints are known, there are several guidelines in current use for determining the limits of R&D spending. Some of these measures are useful guides in determining the overall budget: • The amount spent in the past and/or current year, perhaps adjusted by a factor for inﬂation as well as growth • A percentage of planned net sales, perhaps using past experience as a guide • An amount per employee • A percentage of planned operating proﬁt • A percentage of planned net income

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22.11 Information Sources on R&D Spending

471

• A ﬁxed amount per unit of product sold (experience) or estimated to be sold • A share of estimated cash ﬂow from operations

22.11 INFORMATION SOURCES ON R&D SPENDING Aside from internal experience data developed from company records by either the R&D director or the controller, some useful information may be obtained from several external sources. Thus, trade associations may have available data on a particular industry. The Industrial Research Institute, Inc., of Washington, DC, may be another source. If a company is required to ﬁle a Form 10-K with the Securities and Exchange Commission (SEC), this document may be available. Further, most of the national business publications such as Business Week, Fortune, or Planning Review and others periodically discuss the subject. One of the best sources is the annual “R&D Scoreboard” published in June or July of each year by Business Week. Typical material in each annual report is similar to this: • The amount spent on company sponsored research and development as reported by each entity to the SEC on Form 10-K • R&D expenditures for the year, by industry, as summarized in Exhibit 22.3 • Commentary on R&D’s biggest U.S. spenders • Comparison of R&D expenditures by U.S. companies versus those in other leading countries • Signiﬁcant recent developments in R&D activity

Total 2004 R&D Expenditures ($ Millions)

Per Employee R&D Expenditures

R&D as a % of Sales

R&D as a % of Proﬁts

$ 4,210.4 13,441.4 4,993.0 3,432.3

$ 6,470.8 8,975.9 6,987.4 4,776.9

4.2% 4.0% 4.1% 2.5%

77.7% 115.0% 66.3% 29.5%

2,322.9 154.0 8,504.5 640.8

2,294.7 1,347.2 9,524.0 1,390.8

1.5% 0.9% 5.5% 0.8%

16.6% 82.2% 59.4% 10.7%

Fuel Health Care Housing Leisure Time Products

2,660.4 13,886.9 494.7 1,891.5

4,466.7 18,247.8 2,743.6 8,087.1

0.8% 10.6% 1.8% 5.4%

12.0% 72.7% 22.3% 109.2%

Manufacturing Metals and Mining Ofﬁce Equipment & Services Paper & Forest Products

3,931.1 360.6 17,212.6 440.6

4,314.7 1,541.5 15,739.5 2,051.7

3.0% 0.9% 8.0% 1.1%

49.8% neg neg 27.8%

205.8 4,240.6 $83,023.8

1,141.1 7,149.1 $ 7,476.4

1.0% 3.7 3.8%

31.1% 52.5 64.1%

Industry Aerospace & Defense Automotive Chemicals Conglomerates Consumer Products Containers and Packaging Electrical and Electronics Food

Services Industries Telecommunications All Industry Composite E XHIBIT 22.3

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I NDUSTRY S UMMARY —S ELECTED R&D E XPENDITURE D ATA

FOR

2004

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Ch. 22 Planning and Control of Research and Development Expenses

For example, in 2005 it was reported that R&D managers were learning to “make do” in a period of difﬁcult economic times by such actions as: 1. Discontinuing marginal projects 2. Decentralizing R&D efforts 3. Collaborating with outside experts such as consortiums, universities, other companies, or government laboratories 4. Continuing internationalism in that (a) (b) (c) (d)

More research is now headquartered overseas. Research efforts are more open to foreign participation. New technology is being shared with developing countries. Patent rights are being shared among certain participants.

Of course, any R&D statistical information must be carefully interpreted in that the start of major new projects or the cessation of completed ones can severely impact the quantiﬁed results of a company’s effort.

22.12 ESTABLISHING THE R&D OPERATING BUDGETS Determining the total amount to be spent on R&D for the planning year merely establishes a maximum limit on aggregate expenditures. In terms of effective planning and control, three related segments of the total operating expenses need to be determined: 1. The R&D speciﬁc “projects” and their related costs 2. The indirect expenses associated with the departmental R&D activities, but not part of the project direct expenses 3. The departmental expenses, developed following the organization structure and “responsibility” accounting and reporting — and consisting of the project expenses for which the department manager will be held responsible, and the related (or not related) indirect expenses Because many departmental expenses depend on which projects will be undertaken and on the estimated cost of each, the project selection and cost estimating are discussed ﬁrst. (a) PROJECT SELECTION. The selection of the particular R&D projects is primarily the responsibility of the research director, giving weight to resources available, the amount of risk found acceptable by management, the strategic plan of the company, and a proper balance between the various types of projects. In a practical way, a judgment will be made about the relative amount of effort to be spent on various categories of projects. A typical categorization might include these, perhaps in the order of ascending risk or cost, or reducing chance of economic return: • Sales service (projects originated by the marketing department and involving ﬁeld selling practices and delivery) • Factory service (projects requested by the manufacturing arm and relating to manufacturing processes) • Product improvement (includes efforts to improve appearance, or quality, or usefulness of the product) • New product research (on products about which some facts are known, but which are not yet in the product line) • Fundamental research (research of a fundamental or basic nature) where no foreseeable commercial application is yet envisioned, and which may or may not be in ﬁelds of interest to the company

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473

Numerous inﬂuences will enter into the decision of project selection. The research director, for example, probably would consider these factors, among others: • Availability of qualiﬁed professional personnel. In some time spans, the necessary professional skills simply might not be available. • Urgency of the project from a marketing or manufacturing viewpoint. Some matters may be so important, that further manufacturing or marketing of the product is not feasible until the problem is solved. • Time required for the research. It may be that some signiﬁcant problem probably can be very quickly solved, and it is considered better to resolve the matter before proceeding to other projects with a longer time span. • Prior research already done by others. Clues or signiﬁcant beginnings, either within or without the organization (universities, joint ventures, etc.), may have been found or achieved. It might be the judgment of the head of research that this past effort should be capitalized upon in the present time span. • Prospect of economic gain as the predominant inﬂuence. Perhaps the management may believe the possible economic returns from successful research or development are so high that a given project should be undertaken without delay. The projects to be initiated will depend on the judgment of the research director and other members of top management. However, these general observations are made, including some comments as to how a controller or ﬁnancial executive may be useful: • Because the odds of economic beneﬁt from an investment in pure or fundamental research is quite remote, some managements may wish to place modest limits on such expenditures. • Development projects ordinarily should be given a high priority since successful applications would tend to be more likely. • All development projects should be “ranked” or evaluated much as are capital budget projects (see Chapter 31). The ﬁnancial discipline should be helpful, applying discounted cash ﬂow techniques, or other quantitative methods, to information provided by the research and/or marketing staff in determining: Total investment needed, anticipated revenue, operating expenses, and return on investment The relative risk Potential licensing income and the like (b) SOME QUANTITATIVE TECHNIQUES IN EVALUATING R&D EXPENDITURES. It is no easy task to decide on an economic basis whether R&D on a given project should be undertaken. However, there will be instances when it can be attempted. Consider, ﬁrst, return on assets (ROA), sometimes described as return on investment. The cost – volume – proﬁt relationship (see Chapter 15) may add a dimension to the R&D investment decision. Assume these ﬁve conditions: 1. Management has set a 10% return on gross assets, net after taxes, as the minimum acceptable rate. 2. In one or two years after development is complete, the estimated sales of the newly developed Product T ought to attain a stable level so that aggregate sales should total $100 million. 3. The typical gross margin in the business is 30%, and Product T should be no exception. 4. It is expected that, when research and development is complete, the required asset investment will be: Working capital Plant and equipment Total

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$11,000,000 5,000,000 $16,000,000

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Ch. 22 Planning and Control of Research and Development Expenses

5. The expected income tax rate — federal, state, and local (netted) is 40%. With this sales and gross margin expectation and a minimum 10% return on assets, how much can the company spend on research and development on Product T? Some indication of the approximate expenditure level can be gained from this calculation: income Return on assets Net --------------------------Assets Net income Gross margin R&D Income taxes Income tax (Gross margin R&D) 40% Gross margin Sales 30% ROA 10% By substitution: Net income Gross margin R&D [(Gross margin R&D 40%)] Gross margin R&D [(Gross margin R&D) 40% ROA ------------------------------------------------------------------------------------------------------------------------------------------Total assets ($100,000,000 30%) R&D [($100,000,000 30% R&D) 40%] ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------$16,000,000 Simplify: $1,600,000 $30,000,000 R&D ($30,000,000 R&D) 0.40 $1,600,000 $30,000,000 R&D $12,000,000 0.40 R&D 1,600,000 $18,000,000 R&D 0.40 R&D $16,400,000 R&D 0.40 R&D 0.60 R&D $16,400,000 R&D $27,333,333 Proof: Sales

$100,000,000

Gross margin at 30% Less: R&D Income before taxes Income tax at 40% Net

$ 30,000,000 27,333,333 $ 2,666,667 1,066,667 $ 1,600,000

Assets

$ 16,000,000

ROA

10%

The $27,333,333 permissible R&D can be converted to a budgeted amount per annum. Another quantitative analysis related to percent return on net sales. Some managements judge the acceptability of a product by the adequacy of its percent return on sales. Make these three assumptions and then decide how much can be spent on R&D for the product: 1. The minimum acceptable net return on product sales is 10%. 2. Sales of the new product are expected to aggregate $160 million. 3. The (net) income tax rate (federal and state) is 40%.

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475

The calculation is: income Return on sales Net --------------------------Net sales wherein again, Net income Income taxes Gross margin ROS

Gross margin R&D Income tax (Gross margin R&D) 40% Sales 20% 10%

By substitution: Net income Gross margin R&D (Gross margin R&D) 40% Gross margin R&D (Gross margin R&D) 40% ROS ----------------------------------------------------------------------------------------------------------------------------------------Sales R&D (32,000,000) R&D) 0.40 10% $32,000,000 ----------------------------------------------------------------------------------------------------------------------------$160,000,000 Simplify: R&D $12,800,000 0.40 R&D 0.10 $32,000,000,000 -----------------------------------------------------------------------------------------------------------------------------------$160,000,000 $16,000,000 $19,200,000 0.6 R&D 0.6 R&D $19,200,000 $16,000,000 0.6 R&D $3,200,000 R&D $5,333,333 Proof: Sales

$160,000,000

Gross margin 20% Less: R&D Margin before income taxes Income taxes 40% Net income

$ 32,000,000 5,333,333 26,666,667 10,666,667 $ 16,000,000

Sales

$160,000,000

ROS

10%

(c) PROJECT RISK. As previously mentioned, one factor in determining how much should be spent on a given project is the risk of that project. Although it may be difﬁcult to calculate risk, analysis (by the controller) may provide management with some sense of the relative risk. One approach is based on the logical assumptions that (a) risk increases as a company ventures into new markets and new products, and (b) risks also increase with time from the completion of R&D until product sales commence. The concept is illustrated by the matrix in Exhibit 22.4 wherein the market objective and the time span are the factors of risk. The objective of a completed matrix is to graphically illustrate how relative risk for the planning year compares with the prior year, or how risks on R&D in one division compare with another or how one project may relate to another. The four steps in identifying the relative risk are: 1. The various proposed R&D projects for each division or marketing group or the entity as a whole are grouped by market objective (new product in new market or new product in existing market, etc.) in order of risk

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Ch. 22 Planning and Control of Research and Development Expenses

Increasing Risk

Increasing Risk

Year 1

2

3

Beyond

Total

—— ——

—— ——

—— ——

—— ——

—— ——

New Product in New Market New Product in Current Market Replacement Product in Current Market Improved Product in Current Market

Total E XHIBIT 22.4

M ARKET O BJECTIVE

AND

R ELATIVE R&D R ISK

2. The year when the product will be initially sold is estimated 3. The proposed spending for each product having the same market objective is tabulated, as in Exhibit 22.5 4. The results are summarized by market objective, translated to percent as in Exhibit 22.6 As illustrated in Exhibit 22.6, 30% of the expenditures in planning year 1 (20XX) are contemplated in the area of most risk — new products in new markets, as compared with only 5% in the market area deemed least risky. The research director must judge how prudent such risk is, together with the return on assets for completing products, the total potential return, and so on.

22.13 DETAILED BUDGETING PROCEDURE Having reviewed how the overall expenditures for R&D for a given year might be determined, some of the inﬂuences in determining what projects might be considered, and a couple of illustrations of a possible quantitative approach to judging the desirability of a given project, it might help to summarize a typical budgeting procedure and provide budgetary examples.

M ARKET

H EALTH C ARE D IVISION P LANNED 20XX R&D E XPENDITURES O BJECTIVE : N EW P RODUCT IN C URRENT M ARKET ( DOLLAR AMOUNTS IN THOUSANDS ) Year of Initial Impact

Project

20X1

1 2 3 4 5

$140 90

Total E XHIBIT 22.5

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$230

20X2

20X3

Beyond

Total

$ 80 60

$ 50 40 30

$30 10 10

$140 90 160 110 40

$140

$120

$50

$540

I LLUSTRATIVE R&D E XPENDITURES FOR A M ARKET O BJECTIVE —N EW P RODUCT , C URRENT M ARKET

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22.14 Other Control Methods

477

J OHNSON C OMPANY D ISTRIBUTION OF 20XX R&D E XPENDITURES B Y M ARKET O BJECTIVE AND Y EAR OF I NITIAL C OMMERCIAL I MPACT Effective Year (%) Market Objective New products in new market New product in current market Replacement product in current market Improved product in current market Total E XHIBIT 22.6

20X1

20X2

20X3

30 15 5 5 55

20 10

10

30

10

D ISTRIBUTION OF 20XX P LANNED R&D Y EAR OF I NITIAL I MPACT

BY

Beyond 5

M ARKET O BJECTIVE

5

Total 60 30 5 5 100

AND

These are the eight steps that the research director might take, with the assistance of the controller or ﬁnancial executive, in some phases: 1. Determine the total budget for the planning period. This may include the comparisons with some of the measures discussed earlier. 2. Review the individual projects. Select those deemed the more suitable and determine the total cost in some reasonable degree of detail, as in Exhibit 22.7. Some managements may want the “other expenses” broken down into more detail. 3. Determine each departmental budget, based on the project costs determined in step 2, and the necessary indirect expenses, as in Exhibit 22.8. This well may involve an iterative procedure as between project costs and total departmental budgets. 4. Summarize the project and departmental budgets to arrive at the proposed total R&D planning budget, as in Exhibit 22.9. Supporting this summary would be the project and departmental budgets. 5. Secure necessary approval of the R&D budget (board of directors, etc.). This should be regarded as approval in principle. 6. As speciﬁc projects are to begin, prepare a project budget request, with adjusted or updated data, if applicable, and secure speciﬁc budget approval. 7. Provide periodic control reports, comparing, as in Exhibit 22.10, actual project costs to date and cost to complete, with the budget, and comparing department actual costs with budget, as in Exhibit 22.11. In this latter case, costs are controlled by department, but not by project. 8. Take any necessary corrective action.

22.14 OTHER CONTROL METHODS As previously explained, the control phase of the budgeting process consists of comparing actual expenses and budgeted expenses for the indirect or administrative type expenses of the R&D function. Project direct expenses also could be judged in the same fashion. But it makes more sense, in this latter case, to compare estimated total expenses to complete the project — a continuous or monthly updating process—with the project budget. In this manner, if it appears that expenses are going over budget, perhaps steps can be taken to reduce some of the anticipated costs. Budgetary control probably is the most widely used method of monitoring expense trends, and correcting over-budget conditions. In some instances, performance standards also may be used to control costs—or to supplement budgetary control. While many phases of the R&D effort are varied and not easily subject to measurement, there are circumstances where performance standards may be useful in evaluating some

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Project

Alkyd resin “Q” Paint thinner “S” Melamine “P” Urea surface “L” Urea mold “N” Urea ﬁller “R” Subtotal 1028 1022 1072 1079 1091 2143

1026 1029 1057 1059 1073 1095

S UMMARY P ROJECT B UDGET

Alkyd dryer “K” Wet agent “T” Urea composite “U” Urea fast mold “Y” Phenolic resin “Z” Adhesive “D” Subtotal

E XHIBIT 22.7

102 102 107 107 109 214

Product Improvement

102 102 105 105 107 109

Project No.

— — — — — — —

— — — 65.6 — 91.0 156.6

Professional Labor Hours (100s)

— — — — — — —

— — — 2,624 — 546 3,170

$

Total Costs

Prior Year(s)

60 40 20 480 180 80 860

100 60 100 80 140 460 940

Professional Labor Hours (100s)

138 52 37 840 365 320 1,750

$ 300 150 250 120 350 960 2,130

Professional Salaries

T HE P LASTICS C OMPANY P ROJECT B UDGETS F OR P LANNING Y EAR 20XX ( DOLLARS IN THOUSANDS )

Ch. 22 Planning and Control of Research and Development Expenses

New Product Research

Dept.

478

$

55 13 15 294 106 104 587

76 38 65 30 90 240 539

All Other Wages

193 65 52 1,134 471 424 2,339

$ 376 188 315 150 440 1,200 2,669

Total Salaries and Wages

Planning Year

267 90 75 1,587 660 590 3,271

$ 526 264 457 215 618 1,740 3,820

All Other Expenses

$

460 155 127 2,721 1,131 1,016 5,610

902 452 772 365 1,058 2,940 6,489

Total Costs

— — — — 450 110 560

$ 90 90 — — 180 — 360

Future Years Costs

460 155 127 2,721 1,581 1,126 6,170

992 542 772 2,989 1,238 3,486 10,019

$

Estimated Total Cost

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Project

Anti-caker Solvent remover Antipollutant “K” Subtotal

Product storage Curing rate—#7 Subtotal

E XHIBIT 22.7

3012 3033

216S 219S

102M 105M 112M

— — — 156.6

— — —

— — — —

S UMMARY P ROJECT B UDGET (C ONTINUED )

Reﬂective surfaces Hardening compounds Subtotal Grand total R&D project budget

301 303

Fundamental Research

216 219

Sales Service

102 105 112

Manufacturing Service

Dept.

Project No.

Professional Labor Hours (100s)

— — — $3,170

— — —

— — — —

Total Costs

Prior Year(s)

100 160 260 2,260

20 60 80

40 20 60 120

Professional Labor Hours (100s)

200 240 440 $4,677

30 110 140

60 35 120 215

Professional Salaries

T HE P LASTICS C OMPANY P ROJECT B UDGETS F OR P LANNING Y EAR 20XX ( DOLLARS IN THOUSANDS )

70 80 150 $1,415

12 40 52

30 12 45 87

All Other Wages

270 320 590 $6,092

42 150 192

90 47 165 302

Total Salaries and Wages

Planning Year

380 460 840 $8,655

59 221 280

128 69 247 444

All Other Expenses

— — — $920

— — —

— — — —

Future Years Costs

479

650 780 1,430 $18,837

101 472 472

218 116 412 746

Estimated Total Cost

Other Control Methods

650 780 1,930 $14,747

101 371 472

218 116 412 746

Total Costs

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Ch. 22 Planning and Control of Research and Development Expenses

T HE P LASTICS C OMPANY D EPARTMENT 102—T OLEDO —R&D B UDGET P LANNING Y EAR 20XX Total Professional Labor Hours (100s)

Professional Salaries

All Other (2) Costs

Budget Total

New Project Research Alkyd resin “Q” Paint thinner “S” Subtotal

100 60 160

$300,000 150,000 450,000

$ 602,000 302,000 904,000

$ 902,000 452,000 1,354,000

Product Improvement Alkyd dryer “K” Wet agent “T” Subtotal

60 40 100

138,000 52,000 190,000

322,000 103,000 425,000

460,000 155,000 615,000

Manufacturing Service Anti-caker Total projects

40 300

60,000 $700,000

158,000 $1,487,000

218,000 $2,187,000

Item Projects

Administrative Expenses General Library Research associates Total administrative (1) Grand total budget

290,000 46,000 12,000 348,000 $2,535,000

Notes: (1) Ratio of indirect to project costs

16%

(2) Other Costs: Salaries and wages

$ 212,000

(2) Other Costs: Fringe beneﬁt costs

84,800

(2) Other Costs: Supplies (2) Other Costs: All others

210,000 980,200 $1,487,000

E XHIBIT 22.8

D EPARTMENT P LANNING B UDGET (D EPT . 102)

of the quantitative phases of the work. Some suggested performance standards for those functions that are repetitive and perhaps voluminous include: • Number of tests per employee, per month • Number of formulas developed per labor week • Cost per patent application • Cost per operating hour (pilot plant or lab) • Number of requisitions ﬁlled per worker, per month (lab supply room) • Number of pages of patent applications created per man-day • Cost per professional man-hour of total research or departmental expense

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22.15 Effectiveness of R&D Effort

481

T HE P LASTICS C OMPANY S UMMARY B UDGET FOR R&D P LANNING Y EAR 20XX ( DOLLARS IN THOUSANDS ) Year 20XX Professional Labor Hours (100s)

Professional Salaries

Total Expense

Estimated Current Year Costs

260 940 860 120 80 2,260

$ 440 2,130 1,752 215 140 $4,677

$ 1,430 6,489 5,610 746 472 $14,747

$ 1,220 5,200 5,080 750 460 $12,710

Administrative General administration Department administration Libraries Patent activity Other Total administrative Grand total

580 1,160 120 240 110 2,210 $16,957

520 1,040 110 170 90 1,930 $14,640

Ratio indirect to project costs

15%

15%

Item Project Costs by Category Fundamental research New-product research Product improvement development Manufacturing services Sales service Total direct project costs/hrs.

E XHIBIT 22.9

S UMMARY R&D B UDGET

22.15 EFFECTIVENESS OF R&D EFFORT Management has often asked, and still asks, “Are the R&D expenditures worthwhile?” or “Is the company research effective?” Questions such as these do not relate to budgetary performance or performance standard results. Rather, they go to the heart of the contribution that the R&D activity, or segments of it, makes to the economic well being of the company. Some research efforts, such as basic research, are difﬁcult to measure because no speciﬁc or direct objective is discernible. But the reason for some projects is clearly economic, such as the discovery of a cheaper manufacturing process or a new product. For these, a kind of measurement is possible. Some economic measures or indices that the accountant might suggest, or perhaps assist in developing, include: • For a lower-cost manufacturing process. The savings over 1 to 5 years versus the development expense • For a new product The operating proﬁt of the product over X years as compared to the cost of development Rate of return on new products (DCF) An index of market share:

Sales --------------------------------------Market potential

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5.00 3.33 1.67 40.00 15.00 6.67 71.67

8.33 5.00 8.50 6.67 11.67 38.33 78.50

$

38 12 10 229 90 81 460

72 4 66 31 93 245 511

Total Costs

P ROJECT B UDGET S TATUS R EPORT

1028 1022 1072 1079 1091 2143

Product Improvement Alkyd dryer “K” Wet agent “T” Urea composite “Z” Urea fast mold “Y” Phenolic resin “Z” Adhesive “O” Subtotal

E XHIBIT 22.10

1026 1029 1057 1059 1073 1095

New Product Research Alkyd resin “Q” Paint thinner “S” Melamine “P’ Urea surface “L” Urea mold “N” Urea ﬁller “R” Subtotal

Project No.

Labor Hours (100’s)

Current Month

15 10 5 120 45 20 215

25 15 25 20 35 115 235

Labor Hours (100’s)

117 36 30 697 280 250 1,410

$ 220 112 197 89 271 742 1,631

Costs

Cumulative Year to Date

F OR

$

12 7 2 47 31 14 113

4 — 8 7 12 83 114

Purchase Order Commitments

45 30 15 360 135 60 645

75 45 75 55 105 350 705

Labor Hours (100’s) $

320 110 98 2,066 1,259 962 4,715

693 433 565 2,880 932 2,808 8,311

Costs

Estimated Cost to Complete

T HE P LASTICS C OMPANY P ROJECT B UDGET S TATUS R EPORT THE P ERIOD E NDED M ARCH 31, 20XX ( DOLLARS IN THOUSANDS )

Ch. 22 Planning and Control of Research and Development Expenses

Project

482

— — — — — — —

— — — 65.6 — 91.0 156.6

Labor Hours (100’s)

— — — — — — —

— — — $2,624 — 546 3,170

Costs

Prior Year

449 153 130 2,810 1,570 1,126 6,238

917 545 770 5,600 1,215 4,179 13,226

$

Total Costs

460 155 127 2,721 1,581 1,126 6,170

992 542 772 5,613 1,238 4,032 13,189

$

Budget

Indicated Project

11 2 ( 3) ( 89) — — ( 68)

$ 75 ( 3) 2 13 23 (147) ( 37)

Indicated (Over) Under Budget

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E XHIBIT 22.10

8.33 13.33 21.66 188.50

1.67 5.00 6.67

3.33 1.67 5.00 10.00

57 64 121 $1,221

6 31 37

18 9 35 62

Total Costs

25 40 65 565

5 15 20

10 5 15 30

Labor Hours (100’s)

155 192 347 $3,690

27 90 117

54 30 101 185

Costs

Cumulative Year to Date

P ROJECT B UDGET S TATUS R EPORT (C ONTINUED )

3012 3033

216S 219S

Sales Service Product storage Curing rate #7 Subtotal

Fundamental Research Reﬂective surfaces Hardening compounds Subtotal Grand total— project budgets

102M 105M 112M

Project No.

Manufacturing Service Anti-caker Solvent remover Antipollutant “K” Subtotal

Project

Labor Hours (100’s)

Current Month

F OR

7 6 13 $263

2 6 8

2 1 12 15

Purchase Order Commitments

75 120 195 1,695

15 45 60

30 15 45 90

Labor Hours (100’s)

491 579 1,070 $14,992

71 284 355

154 85 300 541

Costs

Estimated Cost to Complete

T HE P LASTICS C OMPANY P ROJECT B UDGET S TATUS R EPORT THE P ERIOD E NDED M ARCH 31, 20XX ( DOLLARS IN THOUSANDS )

— — — 156.6

— — —

— — — —

Labor Hours (100’s)

— — — $3,170

— — —

— — — —

Costs

Prior Year

650 780 1,430 $22,007

101 371 472

218 116 412 746

Budget

1 9) 8)

483

3) 3 — $(108)

(

( (

8 — ( 3) 5

Indicated (Over) Under Budget

Effectiveness of R&D Effort

653 777 1,430 $22,115

100 380 480

210 116 415 741

Total Costs

Indicated Project

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484

Ch. 22 Planning and Control of Research and Development Expenses An index of share of sales from new products:

Sales of new products ---------------------------------------------------Total sales • For improved products The operating proﬁt from the estimated additional sales over X years versus the develop-

ment cost Some of the ratios or measures suggested above for new products can be adapted for improved products

E XHIBIT 22.11

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P ROJECT B UDGET R EPORT

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22.15 Effectiveness of R&D Effort

485

The effectiveness of R&D effort is principally the responsibility of the executive in charge of such activity. With the high level of foreign competition, in those instances where research and development is a critical success factor for the business, the process of benchmarking may be a means of increasing R&D productivity. Although this method has been used extensively with regard to manufacturing and marketing functions, it can be applied also to R&D activity. As discussed in Chapter 17, benchmarking is the measuring of a company’s functions against those of companies considered to be the best in their class, and the initiation of actions to improve the activity under review. In the event the controller is asked for advice regarding the application of benchmarking in R&D activities, the controller should be aware that the process has been a factor in creating (for the R&D function) the following beneﬁts in some companies: • Signiﬁcant acceleration of the time-to-market for new products and new processes • Assistance in transferring technology from the R&D organization to the business unit involved (an operating division or subsidiary) • Identiﬁcation and deﬁnition of the core R&D technologies needed to support the companies’ planned long-term growth • Help with the companies’ efforts to tap global technical resources • Assistance in evaluating research project selection • Improvement in cross-functional participation in many R&D projects Finally, in judging the effectiveness of product development, a broad business viewpoint must be considered—not merely the R&D project and/or revenue calculated for budget purposes. Management must allow for the right combination or trade-offs between cost, time, and performance requirements. This is where the ﬁnancial executive, and especially the controller, can be of assistance to other management in the periodic evaluation of product development projects. Increasingly, the controller is a member of the “stage gate” group that monitors the progress of the project. The “stage-gate” system segregates a company’s new-product process into a series of development stages. These stages are partitioned by a series of “gates” which are periodic check points for such matters as cost escalation, market changes, quality control, and other risks. Each project must meet certain criteria before it can pass through the gate and down the development path. The senior managers involved, as well as the ﬁnancial executive, review progress as the product approaches its market launch. Typically, in the early development phase, accurate information is lacking and ﬁnancial risk is low. As the project reaches a critical point, a detailed ﬁnancial analysis is desirable. The controller’s department, or chief ﬁnancial ofﬁcer (CFO) integrates ﬁnancial analysis, technical analysis, and manufacturing and marketing plans. Revealed are sales forecasts, prices, proﬁt margins, and possibly impact of a discontinued project. The end result is said to be more efﬁcient development operation, more new product successes, and a more ﬂexible cost latitude (e.g., recognizing the time factor in the product success). The stage-gate system offers a strong role for ﬁnance, but also provides sometimes beneﬁcial cost-time trade-offs and plan changes for the product developers.

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CHAPTER

23

FINANCIAL PLANNING AND CONTROL IN A SERVICE COMPANY 23.1

INTRODUCTION 487

23.2

ORGANIZATIONAL CONSIDERATIONS 488

23.3

DATA CLASSIFICATION 489

23.4

COST OF SERVICES; ACTIVITY-BASED COSTING 490

23.5

COST ACCOUNTING IN A SERVICE ORGANIZATION 490 (a) “Direct” Labor 491 (b) Other Direct Expenses 491 (c) Allocated Expenses 491

23.6

PLANNING SYSTEM 492 (a) Annual Budgets 493

23.7

STRATEGIC PLANNING 498

23.1 INTRODUCTION “Service” businesses have grown rapidly over the past twenty years and now are believed to represent a greater percentage of U.S. jobs and gross domestic product (GDP) than does the manufacturing sector of the economy. This growth is expected to continue as more companies understand the variety of services that can be provided. Some of these services are new, for example, on-line databases. Others are specialized business services that can be supplied cheaper than being done in-house, for example, cleaning services, payroll processing, security, and travel arrangements. Finally, there are the traditional service organizations, such as bankers, brokerage houses, legal ﬁrms, advertising agencies, accountants, insurance companies, and so forth, that have shown steady growth as the economy expanded. Much of what exists in literature on the ﬁnancial planning and control of business has been prepared within the context of a manufacturing organization. However, much of what pertains to the nonproduction aspects of a manufacturing business is also applicable to a service business. The considerations that a controller must address relative to the selling, development, and general and administrative (G&A) expenses are the same in both kinds of businesses. Although certain ratios and relationships may be different, the problems related to the planning and control of cash, accounts receivable, ﬁxed assets, investments, long- and short-term debt, and the like are similar. That leaves as a major area of difference only the planning and control of the “direct” cost of providing the services and the proper assignment of costs to the cost objective — the speciﬁc type of service, the insurance policy size group, or the contract, and so forth. The objective of all businesses is to grow and prosper and thus optimize or maximize, over the longer term, the economic return to the owners. To do that, and perhaps even to survive, it is necessary to have information available that will give a company the ability to analyze and understand where revenue is coming from, what costs were incurred to produce that revenue, and what other costs and expenses the business has incurred. Using this information, unsatisfactory proﬁt performance can be identiﬁed and an analysis made to understand the reasons for poor results and what can be done to improve things. Satisfactory proﬁt performance can also be analyzed to understand 487

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488

Ch. 23 Financial Planning and Control in a Service Company

the reasons for good results and what can be done to expand those areas. Finally, trends can be monitored on a regular basis to identify emerging problems easily and quickly. To perform these essential analyses, the controller must deﬁne the level of detail that is to be recorded in the accounting system. Each ﬁrm will require data based on its unique circumstances including its organization structure, but at a minimum the following segregation should be made as to the elements of: • Product /service • Contract /customer

23.2 ORGANIZATIONAL CONSIDERATIONS A controller of a service company must understand the company’s organization in order to institute a system of control based on responsibility. In its simplest form, if the business is structured by ofﬁce or area, then ofﬁce or area should be the primary income/expense/proﬁt/investment center. If the structure is by contract, then contract proﬁt should be the primary control point. Exhibit 23.1 depicts an ofﬁce-oriented organization (geographic) and Exhibit 23.2, a contract-oriented one (major activity). In these examples, a manager usually would be assigned responsibility for the production of income either for a geographic territory or for a major contract. There are many variations on these alternatives and each company has to make its own determination.

E XHIBIT 23.1

O RGANIZATION

E XHIBIT 23.2

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BY

O FFICE

O RGANIZATION

BY

C ONTRACT

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23.3 Data Classification

489

23.3 DATA CLASSIFICATION After understanding the primary responsibility points in the company organization the controller must next oversee an intelligent series of accounts to record and control the speciﬁc aspects of the business. This account structure will become the business language of the ﬁrm and can inﬂuence employee motivation and actions, company culture, and operating results. The ﬁrst set of judgments in assembling a schedule of accounts is what revenue will be brought into the ﬁrm and what segregation of it is needed to understand and run the business. Taking a legal ﬁrm as an example, revenue might be anticipated from: • Real estate transactions • Preparation of wills • Divorces All revenue would then be recorded into one of these three categories. If the ﬁrm subsequently handled other matters, then new revenue accounts would be opened up as needed. It is also usually of interest in a law ﬁrm to know which lawyer is generating revenue for the ﬁrm so that information would also be captured. The ﬁnal important segregation of revenue would be by client. This information is essential for billing and for client relations. Therefore, in a typical law ﬁrm, the recording of revenue would be: • By ofﬁce (if more than one) • By lawyer • By matter (wills, etc.) • By client It is easy to then summarize revenue into these four totals. It is also possible to re-sort it using any combination of these categories. As another example, in an advertising agency the revenue is derived from individual clients’ placing advertisements in various media. The ﬁrst segregation of revenue then would probably be by client. Further information relative to what media is used is also considered important, so additional segregation might be required for: • Newspaper • Magazine • Television • Radio • Billboard • Flyer The recording could be further segregated into campaigns and products if more than one of each is expected to occur. So in this example of an ad agency, revenue would be recorded: • By client • By product/campaign • By media (magazines, etc.) A different example of revenue segregation is that usually found in a bank operation. In this instance, the organizational responsibility is usually by business area, for example, bank credit cards, international loans, retail (branch ofﬁce) operations, and investment trusts. The primary identiﬁcation of revenue would be into these categories. A second segregation could be geographic (i.e., by country, by city, by ofﬁce). As in the previous examples, the data can be sorted into any combination to allow reporting and analysis by responsibility. Capturing the revenue by key element or activity is essential to being able to understand what is happening in each individual business and to allow sorting and combining of data into useful information available for analysis.

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Ch. 23 Financial Planning and Control in a Service Company

23.4 COST OF SERVICES; ACTIVITY-BASED COSTING Although it is relatively easy to plan and record revenue after the appropriate categories and segregations have been determined, it is sometimes difﬁcult to identify the costs planned and/or incurred to earn the various classiﬁcations of revenue. It is obvious that people have been paid, materials and supplies purchased, and facilities acquired and used by the employees of the company. The task of accumulating and assigning these expenditures to the revenue they generated is the responsibility of the controller and to do so, some kind of cost accounting system must be used. Each type of service business has its own peculiarities, which the controller must learn to identify in developing the proper planning and control system. But the same basic principle applies to each — the need for an activity-based costing (ABC) system. This can provide guidance for service as well as manufacturing businesses. In implementing ABC, a difﬁculty may arise in some service businesses. Most internal operating expenses are employee related. The nature of the job is such that the employees must work on multiple activities, so it is often difﬁcult to isolate employee time devoted to speciﬁc activities. Moreover, activity times may vary greatly by different product, customer, and so on. Given the need for ABC, and the variability of the task, it may be desirable to test sample the operations in arriving at the proper cost assignment. Finally, because of the multiple tasks performed by the employees, and the changes over time in the nature of many service businesses, it may be useful to establish expense performance benchmarks so that the appropriate resources are applied to each task.

23.5 COST ACCOUNTING IN A SERVICE ORGANIZATION In a manufacturing environment a key distinction in cost accounting is the difference between a product cost and a period cost. Product costs are deﬁned as all those things that are necessary to produce the product, and, generally speaking, they all become part of inventory value to be subsequently matched against the revenue they produce. All other items are considered period expenses and are charged against income as they are incurred. Examples of product cost are direct factory labor, direct materials, and other factory overhead costs. Examples of period expenses are research and development (R&D) expenses, marketing expenses, and G&A expenses. In a service organization, there is no product produced, all costs have the characteristics of period expenses, and no inventory is accumulated in the balance sheet as an asset. The direct work done produces revenue in the same period the work is performed, for example, legal work, cleaning services, security. Therefore, the cost of revenue becomes more a classiﬁcation issue than an accumulation and/or deferral issue. However, a cost accounting system is needed to classify all appropriate activities into the correct cost of revenue accounts. Reliable cost information is used by management to: • Plan the service areas or categories • Provide input for pricing purposes • Control cost levels • Analyze proﬁtability • Identify cost reduction opportunities There is not much guidance around to help develop such a system, but many of the concepts used in manufacturing cost accounting have applicability to cost-of-service accounting. Several exceptions to using manufacturing costing techniques are: • Many of the costs in a service company are “ﬁxed” over the short term. Therefore, the traditional distinction of variable costs is generally not as useful in a service business. • Materials are not a signiﬁcant item in the delivery of a service (except in businesses like retailing and restaurants), so it is not necessary to have a comprehensive procedure to identify and record their receipt and utilization.

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23.5 Cost Accounting in a Service Organization

491

Having eliminated materials as an important factor, we can now examine what elements should be included in a service company’s cost accounting system. (a) “DIRECT” LABOR. The primary cost of providing a service is the salary and related expenses of the people who are performing the service. These are the “direct” expenses of a service business. In order to identify the direct cost of revenue, it is necessary to capture the time worked by the “direct” people in the same classiﬁcations as revenue is recorded. This is accomplished by having the direct personnel keep tract of their time and report it to the accounting department. This reporting is so fundamental to an effective information (and billing) system that many ﬁrms use the time reports to also initiate paychecks. If someone does not submit a time report, his or her pay is delayed. These reports generally are prepared and processed each day to ensure accuracy (and also spread processing work over a longer period, thereby eliminating or minimizing the last-minute rush often associated with such an operation). Again, circumstances may dictate variations as to how often and even how time is to be reported. In instances in which people are permanently assigned to the same contract or work effort (e.g., an advertising campaign), then weekly reporting might be an acceptable procedure. In cases where people are usually assigned to the same effort but may occasionally be used somewhere else, then daily exception reporting could be the most effective way to report. A system should then assign the individuals’ pay rate to the hours reported by contract or matter and develop a “cost” of these items by individual. This rate can be either an actual rate by individual or a standard rate by job classiﬁcation or grouping. This data would be recorded in the cost accounts using the same classiﬁcation as the revenue accounts discussed earlier. (b) OTHER DIRECT EXPENSES. In addition to keeping track of the time expended by revenue category, it is also necessary to identify other “direct” expenses by the same categories. These other direct expenses are those that are incurred for a speciﬁc client or a contract. They can be identiﬁed as ordered or incurred as pertaining to a deﬁned accumulation point and so recorded. Examples are: • Services procured (e.g., printing) • Materials purchased (e.g., cleaning supplies) • Travel expenses incurred As these expenses are incurred, they should be recorded using the same classiﬁcations and subclassiﬁcations as the revenue that they were incurred to produce. (c) ALLOCATED EXPENSES. Time and direct expenses are easily identiﬁed to speciﬁc revenue, but there are other expenses that are incurred that, like factory overhead, are necessary to the delivery of a service but are not directly attributable to any speciﬁc contract or customer. These items must be assigned or allocated. (i) Direct (Or Proximate) Overhead. The ﬁrst segregation of these allocated expenses should be those attributable to the “direct” workers and might be called “direct” or “proximate” overhead. Such items would include: • Employee beneﬁts expense (of the direct workers) • Ofﬁce space (including lighting, heating, power, telephone, and mail costs) • Use of desks and other ofﬁce furniture and equipment • Use of a computer and other equipment • Nonbillable time (e.g., time spent at education, meetings) These expenses would be ﬁrst attributed to each direct worker and then assigned to the project that the employee spent his or her time on in direct proportion as the time was spent. In other words, using traditional manufacturing cost accounting terminology, the ﬁrst “overhead” pools to be used would be those that directly supported the direct labor of the services delivered. These pools would probably be charged to the cost of revenue based on the hours of direct labor.

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492

Ch. 23 Financial Planning and Control in a Service Company

(ii) Indirect (or Remote) Overhead. This overhead pool would include all other expenses associated with the production of revenue, but not as directly as the direct pool. It would include such things as a share of secretarial expense, a share of accounting expense, a share of direct supervision expense, and so forth. It would not include R&D, selling, and G&A expenses, nor would it include shares of other income and other expenses. These latter expenses may subsequently be apportioned to revenue categories or ofﬁces or contracts to develop a net proﬁt amount, but they will not be entered into the cost accounting system nor used in determining gross proﬁt amounts and margins. To summarize, the cost of service revenue is to be determined using a cost accounting system that will accumulate and assign to all classes and subclasses of revenue those expenses incurred in direct performance of the service (i.e., labor, purchased services and materials, and directly identiﬁable support activities). The objective of the above is to produce a statement of gross income, cost, and gross proﬁt that gives management a reliable and understandable view of the business. Such a statement prepared in accordance with the above guidelines might look like that in Exhibit 23.3and Exhibit 23.4. With the information developed in Exhibit 23.3, it is easy to then apportion the other operating expenses of the company to develop a complete statement of income and expense by primary cost objective (ofﬁce, client, or service). (See Exhibit 23.4.) These apportionments are usually made using very broad factors, such as percentage of total revenue or percentage of total direct head count. The result is that a responsible executive can see his gross and net contribution to the business and can include the apportioned values in the pricing algorithms. General management also can assess the relative performance of the segments of the company.

23.6 PLANNING SYSTEM Having established an accounting system that will intelligently and fairly present the ﬁnancial transactions of the business, the next step needed to manage and control it is an effective planning system. There seems to be more difﬁculty in nurturing the concepts of sound management in young service ﬁrms than in young manufacturing companies. Perhaps some of the reasons are: • The founder is reluctant to delegate authority as the ﬁrm grows and needs decentralization. • The creative people such as in an advertising agency, or the contentious people such as lawyers or accountants in professional organizations, have a great individuality and like to make their own decisions in an unrestricted environment. • The growth and success of the business in its early years resulted from the summation of individual ideas and actions and no formal system of planning and control was needed. However, if growth is to continue, a clearly deﬁned and coordinated approach to steering the ﬁrm is required. The ﬁrst logical step in this process is the preparation of an annual budget. The annual budget will represent a plan of action developed or agreed to by responsible managers. The budget Ofﬁce/Product Identiﬁcation

Total

Service A

Service B

Gross income Cost of gross income Direct labor Other direct expense Allocated expense —proximate pool Allocated expense —remote pool Total cost Gross proﬁt Gross proﬁt margin E XHIBIT 23.3

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S TATEMENT

OF

G ROSS I NCOME , C OST ,

AND

G ROSS P ROFIT

Service C

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23.6 Planning System

Ofﬁce/Product Identiﬁcation

Total

Service A

Service B

493

Service C

Total gross proﬁt (from Statement of Gross Proﬁt) Apportionments Selling expenses Development expenses General and administrative expenses Total apportioned expense Net income before taxes Income taxes Net income Margin E XHIBIT 23.4

E XAMPLE : I NCOME AND E XPENSE S TATEMENT (I NCLUDING A PPORTIONMENT OF G ENERAL E XPENSES )

should then become part of the ﬁnancial reporting system. Each month (or quarter) statements should be prepared that will display period revenue and/or expenditures compared to budget and variances identiﬁed as favorable or unfavorable. (See Exhibit 23.5.) The annual budget should also represent the tactical implementation of a long-range strategic plan. (a) ANNUAL BUDGETS. (i) Sales Budget. As with any other business, the sales plan in a service company is the foundation for the entire system of plans. Its preparation must be given all the attention required at all levels of the company. It will inﬂuence the human resource plan, the facilities plan, the operating expenses plan, and the cash ﬂow plan. The material covered in Chapter 18, “Planning and Control of Sales,” applies, to a large extent, to a service business and should be helpful to a service industry controller. The responsibility for preparing the short-term sales plan is usually assigned to the individual responsible for the proﬁt contribution of an ofﬁce, contract, product/service, and so on, working in conjunction with the chief sales executive (if there is one). It is this individual who must acquire the knowledge to estimate potential future sales. In order to do this the executive must consider both internal and external matters. The internal considerations include: • Company growth objectives, including expansion to new customers and services • Available resources — human, physical, and ﬁnancial • Planned advertising, promotion, and public relations campaigns • Pricing actions The external considerations include: • Competition (including price) • Growth potential/demographics • Technological changes • General economic trends Chapter 18 also lists some sources of useful economic data. The controller’s contribution to the preparation of the annual sales plan, generally involves helping the responsible executives to identify and use good sources of information, to assist in sales analysis and perhaps most importantly to manage the budget process. This latter effort will do the following: • Establish timing of budget input. • Deﬁne data input including the details required and deﬁnitional consistency. • Provide the necessary forms and worksheets to be prepared.

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Ch. 23 Financial Planning and Control in a Service Company

Current Month Actual

Ofﬁce /Product Identiﬁcation

Plan

Year to Date Actual

Plan

Gross Income Service A Service B Service C Total Cost of Gross Income Service A Direct labor Other direct expense Allocated expense — proximate pool Allocated expense — remote pool Total cost Gross proﬁt Gross proﬁt margin Service B Direct labor Other direct expense Allocated expense — proximate pool Allocated expense — remote pool Total cost Gross proﬁt Gross proﬁt margin Service C Direct labor Other direct expense Allocated expense — proximate pool Allocated expense — remote pool Total cost Gross proﬁt Gross proﬁt margin Total gross proﬁt Margin Apportionments Selling expenses Development expenses General & administrative expense Total apportioned expense Net income before taxes Income taxes Net income Margin E XHIBIT 23.5

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S TATEMENT

OF

G ROSS I NCOME , C OST ,

AND

G ROSS P ROFIT

Variance () Unfavorable

Full Year

C/M

Plan

YTD

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23.6 Planning System

495

• Verify or test the reliability of data and the calculations applied thereto. • Assemble and consolidate input for promulgation to other executives to be used as the basis for preparing their annual budgets. When the annual sales plan has been approved (after an interactive process of change and modiﬁcation), it is then necessary to establish a control track for the plan period by breaking it into quarters and months. This important information will be used to help control operations by comparing actual results to planned results and identifying areas or items that require analysis and action. Exhibit 23.6 illustrates a consolidated sales plan broken down by quarter and month. Each of the services (A, B, C) in the example is the responsibility of a separate executive and the annual sales plan was developed, individually by service. A format useful in the preparation of each service sales plan is shown in Exhibits 23.7 and Exhibit 23.8. Exhibit 23.7 reﬂects one service (A) and shows the expected revenue from all of the contracts that provide that service. The prior year and current year actuals are included for comparative purposes. Exhibit 23.8, continuing the example, reﬂects the lowest level of sales budgeting and therefore the basic projections and decisions. It reﬂects a single contract for twelve months from August of the current year through July of the next year. The manager of this contract believes that it will be renewed with an upward price adjustment of 5 percent and expanded to include additional coverage. This projection was supported by analyses, approved by the executive responsible for Service A and so is included in the sales plan. Each other contract manager would prepare the same kind of estimate, review it with the executive responsible for the service and, when agreed to, it becomes his plan and commitment for the next year’s sales. (ii) Direct Labor Budget. A detailed coverage of direct labor is covered in Chapter 20, “Planning and Control of Manufacturing Costs: Direct Material and Direct Labor.” While the context of T HE I LLUSTRATIVE C OMPANY S ALES P LAN 20XX (000 S OMITTED )

January February March 1st quarter April May June 2nd quarter July August September 3rd quarter October November December 4th quarter Full year E XHIBIT 23.6

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Total

Service A

Service B

Service C

$ 475 475 470 1,420 470 480 495 1,445 495 500 515 1,510 535 535 565 1,635 $6,010

$ 100 110 110 320 110 115 120 345 120 125 130 375 130 130 140 400 $1,440

$ 125 125 125 375 125 125 125 375 125 125 125 375 125 125 125 375 $1,500

$ 250 240 235 725 235 240 250 725 250 250 260 760 280 280 300 860 $3,070

A C ONSOLIDATED S ALES P LAN

BY

P ERIOD

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496

Ch. 23 Financial Planning and Control in a Service Company

T HE I LLUSTRATIVE C OMPANY S ALES P LAN —S ERVICE A BY C ONTRACT 20XX (000 S OMITTED ) Actual

Contract 1 Contract 2 Contract 3 Contract 4 Total E XHIBIT 23.7

Prior Year

Current Year

Plan 20XX

$400 — — — $400

$400 200 150 — $750

$ 400 200 410 430 $1,440

A N A NNUAL S ALES P LAN

BY

C ONTRACT

T HE I LLUSTRATIVE C OMPANY S ALES P LAN —S ERVICE A C ONTRACT 3 20XX (000 S OMITTED ) Actual

January February March April May June July August September October November December Total E XHIBIT 23.8

Prior Year

Current Year

Plan 20XX

$— — — — — — — — — — — — $—

$ — — — — — — — 30 30 30 30 30 $150

$310 30 30 30 30 30 30 40 40 40 40 40 $410

A S ALES P LAN

BY

M ONTH

Chapter 20 is a manufacturing environment, the process of preparing a direct labor budget is generally applicable to a service company. The reader interested in the planning and control of a service business is encouraged to review this chapter since much of the content will be useful to him or her. A brief summary of key points relative to planning labor costs follow. The basic question is to determine the number and skill level of workers needed to provide the services included in the sales budget. The operating executive responsible for delivering the service has the primary responsibility for developing this estimate. The labor input must be assembled with a timing plan by contract and service. The controller should test check the information to ensure its reasonableness and compatibility with the sales plan. The controller’s cost accounting people can then estimate the cost of the labor by applying estimated pay rates to the estimated labor hours by skill category.

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23.6 Planning System

497

T HE I LLUSTRATIVE C OMPANY S ERVICE A—C ONTRACT 3 D IRECT L ABOR B UDGET 20XX (000 S OMITTED )

January February March April May June July August September October November December

Direct Labor Hours

Gross Cost

2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,500 2,500 2,500 2,500 2,500 26,500

$ 20,000 20,000 20,000 20,000 20,000 20,000 20,000 26,250 26,250 26,250 26,250 26,250 $271,250

Note: Assumptions: 25% increase in manpower when contract is renegotiated in August. 5% salary rate increase effective August 1.

E XHIBIT 23.9

A D IRECT L ABOR B UDGET

BY

M ONTH

Using the sales plan for Service A, Contract 3, shown in Exhibit 23.8, the direct labor budget might be summarized as in Exhibit 23.9. (iii) Other Costs of Services Budget. Chapter 21, “Planning and Control of Manufacturing Costs: Manufacturing Expenses,” describes how to identify, plan, control, and allocate overhead expenses in a manufacturing environment. Chapter 22, “Planning and Control of Research and Development Expenses” describes the techniques used for nonmanufacturing items. Both chapters will be helpful in developing the annual budget for other costs of services. As with the direct labor budget, other direct cost-of-service estimates should be prepared by the responsible manager and, after their compilation, be approved by the senior executive. The overhead items will probably ﬁrst be assembled as administrative budgets by knowledgeable, responsible executives and then allocated to the various contracts/clients and so forth, using the cost accounting system described earlier. The other direct costs and overhead budgets should also be prepared by month so that complete budget actual comparisons can be made on a regular, recurring basis. (iv) Other Plans and Budgets. Important to the good management of all businesses are annual plans for ﬁnancial condition and cash ﬂows. Some service businesses pay scant attention to their statement of ﬁnancial position since very often the only signiﬁcant item on it is accounts receivable. However, almost all service businesses are concerned with their cash position and cash ﬂow. It is therefore necessary to carefully develop an effective planning system to manage this important element. Such a system must include the development of a ﬁnancial condition plan for both the full year and interim months.

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Ch. 23 Financial Planning and Control in a Service Company

The elements and techniques that are useful in establishing such plans are the same in all businesses; only the emphasis changes. In a manufacturing business, inventory and property, plant and equipment, are material, and signiﬁcant attention is paid to those items. In a service business, cash and accounts receivable along with short-term debt usually are the matters that are signiﬁcant and require emphasis and attention. The point is that an effective planning system will include budgets for the statement of ﬁnancial position as well as for the statement of operations. These two budgets can then be used to prepare a representative and reliable budgeted cash ﬂow statement.

23.7 STRATEGIC PLANNING Another most important step is the initiation of strategic planning. It is this technique that will identify growth opportunities, human resources needs, and resources allocation requirements. Without strategic planning the average service company will drift aimlessly from one hot opportunity to another. The controller should recognize that much of the service business is dominated by one crucial characteristic: That is, once a day’s utilization is lost, it is lost forever. The service, unlike products, cannot be stored in inventory; last night’s empty hotel room is a lost asset forever. Therefore, proﬁtability is heavily dependent on how effectively the marketing efforts achieve high utilization; and how effectively the company communicates its particular advantages to the customer. All the prerequisites of long-range planning discussed in other sections of this book apply to the service ﬁrm; but the most important is the commitment of top management to the concept. The decision makers must be willing to support the effort with the necessary resources and their own time or the effort will fail. The ﬁnancial history of the ﬁrm can be observed and key ratios, trends, and comparisons developed through the use of prior and current period statements: • Financial condition • Income and expense • Cash ﬂows With this data as a starting point, future activities can be projected and analyzed. The strengths and weaknesses of the ﬁrm can be reviewed and appropriate goals and directions formulated. Some of the considerations that a service company should assess are: • Image of the ﬁrm as perceived by clients and others • Quality of the work, product, location, and accessibility to customers In addition, the following factors should be addressed in developing the strategic plan: • Who and where are the potential new clients/customers? • What will be the source of new hires as they are needed? • What governmental actions will impact the ﬁrm? • What technological improvements can be expected?

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24

PLANNING AND CONTROL OF GENERAL AND ADMINISTRATIVE EXPENSES 24.1

INTRODUCTION 499

24.4

REDUCING G&A EXPENSES 505

24.2

COMPONENTS OF G&A EXPENSE 499

24.5

BUDGETING G&A EXPENSES 509

24.3

CONTROL OVER G&A EXPENSES 500

24.1 INTRODUCTION In this chapter, the planning for and control over the area of general and administrative (G&A) expenses are discussed. Typically an amorphous and poorly controlled area, the G&A expense area hides a signiﬁcant number of expenses that a careful company can take many steps to avoid, or to at least keep from becoming larger. This chapter describes the most common elements of G&A expenses and how to control them, offers a number of pointers on how to reduce them, and ﬁnishes with a discussion of the best budgeting methods a controller can use to plan for as well as mitigate the impact of G&A expenses. By reviewing this chapter, a controller will reach a better understanding of the components of G&A, as well as how to manage them.

24.2 COMPONENTS OF G&A EXPENSE The G&A expense includes costs for a speciﬁc set of departments and expenses, which are both described in this section. These departments and expenses are ones that cannot be directly related to production or sales activities and so are segregated in the chart of accounts under a separate account category. This section not only describes the G&A departments, but also the accounts that are most commonly used within those departments. For a typical company, there are a set of departments that do not relate in any way to production or sales activities, and so by default must be included in the G&A category. These departments address the overall management of the corporation, as well as its ﬁnancial, computer systems, and legal activities. The departments are: • The ofﬁce of the chairman of the board • The ofﬁce of the president • The accounting department • The management information systems department • The treasurer’s department • The internal audit department • The legal department 499

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Ch. 24 Planning and Control of General and Administrative Expenses

For each of these departments, there is a common set of expenses, irrespective of the function of each department. These expenses relate to the ongoing salary, operating, and occupancy costs that any functional area must incur in order to do business. The expenses are: • Salaries and wages • Fringe beneﬁts • Travel and entertainment • Telephones • Repairs and maintenance • Rent • Dues and subscriptions • Utilities • Depreciation • Insurance • Allocated expenses • Other expenses A controller can use the above expenses when setting up any department that falls within the G&A category. However, in addition to these common expenses, there are a large number of additional expenses that do not fall into any clear-cut category, nor can they be listed as being production or sales speciﬁc. These expenses, as shown below, cannot be allocated to other departments (or at least not without the use of a very vague basis of allocation), and so must be grouped into the G&A heading: • Director fees and expenses • Outside legal fees • Audit fees • Corporate expenses (such as registration fees) • Charitable contributions • Consultant fees • Gains or losses on the sale of assets • Cash discounts • Provision for doubtful accounts • Interest expense • Amortization of bond discount A controller can use this information to set up a chart of accounts for the G&A expense area.

24.3 CONTROL OVER G&A EXPENSES Some companies get into trouble with investors and lenders, because they have inadequate controls over their G&A costs, which leads to lower proﬁts. It is possible to eliminate these issues by implementing a variety of controls that are useful for keeping G&A costs within an expected range. This section describes a number of controls that serve this purpose. The potential savings that can be realized through tight control over G&A expenses are usually not as great as those in the manufacturing or sales areas. This is to be expected, because the volume of expenses is far smaller in the G&A area. However, depending on the size of the gross margin, tight control over G&A costs can still lead to a signiﬁcant change in proﬁts, because it is easier to increase proﬁts by reducing costs than it is to increase proﬁts by increasing sales. In the following example, we show the revenues required to cover the cost of a person with a $50,000 salary:

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24.3 Control over G&A Expenses

Salary Level

Gross Margin

Revenue Required

$50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000

90% 80% 70% 60% 50% 40% 30% 20% 10%

$55,556 $62,500 $71,429 $83,333 $100,000 $125,000 $166,666 $250,000 $500,000

501

The table makes it clear that for a low-margin company in particular, it is necessary to increase sales by an enormous amount in order to cover a small additional expense. Thus, it is much easier to increase proﬁts by cutting costs for most companies than it is to increase revenues. Accordingly, the controls noted in this section and the expense reduction ideas listed in the next section are well worth the effort of implementing, even in the G&A area, which does not normally comprise a large percentage of a company’s costs. One of the easier controls to implement is to assign a number of control points to a company’s internal audit group for periodic reviews. The internal audit team can observe operations, procedures, and process ﬂows, and compare expenditures to activity levels, thereby acquiring enough information to determine where control points are at their weakest, and require strengthening. Examples of good internal audit targets in the G&A area include: • Compare process efﬁciencies to those of best-practice companies and recommend changes based on this review. • Conﬁrm the results of consulting engagements, and construct cost-beneﬁt analyses for them to determine which consultants are creating the largest payoff. • Review the bad debt expense to see if there is an unusual number of write-offs, and recommend changes to the credit granting policy based on this review. • Verify that all dues and subscriptions have been properly approved. • Verify that all paychecks cut are meant for current employees. • Verify that assets are categorized in the correct depreciation pools. • Verify that cellular phone usage is for strictly company business. • Verify that charitable contributions are approved in advance. • Verify that insurance expenses are competitive with market rates. • Verify that legal expenses are at market rates. • Verify that ofﬁce equipment is not incurring excessive repair costs. • Verify that phone expenses are in line with market rates. • Verify that scheduled rent changes have been paid. • Verify that there are proper deductions from paychecks for beneﬁts. • Verify that there is approved backup for current employee pay rates. • Verify that travel and entertainment expenses are approved. • Verify that travel and entertainment expenses are in accordance with company policy. Besides the internal audit team, another good control point is the budget. A controller should always hand out a comparison of actual expenses to the budget after each month has been closed, so that all managers in the G&A area can gauge their performance against expectations. In addition, there should be a report that lists the amount of money left in each manager’s budget, so that

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Ch. 24 Planning and Control of General and Administrative Expenses

there is no reason for anyone to demand extra funds towards the end of the ﬁscal year. The strongest control in this area is to have the purchasing system automatically check on remaining budgeted funds, so that a purchase order will be rejected if there are not sufﬁcient funds on hand through the accounting period. Thus, a budget can be used in several ways to create tight control over G&A costs. Another control method is to divide up all G&A costs by responsibility area and tie employee bonuses and pay rate changes to those costs. For example, the building manager can be made directly responsible for all occupancy costs, and will only receive a pay raise by reducing the overall occupancy costs by a preset percentage. When using this method, it is best to set up a range of compensation goals, so that an employee can still go after a lesser target, even when it becomes apparent that the main cost goal is not reachable. To expand on the previous example, there can be a large pay raise if occupancy costs are reduced by 5 percent, a modest pay raise if the reduction is only 2 percent, and a very minor pay raise if the person can do nothing but maintain occupancy costs at their current level. By using this multitiered compensation system that is tied to direct responsibility for G&A costs, there is a much greater chance that managers will pay close attention to those G&A costs that are assigned to them. One problem with dividing up G&A costs by responsibility area is to ﬁnd a reasonable method for doing so, since it is quite possible to erroneously charge G&A costs to the wrong person, which may lead to behavior that does not match company objectives. Fortunately, there are several allocation methods available that allow one to assign costs to facilitate planning and control, by responsibility center, and to cost pools, in case a company is using activity-based costing. The preferred method of allocating G&A costs is based on a hierarchy of alternatives, which are listed in descending order of usability: 1. Allocated based on the amount of resources consumed by the cost center that is receiving the service. For example, if a division is using the central accounting staff to create invoices for it, costs should be allocated to that division based on the cost of creating an invoice, multiplied by the total number created for that division. 2. Allocated based on the relative amount caused by the various cost centers. This method is less precise, because there is not a direct relationship between the activity and the cost, only a presumed one. For example, medical costs can be allocated to a department based on the number of people in a department; we assume that the people in that department take up a proportionate share of medical costs, even though this may not be the case. Other examples are allocating costs based on the material cost of an item (such as material handling costs), based on square footage (such as physical facility costs), or based on energy consumption (such as the rated horsepower of a machine). Though not as accurate as the ﬁrst method, this approach allows one to allocate most costs on a fairly rational basis. 3. Allocated based on the overall activity of a cost center. This method is the least precise, because it is only based on a general level of activity, which may have no bearing on a cost center’s actual expense consumption. An example of an overall activity measure is the three-factor Massachusetts Formula, which is a simple average of a cost center’s payroll, revenue, and assets as a proportion of the same amounts for all cost centers. This approach essentially charges costs to those areas that have the greatest ability to pay for services, irrespective of whether or not they are using them. Exhibit 24.1 shows a number of ways to allocate costs. The exhibit covers activities in a variety of areas, and notes allocation methods that are based on one or more of the preceding allocation methods. The exact allocation method chosen will depend on an individual company’s circumstances. No matter which of these allocation methods is used, one should keep in mind the end result— attaining a greater degree of control over costs. If the allocation method is excessively time consuming or expensive to implement, one must factor this issue into the assumed savings from having a greater degree of control over G&A costs and make a determination regarding the cost effectiveness of the allocation method.

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503

General and Administrative Costs

Possible Allocation Bases

Research and development

Estimated time or usage Sales Assets employed New products developed

Personnel department functions

Number of employees Payroll Number of new hires

Accounting functions

Estimated time or usage Sales Assets employed Employment data

Public relations and corporate promotion

Sales

Purchasing function

Dollar value of purchase orders Number of purchase orders Estimated time or usage Percentage of material cost of purchases

Corporate executives’ salaries

Sales Assets employed Pretax operating income

Treasurer’s functions

Sales Estimated time or usage Assets or liabilities employed

Legal and governmental affairs

Estimated time or usage Sales Assets employed

Tax department

Estimated time or usage Sales Assets employed

Income taxes

Net income

Property taxes

Square feet Real estate valuation

E XHIBIT 24.1

A LLOCATION B ASES

FOR

G&A C OSTS

When allocating costs, one should also consider the impact on the recipient of the allocation. It is best to allocate only those costs over which a recipient has direct control, since the recipient can take direct action to control the cost. If a cost is allocated that the recipient can do nothing about, there is much less reason to make the allocation. For example, computer programming costs can be charged to a cost center for the exact amount of the time needed to develop a requested report—if the manager of that cost center does not want to incur the cost, then he or she should not request that any reports be developed. Alternatively, if senior management wants to encourage the use of certain internal resources, such as legal, accounting, or computer services, it can reduce the activity costs of these functions to below-market rates, which will encourage managers to use them. Either approach involves cost allocations that managers can directly impact by choosing to consume or not consume G&A services. Another way to control G&A costs is to create standards for each activity performed, which can then be used to compare against actual performance, in the same way that labor standards have

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Ch. 24 Planning and Control of General and Administrative Expenses

been used in the manufacturing arena for decades. By tracking performance based on these standards and modifying systems to match or beat the standards, a controller can achieve a high performance G&A function. To create standards for this purpose, use the following steps: • Observe work tasks. Carefully note the steps and duration of a task. This step is fundamental in securing the necessary overall understanding of the problem and in picking those areas of activity that lend themselves to standardization. For example, it will not be possible to create a standard if there are an excessive number of variations that are commonly part of a work routine. In addition, the preliminary review will spot any obviously major weaknesses in a routine. • Select tasks to be standardized. The preliminary review will reveal those routines that are the best candidates for standard creation. The two main criteria for this will be that a routine has enough volume to justify the work of setting a standard, and that a routine does not include so much variation that it is impossible to create a reliable standard. These two criteria will quickly reduce the number of standards to a modest percentage of the total number of routines used in the G&A area. • Determine the unit of work. There must be a measurement base upon which to set a work standard. Examples of units of work follow: Function Billing Check writing Customer statements Filing Mail handling Order handling Order writing Posting Typing

Unit of Standard Measurement Number of invoice lines Number of checks written Number of statements Number of pieces ﬁled Number of pieces handled Number of orders handled Number of order lines Number of postings Number of lines typed

• Determine the best way to set each standard. Various kinds of time and motion studies can be applied to each work routine, depending on the nature of the work. • Test each standard. After a standard has been set, it should be tested with varying workloads to determine whether it is a reasonable standard. Keep in mind that a standard is much less effective if an employee has many tasks to perform, since it is often necessary to jump repeatedly between tasks. In these cases, it may not even be practical to install standards for any but the most high-volume routines. • Apply the standard. This step involves explaining the standard to each employee on whom it will be used, as well as to supervisors. In addition, one should set up a reporting system for tracking this information, and a feedback loop that tells employees how they are doing against the standard. • Audit the standard. There should be a regular schedule of reviews for each standard, so that there is not a problem with a standard becoming so out of date that it no longer reﬂects the current level of efﬁciency of each routine. In addition to the scheduled reviews, there should also be a review every time there are major changes to a routine, possibly due to the implementation of a best practice, which would invalidate a standard. In addition to performance standards, unit cost standards can be applied to measure an individual function or overall activity. Thus, applying cost standards to credit and collection functions may involve these functions and units of measurement, depending on the extent of mechanization. (See Exhibit 24.2.)

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Functional Activity

Unit Cost standard

Credit investigation and approval

Cost per sales order Cost per account sold Cost per credit sales transaction

Credit correspondence records and ﬁles

Cost per sales order Cost per letter Cost per account sold

Preparing invoices

Cost per invoice line Cost per item Cost per invoice Cost per order line Cost per order

Entire accounts receivable records, including posting of charges and credits and preparation of customer statements

Cost per account Cost per sales order Cost per sales transaction

Posting charges

Cost per invoice Cost per shipment

Preparing customers’ statements

Cost per statement Cost per account sold

Posting credits

Cost per remittance Cost per account sold

Calculating commissions on cash collected

Cost per remittance

E XHIBIT 24.2

A PPLYING C OST S TANDARDS

TO

C REDIT

AND

505

C OLLECTION F UNCTIONS

By applying the standard creation methods noted in this section to G&A activities, it is possible to exercise additional control over the more repetitive tasks within the G&A area. There are a number of controls that a controller can implement to ensure that G&A expenses stay within an expected range. These controls include periodic reviews by the internal audit department, both manual and automated comparisons of budgeted to actual costs, and the development of unit cost standards. By using a selection of these controls, there is much less chance that there will be any signiﬁcant variations from expected G&A costs.

24.4 REDUCING G&A EXPENSES Unfortunately, many controllers feel that the G&A expense is a ﬁxed one, and consequently make little effort to reduce it. Although it is true that there are better methodologies for cost reduction in other functional areas of a company, there are still a considerable number of cost reduction techniques that a controller can implement to reduce G&A costs. The principle issue to remember when trying to cut costs is that one must attack the underlying assumptions that are protecting G&A expenses, rather than trying to make incremental adjustments to those expenses by using greater efﬁciencies. In many cases, the only way to bring about massive reductions in G&A costs is to completely eliminate some categories of costs. Why go to this extreme? Because G&A costs do not directly contribute to revenue gains or production efﬁ-

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Ch. 24 Planning and Control of General and Administrative Expenses

ciencies—they are dead weight—and must be constantly reviewed to ensure that they are kept at an absolute minimum, even if the company as a whole is growing at a great rate. If a company consists of a central headquarters that oversees the functions of a large number of facilities or subsidiaries, there may be a chance to reduce a very large proportion of the existing G&A expense. This reduction can be achieved by altering the management concept of the headquarters group. By altering this key underlying assumption of how to manage a company, it becomes possible to decentralize and push management functions down into the various facilities or subsidiaries, thereby vastly reducing the need for most of the staff in the headquarters facility. This approach is the single most effective way to reduce G&A costs. Another general cost reduction concept that applies to nearly all parts of the G&A area is the use of outsourcing. This approach questions the underlying assumption that there is a need for an in-house staff to handle every G&A function. For example, a legal staff can be eliminated in favor of using an outside law ﬁrm that handles company legal issues. Though the hourly cost of using this approach may be quite high, it can be cheaper over time, for several reasons. First, the in-house staff tends to ﬁnd work for itself to do, even though that work may not be entirely necessary. Second, there tends to be a greater emphasis on cost reduction when an expensive outside service is used that charges by the hour (or minute), especially when that cost can be traced back and charged to a speciﬁc department. Finally, the cost becomes a variable one when the ﬁxed cost of the in-house staff is eliminated in favor of one that is incurred only when needed. Thus, outsourcing is a valid approach for reducing G&A costs. Besides the general cost reduction methods just noted, there are a variety of speciﬁc cost areas that deserve the attention of the controller. The following list notes a variety of techniques that can be used to reduce costs in speciﬁc G&A areas: • Audit expense. Most companies hire a group of outside auditors to review the year-end ﬁnancial statements. The cost of this audit can be substantial, especially if company operations are widely separated or if the accounting records are not well organized. A controller can succeed in reducing the audit expense by changing to a different type of review. Instead of a full audit, it may be possible to have the auditors conduct a compilation or review, both of which are less expensive. However, these alternatives do not provide for as complete a review of the accounting records, so the switch may meet with resistance from lenders, who rely on the results of the audit to determine the risk of continued lending to a company. Another way to reduce expenses in this area is to volunteer the services of the accounting staff in assisting the external auditors. Though these services will be limited to a supporting role, it will reduce the hours charged to the company by the auditors, which will reduce the overall cost of the audit. • Bad debt expense. A controller can have some of the accounting or internal auditing employees assist the external auditors during the annual audit of a company’s ﬁnancial records. This can reduce the size of the audit fee, since the hourly rate charged by an external auditor is typically several times the hourly rate paid to employees. This approach has its limitations, since there are only so many tasks that an audit team will allow the in-house staff to take over. • Charitable contributions. This is a rare area for a company to exercise much cost control over, perhaps because there are so many worthy nonproﬁt organizations that are in need of a company’s cash. However, it is reasonable to target a company’s charitable giving to speciﬁc organizations that best meet its charitable giving goals. By creating an approved giving list at the beginning of each year, a company can avoid giving to organizations that are not on the approved list, thereby bringing about a reduction in the cost of contributions while still achieving the company’s overall charitable giving goal. • Equipment lease expense. Many companies purchase all of their ofﬁce equipment at wide intervals, and obtain leases to pay for them without much thought for the terms of those leases, which tend to be high. A better approach is to consolidate all of the leases into a single master lease, which a controller can then shop to a variety of lenders to obtain the best possible lease rate.

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507

• Forms expense. Some companies have such a large expense for the printing of a multitude of forms that they even have a separate line item in the budget to track it. This is a particular problem for paper-intensive companies such as those in the insurance industry. A controller can reduce this expense by conducting a complete review of all forms to see which ones are no longer necessary. Another option is to combine forms, so that the functions performed by many forms can now be completed with just a few. It may also be possible to convert paper-based forms to on-line ones, so that there is no printing expense at all. Another possibility is to reduce the number of copies of each form, so that they are routed to fewer people within a company. This has the double beneﬁt of reducing the paper cost while also reducing the volume of paper working its way through a company. All of these steps can signiﬁcantly reduce a company’s forms expense. • Interest expense. Interest expense is generally classiﬁed with G&A expenses; however, the underlying reason for the expense lies elsewhere. Interest expense is caused by debt, and debt is needed, to a large extent, to fund working capital requirements, such as accounts receivable and inventory. By paying close attention to accounts receivable collections and inventory usage, a controller can have a major impact on the amount of cash being funded through debt, which will shrink the amount of interest expense. • Ofﬁcer salaries. An exceedingly large part of the G&A expense is ofﬁcer salaries. It is quite unlikely that a controller can persuade more senior executives to cut their pay, but it may be possible to inﬂuence the decision to alter the components of ofﬁcer salaries, so that a larger proportion of it is tied to proﬁtability or other similar performance-related targets. By inserting a large variable component into the ofﬁcer salary expense, it is possible to reduce the expense substantially during periods when performance goals are not reached. • Reproduction expense. The cost of copying documents is astronomical at many companies. There are several ways to reduce it. One way is to focus on the expense of the copiers used. For most employees, a very simple copier model that replicates and sorts is all that is needed, with only a small minority of the staff needing a copier with more advanced functions. Accordingly, a controller can replace expensive copiers with simpler ones, while still retaining a few complicated machines for the most complex printing jobs. Another option is to standardize on a single type of copier, which allows a company to stock a limited number of service and replacement parts for all of them, rather than a wide range of parts for a wide range of copiers. In addition, it may be possible to outsource the larger print jobs to a supplier, allowing a controller to speciﬁcally trace the billings for these jobs to the person requesting the work, which brings home to management the exact cost of reproduction, which would otherwise be buried in the overall cost of G&A expenses. • Storage space. A great deal of the ofﬁce space allocated to the G&A function is ﬁlled with documents. A controller can reduce the amount of prime ofﬁce space devoted to record storage by reviewing the documents and consigning all but the most current ones to cheaper off-site storage facilities. Also, a good archiving policy will allow a company to throw away records that have reached the limit of their usefulness, both from a legal and operational perspective, which also reduces the amount of storage space. Finally, some or all documents can be scanned into a database for retrieval through the computer system, which not only eliminates storage space, but also reduces the time that would otherwise be spent ﬁnding records and returning them to storage. • Telephone expense. There are a plethora of options that allow a controller to drop telephone expenses down to just a few pennies a minute, even for long-distance calls. To achieve such a large cost reduction, a controller should ﬁrst review all existing phone invoices to determine the number and cost of extra phone services, and then determine the need for those services. Next, one must determine the number of phone lines used, as well as the need for special phone lines that carry extra charges (usually because they offer extra bandwidth), such as ISDN or T1 lines. Finally, after adjusting the types of services and number of lines, a controller can review the prices offered by different carriers to determine the lowest possible per-minute charges.

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Ch. 24 Planning and Control of General and Administrative Expenses

With Internet phone service now becoming available, the possibility of acquiring phone service for under ﬁve cents a minute is in sight. Since some companies have extremely complex phone systems, it may be best to hire a company that specializes in reviewing phone systems, since they can provide a more knowledgeable view of phone options. Besides the general and speciﬁc cost reduction options that have already been noted in this section, there is also the cost contained in the efﬁciencies of the tasks performed under the umbrella of G&A expenses. By paying close attention to the efﬁciency of these processes, a controller can wring out additional cost savings. The methodology to use when improving G&A efﬁciencies is a simple one. Essentially, one must clear out any unnecessary tasks or paperwork that are cluttering the work area, thereby allowing a clearer view of the underlying processes that require ﬁne tuning. One can then review and eliminate a number of types of duplication, and then focus on automation, reduced cycle times, training, and benchmarking to achieve extremely high levels of efﬁciency. The speciﬁc efﬁciency improvement steps are: • Clean up the area. Though a seemingly simple task, this is one that many people never get past. By reviewing all documents in an area and archiving anything more than a few months old, one can quickly reduce the volume of work that appeared to be part of the backlog of a job. If possible, as much of this old material as possible should be thrown out, in order to save on archiving costs, but just getting it out of the primary work area is the main target, not shifting it into a dumpster. • Eliminate duplicate documents. Once the old paperwork has been eliminated or moved, it is time to compare the remaining documents to determine whether there are any duplicates. If so, it is only necessary to keep one copy. The remainder can be thrown out or archived. • Eliminate duplicate tasks. It is entirely possible that some information is being prepared by more than one person in the same organization. The best way to spot this problem is to bring people together into teams, and review each other’s work. It can be very helpful to include people from widely separated parts of a company, since they will have a better knowledge of any data being prepared in their areas that is already being prepared elsewhere (as they will ﬁnd out by interacting with the review teams). • Eliminate reports. Now it is time to shrink the work being performed. A classic case of work reduction is to make a list of all the reports generated, and then walk them through the organization to see if they are really needed anymore. In addition, one can review the elements of a report to see if some items can be eliminated that require large amounts of data collection or analysis. Thus, either a report can be eliminated, or some of the information in it. • Eliminate multiple approvals. A review team can plot out the ﬂow of documents through an organization, which frequently reveals a large number of unnecessary and redundant approvals that are lengthening the time required to complete processes. By identifying only the most crucial approvals and eliminating all others, the time wasted while waiting for all the other approvals can be removed from processes, dramatically shrinking cycle times. • Use automation. There are many types of automation that can be used to reduce the workload of people in the G&A area. Some are common, such as the automated voice response system that replaces the receptionist, while others, such as document imaging systems, are less well known but also offer signiﬁcant monetary savings. When using automation, it is important to ﬁrst review the capital and ongoing costs of the new systems in comparison to the existing costs, to ensure that there is a sufﬁcient pay back to make the projects worth the time and effort of installation and maintenance. • Provide training. Too many companies make the mistake of assuming that their staffs need no extra training, and then even if they do, the company that foots the bill will not see an adequate return on its training dollars. To avoid these problems, a company should carefully compile a set of training classes for each job title, so that each person receives extremely job-speciﬁc information, rather than generic information that does not give a recipient much practical knowledge. By focusing on targeted training, it is much easier to improve the qual-

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24.5 Budgeting G&A Expenses

509

ity of employees, who return the favor by applying their new knowledge to improve the efﬁciency of their jobs. • Rearrange the workspace. Most employees do not work in areas that allow them to complete the majority of their work while sitting in one place. Instead, they must walk to distant ﬁling cabinets, copiers, or fax machines. By altering the ofﬁce layout to reduce the amount of movement, a controller can achieve a signiﬁcant productivity improvement. Sometimes, the best approach is to multiply the amount of inexpensive ofﬁce equipment. For example, if someone is a heavy user of a copier, typewriter, or fax machine, then procure an inexpensive variety of each one of these ofﬁce tools and set it up right next to that employee; some very low-end copiers are now so cheap that a controller can give one to every employee, if necessary. • Staff for low volume. Some G&A functions have large swings in the volume of transactions they process, especially if the business is a seasonal one. If so, it may be possible to maintain a small core staff that handles a modest volume of work and then bring in temporary workers to cover the workload when the volume of work rises. This approach reduces the overall labor cost, although the temporary staff will be less efﬁcient than the permanent employees, who are more experienced. • Benchmark G&A. Once all of the preceding tasks have been completed, management should not become complacent and think that it has a world-class G&A function. Instead, this is an ideal time to benchmark a company’s operations against those of companies who have become acknowledged masters in certain functional areas. Another way to collect benchmarking information is to use recommendations by the company’s auditors, who see the operations of many companies, and can recommend practices used by other organizations. By seeing how much better these companies handle their G&A areas, management is spurred on to loop back through the preceding tasks and ﬁnd better and better ways to improve the efﬁciency and effectiveness of the function. • Cross-train the staff. Once a company has gone through several of the steps in this process, it will ﬁnd that there are fewer people in the G&A area—so few in some areas that there may be only one person left with a knowledge of how a process works. To avoid the danger of losing this information with a departing employee, it now becomes important to cross-train employees in multiple functional areas. Also, this allows for further reductions, so that one employee can handle multiple functions. There are a multitude of possibilities for reducing G&A costs. These options fall into three main categories. One is to question the underlying assumptions for incurring broad categories of costs. For example, there may be no need for any headquarters staff if the management philosophy is changed to emphasize control at a local level, rather than from headquarters. The next category is changes that target speciﬁc expenses, of which numerous examples were cited. Finally, one can focus on the overall efﬁciency of transactions, for which a variety of steps were noted; by following these steps, a controller can reduce the cycle time and cost of many G&A operations. Taken together, the steps noted in this section can have a dramatic impact on G&A expenses.

24.5 BUDGETING G&A EXPENSES In most companies, G&A expense is not budgeted as a percentage of sales, since it is relatively ﬁxed and does not vary with sales. However, many G&A functions can be viewed as step costs. For example, accounts receivable volume will decline as sales drop; if there is a signiﬁed reduction in sales volume, then the budget for a receivables position would be eliminated. On the other hand, there are many ﬁxed costs. For example, director expenses are ﬁxed, since the same number of board meetings will occur, no matter how much sales volume may vary. However, there are many discretionary costs. Withholding expenditures on discretionary items can have a marked impact on proﬁts, so a separate analysis of discretionary G&A costs should be made available to management, especially if proﬁtability is expected to be a problem.

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510

Ch. 24 Planning and Control of General and Administrative Expenses

Areas where costs may verge on variable costs instead of step costs are the salaries of the payroll, cost accounting, cashier’s, and internal audit departments. The budget preparation procedure for G&A varies somewhat from the procedure used for production, since there is no budget for purchased materials, inventory, cost of goods sold, or direct labor. A typical G&A budget preparation procedure includes: 1. The controller or budget director makes available to each functional executive and/or department head, in either worksheet form or computer accessible data: (a) Actual year-to-date expenses and head count (b) Assumptions to be used for budgetary purposes: percent of pay raise, fringe beneﬁt cost percent, inﬂation rate, generally acceptable rate of expense increase, etc. (c) Any relevant information on the business level, economic conditions, etc. (d) Instructions on preparing the planning budget 2. The department head completes the budget proposal and sends it to his supervisor for approval, who then forwards it to the budget director. 3. The individual department budget requests are reviewed by the budget director, checked for reasonableness and completeness, and, when acceptable, summarized for the central ofﬁce by responsibility. When the aggregate G&A budget is accepted, it becomes part of the annual business plan. 4. Monthly, the department expenses—actual and budget—are compared by the department head, who takes corrective action where appropriate. This report shows any signiﬁcant over- or underrun. Budget performance could also be reported on a graphic basis. This report also explains signiﬁcant overruns. The monthly trend of performance, by group and in total, could be displayed in vertical bar chart or line graph. The entire group performance could be summarized as to budget and actual expense by natural expense category (salaries and wages, travel and entertainment, etc.).

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CHAPTER*

25

PAYROLL 25.1

INTRODUCTION 511

25.6

STATE INCOME TAXES 518

25.2

COMPENSATION 513 (a) Employee or Contractor Status 513 (b) Wage Exemption Guidelines 513 (c) Work Week 513 (d) Frequency of Payment 513 (e) Termination Payments 514

25.7

PAYROLL TAXES FOR EMPLOYEES WORKING ABROAD 518

25.8

REMITTING FEDERAL TAXES 519

25.9

PAYROLL DEDUCTIONS FOR CHILD SUPPORT 520

25.3

FEDERAL INCOME TAXES 515

25.4

SOCIAL SECURITY TAXES 517

25.10 PAYROLL DEDUCTIONS FOR UNPAID TAXES 520

25.5

MEDICARE TAX 517

25.11 UNEMPLOYMENT INSURANCE 521

25.1 INTRODUCTION This chapter covers all the steps required to process payroll, so that one can see the general sequence of steps required. The steps are: 1. Set up new employees. New employees must ﬁll out payroll-speciﬁc information as part of the hiring process, such as the W-4 form and medical insurance forms that may require payroll deductions. Copies of this information should be set aside in the payroll department in anticipation of its inclusion in the next payroll. 2. Collect timecard information. Salaried employees require no change in wages paid for each payroll, but an employer must collect and interpret information about hours worked for nonexempt employees. This may involve having employees scan a badge through a computerized time clock, punch a card in a stamp clock, or manually ﬁll out a timesheet. 3. Verify timecard information. Whatever the type of data collection system used in the last step, the controller must summarize this information and verify that employees have recorded the correct amount of time. This typically involves having supervisors review the information after it has been summarized, though more advanced computerized timekeeping systems can perform most of these tasks automatically. 4. Summarize wages due. This should be a straightforward process of multiplying the number of hours worked by an employee’s standard wage rate. However, it can be complicated by overtime wages, shift differentials, bonuses, or the presence of a wage change partway through the reporting period. 5. Enter employee changes. Employees may ask to have changes made to their paychecks, typically in the form of alterations to the number of tax exemptions allowed, pension deduc* The information in this chapter was summarized with permission from Steven M. Bragg, Essentials of Payroll (Wiley, Hoboken, NJ: 2003).

511

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512

6.

7.

8.

9.

10.

11.

12.

13.

14.

15.

16.

Ch. 25 Payroll

tions, or medical deductions. Much of this information must be recorded for payroll processing purposes, since it may alter the amount of taxes or other types of deductions. Calculate applicable taxes. The controller must either use IRS-supplied tax tables to manually calculate tax withholdings or have a computerized system or a supplier determine this information. Taxes will vary not only by wage levels and tax allowances taken, but also by the amount of wages that have already been earned for the year-to-date. Calculate applicable wage deductions. There are both voluntary and involuntary deductions. Voluntary deductions include payments into pension and medical plans, while involuntary ones include garnishments and union dues. These can be made in regular amounts for each paycheck, once a month, in arrears, or prospectively. The controller must also track goal amounts for some deductions, such as loans or garnishments, in order to know when to stop making deductions when required totals have been reached. Account for separate manual payments. There inevitably will be cases where the controller has issued manual paychecks to employees between payrolls. This may be caused by an incorrect prior paycheck, an advance, or perhaps a termination. Whatever the case, the amount of each manual check should be included in the regular payroll, at least so that it can be included in the formal payroll register for reporting purposes, and sometimes to ensure that the proper amount of employer-speciﬁc taxes are also withheld to accompany the amounts deducted for the employee. Create payroll register. Summarize the wage and deduction information for each employee on a payroll register, which can then be used to compile a journal entry for inclusion in the general ledger, to prepare tax reports, and for general research purposes. This document is always prepared automatically by payroll suppliers or by in-house computerized systems. Verify wage and tax amounts. Conduct a ﬁnal crosscheck of all wage calculations and deductions. This can involve a comparison with the same amounts for prior periods, or a general check for both missing information or numbers that are clearly out of line with expectations. Print paychecks. Print paychecks, either doing so manually on individual checks, or more commonly through a computer printer, with the printouts using a standard format that itemizes all wage calculations and deductions on the remittance advice. If direct deposits are made, a remittance advice should still be printed and issued. Enter payroll information in general ledger. Use the information in the payroll register to compile a journal entry that transfers the payroll expense, all deductions, and the reduction in cash to the general ledger. Send out direct deposit notiﬁcations. If a company arranges with a local bank to issue payments directly to employee accounts, then a notiﬁcation of the accounts to which payments are to be sent and the amounts to be paid must be assembled, stored on tape or other media, and sent to the bank. Deposit withheld taxes. The employer must deposit all related payroll tax deductions and employer-matched taxes at a local bank that is authorized to handle these transactions. The IRS imposes a rigid deposit schedule and format for making deposits that must be followed in order to avoid penalties. Issue paychecks. Paychecks should, at least occasionally, be handed out directly to employees, with proof of identiﬁcation required; this is a useful control point in larger companies where the controller may not know each employee by name, and where there is therefore some risk of paychecks being created for people who no longer work for the company. Issue government payroll reports. The government requires several payroll-related reports at regular intervals, which require information on the payroll register to complete.

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25.2 Compensation

513

25.2 COMPENSATION (a) EMPLOYEE OR CONTRACTOR STATUS. A key issue is whether someone is an employee or a contractor, since the reporting of income to the IRS varies considerably for each one, as well as the tax withholding requirements of the employer. The deﬁning test of an employee is when the company controls not only the types of work done by the employee, but also how the work shall be done. An employer also controls the work of a contractor, but not how the work is done. Other supporting evidence that an individual is a contractor is the presence of a contract between the parties, whether the contractor provides similar services to the public, and whether the contractor is paid based on the completion of speciﬁc tasks, rather than on the passage of time. An employer may be tempted to categorize employees as contractors even when it knows this is not the case, since the employer can avoid matching some payroll taxes by doing so. However, taking this approach leaves an employer liable for all the federal income, Social Security, and Medicare taxes that should have been withheld. Consequently, strict adherence to the rules governing the deﬁnition of an employee and contractor should be followed at all times. (b) WAGE EXEMPTION GUIDELINES. One should be aware of the general rules governing whether an employee is entitled to an hourly wage or a salary, since this can avoid complaints from employees who wish to switch their status from one to the other. The key guidelines for designating a person as being eligible for a salary are: • Administrative. Those in charge of an administrative department, even if they supervise no one, and anyone assisting management with long-term strategy decisions. • Executive. Those who manage more than 50 percent of the time and supervise at least two employees. • Professional. Those who spend at least 50 percent of their time on tasks requiring knowledge obtained through a four-year college degree (including systems analysis, design, and programming work on computer systems, even if a four-year degree was not obtained). The position must also allow for continued independent decision making and minimal close supervision. (c) WORK WEEK. The work week is a ﬁxed period of 168 consecutive hours that is recurring on a consistent basis. The beginning and ending start and stop times and dates can be anything management desires, but it should be consistently applied. Whatever the work week is deﬁned to be, it should be listed in the employee manual to avoid confusion about which hours worked fall into which work week, not only for payment purposes but also for the calculation of overtime. It is unwise to alter the stated work week, since it may be construed as avoidance of overtime payments. For example, a company may have a history of experiencing large amounts of overtime at the end of a month in order to make its delivery targets, so company management elects to change the work week from Monday through Sunday to Wednesday through Tuesday right in the middle of the ﬁnal week in a month, thereby reducing much of the overtime hours that employees would otherwise earn to regular hours. This would be a highly suspect change of work week that might be construed by the government as being intended to avoid wage payments. However, different work weeks can be used for different departments and locations. This is particularly common when a company is acquired, and elects not to conform the acquiree’s work week to its own. If there are many of these acquisitions, a centralize payroll department may ﬁnd itself tracking every conceivable variation on a work week, all within the same organization. (d) FREQUENCY OF PAYMENT. The frequency of payment to employees covers two areas: the number of days over which pay is accumulated before being paid out, and the number of days subsequent to this period before payment is physically made.

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Ch. 25 Payroll

Organizations with a large proportion of employees who are relatively transient or who are at very low pay levels usually pay once a week, since their staffs do not have sufﬁcient funds to make it until the next pay period. If these businesses attempt to lengthen the pay period, they usually ﬁnd that they become a bank to their employees, constantly issuing advances. Consequently, the effort required to issue and track advances offsets the labor savings from calculating and issuing fewer payrolls per month. The most common pay periods are either biweekly (once every two weeks) or semimonthly (twice a month). The semimonthly approach requires 24 payrolls per year, as opposed to the 26 that must be calculated for biweekly payrolls, so there is not much labor difference between the two time periods. However, it is much easier from an accounting perspective to use the semimonthly approach, because the information recorded over two payrolls exactly corresponds to the monthly reporting period, so there are fewer accruals to calculate. Offsetting this advantage is the slight difference between the number of days covered by a semimonthly reporting period and the standard one-week timesheet reporting system. For example, a semimonthly payroll period covers 15 days, whereas the standard seven-day timecards used by employees mean that only 14 days of timecard information is available to include in the payroll. The usual result is that employees are paid for two weeks of work in each semimonthly payroll, except for one payroll every three months, in which a third week is also paid that catches up the timing difference between the timecard system and the payroll system. A monthly pay period is the least common, since it is difﬁcult for low-pay workers to wait so long to be paid. However, it can be useful in cases where employees are highly compensated and can tolerate the long wait. Because there are only 12 payrolls per year, this is highly efﬁcient from the accounting perspective. One downside is that any error in a payroll must usually be rectiﬁed with a manual payment, since it is so long before the adjustment can be made to the next regular payroll. The general provision for payroll periods under state law is that hourly employees be paid no less frequently than biweekly or semimonthly, while exempt employees can generally be paid once a month. Those states having no special provisions at all or generally requiring pay periods of one month or more are Alabama, Colorado, Florida, Idaho, Iowa, Kansas, Minnesota, Montana, Nebraska, North Dakota, Oregon, Pennsylvania, South Carolina, South Dakota, Washington, and Wisconsin. These rules vary considerably by state, so it is best to consult with the local state government to be certain of the rules. The other pay-frequency issue is how long a company can wait after a pay period is completed before it can issue pay to its employees. A delay of several days is usually necessary in order to provide sufﬁcient time to compile timecards, verify totals, correct errors, calculate withholdings, and create checks. If a company outsources its payroll, there may be additional delays built into the process, due to the payroll input dates mandated by the supplier. A typical range of days over which a pay delay occurs is three days to a week. The duration of this interval is frequently mandated by state law, and is summarized in Exhibit 25.1. The days of delay noted in the exhibit are subject to slight changes under certain situations, so one should check applicable state laws to be certain of their exact provisions. Also, any states not shown in the exhibit have no legal provisions for the maximum time period before which payroll payments must be made. (e) TERMINATION PAYMENTS. There are a variety of state laws that govern how soon employees are to be paid after their employment is terminated. The key factor in these laws is whether an employee leaves a company under his or her own volition, or the termination was forced by the company. Exhibit 25.2 lists the time periods by state by which termination pay must be given to those employees who have voluntarily left employment. In all cases, the intervals listed are for the earlier of the next regularly scheduled pay date or the number of days listed in the ﬁrst column. If a state is not listed in the table, then assume that the termination payment is required at the time of the next regularly scheduled pay date.

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25.3 Federal Income Taxes

Allowable Days of Delay 5 6 7 8 9 10 11 12 15 16 18 20 31 Special Provisions E XHIBIT 25.1

State Arizona Massachusetts, Vermont Delaware, Hawaii, New York, Washington Connecticut, Maine, New Hampshire Rhode Island California, Colorado, District of Columbia, Indiana, Louisiana, Mississippi, Montana, New Jersey, New Mexico, Utah Oklahoma Iowa Idaho, Kansas, Michigan, Minnesota, Nevada, Ohio, Pennsylvania, Wyoming Missouri Kentucky Tennessee Wisconsin Illinois (varies by length of pay period)

A LLOWABLE D AYS

OF

P AYMENT D ELAY

Maximum Payment Delay 4 Days 5 Days 7 Days 10 Days 14 Days 15 Days 20 Days 21 Days E XHIBIT 25.2

515

BY

S TATE

Applicable States California Oregon, Wyoming District of Columbia, Nevada Idaho Kentucky, Maine, Nebraska Louisiana, Montana Minnesota Tennessee

R EQUIRED P AY I NTERVAL

FOR

V OLUNTARY T ERMINATIONS

Exhibit 25.3 lists the time periods by state by which termination pay must be given to those employees who have involuntarily left employment. In all cases, the intervals listed are for the earlier of the next regularly scheduled pay date or the number of days listed in the ﬁrst column. If a state is not listed in the table, then assume that the termination payment is required at the time of the next regularly scheduled pay date. Also, note that many more states have adopted early-payment laws for involuntary terminations, indicating a much greater degree of interest in paying off employees who fall into this category.

25.3 FEDERAL INCOME TAXES An employer is required by law to deduct income taxes from employee pay. If it uses a payroll supplier, then the calculation of the appropriate income tax amounts is completely invisible to it, since the supplier handles this task. If it calculates income taxes through a software package, then the software supplier will issue new tax tables each year to accompany the software. Once again, there is little need for an employer to know how the tax tables function. However, if a business calculates its payroll internally and manually, then it needs the wage-bracket tax tables published by the IRS. They are contained within Publications 15 and 15-A, which can be downloaded from the IRS web site at www.irs.gov. These tables are published for a variety of scenarios, such as for sin-

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Ch. 25 Payroll

Maximum Payment Delay Immediately 1 Day 2 Days 3 Days 4 Days 5 Days 6 Days 7 Days 10 Days 14 Days 15 Days 21 Days E XHIBIT 25.3

R EQUIRED P AY I NTERVAL

Applicable States Colorado, Hawaii, Illinois, Massachusetts, Michigan, Minnesota, Missouri, Montana, Nevada Connecticut, District of Columbia, Oregon, Utah South Carolina Alaska, Arizona, Louisiana California, New Hampshire, Vermont, West Virginia New Mexico, Wyoming Texas Arkansas Idaho Kentucky, Nebraska North Dakota Tennessee FOR I NVOLUNTARY

T ERMINATIONS

gle or married employees, for a variety of payroll periods, and for withholding allowances numbering from zero to ten. An example is shown in Exhibit 25.4, which is taken from page 35 of the 2002 Publication 15-A. It lists the amount of income, Social Security, and Medicare taxes to be withheld for a single person. The exhibit is incomplete, showing taxes due only for wages in a small range, and for zero through ﬁve withholding allowances. There are several other, less-used methods for calculating tax withholding amounts that require the override of one’s computerized withholding calculation system with manual calculations. They are: • Basis is annualized wages. Under this approach, calculate an employee’s annual pay rate, and then determine the annual withholding amount in the IRS’s Annual Payroll Period tax table. Then divide this amount by the number of pay periods in the year to determine the deduction for an individual paycheck. • Basis is partial-year employment. This method can be used only at an employee’s written request, which must state the last day of work with any prior employer, that the employee uses the calendar-year accounting method, and that the employee does not expect to work during the year for more than 245 days. The company then compiles all wages paid to the employee during his or her current term of employment, including the current pay period. Next, determine the number of pay periods from the date of the employee’s last employment, through and including the current pay period, and divide this amount into the total wages ﬁgure, resulting in an average wage per pay period. Use the correct tax table to arrive at a withholding amount for the average wage, and multiply this amount by the total number of pay periods, as already calculated. Finally, subtract the total amount of withholdings already made, resulting in the withholding to be made in the current pay period. This approach is requested by employees, such as part-time students or seasonal workers, who expect to be out of work so much during the calendar year that their full-year pay will drop them into a lower tax bracket, resulting in smaller income tax withholdings. • Basis is year-to-date cumulative wages. This method can be used only at an employee’s written request. To calculate it, compile all wages paid to the employee for the year-to-date through and including the current pay period, and divide the sum by the total number of yearto-date pay periods, including the current period. Then use the percentage method to calculate the withholding on this average wage. Multiply the withholding amount by the total number of year-to-date payroll periods, and subtract the actual amount of withholdings made year-to-date. The remainder is the amount to withhold from the employee’s wages during the current pay period. This complicated approach is requested by employees who may have had an excessive amount of taxes withheld from their pay earlier in the year, perhaps due to a large commission

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25.5 Medicare Tax

517

Number of Withholding Allowances Pay of at least $400 410 420 430 440 450 460 470 480 490 E XHIBIT 25.4

But less than $410 420 430 440 450 460 470 480 490 500 T AX T ABLE

0

1

77.98 80.75 82.51 85.28 87.04 89.81 91.57 94.34 96.10 98.87 FOR A

2

69.98 71.75 74.51 76.28 79.04 80.81 83.57 85.34 88.10 89.87

S INGLE F ILER

ON A

60.98 63.75 65.51 68.28 70.04 72.81 74.57 77.34 79.10 81.87

3 51.98 54.75 56.51 59.28 61.04 63.81 65.57 68.34 70.10 72.87

4 43.98 45.75 48.51 50.28 53.04 54.81 57.57 59.34 62.10 63.87

5 37.98 39.75 41.51 43.28 45.04 46.81 48.57 51.34 53.10 55.87

W EEKLY P AYROLL P ERIOD

or bonus payment that bumped them into a higher income tax bracket. By using the cumulative wages calculation, these excessive withholdings may sometimes result in a onetime withholding on the payroll in which this calculation is requested that is much smaller than usual. Several of the alternative tax calculation methods just noted are used because the amount withheld from employee pay for the year-to-date is higher than will be needed by the end of the calendar year. This may be caused by a large payment to an employee earlier in the year, perhaps a commission or bonus; when this happens, the extra payment is typically lumped into the person’s regular pay, which bumps the person into a higher tax bracket on the assumption that he or she always receives this amount of money during every pay period. As a result, there will be an excessively large withholding at the end of the year, and the employee will receive a tax refund. One approach for avoiding the excessive amount of tax withholdings is to separate the supplemental pay from the base pay, and issue two separate payments to an employee. Under this approach, the percentage withheld will likely be smaller than if the pay had been combined into a single paycheck. Another approach that is acceptable to the IRS is to combine the payments together, and then withhold a ﬂat 27 percent rate from it. Under most computerized payroll systems, it is easier to implement the ﬁrst approach.

25.4 SOCIAL SECURITY TAXES Employers are required to withhold 6.2 percent of each employee’s pay, which is forwarded to the government Social Security fund. The employer must also match this amount, so the total remittance to the government is 12.4 percent. This withholding applies to the ﬁrst $84,900 of employee pay in each calendar year, though this number increases regularly by act of Congress. If a company takes over another business or purchases its assets, the buying entity can include the year-to-date wages paid to the acquiree’s employees in determining the amount of Social Security taxes withheld. This reduces the amount of withholdings for those employees who earn more than $84,900 per year, and also reduces the amount of matching taxes paid by the business.

25.5 MEDICARE TAX Employers are required to withhold 1.45 percent of each employee’s pay, which is forwarded to the government Medicare fund. The employer must also match this amount, so the total remittance to the government is 2.9 percent. This withholding applies to all employee earnings during the year, with no upper limit.

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Ch. 25 Payroll

25.6 STATE INCOME TAXES All states require state income tax withholding, with the exceptions of Alaska, Connecticut, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. Those states requiring a business to withhold state income taxes from its employees all have different methods and forms for doing so, which requires a detailed knowledge of the withholding and remittance requirements of each state. If an organization calculates its own payroll, then it will likely be sent this information on a regular basis through the mail by each state government with which it has registered. It can also access this information for most states by visiting their ofﬁcial web sites. A much easier approach is to outsource the payroll processing function, which gives the payroll supplier responsibility for making the correct withholdings and remittances (if the employer chooses this service). Unlike the federal government, which allows most payroll tax payments to be remitted with a single remittance document, states may require employers to use a variety of forms, perhaps one for income taxes, another for unemployment insurance, and another for disability insurance (though this is required only by a small number of states). Given the amount of paperwork involved, a company that remits its own state taxes should construct a calendar of remittances, which the controller can use to ensure that payments are always made, thereby avoiding late-payment penalties and interest charges. If an employer has nonresident employees and the state in which it does business has an income tax, the employer will usually withhold income for each employee’s state of residence. Alternatively, an employer can withhold income on behalf of the state in which it does business, and let the employee claim a credit on his or her state tax return to avoid double taxation. The ability to do this will vary by individual state law.

25.7 PAYROLL TAXES FOR EMPLOYEES WORKING ABROAD Special withholding rules apply if an employee works in other countries. The ﬁrst consideration is the duration of the work abroad. If an employee is working abroad for only part of the year, then normal withholdings must be made, with the employer matching Social Security and Medicare taxes in the normal percentages. However, an employer is not required to withhold Social Security or Medicare taxes if its employees work in any of the following countries: Austria Belgium Canada Finland France Germany

Greece Ireland Italy Korea Luxembourg Netherlands

Norway Portugal Spain Sweden Switzerland United Kingdom

These countries all have “Totalization” agreements with the United States, whereby an employee has to pay Social Security taxes only to the country in which he or she is working. This makes a person exempt from U.S. Social Security and Medicare taxes while working in the listed countries. If another country requires the withholding of income taxes for income earned while working there, then a company does not have to also withhold U.S. taxes, since this would be double taxation. If an employee qualiﬁes for the foreign earned income exclusion, he or she can exclude the ﬁrst $80,000 of foreign earned income from his or her gross income. This exclusion applies only if a person’s home during the tax year is considered to be abroad, or the person is physically present in the foreign country for 330 full days out of a 12-month period (which does not have to correspond to a calendar year). The exclusion must be formally elected by ﬁlling out either the Form 2555 or Form 2555-EZ.

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25.8 REMITTING FEDERAL TAXES Once Social Security, income tax, and Medicare taxes have been withheld from an employee’s pay, they are essentially the property of the federal government, and the company is merely holding them in escrow until the next required remittance date. Depending upon the size of the remittances, a company may periodically cut a check for the remittance amount and deliver it to a local bank or Federal Reserve Bank that is authorized to forward the funds to the IRS. Alternatively, companies with larger remittances are required to make electronic funds transfers directly to the IRS. If a company uses a payroll supplier, then this process is invisible to the company, since the supplier will handle remittances. Assuming that a company processes its own payroll, it must then determine the frequency with which it remits tax deposits to the federal government. A business can make deposits in the following three ways: 1. On a monthly basis. Under this approach, a business must deposit its payroll taxes no later than the ﬁfteenth day of the month following the reporting month. This method can be used only if the total amount of deposits during the “lookback period” is less than $50,000. The lookback period is the four previous quarters during which deposits were reported on the Form 941, beginning with July 1 and ending on June 30 of the next year. When making this determination, include all Social Security, federal income, and Medicare taxes withheld during the lookback period. A new employer will generally fall into this category, because the amount of the lookback period (which does not yet exist) is assumed to be zero. 2. On a semiweekly basis. The government will force one to use the semiweekly deposit schedule if the dollar volume of taxes during the annual lookback period exceeded $50,000. If not, deposits can be made on a monthly basis. The “semiweekly” refers to two possible dates in each week by which deposits must be made if a payroll payment date falls within that week. If a payment date falls on a weekend, Monday, or Tuesday, then the deposit must be made by the following Friday. If the payment date falls on a Wednesday, Thursday, or Friday, then the deposit must be made by Wednesday of the following week. One additional business day is added to this schedule if the day by which a deposit is required falls on a banking holiday. 3. Using electronic funds transfers. The minimum threshold for this approach is $200,000 in deposits during the lookback period, or if the company was required to use it in the previous year. Once a company is required to use this method but does not do so, it will be subject to a 10 percent penalty. Payments are made using the Electronic Federal Tax Payment System (EFTPS). Under this approach, a business notiﬁes its bank of the amount to be deposited with the government; the bank then electronically shifts the funds from the business’s account to the government’s. This approach gives the government more immediate access to the funds. No deposit coupon is required if this approach is used, since it is only required to identify an accompanying check, and this method requires no check. The payment intervals are the same as those used for semiweekly depositors, except that any company accumulating $100,000 of taxes for any payroll must deposit it on the business day immediately following the payroll payment date. A business can enroll in the EFTPS by completing the EFTPS Business Enrollment Form (Form 9779). There is one special case that overrides all of the preceding depositing scenarios. If a company accumulates a payroll tax liability of $100,000 or more as a result of a payroll, the amount must be deposited no later than the next business day, irrespective of the company’s status as determined through the lookback method. This special case does not continue to apply if a company’s subsequent payroll tax liabilities drop below $100,000; however, if a company previously had been a monthly depositor, this situation will result in the company immediately converting to a semiweekly deposit schedule.

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If remittances are to be made to the local bank, then the check must be accompanied by a Form 8109, which is a standard remittance coupon that is used for a variety of tax remittances. In order to obtain a booklet of blank Form 8109s, one must ﬁle for an Employee Identiﬁcation Number (EIN). The EIN is required because the IRS preprints an organization’s EIN, name, and address on each form in the booklet. Filling out the form is simple enough—just enter the dollar amount being remitted, the company’s contact phone number, and darken the ovals corresponding to the type of tax being remitted (in this case, always “941”) and the applicable quarter to which the remittance applies. The information on this form is entered into the IRS database with an optical scanner, so write clearly in order to avoid scanning errors. Special handling of tax deposits is necessary if an employer is a semiweekly depositor, and has multiple pay days within the same semiweekly period, but which apply to different calendar quarters. If this situation arises, the employer must determine which portion of the semiweekly deposit applies to payroll occurring within each of the two calendar quarters, and make a separate deposit for each portion.

25.9 PAYROLL DEDUCTIONS FOR CHILD SUPPORT The controller will almost certainly see court-ordered child support withholding orders at some point during his or her career. There are tightly enforced federal laws that help to track down parents who are not making support payments, and that require their employers to withhold various amounts from their pay in order to meet mandated child support payments. The maximum amount of an employee’s disposable earnings that is subject to child support withholding is 60 percent of his or her pay, or 50 percent if the employee is already making payments to support other children or spouses. Both of these percentages increase by 5 percent if an employee is 12 or more weeks in arrears in making support payments. In order to calculate disposable earnings, subtract all legally mandated deductions from an employee’s gross pay, such as federal and state income taxes, Social Security and Medicare taxes, and any locally mandated disability or unemployment taxes. Voluntary deductions, such as pension and medical insurance deductions, are not used to calculate disposable earnings. When a child support court order is received, it takes precedence over all other types of garnishment orders, with the exception of tax levies that were received prior to the date of the court order. An employer must begin withholding the maximum allowable amount from an employee’s pay no later than the ﬁrst pay period beginning after 14 working days after the posted date of the court order, and must continue to withhold funds until the order is rescinded by the court. A common point of confusion is where to send child support payments. Contrary to the notuncommon demands of the parent who is designated to receive the payments, the payments typically go to a court-designated person, who then disburses the funds to the parent—payments never go straight to the parent. Instructions for remitting funds will be listed on the court order; the employer should follow these instructions to the letter. If an employee leaves employment before the obligations of a court order are discharged, the employer is obliged to notify the issuing enforcement agency of the employee’s last known address, as well as the location of a new employer (if known). The agency needs this information in order to track down the employee and continue to enforce the court order. If an employer chooses to ignore a court order, it will be liable for the total amount that should have been withheld. This means that an employer must act promptly to begin withholding by the date speciﬁed in the court order, and must withhold the full required amount, taking into account the rules noted earlier in this section.

25.10 PAYROLL DEDUCTIONS FOR UNPAID TAXES If an employee does not pay his or her federal or local income taxes, the employer may receive a notiﬁcation from the IRS to garnish that person’s wages in order to repay the taxes. The garnishment will cover not only the original amount of unpaid taxes, but also any penalties and interest expenses added by the government.

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25.11 Unemployment Insurance

521

A garnishment for unpaid taxes takes priority over all other types of garnishments, except for child support orders that were received prior to the date of the tax garnishment. If a business receives orders from multiple taxing authorities to garnish an employee’s wages and there are not enough wages to pay everyone, then the orders are implemented in the order in which they were received. The Notice of Levy on Wages, Salary, and Other Income, Form 668-W, is the standard form used for notifying a company to garnish an employee’s wages. When a Form 668-W order is received to garnish an employee’s wages, the controller must ﬁrst determine if any wages are not subject to the order. Only 15 percent of the following types of wages are subject to a tax payment order issued by the IRS, and they are completely exempt from an unpaid tax order issued by a state government: • Armed forces disability beneﬁts • Pension and annuity payments as speciﬁed under the Railroad Retirement Act • Unemployment compensation beneﬁts • Welfare and Supplemental Social Security payments • Workers’ compensation beneﬁts Once the above types of wages have been accounted for, the controller must determine which deductions can be made from an affected employee’s pay before determining the amount of the tax levy. Allowable deductions include: • Federal and state income taxes • Social Security and Medicare taxes • Increases in deductions over which an employee has no control, such as a medical insurance increase imposed by a health care provider • Deductions required in order to be employed by the company • Deductions in effect prior to the tax garnishment notice, which can include deductions for medical, life and disability insurance, as well as cafeteria plan deductions Once the applicable deductions have been used to reduce an employee’s wages to the amount to which the tax levy will be applied, the controller should use the IRS-supplied tables to determine the amount of net wages that are exempt from the tax levy. These tables are shown in Exhibit 25.5. Once the Form 668-W is received, the company is obligated to begin withholding the mandated amount of taxes from an employee’s next paycheck, even if the applicable wages were earned prior to receipt of the form. The company should forward the withheld amount to the IRS, with the employee’s name and Social Security number noted on the check. If the employee leaves the company while this tax levy is still being deducted, the employer must notify the IRS of this event, and if possible forward the name and address of the new employer to the IRS. If the employee continues to work for the company, then the IRS will inform the company when to stop making these deductions with Form 668-D. If an employer for any reason does not withhold and forward to the IRS the periodic garnishments required by Form 668-W, then the company is liable for the amounts that it should have withheld, as well as a stiff penalty.

25.11 UNEMPLOYMENT INSURANCE The Federal Unemployment Tax (FUTA) is paid by employers only. It is currently set at 6.2 percent of the ﬁrst $7,000 of a person’s wages earned in a year. However, the actual amount paid to the federal government is substantially lower, since employers take a credit based on the amount of funds paid into their state unemployment programs (not including any FUTA payments deducted from employee pay, additional penalties paid as part of the state-assigned percentage, and any voluntary contributions to the state unemployment fund). Employers with a history of minimal layoffs can receive an extra credit above amounts paid into their state funds that brings their total credit against the federal tax to 5.4 percent. When the maximum credit amount is applied to the federal tax rate, the effective rate paid drops to 0.8 percent. This maximum credit is based on 90 percent of the total federal rate.

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Ch. 25 Payroll

E XHIBIT 25.5

T ABLE

FOR

F IGURING

THE

A MOUNT E XEMPT

FROM

L EVY

ON

W AGES

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25.11 Unemployment Insurance

523

If a state experiences a large amount of unemployment claims and uses up its funds, it can borrow money from the federal fund, which must be paid back by the end of the next calendar year. If not, then the amount of the FUTA credit is reduced for employers within that state, which brings in enough additional funds to eventually pay back the loan. An employer must calculate the amount of FUTA taxes owed at the end of each calendar quarter, after which they must be deposited. If there are no new hires during the year, this usually results in nearly all FUTA taxes being paid in the ﬁrst quarter, with the remainder falling into the second quarter. If payroll is outsourced, the supplier makes money by withholding the FUTA tax in every pay period and retaining the funds in an interest-bearing account until they are due for payment to the government at the end of the quarter. State unemployment tax can be quite low, but can range up to 5.4 percent (the amount of the credit allowed against the federal unemployment tax), and some states even exceed this amount. The rate charged is based on a company’s history of avoiding layoffs, which is called an experience rating. If it lays off a large proportion of its employees, then this action will likely drain a signiﬁcant amount from the state’s unemployment funds through the payment of unemployment beneﬁts. Thus, a layoff in one year will likely be followed by a notice increasing the state unemployment tax (or “contribution”) rate. The taxable wage base used by states is required by federal law to be at least as much as the federal level, which is currently set at $7,000. Exhibit 25.6 shows the employer tax rates, employee tax rates (where rarely applicable), taxable wage limits, and coverages for all 50 states, plus the District of Columbia and Puerto Rico. There is also a column covering the new employer tax rate, which lists the default tax rate given to any company that does not yet have an experience rating. This default rate can change in some cases (see the note to the exhibit), depending on the industry in which a new organization is based; industries with historically high employee turnover rates deplete the state unemployment funds more rapidly, so companies operating in those industries are assigned a higher contribution rate. When a person’s employment is terminated, he or she goes to the local state unemployment ofﬁce and applies for unemployment beneﬁts. The state agency then sends a form to the company, asking it to verify basic information about the former employee, such as the amount of hourly pay at the time of termination and the amount and composition of the severance payment. After veriﬁcation, the state sends the employer another form, notifying it of the maximum amount of unemployment beneﬁts that can be paid to the employee (which can be greatly reduced if the employee ﬁnds work soon). A key issue in this process is whether an employee was terminated for cause (such as theft), was laid off, or voluntarily resigned. Unemployment beneﬁts are not paid when a person quits or is terminated for cause, so be sure to contest employee beneﬁt claims if either case was the cause for termination. Proper documentation of the termination is crucial to this determination, which is made by an employee of the state division of employment. If determination is made in favor of the former employee, then any beneﬁts paid will be charged against the company, which will impact its experience rating and therefore increase the amount of its contribution rate in the following year.

State Alabama Alaska

Arizona E XHIBIT 25.6

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Employer Tax Rate

New Employer Tax Rate

2.7%–6.8% 5.4%

2.7% (1)

5.4% Std

2.7%

S TATE W AGE B ASES U SED

FOR

Employee Withholding Rate

Taxable Wage Limit

None 0.5%– 1.0%

$8,000 $25,500

None

$7,000

Coverage Same as federal Any company paying 1+ employees for at least a day in the year Same as federal

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Ch. 25 Payroll

State

Employer Tax Rate

New Employer Tax Rate

Employee Withholding Rate

Taxable Wage Limit

Arkansas

0.5%–8.4%

3.3%

None

$9,000

California

0.7%–5.4%

3.4%

None

$7,000

Colorado

2.7% Std

2.7%

None

$10,000

Connecticut Delaware District of Columbia

0.5%–5.4% 5.4% Std 2.7% Std

2.4% 1.8% 2.7%

None None None

$15,000 $8,500 $9,000

Florida Georgia Hawaii

0.1%–5.4% 5.4% Std 0%–5.4%

2.7% 2.62% 2.4%

None None None

$7,000 $8,500 $29,300

1.5% Std

–

None

$25,700

0.6%–6.8% 5.4% Std 0%–7.5% 5.4% Std 0%–10% 0.15%–6.2% 5.4% Std 0.3%–7.5%

3.1% 2.7% – 2% 2.7% (1) 1.83% 2%

None None None None None None None None

$9,000 $7,000 $18,600 $8,000 $8,000 $7,000 $12,000 $8,500

1.325%– 7.225%

2.2%

None

$10,800

0.1%–8.1%

2.7%

None

$9,500

0.17%–9.07% 5.4% Std 0%–6%

1.29% 2.7% 2.97%

None None None

$21,000 $7,000 $7,000

Idaho

Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland

Massachusetts

Michigan

Minnesota Mississippi Missouri E XHIBIT 25.6

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S TATE W AGE B ASES U SED (C ONTINUED )

FOR

Coverage Any company paying 1+ employees for at least 10 days in the current or preceding year Any company paying 1+ employees in the current or preceding year Any company paying 1+ employees for at least a day in the year Same as federal Same as federal Any company paying 1+ employees in the current year Same as federal Same as federal Any company paying 1+ employees in the current year Any company with 1+ employees in 20 weeks of the current or preceding year Same as federal Same as federal Same as federal Same as federal Same as federal Same as federal Same as federal Any company paying 1+ employees in the current year Any company with 1+ employees in 13 weeks of the current or preceding year Any company with 1+ employees in 20 weeks of the current or preceding year or is subject to FUTA Same as federal Same as federal Same as federal

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25.11 Unemployment Insurance

State

Employer Tax Rate

New Employer Tax Rate

Employee Withholding Rate

Taxable Wage Limit

Montana

6.5% Max

(1)

None

$18,900

Nebraska Nevada

.05%–5.4% 0.25%–5.4%

3.5% 2.95%

None None

$7,000 $20,900

New Hampshire New Jersey

0.05%–6.5% 0.3%–5.4%

2.7% 2.6825%

None None

$8,000 $23,500

New Mexico

0.05%–5.4%

2.7%

None

$15,900

New York

0.7%–9.1%

4.0%

None

$8,500

0%–5.7% 0.49%–10.09% 0.1%–6.5% 0.1%–5.5% 0.9%–5.4%

1.2% 2.08% 2.7% 1.0% 3.0%

None None None None None

$14,700 $17,400 $9,000 $10,500 $25,000

Pennsylvania

1.479%– 9.0712%

3.5%

None

$8,000

Puerto Rico

1.2%–5.4%

2.9%

None

$7,000

Rhode Island

1.66%–9.76%

1.79%

None

$12,000

South Carolina South Dakota Tennessee Texas Utah

0.54%–5.4% 0%–7.0% 0%–10% 0%–6.24% 0.1%–8.1%

2.7% 1.9% 2.7% 2.7% (1)

None None None None None

$7,000 $7,000 $7,000 $9,000 $21,400

Vermont Virginia

0.4%–8.4% 0%–6.2%

(1) 2.5%

None None

$8,000 $8,000

North Carolina North Dakota Ohio Oklahoma Oregon

E XHIBIT 25.6

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S TATE W AGE B ASES U SED (C ONTINUED )

FOR

525

Coverage Any company with payroll of $1,000+ in current or preceding year Same as federal Any company paying 1+ employees in the current year Same as federal Any company paying wages of $1,000+ in current or preceding year Any company with 1+ employees in 20 weeks of the current or preceding year Any company paying $300+ in wages in any calendar quarter Same as federal Same as federal Same as federal Same as federal Any company with 1+ employees in 18 weeks of the year Any company with 1+ employees in the calendar year Any company with 1+ employees in the current or preceding calendar year Any company with 1+ employees in the year Same as federal Same as federal Same as federal Same as federal Any company paying $140+ in wages during any quarter of current or preceding year, or that is subject to FUTA Same as federal Same as federal

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Ch. 25 Payroll

New Employer Tax Rate

Employee Withholding Rate

Taxable Wage Limit

State

Employer Tax Rate

Washington

0.47%–5.6%

(1)

Optional

$28,500

West Virginia Wisconsin Wyoming

1.5%–8.5% 0%–9.75% 0.15%–8.71%

2.7% 3.05% (1)

None None None

$8,000 $10,500 $14,700

Coverage Any company with 1+ employees during the year Same as federal Same as federal Any company with 1+ employees during the year

Note: Industry-based rate is applied for a new employer.

E XHIBIT 25.6

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S TATE W AGE B ASES U SED (C ONTINUED )

FOR

S TATE U NEMPLOYMENT T AX C ALCULATIONS

00_po4.fm Page 527 Tuesday, December 9, 2003 4:42 PM

PART

4

PLANNING AND CONTROL OF THE BALANCE SHEET

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CHAPTER

26

PLANNING AND CONTROL OF CASH AND SHORT-TERM INVESTMENTS 26.1

INTRODUCTION 529

26.2

OBJECTIVES OF CASH PLANNING AND CONTROL 530

26.3

DUTIES OF THE CONTROLLER VERSUS THE TREASURER 530

26.4

THE CASH FORECAST 530 (a) Purposes of Cash Forecasting 530 (b) Cash Forecasting Methods 531 (c) Estimating Cash Receipts 536 (d) Estimating Cash Disbursements 537 (e) FASB Statement of Financial Accounting Standards No. 95: Statement of Cash Flows 538 (f) Relation of Cash Budget to Other Budgets 539 (g) Length of Cash Budget Period 539 (h) Putting the Cash Budget to Work 542

26.5

CASH COLLECTIONS 542 (a) Administration of Cash Receipts 542 (b) Acceleration of Cash Receipts 542 (c) Internal Control of Cash Receipts 543 (d) Illustrative Cash Receipts Procedure 543 (e) Common Methods of Misappropriating Cash 544 (f) Other Means of Detecting Fraud 546

26.6

CASH DISBURSEMENTS 546 (a) Control of Cash Disbursements 546 (b) Administrative Bank Accounts 547

26.7

INTERNAL CONTROL 547 (a) Importance of Internal Control 547 (b) Some Principles of Internal Control 547 (c) Methods of Misappropriating Funds 548 (d) Bank Reconciliations 548 (e) Petty Cash Funds 549 (f) Payrolls 550

26.8

REPORTS ON CASH 550 (a) Cash Reports for Internal Use 550 (b) Cash Flow Analysis for Investment Purposes 552

26.9

CASH FLOW RATIO ANALYSIS 553

26.10 IMPACT OF NEW INFORMATION TECHNOLOGY AND ORGANIZATIONAL STRUCTURES 554 26.11 INVESTMENT OF SHORT-TERM FUNDS 555 (a) Criteria for Selecting Investments 555 (b) Investment Restrictions 555 (c) Investment Controls 557 (d) Reports to Management 557

26.1 INTRODUCTION Most business executives have long been aware of the need for cash. Supplier bills must be paid by cash. Payrolls must be met with cash. The ability of an entity to generate adequate cash has assumed more importance. Witness the attention given cash ﬂow in leveraged buyouts (LBOs) or other proposed mergers or acquisitions. Or consider the standard issued by the Financial Accounting Standards Board (FASB) for cash ﬂow reporting—FAS No. 95, Statement of Cash Flows. In any event, sound cash management is a basic ﬁnancial function. While it is usually the responsibility of the senior ﬁnancial ofﬁcer, the controller has an important role to play. This chapter reviews the phases that the controller either handles or has a direct interest in: 529

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530

Ch. 26 Planning and Control of Cash and Short-Term Investments

• Cash planning, with emphasis on the annual plan • Some aspects of cash control, including internal control • Limited comments on temporary investments, given their close relationship to cash

26.2 OBJECTIVES OF CASH PLANNING AND CONTROL Cash is a particularly vulnerable asset because, without proper controls, it is easily concealed and readily negotiable. But it is something every business needs. From an overall viewpoint, cash management would have these six objectives: 1. Provision of adequate cash for operations—both short and long term 2. Effective utilization of company funds at all times 3. Establishment of accountability for cash receipts and provision of adequate safeguards until the funds are placed in the company depository 4. Establishment of controls to ensure that disbursements are made only for approved and legitimate purposes 5. Maintenance of adequate bank balances, where appropriate, to support proper commercial bank relations 6. Maintenance of adequate cash records

26.3 DUTIES OF THE CONTROLLER VERSUS THE TREASURER With respect to cash management, a cooperative relationship should exist between the controller and treasurer. Duties and responsibilities will vary, depending on the type and size of the business ﬁrm. Under ordinary circumstances, the treasury staff has custody of cash funds and administers the bank accounts. Usually, it is the treasurer who is responsible for maintaining good relations with banks and other investors, providing the timely interest and principal payments on borrowed debt, and investing the excess cash. The treasurer usually would have primary responsibility for cash receipts and disbursement procedures. The controller may have these responsibilities in companies large enough for separate treasury and controllership functions: • Development of some, or all, of the cash forecasts • Review of the internal control system with respect to both receipts and disbursements to assure its adequacy and effectiveness • Reconciliation of bank accounts—as part of a sound internal control system (and not to be done by members of the treasurer’s department who have access to funds or by accounting personnel who record the transactions) • As may be deemed appropriate, preparation of selected cash reports

26.4 THE CASH FORECAST (a) PURPOSES OF CASH FORECASTING. A cash forecast, or cash plan, or cash budget, is a projection of the anticipated cash receipts and disbursements and the resulting cash balance within a speciﬁed period. This is a necessary function in any well-managed plan of cash administration. The operation of any business must be planned within the limits of available funds, and, conversely, the necessary funds must be provided to carry out the planned business operations. In these days of increasing sales and earnings, and taxes, business management is rediscovering that proﬁts are not the same as cash in the bank. The company may show a small proﬁt, or even a loss, and have a very sizable cash balance. Particularly in those industries requiring heavy capital investment, the cash generation by the operations, the “cash ﬂow,” may be very heavy and yet

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26.4 The Cash Forecast

531

result in mediocre proﬁts. For reasons such as these, cash forecasting is being recognized as a vital management function. The basic purpose behind the preparation of the cash budget is to plan so that the business will have the necessary cash—whether from the short-term or long-term viewpoint. Further, when excess cash is to be available, budget preparation offers a means of anticipating an opportunity for effective utilization. Aside from these general purposes, some speciﬁc uses to which a cash budget may be put are: • To point out peaks or seasonal ﬂuctuations in business activity that necessitate larger investments in inventories and receivables • To indicate the time and extent of funds needed to meet maturing obligations, tax payments, and dividend or interest payments • To assist in planning for growth, including the required funds for plant expansion and working capital • To indicate well in advance of needs the extent and duration of funds required from outside sources and thus permit the securing of more advantageous loans • To assist in securing credit from banks and improve the general credit position of the business • To determine the extent and probable duration of funds available for investment • To plan the reduction of bonded indebtedness or other loans • To coordinate the ﬁnancial needs of the subsidiaries and divisions of the company • To permit the company to take advantage of cash discounts and forward purchasing, thereby increasing its earnings (b) CASH FORECASTING METHODS. At least two methods are in widespread use for developing a cash forecast. Although the end product is the estimated cash balance, the methods differ chieﬂy in terms of the starting point of the forecast and the detail made available. These two techniques are described as: 1. Direct estimate of cash receipts and disbursements. This is a detailed forecast of each cost element or function involving cash. It is essentially a projection of the cash records. Such a method is the one most commonly used in business and is quite essential to giving a complete picture of the swings or gyrations in both receipts and disbursements. It is particularly applicable to those concerns subject to wide variations in activity. Moreover, it is very useful for controlling cash ﬂow by comparing actual and forecasted performance. A cash forecast prepared on this basis is shown in Exhibit 26.1. The individual line items will depend on what items are signiﬁcant, and/or on those in which the management is especially interested—presuming the actual data are also readily available from the cash records for comparing budget with actual results. The cash inﬂows and outﬂows from operations are shown; thus, management can easily see the cash ﬂow generated by operations, and the cash ﬂows from investing activities and ﬁnancing activities are readily determinable.If changes in the annual plan (e.g., sales) cause adjustments in cash ﬂow, the use of the computer for this detailed cash planning makes such modiﬁcations rather easy. 2. Adjusted net income (or indirect or reconciliation) method. As the name implies, the starting point for this procedure is the estimated income and expense statement. This projected net income is adjusted for all noncash transactions to arrive at the cash income or loss and is further adjusted for cash transactions that arise because of nonoperating balance sheet changes. A worksheet showing the general method is illustrated in Exhibit 26.2. Because net income is used, the true extent of the gross cash receipts or disbursements is not known. Where a company must work on rather close cash margins, this method probably will not meet the needs. It is applicable chieﬂy where sales volume is relatively stable and the out-of-pocket costs are fairly constant in relation to sales.

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7,980 8,822

3,335 4,091

3,095 4,425

Total cash receipts

Total cash available

E XHIBIT 26.1

S TATEMENT OF

E STIMATED C ASH R ECEIPTS

Total from other activities

D ISBURSEMENT

2,000 500 1,000 3,500

2,000 — — —

— — — —

AND

4,480

3,335

3,095

Total from operations From other activities: Common stock issue Short-term borrowings Long-term debt issue

Miscellaneous

3,975 110 15 360 20

3,255 40 20 — 20

2,985 70 20 — 20

$842

$756

$1,330

Cash and cash equivalents at beginning of period Cash receipts From operations: Collections on account Cash sales Interest receivable Insurance proceeds

March

15,740

14,410

— 500 1,000 3,500

10,910

10,215 220 55 360 60

$1,330

First Quarter Total

T HE M ANUFACTURING C OMPANY E STIMATED C ASH R ECIEPTS AND D ISBURSEMENTS F OR P LAN Y EAR 20XX (D OLLARS IN T HOUSANDS )

February

OF

January

S TATEMENT

Ch. 26 Planning and Control of Cash and Short-Term Investments

Item

532

10,391

8,052

— 3,725 — 3,725

4,327

4,087 200 20 — 20

$2,339

December

24,203

16,958

2,000 3,725 — 3,725

13,233

12,413 710 50 — 20

$7,245

Fourth Quarter Total

59,536

58,206

7,725 1,000 7,725

50,481

47,946 1,730 205 360 240

$1,330

Year Total

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6,840

65 — — 65 3,249 $ 842

416 — — 416 $3,669 $ 756

Total for other activities

Total cash disbursements

E XHIBIT 26.1

S TATEMENT OF

E STIMATED C ASH R ECEIPTS

Cash and cash equivalents at end of period

Capital expenditures

AND

3,150

3,184

3,253

Total from operations For other activities Repayment on long-term debt Dividends

Federal and state income taxes

D ISBURSEMENT (C ONTINUED )

$ 1,982

500 650 2,000

3,690

2,300 1,240 150 —

2,117 1,067 — —

1,972 1,096 — 185

March

$ 1,982

13,758

3,631

981 650 2,000

10,127

6,389 3,403 150 185

First Quarter Total

T HE M ANUFACTURING C OMPANY E STIMATED C ASH R ECIEPTS AND D ISBURSEMENTS F OR P LAN Y EAR 20XX (D OLLARS IN T HOUSANDS )

February

OF

January

Item Cash disbursements For operations Accounts payable and accrued items Payrolls Interest

S TATEMENT

$ 2,796

7,595

650

— 650 —

6,945

1,865 1,380 600 3,100

December

26.4

$ 2,796

56,740

9,596

3,496 2,600 3,500

47,144

24,089 13,700 2,170 7,185

533

Year Total

The Cash Forecast

$ 2,796

21,407

7,181

1,081 2,600 3,500

14,226

5,806 4,610 710 3,100

Fourth Quarter Total

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E XHIBIT 26.2

S TATEMENT OF

$

8 (14) 10 (10) 10 5 29 479

10 (12) 20 (70) 10 5 (17) 483

450 20

$

20

500

February

E STIMATED C ASH F LOWS (I NDIRECT M ETHOD )

Total adjustments Net cash provided by operating activities

Increase in other liabilities

Net income Adjustments (all related to operations) Depreciation and amortization Provision for losses on accounts receivable Increase in receivables Decrease in inventories Decrease in accounts payable and accrued items Increase in income taxes payable

January $

643

43

(20) 10 5

12 (14) 30

20

600

March

T HE R ANDOM C OMPANY S TATEMENT OF E STIMATED C ASH F LOWS F OR P LAN Y EAR 20XX (D OLLARS IN T HOUSANDS )

Ch. 26 Planning and Control of Cash and Short-Term Investments

Item Cash Flows from Operating Activities

534

1,605

55

(100) 30 15

30 (40) 60

60

$ 1,500

First Quarter Total $

835

35

(20) 10 —

15 (5) 10

25

800

December

2,220

120

(40) 30 5

40 (10) 20

75

$ 2,100

Fourth Quarter Total

7,340

340

(220) 120 30

125 (90) 110

265

$ 7,000

Year Total

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E XHIBIT 26.2

S TATEMENT OF

1,853 $ 2,032

1,400 $ 1,853

$ 2,275

2,032

243

2,400

(600)

1,000 2,000

(2,800)

(700) (2,100) —

March

E STIMATED C ASH F LOWS (I NDIRECT M ETHOD ) (C ONTINUED )

Cash and cash equivalents at beginning of period Estimated cash and cash equivalents at end of period

Net change in cash and equivalents

—

Net cash ﬂows provided by ﬁnancing activities 179

—

— —

— —

— —

453

(300)

(30)

Proceeds-sale of facility

Net cash used in investing activities Cash Flows from Financing Activities Proceeds for long-term debt Proceeds from stock issue Dividends paid

February

— (300) —

January

— (100) 70

Item Cash ﬂows from investing activities Purchases of companies M and P, net of Cash acquired Capital expenditures

T HE R ANDOM C OMPANY S TATEMENT OF E STIMATED C ASH F LOWS F OR P LAN Y EAR 20XX (D OLLARS IN T HOUSANDS )

$ 2,275

1,400

875

2,400

(600)

1,000 2,000

(3,130)

(700) (2,500) 70

First Quarter Total

$ 2,385

2,400

(15)

(650)

(650)

— —

(200)

— (200) —

December

26.4

535

$ 2,385

1,400

(550)

(550)

(2,550)

1,000 1,000

(5,805)

(2,575) (3,300) 70

Year Total

The Cash Forecast

$ 2,385

1,215

1,170

(650)

(650)

— —

(400)

— (400) —

Fourth Quarter Total

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536

Ch. 26 Planning and Control of Cash and Short-Term Investments

This format identiﬁes the cash ﬂows according to source—from operating activities, from investing activities, or from ﬁnancing activities. This segregation is that suggested by the FASB for inclusion in published ﬁnancial statements. It may or may not be used for internal planning purposes. If this style is utilized, it permits management to readily see the relative size of each estimated cash ﬂow source approximately as it will appear in the annual report to shareholders. (c) ESTIMATING CASH RECEIPTS. The sources of cash receipts for the typical industrial or commercial ﬁrm are well known: collections on account, cash sales, royalties, rent, dividends, sale of capital items, sale of investments, and new ﬁnancing. These items can be predicted with reasonable accuracy. Usually, the most important recurring sources are collections on account and cash sales. Experience and a knowledge of trends will indicate what share of total sales probably will be for cash. From the sales forecast, then, the total cash sales value can be determined. In a somewhat similar fashion, information can be gleaned from the records to enable the controller to make a careful estimate of collections. Once the experience has been analyzed, the results can be adjusted for trends and applied to the credit sales portrayed in the sales forecast. An example illustrates the technique. Assume that an analysis of collection experience for June sales revealed the following collection data: % of Total Credit Sales 2.1 85.3 8.9 2.8 .3 .5 .1

Description Collected in June July August September October Cash discounts Bad debt losses

$ 100.0

Total

If next year’s sales in June could be expected to fall into the same pattern, then application of the percentages to estimated June credit sales would determine the probable monthly distribution of collections. The same analysis applied to each month of the year would result in a reasonably reliable basis for collection forecasting. The worksheet (June column) for cash collections might look somewhat as: Description

Month of Sale February March April May June Total collections Cash discounts (May) Losses

% Total .4 1.9 7.7 88.3

Sales Net $149,500 160,300 290,100 305,400

2.1

320,000

.5

June Collections $ 598 3,045 22,338 269,668 6,720

305,400

.1

Total

Anticipated discounts must be calculated, since they enter into the proﬁt forecast.

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302,369 (1,527) ( 320) $ 300,522

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26.4 The Cash Forecast

537

These experience factors must be modiﬁed, not only by trends developed over a period of time but also by the estimate of general business conditions as reﬂected in collections, as well as contemplated changes in terms of sale or other credit policies. Reﬁnements in the approach can be made if experience varies widely between geographical territories, types of customers, or channels of distribution. The analysis of collections need not be made every month; it is sufﬁcient if the distribution is checked occasionally. Exhibit 26.3 is an example of a typical statement of estimated cash receipts by customer type. In this instance receipts from particular contracts are set out in addition to the usual collections from customer sales. (d) ESTIMATING CASH DISBURSEMENTS. If a complete operating budget is available, the controller should have little difﬁculty assembling the data into an estimate of cash disbursements. The usual cash disbursements in the typical industrial or commercial ﬁrm consist of salaried and hourly payrolls, materials, taxes, dividends, traveling expense, other operating expenses, interest, purchase of equipment, and retirement of stock.

F OR THE Description Electronics Fixed Price Contracts U.S. Government Progress Payments

C ONSOLIDATED E LECTRONICS C ORPORATION S TATEMENT OF E STIMATED C ASH R ECEIPTS P ERIOD J ANUARY 1, 20XX T HROUGH M ARCH 31, 20XX January February March

Collections on delivery Total Foreign governments Advances Collections on delivery Miscellaneous Total Total receipts—FP contracts Incentive—Commercial Reﬁnery Advances from customers Collections on account Cash sales Total Automotive Advances from customers Collections on delivery

Total

$625,000 333,500

$820,000 470,200

$1,150,000 695,000

$2,595,000 1,498,700

958,500

1,290,200

1,845,000

4,093,700

21,500 32,500 8,000

— 21,000 6,000

10,000 8,500 5,200

31,500 62,000 19,200

62,000

27,000

23,700

112,700

1,020,500

1,317,200

1,868,700

4,206,400

20,000 35,900 4,300

— 39,500 4,000

— 28,000 4,500

20,000 103,400 12,800

60,200

43,500

32,500

136,200

890,000 245,000

410,000 390,000

300,000 250,000

1,600,000 885,000

Total

1,135,000

800,000

550,000

2,485,000

Total collections—electronics Heavy Machine Tools Petroleum Deposits Collections on account

2,215,700

2,160,700

2,451,200

6,827,600

5,500 8,300 2,000

— 9,200 2,000

2,000 6,400 2,000

7,500 23,900 6,000

15,800

11,200

10,400

37,400

Cash sales Total E XHIBIT 26.3

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S TATEMENT

OF

E STIMATED C ASH R ECEIPTS

BY

S OURCE

26_controllership.fm Page 538 Monday, December 8, 2003 4:21 PM

538

Ch. 26 Planning and Control of Cash and Short-Term Investments

C ONSOLIDATED E LECTRONICS C ORPORATION S TATEMENT OF E STIMATED C ASH R ECEIPTS P ERIOD J ANUARY 1, 20XX T HROUGH M ARCH 31, 20XX January February March

F OR THE Description Chemical Collections on account Deposits

12,500 500

11,300 200

8,100 300

Total 31,900 1,000

Cash sales

1,000

750

500

2,250

Total

14,000

12,250

8,900

35,150

29,800

23,450

19,300

72,550

1,000

1,000

1,000

3,000

$ 2,246,500

$ 2,185,150

$ 2,471,500

$ 6,903,150

Total machine tools collections Miscellaneous Total cash receipts E XHIBIT 26.3

S TATEMENT

OF

E STIMATED C ASH R ECEIPTS

BY

S OURCE (C ONTINUED )

From the labor budget, the manufacturing expense budget, and the commercial expense budget, the total anticipated expense for salaries and wages can be secured. Once this ﬁgure is available, the period of cash disbursement can be determined easily, for payrolls must be met on certain dates, closely following the time when earned. Reference to a calendar will establish the pay dates. Separate consideration should be given to the tax deductions from the gross pay, since these are not payable at the same time the net payroll is disbursed—unless special bank accounts are established for the tax deductions. The material budget will set out the material requirements each month. The more important elements probably should be treated individually (e.g., power units or engines). Other items will be grouped together. Only in a few instances is material purchased for cash. However, reference to required inventories and to delivery dates as well as assistance from the purchasing department will establish the time allowed for payments. If 30 days are required, then usage of one month can be moved forward for the purpose of estimating cash payments. The effect of cash discounts should be considered in arriving at the estimated disbursements. The various manufacturing and operating expenses should be considered individually because they are by no means all the same. Some are prepayments or accruals, paid annually, such as property taxes and insurance. Some are noncash items, such as depreciation expense or bad debts. For a large number of individually small items, such as supplies, telephone and telegraph, and traveling expense, an average time lag may be used. Cash requirements for capital additions should be determined from the plant budget or other known plans. No particular difﬁculty presents itself because the needs are relatively ﬁxed and are established by the board of directors or other authority. Usual practice requires the determination of cash receipts and disbursements exclusive of transactions involving voluntary debt retirements, purchase of treasury stock, or funds from bank loans. Decisions relative to these means of securing or disbursing cash are reached when the cash position is known and policy formulated accordingly. When branch plants are involved, all such outlying activities must be consolidated to get the overall picture. A typical cash disbursements budget is illustrated in Exhibit 26.4, with a format found practical for estimating purposes. The treatment of payments on other than a monthly basis is shown. (e) FASB STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 95: STATEMENT OF CASH FLOWS. Having discussed the two methods in general use for estimating cash ﬂows, it may be appropriate to review the standard issued by the FASB relating to statements of cash ﬂow. It could be relevant to the cash forecasting process if management desires that the internal estimating procedure closely parallel the format to be used in reporting cash ﬂow to the investor or security analysts and others.

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26.4 The Cash Forecast

539

The cash reporting procedure prior to this standard in many instances suffered from these weaknesses: • No common deﬁnition of cash. Should it include cash equivalents, compensating balances, postdated checks, and so forth? • No common format. The format for the issuance of a cash ﬂow statement was not distinguished from the statement of changes in ﬁnancial condition. • In many instances, it was difﬁcult to identify the cash ﬂows from normal operating activity. (They were combined with other cash producing/generating activities.) Thus, the potential investor was at a disadvantage in gauging the cash generating potential of the normal everyday activities. The complete FASB Statement of Financial Accounting Standards No. 95, Statement of Cash Flows should be reviewed in its entirety by the controller. Though lengthy, the standard should be useful for many reasons, including: • It provides examples of the cash ﬂow formats that meet the standard for general purpose external ﬁnancial accounting and reporting. Examples of typical statements of cash ﬂows included in the annual report to shareholders is discussed in Chapter 35. • It includes the many helpful deﬁnitions regarding cash ﬂows from the three basic sources: operating, investing, and ﬁnancing activities. • It contains useful background data on cash ﬂow statements and the basis of the FASB for reaching the conclusions it did. • In addition to examples of statements of cash ﬂow for a domestic manufacturing company, it provides an example of a statement of cash ﬂows under the direct method for a domestic manufacturing company with foreign operations. Some examples of current reporting practices are provided later in this chapter. (f) RELATION OF CASH BUDGET TO OTHER BUDGETS. From the preceding discussion, it is readily apparent that preparation of the cash budget is generally dependent on other budgets— the sales forecast, the statement of estimated income and expense, the various operating budgets, the capital budget, and the long-range strategic plan. It is in reality part of a coordinated program of sales and costs correlated with business sheet changes and expected revenues and expenditures. It can be appreciated, also, that the cash budget is a check on the entire budgetary program. If the operating budget goals are achieved, the results will be reﬂected in the cash position. Failure to achieve budgeted performance may result in the treasurer seeking additional sources of cash. Depending on the ﬁnancial position of the company, the cash forecast may have a high priority. Many executives prefer to review the cash forecast ahead of other projected statements, and it may, therefore, take the number one spot in the complete report on expected operations. (g) LENGTH OF CASH BUDGET PERIOD. The length of the budget period depends on several factors, including the purpose the budget is to serve, the ﬁnancial condition of the company, and the opinion of the executives about the practicality and accuracy of estimating. For illustration, a short-term forecast would be used in determining cash requirements, perhaps for one to three months in advance. But if the cash margin is low, an estimate of cash receipts and disbursements may be necessary on a weekly basis or even daily. On the other hand, a ﬁrm with ample cash may develop a cash forecast, by months, for six months, or a year in advance. For the determination of general ﬁnancial policy a longer-term budget is necessary. Some companies feel that estimating beyond three months is inaccurate and restrict the cash budget to this period. Other companies maintain a running budget for three or more months in advance, always adding one month and dropping off the present month. A controller will have to adapt forecasting to the existing conditions. It may be necessary to prepare a short-term cash budget for cash requirements purposes and also a long-term forecast for use in ﬁnancial policy decisions.

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E XHIBIT 26.4

S TATEMENT OF

$1,325,000 325,000 117,500 110,000 30,000 1,907,500 76,000 10,000 3,500 89,500 1,997,000 510,000 10,000 520,000

1,945,000 80,000 10,000 4,000 94,000 2,039,000 420,000 20,000 440,000

February

$1,350,000 325,000 115,000 120,000 35,000

E STIMATED C ASH D ISBURSEMENTS

Total Subcontracted Production

Total Total Raw Materials and Purchased Parts Subcontracted Production Project 615 Project 616

Total Project 616 Power units Radios Other

Other

Project 615 Power units Landing gears Radios Tires and tubes

Raw Material and Purchased Parts

Inventory Items

FOR

January

480,000 10,000 490,000

2,058,500

84,000 12,000 5,000 101,000

1,957,500

$1,375,000 320,000 117,500 110,000 35,000

March

C ONSOLIDATED S PACECRAFT C ORPORATION S TATEMENT OF E STIMATED C ASH D ISBURSEMENTS THE P ERIOD J ANUARY 1 T HROUGH D ECEMBER 31, 20 XX

Ch. 26 Planning and Control of Cash and Short-Term Investments

Description

540

105,000 — 105,000

2,074,000

160,000 24,000 10,000 194,000

1,880,000

$1,300,000 325,000 115,000 110,000 30,000

November

120,000 23,000 143,000

2,187,500

168,000 30,000 12,000 210,000

1,997,500

$1,300,000 415,000 115,000 122,500 25,000

December

3,600,000 150,000 3,750,000

24,204,000

1,200,000 132,000 72,000 1,404,000

22,800,000

$15,840,000 3,900,000 1,380,000 1,320,000 360,000

Total

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$ 3,204,600

$ 3,276,900

E XHIBIT 26.4

S TATEMENT OF

E STIMATED C ASH D ISBURSEMENTS (C ONTINUED )

Total Cash Disbursements

77,000

152,500

Other

Total

610,600 3,127,600

645,400 3,124,400 12,000 12,000 — 51,000 2,000

494,000 31,300 — 72,500 1,800 11,000

596,500 35,900 — — 2,000 11,000

12,000 17,000 20,500 101,000 2,000

458,000 36,000

February

560,000 36,500

January

Administrative expense Selling and advertising Advances to vendors Additions to ﬁxed assets

Other Cash Disbursements

Total Inventory Items

Total Expenses

Other

Salaries and wages—indirect Total salaries and wages Payroll taxes, etc. Property taxes Property insurance Supplies

Description Expenses Salaries and wages—direct

FOR

$ 3,404,400

84,500

17,000 45,000 — 19,500 3,000

3,319,900

771,400

598,500 37,800 122,000 — 2,100 11,000

562,000 36,500

March

C ONSOLIDATED S PACECRAFT C ORPORATION S TATEMENT OF E STIMATED C ASH D ISBURSEMENTS THE P ERIOD J ANUARY 1 T HROUGH D ECEMBER 31, 20 XX

$ 2,939,900

30,000

15,500 11,500 — — 3,000

2,909,900

730,900

693,000 24,900 — — 2,000 11,000

657,000 36,000

November

26.4

541

$ 37,414,300

926,000

168,000 310,000 20,500 397,500 30,000

36,488,300

8,534,300

7,812,000 373,000 122,000 72,500 22,800 132,000

7,380,000 432,000

Total

The Cash Forecast

$ 3,117,400

53,500

12,000 22,500 — 17,000 2,000

3,063,900

733,400

702,000 18,400 — — 2,000 11,000

665,000 37,000

December

26_controllership.fm Page 541 Monday, December 8, 2003 4:21 PM

26_controllership.fm Page 542 Monday, December 8, 2003 4:21 PM

542

Ch. 26 Planning and Control of Cash and Short-Term Investments

(h) PUTTING THE CASH BUDGET TO WORK. The controller can prepare the cash budget in the usual manner, indicating the extent of additional cash funds needed, if any, and the probable duration of such need. However, the responsibility for securing these funds on the most advantageous basis rests with the treasurer or chief ﬁnancial ofﬁcer. The treasurer, and not the chief accounting ofﬁcer, would usually negotiate with banks for loans, or would invest surplus funds. Yet the part played by the controller is not always as routine as might appear. In times of adversity, the controller must be prepared to furnish extra information. Thus the treasurer may need to know the exact cash needs of the following week. This can be furnished by manually adding the bills payable at that time, as well as the payrolls. If the accounts payable are in the computer ﬁle, the requirements can be readily determined by tabulating the applicable due date ﬁle. The same procedure can be used in determining the funds, if any, to be transferred to each branch for the weekly period. Cash requirements must be planned just as other operations are planned. It simply is not satisfactory to assume that a high volume of sales will automatically result in a sound ﬁnancial position or that with a satisfactory budgeted proﬁt and loss statement ﬁnances will take care of themselves. The controller can be an effective voice in establishing the necessity for a well-developed ﬁnancial program.

26.5 CASH COLLECTIONS (a) ADMINISTRATION OF CASH RECEIPTS. One of the primary objectives of ﬁnancial management is the conservation and effective utilization of cash. From the cash collection viewpoint, there are two phases of control: (1) the acceleration of collections, and (2) proper internal control of collections. (b) ACCELERATION OF CASH RECEIPTS. Two methods are commonly used to speed up the collection of receivables: the lockbox system and area concentration banking. The lockbox system involves the establishment of depository accounts in the various geographical areas of signiﬁcant cash collections so that remittances from customers will take less time in transit, preferably not more than one day. Customers mail remittances to the company at a locked post ofﬁce box in the region served by the bank. The bank collects the remittances and deposits the proceeds to the account of the company. Funds in excess of those required to cover costs are periodically transferred to company headquarters. Supporting documents accompanying remittances are mailed by the bank to the company. Collections are thus accelerated through reduction in transit time with resultant lower credit exposure. Arrangements must be made, however, for proper control of credit information. Under the system of area concentration banking, local company units collect remittances and deposit them in the local bank. From the local bank, usually by wire transfers, expeditious movement of funds is made to a few area or regional concentration banks. Funds in excess of compensating balances are automatically transferred by wire to the company’s banking headquarters. By this technique in-transit time is reduced. The controller is expected to be aware of these and other devices for accelerating collections, and to assist the treasurer, should that be necessary. While checks are the predominant means of collecting accounts receivable, an increasing amount of business is handled through electronic fund transfer (EFT). Moreover, there are various combinations of methods and instruments that speed collections: • Lockbox • Depository transfer check (DTC) • Preauthorized draft (PAD) • Automated clearinghouse (ACH) transfer (from one bank to another through the ACH system) • Wire transfer

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26.5 Cash Collections

543

Section 26.8 includes limited comments on the employment of the new technology in use and services that might be expected from the company’s banking institutions. (c) INTERNAL CONTROL OF CASH RECEIPTS. In most business organizations, the usual routine cash transactions are numerous. The following sources are typical: mail receipts, over-the-counter cash sales, sales or collections made by salesmen, solicitors, and so on, and over-the-counter collections on account. Naturally, all businesses have other cash transactions of a less routine nature, such as receipts from the sale of ﬁxed assets, that may be handled by the ofﬁcers or require special procedures. Most of the cash problems will be found to center on the transactions just listed, because the more unusual or less voluminous cash receipts are readily susceptible to a simple check. Regardless of the source of cash, the very basis for the prevention of errors or fraud is the principle of internal check. Such a system involves the separation of the actual handling of cash from the records relating to cash. It requires that the work of one employee be supplemented by the work of another. Certain results must always agree. For example, the daily cash deposit must be the same as the charge to the cash control account. This automatic checking of the work of one employee by another clearly discourages fraud and locates errors. Under such conditions, any peculations are generally restricted to cases of carelessness or collusion. The system of internal control must be designed on the groundwork of the individual organization. However, there are some general suggestions that will be helpful to the controller in reviewing the situation: • All receipts of cash through the mail should be recorded in advance of transfer to the cashier. Periodically, these records should be traced to the deposit slip. • All receipts should be deposited intact daily. This procedure might also require a duplicate deposit slip to be sent by the bank or person making the deposit (other than the cashier) to an independent department—for use in subsequent check or audit. • Responsibility for handling of cash should be clearly deﬁned and deﬁnitely ﬁxed. • Usually, the functions of receiving cash and disbursing cash should be kept entirely separate (except in ﬁnancial institutions). • The actual handling of cash should be entirely separate from the maintenance of records, and the cashiers should not have access to these records. • Tellers, agents, and ﬁeld representatives should be required to give receipts, retaining a duplicate, of course. • Bank reconciliations should be made by those not handling cash or keeping the records. Similarly, the mailing of statements to customers, including the check-off against the ledger accounts, should be done by a third party. The summarizing of cash records also may be handled by a third party. • All employees handling cash or cash records should be required to take a periodic vacation, and someone else should handle the job during such absence. Also, at unannounced times, employees should be shifted in jobs to detect or prevent collusion. • All employees handling cash or cash records should be adequately bonded. • Mechanical and other protective devices should be used where applicable to give added means of check—cash registers, the tape being read by a third party; duplicate sales slips; daily cash blotters. • Where practical, cash sales should be veriﬁed by means of inventory records and periodic physical inventories. (d) ILLUSTRATIVE CASH RECEIPTS PROCEDURE. A simple and effective cash receipts procedure can be executed that embodies some of the controls mentioned in the preceding section and that is adaptable by most industrial ﬁrms receiving cash by mail. All incoming mail not addressed to a speciﬁc individual is opened in the mailroom. Any mail containing remittances is listed on a

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Ch. 26 Planning and Control of Cash and Short-Term Investments

daily remittance sheet prepared in triplicate. The name, check number, date, and amount are detailed on the record (Exhibit 26.5). One copy is forwarded, with the envelopes and remittance slips, to the cashier; a second goes to the auditor, treasurer, or controller; and the third copy is retained by the mailroom. The cashier records the cash received via the mailroom on a daily cash sheet or computer recording (Exhibit 26.6), indicating the nature of the receipt, along with any other receipts from other sources. This cash record is subsequently sent to the accounting department for posting, details as well as summary, after the cashier has made a summary entry. The deposit slip is prepared in quadruplicate. The cashier retains one copy. Three copies go to the bank for receipting, one of which is retained by the bank; another is returned to the cashier as evidence the bank received the funds; and a third is sent to the auditing department or controller’s ofﬁce. This is then compared in total, and occasionally in detail, with the daily cash register. The remittance sheet is also test-checked against the deposit slip. The cashier, of course, does not have access to the accounts receivable records, general ledger, or disbursements. These basic methods may be adapted, in large degree, to personal computer systems. (e) COMMON METHODS OF MISAPPROPRIATING CASH. An enumeration of some of the more common methods of misappropriating company funds may be a guide to the controller in recognizing points to guard against:

E XHIBIT 26.5

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M AILROOM R EMITTANCE S HEET

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Total

D AILY C ASH S HEET

Pierre’s Restaurant

Description Jones Chemical Co. Witmer Candy Co. Prescott Molding Co. Rush Mfg. Co. Monsanto Cyanamid Co. Laughlin Stamping Co. Aero Company Marjorie Jones Adela Castle

E XHIBIT 26.6

1242 846 101 10 322 464 422

Check No.

$ 47,919.52

Debit Cash (101) $ 622.50 9,875,00 4,322.50 12,500.00 16,321.50 421.12 3,820.00 16.00 1.20 19.70

$ 34,339.00

3,820.00

16,321.50

Trade Accounts Receivable (108) $ — 9,875.00 4,322.50

$ 12.500.00

12,500.00

Deposits (104) $ —

$ 1,043.6

421.12

Cash Sales (501) $ 622.50

D AILY C ASH S HEET

$ 17.20

16.00 1.20

Employees Accounts Receivable (106) $ —

Credit

662

Account

26.5

545

$ 19.70

19.70

Amount $ —

Cash Collections

Vending Machine Income

Description

Other

Date April 20, 20xx

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1. Mail receipts (a) Lapping—diverting cash and reporting it some time after it has been collected; usually, funds received from one account are credited against another account from which cash has been diverted earlier (b) Borrowing funds temporarily, without falsifying any records, or simply not recording all cash received (c) Falsifying totals in the cashbook (d) Overstating discounts and allowances (e) Charging off a customer’s account as a bad debt and pocketing the cash (f) Withholding of miscellaneous income, such as insurance refunds 2. Over-the-counter sales (a) (b) (c) (d) (e)

Failing to report all sales and pocketing the cash Underadding the sales slip and pocketing the difference Falsely representing refunds or expenditures Registering a smaller amount than the true amount of sale Pocketing cash overages

3. Collections by salespeople (a) Conversion of checks made payable to “cash” (b) Failure to report sales (c) Overstating amount of trade-ins Where adequate internal control is used, most of these practices cannot be carried on without collusion. (f) OTHER MEANS OF DETECTING FRAUD. In addition to the segregation of duties that has been described, certain other practices may be adopted to further deter any would-be peculator or embezzler. One of these tools is surprise audits by the internal auditor as well as by the public accountants. Another is the prompt follow-up of past-due accounts. Proper instructions to customers about where checks should be mailed, and a speciﬁc request that they be made payable to the company, and not to any individual, also will help. Bonding of all employees, with a detailed check of references, is a measure of protection. Special checking of unusual receipts of a miscellaneous nature will tend to discourage irregularities. For additional comments on internal control and fraud prevention, see Chapter 7.

26.6 CASH DISBURSEMENTS (a) CONTROL OF CASH DISBURSEMENTS. In this area of cash administration, also, there are two aspects of control: (1) the timing of payments, and (2) the system of internal control. Experience indicates the value of maintaining careful controls over the timing of disbursements to ensure that bills are paid only as they are due and not before. In such a manner, cash can be conserved for temporary investment. Another consideration in payment scheduling is the conscious use of cash “ﬂoat.” By recognizing in-transit items and the fact that ordinarily bank balances are greater than book balances because of checks not cleared, book balances of cash may be planned at lower levels. The incoming ﬂoat may be balanced against the outgoing payments. The relationship between the time a check is released to the payee and the time it clears the bank, the disbursement ﬂoat, is made up of three elements:

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26.7 Internal Control

547

1. The time needed for the check to travel by mail or other delivery from the issuer to the payee 2. The time required by the payee to process the check 3. The period required by the banking system to clear the check, that is, the time from deposit by the payee to the time the item is charged to the issuer’s account In controlling this “ﬂoat,” it often is helpful to trace the time interval of large checks to estimate the proper allowance for the period required for checks to clear. The controller should take measures to assure there is no abuse of ﬂoat (e.g., writing of checks on banks in some remote location far from the recipient’s address, so as to secure an additional three or four days of ﬂoat). (b) ADMINISTRATIVE BANK ACCOUNTS. In the control of disbursements, particularly where subsidiary or ﬁeld ofﬁce divisional transactions are involved, several special purpose bank accounts may be used (e.g., imprest accounts, zero balance accounts, and automatic balance accounts). Under an imprest system, the unit operates with a ﬁxed maximum balance. Periodically, such as weekly, or when the fund is below a minimum level, receipted bills are submitted for reimbursement. With a zero balance account system, the clearing account for the organizational segment is kept at a zero balance. When checks are presented for payment, arrangements are such that the bank is authorized to transfer funds from the corporate general account to cover the items. Payment may be made by draft. Comparable arrangements can be made for the treasurer to make wire transfers to the zero bank account on notiﬁcation of the items being presented for payment. Zero bank balance arrangements can facilitate control of payments through one or a limited number of accounts. The system may facilitate a quick check of the corporate cash position. Automatic balance accounts use the same account for receipts and disbursements. When the account is above a speciﬁed maximum level, the excess funds are transferred to the central bank account; conversely, when the balance drops below a minimum level, the bank may call for replenishment.

26.7 INTERNAL CONTROL (a) IMPORTANCE OF INTERNAL CONTROL. Once the cash has been deposited in the bank, it would seem that the major problem of safeguarding the cash has been solved. Control of cash disbursements is a relatively simple matter—if a few rules are followed. After the vendor’s invoice has been approved for payment, the next step usually is the preparation of the check for executive signature. If all disbursements are subject to this top review, how can any problem exist? Yet it is at precisely this point that the greatest danger is met. Any controller who has had to sign numerous checks knows that it is indeed an irksome task—the review to ascertain that receiving reports are attached, the checking of payee against the invoice, and the comparison of amounts. Because it is such a monotonous chore, it is often done in a most perfunctory manner. Yet this operation, carefully done, is essential to the control of disbursements. Where two signatures are required, both signatures need not make the detailed review, but certainly one should. The other can review on a spot-check basis only. There are too many instances where false documents and vouchers used a second time have been the means of securing executive signatures. Prevention of this practice demands careful review before signing checks, as well as other safeguards. It cannot be taken for granted that everything is all right. Those who sign the checks must adopt a questioning attitude on every transaction that appears doubtful or is not fully understood. Indeed, the review of documents attached to checks will often bring to light foolish expenditures and weaknesses in other procedures. (b) SOME PRINCIPLES OF INTERNAL CONTROL. The opportunities for improper or incorrect use of funds are so great that a controller cannot unduly emphasize the need for proper safeguards in the cash disbursement function. Vigilance and sound audit procedures are necessary.

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Ch. 26 Planning and Control of Cash and Short-Term Investments

Although the system of internal control must be tailored to ﬁt the needs of the organization, some general suggestions may be helpful: • Except for petty cash transactions, all disbursements should be made by check. • All checks should be prenumbered, and all numbers accounted for as either used or voided. • All general disbursement checks for amounts in excess of $x (e.g., $5000) should require two signatures. • Responsibility for cash receipts should be divorced from responsibility for cash disbursements. • All persons signing checks or approving disbursements should be adequately bonded. • Bank reconciliations should be made by those who do not sign checks or approve payments. • The keeping of cash records should be entirely separate from the handling of cash disbursements. • Properly approved invoices and other required supporting documents should be a prerequisite to making every disbursement. • Checks for reimbursement of imprest funds and payrolls should be made payable to the individual and not to the company or bearer. • After payment has been made, all supporting documents should be perforated or otherwise mutilated or marked “paid” to prevent reuse. • Mechanical devices should be used to the extent practical (check writers, safety paper, etc.) • Annual vacations or shifts in jobs should be enforced for those handling disbursements. • Approval of vouchers for payment usually should be done by those not responsible for disbursing. • Special authorizations for interbank transfers should be required, and a clearing account, perhaps called Bank Transfers, should be maintained. • All petty cash vouchers should be written in ink or typewritten. • It may be desirable to periodically and independently verify the bona ﬁde existence of the regularly used suppliers of recurring services (e.g., consultants, lawyers). Additional aspects of internal control are addressed in Chapter 7. (c) METHODS OF MISAPPROPRIATING FUNDS. The safeguards just listed are some of those developed on the basis of experience by many ﬁrms. Some common means of perpetrating fraud are: • Preparing false vouchers or presenting vouchers twice for payment • “Kiting,” or unauthorized borrowing by not recording the disbursement, but recording the deposit, in the case of bank transfers • Falsifying footing in cash records • Raising the amount on checks after they have been signed • Understating cash discounts • Cashing unclaimed payroll or dividend checks • Altering petty cash vouchers • Forging checks and destroying them when received from the bank, substituting other canceled checks or charge slips (d) BANK RECONCILIATIONS. An important phase of internal control is the reconciling of the balance per bank statement with the balance per books. This is particularly true with respect to general bank accounts as distinguished from accounts solely for disbursing paychecks. If properly done, the task is much more than a listing of outstanding checks, deposits in transit, and unrecorded bank charges. For example, the deposits and disbursements as shown on the bank statement should be reconciled with those on the books. A convenient form to handle this is illustrated in

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26.7 Internal Control

E XHIBIT 26.7

549

B ANK R ECONCILIATION

Exhibit 26.7. Then, too, it is desirable to compare endorsements with the payee and to check the payee against the record. It has been mentioned previously that bank reconciliations should be handled by someone independent of any cash receipts or disbursements activities. The job can be handled by the controller or may be performed by the bank itself. Particular attention should be paid to outstanding checks of the preceding period and to deposits at the end of the month to detect kiting. (e) PETTY CASH FUNDS. Most businesses must make some small disbursements. To meet these needs, petty cash funds are established that operate on an imprest fund basis, that is, the balances are ﬁxed. At any time the cash, plus the unreimbursed vouchers, should equal the amount of the fund. Numerous funds of this type may be necessary in the branch ofﬁces or at each plant. A uniform receipt and uniform procedure should be provided, including limits on individual disbursements through this channel, proper approvals, and so forth. If it is practicable, the person handling cash receipts or disbursements should not handle petty cash. Other safeguards would include

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Ch. 26 Planning and Control of Cash and Short-Term Investments

surprise cash counts, immediate cancellation of all petty cash slips after payment, and careful scrutiny of reimbursements. Although the fund may be small, very considerable sums can be expended. The controller should not neglect checking this activity. (f) PAYROLLS. In most concerns, payroll disbursements represent a very sizable proportion of all cash payments. Proper safeguards for this disbursement are particularly desirable. The use of a special payroll account is a very common procedure. A check in the exact amount of the total net payroll is deposited in the payroll account against which the individual checks are drawn. This has advantages from an internal control standpoint, and it may facilitate the reconciling of bank accounts. The preparation of the payroll, of course, should be separate from the actual handling of cash. Special payroll audits are advisable—by the internal audit staff—to review procedures, verify rates, check clerical accuracy, and witness the payoff.

26.8 REPORTS ON CASH (a) CASH REPORTS FOR INTERNAL USE. The cash reports used in most businesses are rather simple in nature but still provide important information. Reports on estimated cash requirements and balances or receipts or disbursements are illustrated in Exhibits 26.1 through 26.4 . For information purposes, a simple daily cash report is prepared in some companies for the chief executive and treasurer. It merely summarizes the cash receipts and cash disbursements, as well as balances of major banks. An example is shown in Exhibit 26.8. Such a report may be issued daily, weekly, or monthly, depending on needs. A detailed statement of cash receipts is illustrated in Exhibit 26.9.

AS

OF THE

T HE D AY C OMPANY D AILY C ASH R EPORT C LOSE OF B USINESS , J UNE 16, 20 XX

Balance, June 15, 19xx

$ 135,300 10,200

Receipts

$ 145,500

Total Disbursements

15,300

Balance, June 16, 19xx

130,200

Bank Balances, etc. National City Bank-General

65,900

Commerce National Bank-General

22,100

Ohio Trust Company-General

30,500 $ 118,500

Total Petty Cash and Payroll Funds

$ 130,200

Total E XHIBIT 26.8

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11,700

D AILY C ASH R EPORT

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26.8 Reports on Cash

Account No. 201–1 201–2 201–3 201–5 201–6 303 801 1001–1 1001–2 1001–3 1001–4 6001 6005 6010 Total E XHIBIT 26.9

T HE XYZ C OMPANY S TATEMENT OF D AILY C ASH R ECEIPTS D ATE Name Accounts Receivable—Aircraft Accounts Receivable—Parts Accounts Receivable—Employees Accounts Receivable—Intercompany Accounts Receivable—Miscellaneous Claims Receivable Deposits on Account Cash Sales—Aircraft Cash Sales—Parts Cash Sales—Scrap Cash Sales—Miscellaneous Revenue—Vending Machines Royalty Income Miscellaneous Income and Expense

551

Amount $

$ S TATEMENT

OF

D AILY C ASH R ECEIPTS

From the control viewpoint, it is desirable to know how collections and disbursements compare with estimates. Such information is shown in Exhibit 26.10, as well as the expected cash balance at month end.

F OR

THE

T HE R OTH C OMPANY W EEKLY C ASH R EPORT W EEK E NDED N OVEMBER 16, 20 XX ( THOUSANDS OF DOLLARS ) Month to Date

Description Beginning Cash Balance Cash Receipts Government Wholesale

Actual Week Ended 11/16/xx $ 17,890

Actual $32,511

Estimated $32,510

10,810 19,620 8,330

18,310 67,730 21,100

18,000 65,500 23,400

38,760

107,140

106,900

12,330 12,660 1,890 2,790 13,370 1,060 44,100

12,860 37,010 19,340 8,640 39,990 2,030 119,870

12,300 36,900 14,300 8,920 40,190 2,000 114,610

$ 12,550

$ 19,781

$ 24,800

Retail Total Cash Disbursements Accounts Payable—Expenses Payrolls Material Purchases Federal Taxes Capital Expenditures Other Total Ending Cash Balance

$ 30,000

Estimated Month-End Balance E XHIBIT 26.10

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C OMPARISON

OF

A CTUAL

AND

E STIMATED C ASH A CTIVITY

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Ch. 26 Planning and Control of Cash and Short-Term Investments

In addition to comparing actual and forecasted cash activity, it is also useful to periodically compare book balances with those required to meet service charges of the banks and compensating balances. Such a report compares the “objective” balance with actual book and actual bank balances. This type of report provides a periodic check on effective cash utilization by recording the absence of excessive balances and the progress in keeping bank balances adequate to fairly compensate the ﬁnancial institution. A cash management report is shown in Exhibit 26.11. T HE S TEVEN C OMPANY Q UARTERLY R EPORT ON B ANK B ALANCES A S AT J UNE 30, 20 XX ( THOUSANDS OF DOLLARS ) Actual per Books $ 19,870 17,440 16,850 14,310 10,870 6,430 5,510 4,380

Bank First National City Chase Manhattan Morgan Guaranty Bank of America Chemical Bank First Interstate American Trust Anglo-American National Bank of Commerce

3,000 —

110 (490)

3,020 520

99,040 8,190 760

99,650 7,000 750

610 (1,190) (10)

108,730 8,600

$ 107,990

$ 107,400

$ (590)

$ 117,330

Cash Funds

E XHIBIT 26.11

A CTUAL

Balance per Bank Statement $ 23,070 19,120 17,180 15,810 12,300 7,110 5,840 4,760

2,890 490

Other Local Total Cash in Banks—U.S. Subsidiaries—Foreign

Total Cash

Objective $ 20,200 17,800 16,500 15,700 10,250 5,900 5,800 4,500

(Over) Under Objective $ 330 360 (350) 1,390 (620) (530) 290 120

AND

O BJECTIVE B ANK B ALANCES

There are any number of variations in cash reports, including some that are greatly detailed about daily cash receipts and the like. The suggested reports are merely examples; many may be adapted to computer applications. (b) CASH FLOW ANALYSIS FOR INVESTMENT PURPOSES. Cash ﬂow as a broad measure of company performance is discussed in Chapter 6. Reference also is made to “free cash ﬂow,” a further reﬁnement of cash ﬂow in that from “cash ﬂow” is subtracted a provision for required capital expenditures and, in some calculations, the dividend payments. In this latter case, the subtrahend is the equivalent of “discretionary funds,” and it represents sums that can be spent on acquisitions, stock buybacks, inventory, and many other items. Where reported earnings are heavily reduced by depreciation, cash ﬂow in some industries is an analytical yardstick of choice. It is useful to investors in spotting companies with ample resources to make them rewarding acquisitions. Additionally, corporate raiders are attracted to high cash ﬂow situations because the cash stream may be used to pay down heavy debt incurred in a takeover. Periodically, listings appear comparing stock prices in terms of cash ﬂow. The controller should be aware that cash ﬂow may rank high in judging the investment worth of a company. It is a feature that usually deserves comment in any analytical effort.

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26.9 Cash Flow Ratio Analysis

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26.9 CASH FLOW RATIO ANALYSIS The requirement by the FASB for companies to provide shareholders (with access to the public and to potential investors) with a statement of cash ﬂows, which identiﬁes cash ﬂows from operating activities, as well as that from investing activities and ﬁnancing activities, has facilitated and encouraged the use of certain cash ﬂow ratios. These ratios are useful in the planning and control of cash in that they may provide benchmarks or standards to measure the cash performance of a given company against other entities. Such comparisons may be helpful in evaluating ﬁnancial performance of an acquisition target or other investments. Equally valuable, the ratios may be used to judge trends in the controller’s own company and as compared with competitors or other selected best-in-their class entities. The cash ﬂow ratios are of two types. The sufﬁciency ratios directly measure the ability of a company to generate enough cash ﬂow to meet the needs of the entity, such as the ability to pay long-term debt, provide for needed plant and equipment, and pay dividends to the owners. The efﬁciency ratios indicate how well a company generates cash from selected measures, such as sales, income from continuing operations, and from total assets (or total assets employed). Some sufﬁciency ratios and their derivatives are: Ratio

Derivation

Cash ﬂow adequacy

Cash from operations = -----------------------------------------------------------------------------------Long-term debt paid Funds for assets purchased Dividends paid

Long-term debt repayment

Long-term debt payments = -------------------------------------------------------------Cash from operations

Dividend payout

Dividends = --------------------------------------------------Cash from operations

Reinvestment

Purchase of assets = --------------------------------------------------Cash from operations

Debt coverage

Total debt = --------------------------------------------------Cash from operations

Depreciation-amortization relationship

Depreciation Amortization = ----------------------------------------------------------------------Cash from operations

Some efﬁciency cash ﬂow ratios are: Ratio

Derivation

Cash ﬂow to sales

Cash flow from operations ---------------------------------------------------------------Sales

Cash ﬂow return on assets

Cash flow from operations ------------------------------------------------------------------------------------------Total assets (or total assets employed)

The cash efﬁciency ratios reﬂect the effectiveness or efﬁciency by which cash is generated from either operations or assets. Speciﬁcally: • The cash ﬂow-to-sales ratio reﬂects the percentage of each sales dollar realized as cash. • The operations index reﬂects the ratio of cash generated to the income from continuing operations.

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Ch. 26 Planning and Control of Cash and Short-Term Investments

• The cash ﬂow from assets reﬂects the relative amount of cash which the assets (or assets employed) are able to generate. These ratios will assist in the analysis of ﬁnancial statements. However, there is still a need for a consensus as to what are useful cash ﬂow ratios, and the development of norms or standards for companies and industries. (See Chapter 6 for additional comments about these and other ﬁnancial and operating ratios.)

26.10 IMPACT OF NEW INFORMATION TECHNOLOGY AND ORGANIZATIONAL STRUCTURES The vast majority of the basic cash management functions described earlier in this chapter have been performed for years and will continue to be accomplished. But how they will be done, and what organization structure will do them (who) is subject to change. The pressures or inﬂuences that are causing or accelerating adjustments are many and include: • The substantial improvements in information technology, or computer technology • Growth in the global nature of business • Economic pressures that are causing entities to integrate horizontally, to reduce staff size (such as treasury or controllership functions), to focus on the principal business, and to do more subcontracting or outsourcing • Closer electronic integration with supplier, customer, or other third parties (such as banks) The personal computer and the related software greatly aid in the analysis of data required for a cash forecast, as well as the actual preparation of the cash plan. As corporations and banks electronically integrate, there are many possibilities that should be of interest to the controller (for internal control and other purposes) including: • Using an electronic data interchange (EDI) ﬁle, a customer can supply selling company’s bank directly with invoice data and arrange payment. The bank will then update the payee’s account. • Where banks handle the lockbox operations, they can book images of remittance documents in a computer ﬁle and avoid enormous sorting and reassociation of check copies and the like. Less paperwork means less cost. • Arrangements can be made with a company’s bank for automatic payment of taxes and/or other designated items. This reduces ﬂoat and provides greater control over the payment. • Companies can arrange a system for electronic payment of selected supplier invoices thus reducing paperwork. • For faster information, arrangements can be made for electronic account analysis. • Banks can provide an automated check reconcilement through data transmission. • Other systems have been developed by banks, using modern technology at the time of check presentments to reduce fraud. Aside from the technology involved, companies can select banks to perform duties regularly handled by their own internal departments, such as portfolio management; cash collections, cash disbursements; payroll check preparation, retirement funds custody, accounting, and disbursements. Outsourcing of some ﬁnancial activities is no longer a dirty word. Hopefully, the treasurer will have close contact with the company’s banks in order to keep abreast of what services can be proved (more cheaply) on an outsourcing basis.

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26.11 INVESTMENT OF SHORT-TERM FUNDS In many companies, surplus or excess funds not needed for either operating purposes or compensating bank balances are available for investment, even over weekends. Prudent use of otherwise idle funds can add to income. Although the ﬁnancial ofﬁcer ordinarily will direct the investment of these funds, the controller may be concerned with adequate reporting and control and generally should be somewhat knowledgeable about the subject. (a) CRITERIA FOR SELECTING INVESTMENTS. Given the opportunity for earning additional income from temporary excess funds, what are some of the criteria to be considered in selecting the investment vehicle? There probably are ﬁve, and all somewhat related: 1. Safety of principal. A primary objective should be to avoid instruments that might risk loss of the investment. 2. Price stability. If the company is suddenly called on to liquidate the security to acquire funds, price stability would be important in avoiding a signiﬁcant loss. 3. Marketability. The money manager must consider whether the security can be sold, if required, rather easily and quite quickly. 4. Maturity. Funds may be invested until the demand for cash arises, perhaps as reﬂected in the cash forecast. Hence maturities should relate to prospective cash needs. Temporary investments usually involve maturities of a day or two to as much as a year. 5. Yield. The ﬁnancial ofﬁcer of course is interested in optimizing the earnings or securing at least a competitive return on the investment and is thus interested in the yield. This is not necessarily the most important criterion, because low-risk, high-liquidity investments will not provide the highest yield. The importance attached to each of these factors will depend on the management philosophy, condition of the market, and inclinations of the investing person. Restrictions placed on the operation will inﬂuence the weighting of each. (b) INVESTMENT RESTRICTIONS. Sometimes the board of directors will place restrictions on just how short-term funds may be invested. In other instances, the senior ﬁnancial ofﬁcer will provide such guidelines. Subjects covered would include: • Maximum maturity • Credit rating of issuer • Maximum investment in selected types of securities By user By type of instrument By country By currency

Instruments for investment vary widely, and market conditions may dictate the most desirable at any particular time. Typical money market instruments include: • U.S. Treasury bills • U.S. Treasury notes and bonds • Negotiable certiﬁcates of deposit • Banker’s acceptances • Selected foreign government issues • Federal agency issues

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• Repurchase agreements • Prime commercial paper • Finance company paper • Short-term tax exempts An illustration of the guidelines of an aerospace company for use in making temporary investments is shown in Exhibit 26.12. T HE A EROSPACE S ERVICE C ORPORATION I NTERNAL G UIDELINES FOR T OTAL S HORT -T ERM I NVESTMENTS E FFECTIVE N OVEMBER 1, 20 XX Objective To invest excess cash in only top-quality-short-term investments, for optimum total return, commensurate with corporate liquidity requirements. Liquidity Liquidity shall be provided by minimum and maximum limits as follows: 1. At least $80 million shall be invested in overnight investments and in negotiable marketable obligations of major U.S. issuers. 2. No more than 50% of the total portfolio shall be invested in time deposits or other investments with a lack of liquidity such as commercial paper for which only the dealer and issuer make a market. Diversiﬁcation Diversiﬁcation shall be provided through a limit on each nongovernment issuer as listed next. These are general limits, and in each case quality review may result in elimination or a lower limit for an issuer. Overnight or repurchase investments must meet quality criteria but are not subject to limits on the amount invested. 1. U.S. Government and agencies—no limit. 2. Domestic bank certiﬁcates of deposit, time deposits and banker’s acceptances—$30-million limit for banks with capital accounts in excess of $800 million (top 10 banks); $20 million for banks with capital accounts of $350 to $800 million (second 11 banks); $5 million for all other banks with capital accounts in excess of $250 million (11 banks). 3. U.S. dollar (or fully hedged foreign currency) obligations of foreign banks, each with capital accounts exceeding $500 million—limited to $15 million each for Canadian banks and $10 million each for other foreign banks, subject to an aggregate limit of $75 million for non-Canadian foreign banks. 4. Domestic commercial paper with P-1/A-1 rating only—$20-million limit for issuers with longterm senior debt rating of Aa or better; $10 million for issuers with debt rating of A; and $10 million for commercial bank-holding companies with capital accounts in excess of $500 million, within the overall limit of the ﬂagship bank described in 2 above. 5. Foreign commercial paper unconditionally guaranteed by a prime U.S. issuer and fully hedged, subject to the guarantor’s issuer limit described in 4 above. 6. Obligations of savings and loan associations, each with capital accounts exceeding $250 million— limited to $10 million each. Operating Procedure Payment shall be made only against delivery of a security to a custodian bank. Securities shall be delivered from custody only against payment. Due bills issued by a bank will be accepted for delivery only under exceptional conditions. No due bills issued by a dealer will be accepted. Maturity Limits The average maturity of the entire fund shall be limited to an average of two years. The maximum maturity for each category is as follows: E XHIBIT 26.12

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G UIDELINES

FOR

S HORT- T ERM I NVESTMENTS

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26.11 Investment of Short-Term Funds

U.S. government Municipal obligations Banks CDs and BAs Bank TDs Commercial paper E XHIBIT 26.12

G UIDELINES

557

5 years 2 years 1 year 90 days 270 days FOR

S HORT- T ERM I NVESTMENTS (C ONTINUED )

(c) INVESTMENT CONTROLS. Many securities that companies purchase as short-term investments are negotiable. Additionally, these investments often are paid for through bank wire transfers. Given the nature and frequency of transactions, the control system should be adequate. Many corporations contract with a major commercial bank to serve as custodian of the securities, to make payment on incoming delivery, and to receive funds on outgoing delivery. The form of contract should provide maximum safeguards to the company. Because opportunities for fraud exist, given telephonic transactions and wire transfer of funds, care must be exercised in the form and nature of conﬁrmation secured and the internal controls used in authorizing payment. (d) REPORTS TO MANAGEMENT. Periodic reports to top management, including the board of directors, will depend in part on this group’s interest and the size of the investment portfolio. However, it is suggested, as a minimum, that where investments are signiﬁcant, information should be conveyed regarding the type of investment and yield. Suggested report content would include: • Detail of individual securities, grouped by type and/or maturity • Summary by type • Summary by maturity • Summary by yield • Overall portfolio yield, by maturity • Comparison of yield with selected index or by money manager, if appropriate An illustrative report comparing in-house performance with an outside money manager is shown in Exhibits 26.13 through 26.14 .

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Ch. 26 Planning and Control of Cash and Short-Term Investments

E XHIBIT 26.13

R EPORT

E XHIBIT 26.14

R EPORT TO M ANAGEMENT OF O BLIGATION

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TO

M ANAGEMENT ,

BY I SSUER , ON

ON

S HORT -T ERM I NVESTMENTS

S HORT- T ERM I NVESTMENTS

BY

M ATURITY

AND

T YPE

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CHAPTER

27

PLANNING AND CONTROL OF RECEIVABLES 27.1

INTRODUCTION 559

27.5

27.2

GRANTING CREDIT TO CUSTOMERS 559

MEASUREMENT OF ACCOUNTS RECEIVABLE 564

27.6

27.3

CUSTOMER MARGIN ANALYSIS 561

CONTROL OVER ACCOUNTS RECEIVABLE 566

27.7

27.4

COLLECTIONS TASK 562

BUDGETING FOR ACCOUNTS RECEIVABLE BALANCES 568

27.1 INTRODUCTION The typical goals of the accounts receivable area are to keep the receivable amount as low as possible, in order to reduce working capital needs, while reducing bad debts to a very low level. Unfortunately, a controller may also be subjected to the opposing pressure of granting very high credit levels to customers in order to spur revenue growth, which inevitably leads to high levels of accounts receivable and larger amounts of bad debt. Although it is not possible to fully reconcile these conﬂicting goals and instructions, this chapter describes a number of methods for setting up rational systems for granting credit, analyzing customers, and collecting funds from them. In addition, a number of control methods for ensuring that established credit levels are strictly followed are discussed, as well as how to predict the investment in accounts receivable for budgeting purposes. In short, this chapter describes how to control accounts receivable and predict receivable levels.

27.2 GRANTING CREDIT TO CUSTOMERS When reducing the amount of accounts receivable outstanding, it is best to view the collections process as a funnel. The collections person is dealing with a continuous stream of poor credit risks that are emerging from a funnel full of accounts receivable. Going into the other end of the funnel are sales to customers; unless those sales are ﬁltered somehow, there will be an unending stream of potential bad debt problems. Clearly, then, the best way to avoid collection problems is to pay strict attention to the process of granting credit to customers before the company ever sells them anything. This section discusses the issues related to the important process of granting credit to customers. First of all, why grant credit to a customer? Some companies insist on cash payments, but they ﬁnd that this limits the number of customers who are willing to deal with them. Thus, granting credit widens the range of potential customers. Another reason is that many customers view credit terms as part of the price of the product, and may pay more for a product if a company is willing to grant generous credit terms. Yet another reason is that some industries have a customary number of payment days, and a company will be viewed as “playing hardball” if it demands cash payments at the time of delivery. Consequently, there are a variety of good reasons to grant credit to customers. 559

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However, there are a number of pitfalls that a company must be mindful of when granting credit. Some are so important that a company can be dragged into bankruptcy if it does not closely monitor the process. One danger is of granting too much credit to customers, because this may seriously reduce the amount of available working capital that a company has available for other purposes. Another danger is that improper review of customer ﬁnancial statements or payment history may result in the extension of credit that results in large bad debts. Either problem can reduce a company’s available credit to the point where it cannot issue credit to good customers who deserve to have the credit, resulting in a loss of business. Consequently, a company must maintain tight control over the credit granting process, so that just enough credit is issued to encourage business with a company’s best customers, without going so far as to enhance sales by issuing excessive amounts of credit to customers with poor credit histories. It is difﬁcult to balance the pros and cons of granting credit, since granting an excessive amount of credit will tie up valuable working capital, while a restriction on credit will turn away potential sales. The balance between these two offsetting factors is usually inﬂuenced by the overall corporate strategy. For example, if there is a strong drive in the direction of increasing company proﬁts, it is likely that management will clamp down on the amount of credit granted, since management does not want to incur any extra expense for bad debts. Alternatively, an aggressive management team that wants to increase revenues and market share will probably loosen the credit granting policy to bring in more sales, even though there is a greater risk of increasing the level of bad debt. In either case, the controller or treasurer will be on the receiving end of an order from top management regarding the level of credit to be granted. This is not an area in which middle management is given much say in the type of credit policy that a company will follow. Within the strictures of a company’s established credit policy, there are many steps that a controller can take to ensure that credit is granted in a reliable and consistent manner, and that the policy is strictly followed. The focus of a company’s credit granting policy is in the areas of customer investigation, credit granting, and subsequent control: • Investigate the customer. The easiest and most thorough source of information about a customer is the credit report. The premier issuer of this information is Dun & Bradstreet, which provides phone or computer access to credit report information, so that a credit report can be in the requester’s hands a minute after making the request. Other sources of information are trade references, though these tend to be biased in favor of the customer, since most customers will always be sure to make timely payments to their trade references. A limited amount of information can also be gleaned from a customer’s bank, but this is rarely sufﬁcient information on which to make a credit decision. There may also be detailed ﬁnancial reports available from the Securities and Exchange Commission (SEC) if a company is publicly held, but even this excellent source can be rendered invalid if a company is only dealing with a subsidiary of a publicly held company, since the ﬁnancial results of the subsidiary will not be broken out in the ﬁnancial reports. • Grant credit. Once there is a sufﬁcient amount of ﬁnancial information about a customer, one must determine the amount of credit to give to the customer. This should be a consistent methodology; otherwise, there will be great variations in the amounts of credit granted to customers. Also, a wide range of credit amounts will make salespeople think that credit levels are highly negotiable, so they will attempt to sway the person granting credit to increase the amounts of credit given to their customers. The best approach is to come up with a formula that can be applied consistently to all customers. Though the exact method devised will vary by industry, a simple method is to use the median credit level granted by a customer’s other suppliers, as noted in the credit report, and then reduce this amount by a standard percentage for every day that the customer is late in making payments to its other suppliers. For example, a customer who receives a median amount of $100,000 in credit from its suppliers, and who pays them ten days late, will receive a total credit amount of $50,000 if the controller decides to apply a 5 percent penalty to each day that a customer is late in making pay-

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ments; this approach assumes that there is a direct correlation between a customer’s ability to pay on time and the risk that the customer will default on its payments. • Control subsequent credit transactions. The amount of credit granted will not matter if a company makes a habit of ignoring the established credit limit. This matter is discussed more fully in the Control over Accounts Receivable section later in this chapter; the key point is that there should be an automated check in the order entry system that automatically halts any new customer order that results in a level of credit that exceeds the preestablished limit that is already recorded in the system. If the level of automation is not sufﬁcient to allow this method, a controller can authorize a continuing internal audit of credit levels to ensure that they are not being deliberately or inadvertently avoided by the order entry staff. Either approach ensures that credit levels, once established, will be maintained. A key issue in the credit granting process is when the credit investigation is performed. If a company ﬁnds customers ﬁrst and then asks the controller or treasurer to grant credit, it is common for the salespeople who worked hard to bring in the new customers to lobby equally hard on the customers’ behalf to give them the largest possible amount of credit. This gives the salesperson the best chance of earning a large commission, which can come only from a large amount of sales volume. Granting credit after a sale is made makes the credit granting job an intense one, because there is great pressure from the sales staff to grant credit, which is especially difﬁcult if the credit investigation reveals that a customer is a poor risk. A better approach is to implement some sales planning with the sales staff in advance, so that there is a target list of customers that the sales staff is asked to contact for orders. Using this approach, the controller can investigate potential customers in advance and advise the sales staff to avoid certain ones if their credit histories are poor. By using advance credit checks, a controller can avoid requests for excessive levels of credit by the sales staff. While there is a need to grant credit to customers, one should note the pitfalls of extending too much credit. A methodical company will position credit investigations before new customer contacts, in order to avoid wasted efforts by the sales staff in contacting poor credit risks.

27.3 CUSTOMER MARGIN ANALYSIS Although a formula can be used to grant credit to customers, there will be times when a customer or a salesperson calls to ask for more credit. If an excessive amount of credit is granted and then the customer defaults, the controller may have some explaining to do to a company ofﬁcer or owner. However, there are some cases where a customer is so important to a company’s survival that it is nearly mandatory to give the customer an inordinate amount of credit. How is a controller to make a judgment call regarding when to grant additional credit and when to turn it down? The answer is to use a customer margin analysis. As shown in Exhibit 27.1, a margin analysis is really a matrix that divides up customers into various categories based on the margins and volume that a company experiences with each one. Using the example, if a customer with both low margins and sales volume calls to demand an increase in credit, the controller’s best response may be to chuckle warmly and hang up the phone—adding credit to a customer who yields minimal proﬁts is simply making a bad situation worse. Alternatively, a request to increase credit for any customer with high margins should be looked at very seriously, since there will be a major increase in company proﬁts if sales to this customer increase. Finally, credit to customers with low margins and high revenue volume may require scaling back to a lower level, since there is no reason to support sales volume on which there is no return. Thus, the credit granting decision should be strongly driven by the margins and sales volumes of each customer. It is important to factor customer margins and sales volumes into the decision to grant credit; however, a controller should always keep in mind a customer’s ability to pay down the credit—after all, making lots of money on a customer will not last if the high margins are offset by bad debts.

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Ch. 27 Planning and Control of Receivables

E XHIBIT 27.1

C USTOMER M ARGIN M ATRIX

27.4 COLLECTIONS TASK This section discusses a variety of ways to bring in accounts receivable as soon as possible, resulting in reduced working capital requirements and less risk of accounts becoming signiﬁcantly overdue. The methods for enhancing collections fall into several categories. The ﬁrst is collection techniques, which describes ways to bring in payments on existing debts. The second is altered payment methods, which looks at accelerating the speed with which payments travel from a customer to the accounting department. The ﬁnal method is shrinking the entire billing and collection cycle, which focuses on ways to reduce the time needed to process orders, issue credit, generate invoices, and other matters. The methods are outlined in greater detail as: 1. Collection techniques. This section covers several ways to enhance the efﬁciency and effectiveness of the collections staff in bringing in accounts receivable payments on time. The methods are: (a) Involve the sales staff. The people with the best customer contacts are the sales staff. They can frequently collect on accounts receivable that the collections staff cannot, because the salesperson can contact a different person within the customer’s organization who can order an immediate payment that is otherwise frozen in the accounts payable area. This method is especially effective when the sales staff’s commissions are tied to cash received, rather than sales, so that the sales personnel have a major interest in resolving any collection problems. (b) Create a relationship. It is much easier to collect money from someone you know. The best way to build up this kind of relationship is to take a few extra moments on the phone to chat with the customer’s accounts payable person; by creating even such

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a minor relationship as this, the collections person has a much greater chance of obtaining money from the customer. The relationship can be enhanced by carefully avoiding any confrontations or heated discussions, actions which are common for an inexperienced collections person to make. (c) Follow overdue accounts closely. A customer who is deliberately delaying payments will be much more inclined to make payments to a company that is consistently persistent in calling about overdue accounts, since it is easier to pay these companies at the expense of other companies that are conveniently not calling to inquire about their accounts. It is especially effective to tell a customer when to expect a follow-up call, and then make that call on the predicted day, which reinforces in the customer’s mind the perception that the collections person is not going away, and will continue to make inquiries until the debt is paid. (d) Use leverage. When there is no response from making a multitude of calls and other forms of contact with a customer regarding a payment, it is time to kick the issue upstairs to the controller, or even higher in the organization. When a customer’s accounts payable person is not responding, it is quite possible that a different response can be obtained when the controller contacts his or her counterpart, since there may be a better relationship at that level. In some cases, though usually only for the largest debts, the two presidents may need to correspond. If none of these approaches work, a different kind of leverage may be necessary—cutting off service or shipments until payment is made. However, this approach must be used with care, since such a cutoff may have a drastic effect on customer relations. (e) Create a contact log. All of the previously cited collection methods can be made more effective by using a contact log. This is a simple device that lists the last date on which contact was made, and the next date on which action is required. A collections person can then ﬂip through the log each day to see what actions are needed. It is helpful to include the most recent accounts receivable aging in the log, for easy reference when talking to customers. 2. Altered payment methods. Besides jawboning customers to pay on time, it may be possible to alter the underlying method used to make payments, which can greatly reduce the time required to make collections. Any of the following approaches should be considered to alter the payment method. (a) Lockbox. This is a post ofﬁce box that is opened in a company’s name, but accessed and serviced by a remittance processor, which is normally a bank. By having a bank open mail containing checks and deposit these funds directly into a company’s account, it is possible to reduce the time interval before the money would have been deposited by other means. In addition, lockboxes can be set up close to customers, so that there is a minimal mail ﬂoat time. This also reduces the time before a company must wait to receive payment. (b) Wire transfer. This is a set of telegraphic messages between banks, usually through a Federal Reserve bank, whereby the sending bank instructs the Federal Reserve bank to charge the account of the sending bank and credit the account of the receiving bank. (c) Automated clearinghouse (ACH) transfer. This method allows banks to exchange electronic payments. Usually, the customer initiates a payment directly to the company’s bank account. (d) Depository transfer check (DTC). Under this approach, a bank prepares a DTC on behalf of its customer against the customer’s deposit account at another bank. It is a means for rapidly shifting funds from deposit accounts into concentration accounts from which investments can be made.

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(e) Preauthorized draft (PAD). This is a draft drawn by the company against the bank account of the customer. The method is most commonly used by insurance companies or other lenders where the payment is ﬁxed and repetitive. 3. Shrink the cycle. Besides altering collection methods and changing the type of customer payment, there are many other ways to shrink the cycle that begins with issuing an invoice to a customer and ends with the collection of cash. This last category is a catchall of ways to reduce the time required to complete the entire process. The shrinking methods are: (a) Accelerate billing frequency. If a company only issues invoices once a week, some billings will sit in a pile until the end of the week, when they could have been on their way to a customer much sooner. Daily invoicing should be the rule. (b) Alter payment terms. Sometimes a customer will radically alter its payment timing if there is a large enough early payment discount placed in front of them. Usually, a 2 percent discount for early payment is a sufﬁcient enticement to bring in cash much earlier than was previously the case. However, such a large discount may have a major impact on proﬁts if margins are already low, or if customers were already paying relatively quickly, so it should only be offered to those customers who are extremely late in paying. Although this approach may seem like a reward to those customers who are late in paying, it only reﬂects the realities of the collection situation. (c) Reduce billing errors. One of the most important reasons why customers do not pay is that they disagree with the information on a company invoice. Accordingly, it is imperative that a controller systematically track down errors (which are most easily revealed through the collections process, when customers tell the collections staff about invoicing errors) and ﬁx them as soon as possible. A common mistake is sending an invoice to the wrong address or contact person, while others are to incorrectly price a product or to bill for the wrong product or service, either in type or quantity. There are usually a number of problems to be ﬁxed before all errors are corrected. Even then, careful watch must be maintained over the invoicing process to ensure that errors are kept out. (d) Use electronic billings. Rather than sending a paper invoice, it is possible to use an electronic one, which has the advantage of avoiding the time required to move through the postal system. In addition, such a transmission can be automatically processed by a customer’s computer system without ever being punched in again by a data entry clerk, so there are fewer chances of an error occurring on the customer’s side when paying the invoice. An electronic billing is usually sent by electronic data interchange (EDI), which requires a considerable amount of advance preparation by a company and its customers to set up; because of the advance work required, it is generally best to only use this method with long-term customers with whom a company has a signiﬁcant volume of business. Although a major portion of collecting accounts receivable is contacting customers to request payment, a variety of other techniques have a major impact on the speed with which payments are collected. These techniques include using early payment discounts, electronic invoice delivery, and lockboxes. It takes a complete implementation of all these methods before a company will experience a signiﬁcant decline in the amount of its outstanding accounts receivable.

27.5 MEASUREMENT OF ACCOUNTS RECEIVABLE A controller may feel that, by making many collection improvements, the investment in accounts receivable is being reduced; however, it is impossible to be sure without using several performance measurements. Not all of the measures described in this section need to be implemented, but a

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controller should use a selection of them to gain a clear picture of the state of a company’s accounts receivable. The measurements are: • Accounts receivable turnover ratio. The simplest and one of the most effective ways to see if there are problems with accounts receivable is the turnover ratio. This measure illustrates how rapidly accounts receivable are being converted into cash. To calculate the measure, divide net sales by accounts receivable. For example, if the turnover ratio is 12, then accounts receivable are being collected after precisely one month. If turns are only six, then accounts receivable are going uncollected for two months, and so on. To gain a better idea of ongoing performance, it is best to track the turnover measure with a trend line. • Days old when discount taken. When a customer takes a discount for early payment, it is understood that the payment will be made within the previously agreed-upon guidelines, such as taking a discount only if payment is made within a certain number of days. This measure is designed to spot those customers who take the discount, but who stretch the payment out beyond the standard number of terms. To calculate the measure, one must write a program for the accounting software that lists the date of each invoice paid and the date when cash was applied against the invoice. The difference between these two dates, especially when grouped by customer, will be a good indicator of any ongoing problems with late payments on discount deals. • Days’ sales outstanding. A common measure that may be swapped with the accounts receivable turnover measure is days’ sales outstanding (DSO). This measure converts the amount of open accounts receivable to a ﬁgure that shows the average number of days that accounts are going unpaid. The measure is used somewhat more frequently than turnover, since the number of days outstanding is considered to be somewhat more understandable. To measure it, divide the average accounts receivable by annual credit sales, and multiply by 365. To determine if DSO is reasonable, compare it to the standard payment terms. For example, a DSO of 40 is good if standard terms are 30 days to pay, whereas it is poor if standard terms are only 10 days. If collections are well managed, the DSO should be no more than one third beyond the terms of sale. For a more precise view of the collection operations, the DSO can be calculated for each customer. • Percent of bad debt losses. It is necessary to track the proportion of sales that are written off as bad debts, because a high percentage is a strong indicator of either lax collection practices or an excessively lenient credit granting policy. To calculate the measure, divide the bad debt amount for the month by credit sales. An alternative measure may be to divide the bad debt by sales from several months ago, on the theory that the bad debts were more speciﬁcally related to sales in a previous time period. • Percent of unexplained credits taken. Some customers take credits on a whim, resulting in considerable write-offs for which there is no explanation. If this comes to a reasonable percentage of sales to a customer, that customer should be terminated, since it is cutting into company margins. Researching the credits also requires a large proportion of accounting staff time. To calculate the measure, track all invoices that are not completely paid and divide by sales to customers; this measure should be completed on a customer-by-customer basis to gain a better understanding of which customers are causing the problem. • Reasons for bad debt write-offs. A less common measure is to manually accumulate the reasons why sales are written off as bad debts, and to summarize total bad debts by these explanations. One can then sort the reasons by declining dollar volume to see what problems are arising most frequently, which can lead to steps to ﬁx various credit granting or collection problems. It is also worthwhile to accumulate bad debt information by customer, to see which ones are responsible for the largest number of write-offs. The measurements discussed in this section are useful for determining how rapidly accounts receivable are collected, as well as the size of and reasons for bad debts. Properly tracking these measures results in a ﬁne management tool for altering the methods used to collect accounts

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receivable, as well as the credit granting policy, resulting in faster receivable turnover and fewer bad debt losses.

27.6 CONTROL OVER ACCOUNTS RECEIVABLE This chapter is primarily concerned with the processes needed to grant credit and then collect it. However, an astute controller must be sure that these processes are operational, or else incorrect credit levels will be granted, and collections will not occur as expected. Proper controls are required to ensure that processes function as planned. This section discusses the key controls that one should install to make sure that the accounts receivable function produces results that are within expectations. This section is divided into two parts: controls over the credit granting process, and controls over collections. The ﬁrst part, credit granting, involves controls over the timing of credit processing, ongoing customer monitoring, excess credit, and process reviews: • Control the timing of granting credit. One of the largest problems with granting credit is that it is always a rush—a salesperson runs in with a new customer order and demands an immediate credit check, so that the order can be accepted and the salesperson can earn a commission. Unfortunately, the compressed time period forces a controller to dispense with an appropriate number of credit checks, and may even result in granting credit with no review work at all. A good control over this process is to enforce the early identiﬁcation of sales prospects and the communication of this information to the accounting or treasury departments, so that a thorough credit review can be completed prior to the conclusion of a sale. • Monitor the ﬁnancial condition of customers. A customer may suffer ﬁnancial reverses and suddenly be unable to pay its bills. To avoid being caught with a large amount of outstanding credit in such situations, there should be a control that requires the credit granting staff to annually review the ﬁnancial condition of all customers with signiﬁcant credit lines; this information can come from either the customers or a credit reporting agency. Unfortunately, some companies suffer ﬁnancial reverses that are so sudden that an annual ﬁnancial review will not catch the decline; for these situations, there should be an additional control requiring ﬁnancial reviews for any customer who suddenly begins to stretch out payment dates on open invoices. This control results in rapid action to shrink credit balances where customers are clearly unable to pay. • Review excess credit taken. Some accounting systems allow customers to exceed the credit limits programmed into the accounting database. In such situations, the ofﬁcial credit level is essentially meaningless, since it is not observed. To avoid this problem, the controller should create and review a report that lists all customers who have exceeded their preset credit limits. A controller can then use this report to follow up with the order entry department to ensure that, in the future, credit limits are examined prior to accepting additional orders from customers. • Review the process. Many credit granting processes are excessively cumbersome, for a variety of reasons: They involve too many people, require input from too many sources, and need multiple approvals. The result is a long time period before credit levels are set, as well as too much cost invested in the process. To avoid this problem, there should be a periodic review, preferably by the internal auditing staff, that ﬂowcharts the entire credit granting process, makes recommendations to reduce its cost and cycle time, and which follows up to verify that recommendations have been implemented. An annual review of this type will ensure that the process is lean, as well as responsive to the needs of customers and other departments. Once there are a sufﬁcient number of controls over the credit granting process, one must still be concerned with a company’s ability to collect on credit that has been issued to customers. The controls that assist in this task include using the services of other departments, reviewing cycle time, and watching over bad debt approvals. The controls are:

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• Enroll other departments in the effort. The accounting staff cannot be completely successful in collecting money from customers unless it uses the efforts of other departments. A good control over this issue is to have the internal audit staff check on the collection team’s efforts to use other departments prior to writing off accounts receivable. For example, there should be an effort to capitalize on the services of the sales staff to collect from their customers (which can be made easier if the sales staff’s commissions are only paid when payment is received from customers), or to use other personal relationships, such as between the presidents of the company and the customer, to pay off a debt. • Look for special payment deals. Sometimes, it is difﬁcult to collect payment on an invoice, not because the collections staff is doing a poor job, but because the sales staff agreed to a special payment deal with the customer. Though it is occasionally necessary to agree to special deals, sometimes they happen without proper approvals from management. To detect such deals, there should be an occasional conﬁrmation process with customers, whereby the customers are asked to conﬁrm the payment terms of their invoices. Any disparity between the company’s payment terms and those recorded by the customer should be investigated. • Match invoices to the shipping log. Collection problems can arise when there are incorrect billings, such as when an invoice lists the wrong quantity of a shipped product. To maintain control over this issue, one can conduct a periodic comparison of the quantities noted on invoices to the quantities actually shipped, as noted in the shipping log. Since the amount billed is usually taken from a copy of the bill of lading (BOL), the BOL can also be compared to the bill and the shipping log to see where record inaccuracies are occurring. • Remove other accounts receivable for the receivable account. It is difﬁcult to gain a true understanding of the amount of overdue accounts receivable if the accounts receivable balance is skewed by the presence of miscellaneous items, such as amounts owed from company ofﬁcers or taxing authorities. It is best to strip these accounts out of any receivable turnover calculation, thereby arriving at a “pure” turnover ﬁgure that will reveal the need for additional collection activities. • Report on collection actions taken. It is difﬁcult to collect an account receivable unless there is a history of the efforts previously taken to bring in a payment. Such a record should include the name of the person contacted, the date when this happened, and the nature of the discussion. A good control here is to conduct a periodic review of the contact data for all overdue accounts receivable, and to require better recordkeeping where appropriate. • Report on receivable items by customer. The accounts receivable aging report is the single best control over the collections process, because it clearly shows any invoices that are overdue for payment. The report is sorted by invoice for each customer, and lists invoice amounts by category—current, 30 to 60 days old, 61 to 90 days old, and over 90 days old. By reviewing the totals for each customer, it is an easy matter to determine where the problem accounts and invoices are located, and where additional collection actions are needed. • Review billing frequency. One problem with collections is the time needed to issue an invoice to the customer. A lazy billing person may wait several days or even a week between issuing invoices, which can seriously delay the time before customers will return payments for them. To detect this problem, there should be a continuing audit of the billing process that compares the date on which invoices were created to the date when products actually shipped. Any large disparity between these two dates should be investigated. • Review credits taken. A common problem is that someone in the accounting department “cleans up” the accounts receivable aging by processing a number of credits that write off old accounts. This practice is ﬁne if there is a proper approval process for the credits, but is otherwise only a lazy way to get rid of old accounts without any real effort to collect them. The best way to control this practice is to conduct a periodic review of all credits taken, and to verify that each one was approved by an authorized manager. To save time, it may make sense to allow credits on small balances without any associated approval.

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Ch. 27 Planning and Control of Receivables

• Segregate the accounts receivable and cash receipts functions. When the person who collects cash and applies it to accounts receivable records is the same one who creates invoices, there may be a temptation to keep some of the cash and alter the receivable records with false credits to hide the missing money. The best way to control this potential problem is to split the two functions among different people, so that the problem can only arise if there is collusion between multiple personnel, which is a much less likely occurrence. • Verify pricing. Customers may not want to pay for invoices if the per-unit prices charged to them are incorrect. To control this problem, it is useful to occasionally compare the prices listed on invoices to the ofﬁcial company price list. Any pricing problems require immediate follow-up, as well as rebilling customers if the prices charged to them were incorrect. There are many controls that can be installed to ensure that the credit granting and collection tasks operate as planned. This is an area in which the best intentions for setting up a quality system are not good enough. There must also be a set of ﬁrmly enforced controls that are regularly reviewed and enforced, so that credit is granted only after a reasonable amount of review and collection efforts are made in a timely manner, resulting in the minimal amount of bad debt.

27.7 BUDGETING FOR ACCOUNTS RECEIVABLE BALANCES The planning function of the controller as related to accounts receivable largely has to do with the preparation of the annual business plan, and perhaps plans for a shorter time span. Working closely with the treasurer and/or credit manager, the controller’s responsibilities include: • Determining, within suitable interim time periods, the amount to be invested in accounts receivable for the planning horizon—the accounts receivable budget. Typically this is the month-end balance for each month of annual plan. • Testing the receivable balances to determine that the planned turnover rate or daily investment is acceptable or within the standard. • Based on past experience, or other criteria, estimating the amount required for a reasonable reserve for doubtful accounts. • Consolidating the accounts receivable budget with other related budgets to determine that the entity has adequate funds to meet the needed receivables investment. The determination of the monthly investment in accounts receivable would produce a plan for the next business year substantially similar to that shown in Exhibit 27.2. Additions to the monthly customer accounts receivable balance would be based on the sales plan. Collections would be determined as described in the preceding chapter on cash planning. Essentially the same “entries” would be made using the estimated data as are made for the actual monthly activity. The same process used in calculating the receivables balance for the annual plan may be used for the long-range plan, although only annual (not monthly) estimates need be used. Computer software programs are available to determine the receivable balance and to age the accounts. While the illustration reﬂects the customer accounts receivable activity, a comparable procedure would be used to estimate the “other miscellaneous receivable” balances for such typically small transactions as: • Amounts due from ofﬁcers and employees • Claims receivable • Accounts receivable—special transactions • Notes receivable—miscellaneous

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569

T HE J OHNSTON C OMPANY C USTOMER A CCOUNTS R ECEIVABLE B UDGET F OR T HE Y EAR E NDING D ECEMBER 31, 20XX (D OLLARS IN T HOUSANDS ) Month

Beginning Balance

January

Sales

Cash Collections

Adjustments Dr. (Cr.)

Ending Balance

$

$

$ 15,620

$ 10,340

—

$ 16,200

February

16,200

11,110

9,890

—

17,420

March

17,420

12,370

10,100

(80)

19,610

April

19,610

11,480

11,200

—

19,890

May

19,890

10,270

12,430

—

17,730

June

17,730

9,420

10,300

(60)

16,790

July

16,790

9,240

9,850

—

16,180

August

16,180

9,450

9,610

—

16,020

September

16,020

9,140

9,330

—

15,830

October

15,830

9,090

9,180

—

15,740

November

15,740

9,860

9,010

(110)

16,480

December

16,480

10,430

9,720

(120)

17,070

$ 15,620

$ 122,200

$ 120,380

Total or balance

9,760

* Represents accounts written off.

E XHIBIT 27.2

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P LANNED I NVESTMENT

IN

A CCOUNTS R ECEIVABLES

$ (370)*

$ 17,070

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CHAPTER

28

PLANNING AND CONTROL OF INVENTORIES 28.1

INTRODUCTION 571

28.2

COSTS AND BENEFITS OF CARRYING INVENTORY 571

28.3

ROLE OF THE CONTROLLER 573

28.4

MATERIAL REQUIREMENTS PLANNING SYSTEMS 575

28.5

JIT (a) (b) (c)

MANUFACTURING SYSTEMS 576 JIT Purchasing 577 JIT Delivery 578 JIT Manufacturing 578

28.6

INVENTORY REORDERING SYSTEMS 580

28.7

OBSOLETE INVENTORY 581

28.8

REDUCING INVENTORY 583

28.9

INVENTORY CUTOFF 584

28.10 BUDGETING FOR RAW MATERIALS 585 (a) Budgeting Individual Items of Material 585 (b) Budget Based on Production Factors 586 (c) Materials Purchasing Budget Illustrated 586 28.11 BUDGETING FOR WORK-IN-PROCESS 590 28.12 BUDGETING FOR FINISHED GOODS 591 (a) Budgeting Finished Goods by Individual Items 591 (b) Budgeting Total Finished Quantities and Values 591

28.1 INTRODUCTION A controller who is not familiar with the intricacies of inventory management may have a difﬁcult time determining whether a company has an inventory problem at all, the nature of the problem, and how to ﬁx it. This chapter solves these problems by describing all key aspects of inventory that a controller should be concerned with, including the costs and beneﬁts of having inventory on hand; the various materials management systems and how they impact inventory; types of reordering methodologies; the impact of obsolete inventory on overall valuations, accuracy, and turnover; and how to budget for projected inventories in future periods. Only a thorough grounding in all of these areas will allow a controller to master the art of keeping inventory levels to a minimum without upsetting a company’s customer service levels or its ability to produce to a predetermined production schedule.

28.2 COSTS AND BENEFITS OF CARRYING INVENTORY This chapter deals with a wide range of issues dealing with inventory, to an extent that is greater than in other chapters dealing with other parts of the balance sheet. Why the hoopla? This section notes the many critical factors surrounding inventory, all of which a controller should keep in mind before making a decision that will change the mix or amount of inventory kept on hand. First, what are the beneﬁts of keeping inventory on hand? One is that it covers up mistakes in the production area. For example, if the production process is damaging parts that are being assembled, it makes sense to keep a supply of extra parts on hand to ﬁll in for any shortfalls caused 571

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Ch. 28 Planning and Control of Inventories

by damage to parts. Similarly, it is useful to keep inventory on hand if the supply of parts from suppliers is questionable, which is a common occurrence if a supplier has a track record of not delivering on time or in the expected quantities. Of course, it is also possible to solve the root problem in both cases and ﬁx the reason for damage to parts or replace a supplier. However, these options may require a considerable amount of time; in the meantime, it is useful to keep inventory on hand to cover any problems that may arise. Another reason for keeping a healthy level of inventory on hand is to meet the demands of customers. In particular, if there is a seasonal demand for a company’s products, it makes sense to keep a considerable quantity on hand for those periods when regular production capacity cannot keep up with surging demand. It may also be necessary to keep extra quantities available if demand is not predictable and ﬂuctuates broadly. In these cases, it is difﬁcult to shave inventory levels to reduce working capital requirements, because there is a risk of losing sales. These are good reasons for keeping inventory in stock; however, there are powerful reasons for keeping inventory levels down as much as possible. Even though it is not always mandatory to adhere to the following reasons for reducing inventory, a controller should at least pay close attention to them before approving of a change in inventory strategy that will lead to more on-hand quantities. The following reasons for not keeping inventory on hand are all related to cost: • Building cost. Most forms of inventory must be stored indoors, so one must factor in the cost of either owning or leasing building space, which includes building maintenance, utilities, and taxes. • Carrying cost. When inventory is purchased, a company must expend working capital, which is not free. The best way to determine the cost of working capital is to assume that the money could otherwise have been invested or used to pay off debt, so the interest cost of doing so is the cost of carrying inventory. • Change control cost. Of particular concern to a company that undergoes frequent product redesigns is the cost of moving from old to new component parts. When this happens, there must be a clearly deﬁned breaking point when the new part is used, resulting in the immediate obsolescence of the old part. If a company wants to avoid this type of obsolescence, it must carefully track inventory levels and switch to new parts only when inventory levels of old parts are at a low point. However, this type of close management requires additional staff time. No matter how the issue is handled, change control when inventory is present is expensive. • Counting cost. Most companies still conduct a year-end inventory count, while others prefer ongoing cycle counts to ensure record accuracy. In either case, there is a cost associated with paying employees to count the inventory, which can be exacerbated by sometimes having to shut down the production facility in order to ensure an accurate count. • Damage cost. The problem with having piles of inventory is that one must move it around a lot in order to get at the inventory that is currently needed; when doing so, it is easy to damage inventory. In addition, every time something is moved in or out of the inventory, there is a risk that it will be damaged. The greater the number of moves, the greater the risk of damage. • Handling cost. Moving inventory requires a staff to do the moving. If there is a large amount of inventory, there must be a large staff to do the moving, frequently armed with forklifts or similar equipment to assist the moves. A large warehouse staff adds no value to the product, and consequently is nothing more than a wasteful addition to overhead costs. • Insurance cost. There is a risk that inventory can be destroyed, so there should be an insurance policy that covers damage to it. Though the cost of this policy can be reduced by increasing the deductible, the deductible becomes a cost in the event of an insurance claim. • Obsolescence cost. Inventory may become unusable over time, which is a considerable risk when there is a large amount of inventory on hand, and especially if a company is in an industry with high product change rates, such as the personal computer industry. In these

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cases, a large proportion of inventory may have to be thrown away or disposed of at a substantial discount. • Pilferage cost. If there is inventory, someone may want to steal it, especially if it is a consumer article that is readily used by employees, or an extremely valuable item that can be easily converted into cash, such as consumer electronics or computer parts. By reducing the amount of inventory, there is less need to incur expenses to guard it, while there is also proportionally less inventory available to be stolen. • Racking cost. Most forms of inventory do not just sit in piles on the warehouse ﬂoor. Instead, they are stored in an orderly manner in storage racks, which can be exceedingly expensive, especially if they must be strong enough to support a large amount of storage weight. The above list shows that the costs associated with inventory add up to a substantial amount, so much that a controller must hesitate to support any kind of increase in the amount of inventory kept on hand. Yet, there are good reasons for keeping inventory in speciﬁc situations. How does one reconcile these issues? The best solution is to keep inventory only until systems can be ﬁxed that allow a company to reduce the need for the inventory. System changes that will allow this include switching to a just-in-time (JIT) manufacturing system, using express delivery to avoid storage fees, and using drop shipping straight from suppliers to customers to avoid any in-transit storage by the company. In short, inventory is needed by most companies in the short term, but there may be options over the long term that will allow the amount of inventory to be reduced or even eliminated.

28.3 ROLE OF THE CONTROLLER One of the underlying functions of a controller is to report on the operations of other departments. Due to this staff function, a controller usually does not take direct responsibility for the operations of the materials management function, but rather reports on its operation by a line manager. This section notes the variety of tasks in which a controller can be involved that relate directly to inventory. The tasks are outlined as: 1. Create overall inventory policy. Though the controller must create policy in concert with other members of the management team, he or she has an opportunity to forcefully state the advantages of keeping inventory levels as low as possible, thereby reducing the risk of inventory obsolescence, scrap costs, warehousing costs, and the size of a company’s investment in working capital. 2. Verify that inventory records are accurate. A large part of the typical company’s assets reside in the warehouse. A controller must verify that the inventory listed in a company’s general ledger is actually stored in the warehouse. All of the following inventory information is subject to audit: (a) Overall accuracy. To audit overall inventory accuracy, one must print an inventory report that sorts inventory by location, and compare a sample of items from the report to the actual inventory. However, there may be inventory that does not show up on the report at all, and will therefore never be counted, so one must also pick a number of items at random from the inventory and trace them back to the database. The total number of errors resulting from this audit can then be divided by the total number of items inspected to determine the percentage of inaccuracy for the inventory. (b) High-dollar accuracy. A small inaccuracy in the amount of the most expensive inventory can have a major impact of proﬁts, so a separate audit can review the accuracy of a large proportion of the high-dollar items in stock. This can even be an audit of virtually all high-dollar items. (c) No locations. Despite the most extensive searches, it is probable that there will be inventory that cannot be located. If so, the controller should regularly review a report

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Ch. 28 Planning and Control of Inventories

that lists all inventory in the database for which a location code has not been assigned and determine the company’s monetary exposure if that inventory does not exist. (d) Low usage. Low usage parts take up valuable warehouse space, and should probably be disposed of rather than kept on hand. A controller can easily determine the amount of low usage items simply by printing a list of inventory for which there has been no or low activity for a prespeciﬁed number of months. (e) Unusual costs. Most controllers tend to focus an excessive amount of energy on achieving perfect quantity accuracy, to the detriment of achieving equal levels of cost accuracy. One can avoid this difﬁculty by reviewing inventory reports that list the lowest and highest dollar unit costs in the inventory. Such reviews can spot items that have incorrect costs, resulting in massively high or low inventory values. This is a common problem when a part is assigned a cost based on a speciﬁc unit of measure, but someone changes the unit of measure, resulting in a vastly different cost. For example, a roll of tape may have a cost in the database that is based on the number of rolls of tape, but the engineering department then changes the unit of measure to inches, so that it can more easily enter tape amounts into bills of material. The result is an inventory value that is several thousand times higher than it really should be. 3. Audit inventory controls. A controller must ensure that all current inventory controls operate in their intended manner, which helps to keep inventory quantities from diverging from their intended levels. This function can also be performed by a company’s internal audit department, assuming that it is large enough to have one. 4. Install control points. A controller has a considerable amount of knowledge regarding how to create controls for a variety of systems and situations; this knowledge should be turned toward creating controls that will ensure that inventory is only used for its intended purpose, and not scrapped or diverted for other purposes. These controls should also make it extremely difﬁcult for anyone to illicitly remove inventory from the company. 5. Supervise the annual physical inventory count. If the perpetual inventory system is not accurate, the controller must conduct a physical inventory count, which involves setting up counting procedures and supervising the counting teams that check all inventory quantities. 6. Report on inventory costs. A controller’s prime responsibility is to ensure that the reported cost of inventory is accurate. If it is not, the amount of the cost of goods sold will be inaccurate, which can lead to major inaccuracies in a company’s reported levels of proﬁt. 7. Know how inventory management systems work. A controller must know how a company’s inventory management systems operate, because the type of system used has a direct impact on the control systems needed, as well as the inventory levels needed to feed a company’s production systems. 8. Measure warehouse functions. The results of any audits of the inventory should be posted in a place where the warehouse staff can see them. The measurements should include the overall accuracy of the inventory, the accuracy of high-dollar items, the total number of items in stock and their total cost (in case there is a push to reduce the overall amount of inventory), and also the percentage of jobs that were fully kitted on time (which is used only if the warehouse is supplying a job shop production operation). These measures give the warehouse staff a complete knowledge of the most important operating results of the warehouse. 9. Create inventory management policies and procedures. (a) Low-cost, high-usage items policy. All high-usage, low-cost items shall be removed from the inventory database and maintained in bulk on the production ﬂoor, using visual reorder systems. Exceptions must be approved by management. (b) Inventory accuracy policy. Whatever actions necessary shall be taken to ensure that inventory accuracy is maintained at a level of at least 95%, with a level of 98% for high-dollar items.

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575

(c) Measurement policy. The controller shall provide warehouse performance and status measurements to the warehouse staff on a weekly basis. (d) Purchase quantity policy. Items shall be purchased only for immediate production needs. Blanket purchase orders shall be used whenever possible to assist in reducing the paperwork requirements of this policy. (e) Obsolescence review policy. The materials review board shall review the inventory database for obsolete items no less than once a week. All items that have not been used within the last 12 months shall be disposed of, unless approved by management. (f) Inventory disposition procedure. All items that have not been used in the last 12 months shall be considered obsolete. Of this group, all items with an extended cost of $50 or less shall be thrown out or donated, with no approval required. If the extended cost is between $50 and $500, the purchasing department shall ﬁrst attempt to return it to a supplier, after which it may be thrown out or donated with no additional approval. Items with an extended cost exceeding $500 shall be disposed of only with the prior approval of the vice president of materials management. Given the length and breadth of the discussion in this section, it is obvious that a controller can take a very large role in the management control and review of inventory. This sort of activity is normally welcomed by personnel in the materials management function, because the upshot of these activities is better control over inventory, which leads to reduced time by the materials management staff in looking for missing parts, making rush orders, and other unnecessary activities.

28.4 MATERIAL REQUIREMENTS PLANNING SYSTEMS As noted in Section 28.3, a controller should be well grounded in materials management techniques, in order to know how to make recommendations to improve inventory tracking systems, as well as how to reduce inventory levels to save working capital and other costs. This section provides a brief overview of the most common materials management system, which is material requirements planning, or MRP. There are two types of MRP. One is material requirements planning, and the other is manufacturing resource planning (MRP II). The ﬁrst variety is concerned solely with inventory management, whereas MRP II is a more sophisticated version that also controls direct labor and machine usage. We will conﬁne this discussion to MRP, since it is concerned only with the primary focus of this chapter—inventory. Material requirements planning uses several key databases in the manufacturing system to predict when inventory is needed for the production process. Its purpose is to form an orderly ﬂow of parts to the production department, thereby ensuring that there will be no production stoppages due to parts shortages. When properly used, it can also keep inventory levels down, so that the working capital investment in inventory is minimized. An MRP system works with three databases. The ﬁrst is the production schedule. It takes the quantities and due dates on the production schedule for each product and multiplies it by the second database, which is the bill of materials for each product. The result is a list showing the quantities of parts needed for production, as well as their due dates. The system then compares the parts list to the on-hand inventory, to determine which parts are already in stock. Any parts that are not currently in stock or on order are then ordered, which can be done either manually or automatically by the MRP system, with the option of a manual review by the purchasing department. A ﬁnal feature is that the purchase dates are based on the purchasing lead times required by each supplier, so that amounts ordered will arrive just when needed. In short, an MRP system combines the most common production databases to achieve timely delivery of a sufﬁcient number of parts to complete the production schedule. A controller should be aware of the various advantages and disadvantages of using an MRP system. One problem is that it is highly dependent on a large amount of computing power; the system must recalculate the purchasing schedule at least once a week, which can take many hours of processing time, even with today’s super-fast computers. Another issue is that the system’s results

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Ch. 28 Planning and Control of Inventories

will be incorrect if the underlying databases contain incorrect data. For example, incorrect information in the bill of materials will result in parts overages or shortages on the production ﬂoor. Also, an MRP system allows for purchasing parts in economic order quantities, which means that not all parts ordered will be used at once. This opens the door to the possibility of having unused and obsolete inventory. However, MRP is an excellent way to gain control of a materials management process, ensuring reasonable inventory levels and the efﬁcient marshaling of resources to ensure that products are produced on time. By being aware of the inner workings of an MRP system, a controller can make recommendations to senior management regarding the need to have such a system, or to make modiﬁcations that will result in reduced inventory levels.

28.5 JIT MANUFACTURING SYSTEMS Though JIT manufacturing is widely praised in the press for its ability to streamline entire organizations, improve delivery times, and shrink inventory levels, surprisingly few companies use any of its elements, let alone the entire range of JIT applications. Perhaps a greater understanding of JIT is needed to spur its deployment. Accordingly, this section gives a brief overview of the components of JIT and the impact it can have on inventory levels. Many of the basic factors involved in good inventory management have been brieﬂy reviewed, but a key one yet to be discussed is the inventory and production system the management has chosen to use. None has drawn more attention recently than the just-in-time inventory system. The controllers may have little voice in which system is selected by the manufacturing executives. But they should be generally aware of the central philosophy—which basically is that all inventories are undesirable and should be eliminated or minimized—and the impact on purchasing and delivery systems, as well as the manufacturing system itself. Adopting the just-in-time system requires major changes in purchasing and manufacturing strategies. In purchasing, the JIT system requires the manufacturers to select a few reliable suppliers who deliver, when needed, dependable materials and component parts with zero defects. The JIT manufacturing function is characterized by smaller lot sizes than traditional manufacturing, ﬁxed production schedules for shorter periods, possible machine and process reconﬁguration, as well as automation and a more ﬂexible or multifunction workforce. The objective of a JIT system is to produce and deliver: • Finished goods just in time to be sold • Subassemblies just in time to be assembled into ﬁnished goods • Fabricated parts just in time to be made into subassemblies • Raw materials and purchased parts just in time to be converted to fabricated parts JIT has been described as a “pull” system of production control wherein the ﬁnal assembly line production schedule triggers the withdrawal of materials or required parts at the needed time from the work centers that precede them in the manufacturing process. Workers secure the right quantity of parts to complete an order. Sequentially, each work center supplies parts to the next manufacturing operation and then manufactures parts to replace them. Thus, there is no stockpiling of work-in-process to offset lead times or to meet safety stock levels or the economic order quantities of subsequent production functions. (See the later discussion.) The results of this system are: • Lower inventories and lower carrying costs • Reduced rework and scrap • Improved quality control • Shorter production time and lead time, which assists the next result • Increased productivity

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(a) JIT PURCHASING. A successful JIT system depends, in the ﬁrst instance, on a few reliable and dependable suppliers who maintain a very close buyer-vendor relationship. JIT manufacturers enter into long-term contracts with fewer suppliers. Moreover, the suppliers handle smaller lot sizes, and use statistical quality control techniques to improve the quality of their products (rather than after-the-fact inspection). The suppliers essentially become specialized makers to the manufacturers, with facilities close to the JIT manufacturer’s plant, so as to make easier delivery of their products; and they are involved with the manufacturer in the product design and manufacturing process from the very outset. The controller should be involved in the following special issues regarding JIT purchasing: 1. Target Costing. The controller must include projected product costs in the budgeting process. Under the JIT concept, there is more opportunity to inﬂuence product costs during the design process than later, in the manufacturing process. Thus, the controller should be involved in setting a target product cost and assigning targeted subsidiary part costs to suppliers. Based on this targeted cost information, the controller can prepare the material cost budget. 2. Collusion with Suppliers. Another accounting issue involving JIT purchasing is the possibility of collusion between buyers and suppliers. Since JIT precludes competitive bidding, it may be possible for buyers to select suppliers who will kickback proﬁts to the buyers in exchange for the business. This problem is real, but is mitigated somewhat by the amount of interaction between company employees and the supplier. The product design function under JIT purchasing requires that the company’s design engineers work closely with suppliers, so these people should recognize a sham supplier. A control that the controller can use is to compare supplier prices against those of the market on a spot basis. If prices seem excessive, then the controller should investigate further. Also, the controller can investigate whether or not previously agreed part price changes (usually downwards, for JIT suppliers) have taken place. 3. Purchasing Paperwork. JIT purchases tend to occur frequently and involve small part quantities. Under a traditional accounting system, this would present an increased paperwork problem, for there would be more receiving documentation to match to more invoices, and more checks to cut. Consequently, the controller should consider recording receipts based on the number of parts used in production (based on bills of material), plus parts that were damaged at the fault of the buyer. This system would require very accurate bills of material. 4. Supplier Rating Systems. Before JIT, suppliers ratings were based on the average unit price of parts sold to the company. Under the JIT philosophy, suppliers ratings should include ability to attain part cost targets, percentage of parts arriving on time (“on time” also means “not arriving too early,” for such materials must be moved and stored, creating problems for the buying company), part defect rates, and the percentage of shipments containing the exact amounts ordered. The controller should be involved not only in the design of these information gathering systems, but also in the auditing of them for accuracy. 5. Buyer Measurement Systems. Before JIT, buyer ratings were based on the cost savings achieved from a standard cost for a part. JIT purchasing requires buyers to be facilitators rather than clerks, so that their new jobs require coordinating design teams from the two companies, assisting in qualifying suppliers, and shrinking the supplier base. Under JIT, continuing to judge a buyer based on the purchase price variance would be dysfunctional, since the buyer would be forced to put parts out to bid for the lowest price instead of working with one supplier to achieve a targeted cost. The controller should point out such dysfunctional performance measures to management, and recommend that they be eliminated. New performance measures for buyers are difﬁcult to derive for individual buyers. Instead, the controller should consider formulating performance measures for groups, such as new product design teams that include buyers. A typical performance measure under this scenario would be achieving a product’s cost that was originally targeted by management.

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(b) JIT DELIVERY. JIT manufacturers closely link their production schedules to the suppliers’ delivery schedules. Hence, suppliers and manufacturers are not only relocating, they are also eliminating storage areas and loading docks where delivered material can accumulate. Suppliers may feed materials and parts directly to the assembly lines. (c) JIT MANUFACTURING. As would be expected, with the emphasis on small rather than large lot sizes, changes in manufacturing processes and machine arrangements usually are necessary. Under the typical U.S. production line, similar machines performing similar tasks are grouped together. This supposedly increases labor efﬁciency as well as the economy of large lot size production. Under the JIT system, “group technology” is used so that the small lot work moves rapidly through a common routing over several different types of machines. Hence there is little need for work-in-process inventory. Moreover, rather than performing the task on only one machine, the worker is trained to operate all the machines of the work center. This leads to less boredom and assists in reducing defects, which, in the process, can be identiﬁed rather quickly. For group technology to work, employees must be heavily cross-trained in the use of several pieces of equipment, since one employee will typically operate several machines. Also, since the company must invest in employee training, the cost of losing an employee is higher than would be the case in an assembly line environment, where less training is required. Finally, the employees must be willing to take responsibility for the quality of products produced; since an entire product can be produced by one employee or work group using group technology, part defects can be directly traced to individuals. It is beyond the scope of this volume to discuss in detail the many operational aspects of just-in-time inventory planning and control. However, a review of one company’s experience relative to purchased assemblies will give a good example of the pervasive impact that a JIT system can have on traditional ﬁnancial controls. In this illustration, a high-cost subassembly is purchased from a single supplier with a long time association and under a long-term contract. There is one such assembly in each ﬁnished product. Each day all assemblies needed for that day’s production are delivered at 8:00 A.M. A routine was established between the supplier and the manufacturer whereby the supplier was paid weekly based on the number of ﬁnished products shipped by the manufacturer that week. This procedure eliminated the preparation and handling of purchase orders, receiving reports, inventory details (receipts and disbursements), and invoices—the new control being that if a product were manufactured, tested, and shipped, then the subassembly must have been delivered. This is a very different process from the usual matching of purchase orders, receiving report, and invoice in order to effect payment. Just-in-time concepts strongly impact several accounting processes, reports, and performance measures. The controller should be aware of the following items: 1. Product cost tracking. Under traditional assembly line production techniques, there were many opportunities to reduce product costs by closely examining the production process. However, with JIT, the glaring cost issues (e.g., excessive scrap and inventory levels) are eliminated from the production process. The controller may ﬁnd that cost tracking systems on the production ﬂoor are not revealing cost savings. In fact, the tracking systems may cost more than the savings they generate. Consequently, the controller should consider cutting back on cost tracking systems on the shop ﬂoor and turn more attention to how well in-house and supplier design teams are achieving targeted cost goals when creating new products. 2. Direct labor cost tracking. Traditionally, accountants have closely tracked all direct labor variances with the help of extensive shop ﬂoor labor reporting. However, in many companies, direct labor now accounts for less than 20 percent of a product’s cost, so the cost expended to track direct labor may not be worth the beneﬁt gained by reviewing labor variance reports. Therefore, the controller should consider eliminating direct labor reporting.

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3. Accounting reports. Most accounting reports are issued after the end of the month. Line managers review them and take action sometime well into the following month. With JIT operations, there is no work-in-process buffer to hide manufacturing problems, so line managers can spot most problems within minutes or hours of their occurrence. In short, JIT manufacturing personnel do not need monthly accounting reports as much as they used to. As JIT is implemented, the controller should periodically meet with line managers to ascertain their need for the information. The likely result will be fewer reports. 4. Operational auditing. Under assembly line systems, operational audits focused on sources of waste from the system, such as pilferage, obsolete inventory, and scrap. With the greatly reduced inventory levels used by a JIT system, auditors must now shift their focus to issues that will slow down JIT, such as problems with setup time reductions, process ﬂow and workstation designs, and product designs. 5. JIT performance measures. Under assembly line systems, performance measures related to variances for direct labor and materials. With the assumptions under a JIT system that direct labor and materials costs are ﬁxed and will have few variances, performance measures should shift to attaining targeted output and quality goals, the number of employee suggestions received, and the percentage implemented. 6. Cost generators. Under assembly line systems, cost generators were viewed as direct labor and materials. With the assumptions under a JIT system that direct labor and materials costs are ﬁxed, the controller should target other items. For example, close attention should be paid to: Engineering change orders, which can slow the product release process Space utilization, since excess space should be sublet for additional revenues Inventory levels, since less inventory leads to less space requirements, fewer obsolete

items, less inventory tracking time, and reduced insurance costs Equipment downtime, since product ship dates cannot be achieved if production facilities are not functioning Though this description of a JIT system may lead one to believe that it is entirely different from the previously described MRP system, it is possible to transition from MRP to JIT in an orderly manner. Because a JIT system requires a minuscule amount of inventory, the underlying management principle needed to bring about this transition is an alteration in purchasing policy. A traditional policy under the MRP system is for a company to purchase inventory in those quantities that minimize inventory carrying and ordering costs, which usually results in excess quantities of inventory on hand. The controller must convince management that the more appropriate technique is to purchase only the exact amounts required, which leaves no excess to be stored in inventory. By choking off the ﬂow of incoming inventory, the warehouse and purchasing staffs can then concentrate on gradually reducing the remaining inventory stocks by a variety of means, such as donations, throwaways, and returns to suppliers. Over time, this approach will drastically reduce the inventory to the point where this aspect of a JIT system has been achieved. If management does not feel that there is any reason to transition from an MRP system to a JIT system, a controller can present them with the information in Exhibit 28.1. Result of System

JIT

MRP

Reduces setup time Reduces scrap Reduces raw material inventory Reduces work-in-process inventory Emphasizes zero-defect production

Yes Yes Yes Yes Yes

No No Yes No No

E XHIBIT 28.1

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C OMPARISON

BETWEEN

JIT

AND

MRP S YSTEMS

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Exhibit 28.1 shows that MRP is deﬁcient in a number of areas, which may spur management into making a change away from MRP. However, if there is still some hesitation in moving away from an existing MRP system, it may be possible to effect a partial transition by slowly adding JIT features, such as cellular manufacturing groups and reduced setup times, which work well in either operating environment. In short, JIT principles can effect a drastic reduction in the amount of inventory a controller must contend with, while also improving product quality and the reliability of delivery times to customers. It is a system well worth implementing, either totally or in part.

28.6 INVENTORY REORDERING SYSTEMS The type of inventory reorder system should be of great concern to a controller, because the wrong method can greatly increase the amount of inventory on hand. This section presents a list of reordering methods, shown in declining order of desirability, with the ﬁrst one resulting in the smallest amount of inventory on hand, and the last one the largest. The ﬁrst method, JIT, requires the greatest attention to management systems, while the last is a simple approach that can be easily installed with minimal continuing supervision, which is perhaps why the last approach is the one most commonly used in practice. The reordering systems are: • JIT. This method requires a company to issue a request for the immediate delivery of parts to a supplier as soon as it needs the parts in the production process, with the supplier immediately delivering the exact amount required to the production line. Although this appears to be an elegantly simple approach, it actually requires great attention to the accuracy of bills of material, as well as the selection of suppliers and the quality of incoming goods. It results in almost no on-hand inventory (with the exception of work-in-process), and is therefore the best reordering system from the perspective of reducing a company’s investment in inventory. • MRP. This method calculates the exact amount of inventory needed for scheduled production, based on bills of material, the production schedule, and existing inventory levels. The computer system then generates a recommended ordering level, which is executed by a purchasing person. This is an excellent ordering method, but can result in too much inventory if the ordering levels are supplemented by an economic order quantity, which may result in too much inventory being purchased. • Visual check system. This method is a simple check of stocking levels, with reordering taking place based on the knowledge of the checker of the movement of each inventory item. A more modern variation is to mark lines on storage bins; reordering takes place as soon as inventory falls below the lines. Another variation is to have two storage bins for each item; reordering takes place when the larger, main storage bin is empty, while the smaller emergency bin is used until the reordered amount arrives. This is a good approach for the reordering of large-volume, low-cost items that are otherwise difﬁcult to track, such as ﬁttings and fasteners. • Reservation method. This method recognizes the available stock as well as the physical stock. Available stock is deﬁned as stock on order, plus physical stock, less the unﬁlled requirement. The reorder point is based on the available stock rather than the physical stock. • Minimum–maximum. A very common means for reordering inventory is to use the “minimum–maximum” system, or “MinMax.” The minimum is the lowest acceptable amount of inventory that should be kept on hand, while the maximum is the highest acceptable amount. The minimum represents a margin of safety, while the maximum is usually the minimum level plus the standard ordering quantity. As a general rule, the use of a MinMax system is practical where the rate of sale or use of products is fairly stable and not subject to wide ﬂuctuations or sporadic movements and where the order time is fairly short. However, it is based on a historical view of inventory data and can become inaccurate over time as usage rates vary. For this reason, it is generally inferior to a forward-looking system, such as material requirements planning.

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The best way to still have an operational MinMax system while keeping the inventory investment low is to modify the “min/max” report so that it also shows the time period since a part was used, and its usage volume during the past 12-month period. If the computer system contains information from previous years, this can also be included, so that the report notes any trends in item usage. This additional information can be used by the purchasing staff to modify the minimum and maximum levels “on the ﬂy,” so that the ﬁgures are constantly trimmed to match actual usage. Without this additional information, the minimum and maximum levels for each part will probably be adjusted only once every few years, which may lead to signiﬁcant shortages or surpluses of parts. Thus, modifying the “min/max” report to include usage information allows buyers to change the preset ordering levels to match actual usage. As companies place more and more emphasis on reducing their working capital investments in inventory, the reorder point system will come under more attack. This is because it is based on prior usage, not expected usage. Any reorder system based on what has happened in the past may very well result in orders for inventory items that have declining usage, resulting in excess inventory. The controller should regularly review the usage trends for those parts that are reordered with reorder points, and also correspond with the engineering department to see what parts are to be discontinued. Any part that is to be excluded from future products should immediately have its reorder point removed from the computer system, which will keep a company from ordering more of it when it is no longer needed. In this section, the pros and cons of various inventory reordering systems, with a particular emphasis on their impact on inventory levels, were discussed. A controller who cares about a company’s overall inventory investment would be wise to pay close attention to the types of reordering systems currently in use.

28.7 OBSOLETE INVENTORY A controller should be deeply concerned with the extent and cost of obsolete inventory, because it can have a dramatic effect on a company’s proﬁts. Accounting rules state that the value of all obsolete inventory shall be written off as soon as it is identiﬁed, so a controller should always have current information on the state of this portion of the inventory. This section describes how to obtain information about obsolete inventory, as well as how to track down the causes of obsolescence and eliminate or at least reduce them. The easiest way to determine whether a part is already obsolete or heading in that direction is to create a report that extracts the last usage date for a part from the production or inventory databases. This extracted information can then be sorted by date, with the oldest parts appearing at the top of the report. It is then a simple matter to review this list with the engineering staff to see which of the old parts are not going to be used again. These old parts can also be sorted by extended dollar value and totaled, providing an easy calculation of the total amount of obsolete inventory that a controller must write off on the ﬁnancial statements. An additional approach for determining whether a part is obsolete is reviewing engineering change orders. These documents note those parts being replaced by different ones, as well as when the changeover is scheduled to take place. One can then search the inventory database to see how many of the parts that are being replaced are still in stock, which can then be totaled, yielding another variation on the amount of obsolete inventory on hand. A ﬁnal method for determining the amount of obsolescence is to run a “where used” report, which is a common one when a computer system contains a bill of materials for each product a company produces. The report lists all of the products for which a part is used. If the report lists parts for which there are no product uses, then those parts can be considered obsolete (unless they are new parts being purchased for a new product that does not yet have a bill of materials in the system). To be absolutely certain of a part’s status as being obsolete, it may be possible to use all three methods to derive three lists of obsolete parts, which can then be reviewed with the engineering staff periodically to determine which parts are truly obsolete. In truth, because of the overwhelming workload of the accounting and engineering departments, it is most common to simply

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run the ﬁrst report, showing those parts with the longest period since use, and record those items as obsolete. The preferred approach, however, is to use all the methods, thereby avoiding the disposal of some inventory for which there may still be a use. No matter what approach is used to identify obsolete inventory, it is uncommon to rely only on reports to verify that something is obsolete. Instead, the reports should be examined by a group of people who represent several departments and are authorized to throw out inventory. This group represents the engineering, accounting, production, and materials management departments, and is commonly known as the Materials Review Board (MRB). The group is tasked with not only throwing out obsolete inventory, but also examining parts that are suspected to be defective, and authorizing either rework, scrapping, or the delivery of parts back to suppliers for replacement or credit. The MRB must decide, based on visual inspection, if something is truly obsolete. Although a controller may believe that it is only his or her responsibility to identify obsolete inventory, it is better to provide some value to the company by going a step further and tracking down the causes of obsolescence, so that they can be reduced or even eliminated. This extra step can eliminate a great deal of expense. The primary issues causing obsolescence are: • Excessive purchasing volumes. The purchasing department may be purchasing in very large quantities, in order to save itself the trouble of issuing a multitude of purchase orders for smaller quantities, or because it can obtain lower prices by purchasing in large quantities. This problem can be avoided by attaching purchasing performance goals to minimal on-hand inventory, and can be veriﬁed by continuing reviews by the internal audit staff. • Inadequate bills of material. A well-run purchasing department will use bills of material to determine the parts needed to build a product, and then order them in the correct quantities. If the bill of material is incorrect, then the items purchased will either be the wrong ones, or the correct ones but in the wrong quantities. To avoid this problem, the bills of material must be audited regularly for accuracy. • Low inventory turnover. If there is too much inventory sitting in the warehouse, it will take so long to work through it that some of the inventory is bound to become obsolete before being used. This is partly the fault of the purchasing staff (see previous point), but may also be caused by a conservative production manager who wants to have enormous volumes of all parts kept on hand, so that there is no chance of a stock-out occurring that can interfere with the smooth completion of production goals. Attaching a high inventory turnover target to the goals of the production manager can reduce this problem. • Poor engineering change control. If the engineering department does not verify that old parts are completely used up before installing a new part in a product, the remaining quantities of the old part will be rendered obsolete. This can be a major source of obsolescence. To avoid it, there should be tight control over using up old parts ﬁrst, which can be veriﬁed by the internal audit staff and enforced by top management. • Poor inventory tracking systems. It is easy for a part to become obsolete if no one knows where it is. If it is buried in an odd corner of the warehouse, there is not much chance that it will be used up. To avoid this problem, there should be location codes in the inventory database for every part, along with continual cycle counting to ensure that locations are correct. A periodic audit of location codes will give management a clear view of the accuracy of this information. If a controller can identify any of the above problems as being the cause of obsolescence, quantify the cost of the problem, and aggressively push for changes, there can be a very signiﬁcant cost savings. Many companies that have not reviewed their inventories for a long time will ﬁnd that obsolescence is a much larger problem than they would care to believe. It is not impossible for an older company to ﬁnd that 80 percent of its inventory is obsolete. One can look upon such a problem as a major opportunity, because a company can write off a very large amount and reduce proﬁts, thereby avoiding paying taxes. However, highly leveraged companies are probably using their

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inventories as collateral for loans and will face a reduction in the amount of debt that creditors are willing to lend if the amount of inventory is reduced; in these cases, it is best for a company to embark on an intensive campaign of inventory returns to suppliers, so that it can realize as much cash as possible from the disposition of inventory. Thus, obsolescence can have a major impact on a company’s tax and debt situation.

28.8 REDUCING INVENTORY A controller may be faced with suspected inaccuracies of unknown size in a company’s inventories. If the number of items in stock is minor, then this problem is an easy one to correct—enroll a group of counters and descend on the warehouse for a few hours of counting. However, there are usually many parts, frequently scattered throughout the facility, which are improperly identiﬁed (if at all). In these cases, a controller is faced with a serious problem, since any signiﬁcant inaccuracy has a direct impact on the cost of goods sold and proﬁts. Though a Chapter 60, Inventory Tracking, deals with this topic in great detail, this section brieﬂy describes the tasks a controller can complete in order to reduce the chore of counting inventory, which essentially means reducing the amount of inventory to count. The best way to reduce the work associated with reviewing the accuracy of a perpetual inventory’s cost is to reduce the size of the perpetual inventory. This can be done by using JIT manufacturing techniques. This involves moving goods straight from the supplier to the shop ﬂoor, thereby avoiding the warehouse entirely. To bypass the warehouse, these shipments must be in small enough quantities to avoid the storage of excess amounts in the warehouse, and they must arrive precisely on time to avoid storage until they are needed in the production process. If these two criteria can be met, the quantity of goods stored in the warehouse can be limited to those items that must be ordered in bulk and those items that are delivered too early to be immediately used by the production department. The result for the controller is a minimal inventory quantity to audit, cost, and report on. Another important consideration in establishing sound inventory management is the standardization of materials and products and the simpliﬁcation of the line. Simpliﬁcation is merely the elimination of excess types and sizes. The elimination of those items that do not sell readily can contribute greatly to reducing the inventory which must be carried. Simpliﬁcation is labor-intensive once inventory has been received, for considerable effort is needed to sell off excess inventory and ship it out of the warehouse. Less work is required if simpliﬁcation is treated as a key step in designing new products, so that existing parts are used, rather than stocking new parts that may become obsolete. Standardization is a more general term having to do with the establishment of standards. In the application to inventories, it has reference to the reduction of a line to ﬁxed types, sizes, and characteristics that are considered to be standard. The object is to reduce the number of items, to establish interchangeability of manufactured parts and products, and to establish standards of quality in materials. With a reduction in the possible number of inventory items to be carried, the control problem is facilitated. Standardization extends even to such insigniﬁcant items as fasteners. If similar products can be designed to be assembled with a single bolt instead of ten slight variations on the same bolt size and material, then nine items can be eliminated, and no longer have to be tracked. Every time an item is removed from inventory, cost is reduced in the areas of cycle counting, obsolescence reserves, insurance, material moves, kitting, and receiving. A more efﬁcient inventory tracking system can be achieved if all obsolete inventory is removed from stock. The reason for improved efﬁciency when this happens is that a considerable amount of cycle counting is required to maintain a perpetual inventory. If some of the inventory is deleted, there is less inventory left to cycle count, resulting in a more accurate inventory with less counting effort by the staff. The controller should be aware, however, that overall inventory accuracy may initially decline if obsolete inventory is removed from stock; the reason for this decline is that obsolete inventory represents the most stable part of the inventory (since it is never used). By removing it, the usage level (and therefore the volatility) of the remaining inventory will increase, resulting in reduced initial levels of accuracy.

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One of the major inventory-related problems for a controller is subtracting the value of consignment stock from inventory. This is inventory that is owned by another entity (e.g., a supplier or customer) and therefore cannot be included in the company’s inventory valuation. Because this inventory may have the same appearance as inventory that is owned by the company, the best solution is to immediately store the consignment stock in a segregated area as soon as it is received. The other problem with consignment inventory is identifying it when it ﬁrst arrives on the receiving dock. If the controller enforces the use of purchase orders for all receipts, then either the lack of a purchase order or its identiﬁcation on a special purchase order should be sufﬁcient to identify the consignment stock. If this separate storage requirement is enforced, the accuracy of the physical inventory’s extended cost will be greatly improved. A ﬁnal method for reducing the amount of inventory to count is to shift as much inventory as possible to the shop ﬂoor and expense it as shop supplies. This approach works very well for ﬁttings and fasteners, which are typically of low cost as well as being difﬁcult to count. The approach has an added beneﬁt of making it much easier for production personnel to access the parts, which not only improves employee morale, but also reduces the amount of materials handling, because there are fewer materials to move to the production facility. There are a number of approaches for reducing the amount of inventory that must be counted. By segregating consignment stock, eliminating obsolete inventory, moving small parts to the shop ﬂoor, and using JIT systems, a controller can drastically reduce the inventory counting chore.

28.9 INVENTORY CUTOFF One of the most common problems for a controller is not obtaining a proper period-end cutoff of inventory. The problem stems from receiving inventory while not recording a corresponding account payable. Without the payable amount being listed in the accounting records, inventory will be overstated, resulting in an understated cost-of-goods-sold ﬁgure, which yields an inordinately large proﬁt number. The reverse problem of recording a payable before inventory is recorded is also possible but uncommon, because suppliers tend to send invoices after the shipment of goods, resulting in the inventory arriving ﬁrst and being recorded ﬁrst. If this cutoff problem is not properly dealt with at the end of each reporting period, a controller may end up reporting incorrect proﬁt ﬁgures, which can lead to the hiring of a new controller. How can a controller avoid the cutoff problem? The answer is a simple one, but the execution of the solution is not that simple, because it requires absolutely rigid adherence to an established receiving procedure, as well as the construction and implementation of a computerized matching system. If the procedure and computer system are not adhered to, there will continue to be cutoff problems, no matter what other solutions a controller may attempt to implement. The solution to the cutoff problem is the proper maintenance and use of a receiving log. If the receiving staff religiously and accurately logs all incoming materials into the receiving log, the controller has an excellent tool for comparing accounts payable to receipts, which effectively solves the cutoff problem. For example, a controller can take all incoming invoices that have arrived near the end of the month and manually compare them to the receiving log, to see when items were actually received. If an item was not received until the beginning of the next reporting period, then the corresponding supplier invoice should also not be recorded until the following reporting period. The log can also be used to determine whether any supplier invoices have not been received at all, simply by matching every receipt in the log to an invoice. If there is no invoice, the controller can accrue for the expected amount of the supplier billing. One problem with using a receiving log is that it must be totally accurate—it must include the exact amount received, identify from whom it was sent, and note the correct date of the receipt. It is also important that the items noted as being received in the log are also recorded in the inventory database on the same date and in the correct quantities; otherwise, all of the work performed to match invoices to the receiving log will be in vain, because an inaccurate inventory database will still result in incorrect period-end inventory numbers. Given these problems, an accurate receiving log is still the best way to attain an accurate period-end inventory cutoff.

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The trouble with manually matching supplier invoices to the receiving log is that it is manual— the controller must expend a respectable amount of accounting staff time on the matching process, which can interfere with the timely completion of ﬁnancial statements (which are dependent on the completion of the cutoff analysis). However, it is possible to use automation to avoid nearly all of the matching work. To achieve this, the receiving log must be on-line, not a written document, so that the receiving staff enters information into a database that can then be compared to supplier invoices, which must also be entered into the database in a timely manner. If the receiving log includes a company purchase order number that was used to purchase materials, this number can be used as an index to compare receipts to invoices (which should also note the purchase order number). This automated cross-reference can be performed automatically by the computer, which can then print out a list of receipts for which there are no invoices, as well as a list of invoices for which there are no receipts. The only manual labor is to then review this list and determine whether the information is accurate. If it is, the accounting staff can make accruals that will result in a perfect match of receipts to invoices. Thus, the use of automation and the receiving log will give a controller excellent control over the period-end cutoff problem. The solution to the cutoff problem seems simple; it is easy for it to fail, however, because there are always situations that will result in the incorrect recording of information, usually in the receiving log, that will alter the period-end inventory results. For example, a new receiving person who has not been properly trained may not enter information into the receiving log properly. Also, an overwhelmed receiving department may not enter receipts into the receiving log for several days, which may result in incorrect inventory balances. Also, there may be special situations, such as the receipt of consignment inventory that the company does not own, that are recorded improperly. For all of these situations, the best method of detection is to employ a company’s internal audit staff to conduct an ongoing review of receiving procedures, to determine where problems are arising. Other types of ﬁxes are to periodically retrain the receiving staff, provide extra receiving stafﬁng during periods of high transaction volume, and produce clear procedures for the receipt of all possible items. Only by implementing all of these error checking and error prevention methods will a controller avoid period-end cutoff problems.

28.10 BUDGETING FOR RAW MATERIALS There are basically two methods of developing the inventory budget of raw materials, purchased parts, and supplies: 1. Budget each important item separately based on the production program. 2. Budget materials as a whole or classes of materials, based on selected production factors. Practically all concerns must employ both methods to some extent, although one or the other predominates. The former method is always preferable to the extent that it is practicable, since it allows quantities to be budgeted more precisely. (a) BUDGETING INDIVIDUAL ITEMS OF MATERIAL. The following steps should be taken in budgeting the major individual items of materials and supplies: 1. Determine the physical units of material required for each item of goods to be produced during the budget period. 2. Accumulate these into total physical units of each material item required for the entire production program. 3. Determine for each item of material the quantity that should be on hand periodically to provide for the production program with a reasonable margin of safety. 4. Deduct material inventories that are expected will be on hand at the beginning of the budget period to ascertain the total quantities to be purchased.

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5. Develop a purchasing program which will ensure that the quantities will be on hand at the time they are needed. The purchase program must give effect to such factors as economically sized orders, economy of transportation, and margin of safety against delays. 6. Test the resulting budgeted inventories by standard turnover rates. 7. Translate the inventory and purchase requirements into dollars by applying the expected prices of materials to budgeted quantities. In many instances, it is the controller’s staff that translates the unit requirements and balances into values, based on the data received from production control or purchasing, and so on. In some cooperative efforts, the accounting staff may undertake the entire task of determining quantities and values, based on computer programs agreed to by the manufacturing arm (the explosion of ﬁnished goods requirements into the raw material components, etc.). In practice, many difﬁculties arise in executing the foregoing plan. In fact, it is practicable to apply the plan only to important items of material that are used regularly and in relatively large quantities. Most manufacturing concerns ﬁnd that they must carry hundreds or even thousands of different items of materials and supplies to which this plan cannot be practically applied. Moreover, some concerns cannot express their production programs in units of speciﬁc products. This is true, for example, where goods are partially or entirely made to customers’ speciﬁcations. In such cases, it is necessary to look to past experience to ascertain the rate and the regularity of movement of individual material items and to determine maximum and minimum quantities between which the quantities must be held. This necessitates a program of continuous review of material records as a basis for purchasing and frequent revision of maximum and minimum limits to keep the quantities adjusted to current needs. (b) BUDGET BASED ON PRODUCTION FACTORS. For those items of materials and supplies that cannot be budgeted individually, the budget must be based on general factors of expected production activity, such as total budgeted labor hours, productive hours, standard allowed hours, cost of materials consumed, or cost of goods manufactured. To illustrate, assume that the cost of materials consumed (other than basic materials which are budgeted individually) is budgeted at $1,000,000 and that past experience demonstrates that these materials and supplies should be held to a rate of turnover of ﬁve times per year; then an average inventory of $200,000 should be budgeted. This would mean that individual items of material could be held in stock approximately 73 days (one ﬁfth of 365 days). This could probably be accomplished by instructing the executives in charge to keep on hand an average of 60 days’ supply. Although such a plan cannot be applied rigidly to each item, it serves as a useful guide in the control of individual items and prevents the accumulation of excessive inventories. In the application of this plan, other factors must also be considered. The relationship between the inventory and the selected factor of production activity will vary with the degree of production activity. Thus a turnover of ﬁve times may be satisfactory when materials consumed are at the $1,000,000 level, but it may be necessary to reduce this to four times when the level goes to $750,000. Conversely, it may be desirable to hold it to six times when the level rises to $1,250,000. Moreover, some latitude may be necessitated by the seasonal factor, since it may be necessary to increase the quantities of materials and supplies in certain months in anticipation of seasonal demands. The ratio of inventory to selected production factors at various levels of production activity and in different seasons should be plotted and studied until standard relationships can be established. The entire process can be reﬁned somewhat by establishing different standards for different sections of the materials and supplies inventory. The plan, once in operation, must be closely checked by monthly comparisons of actual and standard ratios. When the rate of inventory movement falls below the standard, the records of individual items must be studied to detect the slow moving items. (c) MATERIALS PURCHASING BUDGET ILLUSTRATED. Some of the problems and methods of determining the total amount of expected purchases may be better understood by illustra-

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tion. Assume, for example, that this information is made available regarding production requirements after a review of the production budget: Class Units Period January February March Subtotal 2nd quarter 3rd quarter 4th quarter Total

W

X

400 300 500 1,200 1,500 1,200 1,000

500 600 400 1,500 1,200 1,500 1,700

4,900

5,900

Amount Y

Z

10,000

$ 20,000

Solely for illustrative purposes, the following four groups of products have been assumed: Class W

Class X Class Y

Class Z

Material of high unit value, for which a deﬁnite quantity and time program is established in advance-such as for stock items. Also, the material is controlled on a MinMax inventory basis for budget purposes. Similar to item W, except that, for budget purposes, MinMax limits are not used. Material items for which deﬁnite quantities are established for the budget period but for which no deﬁnite time program is established, such as special orders on hand. Miscellaneous material items grouped together and budgeted only in terms of total dollar purchases for the budget period.

In actual practice, of course, decisions about production time must be made regarding items using Y and Z classiﬁcations. However, the bases described later in this chapter are applicable in planning the production level. (i) Class W. Where the items are budgeted on a MinMax basis, it usually is necessary to determine the range within which purchases must fall to meet production needs and stay within inventory limits. A method of making such a calculation is shown next: Units For Minimum Inventory

For Maximum Inventory

January production requirements Inventory limit

400 50

400 400

Total Beginning inventory

450 200

800 200

$ 250

$ 600

Limit of receipts (purchases)

Within these limits, the quantity to be purchased will be inﬂuenced by such factors as unit transportation and handling costs, price considerations, storage space, availability of material, capital requirements, and so forth.

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A similar determination would be made for each month for each such raw material, and a schedule of receipts and inventory might then be prepared, somewhat in this fashion: Units Beginning Inventory 200 200

Period January February March

300

Subtotal 2nd quarter 3rd quarter 4th quarter

200 50 50

Total

Receipts 400 400 400

Usage 400 300 500

1,200 1,350 1,200 1,200

1,200 1,500 1,200 1,000

$ 4,950

$ 4,900

Ending Inventory 200 300

Unit Value $200

200

Purchases Budget $ 80,000 80,000 80,000 240,000 270,000 240,000 240,000

50 50 250

$ 990,000

(ii) Class X. It is assumed that the class X materials can be purchased as needed. Since other controls are practical on this type of item and since other procurement problems exist, purchases are determined by the production requirements. A simple extension is all that is required to determine the dollar value of expected purchases: Period January February

Quantity 500

Unit Price $10

Total $ 5,000

600 400

6,000 4,000

Subtotal 2nd quarter

1,500

15,000

1,200

12,000

3rd quarter 4th quarter

1,500 1,700

15,000 17,000

Total

$ 5,900

$ 59,000

March

(iii) Class Y.

The breakdown of the class Y items may be assumed to be:

Item

Quantity

Unit Price

Y-1 Y-2 Y-3 Y-4

1,000 2,000 3,000 4,000

$1.00 1.10 1.20

Total

$ 10,000

1.30

Cost $

1,000 2,200 3,600 5,200

$ 12,000

A determination about the time of purchase must be made, even though no deﬁnite delivery schedules and the like have been set by the customer. In this instance, the distribution of the cost and units might be made on the basis of past experience or budgeted production factors, such as budgeted machine hours. The allocation to periods could be made on past experience, as:

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Past Experience Regarding Similar Units Manufactured

589

Y-1

Y-2

Y-3

Y-4

Total

Values (Purchases Budget)

January

10%

100

200

300

400

1,000

$ 1,200

February

15

150

300

450

600

1,500

1,800

March

10

100

200

300

400

1,000

1,200 4,200

Period

Subtotal

Units

35

350

700

1,050

1,400

3,500

2nd quarter

30

300

600

900

1,200

3,000

3,600

3rd quarter

20

200

400

600

800

2,000

2,400

4th quarter

15

150

300

450

600

1,500

1,800

1,000

2,000

3,000

4,000

10,000

$ 12,000

Total

100%

The breakdown of units is for the beneﬁt of the purchasing department only, inasmuch as the percentages can be applied against the total cost and need not apply to individual units. In practice, if the units are numerous regarding types and are of small value, the quantities of each might not be determined in connection with the forecast.

(iv) Class Z. Where the materials are grouped, past experience again may be the means of determining estimated expenditures by the period of time. Based on production hours, the distribution of class Z items may be assumed to be (cost of such materials assumed to be $2 per production hour):

Period January February March Subtotal 2nd quarter 3rd quarter 4th quarter Total

Productive Hours 870 830 870 2,570 2,600 2,230 2,600 10,000

Amount $1,740 1,660 1,740 5,140 5,200 4,460 5,200 $ 20,000

When all materials have been grouped and the requirements have been determined and translated to cost, the materials budget may be summarized as in Exhibit 28.2. Exhibit 28.2 relates to raw materials. A similar approach would be taken with respect to manufacturing supplies. A few major items might be budgeted as the class W or X items just cited, but the bulk probably would be handled as Z items. Once the requirements as measured by delivery dates have been made ﬁrm, it is necessary for the ﬁnancial department to translate such data into cash disbursement needs through average lag time and so forth.

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T HE B LANK C OMPANY P URCHASES B UDGET F OR THE Y EAR 20XX Class Period January February March Subtotal 2nd quarter 3rd quarter 4th quarter Total E XHIBIT 28.2

W $ 80,000 80,000 80,000

X $ 5,000 6,000 4,000

Y $ 1,200 1,800 1,200

Z $ 1,740 1,660 1,740

240,000

15,000

4,200

5,140

264,340

270,000 240,000 240,000

12,000 15,000 17,000

3,600 2,400 1,800

5,200 4,460 5,200

290,800 261,860 264,000

$ 990,000

$ 59,000

$ 12,000

$ 20,000

$ 1,081,000

$

Total 87,940 899,460 86,940

S AMPLE P URCHASES B UDGET

28.11 BUDGETING FOR WORK-IN-PROCESS The inventory of goods actually in process of production between stocking points can be best estimated by applying standard turnover rates to budgeted production. This may be expressed either in units of production or dollars and may be calculated for individual processes and departments or for the factory as a whole. The former is more accurate. To illustrate this procedure, assume the following inventory and production data for a particular process or department: Process inventory estimated for January 1 Production budgeted for month of January Standard rate of turnover (per month) Average value per unit of goods in this process

500 units 1,200 units 4 times $10

(a) (b) (c)

With a standard turnover rate of four times per month, the average inventory should be 300 units (1,200 + 4). To produce an average inventory of 300 units, the ending inventory should be 100 units: 500 100 300 -------------------------2 Using the symbol X to denote the quantity to be budgeted as ending inventory, the following formula can be applied: 2 ( 1200 ) X 2b ------ a -------------------- 500 100 units 4 c Value of ending inventory is $1,000 (100 × $10). Where the formula produces a minus quantity (as it will if beginning inventory is excessive), the case should be studied as an individual problem and a speciﬁc estimate made for the process or department in question. Control over the work-in-process inventories can be exercised by a continuous check of turnover rates. Where the individual processes, departments, or plants are revealed to be excessive they should then be subjected to individual investigation. The control of work-in-process inventories has been sorely neglected in many concerns. The time between which material enters the factory and emerges as the ﬁnished product is frequently much longer than necessary for efﬁcient production. An extensive study of the automobile tire industry revealed an amazing spread of time between ﬁve leading manufacturers, one company

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591

having an inventory ﬂoat six times that of another. This study indicated also, by an analysis of the causes of the ﬂoat time, that substantial reductions could be made in all ﬁve of the companies without interference with production efﬁciency. Although it is desirable to reduce the investment in goods actually being processed to a minimum consistent with efﬁcient production, it is frequently desirable to maintain substantial inventories of parts and partially ﬁnished goods as a means of reducing ﬁnished inventories. Parts, partial assemblies, processed stock, or any type of work-in-process that is stocked at certain points should be budgeted and controlled in the same manner as materials. That is, inventory quantities should be set for each individual item, based on the production program; or inventory limits should be set that will conform to standard rates of turnover. In the former case, control must be exercised through the enforcement of the production program; in the latter case, maximum and minimum quantities must be established and enforced for each individual item. With the planned cost input to work-in-process known from the materials usage budget, the direct labor budget, and the manufacturing expense budget (see Chapters 20 and 21), and the quantities of planned completed goods furnished by manufacturing, the controller may develop the planned work-in-process, time-phased (condensed), as shown in Exhibit 28.3. The reasonableness of the budgeted inventory level should be tested by one of the several methods suggested in this chapter (turnover, etc.).

28.12 BUDGETING FOR FINISHED GOODS The budget of ﬁnished goods inventory (or merchandise in the case of trading concerns) must be based on the sales budget. If, for example, it is expected that 500 units of item A will be sold during the budget period, it must be ascertained what number of units must be kept in stock to support such a sales program. It is seldom possible to predetermine the exact quantity that will be demanded by customers day by day. Some margin of safety must be maintained by means of the ﬁnished goods inventory so that satisfactory deliveries can be made. With this margin established, it is possible to develop a program of production or purchases whereby the stock will be replenished as needed. (a) BUDGETING FINISHED GOODS BY INDIVIDUAL ITEMS. Two general methods may be employed in budgeting the ﬁnished goods inventory. Under the ﬁrst method, a budget is established for each item separately. This is done by studying the past sales record and the sales program of each item and determining the quantity that should be on hand at various dates (usually, the close of each month) throughout the budget period. The detailed production or purchase program can then be developed to provide such quantities over and above current sales requirements. The total budget is merely the sum of the budgets of individual items. This total budget can then be tested by the rate of turnover desired as proof that a satisfactory relationship will be maintained between inventory and sales and that it harmonizes with the general ﬁnancial program. If it fails in either respect, revision must be made in the program of sales, production, or ﬁnance until a proper coordination is effected. Under this plan, control over the inventory is effected by means of enforcement of the sales and production programs. If either varies to any important degree from the budget, the other must be revised to a compensating degree and the inventory budget revised accordingly. Where the sales and production programs can be enforced with reasonable certainty, this is the preferable method. It is particularly suitable for those concerns that manufacture a comparatively small number of items in large quantities. The application is similar in principle to that illustrated in connection with raw materials controlled budget-wise by minimums and maximums. (b) BUDGETING TOTAL FINISHED QUANTITIES AND VALUES. Where the sales of individual items ﬂuctuate considerably and where such ﬂuctuations must be watched for hundreds or even thousands of items, a second plan is preferable. Here basic policies are adopted relative to the relationship that must be maintained between ﬁnished inventory and sales. This may be done by

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E XHIBIT 28.3

B UDGET

Grand Total

Total—Quarter 1 Quarter 2 Quarter 3 Quarter 4

FOR

375,000 432,000 353,000 327,000 $ 1,487,000

264,800 261,950 256,180 250,580 $ 264,800 W ORK- IN- P ROCESS

Direct Material $ 110,000 120,000 145,000

Beginning Inventory $ 264,800 258,300 271,800

Ch. 28 Planning and Control of Inventories

Month/Quarter January February March

592

$ 1,142,540

332,640 271,800 250,800

287,300

$ 1,428,250

415,800 338,700 314,600

359,150

Charges to Work-in-Process Manufacturing Direct Labor Expense $ 84,700 $ 105,900 92,400 115,500 110,200 137,750

T HE I LLUSTRATIVE C OMPANY B UDGET FOR W ORK - IN -P ROCESS F OR THE P LAN Y EAR 20XX (D OLLARS IN H UNDREDS )

1,180,440 963,500 892,400

1,021,450

$ 4,057,790

$

Total 300,600 327,900 392,950

$ 4,059,910

1,186,210 969,100 880,300

1,024,300

Transfers to Finished Goods $ 307,100 314,400 402,800

$ 262,680

256,180 250,580 262,680

261,950

Ending Inventory $ 258,300 271,800 261,950

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establishing standard rates of turnover for the inventory as a whole or for different sections of the inventory. For example, it may be decided that a unit turnover rate of three times per year should be maintained for a certain class of goods or that the dollar inventory or another class must not average more than one fourth of the annual dollar cost of sales. The budget is then based on such relationships, and the proper executives are charged with the responsibility of controlling the quantities of individual items in such a manner that the resulting total inventories will conform to the basic standards of turnover. With such standard turnover rates as basic guides, those in charge of inventory control must then examine each item in the inventory; collect information about its past rate of movement, irregularity of demand, expected future demand, and economical production quantity; and establish maximum and minimum quantities, and quantities to order. Once the governing quantities are established, they must be closely watched and frequently revised if the inventory is to be properly controlled. The establishment and use of maximum, minimum, and order quantities can never be resolved into a purely clerical routine if it is to be effective as an inventory control device. A certain element of executive judgment is necessary in the application of the plan. If, for example, the quantities are based on past sales, they must be revised as the current sales trend indicates a change in sales demand. Moreover, allowance must be made for seasonal demands. This is sometimes accomplished by setting different limits for different seasons. The most frequent cause of the failure of such inventory control plans is the assignment of unqualiﬁed personnel to the task of operating the plan and the failure to maintain a continuous review of sales experience relative to individual items. The tendency in far too many cases is to resolve the matter into a purely clerical routine and assign to it clerks capable only of routine execution. The danger is particularly great in concerns carrying thousands of items in ﬁnished stock, with the result that many quantities are excessive and many obsolete and slow-moving items accumulate in stock. The successful execution of an inventory control plan requires continuous study and research, meticulous records of individual items and their movement, and a considerable amount of individual judgment. The plan, once in operation, should be continually tested by comparing the actual rates of turnover with those prescribed by the general budget program. If this test is applied to individual sections of the ﬁnished inventory, it will reveal the particular divisions that fail to meet the prescribed rates of movement. The work of correction can then be localized to these divisions. T HE I LLUSTRATIVE C OMPANY F INISHED G OODS I NVENTORY B UDGET F OR THE P LAN Y EAR 20XX (D OLLARS IN H UNDREDS )

Month/Quarter January February March Total—Quarter 1 Quarter 2 Quarter 3 Quarter 4 Grand total E XHIBIT 28.4

Beginning Inventory $ 329,600 342,300 309,600

Transfers from Workin-Process $ 307,100 314,400 402,800

Purchased Parts (a) $ 71,000 72,000 80,000

Cost of Goods Sold $ 365,400 419,100 472,500

Ending Inventory $ 342,300 309,600 319,900

329,600 319,900 326,910 319,910

1,024,300 1,186,210 969,100 880,300

223,000 64,500 41,400 49,600

1,257,000 1,243,700 1,017,500 932,900

319,900 326,910 319,910 316,910

$ 329,600

$ 4,059,910

$ 378,500

$ 4,451,100

$ 316,910

B UDGET

FOR

F INISHED G OODS I NVENTORY

Note: (a) Certain purchased parts are acquired for sale to customers, and do not enter work-in-process

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Ch. 28 Planning and Control of Inventories

Whenever possible, the plan of ﬁnished inventory control should be exercised in terms of units. When this is not practicable, it must be based on dollar amounts. T HE I LLUSTRATIVE C OMPANY S UMMARY OF B UDGETED I NVENTORIES F OR THE P LAN Y EAR 20XX (D OLLARS IN T HOUSANDS )

Item Beginning inventory Quarter ending inventory March June September Year ending inventory Total annual usage— estimated Daily average (255 days) Number of days usage on hand—year end E XHIBIT 28.5

S UMMARY

Raw Materials and Purchased Parts $ 186,400

Work-inProcess $ 264,800

183,400 176,400 169,400 $

200,400

Finished Goods $ 329,600

261,950 256,180 250,580 $

262,680

319,900 326,910 319,910 $

316,910

$ 1,487,000

$ 4,059,910

$ 4,451,100

$

$

$

5,831

15,921

34.4 OF

16.5

$

Total 780,800

765,250 759,490 739,890 $

779,990

17,455 18.2

B UDGETED I NVENTORIES

In the context of preparing the annual business plan in monetary terms, and based on the quantities of ﬁnished goods (furnished by the cognizant executive) deemed necessary for an adequate inventory, the controller can develop the budget for the ﬁnished goods inventory, much as is shown in condensed form in Exhibit 28.4. When the total of the inventory segments is known, the total inventory budget for the company can be summarized as in Exhibit 28.5. Such a summary can be useful in discussing inventory levels with management. Any pertinent ratios can be included. Again, in testing the reasonableness of the annual business plan, the inventory—by segments, or perhaps in total—should be tested by turnover rate or another device suggested for control (or planning) purposes.

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CHAPTER

29

VALUATION OF INVENTORIES 29.1

SIGNIFICANCE OF PROPER INVENTORY VALUATION 595

29.7

CONSISTENCY IN VALUATION 600

29.2

CONTROLLER’S RESPONSIBILITY FOR INVENTORY VALUATION 596

29.8

29.3

EMPHASIS ON THE COST BASIS 596

FEDERAL INCOME TAX CONSIDERATIONS IN VALUING INVENTORIES 600

29.4

INVENTORY CHARACTERISTICS AND EFFECT OF THE VALUATION BASE 597

29.9

INTERIM STATEMENTS 601

29.5

SELECTION OF THE COST BASE 598

29.10 OTHER INVENTORY VALUATION PROBLEMS 601

29.6

DEPARTURE FROM THE COST BASE 599

29.11 INVENTORY RESERVES 602

29.1 SIGNIFICANCE OF PROPER INVENTORY VALUATION The selection of the principle or method to value the inventory has a signiﬁcant impact on the reported earnings and the ﬁnancial condition of the particular company. Since the inventories are usually the most signiﬁcant item in the current assets, the method of valuing inventories is a very important factor in determining the results from operations and the ﬁnancial condition. One of the objectives of accounting for inventories, including valuation, is to determine income properly by matching the applicable costs against the revenues of the ﬁrm. In the normal course of business, goods are purchased or manufactured and then sold; other merchandise is secured for additional sales. In this process of selling and either buying or making other goods for sale, it can be seen that the inventory is the “residual value”—the value remaining after costs have been applied to sales or the amount chargeable against future sales. A demonstration of the effect of inventory valuation by using different methods is simple. For example, suppose a dealer purchased an airplane for $250,000 and sold it for $300,000. Suppose further that the dealer also had purchased another identical airplane for resale at a cost of $270,000. What is the proﬁt? On one basis—ﬁrst in–ﬁrst out (FIFO), it is $50,000. By another method of valuation—last in–ﬁrst out (LIFO), the proﬁt is $30,000 ($300,000 less $270,000). Which is correct? The method of valuing inventories has a dramatic effect on the statement of income and expense. The controller has the responsibility for determining which method or basis of valuation more clearly reﬂects the results from operations or income. Another objective of inventory valuation is to state correctly the ﬁnancial position, the ﬁnancial condition of a going concern, not one going out of business or in liquidation. The objective may be less important than income determination, since the actual value of inventory cannot be determined until sales are made in the normal course of future business. However, there are no conﬂicts between the two objectives about the selection of a valuation method. The subject of inventory valuation includes not only a selection of the proper basis and method of valuation but also a determination about what costs are to be included. For example, should expenses that the purchasing or accounting departments incur be included? Is freight-in a proper 595

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Ch. 29 Valuation of Inventories

cost to include in inventory? What about handling and storage costs? These kinds of questions can have a great signiﬁcance in valuing inventories.

29.2 CONTROLLER’S RESPONSIBILITY FOR INVENTORY VALUATION There are many alternatives available to the accountant in valuing inventories; this means that the subject must be researched and analyses made to determine the most appropriate method. Thus inventory valuation is not an easy task and is not readily understood by many executives or managers. The controller must develop an awareness on the part of management about the effect different methods of valuation have on proﬁts. To do this, several different methods should be applied and the results analyzed and interpreted for management’s consideration. The controller must take the initiative in developing inventory valuation methods. Some of the duties and responsibilities to be assumed are: • Select the basis of valuation that will most satisfactorily reﬂect income. The board of directors or chief executive actually may approve or select the method. However, the controller should prepare the case and guide or inﬂuence the decision. The controller should be the member of the management team most familiar with the ramiﬁcations. • Where necessary or desirable, prepare supplementary data about the effect on income of different bases, or changes in bases, of valuation, including standard cost changes and inﬂation. • Provide for a continuous review of procedures and records to assure that inventories are being properly valued. This will include procedures for notiﬁcation when materials become unsalable and for keeping abreast of market conditions. It will involve constant vigilance about the effect of manufacturing developments on inventory balance and value. The controller is not the most qualiﬁed person to determine material obsolescence. Instead, a materials review board (MRB) should be created to periodically review the inventory. The MRB has representatives on it from the accounting, quality control, engineering, sales, and materials departments. The combined expertise of this group can be relied upon to identify unsalable materials. • Study the effect of tax legislation on inventory valuation and records and make any necessary changes in the accounting procedures so as to economically have available the required tax basis data. Act in the best interests of the company in dealing with the representatives of the Internal Revenue Service (IRS) and other taxing authorities.

29.3 EMPHASIS ON THE COST BASIS Most of the methods of valuing inventories involve “cost.” Our entire system of accounting is based on cost, and this same concept is applied to inventories. As related to inventory, cost may be deﬁned as the sum of all applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. Just what are “applicable” expenditures and charges? The cost principle is easy to state but difﬁcult to apply. Judgment must be exercised in determining what costs ought to be included, and a consistent policy must be followed. It is generally accepted practice to exclude from inventory costs that share of general and administrative expense not clearly related to production. However, exclusion of all overhead charges from inventory costs would not constitute acceptable accounting practice. Then, too, abnormal costs of various types may be of such magnitude that they require omission. Some examples are excess spoilage, rehandling costs, and idle facility expense. Product costing generally has followed the absorption costing concept as stipulated by generally accepted accounting principles (GAAP). On this basis, product costs have been deﬁned in this manner:

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597

Those costs of raw materials, direct labor, and other costs that are directly or indirectly involved in the production of goods and services for sale to customers. Indirect costs include such items as factory depreciation, equipment maintenance, factory utilities, and wages for facilitating services in the plants.1

29.4 INVENTORY CHARACTERISTICS AND EFFECT OF THE VALUATION BASE In a stable price economy fewer questions of inventory valuation policy normally arise. It is in periods of rapid price change that the valuation base selected may have a signiﬁcant inﬂuence on income determination. The effect of price changes is not uniform in every industry or in every company. Certain features or characteristics of the inventory determine the effect of price changes on an individual business concern, including: • Degree of selling price responsiveness to cost changes • Relative share of investment in inventories • Possibility of price hedge • Rate of turnover • Rate of inﬂation The heart of the problem is the responsiveness of selling price changes to costs. If prices bear little immediate relationship to costs, then the selling price to be realized on the disposition of the present inventory will not impair its value. There will be no problem of write-down. Relative size or importance of the inventory is a factor, for the larger the inventory, the greater the risk and the more signiﬁcant the write-down if values decline greatly. Certainly, a ﬁrm whose major investment is in inventory is considerably more vulnerable to market changes than one that requires a heavy investment in plant and equipment to engage in business. Under these latter circumstances the effect of price changes may be considerably diluted. There are more costs associated with large inventories than just the risk of loss due to price changes. The following list should also be considered: • Cost of maintaining labor routings for those items in stock at period end • Cost of maintaining bills of material for those items in stock at period end • Cost of raw material cost accumulations for those items in stock at period end • Cost of obsolescence • Cost of property taxes • Cost of insurance (for warehouse facilities as well as the inventory in the warehouse) • Cost of inventory tracking (such as cycle counting and periodic audits) • Cost of inventory handling • Cost of labor required to track old parts to be used up from stock before a newly engineered design replaces those parts • Cost of money tied up in the inventory The reduction in risk when hedging operations are possible is known to those who use the process. Losses on the stock inventory are offset by gains on the futures. A similar hedge on ﬁnished goods inventory, of course, is accomplished by ﬁrm sales contracts. Finally, inventory turnover is important. If the turnover is rapid, a shorter time will lapse between the sale of the goods and purchase of items for additional sales. Consequently, in periods of upswing or downswing the ﬂuctuations will not be as violent, even when a traditional method of inventory costing, such as the FIFO, is used. 1. National Association of Accountants, “Management Accounting Terminology,” Statement on Management Accounting No. 2, NAA, 1983, p. 83.

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Ch. 29 Valuation of Inventories

29.5 SELECTION OF THE COST BASE The primary objective in choosing a cost basis for valuing inventories is to select that method which, under the circumstances, will most satisfactorily reﬂect the income of the period. In many instances, the units sold are not identiﬁable with the speciﬁc cost of the item, or at least such an application is impractical. For this reason, a variety of cost applications have been developed that recognize differences in the relationship of costs to selling prices under various conditions. For example, the LIFO method may be applicable where sales prices are promptly affected by changes in reproduction costs. In another situation, the conventional FIFO method may apply. Circumstances of the individual company or industry must govern, but uniform methods within the industry will permit useful comparisons. A very brief description of the ten more common inventory valuation methods based on costs follows: 1. Identiﬁed or speciﬁc costs. Under this method, purchases are not commingled but are kept separate. The issue or sale is priced at the exact cost of the speciﬁc item. Such a system is not widely adopted because it requires too much physical attention as well as accounting detail. It is sometimes used in costing perishable stock or nonstandard units that have been purchased for a speciﬁc job. 2. First in–ﬁrst out. This means is often known as the original cost method. It assumes that items ﬁrst received are ﬁrst issued. To illustrate the operation, assume an opening inventory of 50 units at $10 each, receipts on January 11 of 10 units at a cost of $15, and issues on January 3 and 12 of 40 each. The issue on January 3 would be costed at $10 per unit, leaving a balance of 10 units at $10 each. The issue of January 12 would be priced: 10 units at $10 each 30 units at $15 each

$ 100 450

Total

$ 550

The requisition must be priced on two bases since two different acquisitions were issued. 3. Simple arithmetic average cost. The average is computed by dividing the total unit prices for the inventory on hand by the number of such prices, without regard to the quantities to which the prices relate. It is mathematically unsound. 4. Weighted average cost. This procedure involves the determination after each receipt of the total quantity and value on hand. The total units are divided into the total value to secure an average unit cost. All issues are priced at this average cost until the next receipt, when the new average is computed. The unit price must be carried out to sufﬁcient decimal places to retain accuracy. Disadvantages of this method include the detail calculations necessary and the length of time taken to reﬂect recent purchases in the average. It has the advantage of stabilizing costs when prices ﬂuctuate. 5. Moving average cost. This method uses an average price of a convenient period of time, such as three or six months. It is a variation of the weighted average method. The effect of price ﬂuctuations is minimized. 6. Monthly average cost. The total beginning inventory and the receipts for the month are divided into the aggregate cost to determine an average. This average is then applied to the issues for the period. The method has the advantage of eliminating some clerical work. But the disadvantage is that the requisitions cannot be costed for the month until the new average cost is determined. Sometimes this disadvantage is avoided by using the previous monthly average. The period of time over which the receipts are accumulated need not necessarily be a month, nor need the end of the period coincide with the monthly closing.

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599

7. Standard cost. As the name implies, a predetermined or standard cost is used. The price variance on raw materials may be recognized when the material is received or when it is issued into process. Use of standard costs eliminates much clerical effort. No cost columns are needed on the ledger cards, and the repeated calculation of unit costs is avoided. 8. Last in–ﬁrst out cost. The use of this method assumes that the last unit purchased is the ﬁrst to be requisitioned. The mechanics used are very similar to the FIFO method, except that requisitions are priced at the cost of the most recent purchase. For example, assume that 100 units are purchased at $4 each and that later 50 units are purchased at $6 each. A requisition for 75 units would be priced as: 50 units at $6 25 units at $4

$ 300 100

75 Total

$ 400

The purpose of the LIFO method is to state, as closely as possible, the cost of goods sold at the current market cost. This method reduces unrealized inventory proﬁts to a minimum. The following problems with LIFO must be considered: Recordkeeping is more extensive than that required for other valuation methods. If the

oldest inventory costing layers are never used, the company can have costing layers that go back many decades. If inventory levels drop to zero at period-end, the proﬁt impact could be enormous, for the oldest cost layers may stretch back many years to times when product costs were signiﬁcantly different. For example, Product A currently costs $10 to build. If the oldest Product A cost layer is only $1 and all of the inventory is used, then the gross margin on sales of the oldest cost layer will increase by $9, yielding a startling improvement in the gross margin percentage. 9. Replacement cost. By this method, the inventory is priced at the cost that would be incurred to replace it at current prices and in its current condition. It can be seen that the method is not the same as LIFO, for the latter uses the latest price on the books, which is not necessarily replacement cost. The method has many practical difﬁculties, is not approved by the IRS, and is not considered a GAAP. If used for internal purposes, it must be adjusted for external reporting. 10. Retail inventory method. This method is used largely in department stores, where the inventories are marked item by item at selling price rather than cost. The average margin or markup is determined for the period, and this is applied against the ending inventory at retail to ascertain cost. It is a type of average costing. For details on each of these costing methods, the reader is referred to the many excellent accounting texts on the subject.

29.6 DEPARTURE FROM THE COST BASE Under ordinary circumstances inventories should be valued at cost. There are occasions, though, where cost is not a proper measure of the charge against the revenues of future periods. In such instances, a departure from the cost basis is necessary if the utility of the goods disposed of in the ordinary course of business is less than cost. Loss in value can occur by reason of damage, deterioration, obsolescence, changes in the price level, and other causes. Such loss should be recognized as a charge against the period in which it occurs. In these instances, the goods should be valued at “market,” which will be lower than cost. How, then, is “market” deﬁned? As used in the phrase “lower of cost or market” the term signiﬁes current replacement cost by either purchase or manufacture, whichever is applicable. However,

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Ch. 29 Valuation of Inventories

there are deﬁnite limits to the application of this rule. Market should not exceed the estimated selling price, less the costs of completion and disposal. On the other extreme, it should not be less than the estimated net realizable value, minus an allowance for the normal proﬁt margin. The explanation of the phrase “lower of cost or market” may be stated as: . . . is that the valuation of the inventory should be kept as conservative as possible. If the generally accepted market value of an item is clearly lower than the cost at which the same item is being maintained in the inventory database, then it is reasonable to make a reduction in the cost basis of the inventory to adjust to the lower market-based cost. Not making this adjustment could artiﬁcially inﬂate the value of the inventory to such a substantial degree that people who use the ﬁnancial statements to make decisions, such as lenders who grant credit based on the size of the borrowing base (which usually includes inventory) could be misled by the reported inventory value. The only exception to this value reduction rule when there is a clear-cut sales contract that allows a company to sell its inventory at a ﬁxed price in the future, irrespective of its current valuation; in this case, the sales contract nulliﬁes the impact of low inventory valuation.

In applying the rule of cost or market, whichever is lower, the question arises about whether the test should be applied directly to each item of the inventory or to the total inventory or major categories. Since the purpose is properly to reﬂect income of the period, the method that achieves this objective should be used. In practice, most companies apply the rule to each item in the inventory. There are instances, however, when application of the total inventory would have the greatest signiﬁcance. Thus one component may be less than cost, and another component to the same article may have a market value equally higher than cost. If a balanced inventory condition exists, no adjustment might be necessary.

29.7 CONSISTENCY IN VALUATION Irrespective of the method of pricing the inventory, an essential requirement is consistency from period to period. Over the long run, the basis of valuing inventories will not affect the total proﬁt or loss from operations. However, from quarter to quarter or year to year the effect on proﬁt can be signiﬁcant if the basis or method is changed. If circumstances require a change, the reason for the change and the effect on proﬁt should be fully disclosed in the ﬁnancial statements presented to management and the shareholders. In addition, advance approval should be obtained from appropriate governmental agencies, if required. These items can cause inconsistent valuations: • Changes to an inaccurate bill of material (BOM) from a previous period • Changes to an inaccurate labor routing from a previous period • Changes to BOMs and labor routings that affect items that are still in stock from the previous period • Changes in run sizes that impact labor routings from a previous period • Changes in labor dollars that impact overhead, since overhead is usually calculated as a percentage of labor

29.8 FEDERAL INCOME TAX CONSIDERATIONS IN VALUING INVENTORIES The valuation of inventory is obviously required to determine taxable income. We have considered the general principles of inventory valuation from the standpoint of good business practices, and, presumably, such methods would be acceptable for determination of taxable income. However, the Internal Revenue Code (IRC) and the Treasury regulations provide speciﬁc criteria that must be followed. Section 1.471.2 of the Treasury regulations provides two tests to which each inventory must conform: 1. It must conform as nearly as possible to the best accounting practice in the trade or business. 2. It must clearly reﬂect the income.

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29.10 Other Inventory Valuation Problems

601

Section 1.471-2 of the Treasury regulations further provides that to clearly reﬂect income, the inventory practice should be consistent from year to year, and greater weight is given to consistency than to any particular inventory method or basis of valuation. For those companies using the LIFO valuation method and who are pursuing just-in-time production techniques, note that the cost of goods sold percentage will vary drastically while the inventory is being reduced, since old cost layers with possibly very different costs will be used up; this change may draw an inquiry from the Internal Revenue Service, so ensure that your documentation of cost changes is accurate and complete. The bases of valuation most commonly used by business concerns and that meet the requirements of the Treasury regulations are (1) cost and (2) cost or market,1 whichever is lower. Under Section 1.472.1 the taxpayer is permitted to use the LIFO inventory method, provided the election of the method is approved by the commissioner and is consistently used. To more fully understand the transition to this method it is recommended that the full section of the Treasury regulation be studied in detail. The Treasury regulations relating to the valuation of inventories are extensive, and many provisions are applicable to certain industries. The controller should thoroughly understand the applicable regulations and consult tax counsel to develop inventory valuation methods that will maximize a favorable tax position for the company.

29.9 INTERIM STATEMENTS The method of valuing inventories poses no particular problems in connection with the preparation of interim statements. Under certain conditions, however, adjustments may be required, depending on the method used, such as LIFO. Generally, the controller must study the situation and determine the best practice under the circumstances for preparing interim reports. Many companies issue interim ﬁnancial reports that do not incorporate accurate perpetual inventory ﬁgures. Instead, they estimate the cost of goods sold based on the previous year’s actual gross margin. This method can subject the company to year-end surprises if product costs have changed from the previous year. For more information on setting up a perpetual inventory system, see Chapter 60.

29.10 OTHER INVENTORY VALUATION PROBLEMS The inclusion or exclusion of certain costs in inventory is a task that takes a considerable amount of study and effort. Normally, we think of inventory valuation as applicable to direct labor and material, although other components of inventory should be considered. • Storage and handling costs. One debatable point is whether storage and handling charges should be included in raw material inventories. Many companies do not write up the raw materials to include such costs. Instead, they consider them part of the general manufacturing overhead and prorate the charges to work in process and ﬁnished goods. Such a practice is satisfactory unless there is a great variation or irregularity between receipts and consumption of the material. Under such circumstances, it may be permissible to include normal storage and handling costs in the raw material valuation. • Purchasing department expense. A similar question is raised with respect to purchasing department overhead as well as the clerical costs of the accounting department that are related to raw materials. The costs of these departments generally would continue the same from one period to another regardless of receipts. Thus they are more attributable to the accounting period than to batches of material, and it is not desirable to increase raw material inventory value by these expenses. They may be treated more properly as manufacturing overhead.

1. Sections 1.471.3 and 1.471.4 of the Treasury regulations.

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Ch. 29 Valuation of Inventories

• Inbound transportation costs. Where the cost of getting the goods to the factory site is identiﬁable with particular material or lots, the cost may properly be added to the raw material. If such allocation is impractical, it may be considered part of the manufacturing overhead. • Overhead and burden. In most cases, some indirect costs will be included in inventory values. For example, fringe beneﬁt costs may be included as part of the labor rate applied to direct factory hours. In other instances only variable overhead costs are included, and ﬁxed overhead costs are considered as period costs. Some practices consider all factory costs as part of production and thus included in the inventory value. General and administrative costs are normally not part of inventory and are period costed. The proper treatment of these costs must be considered in the light of GAAP and the applicable tax regulations. Also, the overall discussion of overhead issues will become less important as more companies adopt just-in-time inventory systems. As inventories shrink, the impact of changes in the overhead structure will have a smaller impact on the ﬁnancial statements, for the amount of overhead in the period-end inventory will shrink dramatically.

29.11 INVENTORY RESERVES Inventory reserves are sometimes used to properly value the inventory. It may be well to emphasize here that controllers should take every precaution to report income as it is and not develop unsound reasons for reserves to report predetermined income. Extreme care should be exercised in creating any inventory reserves by charges to current operations that are not fully substantiated and documented. As previously discussed in Section 29.2, the MRB is the ideal group to identify unsalable materials. The identiﬁcation and resulting documentation of these materials by the MRB should be the basis for calculation of an inventory reserve. The Financial Accounting Standards Board (FASB) has determined that an accrual of an estimated loss charged to income must meet both of the following conditions: 1. Information available prior to issuance of the ﬁnancial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the ﬁnancial statements. It is implicit in this condition that it must be probable that one or more future events will occur conﬁrming the fact of the loss. 2. The amount of loss can be reasonably estimated.1 The reserves under consideration here are those for which the provision is charged against the operations, the reserve itself being deducted from the inventory in the balance sheet, in accordance with generally accepted accounting principles. If such a practice is followed, any charges made against the reserve should be approved by the controller and separately reported to management, indicating the reasons for the charge. These charges should be analyzed and strictly controlled to preclude burying of losses and suppressing visibility by management.

1. Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies.”

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CHAPTER

30

ACCOUNTING AND REPORTING FOR SELECTED INVESTMENTS AND EMPLOYEE BENEFIT PLANS 30.1

INTRODUCTION 603

30.2

IMPROVING THE INVESTMENT DECISION PROCESS 604

30.3

RELEVANT FINANCIAL ACCOUNTING STANDARDS 604

30.4

ROLE OF THE CONTROLLER 605

30.5

ACCOUNTING RECORDS FOR SELECTED INVESTMENTS 606

30.6

FINANCIAL REPORTS ON SELECTED INVESTMENTS 609

30.7

ACCOUNTING AND DISCLOSURE REQUIREMENTS AND PRACTICES FOR EMPLOYEE BENEFIT PLANS 609 (a) Investment Policy 610 (b) Selection of Fund Managers 613 (c) Selection of the Plan(s) Trustees 613 (d) Interface with the Actuary 613 (e) Qualiﬁcation with the IRS 613 (f) Financial and Other Disclosure Requirements 614 (g) Evaluating Fund and Manager Performance 614 (h) Other Reports to Management and/or Plan Participants 615 (i) Other Administrative Matters 618

30.1 INTRODUCTION In a broad sense, business management may be regarded as the management of investments— investments in cash, receivables, inventories, plant and equipment, and other objects. The planning and control of each of these investments has been discussed. However, they are reviewed individually and not necessarily as compared with alternatives. In deciding on a given investment, techniques of evaluation were discussed: relative return on assets, internal rate of return, discounted cash ﬂow, and so on. Some of the more sophisticated methods are reviewed as applied to plant and equipment (Chapter 31), or acquisitions and mergers (Chapter 52). The return on identiﬁed programs or projects was discussed, for example, programs for research and development (Chapter 22). The same technique applies to manufacturing projects—such as building a particular aircraft. It also applies to selected products when considering the setting of sales prices (Chapters 18 and 19). One broad area of investment has not been reviewed—debt and equity securities. This is a ﬁeld that is growing in importance and complexity as businesses increase in size, and as they develop from national enterprises into multinational or global companies. Not only are the investment opportunities (and risks) becoming more numerous, but also the instruments themselves are becoming more complex. In addition to stocks and bonds, there are options, warrants, mort603

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Ch. 30 Accounting and Reporting for Selected Investments and Employee Benefit Plans

gage-based securities, derivatives, and a host of others. A review of the balance sheets of business entities reveals a larger number of asset classiﬁcations and related footnotes than several years ago, for example, investments in equity securities, investments in debt securities, “other investments,” employee beneﬁt plan assets (and liabilities). Given this diversity and complexity, it is desirable to brieﬂy comment on the controller’s viewpoint in the more complicated investment management environment and the impact of ﬁnancial accounting standards.

30.2 IMPROVING THE INVESTMENT DECISION PROCESS When the investment decisions are relatively few and simple, they can be viewed individually, without regard to other potential alternatives or needs. Each often is considered solely on its own. After the investment is made, the monitoring process stops. In today’s competitive environment, a broader view of the process must be taken by the controller. The need is greater as the business becomes larger, enmeshed in a complex organizational structure, and as the complexity of the decisions increases. When the business is small, the owner is involved in most phases and makes most of the decisions, but as the business grows, this personal contact becomes diluted. Most experienced ﬁnancial executives know that the amount of thinking and analysis involved in an investment decision varies greatly depending on the nature of the investment. For example, the effort devoted to deciding where to invest temporary surplus cash is much less than that related to making a sizable investment in plant and equipment, or acquisition of a new company. However, most investment decisions should form a consistent pattern and ﬁt a matrix that moves the entity toward its mission. For example, an investment in a minority position in a business in Thailand, and another acquiring a subsidiary in Mexico should in some way be related to the overall strategy of the entity. Otherwise, the pieces will not ﬁnally ﬁt together. When making a signiﬁcant investment decision, the action must be part of an investment management program that should involve these ﬁve related, key processes: 1. Strategic planning (see Chapter 12). (a) Identifying the company mission or purpose. (b) Establishing related goals and objectives (including the annual plan to meet the long-term objective). (c) Establishing check points and performance targets to measure progress. 2. Identiﬁcation of alternative approaches to meeting the objective. Example: acquisition, merger, divestment, or self-growth of capability. (a) Includes identifying costs (and true cost drivers) of the option. 3. Assessing, analyzing, and evaluating the alternative investments, including the risks. 4. Implementing the action. Included would be assigning the responsibility for execution, integrating the investment object into the entity, and establishing a monitoring or tracking system. 5. Monitoring investment performance versus the plan.These processes, though most obvious when using resources to purchase plant and equipment or acquisitions, can and should apply to most signiﬁcant investments. The complexity of the process increases with the size of the company, the size of the project, and the levels of management involved. But the process should not be overlooked even in making investments in minority positions, equities, and other securities.

30.3 RELEVANT FINANCIAL ACCOUNTING STANDARDS Certain classes of investments—securities, as distinguished from working capital (cash, accounts receivable, inventories, and current liabilities) or plant and equipment—require special considerations.

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605

The growth in multinational companies and global companies has increased the need, opportunities, and risks in making certain investments. Moreover, the explosion in the types of investments possible, and the need for appropriate disclosure, has raised serious questions about the adequacy of the accounting and reporting guidelines for these investments. This, in turn, has caused the Financial Accounting Standards Board (FASB) to address these matters, and to issue numerous statements. The controller must assume responsibility for application of the proper accounting treatment and meeting disclosure requirements for the entity. The many Statements of Financial Accounting Standards (SFASs) are a topic for a specialized book, however, one guideline of widespread application deserves comment—SFAS No. 115—Accounting for Certain Investments in Debt and Equity Securities, issued in September 1993. The controller should read and understand this SFAS in its entirety. However, this summary brieﬂy discusses some major aspects which may impact the general accounting and required disclosures, and may inﬂuence the internal management reporting. SFAS No. 115 addresses the accounting and reporting for investments in equity securities that have readily determinable fair values, and for all investments in debt securities. These investments are to be classiﬁed in three categories and accounted for as: 1. Debt securities that the enterprise has the positive intent and ability to hold to maturity are to be classiﬁed as held-to-maturity securities and to be reported at amortized cost. 2. Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are to be classiﬁed as trading securities, and are to be reported at fair value, with the unrealized gains and losses to be included in earnings. 3. Debt and equity securities not classiﬁed as either held-to-maturity securities or trading securities are to be classiﬁed as available-for-sale securities, and are to be reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders’ equity. The SFAS contains many exceptions and limitations. It should be mentioned that the FASB chose to use the term fair value rather than market value (intending the term to be applicable whether the market for an item is active or inactive, primary or secondary, paragraphs 10a and b). There are, as expected, exceptions taken to the Statement in that fair value is not applied to all debt securities, and the standard does not solve the income manipulation problem (through the reclassiﬁcation of the security into the trading category).

30.4 ROLE OF THE CONTROLLER The controller normally would not be the executive managing any one of the three types of investments just discussed, or any related ones. Rather, this function usually would fall under the responsibilities of the chief ﬁnancial ofﬁcer (CFO) or treasurer and the relevant staff. The role of the controller regarding the categories of investments under discussion includes: • Ascertaining that the proper accounting standards or principles are applied in the classiﬁcation and valuation of the assets, and related liabilities, if any • Assuring that the proper supporting or “detail” records are maintained on a current basis to provide proper accountability and description of the assets and the related ﬁnancial facts • Determining that proper reports are issued to provide the ﬁnancial information needed to properly oversee the management of the assets. This will include, as deemed appropriate, reports to the board of directors, executive management, trustees, if any, and fund managers • As applicable, assuring that proper, timely, and adequate disclosure is made to the Internal Revenue Service (IRS), the Securities and Exchange Commission (SEC), the Department of Labor and other appropriate government agencies, and to participants in deﬁned beneﬁt plans, or deﬁned contribution plans (such as a 401(k) savings plan)

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Ch. 30 Accounting and Reporting for Selected Investments and Employee Benefit Plans

• Performing any necessary reviews or audits to ascertain that an adequate internal control system exists and is operating properly • As deemed appropriate, periodically taking, or causing to be taken, a physical inventory of the assets • In those instances where ﬁnancial know-how or analysis may be helpful and is requested by fund trustees, managers, or independent accountants, providing appropriate assistance The next sections elaborate on some of these functions.

30.5 ACCOUNTING RECORDS FOR SELECTED INVESTMENTS For many reasons, a business entity may invest in equity securities or debt instruments. While the number of issues may not be great, it is highly desirable that a systematic manner be used to record information relative to the purchase, including the objective, and sale, adjustments made to the carrying value, income received, and relevant legal or tax information. In addition to the data required for proper valuations, detailed records are necessary to provide the information needed to manage the portfolio, as well as to establish and support gain or loss for tax purposes. The ﬁle of invoices or statements from the broker may be thought sufﬁcient in some cases. Indeed, these documents are the source of much information. Generally, however, it is necessary to establish a control account or accounts for investments in securities and to support this with a securities ledger or register. Such a record may be a simple loose-leaf book or a formal ledger (which may be a computer printout) as illustrated in Exhibits 30.1 through 30.2 . Often such records, with substantial related detail and much abbreviation, are maintained in computer ﬁles, with printouts available when required. The basic information to be included in the securities ledgers consists of: • For Stocks Description of issue—name, type, par value, certiﬁcate numbers Dividend dates Record of purchase—date, number of shares, price, commission, tax, total cost, broker Date and amount of dividends received Record of sale or disposition—date, broker, number of shares, sale or call price, commis-

sion, net proceeds Dividends in arrears Loss or gain • For Bonds Description of issue—name, interest rate, maturity date, interest dates, serial numbers, tax

position Record of purchase—date, broker, price, accrued interest, commission, tax, total cost, maturity value Date and amount of interest received Amortization of premium or discount Record of disposition—date, broker, redemption or sale price, accrued interest, commission, net proceeds Loss or gain

The ledger may be kept alphabetically by issuer. Where a large number of transactions are involved, computers are useful.

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50

Oct. 3

E XHIBIT 30.1

35

$30

S TOCK L EDGER S HEET

*Gives effect to commision and tax

100 1,770

$3,020

*Cost

Nov. 15

Sep. 30

19XX

Date

25

25

No. of Shares

Price

$100

No. of Shares

Par Value Sold

Common

ABC Corporation

Bought

Jan. 30

19XX

Date

Class

Issued By

38

$36

Price

30.5

940

$890

*Total Received

100

125

75

100

No. of Shares

32.28

32.28

30.20

$30.20

Average Price

607

3.228

4.035

2.265

$3,020

Cost

Accounting Records for Selected Investments

133.00

$135.00

Proﬁt or Loss

Balance

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E XHIBIT 30.2

Jul. 1

Dec. 31 19X1 Jun. 30

19X0 Apr.1 Jun. 30

B OND L EDGER S HEET

1

2

5,200.00

100.00

Can. Natl. Bk.

107

50.00

Credit

Premium

10,750

Debit

100.00

107 1/2

Price

Remarks

Balance

Proﬁt or Loss

5,250

10,500

10,600

10,750 10,700

100.00

Due 1990 6/30 12/.31 1990 6/30

250.00

$10,750.00

Cost Accrued Interest

10%

Price

Premium

Marks & Co. Premium

Memo

Redeemable Pieces

Jun. 30–Dec. 31 No

Interest Payable

Date

Dec. 31, 2010

9.3%

10%

When Due

Actual Rate

Nominal Rate

B1676, B1677 $5,000 First Trust Co., Detroit First Trust Co., Detroit Jan. 1, 1990

ABC Marks and Co.

Description: Numbers Denomination Where Payable Trustee Dated

Purchased Through

Asher Company, First Mortgage: Sinking Fund 1999

Ch. 30 Accounting and Reporting for Selected Investments and Employee Benefit Plans

Name of Bond

608

5.00

500.00 500.00

Interest Amount

$5,000

Paid 1990 6/30 12/31 1990 6/30

Face Amount

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609

30.6 FINANCIAL REPORTS ON SELECTED INVESTMENTS The activity in investments for most industrial ﬁrms normally will be quite limited and few reports need be prepared. Periodic reports to management to show the details of the investment would appear desirable. These may be simple reports containing the following information and any other data considered relevant (see Exhibit 30.3): • For Each Security Name of security Cost Market value Effective yield (rate) Dividend or interest received to date

• For All Investments Overall rate of return Cost and market value

Where signiﬁcant movement takes place, it is desirable to advise management of the purchase or sale, together with the gain or loss in case of disposition.

30.7 ACCOUNTING AND DISCLOSURE REQUIREMENTS AND PRACTICES FOR EMPLOYEE BENEFIT PLANS The accounting and reporting requirements or practices for certain equity investments or debt instruments, previously commented upon, are relatively simple. However, when the subject changes to comparable requirements and practices for employee retirement or beneﬁt plans, the T HE I LLUSTRATIVE C OMPANY I NVESTMENT P OSITION A S OF J ULY 31, 20 XX

Security 1. ABC Corporation 2. Atlas Construction 3. National Co. 4. USA Corporation 5. JPC Corporation 6. Security Co.

Number of Shares 500 100 1,000 1,000 100 500

Total or average

Market Value $ 37,000 2,400 30,000 65,500 1,900 42,000

Purchase Price 431,000 2,400 31,000 64,000 1,875 38,000

Rate of Return* 5.2% 6.3 6.5 7.8 7.5 5.3

Total Dividends for Year to Date $ 800 75 1,000 2,000 70 1,000

$ 178,800

$ 168,275

6.5%

$ 4,945

*Based on payments for past twelve months, or current rate if believed more applicable

E XHIBIT 30.3

R EPORT

ON I NVESTMENT

P OSITION

map becomes complex, with many exceptions, and a great many rules. For this reason, and because funded plan assets most often are held in restricted trusts or foundations that are segregated from the assets of the company, discussion of employee beneﬁt accounting and reporting is discussed separately from other investments. First, there are guidelines published by the FASB, including:

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• FASB Statement No. 87, Employees’ Accounting for Pensions • FASB Statement No. 88, Employers’ Accounting for Settlements and Curtailments of Deﬁned Beneﬁt Pension Plans and for Termination Beneﬁts • SFAS No. 106, Employers Accounting for Postretirement Beneﬁts Other Than Pensions • SFAS No. 112, Employers’ Accounting for Postemployment Beneﬁts The controller should be aware of the requirements of these Statements, together with any amendments. Additionally, employee pension beneﬁt plans or qualiﬁed retirement plans are governed by both the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code, as well as other related regulations. The rules relate to deﬁned beneﬁt plans of various types, and deﬁned contribution plans, including proﬁt sharing plans, money purchase pension plans, 401(k) savings plans, thrift or savings plans, and stock bonus plans. Moreover, there are qualiﬁcation requirements, ﬁduciary responsibilities, reporting requirements, audit requirements, and disclosures to participants requirements of which the controller should have a general knowledge. Aside from the requirements imposed by external forces, the controller must consider what further communications or reports are desirable to properly inform the board of directors, executive management, and plan participants. Given the extensive investment needs of most employee beneﬁt plans, the extreme importance of meeting the accounting, reporting, legal, and tax requirements, some selected topics are brieﬂy discussed in the next section. (a) INVESTMENT POLICY. Statements of investment policy are guidelines to be used in the earning of investment income. Usually, they are expressed in broad terms and reﬂect the views of management, including the investment committee, about how funds should be invested. Even where outside money managers are employed—and although the “prudent” rule is followed—it is usually desirable to speciﬁcally indicate the six matters listed next and, as appropriate, include the terms in the contract with the fund manager: • The general policy • The performance objectives • The extent of risk acceptable • General constraints • Speciﬁc restrictions • Reporting and accountability With time and experience, these guidelines will change, and, of course, they must be tailored to basic changes in the marketplace and the needs of the company. An illustration of the policies and objectives for the retirement funds of an aerospace company is quoted next.

STATEMENT OF POLICIES AND OBJECTIVES FOR INVESTMENTS OF THE COMPANY’S RETIREMENT FUNDS A. P OLICY It is the policy of the Corporation to invest the assets of the pension funds for total return over a period of several years, and not emphasize the return on any single segment of assets, i.e., equity securities, etc. We seek the maximum return consistent with the ﬁduciary character of the funds, and in recognition of the importance of the preservation of capital and the needs of annuitants for timely payment of beneﬁts.

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B. P ERFORMANCE ObjectivesEquity securities in the funds in the aggregate should earn not less than 10% compounded annually over a period of 3–5 years. It is expected that this rate of return will be achieved over a complete security market cycle. While this rate of return is basic, a supplemental guide shall be to outperform the Standard & Poor’s 500 Index by 10%. Thus, if the S&P Index increases by 10% on an annual basis, the funds’ appreciation is expected to be an appreciation of 11%. Conversely, if the S&P 500 represents a depreciation of 10%, the company funds should depreciate by only 9%. The target of an absolute rate of return of 10% is considered more important than the relative goal. Consistency of investment yield is signiﬁcant. If two equity funds earn the same over a 3–5-year period, we would express preference with that one with interim results less volatile. Fixed income securities are expected to earn on an average over a 3–5-year period at least 9%, and should be 10% better than the Salomon Smith Barney High Grade Corporate Bond Performance Index, or any comparable Index. Real estate investments should earn a rate roughly comparable to the common stock index. C. R ISKS To the extent that risk is measurable, these guidelines are applicable: 1. The risk inherent in a 15–25% potential annual appreciation is acceptable; but the risk factor involved in seeking substantially greater appreciation than this is considered too aggressive. 2. The risk inherent in assuring a 9% or less potential annual appreciation in equity securities would be considered as too conservative. D. G ENERAL G UIDELINES Subject to the following guidelines, portfolio managers have full discretion in making investment decisions: 1. Company securities—The retirement funds shall not invest in securities of the Corporation, its subsidiaries, or its afﬁliates. 2. Diversiﬁcation—No more than 10% of the funds, on a cost basis, should be invested in any one security and, preferably, no more than 5%. No more than 15% of the cost value of the funds should be invested in a single industry classiﬁcation. While subject to change, based on the economic outlook, the investment in equity and ﬁxed income securities should be generally limited to this share of the total funding, on a market basis:

Equities Fixed income securities Real estate (direct investments) Cash equivalents Total

Fixed Fund

Equity Fund

20% 70 5 5 100%

80% 10 5 5 100%

The cash equivalent fund is subject to adjustment upward or downward depending on the trustees’ estimate of the immediate term outlook in the equity or bond markets. 3. Marketable securities—Generally, equities should be invested in marketable securities, which may include convertibles. Any exceptions, such as letter stock or restricted stock, should be cleared with the company. It is recognized that, to the extent that some of the equity funds are invested in a venture type capital, these funds will be less marketable.

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E. R ESTRICTIONS It is contemplated that the trustees will be governed by the Prudent Man rule. Operating within this rule, the Investment Board believes that these types of ﬁnancial activities should be prohibited: 1. 2. 3. 4. 5. 6.

Purchases of foreign issues unless registered on the New York Stock Exchange Short sales Puts, calls, straddles, or hedges Margin purchases or other uses of borrowed funds Purchase of securities of the investment manager’s organizations Purchase of more than 5% of the total cost value of the funds in over-the-counter securities, unless express permission is given

F. R EPORTING

AND

A CCOUNTABILITY

The investment manager will be requested to meet and review with the Investment Board, as required, the following items: 1. Current and expected performance of the equity and bond markets 2. The economic outlook 3. Current plan for investments in speciﬁc types of securities (aggressive growth, moderate growth, etc.) 4. Performance for the latest three-month period, and the last 12 months, and since the inception of the fund 5. A quarterly report for the Investment Board, containing at a minimum the following information: (a) Fund activity report: Market value—beginning of year Net contributions Investment income Realized gain (or loss) Unrealized gain Market value—end of year Cumulative net contribution to date Cumulative investment return (b) Statement of all property on hand showing cost, market, and unrealized gain or loss. Percentage of total funds invested should be shown for each security and each industry. (c) Sales during period showing cost, market, and realized gain or loss. (d) Purchases during period. (e) Performance ﬁgures on a total fund basis— (i) For the quarter, year to date, and each of the prior two years (ii) Compound rate of return from inception to date, three years to date, 12 months to date, and year to date (iii) Comparable performance ﬁgures for S&P 500, Dow Jones Industrial Average (DJIA), and any other indices you consider appropriate (f) Short (1–2 pages) report by the fund manager covering investment outlook, changes if any in investment philosophy, and comments on performance of the fund during the past quarter In addition to meeting with the Investment Board, there will be more frequent meetings, as circumstances require, with the chief ﬁnancial ofﬁcer of the company and the administrator of the retirement plans.

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G. M ISCELLANEOUS 1. While the need to change securities in the portfolio is understood, the Investment Board will periodically review the turnover of securities to see that it is not excessive. 2. In recognition of the right of the trustees to secure on a most advantageous basis the necessary research services, etc., the Investment Board will not direct any share of the brokerage business. (b) SELECTION OF FUND MANAGERS. Most medium-sized to large enterprises sponsor trusteed pension plans. In creating and operating the plans, the company must decide the degree to which it wishes to be involved in the investment process. It may administer the trust itself, with company ofﬁcers acting as trustees, and a bank acting as custodian of the securities. On the other hand, it may manage none or only a small portion, with most of the direct investment responsibility placed on outside money managers. Whether the fund will be internally administered will depend, among other things, on the availability of competent people, the relative costs, and the degree of responsibility the company or the management wishes to assume—given the presence of ERISA requirements. Many corporate managements believe that the investment of retirement funds is a highly specialized activity best handled by those who devote full time to such activity. Usually, the ﬁnancial vice president, or treasurer, perhaps with the advice of the controller, selects the manager or stable of several managers. Factors to be considered in selecting the particular ﬁrm include: • A proven track record (although this does not assure future top performance). • A compatible investment philosophy. • An organization structured and manned to be able to adequately serve the client company. The organization would be capable of providing a research staff, efﬁcient execution of trades, and good communication and reports. Some companies hire several money managers, each with different “styles” of investment in some cases and each with differing strengths to achieve a type of diversiﬁcation. Some investment companies may do well managing equity investments, and others perform better in the ﬁxed income ﬁeld. In any event, once managers are selected, the performance should be monitored. To reiterate, the management contract should spell out the terms and restrictions and so forth. (c) SELECTION OF THE PLAN(S) TRUSTEES. Although the money managers make the investments, that is, buy and sell the speciﬁc securities based on their expertise, usually a bank is hired as trustee and custodian of the assets. Securities are handled by the custodian. The custodian must have the ability to properly account for the securities and related income and provide the necessary detailed reports. In selecting the custodian, examination of the computer capabilities and a review with other customers may be desirable. Often, a master trust is established with one custodian for all types of pension or employee beneﬁt plans that involve the holding of stocks or bonds. (d) INTERFACE WITH THE ACTUARY. Once or twice a year the controller may interface with the actuary. Actuaries are the independent professionals who make the pension cost estimates. Through the discounting process, the present value of expected, future beneﬁt payments are established. From this and related information the annual plan contribution is determined. The controller should be familiar, in a general way, with the process and results. Aside from indicating the amount to be paid into the funds, the actuarial report is the basis for the footnote to the ﬁnancial statements. See Financial and Other Disclosure Requirements [subsection (f)]. (e) QUALIFICATION WITH THE IRS. The controller is interested in seeing that pension plan contributions by the company are tax deductible in the year in which made and that the fund earn-

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Ch. 30 Accounting and Reporting for Selected Investments and Employee Benefit Plans

ings are tax free. In order to qualify for the privileged tax treatment, all conditions set out by the IRS must be fulﬁlled. The objective is to ensure that the trust funds are used exclusively for the beneﬁt of the employees or their beneﬁciaries. A trust may lose its qualiﬁed status by engaging in certain prohibited transactions, including lending assets to the sponsor without adequate security; providing the means by which the plans discriminate in favor of special groups of employees, such as corporate ofﬁcers; or diverting corpus or income to the employer. The controller, usually being responsible for tax administration and accounting, should make certain the company does all things necessary to qualify under the IRS directives. The rules set up by the U.S. Treasury (which are subject to change) include: • The plan must be in writing and must be communicated to the employees for whose beneﬁt the plan is operated. • The plan must offer deferred compensation; it must be funded; and, on plan termination, the employees’ interest must vest to the extent of the assets. • The plan must be permanent, and the trust must be valid under state laws and must operate for the exclusive beneﬁt of the employees and their beneﬁciaries; and, ﬁnally, it must qualify as exempt from federal income tax. • As previously stated, it must not discriminate in favor of owners, ofﬁcers, or high-salaried employees. (f) FINANCIAL AND OTHER DISCLOSURE REQUIREMENTS. ERISA greatly increased the reporting and disclosure requirements for pension beneﬁt and welfare beneﬁt plans. Various reports must be prepared and ﬁled with the IRS, some with copies to the Department of Labor (DOL) as well as the Pension Beneﬁt Guaranty Corporation. Initially, the plan administrator is required to ﬁle a summary plan description with the DOL, and to supplement it with amended descriptions, as necessary. The most signiﬁcant report is probably the annual report (Form 5500). For plans with 100 or more participants, the annual report, with certain exceptions must contain these data: 1. The ﬁnancial statements, including: (a) Current value of plan assets and liabilities, at the beginning and end of the plan year (b) Plan income, expenses, and changes in net assets for the plan year, with payments to/ from insurance carriers (c) These supporting schedules: (i) Schedule A—Insurance Information (ii) Schedule B—Actuarial Information (iii) Schedule C—Service Providers and Trustee Information (for each plan or fund) (d) Footnotes required for a full and fair presentation 2. The report of the independent public accountant (g) EVALUATING FUND AND MANAGER PERFORMANCE. One of the more difﬁcult ﬁnancial management tasks is that of evaluating pension fund performance. A ﬁrm with an exceptional record in a “down” market may perform relatively poorly in a “bull” market. What might constitute acceptable performance in the eyes of one corporate management might be deemed unacceptable by another. Then, too, performance over a few quarters of a year or two probably is not indicative. What must be judged is performance over several years, perhaps through a complete market cycle. Although quarterly or annual review is desirable, it is long-term performance that should govern. The rate of return, relative as well as absolute, over a period of years, probably is the only fair measure. Rates of return should be calculated for each fund manager. These may be compared with appropriate measures such as:

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615

• For Equities The Standard and Poor’s Index of 500 stocks The Becker Data Bank

• For Fixed-Income Securities The Salomon Smith Barney Index For each manager, comparisons can be made against other managers of similar funds used by the enterprise and to any number of published fund results. Measurement of a manager must involve the changes in market values from period to period and the manner in which consideration is given to the timing of cash ﬂows into and out of the fund. Risk also must be weighted in the evaluation. Two statistical measures commonly used are the internal rate of return (discounted cash ﬂow) and the time-weighted rate of return. Measurement of risk is attempted through variability in the rates of return and volatility comparisons. The controller may work with the treasurer in developing acceptable measuring devices, reports, and other analyses. An example of a comparative report of equity managers’ performance with each other, with the composite of all, and with two indexes is shown in Exhibit 30.4. Any number of analyses may be prepared, depending on what the ﬁnancial executive performing surveillance of the money managers feels will be helpful and the available data provided through the computer program. A tabulation to identify each individual investment, market value, percentage of total portfolio, P/E ratio, and the gain or loss is illustrated in Exhibit 30.5. (h) OTHER REPORTS TO MANAGEMENT AND/OR PLAN PARTICIPANTS. The ERISA reports discussed earlier represent mandatory reporting. Additionally, the annual report to shareholders usually provides summarized information concerning accumulated beneﬁt obligations of a business entity vs. the plan assets at fair value, together with limited data on assumed long-term rates of return on pension assets and so on. But what other ﬁnancial data should be presented to the board of directors or executive management to provide a sense of relative fund performance and signiﬁcant ﬁnancial aspects or risks? Readily understandable ﬁnancial facts should also be provided to plan participants. Depending on the interest of the board of directors and executive management and the considered opinion of the ﬁnancial executives as to the truly important aspects of the investment performance, and so on, about which these ofﬁcials should be informed, some suggested topics for presentation are: • Comparative asset allocation of funds (see Exhibit 30.6) • Comparative rates of return on asset sectors over several years (see Exhibit 30.7) • Historical comparison of retirement plan assets versus projected beneﬁt obligations (see Exhibit 30.8) • Projection of estimated retirement plan assets versus projected beneﬁt obligations • For an equity fund—the top 25 holdings by company Financial information for plan participants should be limited in quantity so as not to confuse, and should be summarized in nature and limited to historical data (not projected results). As an example, one high-technology company provides semiannual data on the savings plan as: • Financial summary by fund segment (see Exhibit 30.9) • Investment performance by fund segment (see Exhibit 30.10) • A summary of the categories of ﬁnancial instruments in each fund (see Exhibits 30.11 through 30.13 ) • A summary of the stock fund by industry investment (see Exhibit 30.14) • The top 25 equity investments in the stock fund (see Exhibit 30.15)

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E XHIBIT 30.4

23.8% 18.3 1.5 16.6 15.7 15.5 10.5

Manager B Manager D Composite Becker Median Manager A Manager C S&P 500

E QUITY F UND P ERFORMANCE — BY M ANAGER

12-31-X1

12-31-X2

Year Ended

–4.7% –4.8 –5.3 –5.5 –5.6 –6.3 –7.2

Manager B Manager C Composite Manager D Manager A Becker Median S&P 500

12-31-X3

E QUITY F UND C OMPARATIVE P ERFORMANCE S UMMARY ( TIME WEIGHTED , TOTAL RETURN )

Ch. 30 Accounting and Reporting for Selected Investments and Employee Benefit Plans

S&P 500 Manager A Manager B Becker Median Manager C Composite Manager D

616

11.1% 9.5 9.5 8.7 8.5 7.2 6.6

Year to Date 9-30-X4 (Unannualized) Manager E Manager B Manager A Composite S&P 500 Manager D Manager C Becker Median

31.8% 20.6 19.6 19.4 18.4 17.2 16.3 15.8

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617

M ANAGER C—E QUITY P ERIOD (E NDED S EPTEMBER 30, 20 XX ) Percentage of Dollar Gain Security Name Market Value Assets P/E Ratio (Loss) ABC Company $ 2,688,125 4.91 9.29 $ 340,480 DEF Corporation 2,261,350 4.13 7.33 240,038 GHI Corporation 2,033,775 3.71 15.66 237,127 JKL Ltd. 1,955,000 3.57 19.23 284,090 MNO Company 1,842,675 3.37 6.92 245,733 \/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\/\ UUU Corporation 592,500 1.08 7.18 93,619 VVV Compabny 556,250 1.02 7.02 15,755 WWW Company 554,200 1.01 34.00 98,538 XXX Industries 356,103 0.65 12.32 –14,313 YYY Ltd. 343,838 0.63 7.67 –93,706 7,650 0.01 NA 7,650 ZZZ Corporation $ 54,755,683

Total E XHIBIT 30.5

100.00%

12.00

$ 7,757,733

I NVESTMENT P ORTFOLIO S UMMARY —M ANAGER C T HE D OUGLAS C OMPANY R ETIREMENT P LAN —F UND A LLOCATION P ERCENTAGE Year

Fund U.S. Equity Fixed income International equity Fund R Total E XHIBIT 30.6

2008 50.25% 38.50 4.15 7.10 100.00

2007 48.60% 37.00 6.30 8.10

2006 47.75% 35.40 7.25 9.60

100.00

100.00

2005 46.70% 36.10 8.00 9.20 100.00

R ETIREMENT P LAN —F UND A LLOCATION T HE D OUGLAS C OMPANY R ETIREMENT P LAN C OMPARATIVE R ATES OF R ETURN 2002–2005

Sector Equities Fixed income Real estate Total E XHIBIT 30.7

2005 15.10% 9.50 8.80 11.70

2004 14.70% 9.00 9.00 12.10

R ETIREMENT P LAN —C OMPARATIVE R ATES

2003 14.50% 8.70 10.60 12.00 OF

2002 14.30% 7.90 12.70 11.73

R ETURN

To fully comprehend the extent of the detail required, the reader probably should scan a copy of Form 5500 and the supporting schedules. In addition to providing reports to the agencies of the federal government, ERISA requires that a Summary Annual Report (SAR) be provided to plan participants (for each relevant plan). Additionally, the plan participants have the right to request and receive a copy of the full annual report (usually for a fee).

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Some discussion with participants will let you know other subjects of interest to them. In summary, the various management groups (board of directors, investment committee, executive management) should be advised of the important aspects (ﬁnancial and otherwise) of the beneﬁt plans so that they are reasonably informed, and can reach informed conclusions. The plan participants should have made available to them all legally required data and any further information to make the general aspects of the plan ﬁnancial status understandable to them. (i) OTHER ADMINISTRATIVE MATTERS. Aside from the subjects covered earlier in this chapter, there is a multitude of administrative matters that typically are delegated to the ﬁnancial executives most closely associated with pension plan management. The controller should be aware of the actions required, some of which may be his responsibility. Four are outlined here: 1. Proper internal procedures to readily identify retirement beneﬁt payments due to the retirees and other employees 2. Proper cost allocation procedures for each proﬁt center and the like, if applicable 3. Adequate internal control procedures relating to: Investments (purchases, sales, and income proceeds) Operating expenses Beneﬁt payments Withdrawals

Included should be periodic audits by the internal auditors. 4. Independent audits by a public accounting ﬁrm

T HE M C D ONALD C ORPORATION R ETIREMENT P LAN —F UNDED S TATUS (D OLLARS IN M ILLIONS ) A S OF D ECEMBER 31 Description Actuarial present value of beneﬁt obligations Vested beneﬁts Nonvested beneﬁts Accumulated beneﬁt obligations Effect of assumed wage increases Projected beneﬁt obligations Less: Fair value of plan assets Excess of assets over projected beneﬁt obligations Unrecognized items: Prior service costs Net gain Accrued pension asset included in Statement of ﬁnancial position E XHIBIT 30.8

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2010

2009

2008

2007

$2,310 182

$2,051 160

$1,901 140

$1,700 120

2,492

2,211

2,041

1,820

501

450

417

362

2,993 3,740

2,661 3,304

2,458 3,116

2,182 2,916

(751)

(643)

(658)

(734)

(90) 307

(112) 234

(102) 314

(90) 401

$ (77)

$ (521)

$ (446)

$ (423)

R ETIREMENT P LAN —F UNDED S TATUS

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30.7 Accounting and Disclosure Requirements and Practices for Employee Benefit Plans

H IGH T ECHNOLOGY , I NC . S AVINGS P LAN F INANCIAL S UMMARY (D OLLARS IN M ILLIONS ) A S OF J UNE 30, 20XX Fund Stock Fund Bond Fund Money Market Fund

$

Hi-Tech. Inc. Fund (ESOP)

$ 1,168.0

Total E XHIBIT 30.9

S AVINGS P LAN —F INANCIAL S UMMARY

H IGH T ECHNOLOGY , I NC . S AVINGS P LAN I NVESTMENT P ERFORMANCE F OR P ERIOD E NDED J UNE 30, 20XX Latest Preceding Six Fund Months Year 5 Years Stock 3.20% 4.70% 72.30% Bond 1.15 5.00 51.60 Money Market .97 3.75 22.15 Hi-Tech (ESOP) .30% –1.10% 38.34% E XHIBIT 30.10

549.3 158.6 243.7 216.4

10 Years 291.10% 215.30 100.50 41.00%

S AVINGS P LAN —F UND P ERFORMANCE

H IGH T ECHNOLOGY , I NC . S AVINGS P LAN B OND F UND —P ORTFOLIO S TRUCTURE A S OF J UNE 30, 20XX Instrument Federal agency obligations U.S. Treasury notes Banking and ﬁnancial—various Wells Fargo Fund—temporary cash Industrials U.S. Treasury bonds Government obligations Other U.S. government securities Other corporate obligations Total E XHIBIT 30.11

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% of Fund 29.37% 25.61 14.22 12.20 9.10 3.46 2.70 1.91 1.43 100.00%

S AVINGS P LAN —B OND F UND P ORTFOLIO S TRUCTURE

619

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Ch. 30 Accounting and Reporting for Selected Investments and Employee Benefit Plans

S AVINGS P LAN M ONEY M ARKET F UND —P ORTFOLIO S TRUCTURE A S OF J UNE 30, 20XX Instrument U.S. Treasuries Wells Fargo Fund—temporary cash Medium-term notes Certiﬁcates of deposit Asset-backed securities Repurchase agreements Government agencies Deposit notes

% of Fund 43.52% 20.40 17.00 6.98 4.05 2.68 2.40 1.48 1.49

Commercial paper

100.00%

Total E XHIBIT 30.12

S AVINGS P LAN —M ONEY M ARKET F UND —P ORTFOLIO S TRUCTURE

H IGH T ECHNOLOGY , I NC . S AVINGS P LAN H I -T ECH , I NC . F UND (ESOP) (D OLLARS IN M ILLIONS ) A S OF J UNE 30, 20XX Market Value High Technology, Inc. Shares held—5,436,201, or 10.1% of outstanding stock, at $37.56 per share Dividends

$204.2 10.2 2.0

Cash

$ 216.4

Total E XHIBIT 30.13

S AVINGS P LAN —C OMPANY S TOCK

H IGH T ECHNOLOGY , I NC . S AVINGS P LAN S TOCK F UND —S TRUCTURE A S OF J UNE 30, 20XX

BY I NDUSTRY

Industry Ofﬁce equipment & electronics Consumer Retailing Pharmaceuticals Medical supplies Utility—telephone Banks Oil—domestic Oil—international Transportation—railroads Leisure and recreation E XHIBIT 30.14

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S AVINGS P LAN —S TOCK F UND —I NDUSTRY S TRUCTURE

% of Fund 7.94% 7.00 6.20 4.97 4.59 4.01 4.00 3.70 2.91 2.04 2.00

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30.7 Accounting and Disclosure Requirements and Practices for Employee Benefit Plans

Industry Automotive Chemical Forest products Paper products Electrical equipment Oil service Beverage Machinery Food Utility—electric

% of Fund 1.92 1.87 1.65 1.62 1.59 1.50 1.46 1.39 1.23 .70 35.72

All others

$ 100.00

Total E XHIBIT 30.14

S AVINGS P LAN —S TOCK F UND —I NDUSTRY S TRUCTURE (C ONTINUED )

H IGH T ECHNOLOGY , I NC . S AVINGS P LAN S TOCK F UND —T OP 25 E QUITIES (A LL C OMMON ) A S OF J UNE 30, 20XX Security Pﬁzer, Inc. Royal Dutch Petroleum Johnson & Johnson Atlantic Richﬁeld Co. (ARCO) Chrysler Corp. Hewlett-Packard Co. Dayton-Hudson Co. CSX Corp. Merck & Co. Procter & Gamble Abbott Laboratories Colgate-Palmolive Schumberger, Ltd. Ford Motor Co. AT&T Minnesota, Mining & Mfg. Co. CPC International Kimberly-Clark Coca Cola General Electric Company Chevron Weyerhaeuser Co. Disney Co. (Walt) Monsanto Co. Citicorp E XHIBIT 30.15

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S AVINGS P LAN —H IGHEST E QUITY I NSTRUMENTS

% of Fund 1.31% 1.06 1.00 .98 .86 .85 .72 .66 .66 .57 .56 .55 .54 .53 .53 .49 .47 .46 .46 .44 .41 .38 .36 .35 .35

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CHAPTER

31

PLANNING AND CONTROL OF PLANT AND EQUIPMENT OR CAPITAL ASSETS 31.1

IMPACT OF CAPITAL EXPENDITURES 623

31.16 IMPACT OF ACTIVITY-BASED COSTING 639

31.2

CONTROLLER’S RESPONSIBILITY 624

31.3

CAPITAL BUDGETING PROCESS 625

31.17 CLASSIFYING AND RANKING PROPOSED CAPITAL PROJECTS 639

31.4

ESTABLISHING THE LIMIT OF THE CAPITAL BUDGET 626

31.5

INFORMATION SUPPORTING CAPITAL EXPENDITURE PROPOSALS 627

31.18 BOARD OF DIRECTORS’ APPROVAL 641 (a) Impact of Generally Accepted Accounting Principles 641 31.19 PROJECT AUTHORIZATION 645

31.6

METHODS OF EVALUATING PROJECTS 628

31.20 ACCOUNTING CONTROL OF THE PROJECT 648

31.7

PAYBACK METHOD 629

31.8

OPERATORS’ METHOD 630

31.21 POSTPROJECT APPRAISALS OR AUDITS 648

31.9

ACCOUNTANTS’ METHOD 630

31.10 DISCOUNTED CASH FLOW METHODS 632 (a) Investors’ Method: Internal Rate of Return 632 (b) Net Present Value 633 31.11 HURDLE RATES 636 (a) Value of Hurdle Rates 636 (b) A Single Hurdle Rate 636 31.12 COST OF CAPITAL—A HURDLE RATE 637 (a) Multiple Hurdle Rates 637 31.13 INFLATION 638 31.14 FOREIGN INVESTMENTS 638 31.15 IMPACT OF THE NEW MANUFACTURING ENVIRONMENT 639

31.22 OTHER ASPECTS OF CAPITAL EXPENDITURES 649 (a) Working Capital 649 (b) Lease versus Buy Decisions 649 (c) Mutually Exclusive Capital Proposals 652 (d) Plant and Equipment Records 653 (e) Internal Control and Accounting Requirements 655 (f) Idle Equipment 655 (g) Depreciation Accounting 656 (h) Obsolescence 657 (i) Fully Depreciated Assets 657 (j) Appraisals and Appraisal Records 657 (k) Loss or Gain on the Sale of Fixed Assets 658 (l) Funds for Plant Replacement and Expansion 658 (m) Plant and Equipment in Relation to Taxes 658

31.1 IMPACT OF CAPITAL EXPENDITURES Capital expenditure planning and control are critical to the long-term ﬁnancial health of any company operating in the private enterprise system. Generally, expenditures for ﬁxed assets require signiﬁcant ﬁnancial resources, decisions are difﬁcult to reverse, and the investment affects ﬁnan623

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Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

cial performance over a long period of time. The statement “Today’s decisions determine tomorrow’s proﬁts” is pertinent to the planning and control of ﬁxed assets. Investment in capital assets has other ramiﬁcations or possible consequences not found in the typical day-to-day expenditures of a business. First, once funds have been used for the purchase of plant and equipment, it may be a long time before they are recovered. Unwise expenditures of this nature are difﬁcult to retrieve without serious loss to the investor. Needless to say, imprudent long-term commitments can result in bankruptcy or other ﬁnancial embarrassment. Second, a substantial increase in capital investment is likely to cause a much higher break-even point for the business. Large outlays for plant, machinery, and equipment carry with them higher depreciation charges, heavier insurance costs, greater property taxes, and possibly an expanded maintenance expense. All these tend to raise the sales volume at which the business will begin to earn a proﬁt. In today’s highly competitive environment, it is mandatory that companies make signiﬁcant investments in ﬁxed assets to improve productivity and take advantage of the technological gains being experienced in manufacturing equipment. The sophisticated manufacturing and processing techniques available make investment decisions more important; however, the sizable amounts invested allow for greater rewards in increased productivity and higher return on investment. This opportunity carries with it additional risks relative to the increasing costs of a plant and equipment. These conditions make it imperative that wisdom and prudent judgment be exercised in making investments in capital assets. Management decisions must be made utilizing analytical approaches. There are numerous mathematical techniques to assist in eliminating uneconomic investments and systematically establish priorities. Since these investment decisions have a long-term impact on the business, it requires an intelligent approach to the problem.

31.2 CONTROLLER’S RESPONSIBILITY What part should the controller play in the planning and control of capital commitments and expenditures? The board of directors and the chief executive ofﬁcer (CEO) usually rely on ﬁrst-level management to analyze the capital asset requirements and determine, on a priority basis, which investments are in the best long-term interests of the company. The controller has a key role to play in making the determinations. All the functional departments, like sales or manufacturing, will have valid reasons for expansion or cost savings through the purchase of new plant and equipment. In addition, each operating unit will have a real need to increase the capital asset expenditures to meet its goals and objectives. The controller, with the ﬁnancial knowledge of all company operations, should be able to apply objectivity by making a thorough analysis of the proposed expenditures. In many cases, heavy losses have been incurred because the decision was made with an optimistic outlook but without adequate ﬁnancial analysis. The responsibility is placed on the controller’s staff to make an objective appraisal of the potential savings and return on investment. The board of directors and the CEO must have a proper evaluation of proposed expenditures if they are to carry out their responsibilities effectively. After the decisions have been made to make the investments, the controller must establish proper accountability, measure performance, and institute recording and reporting procedures for control. The following is a list of thirteen functions that relate in some way to the planning and control of ﬁxed assets and that typically come within the purview of the controller: 1. Establish a practical and satisfactory procedure for the planning and control of ﬁxed assets. 2. Establish suitable standards or guides, also called hurdle rates, as to what constitutes an acceptable minimum rate of return on the types of ﬁxed assets under consideration. 3. Review all requests for capital expenditures, which are based on economic justiﬁcation, to verify the probable rate of return. 4. In the context of the business plans—whether short term or long range—ascertain that the plant and equipment expenditures required to meet the manufacturing and sales plans (or

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31.3 Capital Budgeting Process

625

plans for research and development [R&D] or any other function) are included in such plan, and that the funds are available. 5. As required, establish controls to assure that capital expenditures are kept within authorized limits. 6. As requested, or through initiative, review and consider suitable economic alternatives to asset purchases, such as leasing or renting, or buying the manufactured item from others—a part of the “make-or-buy” decision. 7. Establish an adequate reporting system that advises the proper segment of management on matters related to ﬁxed assets, including: Maintenance costs by classes of equipment Idle time of equipment Relative productivity by types or age of equipment and so forth Actual costs versus budgeted or estimated costs (as in the construction or purchase of

plant and machinery, etc.) 8. Design and maintain property records, and related physical requirements (numbering, etc.) to accomplish: Identifying the asset Describing its location, age, and the like Tracking transfers Properly accounting for depreciation, retirement, and sale

9. Develop and maintain an appropriate depreciation policy for each type of equipment—for book and tax purposes, each separate, if advisable. 10. Develop and maintain the appropriate accounting basis for the assets, including proper reserves. 11. Ascertain that proper insurance coverage is maintained. 12. See that asset acquisition and disposition is handled in the most appropriate fashion taxwise. 13. Ascertain that proper internal control procedures apply to the machinery and equipment or any other ﬁxed asset. While the controller and staff have certain accounting, evaluation, auditing, and reporting requirements to meet, it should be understood that the line executives have the major responsibility for the acquisition, maintenance, and protection of the ﬁxed assets.

31.3 CAPITAL BUDGETING PROCESS Having mentioned the responsibilities related to ﬁxed assets that are typically assigned to the controller, we devote the principal part of this chapter to the capital budgeting process. Most of the accounting and reporting duties are known to the average controller, but more involvement in the budget procedure needs to be encouraged. Given the relative inﬂexibility that exists once capital commitments are made, it is desirable that the CEO and other high functional executives be provided a suitable framework and basis for selecting the essential or economically justiﬁed projects from among the many proposals—even though their intuitive judgment may be a key factor. And when the undertaking begins, the expenditures must be held within the authorized limits. Moreover, for the larger projects at least, management is entitled, once the asset begins to operate, to be periodically informed how the actual economics compare with the anticipated earnings or savings. The sequential steps in a well-conceived capital budgeting process are outlined below. It should be understood that these steps are not all performed by the controller, but rather by the appropriate line executive. (In separate sections, some of the more analytical facets are explored.)

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Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

1. For the planning period of the short-term budget, which may be a year or two, determine the outer limit or a permissible range for capital commitments or expenditures for the company as a whole, and for each major division or function. This is desirable so that the cognizant executive has some guidance as to how much he can spend in the planning period. (There must be a starting point, and this is as good a one as any.) Depending on the circumstances, this may be an iterative procedure. 2. Through the appropriate organizational channels, encourage the presentation of worthy capital investment projects. For major projects, the target rate of return should be provided, and any other useful guidelines should be furnished (corporate objectives, plans for expansion, etc.). 3. When the proposals are received (and presumably there are many) make a preliminary screening to eliminate those that do not support the strategic plan, or that are obviously not economically or politically supportable. 4. After this preliminary screening: (a) Classify all projects as to urgency of need. (b) Also, calculate the supposed economic beneﬁts. Those performing this task must be given guidance as to (1) the method of determining the rate of return and (2) the underlying data required to support the proposal. 5. When the data on proposed projects are submitted for top management approval, the ﬁnancial staff should review and check the material as to: (a) Adequacy and validity of nontechnical data (b) Rate of return and the related calculations (c) Compatibility with (i) Other capital budget criteria (ii) Financial resources available (iii) Financial constraints of the total or divisional budget and so forth 6. When the proposals have been reviewed and analyzed, and approved by top management, the data must be presented to the board of directors and approval secured in principle. 7. When the time approaches for starting a major project, the speciﬁc authorization should be reviewed and approved by the appropriate members of management. This process may require a recheck of underlying data to be sure no fundamentals have changed. 8. As a control device, when a project has started, periodic reports should be prepared to indicate costs incurred to date, and estimated cost to complete—among other information deemed critical. 9. At stipulated times, and for a stated period, after a major project has been completed, a post-audit should be made comparing actual and estimated cash ﬂow. As can be deduced, the role of the controller and staff as to capital budgeting relates to the ﬁnancial planning, the establishment and monitoring of the capital budgeting procedure, the economic analyses, and the control reports during and after completion.

31.4 ESTABLISHING THE LIMIT OF THE CAPITAL BUDGET A common beginning point in the annual planning process is to set a maximum amount that may be spent on capital expenditures. There will be occasions when the “normal” limit is set aside because of an unusual investment opportunity or other extraordinary circumstances. Normally, however, top management will set a capital budget amount, based on its judgment and considering such factors as:

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31.5 Information Supporting Capital Expenditure Proposals

627

• Estimated internal cash generation (net income plus depreciation and changes in receivables and inventory investment, etc.) • Availability and cost of external funds • Present capital structure of the company (too much debt, etc.) • Strategic plans and corporate goals and objectives • Stage of the business cycle • Near- and medium-term growth prospects of the company and the industry • Present and anticipated inﬂation rates • Expected rate of return on capital projects as compared with cost of capital or other hurdle rates • Age and condition of present plant and equipment • New technological developments and need to remain competitive • Anticipated competitor actions • Relative investment in plant and equipment as compared to industry or selected competitors At different times, each of these factors will seem more compelling than others. As an additional rule of thumb for “normal” capital expenditures, some managements determine the limit based on the (a) amount of depreciation, plus (b) one third of the net income. The remaining two thirds of net income are used equally: one half for dividend payout to shareholders, and the other half for working capital. In considering the company investment in plant and equipment versus the industry, these two ratios may provide some guidance (see Chapter 6): 1. Ratio of ﬁxed assets to net worth. This ratio, when compared with those of competitors, indicates how much of the net worth is used to ﬁnance plant and equipment vs. working capital. 2. Turnover of plant and equipment. The ratio of net sales to plant and equipment, when compared to industry data, to speciﬁc companies, or to published ratios such as those issued by Dun & Bradstreet, shows whether too much is invested in ﬁxed assets for the sales volume being achieved.

31.5 INFORMATION SUPPORTING CAPITAL EXPENDITURE PROPOSALS An important element in a sound capital budgeting procedure is securing adequate and accurate information about the proposal. In this connection, the reason for the expenditure is a relevant factor in just what data are needed. In a sense, a capital expenditure may call for a replacement decision, that is, an existing piece of equipment is to be replaced. For such a decision the information necessary would include: • The investment and installation cost of the new piece of equipment • The salvage value of the old machinery • The economic life of the new equipment • The operating cost of the new item over its life Presumably, the economic decision would relate directly to the lower cost of production with the new piece of equipment, and possibly the opportunity to produce a greater quantity of output. In contrast, consider an expansion type of decision. Assume a company wants to produce a new product to be sold in a new market. Then, not only must the economic data on the acquisition and operation of the new equipment be available, but also marketing information is required, such as estimates of:

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Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

• The market potential for the new product • The probable sales quantity and value of the output for X years • The marketing or distribution cost Such a capital investment obviously will involve more risk than a replacement decision. One other comment may be germane to securing good ideas and adequate information about new capital items. First, those who would use the equipment and are knowledgeable should be consulted. Too often management does not listen to this valuable source of information. Secondly, management should encourage the ﬂow of ideas about capital expenditures, especially new processes and perhaps new products. It is far better to have too many good ideas than not enough. Ideas should be sought from many elements of the organization and compared. What is most desirable is a balanced agenda, rather than a limiting of ideas to any one department or single source. As is discussed later, economic data on proposals normally should include all relevant cash ﬂow information—cash outgo—the complete installation costs and operating expense, and cash inﬂow—the expected net sales revenues less related marketing expense, and so on. Any relevant economic data should be made available, such as tax data, inﬂation outlook, economic life of the project, other equipment needed, capacity data, cost information, and salvage value. Here is an expanded list of the reasons that capital expenditures are made, all of which have a bearing on input data: • To enable continued operation of the business • To meet pollution control requirements • To meet safety needs • To reduce manufacturing or marketing (distribution) costs through more efﬁcient use of labor, material, or overhead • To improve the quality of the product • To meet product delivery requirements • To increase sales volume of existing or new products • To diversify operations • To expand overseas and so forth

31.6 METHODS OF EVALUATING PROJECTS In an effort to invest funds wisely in capital projects, companies have developed several evaluation techniques. It is these expenditures that provide the foundation for the ﬁrm’s growth, efﬁciency, and competitive strength. Because most companies do not have sufﬁcient funds to undertake all projects, some means must be found to evaluate the alternate courses of action. Such decisions are not merely the application of a formula. The evaluation of quantitative information must be blended with good judgment, and perhaps good fortune, to produce that aggregate wisdom in capital expenditures that will largely determine the company’s future earning power. As will be seen, some entities have rather simple procedures while some of the more capital intensive managements feel a need for more sophisticated methods. Those companies using the more analytical tools ﬁnd these three elements essential: 1. An estimate of the expected capital outlay, as well as the amount and timing of the estimated future beneﬁts—the cash ﬂow 2. A technique for relating the expected future beneﬁts to a measure of cost—perhaps the cost of capital, or other “hurdle rates” 3. A means of evaluating the risk—which relates to (a) the probability of attaining the estimated rate of return, and (b) a sense of how changes in the assumptions can affect the calculated return The two more important valuation methods in use, which are quantitative in nature, consist of the following or some variation thereof:

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31.7 Payback Method

629

1. Payback method. This is the simple calculation of the number of years required for the proceeds of the project to recoup the original investment. 2. Rate of return methods. Among them are: (a) The operators’ method, so called because it is often used to measure operating efﬁciency in a plant or division. It may be deﬁned as the relationship of annual cash return, plus depreciation, to the original investment. (b) The accountants’ method, perhaps so named because the accounting concept of average book value and earnings (or book proﬁt) is employed. This method is merely the relationship of proﬁt after depreciation to average annual outstanding investment. (c) The investors’ method or discounted cash ﬂow method. This rate of return concept recognizes the time value of money. It involves a calculation of the present worth of a ﬂow of funds.

31.7 PAYBACK METHOD Assume that project A calls for an investment of $1,000,000 and that the average annual income before depreciation is expected to be $300,000. Then the payback in years would be 3.3 years, calculated thus: Investment Payback time in years ---------------------------------------------------------------------------------Yearly net income Depreciation $1,000,000 = ----------------------------------------------------$200,000 $100,000 = 3.3 years In circumstances where the net income and depreciation are not approximately level each year, then the method may be reﬁned to reﬂect cash ﬂow each year to arrive at the payback time— instead of the average earnings. For example, assume an increasing stream of cash inﬂow followed by a decrease, then a matrix as in Exhibit 31.1, can be completed. In this illustration, the payback is completed in 5 1/2 years (5 years plus a $900,000/$1,800,000 fractional year). Brieﬂy stated, the payback method offers these four advantages: 1. It may be useful in those instances where a business ﬁrm is on rather lean rations cashwise and must accept proposals that appear to promise a payback, for example, in two years or less. 2. Payback can be helpful in appraising very risky investments where the threat of expropriation or capital wastage is high and difﬁcult to predict. It weighs near-year earnings heavily. 3. It is a simple manner of computation and easily understood. 4. It may serve as a rough indicator of proﬁtability to reject obviously undesirable proposals. There are, however, three very basic disadvantages to the payback method:

Year 0 1 2 3 4 5 6 E XHIBIT 31.1

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Cash Outﬂow $10,000,000 — — — — — — P AYBACK P ERIOD —U NEVEN C ASH F LOW

Cash Inﬂow — $1,200,000 $1,500,000 $1,800,000 $2,500,000 $2,200,000 $1,800,000

Net Investment (Recovery) $10,000,000 8,800,000 7,300,000 5,600,000 3,100,000 900,000 (900,000)

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Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

1. Failure to consider the earnings after the initial outlay has been recouped. Yet the cash ﬂow after payback is the real factor in determining proﬁtability. In effect, the method confuses recovery of capital with proﬁtability. In the foregoing example, if the economic life of the project is only 3.3 years, there is zero proﬁt. If on the other hand, the capital life is 10 years, the rate of return will differ signiﬁcantly from that produced by a 4-year life. 2. Undue emphasis on liquidity. Restriction of fund investment to short payback may cause rejection of a highly proﬁtable source of earnings. Liquidity assumes importance only under conditions of tight money. 3. Capital obsolescence or wastage is not recognized. The gradual loss of economic value is ignored—the economic life is not considered. This deﬁciency is closely related to item 1. Similarly, the usual (average) method of computation does not reﬂect irregularity in the earning pattern.

31.8 OPERATORS’ METHOD A manner of ﬁguring return on investment, using the ﬁgures of the payback method, is: earnings Depreciation Return on investment Annual -----------------------------------------------------------------------------Original investment $200,000 $100,000 = ----------------------------------------------------$1,000,000 = 30% The technique may be varied to include total required investment, including working capital. The operators’ method has these three advantages: 1. It is simple to understand and calculate. 2. In contrast with the payout method, it gives some weight to length of life and overall proﬁtability. 3. It facilitates comparison with other companies or divisions or projects, especially where the life spans are roughly comparable. The basic disadvantage is that it does not recognize the time value of cash ﬂow. Competing projects may have equal returns, but the distribution of earnings, plus depreciation, may vary signiﬁcantly between them year by year and/or the total period over which equal annual returns are received may vary between projects.

31.9 ACCOUNTANTS’ METHOD This technique relates earnings to the average outstanding investment rather than the initial investment or assets employed. It is based on the underlying premise that capital recovered as depreciation is therefore available for use in other projects and should not be considered a charge against the original project. There are variations in this method, also, in that the return may be ﬁgured before or after income tax, and differing depreciation bases may be employed. The rate of return using the accountants’ method and assuming a 10-year life and straight-line depreciation on project A is shown in Exhibit 31.2. This basic procedure has two chief shortcomings. First, it is heavily inﬂuenced by the depreciation basis used. Double-declining balance depreciation will, of course, reduce the average investment outstanding and increase the rate of return. Second, it fails to reﬂect the time value of funds. In the example, if the average investment was the same but income was accelerated in the early years and decelerated in later years (with no change in total amount) the rate of return would be identical. Such conditions are reﬂected in Exhibit 31.3. By many measures, the cash ﬂow shown in

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31.9 Accountants’ Method

631

R ETURN ON I NVESTMENT —T HE A CCOUNTANTS ’ M ETHOD A VERAGE B OOK I NVESTMENT AND A VERAGE P ROFIT P ROJECT A

Year 1 2 3 4 9 10 Total

Net Earnings Before Depreciation $ 300,000 300,000 300,000 300,000 — — — — 300,000 300,000

Depreciation $ 100,000 100,000 100,000 100,000 — — — — 100,000 100,000

Net Proﬁt $ 200,000 200,000 200,000 200,000 — — — — 200,000 200,000

Average Instrument Outstanding $ 950,000 950,000 950,000 950,000 — — — — 950,000 950,000

$ 3,000,000

$ 1,000,000

$ 2,000,000

$ 5,000,000

Profit after depreciation Rate of return ---------------------------------------------------------------------------Average outstanding investment $2,000,000 --------------------------$5,000,000 40% E XHIBIT 31.2

R ETURN

ON I NVESTMENT —T HE

R ETURN

ON I NVESTMENT —T HE

Net Earnings Before Depreciation $ 400,000 400,000 400,000 400,000 400,000 200,000 200,000 200,000 200,000 200,000

Year 1 2 3 4 5 6 7 8 9 10

$ 3,000,000

Total

A CCOUNTANTS ’ M ETHOD

A CCOUNTANTS ’ M ETHOD D ECREASING P ROFIT P ROJECT A

Depreciation $ 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000

Net Proﬁt $ 300,000 300,000 300,000 300,000 300,000 100,000 100,000 100,000 100,000 100,000

Average Instrument Outstanding $ 950,000 850,000 750,000 650,000 550,000 450,000 350,000 250,000 150,000 50,000

$ 1,000,000

$ 2,000,000

$ 5,000,000

Profit after depreciation Rate of return ---------------------------------------------------------------------------Average outstanding investment $2,000,000 --------------------------$5,000,000 40% E XHIBIT 31.3

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R ETURN

ON I NVESTMENT —D ECREASING

P ROFIT C ONDITION

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Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

this illustration is more desirable than that reﬂected in Exhibit 31.2, because a greater share of the proﬁt is secured earlier in the project life, and is thus available for other investment. Most projects do vary in income pattern, and the evaluation procedure probably should reﬂect this difference. The accountants’ method offers the advantage of simplicity over the discounted cash ﬂow approach.

31.10 DISCOUNTED CASH FLOW METHODS Given the importance of capital expenditures to business, especially the capital intensive enterprises such as steel or chemicals, much thought has been directed to ways and means of comparing investment opportunities. It becomes very difﬁcult to compare one project with another, particularly when the cash ﬂow patterns vary or are quite different. When cash is received becomes very important in that cash receipts may be invested and earn something. The sooner the funds are in hand, the more quickly they can be put to work. Accordingly, the discounted cash ﬂow principle has been adopted as a far superior tool in ranking and judging the proﬁtability of the investments. The principle may be applied in two forms: 1. The investors’ method, also known as the internal rate of return (IRR) 2. The net present value (NPV) The ﬁrst one actually involves the determination of what rate of return is estimated. The second method applies a predetermined rate, or hurdle, to the estimated stream of cash to ascertain the present value of the proposed investment. (a) INVESTORS’ METHOD: INTERNAL RATE OF RETURN. Technically, the rate of return on any project is that rate at which the sum of the stream of after-tax (cash) earnings, discounted yearly according to present worth, equals the cost of the project. Stating it another way, the rate of return is the maximum constant rate of return that a project could earn throughout the life of the outstanding investment and just break even. The method may be simply described by an example. Assume that an investment of $1,000 may be made and, over a ﬁve-year period, cash ﬂow of $250 may be secured. What is the rate of return? By a cut-and-try method, and the use of present value tables, we arrive at 8%. The application of the 8% factor to the cash ﬂow results in a present value of approximately $1,000 is: 8% Annual Cash Flow (a)

Discount Factor (b)

Present Value

1

$ 250

.926

$ 232

2

250

.857

214

3

250

.794

198

4

250

.735

184

5

250

.681

170

Year

Total present value

(a) (b)

$ 998

The proof of the computation is the determination of an 8% annual charge with the balance applicable to principal, just as bankers calculate rates of return.

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31.10 Discounted Cash Flow Methods

Year 0 1 2 3 4 5 *Due

Cash Flow (a) $— 250 250 250 250 250

Return at 8% of Investment Outstanding at Beginning of Year (b) $— 80 66 52 36 19

Balance Applicable to Investment

(c) (a b) $— 170 184 198 214 231

633

Outstanding Investment at Year-End (d) $1,000 830 646 448 234 3*

to rounding.

By trial and error, application of the proper discount factor can be explored until the proper one is found. Using a 10% discount factor and a 40% discount factor, the $1,000,000 assumed investment, discussed in connection with other evaluation methods, to be recouped over 10 years, results in a 36% rate of return, as shown in Exhibit 31.4. The steps in application of the method may be described as: • Determine the amount and year of the investment. • Determine, by years, the cash ﬂow after income taxes by reason of the investment. • Extend such cash ﬂow by two discount factors to arrive at present worth. • Apply various discount factors until the calculation of one comes close to the original investment and interpolate, if necessary, to arrive at a more accurate ﬁgure. The disadvantages of the discounted cash ﬂow method are: • It is somewhat more complex than other methods; this apparent handicap is minor in that those who must apply the technique grasp it rather readily after a couple of trials. • It requires more time for calculation. However, the availability of handheld computers, or desktop computers, with a software package or built-in programs, makes the calculations rather painless. • An implicit or inherent assumption is that reinvestment will be at the same rate as the calculated rate of return. These disadvantages are more than offset by the beneﬁts. Among them are: • Proper weighting is given to the time value of investments and cash ﬂow. • The use of cash ﬂow minimizes the effect of arbitrary decisions about capital versus expenses, depreciation, and so on. • Is comparable with the cost-of-capital concept. • Is a valuable tool for the ﬁnancial analyst in evaluating alternatives. • Brings out explicit reasoning for selecting one project over another. (b) NET PRESENT VALUE. The typical capital investment is composed of a string of cash ﬂows, both in and out, that will continue until the investment is eventually liquidated at some point in the future. These cash ﬂows are comprised of many things: the initial payment for equipment, continuing maintenance costs, salvage value of the equipment when it is eventually sold, tax payments, receipts from product sold, and so on. The trouble is, since the cash ﬂows are coming in and going out over a period of many years, how do we make them comparable for an analysis that is done in the present? By applying the discount rate to each anticipated cash ﬂow, we can reduce and

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634

Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

I NTERNAL R ATE OF R ETURN P RESENT V ALUE OF S TREAM C ASH 10% Discount Rate 40% Discount Rate Years from Start (Expenditure) Discount of Operation or Income Factor Amount—M Discount Factor Amount—M $ (1000.0) $ (1,000.0) $ (1,000,000) 0 0 to 1 2 3 4 5 6 7 8 9 10

300,000 300,000 300,000 300,000 300,000 300,000 300,000 300,000 300,000 300,000

.953 .866 .788 .716 .651 .592 .538 .489 .444 .404

285.9 259.8 236.4 214.8 195.3 177.6 161.4 146.7 133.2 121.2

.844 .603 .431 .308 .220 .157 .112 .080 .060 .041

253.2 180.9 129.3 92.4 66.0 47.1 33.6 24.0 18.0 12.3

Total Cash Flow $ 3,000,000 $ 1,932.3

Discounted cash ﬂow

$

856.8

Discounted rate of return:

1, 932 1, 000 10% 30% -------------------------------------- 36% 1, 932 857 E XHIBIT 31.4

T RIAL

AND

E RROR —C OMPUTATION

OF I NTERNAL

R ATE

OF

R ETURN

then add them together, which yields a single combined ﬁgure that represents the current value of the entire capital investment. This is known as its net present value. For an example of how net present value works, we have listed in Exhibit 31.5 the cash ﬂows, both in and out, for a capital investment that is expected to last for ﬁve years. The year is listed in the ﬁrst column, the amount of the cash ﬂow in the second column, and the discount rate in the third column. The ﬁnal column multiplies the cash ﬂow from the second column by the discount rate in the third column to yield the present value of each cash ﬂow. The grand-total cash ﬂow is listed in the lower right corner of the exhibit. Notice that the discount factor in Exhibit 31.5 becomes progressively smaller in later years, since cash ﬂows further in the future are worth less than those that will be received sooner. The discount factor is published in present value tables, which are listed in many accounting and ﬁnance textbooks. They are also a standard feature in midrange handheld calculators. Another variation is to use the following formula to manually compute a present value: ( Future cash flow ) Present value of a future cash flow --------------------------------------------------------------------------------------------------------------------------------------------( squared by the number of periods of discounting) ( 1 Discount rate ) Using the above formula, if we expect to receive $75,000 in one year, and the discount rate is 15%, then the calculation is: $75,000 Present value ---------------------( 1 .15 ) Present value $65,217.39 The example shown in Exhibit 31.5 was of the simplest possible kind. In reality, there are several additional factors to take into consideration. First, there may be multiple cash inﬂows and outﬂows in each period, rather than the single lump sum that was shown in the example. If a CFO wants to know precisely what is the cause of each cash ﬂow, then it is best to add a line to the net present value calculation that clearly identiﬁes the nature of each item, and discounts it separately from the other line items. An alternative way is to create a net present value table that leaves room

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31.10 Discounted Cash Flow Methods

Year

Cash Flow

Discount Factor*

Present Value

0 1 2 3 4 5

–$100,000 +25,000 +25,000 +25,000 +30,000 +30,000

1.000 .9259 .8573 .7938 .7350 .6806 Net Present Value

–$100,000 +23,148 +21,433 +19,845 +22,050 +20,418 +$6,894

635

Note: Discount factor is 8 %.

E XHIBIT 31.5

S IMPLIFIED N ET P RESENT V ALUE E XAMPLE

for multiple cash ﬂow line items while keeping the format down to a minimum size. Another issue is which items to include in the analysis and which to exclude. The basic rule of thumb is that it must be included if it impacts cash ﬂow, and stays out if it does not. The most common cash ﬂow line items to include in a net present value analysis are: • Cash inﬂows from sales. If a capital investment results in added sales, then all gross margins attributable to that investment must be included in the analysis. • Cash inﬂows and outﬂows for equipment purchases and sales. There should be a cash outﬂow when a product is purchased, as well as a cash inﬂow when the equipment is no longer needed and is sold off. • Cash inﬂows and outﬂows for working capital. When a capital investment occurs, it normally involves the use of some additional inventory. If there are added sales, then there will probably be additional accounts receivable. In either case, these are additional investments that must be included in the analysis as cash outﬂows. Also, if the investment is ever terminated, then the inventory presumably will be sold off and the accounts receivable collected, so there should be line items in the analysis, located at the end of the project time line, showing the cash inﬂows from the liquidation of working capital. • Cash outﬂows for maintenance. If there is production equipment involved, then there will be periodic maintenance needed to ensure that it runs properly. If there is a maintenance contract with a supplier that provides the servicing, then this too should be included in the analysis. • Cash outﬂows for taxes. If there is a proﬁt from new sales that are attributable to the capital investment, then the incremental income tax that can be traced to those incremental sales must be included in the analysis. Also, if there is a signiﬁcant quantity of production equipment involved, the annual personal property taxes that can be traced to that equipment should also be included. • Cash inﬂows for the tax effect of depreciation. Depreciation is an allowable tax deduction. Accordingly, the depreciation created by the purchase of capital equipment should be offset against the cash outﬂow caused by income taxes. Though depreciation is really just an accrual, it does have a net cash ﬂow impact caused by a reduction in taxes, and so should be included in the net present value calculation. The net present value approach is the best way to see if a proposed capital investment has a sufﬁcient rate of return to justify the use of any required funds. Also, because it reveals the amount of cash created in excess of the corporate hurdle rate, it allows management to rank projects by the amount of cash they can potentially spin off, which is a good way to determine which projects to fund if there is not enough cash available to pay for an entire set of proposed investments.

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Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

31.11 HURDLE RATES A hurdle rate is the minimum rate of return that a capital project should earn if it is to be judged acceptable. In reviewing this subject, on which there are a variety of opinions, perhaps these aspects are the more important ones: • Value of using any hurdle rate • Value of using a single hurdle rate • Value of using multiple hurdle rates (a) VALUE OF HURDLE RATES. of alleged reasons, including:

Many companies do not establish hurdle rates, for a variety

• There is a large element of subjectivity in capital investments, and management wishes to review all proposals. It does not want to eliminate any from consideration simply because of the rate of return. • When new business areas are to be considered, it is difﬁcult to set a suitable hurdle rate. • Many projects must be undertaken regardless of economic reasons: pollution abatement, safety equipment, and the like. • If hurdle rates are used, then data will be manipulated so that the minimum proﬁt rate will seem attainable. If management wishes to maintain ﬂexibility in its capital budgeting process, it seems this can still be done with proper instructions or guidelines, despite the existence of hurdle rates. Thus, provision can be made for some expenditures that do not relate directly to a given proﬁt rate. Moreover, sound analytical procedures, including dismissal, can minimize any efforts to fabricate justiﬁcation data. Additionally, if a for-proﬁt business is an economic institution, and the authors think it is, and if the management task is to enhance shareholder value, then it seems guidelines must include proﬁt rates which by and large do not dilute the shareholder’s equity. (b) A SINGLE HURDLE RATE. A great many companies that employ the hurdle rate concept use a single rate, as distinguished from different rates for various kinds of expenditures. The reasoning in the application of one hurdle rate is basically this: • The cost of capital, a good point of departure, is about the same for all segments of the company (divisions, subsidiaries, product lines, etc.). • The additional risk in attempting to earn an acceptable return on equity is essentially the same for all parts of the company. • Given the elements of error in estimating the rate of return on the capital project, the future cost of capital, and the subjective nature of the decision, it isn’t worth the effort to establish several hurdle rates. One of the common single hurdle rates employed is closely associated with the cost of capital (discussed in the next section and in Chapter 33). Some projects do not earn the cost of capital, so a factor must be added as the goal of other projects so that, on average, the proper earnings level is maintained. A single hurdle rate might be established thus: Cost of capital Allowance to offset sublevel projects Proﬁt goal for capital projects

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31.12 Cost of Capital—A Hurdle Rate

637

31.12 COST OF CAPITAL—A HURDLE RATE Technically, the cost of capital is the rate of return the long-term debt holders and shareholders require to persuade them to furnish the required capital. Thus, assume that: • A company capital structure target objective is $500,000,000 composed of 25% debt and 75% equity. • In the current market environment long-term bondholders require a 10% return (6% cost to the company after income taxes); a 17% return on equity is the going earnings rate. Then the cost of capital would be calculated as:

Structure Senior debt Common stock

Capitalization $ 125,000,000 375,000,000

Total

$ 500,000,000

Required Rate of Return (After Income Taxes) 6.0% 17.0%

Required Amount of Return $ 7,500,000 63,750,000 $ 71,250,000

$71,250,000 Cost of capital -------------------------------500, 000, 000 = 14% It could be argued that if the company is to attract the capital required to stay in business, then, on average, all its capital investments should earn at least 14% after taxes. If this does not occur, then the shareholder return would be diluted. Of course, it would be well to consult with the investment bankers as to the bondholder and shareholder expectations on earnings of the company and industry for the next several years. Depending on their views, a cost of future capital might be determined based on the relation of expected earnings to expected market value of the stock, plus the yield the bondholders might require. In this manner, the minimum return for capital projects could be estimated. This calculation represents the average cost of capital and seems a fair basis for capital investment decisions viewed on the thesis that the true cost of capital is calculated on a pool basis. However, there might be some circumstances where the marginal or incremental cost of capital basis may be calculated for informational use. This is the cost of capital for the most recent capital transaction considered, such as the opportunity cost of not repurchasing common stock, or of not repaying debt. However, this application would be viewed as the cost of a speciﬁc source of capital. It seems to the authors that the pool concept of capital is the more appropriate basis for evaluating capital expenditures. In any event, cost of capital, or cost of capital adjusted for some subnormal rates of return on some projects, might be a suitable hurdle rate. (a) MULTIPLE HURDLE RATES. In these days of multinational companies, and conglomerates operating in many business sectors, a case could be made for using multiple hurdle rates. The use of multiple hurdle rates could be justiﬁed for different segments of a business where: • Different business risk exists (threat of expropriation, adverse business environment, etc.). • Rates of return expectations are markedly different (as in some non-U.S. geographical areas). • Experienced earnings rates are much different. • Differing business strategies may apply and require different hurdle rates for a time.

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Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

However, whether different hurdle rates should be determined, or whether management should make mental adjustments to a single hurdle rate, depends on management inclinations. Intuitive judgment still plays an important role in capital expenditure decisions.

31.13 INFLATION Those involved in analyzing capital investments may ponder how inﬂation should be handled. Even so-called “modest” inﬂation rates of 5% or 6% can signiﬁcantly inﬂuence results. In the budgetary process, these questions should be considered: • Should adjustments be made for inﬂation in the cash ﬂows? • Should one inﬂation rate be applied to the entire period, or should year-to-date adjustments be made? • If available, should speciﬁc estimated inﬂation rates be used on each factor (i.e., wages, material costs, product prices)? • Should the hurdle rate be adjusted to provide for inﬂation? Four comments on these questions are: 1. Many companies do not adjust for inﬂation. The reasons for not recognizing inﬂation range from the pragmatic—that product prices and revenues changes probably will at least match cost movements—to the recognition of the difﬁculty in getting a reliable rate estimate. However, those more analytical souls, and those using DCF techniques and the computer, are more likely to adjust for inﬂation. 2. Many analysts engaged in long-range planning use an average inﬂation rate because of the difﬁculty of getting more realistic data. However, if estimates of inﬂation by near-term years are available, perhaps these should be used, with an average “guess” for the later years. 3. Speciﬁc price indices exist for some materials, or groups of materials, and for wages in particular industries. With the availability of computers, if the company believes there will be wide variations of inﬂation in segments of the business, it might be well to test the results of applying speciﬁc inﬂation indexes. 4. If cash ﬂows are adjusted for inﬂation, then the hurdle rate also probably should be adjusted for estimated inﬂation. However, if constant dollars are used in projections, then obviously the hurdle rate should not be adjusted for estimated inﬂation. In reaching conclusions on any of these points the analysts probably should secure estimates of inﬂation, and experiment on the computer with the impact on the answer.

31.14 FOREIGN INVESTMENTS Investments by the multinationals in countries with hyperinﬂation rates must separately consider the effect of these conditions on the real rate of return—and the desirability of making any capital investments at all. When a discounted cash ﬂow method (or, indeed, any method) is used to evaluate investments in another country, it is to be emphasized that the signiﬁcant test is the cash ﬂow to the parent— not to the foreign subsidiary or entity. Among the impediments to cash ﬂow to the parent, which must be considered (for each year) and factored into the decision, are such items as: • Currency restrictions • Fluctuations in the foreign exchange rate • Political risk • Withholding taxes

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31.17 Classifying and Ranking Proposed Capital Projects

639

• Inﬂation (as mentioned) Limited discussion of these topics is contained in Chapter 9.

31.15 IMPACT OF THE NEW MANUFACTURING ENVIRONMENT Investments are made in capital assets with the expectation that the return will be sufﬁciently high not only to recoup the cost but also to pass the hurdle rate for such an expenditure. But the nature of the investment is changing, as are the attendant risks, in the new manufacturing environment. The nature of this net setting is reﬂected in these characteristics: • While automation is viewed as a primary source of additional income, this often is preceded by redesigning and simplifying the manufacturing process, before automation is considered. Many companies have achieved signiﬁcant savings simply by rearranging the plant ﬂoor, establishing more streamlined procedures, and eliminating the non-value-adding functions such as material storage and handling. After this rearrangement is accomplished, then automation might be considered. • Investments are becoming more signiﬁcant in themselves. While a stand-alone grinder may cost $1 million, an automated factory can cost $50 million or $100 million. Moreover, much of the cost may be in engineering, software development, and implementation. • The equipment involved often is more complex than formerly, and the beneﬁts can be more indirect and perhaps more intangible. If there are basic improvements in quality, in delivery schedules, and in customer satisfaction (which seems to be the emphasis today), then methods can be found to measure these beneﬁts. (These gains may lie in improvements or lower costs in the support functions—such as purchasing, inventory control, and greater sales volume.) • Because of the high investment cost, the period required to earn the desired return on investment is longer. This longer-term horizon, together with the intangibles to be considered and the greater uncertainty, require the controller, budget ofﬁcer, or management accountant to be more discerning in his evaluation. Usually the indirect savings and intangible beneﬁts need to be recognized and included in the investment analysis. (The direct beneﬁts may be insufﬁcient to justify the investment.)

31.16 IMPACT OF ACTIVITY-BASED COSTING Chapter 5 discusses some of the changes required in the typical cost system as the result of activity-based costing. However, it should be mentioned here that one output of the cost system may be used to determine the real net cash ﬂow from the capital investment—and that is the sales revenues less the variable costs or direct cash costs of the speciﬁc products to be manufactured. Often, the allocation methods and the depreciation system do not reﬂect the realities of the manufacturing process. Hence, the relevant cost of sales may be substantially incorrect, leading to an improper cash ﬂow calculation. Alternatively, the technology costs related to the product may be in error and, the larger the technology costs, the greater the impact of misallocation of product costs. Accordingly, the controller as well as the ﬁnancial analyst developing, or reviewing, the capital investment justiﬁcation should ascertain that the costing system accurately mirrors the resources needed in the relevant decision.

31.17 CLASSIFYING AND RANKING PROPOSED CAPITAL PROJECTS When the reviews and analyses have been completed, it is necessary to bring order out of chaos, and to classify and rank the projects in some order of priority for discussion purposes. This is a necessary procedure because usually there are many more proposed capital expenditures than would normally be undertaken within the bounds of ﬁnancial capability. Projects are ranked for

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640

Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

discussion with top management (and the board of directors) on the basis of perceived need. While proﬁtability may be a ranking factor for some categories, it does not follow that it is the only basis. A practical grouping that would be understood by management and operation executives alike might be in some such order as: 1. Absolutely essential: (a) Installation of equipment required by government agencies, such as: (i) Safety devices (ii) Pollution abatement vehicles without which the business would be shut down (b) Replacement of inoperable facilities without which the company could not remain in business 2. Highly necessary: (a) State-of-the-art quality control devices (b) New ﬂame-retardant painting facilities (c) High-intensity laser drills 3. Economically justiﬁed projects: (a) New facilities in Vancouver, British Columbia (b) Robot assembly line for casings (c) Warehouse in Denver, Colorado 4. All other: (a) Community center in Delaware, Maryland (public relations) (b) New lighting facilities in parking area (two shifts will be starting) (c) Outdoor cafeteria facilities for employees For projects based on the economic return, usually these projects may be ranked by rate of return. An example is shown in Exhibit 31.6. It will be noted that a proﬁtability index also is provided. As explained under the “mutually exclusive projects” section, on some occasions the proposal with the highest rate of return may not be the one with the highest proﬁtability index. T HE M ONEY C OMPANY P ROPOSED C APITAL P ROJECTS R ANKED BY I NTERNAL R ATE OF R ETURN F OR THE 20XX C APITAL B UDGET Priority Ranking 1 2 3 4 5 6

Description and Location Electronics Assembly Plant—Wayne, Michigan Robot Assembly Line—Hawthorne, Calif. Computer Assisted Design Facility— Hawthorne, Calif. Spray Equipment—Boston, Mass. Material Handling System—San Francisco, Calif. Composite Materials Equipment— Pomona, Calif.

Internal Rate of Return

Proﬁt– ability Index

Cost

37.90%

1.62

$ 7,980,000

29.75

1.40

6,300,000

28.00 25.00

1.25 1.20

4,500,000 2,500,000

25.00

1.24

4,610,000

22.00

1.10

E XHIBIT 31.6

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P ROPOSED C APITAL P ROJECTS

5,100,000 $ 30,990,000

Total BY

E CONOMIC R ANKING

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31.18 Board of Directors’ Approval

641

While a ranked list of economically desirable projects may be provided, which keeps the total capital budget request within the guideline amount, sometimes a “contingent capital budget project” listing also is prepared in the event management or the board of directors decides to appropriate more funds than originally contemplated. These projects would rank just below the formal proposals as to rates of return.

31.18 BOARD OF DIRECTORS’ APPROVAL Under normal circumstances, when management has decided what capital budget projects should be undertaken and be included in the annual business plan, approval of the board of directors is sought. Usually either the chief operating ofﬁcer of the vice president in charge of facilities makes the presentation, perhaps with a visual aid much like that shown in Exhibit 31.7. The data are presented in some logical form and display the signiﬁcant facts. The objective is to make the board aware of the reason for, beneﬁts of, and risks attached to, each project. The information included in the proposal as reﬂected in Exhibit 31.7 contains: • An identiﬁcation of each project • The priority and category of each project • The reason for the proposed item • The total anticipated cost • The rate of return (where this is the basis of selection) • The timing of the expenditures • A contingency fund in the event of cost overruns Any cost estimates, the rate of return, and availability of funds, and so forth should be checked, or calculated, by the controller’s ofﬁce before submission to the board (or management). In securing the approval of the board of directors, there is one other aspect that often should be brought to the attention of the board and that has to do with GAAP. (a) IMPACT OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES. Just as the discussion of activity-based costing (ABC) has stimulated management accountants to recheck the cost drivers and allocation methods of the cost systems used in their companies, so also recent articles about the tendency of GAAP applications to discourage needed investment in new equipment such as computer integrated technology, is causing some thought about the accounting methodology in use in certain circumstances. Some of the alleged difﬁculty arises because of the practice of expensing, and not capitalizing, the startup costs of the new project, or perhaps the tendency to focus on short-term earnings, or the failure to recognize life-cycle accounting. The impact of a capital expenditure on earnings may cause the small company to reﬂect a loss in the initial years after the investment, even though the ultimate rate of return is excellent. Allegedly, a prospective loss might deter some banks from making a loan. (A diligent bank will carefully examine the cause of any expected loss.) This brings us to a consideration of what information should be provided to the board of directors and top management about the impact of new product development or major capital expenditures on the earnings of the company. It has nothing to do directly with the rate of return or project justiﬁcation; these are separate considerations. It does relate to making the decision makers aware of the proﬁt impact of capital investments and the related costs. Perhaps these three supplemental forecast earnings statements may be useful to an informed management when considering any major expenditure (as well as for the purpose of obtaining necessary ﬁnancing): 1. A statement of estimated income and expense without the new investment—for a number of years in the future 2. A statement of estimated income and expense, with the new investment, using GAAP (with emphasis on startup expenses and depreciation)—if that is a point to emphasize

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512

— —

Cadmium grinders— Toronto

562

50

—

50

A NNUAL C APITAL B UDGET R EQUEST

200

Total replacements, etc.

E XHIBIT 31.7

200

—

Delivery equipment— Denver

Total

200

Quality control upgrading—all plants

Competitive necessity

Total

—

—

—

$—

Solvent disposal— Chicago

$ 512

1st Quarter

Safety equipment— Plant 5

Absolutely essential

Replacements and Substitutions

Prior Years

1,335

475

375

100

860

400

—

$ 460

2nd Quarter

1,278

300

—

300

978

350

500

$ 128

Last Half

New

Appropriation

3,175

825

375

450

2,350

750

500

$ 1,100

Total 20X4

3,375

1,025

375

650

2,350

750

500

$ 1,100

Return on Total Investments Commitments (DCF)

T HE C ALIFORNIA C OMPANY A NNUAL C APITAL B UDGET R EQUEST —20X4 ( DOLLARS IN THOUSANDS )

Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

Project Description

642

100

100

—

100

—

—

—

$ —

Prior Years

2,985

885

375

510

2,100

750

250

$ 1,100

20X4

290

40

—

40

250

—

250

$—

20X5

Expenditures

—

—

—

—

—

—

—

$—

Later Years

3,375

1,025

375

650

2,350

750

500

$ 1,100

Total

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E XHIBIT 31.7

Grand total

Contingency $ 5,453

A NNUAL C APITAL B UDGET R EQUEST (C ONTINUED )

$ 4,375

215

$ 13,220

$ 2,762

75

75

140

9,200

1,400

3,000

4,800

Total 20X4

$ 1,050

140

75

—

4,100

1,400

2,000

700

Last Half

630

—

—

140

2,900

—

600

2,300

2nd Quarter

—

—

—

—

Landscaping, Plant 5

Total

—

—

Community facilities, Cleveland

Other

2,200

850

Total expansion

—

—

Pneumatic loading system, Chicago

400

1,800

1st Quarter

—

850

Prior Years

Warehouse, Toronto

Manufacturing facility, Cleveland

Expansion

Project Description

New

Appropriation

$ 14,270

630

215

75

140

10,050

1,400

3,000

5,650

14.00

17.50

26.50%

Return on Total Investments Commitments (DCF)

$ 850

—

—

—

750

—

—

750

Prior Years

31.18

$ 1,290

—

—

—

1,000

400

600

—

20X5

$—

—

—

—

—

—

—

—

Later Years

643

$ 14,270

630

215

75

140

10,050

1,400

3,00

5,650

Total

Board of Directors’ Approval

$ 12,130

630

215

75

140

8,300

1,000

2,400

4,900

20X4

Expenditures

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644

Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

3. A statement of estimated income and expense, with the new investment, with a modiﬁed or alternative capitalization and depreciation practice. These are illustrated in Exhibits 31.8 through 31.10. Exhibit 31.8 shows the anticipated decline in the operating proﬁt of the Electronics Division without the investment under consideration (new manufacturing equipment also having additional capacity). Exhibit 31.9 reﬂects the tremendous increase in operating proﬁt, after the ﬁrst two years, by making the investment in Project X. It also shows the effect of the write-off, in the years of incurrence of the startup costs, and the depreciation of the capital asset cost of $1,500,000 over a ﬁve-year life (straight line depreciation, with a one-half year of depreciation in 20XX). The use of a generally accepted accounting practice involving immediate write-off of startup costs in the years of occurrence, and commencement as early as possible of depreciation charges on a straight line ﬁve-year basis (not on a per unit of output), causes an operating loss in 20XX and a severe reduction in operating proﬁt in 20X1. Exhibit 31.10 shows the impact of a less conservative accounting practice—the immediate capitalization of the startup costs, with the subsequent amortization of the charge over a two-year period of operation, and the deferment of immediate depreciation of the capital assets, also for a two-year period, and a subsequent write-off over a ﬁve-year period. Such a practice avoids an operating loss in the ﬁrst year of operations and avoids a large reduction in the operating proﬁt of the second year of operation—with the heavier additional costs being deferred until there is a signiﬁcant pickup in sales and operating proﬁt (before such additional charges). Providing such data to the board of directors advises them of the impact on expected operating proﬁt of the proposed investment on two different accounting bases. This information would be in addition to that listed earlier. It rounds out the ﬁnancial picture and perhaps avoids later questions. The annual plan and strategic plan should incorporate the effect of the expenditures on the statement of income and expense, the statement of ﬁnancial position, and the statement of cash ﬂows. This same data should be made available to the commercial banks, or other ﬁnancial sources, who are asked to provide the ﬁnancing. The authors suggest full disclosure of the ﬁnancial statements of the annual plan and long-range plan to the ﬁnancing institution, including the schedule for complete payment of the obligation. When and if the board approves the project, the cognizant ofﬁcer is notiﬁed. This constitutes an approval in principle. Speciﬁc project approval, as discussed in the next section, is required before the project may proceed. T HE J OHNSON C OMPANY E LECTRONICS D IVISION S TATEMENT OF E STIMATED I NCOME AND E XPENSES W ITHOUT P ROJECT X I NVESTMENT 20XX T HROUGH 20X6 (D OLLARS IN T HOUSANDS ) Item Net sales Cost of sales Gross proﬁt Selling expense General and administrative expense Operating proﬁt or (loss) E XHIBIT 31.8

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S TATEMENT

OF

Year 20XX 20X1 20X2 20X3 20X4 20X5 20X6 $2,500 $2,400 $2,100 $1,900 $1,700 $1,500 $1,200 1,500 1,440 1,300 1,200 1,100 1,050 1,000 1,000 200

960 200

800 200

700 200

600 200

450 200

200 200

100

100

90

90

90

90

80

$ 700

$ 660

$ 510

$ 410

$ 310

E STIMATED I NCOME

AND

E XPENSE

WITHOUT

$ 160 $ (80)

P ROJECT X I NVESTMENT

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31.19 Project Authorization

W ITH

645

T HE J OHNSON C OMPANY E LECTRONICS D IVISION S TATEMENT OF E STIMATED I NCOME AND E XPENSES P ROJECT X I NVESTMENT U SING C URRENT A CCOUNTING P RACTICES (GAAP) 20XX T HROUGH 20X6 (D OLLARS IN THOUSANDS ) Year

Item

20XX

20X1

20X2

20X3

20X4

20X5

20X6

Net sales

$2,500

$2,700

$3,200

$4,000

$5,000

$6,000

$7,000

1,500

1,620

1,920

2,400

2,500

3,000

3,500

1,000

1,080

1,280

1,600

2,500

3,000

3,500

200

200

200

200

200

200

250

100

100

100

100

100

100

100

700

780

980

1,300

2,200

2,700

3,150

Startup expenses

500

100

—

—

—

—

—

Additional depreciation

150

300

300

300

300

150

—

$ (50)

$ 380

$ 680

$ 1,000

$ 1,900

$ 2,550

$ 3,150

Cost of sales Gross proﬁt Selling expense General and administrative expense Operating proﬁt before startup expenses and additional depreciation

Operating proﬁt E XHIBIT 31.9

S TATEMENT OF E STIMATED I NCOME AND E XPENSE WITH P ROJECT X I NVESTMENT U SING C URRENT A CCOUNTING P RACTICES (GAAP)

31.19 PROJECT AUTHORIZATION Under most circumstances, the analysis and review done in connection with securing project approval by the board of directors should be sufﬁcient to complete a detailed authorization request. However, circumstances do change, and a period of six months might pass between the gathering and analysis of data for the board review. So sometimes this re-review is worthwhile. Also, it causes the project sponsors to commit in writing to the project. An illustrative form is shown in Exhibit 31.11. T HE J OHNSON C OMPANY E LECTRONICS D IVISION S TATEMENT OF I NCOME AND E XPENSES W ITH P ROJECT X I NVESTMENT AND W ITH M ODIFIED C APITALIZATION AND D EPRECIATION P RACTICE 20XX T HROUGH 20X6 (D OLLARS I N T HOUSANDS ) Year Item

20XX

20X1

20X2

20X3

20X4

20X5

20X6

Net sales

$2,500

$2,700

$3,200

$4,000

$5,000

$6,000

$7,000

Cost of sales

1,500

1,620

1,920

2,400

2,500

3,000

3,500

Gross proﬁt

1,000

1,080

1,280

1,600

2,500

3,000

3,500

E XHIBIT 31.10

S TATEMENT OF E STIMATED I NCOME AND E XPENSE M ODIFIED A CCOUNTING P RACTICES

WITH

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WITH

P ROJECT X I NVESTMENT

AND

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646

Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

Year 20XX

20X1

20X2

20X3

20X4

20X5

20X6

Selling expense

200

200

200

200

200

200

250

General and administrative expense

100

100

100

100

100

100

100

980

1,300

2,200

2,700

3,150

300

300

Item

Operating proﬁt before startup expenses and additional depreciation

700

780

Startup cost capitalized

500*

100*

Additional depreciation capitalized

150*

300*

Amortization of startup costs (1) Amortization of capitalized depreciation (2)

225

225

—

—

300

300

300

150

—

$ 700

$ 780

$ 155

$ 475

$ 1,900

$ 2,550

$ 3,150

Additional depreciation Operating proﬁt *See related write-offs (1) and (2).

E XHIBIT 31.10

S TATEMENT OF E STIMATED I NCOME AND E XPENSE WITH P ROJECT X I NVESTMENT M ODIFIED A CCOUNTING P RACTICES (C ONTINUED )

AND

WITH

R EQUEST

FOR

E QUIPMENT

AND

F ACILITY A UTHORIZATION A.F.E. No. _______________ Date: ____________________

Division

Plant

This request for authorization of a capital commitment and expenditure is made necessary by: Normal replacement

New product

Change in manufacturing process

x Increased volume

Cost reduction

Styling changes

x Environmental regulations Title: Pneumatic bagging equipment Description and Justiﬁcation: The present conveyor and manual handling system is too slow. It is anticipated that the state-of-the-art equipment will permit a volume of 1,500,000 2-lb. bags per year, with a reduction of 5 operators. Use added pages if necessary. E XHIBIT 31.11

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R EQUEST

FOR

E QUIPMENT

AND

F ACILITY A UTHORIZATION

31_controllership.fm Page 647 Monday, December 8, 2003 4:39 PM

31.19 Project Authorization

647

Estimated Cost: Return on Investment Machinery and equipment

$105,700

Installation

(DCF method)

43%

25,000

Total

130,700

Contingency 5%

6,535 $ 137,235

Total

Payback period

2.1 yrs.

Estimated useful life

8 yrs.

Salvage value

$ 2,000

Controller Comments and Recommendations:

Accounting Dept.

Cash ﬂow appears conservative

Acct. No. Return is above hurdle rate of 20% for this type of investment

Amount

Capital M&E 21–310

$ 131,235

Expense—sales tax 21–407

6,000

Total

$ 137,235

Approval recommended

Controller Approval and Authorization

Date

Requested by Approved

Rejected

Approved by Department head Plant manager Division manager Executive Committee Reason for Rejection:

E XHIBIT 31.11

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R EQUEST

FOR

E QUIPMENT

AND

F ACILITY A UTHORIZATION (C ONTINUED )

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648

Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

It should be mentioned that authority required to commence a project depends on the amount of the request. While approval of the president for all projects might be needed in a small ﬁrm, in larger ones there might be an ascending scale of required approvals, perhaps as: Amount Less than $10,000 $10,000-99,999 $100,000-499,999 Over $500,000

Required Approval Plant Manager General Manager Chief Operating Ofﬁcer Chief Executive Ofﬁcer

The sample form provides for comments and recommendations by the controller as well as the line approval (depending on the amount).

31.20 ACCOUNTING CONTROL OF THE PROJECT When the work authorization has been properly approved, then the task of the controller is to keep tabs on both commitments and expenditures as well as expected costs to complete the project, and periodically report the data to the cognizant executive. Typically these ﬁgures are reported by project or work order: • Amount authorized • Actual commitments to date • Actual costs incurred to date • Estimated cost to complete • Indicated total cost • Indicated overrun or underrun compared to the project budget An illustrated report, prepared monthly and in which control is by appropriation number, is shown in Exhibit 31.12. For large and complicated projects a computer application may be appropriate.

31.21 POSTPROJECT APPRAISALS OR AUDITS In many companies adequate analyses are made as to the apparent economic desirability of a project, and acquisition costs are held within estimate. Yet the project may not achieve the estimated rate of return. A sad truth is that some managements are unaware of such a condition because there is no follow-up on performance. For large projects, especially, after a limited or reasonable period beyond completion—perhaps two years on a very large capital investment—when all the “bugs” are worked out, it is suggested that a postaudit be made. The review might be undertaken by the internal audit group, or perhaps a management team consisting of line managers involved with the project (but not among the original justiﬁcation group) and some members of the controller’s staff. The objective, of course, is to compare actual earnings or savings with the plan, ascertain why the deviation occurred, and what steps should be taken to improve capital investment planning and control. The scope might range from the strategic planning aspects (should the company be in the business?) through to the detailed control procedures.

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31.22 Other Aspects of Capital Expenditures

649

The following advantages may accrue from an intelligently planned postaudit: • It may detect weaknesses in strategic planning that lead to poor decisions, which in turn impact the capital budget procedures. • Environmental factors that inﬂuence the business but were not recognized might be detected. • Experience can focus attention on basic weaknesses in overall plans, policies, or procedures as related to capital expenditures. • Strengths or weaknesses in individual performance can be detected and corrected—such as a tendency to have overly optimistic estimates. • It may enable corrections in other current projects prior to completion of commitments or expenditures. • It affords a training opportunity for the operating and planning staff through the review of the entire capital budgeting procedure. • Prior knowledge of the follow-up encourages reasonable caution in making projections or preparing the justiﬁcation. • It may detect evidence of manufactured input data. The scope and postcompletion period of the review will depend on circumstances. Some companies limit the audit only to major projects over $1 million and only until the payback period is completed. A simple form of graphic report quickly summarizing actual and expected performance is illustrated in Exhibit 31.13. The postaudit report commentary, of course, can touch on estimated cash ﬂow to date of the audit as compared with actual cash ﬂow, old versus new break-even points, and operating expenses, planned versus actual, as well as other pertinent observations.

31.22 OTHER ASPECTS OF CAPITAL EXPENDITURES (a) WORKING CAPITAL. This chapter, up to this point, has dealt with capital expenditures in the strictest sense. In many cases this is proper in that, when a capital expenditure other than cash outﬂow is made, there is no impact on working capital. Yet, many instances, such as growth or expansion in the business, will require additional investment in inventory and receivables as well as the plant and equipment needs. Sufﬁce it to say that if additional working capital is necessary, then it should be reﬂected in the investment requirement and in the rate of return calculation. It is partially offset by the salvage value recovery when the business ceases. (b) LEASE VERSUS BUY DECISIONS. Technically speaking, the acquisition of a long-term asset, whether purchased or leased, should be included in the capital budget. However, the rental of the asset or leasing it on a short-term basis would not warrant this treatment. The discounted cash ﬂow technique may be useful in reaching a decision whether to lease or buy, and several good reference sources are available on the subject. The best method to be used is either IRR or NPV, and treatment of some of the variables is controversial. The authors suggest the NPV method is perhaps easy to apply. If the marginal ﬁnancing (net of taxes) cost of funds to purchase the asset is known, the same discount rate can be applied to the stream of lease payments to

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E XHIBIT 31.12

46

42

AND

E XPENDITURES

950 6/30/20XX* 6/30/20XX* 6/30/20XX* 940

360 180 400

515

300 75 140

330

40 30 260

501

1,240

2,450 495 496 497

—

500

850

10/31/20XX*

462

$ 107 394

$ 125 1,475

2/20/20XX 9/01/20XX*

$— 740

Actual Original Outstanding Expenditures to Date Estimate Commitments

460 461

$2,500

Work Order Amount No. Appropriated

C APITAL A PPROPRIATIONS

Total appropriation 46

Delivery Fleet 4 ton 1 ton 1/2 ton pick-up

Total appropriation 42

Northridge Plant Site clearance Buildings Machinery and equipment

Description

Actual Completion Date

M AGRAUDY M ANUFACTURING C O . C APITAL A PPROPRIATION AND E XPENDITURE S TATUS R EPORT FOR THE P ERIOD E NDED A PRIL 30, 20XX ( DOLLARS IN THOUSANDS )

Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

Appropriation No.

650

70

10 60 —

676

360

$— 316

Estimated Cost to Complete

915

350 165 400

2,417

860

$ 107 1,450

35

$ 83

25

10 15 —

33

(10)

$ 18 25

Indicated Appropri- Original Total Cost ation Estimate

Amount (Over)/Under

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Estimated

E XHIBIT 31.12

*

50

Grand total

Miscellaneous Robot assemblers Security system—plant 5 Proﬁler—plant 6 Fleet communications Lab pilot plant Pallets Forklift trucks New gates— employee parking All others— complete Total appropriation 50

Description

C APITAL A PPROPRIATIONS

Appropriation No.

E XPENDITURES (C ONTINUED )

1,680

AND

255

500

$ 5,070

—

75

8/31/20XX*

562

$ 5,200

—

75 290 50 150

7/01/20XX* 11/30/20XX* 4/30/20XX 9/30/20XX*

534 542 549 550

$ 2,010

30 40 — 75

— 10

100 90

3/31/20XX 6/30/20XX*

100

529 533

350

31.22

$ 2,074

1,243

515

5

50 160 52 70

97 80

214

$ 908

162

—

67

5 55 — 5

— 10

20

Estimated Cost to Complete

$ 4,992

1,660

515

72

85 255 52 150

97 100

334

$ 208

90

651

$ 78

20

(15)

3

(10) 35 ( 2) —

3 (10)

16 16

Indicated Appropri- Original Total Cost ation Estimate

Other Aspects of Capital Expenditures

Actual Original Outstanding Expenditures Estimate Commitments to Date

5/20/20XX

*

Actual Completion Date

525

1,750

Work Order Amount No. Appropriated

Amount (Over)/Under

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652

Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

E XHIBIT 31.13

C APITAL E XPENDITURE P ERFORMANCE R EPORT

arrive at the net present value. Usually the alternative with the lower NPV, and the higher savings, should be the one selected. The comparative net present values of lease vs. purchase (with no investment tax credit) are shown in Exhibit 31.15. This application assumes a 15% interest borrowing rate, less a 40% tax rate, or a net cost of 9%. The net savings through purchase may be calculated as: Present value of purchase Less: Present value of related tax savings

$1,000,000 311,120

Net purchase cost

$ 688,880

Savings (NPV) by purchase over lease: Present value of lease cost Net purchase cost (above)

$ 733,632 688,880

Net savings

$

44,752

(c) MUTUALLY EXCLUSIVE CAPITAL PROPOSALS. In the capital budgeting process there may be instances when the estimated rate of return on any two projects is the same, but funds are available for only one. The two projects, by deﬁnition, are mutually exclusive. How should a decision be made as to which proposal to accept? One complicating factor is that the IRR method may rank projects somewhat differently than the NPV approach. Such a condition can arise because the IRR method assumes that funds generated are reinvested at the discounted rate calculated for the initial investment. The NPV method assumes funds are reinvested at the rate used for discounting, which is often the cost of capital. Other reasons for differing evaluations relate to different project lines and different initial investments. When the projects are mutually exclusive, one

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31.22 Other Aspects of Capital Expenditures

653

NPV C ALCULATION L EASE VS . B UY A. P URCHASE B ASIS Accelerated Cost Recovery

Year 1 2 3 4 5 6 7 8 9 Total

Income Tax Savings (40% Rate)

$ 200,000 200,000 200,000 200,000 200,000 — — — —

$ 80,000 80,000 80,000 80,000 80,000 — — — —

$ 1,000,000

$ 400,000

Discount Factor (9%) .917 .842 .772 .708 .650

Present Value $ 73,360 67,360 61,760 56,640 52,000 — — — — $ 311,120

NPV C ALCULATION L EASE VS . B UY B. L ONG -T ERM L EASE B ASIS Year 1 2 3 4 5 6 7 8 9 Total E XHIBIT 31.14

Pretax Lease Rental $ 280,000 280,000 270,000 270,000 120,000 120,000 120,000 120,000 120,000

Tax Savings at 40& Rate $112,000 112,000 108,000 108,000 48,000 48,000 48,000 48,000 48,000

After-Tax Lease Cost $ 168,000 168,000 162,000 162,000 72,000 72,000 72,000 72,000 72,000

$ 1,700,000

$ 680,000

$ 1,020,000

NPV C ALCULATION —L EASE

VERSUS

Discount Factor (9%) .917 .842 .772 .708 .650 .596 .547 .502 .460

Net Present Value $154,056 141,456 125,064 114,696 46,800 42,912 39,384 36,144 33,120 $ 733,632

B UY

way of making a decision is to (1) calculate the differences in cash ﬂow, and (2) apply the opportunity cost rate, or cost of capital rate, to these cash ﬂow differences. Assuming the incremental or opportunity cost rate is higher than the capital budget cut-off rate, then the proposal with the higher value should be selected. As reﬂected in Exhibit 31.15, Project B should be accepted. (d) PLANT AND EQUIPMENT RECORDS. Adequate plant and equipment records are a necessary adjunct to effective control. They provide a convenient source of information for planning and control purposes as well as for insurance and tax purposes. Some of the advantages may be enumerated as: 1. Provide necessary detailed information about the original cost (and depreciation reserves) of ﬁxed assets by type of equipment or location. 2. Make available comparative data for purchase of new equipment or replacements.

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654

Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

M UTUALLY E XCLUSIVE P ROJECTS C OMPARATIVE C ASH F LOWS ( DOLLARS IN THOUSANDS ) Cash Flows Year

A

0 1 2 3 4 5 6 7

$(50,000) 12,000 14,000 15,000 15,000 15,000 15,000 10,000

Total

$ 46,000

B $(90,000) 30,000 35,000 35,000 35,000 34,000 30,000 21,000 $ 130,000

Present Value at 20%* B–A Difference $(40,000) 18,000 21,000 20,000 20,000 19,000 15,000 11,000

Factor 1.00 .833 .694 .579 .482 .402 .335 .279

Amount $(40,000) 14,994 14,574 11,580 9,640 7,638 5,025 3,069

$ 84,000

$ 26,520

*Incremental rate of 20% exceeds cut-off rate of 17%.

E XHIBIT 31.15

I NCREMENTAL I NVESTMENT —M UTUALLY E XCLUSIVE P ROJECTS

3. Provide basic information to determine proper depreciation charges by department or cost center and serve as a basis for the distribution of other ﬁxed charges such as property taxes and insurance. 4. Establish the basis for property accountability. 5. Provide detailed information on assets and depreciation for income tax purposes. 6. Are a source of basic information in checking claims and supporting the company position relative to personal and real property tax returns? 7. Serve as evidence and a source of information for insurance coverage and claims. 8. Provide the basis for determining gain or loss on the disposition of ﬁxed assets. 9. Provide basic data for control reports by individual units of equipment. Property records include the plant ledgers and detailed equipment cards. The ledgers will follow the basic property classiﬁcations of the company. Detailed records must be designed to suit the individual needs of the company. Information in a data bank, preferably stored in a computer, should include: • Name of asset • Type of equipment • Control number • Description • Size • Model • Style • Serial number • Motor number • Purchased new or used

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• Date purchased • Vendor • Invoice number • Purchase order number • Location Plant Building Floor Department • Account number

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31.22 Other Aspects of Capital Expenditures

• Transfer information • Original cost information Purchase cost Freight Tax Installation cost

655

• Additions to • Date retired • Sold to • Scrapped • Cost recovered • Depreciation data

Material

Estimated life

Labor

Annual depreciation

Overhead

Basis

Additional information may be required in particular companies. However, a database should be complete so that appropriate reports can be prepared. There are numerous software packages available that permit the generation of most conceivable needs as regards reports or ﬁxed assets. (e) INTERNAL CONTROL AND ACCOUNTING REQUIREMENTS. Once the property has been acquired, the matter of proper accounting and control arises. Usually, such duties become the responsibility of the controller. The problem is essentially very simple, but a few suggestions may prove helpful: • All ﬁxed assets should be identiﬁed, preferably at the time of receipt; a serial number may be assigned and should be afﬁxed to the item. Use of metal tags or electrical engraving is a common method of marking the equipment. • Machinery and equipment assigned to a particular department should not be transferred without the written approval of the department head responsible for the physical control of the property. This procedure is essential to know the location for insurance purposes and to correctly charge depreciation, etc. • No item of equipment should be permitted to leave the plant without a property pass signed by the proper authority. • Periodically, a physical inventory should be taken of all ﬁxed assets. • Detailed records should be maintained on each piece of equipment or similar groups. • Purchase requisitions and requests for appropriations should be reviewed to assure that piecemeal acquisitions are not made to avoid the approval of higher authority. Thus if all expenditures over $100 require the signature of the general manager, individual requisitions may be submitted for each table or each chair to avoid securing such approval. • Retirement of ﬁxed assets by sale or scrapping should require certain approvals to guard against the disposal of equipment that could be used in other departments. • If possible, bids should be secured on any sizable acquisitions. • Provision should be made for proper insurance coverage during construction as well as on completion. • Expenses should be carefully checked to decrease the possibility that portions of capital expenditures are treated as expenses to avoid budget overruns. (f) IDLE EQUIPMENT. Another phase of control over ﬁxed assets relates to unused facilities, whether only of short duration or for more extended periods. In every business, it can reasonably be expected that some loss will be sustained because of idle facilities and/or idle workers. The objective is to inform management of these losses and place responsibility in an attempt to eliminate the avoidable and unnecessary costs. But aside from stimulating action to eliminate the causes of short-term idleness, such information may be a guide in determining whether additional facilities are

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Ch. 31 Planning and Control of Plant and Equipment or Capital Assets

necessary. Also, such knowledge may encourage disposal of any permanently excess equipment, giving consideration to the medium-term plans. Losses resulting from unused plant facilities are not limited to the ﬁxed charges of depreciation, property taxes, and insurance. Very often idle equipment also results in lost labor, power, and light, as well as other continuing overhead expenses, to say nothing of startup time and lost income from lost sales. Causes of idle time may be threefold: 1. Those controllable by the production staff. These may result from: (a) (b) (c) (d) (e) (f)

Poor planning by the foreperson or other production department staff member Lack of material Lack of tools or other equipment Lack of power Machine breakdown Improper supervision or instructions, etc.

2. Those resulting from administrative decisions. For example, a decision to build an addition may force the temporary shutdown of other facilities. Again, management may decide to add equipment for later use. Here certain idle plant costs may be incurred until the expected demand develops. 3. Those arising from economic causes. Included are the causes beyond the control of management, such as cyclical or seasonal demand. In somewhat the same class is idle time resulting from excess capacity in the industry. The effect of such conditions may be partially offset by efﬁcient sales planning and aggressive sales effort. The cause of idle time is important in determining the proper accounting treatment. Where idle facilities result from economic causes or are otherwise highly abnormal—such as a prolonged strike—it may be desirable for the controller to have such costs segregated and handled as a separate charge in the statement of income and expense. Such expenses should not be included in inventory or cost of sales. Some companies isolate in the manufacturing expenses the cost of idle time that is controllable by the production staff. In other cases, a simple reporting of the hours is all that is necessary. Where it is desirable to charge the costs of idle time to a separate account the segregation is simple through a comparison of normal and actual hours and the use of standard rates. (g) DEPRECIATION ACCOUNTING. Depreciation has been deﬁned in many ways, such as a dictionary deﬁnition, “decline in value of an asset due to such causes as wear and tear, action of the elements, obsolescence and inadequacy.” The accounting profession has considered several deﬁnitions, and after long consideration the American Institute of Certiﬁed Public Accountants (AICPA) Committee on Terminology formulated the following deﬁnition: Depreciation accounting is a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a process of allocation, not of valuation. Depreciation for the year is the portion of the total charge under such a system that is allocated to the year. Although the allocation may properly take into account occurrences during the year, it is not intended to be a measurement of the effect of all such occurrences.1

In arriving at the applicable charges for depreciation, there are at least three related objectives of proper accounting: (1) to state earnings correctly; (2) to protect the investment of owners and creditors by maintaining the integrity of the ﬁxed capital accounts (a write-off of plant and equip-

1. Paul Grady, Inventory of Generally Accepted Accounting Principles of Business Enterprises.

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ment over the useful life, by charges against income, tends to avoid the payment of dividends out of capital); and (3) to secure useful costs through proper depreciation allocations to cost centers. Another objective might be to maximize tax deductions (depreciation) under the applicable IRS code. The accomplishment of these objectives must lie largely in the controller’s hands. The determination of the useful life of the plant and equipment is largely an engineering problem. However, the ramiﬁcations and implications of depreciation policy—such matters as treatment of obsolescence, accounting for retirements, determination of allocation methods, and selection of individual or group rates—are best understood by the accountant. For these reasons, the controller should be the primary force in recommending to management, as may be necessary, the policies to be followed. (h) OBSOLESCENCE. Obsolescence, sometimes called functional depreciation as distinguished from physical depreciation, can be a highly signiﬁcant factor in determining useful economic life. More often than not, the usefulness of facilities is likely to be limited by obsolescence, so that it may outweigh the depreciation factor. Such a condition can occur as a result of two causes. The product manufactured may be replaced by another, so that the need no longer exists for the facility. Or a new type of asset—one that produces at a much lower cost—may be developed to supersede present manufacturing equipment. Sometimes the need for expanded capacity has the effect of rendering obsolete or inadequate the existing asset. Obsolescence may be of two kinds—normal or special. The former is the normal loss in value and can be anticipated in the same degree as other depreciation factors. It should be included in the estimate of useful life. Extraordinary or special obsolescence, on the other hand, can rarely be foreseen. The controller’s responsibility generally should extend to a review of past experience and trends to determine whether obsolescence is an important consideration in his industry. If so, then it should be duly recognized in the useful life estimates. In accounting for obsolescence, the question must be settled about whether a distinction should be made in the accounts between charges for obsolescence and depreciation. In practice, the normal obsolescence will be combined with depreciation in both the provision and the reserve. A highly abnormal and signiﬁcant obsolescence loss probably should be segregated in the income and expense statement. Aside from this, circumstances may indicate the desirability of segregating a reserve for obsolescence. It may not be possible to identify obsolescence with a particular asset, although experience will indicate the approximate amount. This can be handled as a general provision without regard to the individual piece of equipment. (i) FULLY DEPRECIATED ASSETS. In properly stating on the balance sheet the value of ﬁxed assets and in making the proper charge to manufacturing costs for the use of the plant and equipment, the question is raised about the correct accounting treatment of fully depreciated assets. If the facilities are no longer of use, they should be retired and the amount removed from both the asset and the reserve. If the item is fully depreciated but still in use, then the depreciation charge to the earnings statement must be discontinued—unless a composite useful life estimate or a composite depreciation rate is being used. The controller should consider these conditions, as well as increased maintenance costs, in evaluating operating performance and in preparing useful reports for management. (j) APPRAISALS AND APPRAISAL RECORDS. Management may request appraisals of property for any one of several reasons: for the purchase or sale of property, for reorganization or liquidations, for ﬁnancing when the property is collateral, for insurance purposes, for taxation purposes, and for control purposes when the records do not indicate investment by process or cost center. The basis of valuing ﬁxed assets has already been reviewed, and the desirability of stating such property at original cost has been emphasized. However, occasions arise when management directs

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the valuation of property on another basis, perhaps to remove extremely high depreciation charges. When appraisals are recorded, the original cost and depreciation on original cost should continue to be reﬂected in the detail records, along with the appraised value and depreciation thereon. (k) LOSS OR GAIN ON THE SALE OF FIXED ASSETS. The matter of accounting for the loss or gain on the sale or other disposition of ﬁxed assets is primarily one of accounting theory. Some have supported the proposition that losses resulting from premature retirement or technological advances are properly capitalized and charged against future operations. Most authorities do not concur in this view. The sound value—or asset value, less accumulated depreciation—for all assets retired is a loss that should be charged off as incurred. It is in the nature of a correction of prior proﬁts. Usual practice is to carry such gain or loss, if important, in the nonoperating section of the statement of income and expense. (l) FUNDS FOR PLANT REPLACEMENT AND EXPANSION. Unfortunately, a great deal of confusion has arisen among laymen about the distinction between a reserve and a fund. Some think that the creation of a depreciation reserve also establishes a fund to replace the property. Accountants know that a reserve may exist independent of a fund and that a fund can exist without a reserve. The depreciation reserve does not represent a fund of cash or other assets that have been set aside. It only expresses the usage of the asset. If the operation has been proﬁtable, and if dividends have not been paid in excess of the net income after recognizing depreciation, then values of some sort are available to offset the charge for use of the plant and equipment. Most companies do not establish funds for property expansion or replacement but use the general funds instead. However, such funds can be created, and some exponents believe that public utilities and wasting asset industries, such as mining, should establish such funds. Such funds are not necessarily to be measured by the depreciation reserve, because replacement costs may be quite different. The depreciation reserve is a measure of expired past value, not future requirements for replacement. (m) PLANT AND EQUIPMENT IN RELATION TO TAXES. Many local communities and states levy real and personal property taxes or enforce payment of franchise taxes based on property values. Maintenance of adequate records can be a means of satisfying the taxing authorities on problems of valuation. Plant and property values, through the resulting depreciation charges, are important from the federal income tax viewpoint. As mentioned previously, the depreciation allowance for tax purposes, if signiﬁcantly different from depreciation for book purposes, can distort the proﬁt before taxes and the tax charge. Where the estimate of useful life and the base for tax and book purposes are not greatly different, an effort should be made to bring the two in line. It may save the maintenance of a separate set of records. In any event, the burden of proof about the correctness of the depreciation claimed is placed on the taxpayer, who must keep the necessary records and other data to support the claim.

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CHAPTER

32

MANAGEMENT OF LIABILITIES 32.1

INTRODUCTION 659

32.8

CORRECTIVE ACTION 668

32.2

LIABILITIES DEFINED 659

32.9

RISKS OF TOO MUCH DEBT 668

32.3

OBJECTIVES OF LIABILITY MANAGEMENT 660

32.10 SOME BENEFITS FROM DEBT INCURRENCE 669

32.4

DIRECT LIABILITIES 660 (a) Current Liabilities 660 (b) Long-Term Liabilities 661

32.11 SOURCES OF INFORMATION ON DEBT CAPACITY 669

32.5

ILLUSTRATIVE PROVISIONS OF CREDIT AGREEMENTS 662

32.6

PLANNING THE CURRENT LIABILITIES 666

32.7

STANDARDS TO MEASURE AND CONTROL CURRENT LIABILITIES 667 (a) Current Ratio 667 (b) Quick Ratio 667 (c) Minimum Net Working Capital 667 (d) Current Debt to Net Worth 668 (e) Current Debt to Inventory 668 (f) Number of Days’ Payables on Hand 668

32.12 STANDARDS FOR DEBT CAPACITY 669 32.13 BOND RATINGS 670 32.14 LEVERAGE 671 32.15 CONTINGENCIES 671 (a) Treatment of Long-Term Liabilities in the Annual Business Plan 671 32.16 LONG-RANGE FINANCIAL PLAN 672 32.17 MANAGING LIABILITIES: SOME PRACTICAL STEPS 672 32.18 ACCOUNTING REPORTS ON LIABILITIES 673 32.19 INTERNAL CONTROLS 674

32.1 INTRODUCTION It often has been said that the management, or planning and control, of the assets (excepting cash and temporary investments) of an enterprise rests largely in the hands of the operating executives but that management, or planning and control, of the liabilities and equity of the company is primarily the responsibility of the ﬁnancial executives. In a certain sense this is true—up to a point— and the ﬁnancial ofﬁcers must exercise control over the liabilities of the entity to preserve its economic health. The comments in this chapter relate to the practical or pragmatic considerations regarding liability planning and control, of which the controller must be intimately familiar. Remarks will relate to the traditional types of liabilities as well as new developments and concerns in this ﬁeld of management.

32.2 LIABILITIES DEFINED Although it is not the purpose of the chapter to deal at length with the accounting niceties regarding the recording of the liabilities of a company, the subject is deﬁned for our purposes as: 659

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Liabilities are the economic obligations of an enterprise that are recognized and measured in conformity with generally accepted accounting principles. Liabilities also include certain deferred credits that are not obligations (such as, for example, deferred credits from income tax allocations) but that are recognized and measured in conformity with generally accepted accounting principles.

Liabilities are measured at amounts established in the exchanges involved, usually the amounts to be paid but sometimes at discounted rates.

32.3 OBJECTIVES OF LIABILITY MANAGEMENT In the basic sense, the purpose of liability management is to assure that the enterprise has “cash adequacy”—the ability to meet cash requirements for any purpose signiﬁcant to the short- or long-term ﬁnancial health of the company. It is not merely to avoid insolvency or bankruptcy. From the standpoint of the controller, the more speciﬁc objectives of liability management might include: • The recording and disclosure in accordance with generally accepted accounting principles of the ﬁnancial obligations of the company. • The reporting in proper form, as required by indentures or credit agreements, of the corporate liabilities. • Through effective planning and control, the maintenance of a sound ﬁnancial structure, including the proper relationship of debt to equity capital. • Continuance of the ability to secure necessary borrowed funds in a timely manner and at a cost that is competitive. • To institute and maintain controls that restrict commitments within well-deﬁned limits so that they do not result ultimately in excessive and burdensome liabilities. • To enable the company to be so well regarded in the ﬁnancial marketplace that its common (and preferred) stock will command respect far into the future with an acceptable price-earnings ratio, and that the stock will reﬂect a gradual increase in earnings per share and consequent long-term appreciation for the beneﬁt of the owners. • To permit the company to maintain a prudent dividend policy. All of these objectives of liability management are interrelated.

32.4 DIRECT LIABILITIES In an attempt to categorize the types of liabilities and to indicate some of the matters to be considered by the controller, a brief commentary follows. (a) CURRENT LIABILITIES. Generally, liabilities classiﬁed as current are those due to be paid within the operating cycle—that ordinarily is within a period of one year. The importance of the proper segregation of current liabilities from other liabilities rests in the role played by various ﬁnancial ratios, such as the current ratio, when funds are borrowed. By another related deﬁnition, current liabilities include those obligations whose liquidation reasonably is expected to require the use of existing current assets or the creation of new current liabilities. Included in current liabilities are: • Notes payable. Represent the obligations of the company under legal instruments in which there exists an explicit promise to pay a speciﬁed amount at a speciﬁed time. • Accounts payable. Accounts payable usually are largely trade accounts payable and represent the obligations of the ﬁrm to its suppliers. Since these liabilities are recorded at the time the title passes to the goods or the services are received, the ﬁnancial ofﬁcers should be satisﬁed that clean cutoffs on the obligations exist. This is especially true in those instances where the

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working capital or current ratio requirement is critical in a credit agreement or the company is nearing the limits speciﬁed. Additionally, credit balances in various asset accounts, such as accounts receivable, usually are reclassiﬁed to the accounts payable category—especially at year end—or when ﬁnancial statements are published. • Accrued expenses. When an obligation exists by reason of the beneﬁts having been received but is not yet due and payable, it normally would be recorded as an accrued expense. Included would be such items as accruals for wages, salaries, commissions, rents, royalties, pension costs, and income and other taxes. • Accrued income taxes. Special mention is made of this liability, since often it is composed of two segments. The normal tax due within a year would be recorded under current liabilities as “currently payable.” However, using the principle of matching costs with related revenues, yet recognizing that the tax laws permit the reporting of income in a different ﬁscal period than generally accepted accounting principles would either permit or require, there may be includable under current liabilities a “deferred” income tax obligation. There are rather continuously numerous ofﬁcial releases by the Financial Accounting Standards Board (FASB), which provide new standards concerning income tax accounting. For example, in May 1992, the body issued Statement of Financial Accounting Standards No. 109—Accounting for Income Taxes. It supersedes FASB Statement No. 96, Accounting for Income Taxes and amends or supersedes a number of other accounting pronouncements. Statement No. 109 established ﬁnancial accounting and reporting standards for the effects of income taxes that result from an enterprise’s activities during the current and preceding years. It requires an asset and liability approach for ﬁnancial accounting and reporting for income taxes. As the Standard says, “The objectives of accounting for income taxes are to recognize (a) the amount of taxes payable or refundable for the current year, and (b) deferred tax liabilities and assets for future tax consequences of events that have been recognized in an enterprise’s ﬁnancial statements or tax returns.” It is assumed the controller will keep abreast of tax reporting requirements and will see that the tax liability is properly recognized. (See also Chapter 16.) This distinction becomes important in calculating cash ﬂows and when considering acceptable terms in indentures or credit agreements. (b) LONG-TERM LIABILITIES. Long-term liabilities, by deﬁnition, represent those obligations due in more than one year or those to be paid out of noncurrent assets. Only three limited comments need be made. 1. Long-term leases. If at its inception a lease meets one or more of the following criteria, it shall be classiﬁed as a capital lease by the lessee and placed on the balance sheet. Otherwise, it would be treated as an operating lease, with appropriate disclosure. The criteria for capitalization include: (a) The lease transfers ownership of the property to the lessee by the end of the lease term. (b) The lease contains a bargain purchase option. (c) The lease term is equal to 75% or more of the estimated economic life of the leased property (with certain exceptions). (d) The present value at the beginning of the lease term of the minimum lease payments— excluding certain costs—equals or exceeds 90% of the fair market value of the property over the related investment tax credit retained or expected to be used by the lessor. For the speciﬁc criteria and the exceptions, reference should be made to the literature of the American Institute of Certiﬁed Public Accountants (AICPA). 2. Bonds. Bonds are essentially long-term corporate notes issued under a formal legal procedure and secured either by the pledge of speciﬁc properties, or revenues, or the general credit of the issuer. Bonds differ from individual notes in that each represents a fractional

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interest of participation in a group contract, usually with a trustee acting as intermediary. The terms of the contract are set forth in the trust indenture. 3. Other long-term obligations, etc. Depending on circumstances, there may exist other obligations and like items that are classiﬁed either as long-term obligations or items carried in the long-term section of the balance sheet above the shareholders’ equity. These may include such items as: Deferred income taxes Deferred compensation Accrued product warranty Employees pension, indemnity, retirement, and related provision Negative goodwill Minority interests The reader is referred to the various publications of the AICPA about the generally accepted principles that govern the recording of the item.

32.5 ILLUSTRATIVE PROVISIONS OF CREDIT AGREEMENTS To be sure, within limits, indentures or credit agreements will be tailored to ﬁt the desires of both the lender and the borrower. However, a great number of standard provisions apply to many loan agreements. Before further discussing the recording of the liabilities and, indeed, before considering the planning of indebtedness, it may be helpful to be aware of some of these usual provisions that relate to indebtedness limits and certain uses of cash. Excerpts from the note agreement for a ten-year private placement loan from an insurance company to a manufacturing concern include: 6A. Current Ratio Requirement. The Company covenants that it will not permit Consolidated Current Assets at any time to be less than an amount equal to 150% of Consolidated Current Liabilities. 6B. Dividend Limitation. The Company covenants that it will not pay or declare any dividend on any class of its stock or make any other distribution on account of any class of its stock, or redeem, purchase or otherwise acquire, directly or indirectly, any shares of its stock (all of the foregoing being herein called “Restricted Payments”) except out of Consolidated Net Earnings Available For Restricted Payments; provided, however, that notwithstanding the foregoing limitations, the Company may make sinking fund and dividend payments on its outstanding preferred stock not in excess of $3,300,000 in the aggregate in any year, but provided further, that the amount of any such sinking fund payments and the amount of any such dividends paid or declared shall be included in any subsequent computation pursuant to this paragraph 6B. “Consolidated Net Earnings” shall mean consolidated gross revenues of the Company and its Subsidiaries less all operating and non-operating expenses of the Company and its Subsidiaries including all charges of a proper character (including current and deferred taxes on income, provision for taxes on unremitted foreign earnings which are included in gross revenues and current additions to reserves), but not including in gross revenues any gains (net of expenses and taxes applicable thereto) in excess of losses resulting from the sale, conversion or other disposition of capital assets (i.e., assets other than current assets), any gains resulting from the write-up of assets, any equity of the Company or any Subsidiary in the undistributed earnings of any corporation which is not a Subsidiary, any earnings of any corporation acquired by the Company or any Subsidiary through purchase, merger or consolidation or otherwise for any year prior to the year of acquisition, or any deferred credits representing the excess of the equity in any Subsidiary at the date of acquisition over the cost of the investment in such Subsidiary; all determined in accordance with generally accepted accounting principles including the making of appropriate deductions for minority interests in Subsidiaries. “Consolidated Net Earnings Available For Restricted Payments” shall mean an amount equal to (1) the sum of $10,000,000 plus 90% (or minus 100% in case of a deﬁcit) of Consolidated Net Earnings for the period (taken as one accounting period) commencing on August 1, 20XX, and terminating at the end of the last ﬁscal quarter preceding the date of any proposed Restricted Payment, less (2) the sum of (a) the aggregate amount of all

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dividends and other distributions paid or declared by the Company on any class of its stock after July 31, 20XX, and (b) the excess of the aggregate amount expended, directly or indirectly, after July 31, 20XX, for the redemption, purchase or other acquisition of any shares of its stock, over the aggregate amount received after July 31, 20XX as the net cash proceeds of the sale of any shares of its stock. In the event that any shares of stock of the Company are issued upon conversion of convertible notes, bonds or debentures of the Company, the proceeds of the shares of stock so issued shall be deemed to be an amount equal to the principal amount of the obligations so converted. There shall not be included in Restricted Payments or in any computation of Consolidated Net Earnings Available For Restricted Payments: (x) dividends paid, or distributions made, in stock of the Company; or (y) exchanges of stock of one or more classes of the Company, except to the extent that cash or other value is involved in such exchange. The term “stock” as used in this paragraph 6B shall include warrants or options to purchase stock. The company will not: 6C(2) Debt—Create, incur, assume, guarantee or in any way become liable for any Funded Debt in addition to the Funded Debt referred to in paragraph 8D, or create, incur, assume or suffer to exist any Current Debt, except (i) Funded Debt of the Company or any Subsidiary provided that, after giving effect thereto and to the concurrent repayment of any other Funded Debt, Consolidated Net Tangible Assets shall be not less than an amount equal to (a) 250% of Consolidated Senior Funded Debt, and (b) 150% of Consolidated Funded Debt, and further provided that no Subsidiary shall create, incur, assume, guarantee or in any way become liable for any Funded Debt permitted by this clause (i) unless such Funded Debt shall be secured by a Lien on its property permitted by clauses (v), (vii) or (viii) of paragraph 6C(1), shall be of the type referred to in clause (iii) of paragraph 10G or shall constitute Funded Debt payable to the Company or another Subsidiary, and (ii) Current Debt of the Company or any Subsidiary, provided that the aggregate Current Debt of the Company and its Subsidiaries permitted by this clause (ii) shall not be in excess of the Permitted Amount on any day after December 31, 20XX unless, during the ﬁfteen months’ period immediately preceding such day, the aggregate Current Debt of the Company and its Subsidiaries permitted by this clause (ii) shall not have been in excess of the Permitted Amount for at least 60 consecutive days, and further provided that no Subsidiary shall create, incur, assume or suffer to exist any Current Debt permitted by this clause (ii) unless such Current Debt shall be secured by a Lien on its property permitted by clauses (v), (vii) or (viii) of paragraph 6C(1) or shall constitute Current Debt payable to the Company or another Subsidiary: 6E. Subordinated Debt. The Company covenants that it will not (i) pay, prepay, redeem, purchase or otherwise acquire for value any Subordinated Debt except as required by the original provisions of the instruments evidencing Subordinated Debt or pursuant to which Subordinated Debt shall have been issued, (ii) amend the instruments evidencing Subordinated Debt or pursuant to which Subordinated Debt may have been issued in such manner as to terminate, impair or have adverse effect upon the subordination of the Subordinated Debt, or any part thereof, to the indebtedness evidenced by the Notes; or (iii) take or attempt to take any action whereby the subordination of the Subordinated Debt, or any part thereof, to the indebtedness evidenced by the Notes might be terminated, impaired or adversely affected. The term “Subordinated Debt” as used in this paragraph 6E shall mean any Funded Debt of the Company or any Subsidiary which does not constitute Senior Funded Debt.

Thus, it can be seen that overall debt constraints are included in this agreement and usually are a part of most credit agreements. With respect to securing short-term credit, certain other types of restrictions may apply. Excerpts from a loan and credit agreement for short-term borrowing under a revolving line of credit between a manufacturer and a group of commercial banks contain clauses that, under speciﬁed conditions, do: • Restrict certain payments (such as cash dividends or purchases of company stock). • Restrict the sale or lease of assets. • Require the maintenance of a given ratio of shareholders’ equity to senior indebtedness and a minimum amount of shareholders’ equity. • Place restraints on speciﬁc contingent liabilities.

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• Place limitations on acquisitions of other companies. • Place limitations both on certain speciﬁc debts and on overall consolidated indebtedness. The speciﬁc wording of some of the clauses relating to covenants or restrictions may be of interest: Minimum Working Capital. Maintain Consolidated Working Capital at a level whereby consolidated current assets are at least 175% of consolidated current liabilities of the Company and all Consolidated Subsidiaries and, in any event, of at least $200,000,000. In any calculation of Consolidated Working Capital, an amount equal to Covered Customer Advances shall be excluded from both consolidated current assets and consolidated current liabilities and deferred income taxes reported by the Company as a current liability in its consolidated balance sheet shall be excluded from consolidated current liabilities. Negative Covenants. So long as credit shall remain available to the Company hereunder and until the payment in full of all Notes outstanding hereunder and the performance of all other obligations of the Company hereunder, the Company will not, and will not permit any Consolidated Subsidiary to, without the prior written consent of Banks holding at least 66 2/3% in aggregate unpaid principal amount of the Notes, or, if no Notes are then outstanding, Banks having at least 66 2/3% of the aggregate commitments to make loans hereunder: Restrictive Payments. Declare, pay or authorize any Restricted Payment if (a) any such Restricted Payment is not paid out of Consolidated Net Earnings Available For Restricted Payments and (b) at the time of, and immediately after, the making of any such Restricted Payment (or the declaration of any such dividend except a stock dividend) no Event of Default speciﬁed in § 8 and no event which with notice or lapse of time or both would become such an Event of Default has occurred and (c) the making of any such Restricted Payment would reduce Consolidated Tangible Shareholders’ Equity below $225,000,000. Sale, Lease, etc. Sell, lease, assign, transfer or otherwise dispose of any of its assets, tangible and intangible (other than investments permitted by § 7B(7) and obsolete or worn-out property or real estate not used or useful in its business), whether now owned or hereafter acquired, excluding from the operation of this clause sales, leases, assignments, transfers and other dispositions (a) in the ordinary and normal operation of its business and for a full and adequate consideration, (b) between the Company and any Consolidated Subsidiary, and between Consolidated Subsidiaries and (c) by the Company not in the ordinary and normal operation of its business provided the value on the Company’s books of assets so transferred shall not exceed 10% of Consolidated Tangible Shareholders’ Equity in the aggregate in any calendar year. Maintenance of Shareholder’s Equity. Permit the amount of Consolidated Tangible Shareholders’ Equity at any time to be less than 100% of the then aggregate outstanding amount of Consolidated Senior Indebtedness or less than $225,000,000. Contingent Liabilities. Assume, guarantee (which for purposes of this clause (4) shall include agreements to purchase or to provide funds for the payment of obligations of, to maintain the net worth or working capital or other ﬁnancial test of, or otherwise become liable upon the obligations of, any person, ﬁrm or corporation) or endorse any obligation of any other person, ﬁrm or corporation (except the Company or a Consolidated Subsidiary, or any captive insurance subsidiary, as the case may be, as permitted by this clause (4)) or permit to exist any assumption, guarantee or endorsement, excluding from the operation of this clause, (a) assumptions, guaranties and endorsements in the ordinary and normal operation of its business as presently conducted, it being understood that performance guaranty bonds, bank guaranties for foreign work, advance payment bonds, direct guarantees for performance, or other surety bonds will be so considered; (b) guarantees by the Company or any Consolidated Subsidiary or direct obligations of the Company or any Consolidated Subsidiary for the payment of money, whether domestic or foreign, so long as an amount equal to the aggregate amount of such guaranteed obligations is deemed to be (without duplication). Indebtedness and/or Consolidated Senior Indebtedness, as the case may be, for purposes of §§ 7b(8) and 7B(9); (c) guarantees of the Company or any Consolidated Subsidiary issued, or obligations assumed, in connection with acquisitions of assets permitted under § 7B(5), provided that obligations for borrowed money (whether guaranteed or assumed) shall be treated as provided in the next preceding clause (b); and (d) guaranties by the Company or any Consolidated Subsidiary of direct obligations of third parties for the payment of money, provided that if the then aggregate amount of such obligations shall exceed an amount equal to 15% of

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Consolidated Tangible Shareholders’ Equity, the amount of such excess shall be deemed Consolidated Senior Indebtedness for purposes of this Agreement. Acquisition of Assets. Acquire any assets of any other person through merger, consolidation or otherwise (including acquisition of capital stock of any other person if such acquisition is analogous in either purpose or effect to a consolidated or merger) except in the ordinary course of business, unless after giving effect to such acquisition (a) the Company shall be the surviving corporation, and (b) no Event of Default speciﬁed in § 8 or event which with notice or lapse of time or both would become such an Event of Default shall have occurred. Other Debt. Incur or have outstanding any Indebtedness or become or be liable with respect to any Indebtedness or sell any obligations of the Company or any Consolidated Subsidiary, excluding from the operation of this covenant, (a) the Notes: (b) indebtedness, other than for borrowed money, incurred in the ordinary course of business of the Company or a Consolidated Subsidiary, provided such indebtedness is not prohibited under § 78B(4) or 7B(5); (c) liabilities in connection with capitalized leases; (d) loans by the Company to Consolidated Subsidiaries, and loans by Consolidated Subsidiaries to the Company and other Consolidated Subsidiaries; (e) indebtedness of the Company to Prudential, not exceeding $13,500,000, incurred pursuant to the Prudential Loan Agreement; (f) commercial paper of the Company having a maturity of not more than nine months from its date, in amounts which in the aggregate do not exceed at any time outstanding the lesser of $75,000,000 or the sum of the unused Revolving Credit Commitments plus Bank lines of credit; (g) existing indebtedness of Consolidated Subsidiaries not in excess of $2,075,000, provided that as said debt is paid or reduced it shall not be increased; (h) a loan of X Company from a foreign bank in the amount of $2,075,000 (or the lira equivalent thereof), provided that as said debt is paid or reduced it shall not be increased; (i) secured indebtedness permitted by § 7B(6)(g) in an aggregate amount not to exceed the $100,000,000 original principal amount, provided that as said debt is paid or reduced it shall not be increased; (j) other Consolidated Senior Indebtedness of the Company and Consolidated Subsidiaries which does not exceed $30,000,000 in the aggregate at any time, provided that the maturity of all such indebtedness in excess of an aggregate of $5,000,000 has been consented to in writing by Banks holding at least 66 2/3% in aggregate unpaid principal amount of the Notes, or, if no Notes are then outstanding, Banks having at least 66 2/3% of the aggregate commitments to make loans hereunder; (k) borrowings from foreign sources in amounts not exceeding the equivalent of $50,000,000, provided the maturity and terms of all such indebtedness in excess of an aggregate of $5,000,000 has been consented to in writing by Banks holding at least 66 2/3% in aggregate unpaid principal amount of the Notes, or, if no Notes are then outstanding, Banks having at least 66 2/3% of the aggregate commitments to make loans hereunder; (l) Subordinated Debt of the Company; and (m) other Consolidated Senior Indebtedness of the Company (but not of any Consolidated Subsidiary), whether domestic or foreign, so long as after incurrence thereof (i) the then aggregate outstanding amount of Consolidated Senior Indebtedness of the Company and all Consolidated Subsidiaries would not exceed 100% of Consolidated Tangible Shareholders’ Equity and (ii) neither the Company nor any Consolidated Subsidiary would be in default under this Agreement.

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Limitation on Consolidated Indebtedness. Permit the Consolidated Indebtedness of the Company and all Consolidated Subsidiaries at any time to be more than 200% of Consolidated Tangible Shareholders’ Equity.

In the day-to-day administration of loan agreements, it is obvious that the controller should be aware of the terms and should report the ﬁnancial condition and ﬁnancial data as required in the contract. Of equal or more importance, however, should be the controller’s review of proposed ﬁnancial actions to determine whether they would violate any present agreements and then to take appropriate action. Aside from the reporting requirements, the controller should be aware of management’s obligation not only to the shareholders, but also to the suppliers of debt capital. The indenture agreement may still be the best way of protecting the interests of the senior long-term lender. However, given some recent experiences wherein investment-grade bonds have been converted essentially into junk bonds in a very short period, the credit agreement may require more restrictive measures, taking into account the creativity of some lawyers, and the use of technical devices to circumvent some protective clauses. Many entities are now demanding the “poison put” provision discussed in the section on developments in the ﬁxed income market.

32.6 PLANNING THE CURRENT LIABILITIES Having discussed in a general way the different types of liabilities, it is now in order to review the planning process ﬁrst for the current liabilities and later for long-term debt. Planning of any speciﬁcity for current liabilities for most concerns relates to the annual business plan, for the next year or so, or to an even shorter time span. Basically, the short-term planning involves these three steps: 1. Determining, based on the operating requirements for each month and each month end, the level of each type of obligation expected (e.g., accounts payable, accrued expenses, accrued salaries and wages, accrued income taxes, notes payable, dividends payable). 2. Ascertaining from the cash forecast (see Chapter 26) whether any borrowings are necessary to meet the payment requirements, and incorporating this need and the payments into the plan. 3. Testing the consolidated plan at selected intervals, such as every reporting period or every quarter, to see if the terms of any or all credit agreements are being met—or if the indebtedness is within company norms or standards—and taking appropriate action if not (securing bank waivers, deferral of purchases, securing of special terms from suppliers, acceleration of cash receipts, etc.). It may be observed that the level of most current liabilities, other than notes payable, will be the result of other operating segments of the annual plan. Thus, accounts payable will relate to purchases for inventory or obligations for current operating expenses; accrued salaries and wages will relate to the planned payrolls for the continuing operations, and so on. Any required short-term borrowings will derive from the cash planning. In planning any element of current payables, it is practical to accumulate the segment based on the normal grouping of costs and expenses needed for each type of transaction. Thus, as reﬂected in Exhibit 32.1, the aggregate liability for purchases of raw materials and purchased parts (probably one entry in planning material purchases) is recorded for each month. Perhaps all other current purchases of an expense nature are journalized for each month. Any signiﬁcant “other transaction” is recorded separately for the plan, just as would be done for the actual expense. Payments would be estimated based on an average lag time as described in Chapter 26. The estimate of accrued salaries and wages is shown in Exhibit 32.2. The additions to the accrual would be in those groupings used to determine manufacturing costs (inventory) or other logical accumulations. Based on the required borrowings and repayments as determined in the cash forecast, the plan for notes payable could be developed as in Exhibit 32.3.

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The same procedure would be followed for each liability grouping deemed necessary and practical in the current liability planning cycle. When all the current liabilities balances have been determined, they should be summarized as in Exhibit 32.4. As explained in the next section, the planned balances, as well as actual balances, should be measured against acceptable standards, as well as credit agreement requirements, and so on. The above discussion of planning the current liabilities has been covered in the context of the annual business plan or any other short-term plan. The same principles would apply with respect to strategic planning or long-range planning (see Chapters 12 and 13), except that the time span usually can be by year and need not be by quarter or month. Moreover, the estimates may be arrived at on a ratio basis, and much less preciseness and detail usually are satisfactory.

32.7 STANDARDS TO MEASURE AND CONTROL CURRENT LIABILITIES The planning task of the controller does not consist merely of determining what the level of current liabilities will be at stipulated times, based on operating plans or capital budgets or other ﬁnancial plans. Additionally, these planned levels should be tested for acceptability. The standards by which such acceptability is judged should include (a) any legal requirements, such as those in bank lending agreements or in bond indentures and so forth; (b) those developed by the company (probably by the ﬁnancial ofﬁcers) as deemed prudent to avoid undue ﬁnancial exposure; or (c) those acceptable to knowledgeable persons in the industry. Dun & Bradstreet, for example, periodically issues selected ratios on each industry, showing the median and upper and lower quartile for certain operating ratios and ﬁnancial conditions. The company could measure itself against these industry ratios or against performance of selected competitors or against standards developed or used by commercial bankers, investment bankers, or ﬁnancial analysts. If these tests reveal unacceptable conditions, then corrective action should be taken, as discussed in the next section. Some suggested ratios used to measure the acceptability of current liabilities include: • Current ratio • Quick ratio • Minimum net working capital • Current debt to net worth • Current debt to inventory • Number of days’ payables on hand (accounts payable turnover) (a) CURRENT RATIO. The current ratio is discussed in Chapter 6. However, some brief comments are added here. The current ratio is calculated by dividing the current assets by the current liabilities. It measures the protection the creditors have, even if the current assets prove to be less valuable than anticipated. Years ago, a ratio deemed satisfactory was 2 to 1. However, with the advent of the computer and improved receivables and inventory control, a ratio of between 1 to 1 and 2 to 1 is usually acceptable. (b) QUICK RATIO. The quick ratio, also discussed in Chapter 6, measures the relationship of the highly liquid assets—cash, temporary investments, and accounts receivable—to current liabilities. This ratio, also known as the liquidity ratio or acid test, is an indicator of what very liquid assets are available to meet the demands of the short-term creditors. (c) MINIMUM NET WORKING CAPITAL. This is an absolute amount—the difference between current assets and current liabilities. Some loan and credit agreements, including the one illustrated earlier, require a minimum amount of working capital at all times. The net amount indi-

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cates the extent to which the current assets could shrink and yet be sufﬁcient to meet the current liabilities. (d) CURRENT DEBT TO NET WORTH. To the extent that assets are ﬁnanced by the owners, there is more protection (more assets) for the creditors. A low current debt (or total debt) to net worth ratio is some measure of how the owners are supplying more relative funds. (e) CURRENT DEBT TO INVENTORY. A high ratio of current debt as related to inventory would suggest that goods are purchased, processed, and sold without payments being made to suppliers. Depending on the relative ratio, as compared to the industry and trade practice, a high relationship would indicate inadequate ﬁnancing. (f) NUMBER OF DAYS’ PAYABLES ON HAND. The number of days’ payables on hand is determined by dividing the accounts payable balance by the amount of purchases, and multiplying by the days in the period. For example, in Exhibit 32.1: • The quarterly accounts payable balance planned is $81,310,000. • Purchases for the period were planned at $246,890,000. • Business days in the period are 65. Number of days payables on hand $81,310,000 $246,890,000 .3293369 65 days 21.41 days Such a result should be checked against industry standards, if available.

32.8 CORRECTIVE ACTION If the annual plan reﬂects an unsatisfactory condition regarding current liabilities, or if actual results are not acceptable, what action can be taken? The controller might examine these alternatives with the appropriate line executive: • Possibility of reducing inventory levels through different purchasing terms, inventory handling methods, or inventory control, for example, just-in-time (JIT) inventories • Reducing accounts receivable by granting special terms or cash discounts and the like • Making special arrangements with suppliers to receive goods on consignment or special payment terms • As a last resort, if the conditions appear temporary, asking the lenders to waive or relax the restrictive terms for a limited period If the condition appears more permanent, perhaps additional equity capital or long-term debt may be desirable. Less ambitious business plans may be considered for a time: less capital expenditures, lower sales volume, and so forth. If actual unsatisfactory conditions emerge, then some of these same planning alternatives may need to be reviewed.

32.9 RISKS OF TOO MUCH DEBT The subject of long-term debt is closely related to the capital structure of the entity—meaning the combination of shareholders’ equity and long-term debt that should be used to provide for the ﬁnancing needs over the span of several years. In considering this subject, the goal of the ﬁnancial executive should be to so arrange the ﬁnancing that the owners of the business will receive the maximum economic beneﬁt over the longer run, through the increase in the share price and constantly rising dividend income. It can be demonstrated over a period of time, assuming normal proﬁtability and the deductibility of interest expense for tax purposes, that prudent borrowing will increase the return to the shareholder. Given this potential of gain, there exists a powerful deterrent that discourages using

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long-term debt to the maximum of its availability. That deterrent is the risk associated with servicing the debt. For debts and debt service must be paid when due regardless of the ﬁnancial condition of the company to avoid unwelcome restraints or, worse, the loss of the enterprise.

32.10 SOME BENEFITS FROM DEBT INCURRENCE While the prudent ﬁnancial executive should be aware of the risks of excessive debt, it is also necessary to recognize some of the advantages of a reasonable debt load. Here are a few: • Debt reduces tax payments. Because most interest cost is income tax deductible, tax payments are lower. This assists in reducing the cost of capital used in the business. • Prudent borrowings can increase the return on capital to the owners. If the earnings from this borrowed capital exceed the cost net of taxes, then the return to the shareholder is higher. (See Section 32.14 on leverage.) • Debt imposes a discipline on management as to normal operations. Investors know that too much cash can encourage wasteful spending practices. They tend to watch performance more carefully if sizable debt exists. Additionally, the management is more sensitive to the need for frugality to repay the debt. So more careful spending results. • Debt motivates managers and owners. Lowering the equity base with borrowed funds probably makes it easier for the management group to acquire a signiﬁcant stake. • Debt causes a more appropriate review of proposed capital expenditures and acquisitions. Rigid repayment schedules probably cause a closer look at the economics of proposed expenditures as well as those units that don’t produce sufﬁcient earnings. In summary, as one executive stated, “Debt is a just-in-time ﬁnancial system.”

32.11 SOURCES OF INFORMATION ON DEBT CAPACITY For long-range ﬁnancial planning, as well as judging the proposed terms or rating of contemplated new debt, what sources are available to secure guidance? In the ﬁnal analysis, it must be management judgment that decides on acceptable limits for debt capacity. Some guidance in arriving at a decision may come from: • Institutional lenders or intermediaries. Lenders, or commercial bankers, or investment bankers negotiate long-term loans at rather frequent intervals in contrast to the ﬁnancial ofﬁcer of an industrial enterprise. Consequently, they will be more familiar with the terms of recent agreements. Presumably, also, they are conservative and will tend to err in the conservative direction. They should be able to judge if proposed standards will be acceptable in the marketplace. • Action of competitors. Ordinarily, the ﬁnancial statements and loan agreements of comparable companies in the same industry are available. From such public information, individual companies and group norms can be obtained, together with ranges. • Analysis of past practice. Finally, historical analysis of debt and income behavior in the particular company in times of adversity and normal conditions may provide some guide.

32.12 STANDARDS FOR DEBT CAPACITY Conventionally, there are two types of standards by which to judge long-term debt capacity: a capitalization standard and an earnings coverage standard. In arriving at a debt policy for a particular company, each should be considered and interrelated. In working with internally generated data, the controller can make reﬁnements ordinarily not possible with public data of other companies, thus guiding management about an acceptable relationship.

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A widely used standard, often employed as a constraint in credit agreements, is the long-term debt-to-equity ratio. Thus long-term debt should not be more than, say, 25 percent of equity capital. It can also be expressed as a percent of total capitalization. In using such a standard, several determinatives should be calculated, showing the impact, for example, of a 20 percent debt ratio versus a 25 percent ratio to judge the risk involved. Then, too, recognition must be given to the often wide variation between the principal of the debt and the annual debt service charge of interest and debt repayment. A loan may be paid off in 5 or 30 years. Whereas the ratio of debt to equity may be the same in each case in a given year, the debt service burden is substantially different. Conversely, whereas the debt ratio could improve dramatically with a shorter-term loan, the debt service drain remains the same until complete repayment. The “earnings coverage standard” measures the total annual amount required for debt service to the net earnings available for servicing the debt. By relating the annual cash outﬂow for debt service (and perhaps other items) to the net earnings available for this purpose, it seeks to assure that even in times of adversity there are sufﬁcient funds to meet the obligation. Obviously, the greater the probable change in cash ﬂow, the higher the desired times-coverage ratio. The observed times coverage varies greatly by industry and by company. Typical well-ﬁnanced companies may have a coverage of ﬁfteen times or more. In making analyses of the company, the controller can apply a great deal of sophistication in changing anticipated cash outﬂows to judge the impact. Thus it may be desirable to measure not only times coverage of net income to debt service but also other cash requirements that should not be disturbed, that is, dividends for shareholders, or certain research and development expenditures, or expected inventory build-up, or minimum capital expenditures. Each major cash outﬂow should be considered and reasonable sums provided even in times of adversity. An example of an analysis that might be made is shown in Exhibit 32.5. In this illustration, actual and planned cash sources and uses are satisfactory in the planning period. The debt coverage ratios are very good. However, with a major drop in sales, even planned cutbacks in receivables, inventory, and capital expenditures result in coverage ratios that although adequate are substantially below the levels the ﬁnancial management considers desirable in a cyclical type of business. The need for a new debt issue in 20X5 should be reexamined in terms of the probability or danger of a sales decline. However, a long-term debt has been continually declining from 16 percent of capitalization in 20XX to 11 percent in 20X4; and even with the planned $70 million new debt issue in 20X5 it reaches only 17 percent. Hence, the critical point in this example is earnings coverage, not capitalization. The magnitude of the probable downturn in earnings and changes in various cash outﬂows under such circumstances should be considered. A range of the most probable contraction in sales volume and, therefore, in net income should be determined and resulting times coverage determined. In the ﬁnal analysis, debt policy or appropriate capital structure can be determined only by an examination of the factors in the company and in the industry that inﬂuence the ability to repay debt. It is a matter of judgment and foresight regarding likely conditions, conservatively arrived at—and not mathematics.

32.13 BOND RATINGS There exists a signiﬁcant difference in interest cost, depending on the quality rating assigned to debt securities by the three rating agencies, and this is an important consideration in selecting aggregate debt limits. Standard and Poor’s (S&P), Moody’s Investor Service, and Fitch Investor’s Service—the three debt rating agencies—assign ratings that characterize judgment about the quality or inherent risk in any given security. The rating will depend, among many other factors, on the debt coverage relationship. The symbols Moody’s uses for the highest four ratings may be summarized or characterized as: 1. Aaa. The best quality; smallest degree of investment risk and generally considered “gilt edge.”

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2. Aa. Judged to be of high quality by all standards. 3. A. Higher medium grade obligations, with some elements that may be present to suggest a susceptibility to impairment at some time in the future. 4. Baa. Lower medium grade. Lack outstanding investment characteristics and, in fact, have speculative characteristics as well. The objective of many well-ﬁnanced companies is to secure at least an Aa rating for its bonds. Presentations to secure the bond ratings should be carefully prepared, because poor ratings are not easily overcome. In determining a debt rating, the agencies need adequate ﬁnancial data, such as: • Consolidated balance sheets—perhaps ﬁve historical years and ﬁve projected years. • Consolidated statements of income and retained earnings for ﬁve years historical and ﬁve years projected. Included would be dividends paid and per share data, including earnings, dividends, and book value. • Consolidated statement of cash ﬂows—again ﬁve historical years and ﬁve prospective years. • Product group statements for historical and projected data regarding sales, operating margin, and margin rate. The ratio analysis, including the coverage ratios, found helpful to the rating agencies is shown in Exhibit 32.6.

32.14 LEVERAGE In considering capital structure, the ﬁnancial ofﬁcers necessarily must recognize and study the impact of leverage. Essentially, leverage consists of ﬁnancing an enterprise with senior obligations to increase the rate of return on the common equity. The action is known also as “trading on the equity.” An application of leverage is shown in Exhibit 32.7. Assume that the management has been earning, before income taxes, 37% on capitalization; that it believes it can continue to achieve this same return; and that the company can borrow at an 11% rate. If it borrows 20% of equity and continues the rate of return on assets, the earnings per share, with favorable leverage, increase from $5.00 to $5.70 and the return on equity rises from 19.98 to 22.79%. However, if, under unfavorable leverage conditions, management were too optimistic and the earnings rate less than the bond interest rate, the results can be unsatisfactory—as illustrated in Exhibit 32.8. Here, the rate of return on capitalization was less than the bond interest rate. From an investor standpoint, in good times, the leverage increases the earnings per share and the price of the stock. However, in adverse times, the reverse condition exists, and the stock of a leveraged company becomes less attractive.

32.15 CONTINGENCIES To this point in this chapter, the discussion has been related to direct liabilities of the enterprise. However, the management of liabilities must extend to contingent liabilities, including proper accounting for the items and proper disclosure. Aside from the matters covered herein, the controller should recognize that contingent liabilities of certain types may be weighted by a lending institution in agreeing to amounts and terms and conditions in a proposed loan agreement. Moreover, in planning for the direct liabilities of the enterprise, the controller may ﬁnd it necessary to estimate the timing and amount of contingent liabilities that should be treated as direct debt on a probability basis. (a) TREATMENT OF LONG-TERM LIABILITIES IN THE ANNUAL BUSINESS PLAN. Planning the long-term debt status for the coming year is one segment of the annual business plan. This phase of the business may be reported only as presented in the statement of ﬁnancial position, with the beginning-of-the-year status and the end-of-the-year status indicated. However, if the items are

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numerous enough, or if the attention of the management and the board of directors should be directed to this matter, then the plan for long-term debt may be summarized and presented on an exhibit as in Exhibit 32.9. It should be noted that the proposed transactions are disclosed, as well as key ratios. In all published ﬁnancial statements, the controller has the responsibility to properly value and properly disclose the signiﬁcant long-term obligations in accordance with generally accepted accounting principles (GAAP). It is suggested that in most instances the same basis be used in the planning statements. Obligations and contingent obligations that are covered by footnote in the annual report to shareholders can be disclosed by oral or written commentary in reviewing the annual plan (or long-range plan) with management or the board of directors.

32.16 LONG-RANGE FINANCIAL PLAN As mentioned in Chapter 13, the strategic plans and long-range ﬁnancial plans are much less detailed than the annual business plan. Accordingly, summarized data, much as presented in Exhibit 13.14, may be the only information formulated and provided to the management and the board of directors—unless, of course, they desire more detail, or if, because of great risks and the like, it is imperative these groups fully understand the debt status. In arriving at the planned indebtedness levels for the long-range plan, the process is much as implied in Exhibit 32.5; that is, the plans are summarized year by year in sequence. If more capital is required to meet cash outﬂow or to correct an unsatisfactory current debt picture, then long-term capital is planned. If it appears the marketplace will accept indebtedness under suitable terms, then borrowings can be assumed. If the long-term debt percentage would be too high or if service coverage would be insufﬁcient, then the sale of equity may be the route necessary. Again, the objective of the ﬁnancial ofﬁcers should be to maintain the company in such good ﬁnancial health that, under most circumstances (good times or poor), it should be able to secure any needed capital under reasonably acceptable terms. An illustration of the process of allocating long-term fund needs as between long-term debt and shareholders’ equity is presented in Chapter 33 (Section 32.12).

32.17 MANAGING LIABILITIES: SOME PRACTICAL STEPS We have reviewed the objectives of liability management, planning the liabilities, and, among other things, provided some of the standards to measure the amount of current debt as well as long-term debt. While the concerns of the controller and other ﬁnancial executives have been addressed, perhaps it will be helpful to summarize some of the desirable steps in properly managing liabilities. Because of the differing nature of the various types of liabilities, it is practical in the accounting, planning, and control activities to treat each group separately. Here, then, are some suggestions as to what the controller might do to assist in properly managing the liabilities: • Current Liabilities Plan the liabilities by month or quarter or year as may be applicable (as in the annual

business plan or longer-term strategic plan). This can be accomplished after the various assets levels (cash, receivables, inventories, plant, and equipment) are planned and when the operational plans (sales, manufacturing expenses, direct labor, direct material, selling expense, general and administrative) are completed. It is practical to group the current liabilities according to the categories to be identiﬁed in the Statement of Estimated Financial Position, such as accounts payable, accrued salaries and wages, accrued expenses, accrued income taxes, notes payable. The accounts payable plan or budget, when ﬁnalized, for the annual plan might appear as in Exhibit 32.10. The budget or plan for all current liabilities, by quarter, for the annual plan could be somewhat as in Exhibit 32.11. Note that certain pertinent ratios are shown. Test the plan for compliance with credit agreements or other internally developed standards such as current ratio, inventory turns, net working capital, and industry average or competitor performance. If necessary, modify the plan.

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Analyze each line item for ways to reduce the obligation, for example, use of JIT invento-

ries to reduce accounts payable or notes payable. “What if” analyses of actions on other assets (terms of sale, etc.) or liabilities can be made to improve the status, if warranted. Take any appropriate action. Monitor the monthly or quarterly balances for any unfavorable developing trends, and take appropriate action. Issue the appropriate control or informational reports, such as to the supervisor of accounts payable, board of directors, or creditors. This might include updating the projected debt status to the year end. When appropriate, as in major developments, revise the ﬁnancial plan. • Long-Term Liabilities Plan the long-term debt, by appropriate category, as in Exhibit 32.9, for the annual plan,

or strategic plan, based on the commentary or factors reviewed in the chapter. Test the plan, before ﬁnalizing, against credit agreement requirements, or standards for

debt capacity, including that which might exist under the least favorable business conditions which are likely to prevail in the planning period. Adjust the plan, if required. Monitor actual performance or condition periodically during the plan term for unfavorable developments, and take appropriate action. Report on the ﬁnancial condition and outlook to the appropriate interests (bankers, bondholders, board of directors, etc.). • As to All Indebtedness Items Review the accounting to ascertain that GAAP are followed, to the extent practical. Periodically have the internal controls checked to assure the system is functioning prop-

erly. (See also Chapter 7.) Keep reasonably informed on the status and probable trend of the debt market, and the new debt instruments, both short and long term. If appropriate, this includes foreign markets. Such information may be gained from informal discussions with commercial bankers as well as investment bankers. Perusal of ﬁnancial and business literature or periodicals also may be helpful. Additionally, the controller and other ﬁnancial executives should be sensitive as to the impact of new debt issues on the holders of existing debt. By following these few commonsense practices, there should be no unpleasant surprises regarding the management of liabilities.

32.18 ACCOUNTING REPORTS ON LIABILITIES Reports with respect to the status and management of liabilities will depend on the business needs. A limited number are necessary for monitoring the actual status and to disclose the results of shortand long-term planning. A suggested list includes: • Usual monthly statement of ﬁnancial condition perhaps by organization segment, comparing actual and planned status • Monthly or quarterly comparison of actual liabilities with amounts, by detailed category, as compared with permitted amounts under credit agreements • Planning reports comparing required indebtedness as compared to credit agreements and debt capacity • Periodic analysis of special liabilities, whether actual or contingent • Long-term leases • Unfunded pension plan liabilities

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• Exposures of various health care plan trusts and so forth • Foreign currency exposure • Aging of payables • Comparison of actual and budgeted obligations • Detailed liability reports as required by credit agreements • Periodic summaries of contingent liabilities and likely actual liability The controller should prepare those reports for ﬁnancial management, or general management, as appropriate, to guide the business, with suitable oral or written commentary.

32.19 INTERNAL CONTROLS Internal control of liabilities runs the gamut from routine accounts payable and payroll disbursements to the periodic payment of notes payable under the various indenture terms and the like. A fundamentally sound routine for the recording of liabilities is basic to a well-founded disbursements procedure. The essence of the problem is to make certain that no improper liabilities are placed in line for payment. Routines must be instituted to see that all liabilities are properly certiﬁed or approved by designated authority. The proper comparison of receiving reports, purchase orders, and invoices by those handling the detail disbursement procedure eliminates many duties by the ofﬁcers; but the liabilities not covered by these channels must have the necessary review. The controller or treasurer, for example, must approve the payrolls before payment. The chief purchasing agent, or chief engineer, or treasurer, or some ofﬁcial must approve invoices for services, because no receiving report is issued. Certain special transactions may require the approval of the president. Again, invoices for such items should be checked against the voucher ﬁle for duplicate payments. In summary, the controller should consider the system of recording payables somewhat independently of the disbursements procedure to give added assurance that the necessary controls exist. Additional commentary on internal controls is presented in Chapter 7. Moreover, if computers play a large part in processing liabilities, much acceptable software is available. However, the existence and extent of internal controls should be checked.

F OR

THE

Item Balance, beginning of month Add: Purchases—raw material Purchases—capital assets Manufacturing expenses Marketing expenses Research and development Administrative expense All other Total additions E XHIBIT 32.1

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T HE I LLUSTRATIVE C OMPANY A CCOUNTS P AYABLE B UDGET P LAN Y EAR E NDING D ECEMBER 31, 20XX ( DOLLARS IN THOUSANDS ) January $ 82,360

February $88,530

March $79,560

1st Quarter $ 82,360

Annual Total $ 82,360

71,200 3,450 4,810 3,270 1,920 2,470 80

65,840 1,070 4,650 2,970 1,840 2,560 40

67,430 860 4,850 3,110 1,870 2,500 100

204,470 5,380 14,310 9,350 5,630 7,530 220

832,880 14,970 58,210 39,620 24,940 33,160 860

87,200

78,970

80,720

246,890

1,004,640

A CCOUNTS P AYABLE P LAN

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F OR

Item Deduct: Payments Raw material Capital assets Operating expenses

THE

T HE I LLUSTRATIVE C OMPANY A CCOUNTS P AYABLE B UDGET P LAN Y EAR E NDING D ECEMBER 31, 20XX ( DOLLARS IN THOUSANDS ) March

1st Quarter

Annual Total

72,010 3,450 12,400 80

65,840 1,070 12,020 40

207,650 5,040 35,030 220

840,120 13,810 144,950 860

81,030

87,940

78,970

247,940

999,740

$ 88,530

$ 79,560

$ 81,310

$ 81,310

$ 87,260

January

February

69,800 520 10,610 100

Total deductions Balance, end of month

All others

E XHIBIT 32.1

675

A CCOUNTS P AYABLE P LAN (C ONTINUED )

F OR

Item Balance, beginning of month

T HE I LLUSTRATIVE C OMPANY A CCRUED S ALARIES AND W AGES B UDGET THE P LAN Y EAR E NDING D ECEMBER 31, 20XX ( DOLLARS IN THOUSANDS ) January $ 26,310

February

March

1st Quarter

Annual Total

$ 30,850

$ 34,710

$ 26,310

$ 26,310

85,030 31,810

82,100 30,720

85,620 31,940

252,750 94,470

1,060,40 0 375,100

1,420 20,640

1,380 20,600

1,430 20,650

4,230 61,890

16,920 247,560

138,900

134,800

139,640

413,340

1,699,980

41,800 92,560

42,300 88,640

42,300 107,710

126,400 288,910

506,600 1,155,640

134,360

130,940

150,010

415,310

1,662,240

$ 30,850

$ 34,710

$ 24,340

$ 24,340

$ 37,740

Add: Gross payrolls Manufacturing Marketing Research and development Administrative Total additions Deduct: Payments Salaries Wages Total payments Balance, end of month E XHIBIT 32.2

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A CCRUED S ALARIES

AND

W AGES B UDGET

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676

Ch. 32 Management of Liabilities

T HE I LLUSTRATIVE C OMPANY N OTES P AYABLE B UDGET F OR THE P LAN Y EAR E NDING D ECEMBER 31, 20XX ( DOLLARS IN THOUSANDS ) Beginning Balance Borrowings Repayments $ — $2,500 $ — 2,500 — — 2,500 2,500 — 5,000 — — 5,000 — 1,000 4,000 — 500 3,500 — 500 3,000 — 1,000 2,000 — — 2,000 — 1,000 1,000 — — — 1,000 1,000

Month January February March April May June July August September October November December

$ —

Total E XHIBIT 32.3

$ 5,000

Ending Balance $2,500 2,500 5,000 5,000 4,000 3,500 3,000 2,000 2,000 1,000 1,000 —

$ 5,000

$

—

N OTES P AYABLE B ORROWING P LAN

Item Notes payable Current maturities of long-term debt Accounts payable Dividends payable Accrued salaries and wages Accrued income taxes Other accrued items

T HE I LLUSTRATIVE C OMPANY S UMMARY OF C URRENT L IABILITIES P LAN F OR THE P LAN Y EAR E NDING D ECEMBER 31, 20XX Plan Year Ending 12/31/XX Estimated Balance Quarter Current Year 1 2 3 $ — $ 5,000 $ 3,500 $ 2,000

Total

4 $

—

2,500 82,360 870

— 81,310 910

— 83,240 910

— 85,190 910

2,500 87,260 910

26,310

24,340

28,920

34,870

37,740

1,450 90

1,500 100

1,500 100

1,500 120

1,500 120

$ 113,580

$ 113,160

$ 118,170

$ 124,590

$ 130,030

2.0:1 0.39:1 113,580

2.0:1 0.40:1 113,160

2.1:1 0.41:1 129,987

2.1:1 0.41:1 137,049

2.2:1 0.42:1 156,036

0.25:1

0.25:1

0.26:1

0.27:1

0.28:1

23.6

21.4

22.5

22.9

23.6

Selected Ratios Current ratio Quick ratio Net working capital Current liabilities to net worth Number of days purchases in payables E XHIBIT 32.4

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S UMMARY

OF

C URRENT L IABILITIES P LAN

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E XHIBIT 32.5

A NALYSIS

Total sources

Sale of ﬁxed assets

OF

158,000 — 10,000 1,000 4,000

76,000 42,000 40,000

AND

137,000 — 10,000 1,000 —

82,000 45,000 10,000

$ 148,000

$

Actual 20X1

$ 78,500

97,000 — (20,000) 1,500 —

$ 90,000 47,000 (40,000)

20X2

131,000 — 20,000 2,000 3,000

93,000 48,000 (10,000)

$ 156,000

$

20X3

$ 190,000

158,000 — 30,000 2,000 —

$ 97,000 51,000 10,000

20X4

Planned

T HE A EROSPACE C OMPANY U SES OF C ASH AND D EBT C OVERAGE ( DOLLARS IN THOUSANDS )

AND

S ELECTED D EBT C OVERAGE

$ 173,000

$

C ASH A VAILABILITY

Deferred income taxes Total internal generation Anticipated 20X5 debt offering Loan and credit agreement—revolving Common stockóunder options

Sources of Cash Net income Depreciation and amortization

20XX

S OURCES

$ 283,000

172,000 70,000 40,000 1,000 —

$100,000 52,000 20,000

20X5

32.19

677

$ 162,000

82,000 70,000 10,000 — —

$ 50,000 52,000 (20,000)

30%

Internal Controls

$ 192,000

102,000 70,000 20,000 — —

$ 70,000 52,000 (20,000)

20%

20X5 with Sales Decline

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Ch. 32 Management of Liabilities

E XHIBIT 32.5

A NALYSIS

OF

Actual

15

16

13

4.1

8.6 5.1

$ (18,500)

1,000 (20,000) 2,000 37,000 27,000 45,000 5,000 97,000

20X2

S ELECTED D EBT C OVERAGE (C ONTINUED )

3.9

3.8

AND

7.9 4.7

7.6 4.5

$ 13,000

$ (33,000)

20X1

12

4.1

8.8 5.3

$ 59,500

— (10,000) — 41,000 28,000 30,000 7,500 96,500

20X3

11

4.3

9.1 5.4

$ 12,500

5,000 25,000 7,000 43,000 30,000 60,000 7,500 177,500

20X4

Planned

T HE A EROSPACE C OMPANY U SES OF C ASH AND D EBT C OVERAGE ( DOLLARS IN THOUSANDS )

AND

5,000 20,000 10,000 31,000 25,000 40,000 4,000 135,000

20XX

S OURCES

10,000 40,000 30,000 50,000 22,000 50,000 4,000 206,000

C ASH A VAILABILITY

Other Data—Coverage Pretax income and interest/interest Net income before interest/interest Pretax income before rent and interest/ rent and interest Long-term debt as percentage of capitalization

Increase (decrease) in cash

Total uses

Uses of Funds Accounts payable Inventories Accounts receivable Income taxes (current) Dividends Capital expenditures Debt repayment

678

17

3.9

7.2 4.3

$ 13,900

20,000 40,000 10,000 44,600 32,000 65,000 7,500 269,100

20X5

3.1

5.3 3.3

$ 63,000

10,000 30,000 (20,000) 44,600 32,000 25,000 7,500 129,000

20%

2.5

4.1 2.7

$ 67,900

5,000 10,000 (30,000) 44,600 32,000 25,000 7,500 94,100

30%

20X5 with Sales Decline

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E XHIBIT 32.6

R ATIO A NALYSIS FOR

U SE BY

R ATING A GENCY

Net income, rents, and interest/rents and interest

Net income and interest/interest

Proﬁt before interest and income taxes/interest

Coverage Ratios Proﬁt before rents, interest, income taxes, and non-cash charges/rents and interest Proﬁt before rents, interest, and income taxes/rents and interest

Long-term debt as percent of total capitalization

Net tangible assets†/long-term debt

Net property and investments/long-term debt

Net property/long-term debt

Net current assets/long-term debt*

Financial Ratios

20XX Senior Total

20X1 Senior Total

20X2 Senior Total

20X3 Senior Total

Years Ended December 31

A EROSPACE C ORPORATION R ATIO A NALYSIS

20X4 Senior Total

20X5 Senior Total

20X6 Senior Total

32.19

20X8 Senior Total

679

20X9 Senior Total

Internal Controls

20X7 Senior Total

Projected Years Ended December 31

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Ch. 32 Management of Liabilities

20XX Senior Total

20X1 Senior Total

20X2 Senior Total

20X3 Senior Total

Years Ended December 31

A EROSPACE C ORPORATION R ATIO A NALYSIS

20X4 Senior Total

20X5 Senior Total

20X6 Senior Total

20X7 Senior Total

E XHIBIT 32.6

R ATIO A NALYSIS FOR

U SE BY

R ATING A GENCY (C ONTINUED )

20X8 Senior Total

Projected Years Ended December 31

Inventory as percent of sales * Long-term debt includes in all cases current maturities. † Net tangible assets are deﬁned as total assets less current liabilities, intangible assets, other deferred liabilities, plus current maturities of long-term debt. ‡ Annual rentals paid capitalized at ten times.

Accounts receivable as percent of sales

Net income as percent of net worth

Net income as percent of net sales

Pretax proﬁt as percent of net sales

Net sales/net property

Net sales/net current assets

Current assets/total assets

Current assets/current liabilities

Operating and Other Ratios

Long-term debt and capitalized rents‡/net income and noncash charges

680

20X9 Senior Total

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32.19 Internal Controls

681

I LLUSTRATION OF L EVERAGE U NDER F AVORABLE C ONDITIONS 100% Common Stock

Common Stock, plus Bond Capitalization

Capitalization Bonds (11%)

$

Common stock Total

— 100,000,000

$ 20,000,000 100,000,000

$ 100,000,000

$ 120,000,000

4,000,000

4,000,000

$ 37,000,000

$ 44,400,000 2,200,000

Number of common shares Income Income before taxes and interest Bond interest

—

$ 42,200,000

Income taxes (46%)

$ 37,000,000 17,020,000

Net income for common

$ 19,980,000

$ 22,788,000

Income before taxes

Return on equity Earnings per common share Dividend (40% payout) E XHIBIT 32.7

19,412,000

19.9% $5.00 $2.00

22.79% $5.70 $2.28

F AVORABLE L EVERAGE

I LLUSTRATION OF L EVERAGE U NDER U NFAVORABLE C ONDITIONS 100% Common Stock Capitalization Bonds (11%)

$

Common Stock, plus Bond Capitalization

Common stock

— 100,000,000

Total

100,000,000

120,000,000

4,000,000

4,000,000

$ 10,000,000 —

$ 10,000,000 2,200,000

10,000,000 4,600,000

7,800,000 3,588,000

Number of common shares Income Income before interest and taxes Bond interest Income before taxes Income taxes (46%) Net income for common Return on equity Earnings per common share Dividend (40% payout) E XHIBIT 32.8

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U NFAVORABLE L EVERAGE

$

4,400,000 4.4% $ 1.10 $ .44

$

$

20,000,000 100,000,000

4,212,000 4.21% $ 1.05 $ .42

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Ch. 32 Management of Liabilities

12/31/97

Subordinated debentures

17,700 $ 94,700

69,960 $ 210,010

E XHIBIT 32.9

S UMMARY

OF

P LANNED L ONG- T ERM D EBT

Times interest charges covered

12.2

22

5,600 12,100 —

29,400 37,800 2,760

— — 75,000 2,000 — 77,000

$

140,050

$ 49,200 50,000 — 5,850 35,000

63

11%

Floating Prime + 1 1/2% 14% 13% 10%–15%

Debt to equity ratio

F OR

T HE M AGRAUDY C OMPANY N O . 2 L ONG -T ERM D EBT P LAN Y EAR E NDING D ECEMBER 31, 20XX ( DOLLARS IN THOUSANDS ) Estimated Beginning New Interest Rate Balance Indebtedness

Long-term debt as percent of total capitalization

Selected Ratios

Total long-term obligations

Total

Total Other Long-Term Obligations Capital lease obligations Accrued warranty costs Other miscellaneous

Loan from insurance company Proposed mortgage loan Other notes payable

Maturity Date

9/30/98 12/31/99 6/30/03 12/31/94

Long-Term Debt Bank term loans

Issue

682

$ 27,910

11,860

4,000 7,100 760

16,050

$ 4,200 5,000 — 2,850 4,000

Payments on Debt

9.6

60

24

$ 276,800

75,800

31,000 42,800 2,000

201,000

$ 45,000 45,000 75,000 5,000 31,000

Planned Ending Balance

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All others Total additions

Purchases—capital items Subtotal Expenses— Manufacturing Selling Research and development General and administrative

Purchases—raw materials and parts

E XHIBIT 32.10

A CCOUNTS P AYABLE B UDGET

Balance, end of month

Total deductions

—Operating expenses

Deduct: Payments—Raw materials and purchased parts —Capital items

Add:

Item Balance, beginning of month

34,000 19,500

$ 29,800

23,700

33,900

25,700

4,300 2,000 1,400 1,900 200

4,800 2,100 1,200 1,900 100

14,400 9,500 10,100

13,900

23,800

13,600 1,500 10,600

12,400 1,500

Feb. 29,800

14,300 9,500

Jan. $21,600

18,800

25,600

12,900 1,500 11,200

24,900

4,500 2,300 1,500 1,900 100

14,600

13,600 1,000

1st Quarter March 19,500

T HE N EW Y ORK C OMPANY A CCOUNTS P AYABLE B UDGET F OR THE Y EAR E NDING 12/31/XX (D OLLARS IN M ILLIONS )

32.19

18,800

85,300

40,900 12,500 31,900

82,500

13,600 6,400 4,100 5,700 400

52,300

40,300 12,000

Total 21,600

3,000

Internal Controls

$

305,900

161,700 20,000 124,200

287,300

52,400 25,900 15,000 22,800 1,400

169,800

149,800 20,000

Year 20XX $ 21,600

683

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Ch. 32 Management of Liabilities

E XHIBIT 32.11

S UMMARY —C URRENT L IABILITY P LAN

Selected ratios/balances Current ratio Quick ratio Net working capital

Total

Item Notes Payable—banks Current Maturities— long-term debt Accounts payable Accrual salaries and wages Accrual income taxes Other accrued items

684

2.2 to 1 .70 to 1 71,500

32,500

$ 35,800

1.9 to 1 .50 to 1 $ 68,020

1 4,100 1,400 18,800 5,200 2,300 700

Estimated Balance 12/31/ XX—1 $ 4,700 1,500 21,600 5,800 1,400 800

T HE N EW Y ORK C OMPANY S UMMARY —C URRENT L IABILITY B UDGET F OR T HE P LAN Y EAR E NDING 12/31/XX (D OLLARS IN M ILLIONS )

2.4 to 1 .70 to 1 76,320

31,800

2.4 to 1 .80 to 1 59,520

24,800

Plan Year Ending 12/31/XX Quarter 2 3 3,600 3,000 1,300 1,200 17,400 10,600 6,400 6,900 2,500 2,500 600 600

2.5 to 1 1.1 to 1 $ 39,000

15,600

4 $ 2,000 1,200 3,000 7,400 1,500 500

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CHAPTER

33

MANAGEMENT OF SHAREHOLDERS’ EQUITY 33.1

INTRODUCTION 685

33.2

IMPORTANCE OF SHAREHOLDERS’ EQUITY 686

33.12 DIVIDEND POLICY 695 (a) To Pay or Not to Pay Cash Dividends 696

33.3

ROLE OF THE CONTROLLER 686

33.13 LONG-TERM DEBT RATIOS 697

33.4

GROWTH OF EQUITY AS A SOURCE OF CAPITAL 687

33.5

RETURN ON EQUITY AS RELATED TO GROWTH IN EARNINGS PER SHARE 687

33.6

GROWTH IN EARNINGS PER SHARE 688

33.7

COST OF CAPITAL 688

33.8

COMPONENTS OF COST OF CAPITAL 690

33.9

CALCULATING THE COST OF DEBT 691

33.10 CALCULATING THE COST OF EQUITY 692 33.11 CALCULATING THE WEIGHTED COST OF CAPITAL 694

33.14 OTHER TRANSACTIONS AFFECTING SHAREHOLDERS’ EQUITY 698 33.15 LONG-TERM EQUITY PLANNING 698 (a) Allocating Long-Term Funds between Debt and Equity 698 (b) Other Suggestions in Managing the Capital Structure 701 33.16 SHORT-TERM PLAN FOR SHAREHOLDERS’ EQUITY 704 33.17 OTHER CONSIDERATIONS 704 (a) Dividend Reinvestment Programs 704 (b) Stock Dividends and Stock Splits 704 (c) Repurchase of Common Shares 706 (d) Capital Stock Records 706

33.1 INTRODUCTION Shareholders’ equity is the interest of the shareholders, or owners, in the assets of a company, and at any time is the cumulative net result of past transactions affecting this segment of the balance sheet. This equity is created initially by the owner’s investment in the entity, and may be increased from time to time by additional investments, as well as by net earnings. It is reduced by distributions of the equity to the owners (usually as dividends). Further, it may also decrease if the enterprise is unproﬁtable. When all liabilities are satisﬁed, the balance—the residual—belongs to the owners. Basic accounting concepts govern the accounting for shareholders’ equity as a whole, for each class of shareholder, and for the various segments of the equity interest, such as capital stock, contributed capital, or earned capital. This chapter does not deal with the accounting niceties regarding the ownership interest. It is assumed the controller is well grounded in such proper treatment, or will become so. The concerns relate to the shareholders’ interest as a total and not any special accounting segments. 685

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Ch. 33 Management of Shareholders’ Equity

33.2 IMPORTANCE OF SHAREHOLDERS’ EQUITY As previously stated, capital structure is composed of all long-term obligations and shareholders’ equity—in a sense, the “permanent” capital. Some would describe the capital structure of the enterprise as the cornerstone of ﬁnancial policy. Such policy must be so planned that it will command respect from investors far into the future. But of the two basic elements, it is the shareholders’ equity that is critical. This equity must provide a margin of safety to protect the senior obligations. Stated another way, in most instances, without the shareholders’ equity, no senior obligations could be issued. It is for this reason, among others, that proper management of the equity is of paramount importance. In a sense, the controller, together with other members of ﬁnancial management, must safeguard the long-term ﬁnancial interests of not only the shareholders but also the providers of long-term credit, to say nothing of the sources of short-term capital such as commercial banks and suppliers. This is accomplished, in part, by properly planning and controlling the equity base of the enterprise.

33.3 ROLE OF THE CONTROLLER Given the importance of shareholders’ equity and the need to manage it prudently, what should be the role of the controller? In a general sense, as one of the principal ﬁnancial ofﬁcers of the corporation, the controller must properly account for the shareholders’ equity, providing those analyses and recommending those actions that are consistent with enhancing shareholder value over the long term. The task would require attention to these speciﬁc actions: • Properly accounting for the shareholders’ equity in accordance with generally accepted accounting principles (GAAP). This includes the historical analysis of the source of the equity and the segregation of the cumulative equity by class of shareholder. • Preparing the appropriate reports on the status and changes in shareholders’ equity as required by agencies of the U.S. government (e.g., Securities and Exchange Commission), by management, and by credit agreements and other contracts. • Making the necessary analyses to assist in planning the most appropriate source (debt or shareholders’ equity) of new funds, and the timing and amount required of each. • As appropriate, maintaining in proper and economical form the capital stock records of the individual shareholders, with the related meaningful analysis (by nature of owner—individual, institution, and so forth—by geographic area, by size of holding, etc.) or assuring that it is done. (In larger ﬁrms, a separate department or an outside service might perform these functions.) • Periodically making the required analysis, reporting on, and making recommendations or observations on such matters as: Dividend policy Dividend reinvestment plans Stock splits or dividends Stock repurchase Capital structure Trend and outlook for earnings per share Cost of capital for the company and industry Tax legislation as it affects shareholders Price action of the market price of the stock, and inﬂuences on it

Plainly, there is a grassland of ﬁnancial subjects on which the controller can graze and in due course make useful suggestions. Before a discussion of speciﬁcs about the planning phases regarding shareholders’ equity, some interesting relationships should be understood:

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33.5 Return on Equity as Related to Growth in Earnings Per Share

687

• Rate of growth in equity as related to the return on equity (ROE) • Growth in earnings per share as related to ROE • Cost of capital • Dividend payout ratio • Relationship of long-term debt to equity

33.4 GROWTH OF EQUITY AS A SOURCE OF CAPITAL As a company grows, it usually requires additional funds to ﬁnance working capital and plant and equipment, as well as for other purposes. Of course, it could issue additional shares of stock, but this might dilute earnings per share for a time or perhaps raise questions of control. Another alternative is to borrow long-term funds. Some managements may wish to do neither. As a result, the remaining source of long-term capital (excluding some assets sales, etc.) is the growth in retained earnings. But such a method is typically a slow way to gain additional capital. The rate of growth of equity is germane to establishing target rates of return on equity, selecting sources of capital, and monitoring dividend policy. The annual growth in shareholders’ equity from internal sources may be deﬁned as the rate of return earned on such equity multiplied by the percentage of the earnings retained. It may be represented by this formula: G R(1 P) where G annual percentage growth on shareholders equity R annual net rate of return P the payout ratio or share of earnings annually paid out as dividends

As an example, if a company can earn about 23% each year on its equity, and the payout ratio is 40%, then shareholders’ equity will grow at 14% per year, calculated as: G = = =

0.23 ( 1 0.40 ) 0.23 ( 0.60 ) 0.14 14%

Under these circumstances, if the management thinks the company can grow in sales and earnings at about 30% per year, if additional funds will be needed at about this same rate, and if the dividend payout is to remain at 40%, then management will require some outside capital for the growth potential to be realized.

33.5 RETURN ON EQUITY AS RELATED TO GROWTH IN EARNINGS PER SHARE Another facet of the shareholders’ equity role is the relationship of the ROE to the rate of annual increase in earnings per share (EPS). This connection is often not understood even by some ﬁnancial executives. Basically, the rate of return on shareholders’ equity, when adjusted for the payout ratio, produces the rate of growth per year in EPS. It may be expressed in this formula: Growth per year in EPS ROE retention ratio

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688

Ch. 33 Management of Shareholders’ Equity

This relationship is illustrated in Exhibit 33.1. Thus, assuming a constant return on equity of 20% and a constant dividend payout ratio of 25%, the EPS growth rate is calculated by means of the same formula as for the growth of shareholders’ equity: G =

R (1 P) 0.20 0.20 ( 0.75 ) 0.15 15%

For illustrative purposes to management or the board of directors, these same factors can be translated into book value per share, earnings per share, and dividends per share, as shown in Exhibit 33.2. In such terms, explanations about the shareholders’ interest often are more easily understood. It is to be noted in Exhibit 33.2 that, with a constant dividend payout ratio, the annual dividend rate of increase is the same as the annual growth rate in EPS.

33.6 GROWTH IN EARNINGS PER SHARE Prudent ﬁnancial planning will consider the impact of decisions on EPS. Management is concerned with the growth in EPS since one of its tasks is to enhance shareholder value. And continual increases in EPS each year will raise shareholder value through its recognition in a higher P/E ratio and usually a rising dividend payment. Moreover, the growth in EPS is one of the measures of management as viewed by the ﬁnancial community, including ﬁnancial analysts. Given the importance of EPS, ﬁnancial ofﬁcers should bear in mind that the EPS will increase as a result of any one of these actions: • The plow-back of some share of earnings, even as long as the rate of return on equity remains just constant—as illustrated by the calculations in Exhibits 33.1 through 33.2 . (A growth in EPS does not necessarily mean that the management is achieving a higher rate of return on equity.) • An actual increase in the rate of return earned on shareholders’ equity • Repurchase of common shares as long as the rate of return on equity does not decrease • Use of prudent borrowing—ﬁnancial leverage (see Chapter 32) • Acquisition of a company whose stock is selling at a lower P/E than the acquiring company (see Chapter 52) • Sale of shares of common stock above the book value of existing shares, assuming the ROE is maintained Financial planning should keep all the alternatives in mind. But of all these actions, the one most likely sustainable and translatable into a healthy growth in EPS is a constant, or increasing, return on shareholders’ equity.

33.7 COST OF CAPITAL Investors are willing to place funds at risk in the expectation of recovering such capital and making a reasonable return. Some individuals or companies might prefer to invest in a practically risk-free security, such as U.S. government bonds; others will assume greater risks but expect a correspondingly higher rate of return. Cost of capital, then, may be deﬁned as the rate of return that must be paid to investors to induce them to supply the necessary funds (through the particular instrument under discussion). Thus, the cost of a bond would be represented by the interest payments plus the recovery of the bond purchase price, perhaps plus some capital gains. The cost of common shares issued would be represented by the dividend paid plus the appreciation of the stock. Capital will ﬂow to those markets where investors expect to receive a rate of return consistent with their assessment of the ﬁnancial and other risks, and a rate that is competitive with alternative investments.

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87,450 100,568 115,653

437,252

502,839

578,265

20X4

20X5

20X6

20X7 VERSUS

76,044

380,219

20X3

E QUITY

66,125

330,625

20X2

ON

57,500

287,500

20X1

C ONSTANT R ETURN

$ 50,000

$ 250,000

Year

E XHIBIT 33.1

Net Income

Beginning Shareholders’ Equity

EPS G ROWTH

28,913

25,142

21,863

19,011

16,531

14,375

$ 12,500

Dividends Paid

( DOLLARS

665,005

578,265

502,839

437,252

380,219

330,625

$ 287,500

Ending Shareholders’ Equity

20

20

20

20

20

20

20%

Rate of Return on Beginning Equity

IN THOUSANDS EXCEPT PER SHARE )

T HE E LECTRONIC C OMPANY R ETURN ON E QUITY VS . EPS G ROWTH

25

25

25

25

25

25

25%

Dividend Payout (%)

33.7

15

15

15

15

15

15%

—

689

Growth in EPS(%)

Cost of Capital

11.57

10.06

8.75

7.60

6.61

5.75

$ 5.00

EPS

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Ch. 33 Management of Shareholders’ Equity

R ETURN Year Book value, beginning *

Earnings Dividends† Retained earnings Book value, ending

1

2

3

4

5

6

7

$ 25.00

$ 28.75

$ 33.06

$ 38.02

$ 43.72

$ 50.28

$ 57.82

5.00 1.25

5.75 1.44

6.61 1.65

7.60 1.90

8.75 2.19

10.06 2.52

11.57 2.89

3.75

4.31

4.96

5.70

6.56

7.54

8.68

$ 28.75

$ 33.06

$ 38.02

$ 43.72

$ 50.28

$ 57.82

$ 66.50

.86 15

.99 15

1.15 15

1.31 15

$ 1.51 15%

.21 15

.25 15

.29 15

.33 15

$

Increase in EPS: Amount $ .75 Percent 15% Increase in dividends: Amount $ .19 Percent 15% * At 20% on beginning equity † At 25% payout rate E XHIBIT 33.2

P ER S HARE D ATA E QUITY VS . EPS G ROWTH

ON

P ER S HARE —ROE

VS .

.37 15%

G ROWTH R ATE

Knowledge of the cost of capital is important for two reasons: • The ﬁnancial manager must know what the cost of capital is and offer securities that provide a competitive rate, in order to be able to attract the required funds to the business. • In making investment decisions, such as for plant and equipment, the ﬁnancial manager must secure a return that is, on average, at least as high as the cost of capital. Otherwise, there is no reason to make an investment that yields only the cost or less. The manager is expected to gain something for the shareholder. Hence, the cost of capital theoretically sets the ﬂoor as the minimum rate of return before any investment should even be considered. Prudent management of the shareholders’ equity, then, involves: • Attempting to ﬁnance the company so as to achieve the optimum capital structure, and, hence, a reasonable cost of capital • Properly determining the cost of capital, and employing such knowledge in relevant investment decisions

33.8 COMPONENTS OF COST OF CAPITAL 1 Before determining the amount of a company’s cost of capital, it is necessary to determine its components. The following two sections describe in detail how to arrive at the cost of capital for these

1. Reprinted with permission from pp. 270-278 of Steven M. Bragg, Financial Analysis (Wiley, Hoboken, NJ: 2000).

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components. The weighted average calculation that brings together all the elements of the cost of capital is then described in the “Calculating the Weighted Cost of Capital” section. The ﬁrst component of the cost of capital is debt. This is a company’s commitment to return to a lender both the interest and principal on an initial or series of payments to the company by the lender. This can be short-term debt, which is typically paid back in full within one year, or longterm debt, which can be repaid over many years, with either continual principal repayments, large repayments at set intervals, or a large payment when the entire debt is due, which is called a balloon payment. All these forms of repayment can be combined in an inﬁnite number of ways to arrive at a repayment plan that is uniquely structured to ﬁt the needs of the individual corporation. The second component of the cost of capital is preferred stock. This is a form of equity that is issued to stockholders and that carries a speciﬁc interest rate. The company is obligated to pay only the stated interest rate to shareholders at stated intervals, but not the initial payment of funds to the company, which it may keep in perpetuity, unless it chooses to buy back the stock. There may also be conversion options, so that a shareholder can convert the preferred stock to common stock in some predetermined proportion. This type of stock is attractive to those companies that do not want to dilute earnings per share with additional common stock, and that also do not want to incur the burden of principal repayments. Though there is an obligation to pay shareholders the stated interest rate, it is usually possible to delay payment if the funds are not available, though the interest will accumulate and must be paid when cash is available. The third and ﬁnal component of the cost of capital is common stock. A company is not required to pay anything to its shareholders in exchange for the stock, which makes this the least risky form of funding available. Instead, shareholders rely on a combination of dividend payments, as authorized by the Board of Directors (and which are entirely at the option of the Board—authorization is not required by law), and appreciation in the value of the shares. However, since shareholders indirectly control the corporation through the Board of Directors, actions by management that depress the stock price or lead to a reduction in the dividend payment can lead to the ﬁring of management by the Board of Directors. Also, since shareholders typically expect a high return on investment in exchange for their money, the actual cost of these funds is the highest of all the components of the cost of capital. As will be discussed in the next two sections, the least expensive of the three forms of funding is debt, followed by preferred stock and common stock. The main reason for the differences between the costs of the three components is the impact of taxes on various kinds of interest payments. This is of particular concern when discussing debt, which is covered in the next section.

33.9 CALCULATING THE COST OF DEBT This section covers the main factors to consider when calculating the cost of debt, and also notes how these factors must be incorporated into the ﬁnal cost calculation. We also note how the net result of these calculations is a form of funding that is less expensive than the cost of equity, which is covered in the next section. When calculating the cost of debt, it is important to remember that the interest expense is tax deductible. This means that the tax paid by the company is reduced by the tax rate multiplied by the interest expense. An example is shown in Exhibit 33.3, where we assume that $1,000,000 of debt has a basic interest rate of 9.5 percent, and the corporate tax rate is 35 percent. The example clearly shows that the impact of taxes on the cost of debt signiﬁcantly reduces the overall debt cost, thereby making this a most desirable form of funding. If a company is not currently turning a proﬁt, and therefore not in a position to pay taxes, one may question whether or not the company should factor the impact of taxes into the interest calculation. The answer is still yes, because any net loss will carry forward to the next reporting period, when the company can offset future earnings against the accumulated loss to avoid paying taxes at that time. Thus, the reduction in interest costs caused by the tax deductibility of interest is still applicable even if a company is not currently in a position to pay income taxes.

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Ch. 33 Management of Shareholders’ Equity

( Interest expense ) ( 1 Tax rate ) Net after-tax interest expense --------------------------------------------------------------------------------------Amount of debt Or, $95,000 ( 1 .35 ) Net after-tax interest expense -------------------------------------------------$1,000,000 $61,750 --------------------------- 6.175% $1,000,000 E XHIBIT 33.3

C ALCULATING

THE I NTEREST

C OST

OF

D EBT , N ET

OF

T AXES

Another issue is the cost of acquiring debt, and how this cost should be factored into the overall cost of debt calculation. When obtaining debt, either through a private placement or simply through a local bank, there are usually extra fees involved, which may include placement or brokerage fees, documentation fees, or the price of a bank audit. In the case of a private placement, the company may set a ﬁxed percentage interest payment on the debt, but ﬁnd that prospective borrowers will not purchase the debt instruments unless they can do so at a discount, thereby effectively increasing the interest rate they will earn on the debt. In both cases, the company is receiving less cash than initially expected, but must still pay out the same amount of interest expense. In effect, this raises the cost of the debt. To carry forward the example in Exhibits 33.3 through 33.4 , we assume that the interest payments are the same, but that brokerage fees were $25,000 and that the debt was sold at a 2% discount. The result is an increase in the actual interest rate. ( Interest expense ) ( 1 Tax rate ) ------------------------------------------------------------------------------------------------------------------------------------------ Net after-tax interest expense ( Amount of debt ) ( Fees ) ( Discount on sale of debt ) Or, $95,000 ( 1 .35 ) Net after-tax interest expense -------------------------------------------------$1,000,000 $61,750 ---------------------- 6.466% $955,000 Note: There can also be a premium on sale of debt instead of a discount, if investors are willing to pay extra for the interest rate offered. This usually occurs when the rate offered is higher than the current market rate, or if the risk of non-payment is so low that this is perceived as an extra beneﬁt by investors.

E XHIBIT 33.4

C ALCULATING

THE I NTEREST

C OST

OF

D EBT , N ET

OF

T AXES , F EES ,

AND

D ISCOUNTS .

When compared to the cost of equity that is discussed in the following section, it becomes apparent that debt is a much less expensive form of funding than equity. However, though it may be tempting to alter a company’s capital structure to increase the proportion of debt, thereby reducing the overall cost of capital, there is a signiﬁcant risk of being unable to make debt payments in the event of a reduction in cash ﬂow, possibly resulting in bankruptcy.

33.10 CALCULATING THE COST OF EQUITY This section shows how to calculate the cost of the two main forms of equity, which are preferred stock and common stock. These calculations, as well as those from the preceding section on the cost of debt, are then combined in the following section to determine the weighted cost of capital. Preferred stock stands at a midway point between debt and common stock. It requires an interest payment to the holder of each share of preferred stock, but does not require repayment to the shareholder of the amount paid for each share. There are a few special cases where the terms underlying the issuance of a particular set of preferred shares will require an additional payment to shareholders if company earnings exceed a speciﬁed level, but this is a rare situation. Also, some

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preferred shares carry provisions that allow delayed interest payments to be cumulative, so that they must all be paid before dividends can be paid out to holders of common stock. The main feature shared by all kinds of preferred stock is that, under the tax laws, interest payments are treated as dividends instead of interest expense, which means that these payments are not tax deductible. This is a key issue, for it greatly increases the cost of funds for any company using this funding source. By way of comparison, if a company has a choice between issuing debt or preferred stock at the same rate, the difference in cost will be the tax savings on the debt. In the following example, a company issues $1,000,000 of debt and $1,000,000 of preferred stock, both at 9% interest rates, with an assumed 35% tax rate. Debt cost Principal ( Interest rate ( 1 Tax rate ) ) Debt cost $1,000,000 ( 9% ( 1 .35 ) ) $58,500 $1,000,000 ( 9% .65 ) If the same information is used to calculate the cost of payments using preferred stock, we have the following result: Preferred stock interest cost Principal Interest rate Preferred stock interest cost $1,000,000 9% $90,000 $1,000,000 9% The above example shows that the differential caused by the applicability of taxes to debt payments makes preferred stock a much more expensive alternative. This being the case, why does anyone use preferred stock? The main reason is that there is no requirement to repay the stockholder for the initial investment, whereas debt requires either a periodic or balloon payment of principal to eventually pay back the original amount. Companies can also eliminate the preferred stock interest payments if they include a convertibility feature into the stock agreement that allows for a conversion to common stock at some preset price point for the common stock. Thus, in cases where a company does not want to repay principal any time soon, but does not want to increase the amount of common shares outstanding, preferred stock provides a convenient, though expensive, alternative. The most difﬁcult cost of funding to calculate by far is common stock, because there is no preset payment from which to derive a cost. Instead, it appears to be free money, since investors hand over cash without any predetermined payment or even any expectation of having the company eventually pay them back for the stock. Unfortunately, the opposite is the case. Since holders of common stock have the most at risk (they are the last ones paid off in the event of bankruptcy), they are the ones who want the most in return. Any management team that ignores holders of its common stock and does nothing to give them a return on their investments will ﬁnd that these people will either vote in a new board of directors that will ﬁnd a new management team, or else they will sell off their shares at a loss to new investors, thereby driving down the value of the stock and opening up the company to the attentions of a corporate raider who will also remove the management team. One way to determine the cost of common stock is to make a guess at the amount of future dividend payments to stockholders, and discount this stream of payments back into a net present value. The problem with this approach is that the amount of dividends paid out is problematic, since they are declared at the discretion of the board of directors. Also, there is no provision in this calculation for changes in the underlying value of the stock; for some companies that do not pay any dividends, this is the only way in which a stockholder will be compensated. A better method is called the capital asset pricing model (CAPM). Without going into the very considerable theoretical detail behind this system, it essentially derives the cost of capital by determining the relative risk of holding the stock of a speciﬁc company as compared to a mix of all stocks in the market. This risk is composed of three elements. The ﬁrst is the return that any investor can expect from a risk-free investment, which is usually deﬁned as the return on a U.S. government security. The second element is the return from a set of securities considered to have an

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Ch. 33 Management of Shareholders’ Equity

average level of risk. This can be the average return on a large “market basket” of stocks, such as the Standard & Poor’s 500, the Dow Jones Industrials, or some other large cluster of stocks. The ﬁnal element is a company’s beta, which deﬁnes the amount by which a speciﬁc stock’s returns vary from the returns of stocks with an average risk level. This information is provided by several of the major investment services, such as Value Line. A beta of 1.0 means that a speciﬁc stock is exactly as risky as the average stock, while a beta of 0.8 would represent a lower level of risk and a beta of 1.4 would be higher. When combined, this information yields the baseline return to be expected on any investment (the risk-free return), plus an added return that is based on the level of risk that an investor is assuming by purchasing a speciﬁc stock. This methodology is totally based on the assumption that the level of risk equates directly to the level of return, which a vast amount of additional research has determined to be a reasonably accurate way to determine the cost of equity capital. The main problem with this approach is that a company’s beta will vary over time, since it may add or subtract subsidiaries that are more or less risky, resulting in an altered degree of risk. Because of the likelihood of change, one must regularly recompute the equity cost of capital to determine the most recent cost. The calculation of the equity cost of capital using the CAPM methodology is relatively simple, once one has accumulated all the components of the equation. For example, if the risk-free cost of capital is 5%, the return on the Dow Jones Industrials is 12%, and ABC Company’s beta is 1.5, the cost of equity for ABC Company would be: Cost of equity capital Cost of equity capital Cost of equity capital Cost of equity capital Cost of equity capital

Risk-free return Beta ( Average stock return Risk-free return ) 5% 1.5 ( 12% 5% ) 5% 1.5 7% 5% 10.5% 15.5%

Though the example uses a rather high beta that increases the cost of the stock, it is evident that, far from being an inexpensive form of funding, common stock is actually the most expensive, given the size of returns that investors demand in exchange for putting their money at risk with a company. Accordingly, this form of funding should be used the most sparingly in order to keep the cost of capital at a lower level.

33.11 CALCULATING THE WEIGHTED COST OF CAPITAL Now that we have derived the costs of debt, preferred stock, and common stock, it is time to assemble all three costs into a weighted cost of capital. This section is structured in an example format, showing the method by which the weighted cost of capital of the Canary Corporation is calculated. Following that, there is a short discussion of how the cost of capital can be used. The chief ﬁnancial ofﬁcer of the Canary Corporation, Mr. Birdsong, is interested in determining the company’s weighted cost of capital, to be used to ensure that projects have a sufﬁcient return on investment, which will keep the company from going to seed. There are two debt offerings on the books. The ﬁrst is $1,000,000 that was sold below par value, which garnered $980,000 in cash proceeds. The company must pay interest of 8.5% on this debt. The second is for $3,000,000 and was sold at par, but included legal fees of $25,000. The interest rate on this debt is 10%. There is also $2,500,000 of preferred stock on the books, which requires annual interest (or dividend) payments amounting to 9% of the amount contributed to the company by investors. Finally, there is $4,000,000 of common stock on the books. The risk-free rate of interest, as deﬁned by the return on current U.S. government securities, is 6%, while the return expected from a typical market basket of related stocks is 12%. The company’s beta is 1.2, and it currently pays income taxes at a marginal rate of 35%. What is the Canary Company’s weighted cost of capital? The method we will use is to separately compile the percentage cost of each form of funding, and then calculate the weighted cost of capital, based on the amount of funding and percentage cost of each of the above forms of funding. We begin with the ﬁrst debt item, which was $1,000,000 of debt

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that was sold for $20,000 less than par value, at 8.5% debt. The marginal income tax rate is 35%. The calculation is as follows. ( Interest expense ) ( 1 Tax rate ) ) Amount of debt Net after-tax interest percent (----------------------------------------------------------------------------------------------------------------------------------------( Amount of debt ) ( Discount on sale of debt ) ( ( 8.5% ) ( 1 .35 ) ) $1,000,000 Net after-tax interest percent ----------------------------------------------------------------------------------------------------------------( Amount of debt ) ( Discount on sale of debt ) Net after-tax interest percent 5.638% We employ the same method for the second debt instrument, for which there is $3,000,000 of debt that was sold at par; $25,000 in legal fees were incurred to place the debt, which pays 10% interest. The marginal income tax rate remains at 35%. The calculation is as follows: ( Interest expense ) ( 1 Tax rate ) ) Amount of debt Net after-tax interest percent (----------------------------------------------------------------------------------------------------------------------------------------( Amount of debt ) ( Legal expenses ) ( 10% ) ( 1 .35 ) ) $3,000,000 Net after-tax interest percent (-------------------------------------------------------------------------------------$3,000,000 $25,000 Net after-tax interest percent 7.091% Having completed the interest expense for the two debt offerings, we move on to the cost of the preferred stock. As noted above, there is $2,500,000 of preferred stock on the books, with an interest rate of 9%. The marginal corporate income tax does not apply, since the interest payments are treated like dividends, and are not deductible. The calculation is the simplest of all, for the answer is 9%, since there is no income tax to confuse the issue. To arrive at the cost of equity capital, we take from the example a return on risk-free securities of 6%, a return of 12% that is expected from a typical market basket of related stocks, and a beta of 1.2. We then plug this information into the following formula to arrive at the cost of equity capital: Cost of equity capital Risk-free return Beta ( Average stock return Risk-free return ) Cost of equity capital 6% 1.2 ( 12% 6% ) Cost of equity capital 13.2% Now that we know the cost of each type of funding, we can construct a table such as the one shown in Exhibit 33.5 that lists the amount of each type of funding and its related cost, which we can quickly sum to arrive at a weighted cost of capital.

Type of Funding

Amount of Funding

Percentage Cost

Dollar Cost

Debt number 1 Debt number 2 Preferred stock Common stock Totals

$980,000 2,975,000 2,500,000 4,000,000 $10,455,000

5.638% 7.091% 9.000% 13.200% 9.75%

$55,252 210,957 225,000 528,000 $1,019,209

E XHIBIT 33.5

W EIGHTED C OST

OF

C APITAL C ALCULATION

When combined into the weighted average calculation shown in Exhibit 33.5, we see that the weighted cost of capital is 9.75%. Though there is some considerably less expensive debt on the books, the majority of the funding is comprised of more expensive common and preferred stock, which drives up the overall cost of capital.

33.12 DIVIDEND POLICY Dividend policy is a factor to be considered in the management of shareholders’ equity in that:

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Ch. 33 Management of Shareholders’ Equity

• Cash dividends paid are the largest recurring charge against retained earnings for most U.S. corporations. • The amount of dividends paid, which reduces the amount of equity remaining, will have an impact on the amount of long-term debt that can be prudently issued in view of the long-term debt to equity ratio that usually governs ﬁnancing. • Dividend payout is an inﬂuence on the reception of new stock issues. • Dividend policy is an element in most loan and credit agreements—with restrictions on how much may be paid. (a) TO PAY OR NOT TO PAY CASH DIVIDENDS. If a company has discontinued cash dividends, for whatever reason, or if a corporation has never paid a cash dividend, then most readers would appreciate the desirability of discussing whether cash dividends should be paid. However, even if cash dividends are now being disbursed, the question should be considered. Some companies do not pay cash dividends on the basis that they can earn a higher rate of return on reinvested earnings than can a shareholder by directly investing in new purchases of stock. This may or may not be true. It should be recognized that one purpose of sound ﬁnancial management is to maximize the return to the shareholder over the longer period. Therefore, this is the criterion: In the company involved, will it serve to increase the long-term return to the shareholder by paying a dividend? This question is asked in the context that the return to the common shareholder consists of two parts: (1) the dividend and (2) the appreciation in the price of the security. The ﬁnancial management of the ﬁrm should consider the type of investor attracted to the stock and the expectation of the investors. The examination of the actions of other companies and the opinion of knowledgeable investment bankers may be helpful. In general, the ability to invest all the earnings at an acceptable rate of return is not a convincing reason to pay no dividend. After all, a dividend is here and now, and future growth is more problematical. Probably, other than in the case of a highly speculative situation or a company in severe ﬁnancial difﬁculty, some case dividend should be paid. This decision, however, is judgmental. Dividend payments are determined by a number of inﬂuences, including: • The need for additional capital for expansion or other reasons • Cash ﬂow of the enterprise • Industry practice • Shareholders’ expectations The amount to be paid may be calculated in one of two ways: (1) by the dividend payout ratio or (2) as a percentage of beginning net worth each year. The most common practice is to measure dividends as a percentage of earnings. This payout ratio is determined as: Annual dividends paid to common shareholders = ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Annual earnings available for common shareholders (after preferred dividends) In this example, the payout ratio of 25% is calculated in this fashion: Payout ratio $12,500,000 -----------------------------$50,000,000 0.25 25% Another way of calculating dividends, although less common than the payout method, is as a percentage of beginning net worth (book value attributable to common shares). The procedure is:

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697

dividends paid to common shareholders Dividend payment ratio Annual -----------------------------------------------------------------------------------------------------------------Beginning common shareholder book value (or retained earnings) $12,500,000 = --------------------------------$156,250,000 = 0.08 = 8% It has been suggested that a primary proﬁt goal of an enterprise should be a speciﬁed rate of return on shareholders’ equity. If this is accepted as a primary planning tool, then there is a certain logic that could justify using this same base (shareholders’ equity) for the calculation of dividend payments—at least for internal planning purposes. Moreover, because earnings do ﬂuctuate, there is an added stabilizing inﬂuence if dividends are based on book value. Also, as long as shareholders’ equity is increasing and dividends are a constant rate of beginning net worth, then dividends would increase, the dividend payout ratio would drop, and the retention share of earnings would increase. Dividend-paying practices send a message to the ﬁnancial community, and investors and analysts accept the pattern as an indication of future payments. Hence, when a dividend payment rate is set, a dividend reduction should be avoided if at all possible. Dividend payment patterns may follow any one of several, such as: • A constant or regular quarterly payment • A constant pattern with regularly recurring increases—perhaps the same quarter each year • A constant pattern with irregular increases • A constant pattern with period extras so as to avoid committing to regular increases In planning, any erratic pattern should be avoided.

33.13 LONG-TERM DEBT RATIOS The subject of debt capacity is discussed in Chapter 32. However, the management of shareholders’ equity must always keep debt relationships in mind when planning future ﬁnancing, whether they be debt or equity. There are two principal ratios used by rating agencies and the ﬁnancial marketplace in judging the debt worthiness (or the value of equity) of an enterprise: 1. Ratio of long-term debt to equity. 2. Ratio of long-term debt to total capitalization. The ﬁrst ratio is calculated as: Long-term debt Long-term debt to equity ----------------------------------------------Shareholders equity It compares the investment of the long-term creditors to that of the owners. Generally, a ratio of greater than 1 is an indication of excessive debt. However, a company ratio should be compared to others in the industry (the leaders) or to industry averages, such as those published by Dun & Bradstreet, Inc. The second ratio is calculated in this fashion: Long-term debt Long-term debt to total capitalization ----------------------------------------------------------------------------------------------------------------Total capitalization (including long-term debts) Again, a ratio of greater than 50%, as a rule of thumb, reﬂects excessive use of debt. Comparisons should be made with selected industry members (judged to be prudent business people) and industry averages.

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Ch. 33 Management of Shareholders’ Equity

33.14 OTHER TRANSACTIONS AFFECTING SHAREHOLDERS’ EQUITY In the management of shareholders’ equity, any actions that are expected to impact this element of the ﬁnancial statements should be reﬂected in the plans—the annual plan or the long-range plan, as may be appropriate. While earnings and dividends have been discussed, there are a host of other transactions that might be involved, including: • Repurchase of common shares • Conversion of preferred shares or convertible debentures • Dividend reinvestment programs • Exercise of stock options • New issues of shares • Special write-offs or adjustments Before approving any such actions or agreements on such matters, the management should consider their impact on debt capacity, especially where debt ratios already are high.

33.15 LONG-TERM EQUITY PLANNING For those entities with a practical ﬁnancial planning system, the long-term planning sequence might be something like this: • The company ﬁnancial management has determined, or determines, what is an acceptable capital structure and gets the agreement of management and the board of directors. • As a step in the long-range ﬁnancial planning, the amount of funds required in excess of those available is determined by year, in an approximate amount. • Based on the needs over several years, the desired capital structure, the relative cost of each segment of capital (debt or equity), the cost of each debt issue, and any constraints imposed by credit agreements, or the judgment of management, the long-term fund requirements are allocated between long-term debt and equity. • For the annual business plan, any actions deemed necessary in the ﬁrst year of the long-range plan are incorporated with the other usual annual transactions to form the equity budget for the year. This is another way of saying that, ordinarily, the needs of additional equity capital are known some time in advance. They can be planned to take advantage of propitious market conditions, under generally acceptable terms, with the result that the cost of capital is usually competitive. Normally, good planning will let management know well in advance the amount and timing of the requirements; it is not a sudden discovery. And the company continues to move toward its desired optimum capital structure. (a) ALLOCATING LONG-TERM FUNDS BETWEEN DEBT AND EQUITY. Now, let us provide some illustrations of these points. Assume that the company management has agreed with the recommendation of the chief ﬁnancial ofﬁcer (CFO), concurred in by the controller, and that the capital structure should be:

Segment Long-term debt Shareholders’ equity Total

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Preferred Structure 20.0% 80.0% 100.0%

Minimally Acceptable Structure 25.0% 75.0% 100.0%

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Moreover, at the end of the current year (20XX) the capital structure is expected to be (unacceptable): Long-term debt Shareholders’ equity

31.5% 68.5% 100.0%

Total

In the process of completing the strategic planning cycle and the related long-range ﬁnancial plan, the required long-term funds, without designation as to type or source, are estimated to be $67 million in three years, as reﬂected in Exhibit 33.6, for a program of substantial growth. Furthermore, after a slight hesitation in plan years 4 and 5, management thinks the cycle is to repeat again. Now, here, are some comments looking to the year-by-year review for allocation purposes between long-term debt and equity: • General. Since the cost of equity capital is highest, and issuance of new equity tends to dilute earnings, equity capital should generally be used sparingly—only to maintain the borrowing base and to reach and remain at the desired capital structure. • Current year. At the end of the current year, equity will provide only 68.5% of capital (Exhibit 33.7)—as compared to management’s target of 80% and a minimally acceptable level of 75%. Obviously, the debt share of capitalization is too high. • Plan year 20X1. Given the start of an acceleration in annual earnings, management decides to hold the dividend payout ratio to 20%, and to borrow the needed $8 million under the term loan agreement (interest rate of 15%). The equity share of capitalization, even so, will increase from 68.5% to 72%. • Plan year 20X2. With $28 million in new funds required, the company decides, in view of the heavy investment in ﬁxed assets and a lower borrowing rate available (12%), to issue a new

T HE J OHNSON C OMPANY F UND R EQUIREMENTS L ONG -R ANGE P LAN ( DOLLARS IN MILLIONS ) Plan Year Current Year (Estimated)

Item

1

2

3

4

5

Total

Dividends

$ 25 12 15 8

$ 30 12 14 9

$ 36 12 40 10

$ 42 12 50 12

$ 55 12 15 14

$ 30 15 40 15

$193 63 159 60

Total

$ 60

$ 65

$ 98

$116

$ 96

$100

$475

$ 40 10

$ 45 12

$ 50 20

$ 60 25

$ 70 28

$ 75 31

$300 116

$ 50

$ 57

$ 70

$ 85

$ 98

$ 106

$416

Funds required (excess)

$ 10

$ 8

$ 28

$ 31

$ (2)

$ (6)

$ 59

Cumulative funds required (net)

$ 10

$ 8

$ 36

$ 67

$ 65

$ 59

Funds Required

Working capital Long-term debt repayment Fixed assets

Internally Generated Funds

Net income Depreciation Total

E XHIBIT 33.6

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L ONG- T ERM F UND R EQUIREMENTS

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Ch. 33 Management of Shareholders’ Equity

mortgage bond. Some of the funds will be “taken down” or received this plan year and the balance in the next year. Despite the high level of borrowing, the equity share remains at 72%. The management decides it can “live with” such a level for a temporary period, given the high level of income. • Plan year 20X3. The balance of the new mortgage bond proceeds covers the requirements with no reduction in the equity share of capitalization. • Plan year 20X4. With the net income now at a level of $70 million, and a proposal by an insurance company to provide new funds through a new mortgage bond, management decides to (a) accept this new loan of $58 million and (b) pay off the more expensive term loan. Given the continued high level of earnings, equity capital at year end will provide 76% of the capitalization. This is within the minimally acceptable standard used by the company. • Plan year 20X5. In this last year of the ﬁve-year long-range plan, management believes the growth cycle is ready to start again. Without going through the complete long-range planning cycle again, it asks the ﬁnancial vice president to estimate fund requirements for two more years—the “contingency” years. This quick review discloses that another $50 million will be needed in 20X6, with possibly a limited amount required also in 20X7. Accordingly, to raise the equity capitalization to the desired 80% level (20X6 borrowings considered) and to provide the needed equity base for the 20X6 borrowings and expansion in future years, it plans for an issue of $50 million in equity funds.

Y EARS

T HE J OHNSON C OMPANY A LLOCATION OF L ONG -T ERM F UNDS B ETWEEN D EBT AND E QUITY FOR T HE P LAN 20X1 T HROUGH 20X5, AND C ONTINGENCY Y EARS 20X6 ( DOLLARS IN MILLIONS ) Beginning New Equity Balance Net Income Dividends Offering

Year/Item Shareholders’ Equity Current year Plan years 20X1 20X2 20X3 20X4 20X5 Contingency years 20X6 20X7

$ 40

$8

$—

$ 292

292 328 368 416 472

45 50 60 70 75

9 10 12 14 15

— — — — 50

328 368 416 472 582

582 646

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80 16 85 17 Debt Beginning Balance Repayments

— — New Funds

646 714 Ending Balance

$ 100 46 146

$ 10 2 12

$— — —

$ 90 44 134

90 44

10 2

8 —

88 42

134

12

8

130

L ONG- T ERM F UND A LLOCATION

20X7

Ending Balance

$ 260

Long-term debt Current year—estimate Term loan Mortgage bonds—present Plan years 20X1 Term loan Mortgage bond—present E XHIBIT 33.7

AND

Year-end Percentage of Capitalization 68.5% 72.0 72.0 72.0 76.0 81.0 80.0 83.0

31.5

28.0

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33.15 Long-Term Equity Planning

Beginning Debt Balance Repayments

New Funds

701

Year-end Ending Percentage of Balance Capitalization

20X2 Term loan Mortgage bond—present Mortgage bond—new

88 42 —

10 2 —

— 28

78 40 28

130

12

28

146

78 40 28

10 2

— — 31

68 38 59

146

12

31

165

68 38 59

68 2 —

58

— 36 117

165

70

58

153

36 117

13 2

— —

23 115

153

15

23 115

13 10

28.0

20X3 Term loan Mortgage bond—present Mortgage bond—new

28.0

20X4 Term loan Mortgage bond—present Mortgage bond—new

20X5 Mortgage bond—present Mortgage bond—new

138

24.0

19.0

Contingency Years 20X6 Mortgage bond—present Mortgage bond—new Debenture—new

— —

10

50

105 50

$50

165

138

23

10 105

10 10

— 95

50

—

50

$165

$20

$145

20.0

20X7 Mortgage bond—present Mortgage bond—new Debenture

17.0

Note: The sum of the equity capitalization share at year end and that of long-term debt equals 100%.

E XHIBIT 33.7

L ONG- T ERM F UND A LLOCATION (C ONTINUED )

The management and board of directors feel comfortable with the increased equity base both in the event of a downturn in business for a limited period, or should it need to borrow additional funds. The summary of the planned debt reduction, new indebtedness to be incurred, shareholders’ equity, and capitalization percentages is given in Exhibit 33.8. These planned capitalization changes also will be reﬂected in the statements of planned ﬁnancial position for the years ended December 31, 20X1 through 20X5. (b) OTHER SUGGESTIONS IN MANAGING THE CAPITAL STRUCTURE. Section 33.15 provides guidance in allocating required funds annually between debt and equity. The disposition depends on the urgency of attaining a given preferred capital structure, or meeting debt indenture constraints, or other limitations. But managing the capital structure involves more than allocating

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11.5%

Mortgage bond (new)

68.5% 100.0%

— 292 $ 426

Net issue

E XHIBIT 33.8

S UMMARY

OF

P LANNED C HANGES IN

C APITAL S TRUCTURE

Note: (a) To be paid off in 20X6—$13 million; 20X7—$10 million.

Total

Subtotal

—

Dividends

31.5%

{

Percentage

—

292

134

44 — —

$ 90

Amount

Net income

Beginning balance

Shareholders’ Equity

Total

14% 12%

Long-Term Debt Term loan (existing)

Mortgage bon (existing) Mortgage bond (new)

15%

Item

$ 56

— 40 $ 32

(10)

— 36

50

16

( 2) 28

$ (10)

20X2

( 9)

45

( 4)

$ (10) 8 ( 2) — —

20X1

58

$ 67

— 48

(12)

60

$ 44

— 56

(14)

70

(12)

31 19

( 2) —

$ (68)

20X4

( 2) —

$ (10)

20X3

Increase (Decrease)

T HE J OHNSON C OMPANY P LANNED C HANGES IN C APITAL S TRUCTURE P LAN Y EARS 20X1 T HROUGH 20X5 ( DOLLARS IN MILLIONS ) Beginning Balance 1/1/X1

Ch. 33 Management of Shareholders’ Equity

Interest Rate

702

$ 95

50 110

(15)

75

(15)

$(13) ( 2)

20X5

$ 720

582

50

(60)

300

292

138

89

23(a) 26

$—

Amount

$ 100.0%

81.0%

19.0%

—

Percentage

Ending Balance 12/31/X5

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33.15 Long-Term Equity Planning

703

the new capital needs between debt and equity. It also includes watching for signals that funding problems are slowly (or faster) developing, as well as providing safeguards against unwarranted action by the suppliers of funds. A few of the steps that might be taken by ﬁnancial management to avoid being caught off guard could include: • Be sensitive to those product lines which provide the highest return on capital as compared to those that consume or require relatively heavy amounts of capital, and produce a low rate of return. Thus, if a small share of the products requires, say, 70% of the new capital needs, and provides at least 70% of the return on capital, then the situation seems satisfactory. If, however, the products consuming 70% of the capital supply but a small return, then the matter requires careful monitoring. Perhaps a hurdle rate is needed by product line, or geographic area, or other factor. Then, careful estimates of requirements, by year, and expected return, by year, are made. Finally, actual performance then should be monitored to see if the expected increasing yields are forthcoming. Conservatism is required in predicting the capital requirements as well as the yield. • Continuously monitor the equity markets in an effort to judge when new equity should be acquired. There are several stock market indicators to be followed which provide clues on the strength of the market, whether the market is overvalued, and whether new capital stock may be sold without diluting earnings. Included are: The Standard & Poor’s (S&P) 500 price earnings ratio, as well as the price/earnings ratio

of the company stock. The S&P 500 dividend yield and the yield of the company security. Price-to-book ratio. Typically the price of a stock is considerably higher than its book

value. One major reason is inﬂation, since book value understates the replacement cost of the underlying assets. Since about 1950, the S&P Industrials index has moved in a wide band deﬁned in market bottoms as one times book value, and 2.5 times book value near market tops. So, this ratio may be a signal as to whether the market is overvalued. This price-to-book measure sometimes is less signiﬁcant than others due to the inﬂuence of large stock buy-back programs, corporate restructuring, or merger frenzy. The market breadth. Changes in the Dow Jones average versus the S&P 500 or the Nasdaq index. The relative trading volume. A high volume of, say, more than 200 million shares traded is said to be the sign of a strong market. Such factors, as well as the advice of investment bankers, may aid management in deciding on the approximate timing of a new stock issue. • Be careful in the search for the lowest cost sources of capital. Not only must the cost be competitive, but the method and terms should be acceptable. Thus, in a private placement, perhaps the provisions should include a buy-back option to avoid the creation of a major voting block. Or maybe the acquisition of a cash-heavy source (existing cash balances and high cash ﬂow) may be feasible. • Periodically check the cost of carrying current assets versus the return. Must a switch be made from asset intensive activities to low-cost service type business? • Analyze existing investment in assets for sales candidates or improved utilization possibilities. Strategic planning implies more than calculating the changes in each asset category each year, based on expected operations and existing turnover rates. It requires an analysis of turn-

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Ch. 33 Management of Shareholders’ Equity

over to see where improvements can be made (e.g., use of just-in-time [JIT] inventory methods) or idle assets, such as land which may be sold. • Relate predictable seasonal asset investment patterns, or cyclical ones, to incentives so as to reduce capital requirements. Customers can be given special terms for early orders or early payment. Or, if an economic upturn is anticipated, this knowledge can be used to an advantage in inducing earlier-than-usual orders. Proper strategic planning should look beyond operational expectations to wise asset usage (and prudent use of supplier credits).

33.16 SHORT-TERM PLAN FOR SHAREHOLDERS’ EQUITY In terms of management of shareholders’ equity, the emphasis should be on planning—especially long-term planning so as to achieve the proper capital structure and use it as the basis for prudent borrowing. Additionally, the many other aspects already discussed need to be reviewed, and policies and practices developed or continued that will enhance the shareholders’ value. Having said this, the annual business plan for the next year or two should reﬂect all anticipated near-term actions that impinge on the equity section or on the ﬁnancial statements. When completed, that section of the plan relating to shareholders’ equity may be summarized as in Exhibit 33.9.

33.17 OTHER CONSIDERATIONS (a) DIVIDEND REINVESTMENT PROGRAMS. A supplementary facet of dividend policy is the question of offering a dividend reinvestment plan to investors. Under such a plan, shareholders may invest their cash dividends in the common stock of the company—sometimes at market price, usually with no brokerage fee, and sometimes at a discount, that is, 5% of the market price. Many dividend investment marketing plans utilize shares purchased in the open market. Others permit the issue of original shares directly by the company. Dividend investment plans have now been expanded to permit the purchase of additional shares over and above the dividend amount with cash payments—sometimes with a ceiling on such quarterly or annual purchases, say, of $5 million. Also, some companies permit the preferred shareholders or bond holders to purchase common shares with the quarterly or semiannual dividend or interest payments. Financial ofﬁcers should consider such a practice. The costs of operating the program versus the probable level of participation (based on industry experience, etc.) should be weighed. Trustees who handle such plans for other corporations, competitors or otherwise, may be helpful sources of information. (b) STOCK DIVIDENDS AND STOCK SPLITS. This chapter is not intended to be a treatise on the types of stocks that may be issued or their advantages or disadvantages, and the many related subjects. However, the controller should be aware of the accounting treatment of stock dividends as well as stock splits and the arguments for and against the issuance of such designated shares. Basically, the New York Stock Exchange has ruled that the issuance of 25% or less of stock is a stock dividend and that the issuance of more than 25% is a stock split. Both are essentially paper transactions that do not change the total equity of the company but do increase the number of pieces or shares. However, depending on state law, the accounting treatment may differ. Thus a stock split may not change retained earnings; only the par or stated value is changed. A stock dividend may cause the paid-in-capital accounts and retained earnings to be modiﬁed (but not the total equity). The controller should be aware of the pros and cons, the expense involved, and the procedure for issuance of dividends, or splits, or reverse splits.

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$ 32,400

$ 158,500

November

OF

$ 6,480

1,520

1,620

1,620

$ 1,720

Dividend Payments

E XHIBIT 33.9

B UDGET

FOR

S HAREHOLDERS ’ E QUITY

$ 5,200

1,000

1,000

1,200

$ 1,000 1,000

Purchase of Treasury Shares (a)

$ 380

100

100

100

$ 80

Estimated Dividend Reinvestments

T HE J ONES C OMPANY P LANNED C HANGES IN S HAREHOLDERS ’ E QUITY F OR THE P LAN Y EAR 20XX ( DOLLARS IN THOUSANDS )

Note: (a) Board to be asked to authorize 130,000 shares at average price of $40 per share.

Total

December

2,710 2,800

177,010 180,420

January February March April May June July August September October

$ 2,650 2,410 2,790 2,840 2,620 2,530 2,600 2,860 2,820 2,770

$ 158,500 160,150 162,060 163,210 166,050 167,970 168,980 170,580 173,940 175,240

Month

Estimated Net Income

Beginning Balance

S TATEMENT

33.17

705

$ 181,800

180,420 181,800

$ 160,150 162,060 163,210 166,050 167,970 168,980 170,580 173,940 175,240 177,010

Ending Balance

Other Considerations

$ 2,200

700

500

500

$ 500

Estimated Options Exercised

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Ch. 33 Management of Shareholders’ Equity

(c) REPURCHASE OF COMMON SHARES. Another subject to be considered by the ﬁnancial management is the repurchase of common shares. Conceptually, a company is enfranchised to invest capital in the production of goods or services. Hence it should not knowingly invest in projects that will not provide a sufﬁciently high rate of return to adequately compensate the investors for the risk assumed. In other words, the enterprise should not invest simply because funds or capital are available. Business management should identify sufﬁciently proﬁtable projects that are consistent with corporate strategy, determine the capital required, and make the investment. Hence shareholders might interpret the purchase of common stock as the lack of available investment opportunities. To some, the purchase of company stock is not an “investment” but a return of capital. It is “disﬁnancing.” Some legitimate reasons for the purchase of common stock are: • Shares may be needed for stock options or employee stock purchase plans, but the management does not wish to increase the total shares outstanding. • Shares are required in the exercise of outstanding warrants or for the conversion of outstanding convertibles, without issuing “new” shares. • Shares are needed for a corporate acquisition. Some guidelines to be heeded in considering a decision to repurchase shares are: • If a company is excessively leveraged, it might do well to use cash to pay down existing long-term debt to reach the capital structure goal it envisages and not repurchase common shares. • The management should examine its cash requirements for a reasonable time into the future, including ﬁxed asset requirements, project ﬁnancing (working capital) needs, and other investment options, before it concludes that excess cash is available and that the equity capital genuinely is in excess of the apparent long-term demands. • The cash dividend policy should be examined to see that it helps increase the market price of the stock. • Only after such a review, should the conclusion be reached to dispose of “excess equity” through the purchase of the company stock. Given these conditions, timing may be important. Thus, if the market price of the stock is below book value, the purchase of shares in fact increases the book value of the remaining shares. It might be prudent to purchase shares below book value rather than at a price that dilutes the shareholders’ equity. (d) CAPITAL STOCK RECORDS. An administrative concern in the management of shareholders’ equity relates to the maintenance of necessary capital stock records. In the larger companies, the stock ledgers and transfer records are kept by the transfer agent. The information relative to payment of dividends on outstanding shares, for example, is secured from this source. Quite often, the database is contained on computer ﬁles, and any number of sortings can produce relevant data regarding ownership: • Geographic dispersion • Nature of owners (individual, institution, etc.) • History and timing of purchases • Market price activity • Volume of sales and the like Under these circumstances, a ledger control account for each class of stock is all that is maintained by the company. If a corporation conducts its own transfer department, then a separate account must be maintained for each stockholder regarding each class of stock. An illustrative simple form is shown in Exhibit 33.10. The ledger might contain:

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33.17 Other Considerations

707

• Name and address of holder with provision for address change • Date of changes in holdings • Certiﬁcate numbers issued and surrendered • Number of shares in each transaction • Total number of shares held Name and Address John C. Doe 4161 Maxwell St. Toledo, Ohio 43612 Common Old Balance

Date

Page

100 150

Dec. 12, 20XX Jan. 16, 20X1 Nov. 17, 20X1

20 31 110

E XHIBIT 33.10

Certiﬁcate No. Dr. Cr.

No. of Shares Dr. Cr.

C 122 C 196 C 321

100 50 100

New Balance 100 150 50

C APITAL S TOCK L EDGER S HEET

Optional information might include a record of dividend payments and the data mentioned above for the computer ﬁles. The stock ledgers should be supported by registration and transfer records that give the details of each transaction. Transfer journals are not required in all states. In circumstances that justify it economically, computer applications may be desirable. Finally, of course, sufﬁcient records must be maintained to satisfy the reporting needs of the federal and state government—foreign holdings, large holdings, and so on. The management, of course, has an interest in monitoring, perhaps monthly, large holdings and the changes therein. Such a review may provide signals about possible take-over attempts and the like. For this purpose, as well as soliciting proxies, the services of outside consultants, such as Georgeson & Co., that specialize in such matters, may be used.

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PART

FINANCIAL AND RELATED REPORTS

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CHAPTER

34

INTERNAL MANAGEMENT REPORTS 34.1

INTRODUCTION 711

34.6

CAPACITY REPORTS 728

34.2

RULES OF REPORTING 711

34.7

SALES AND EXPENSE REPORTS 730

34.3

STATUS REPORTS 714

34.8

PAYROLL REPORTS 730

34.4

MARGIN REPORTS 714

34.9

GRAPHICAL REPORT LAYOUTS 737

34.5

CASH REPORTS 719

34.1 INTRODUCTION Much of the accountant’s work must be translated into a report format that is readily understandable to the layman. Some of these reports are the ﬁnancial statements, the rules for which are laid down in many other chapters of this book in accordance with GAAP. However, there are no rules for internal management reports. The accountant can use any format that results in the greatest comprehension of accounting information. In this chapter, we focus on speciﬁc examples of internal reports that can be adapted to fulﬁll this comprehension requirement.

34.2 RULES OF REPORTING When preparing reports for internal consumption, the controller should observe several general principles. By following them, the controller will produce reports that are timely and relevant, addressing the immediate and most pressing needs of the management team. The following rules are clustered into several main categories. The ﬁrst one involves giving management only the exact information it needs, for an excessive amount of irrelevant information clutters a report and can very effectively hide the data that management needs the most. The rules in this ﬁrst category are: • Report only by exception. Report on out-of-the-ordinary revenues and expenses. Due to the large amount of activity in any single function, the responsible manager does not have the time to follow up on every detail. Instead, the manager wants to avoid wasting time looking at areas that are proceeding according to plan and review only information about those that are not. For example, a report may show only items that vary from the budget by more than 10 percent. • Report only by responsibility area. A reader only wants to see information that is of direct concern to him or her. This means that the controller must subdivide information so that reports show only revenues, margins, costs, and other information for each person’s area of responsibility. This greatly focuses the reader on only what is of most importance. A responsibility area, or center, may be of three types. First, a responsibility center may be a cost center if the supervisor is held responsible for costs only (i.e., the expenses of the department or the direct material or direct labor costs incurred). Second, a responsibility center may broaden into a proﬁt center if the supervisor is held accountable for a stipulated proﬁt contribution. Thus, a given sales ofﬁce, subsidiary, or division might be a proﬁt center. Finally, if a manager is held responsible not only for proﬁt results but also for the investment required to produce the margin or proﬁt, then the responsibility center is an investment center. 711

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Ch. 34 Internal Management Reports

• Report only when needed. Even if the accounting staff is reporting the correct information, it may still be overwhelming the recipient because it is issuing reports too frequently. For example, many senior executives only want to see information once a month or quarter, whereas forepersons may need reports every day. Report frequency is just as important as report content. • Reduce the level of detail for higher levels of management. It is perhaps obvious that the kind of information needed by a salesperson differs from that furnished to the sales manager. With a broad area of responsibility, the sales manager cannot look at every detail on each territory. This issue is even more critical for the highest levels of management, where there are so many functional areas reporting in that managers would be completely swamped with information if they were presented with all the detailed information used by the lowest-level employees. If a top-level manager spots a problem on a summary report, it is an easy matter to then request additional information in order to spot the nature of the problem. Thus, presenting increasingly summarized information to higher levels of management is vital to the ability of those management layers to make key decisions. • Keep reports simple and clear. A report should have a clean and simple layout so that a reader does not have to call the accounting department to ask for an explanation. A report should not contain any technical language that a reader cannot easily understand. If technical language or obscure acronyms are unavoidable, note explanations at the bottom of the report. The next main category is that a report must give readers a comparison against which to judge the information presented, so that they will know if the information they are reviewing varies signiﬁcantly from expectations. The rules in this category are: • Provide comparative information. Actual performance information alone is usually of little signiﬁcance. For someone to know if there is a problem, the actual information must be compared to a budget, standard, or past performance number. • Show trends. If there is no comparative information available to use as a baseline, the controller can create reports that show trends in the data over time. This type of information is best shown graphically, because most people understand this type of presentation better than a straight numerical report layout. Another option is to show the trend in comparison to a related ﬁgure. For example, a graph showing an increasing trend in warehouse costs becomes much more informative when presented next to a trend line showing a decrease in the number of transactions handled by the warehouse; this format immediately tells management that there is a problem requiring correction. • Include commentary. Sometimes, even with comparative information or trend lines, the importance of information is not immediately obvious. The controller can avoid this problem by including a brief paragraph at the beginning of a report, or perhaps an executive summary, that clearly points out the primary areas that the reader should review. It is also important to ﬁne-tune reports to the audience. The following rules note that timeliness, commentary, and other factors are important for making reports understandable and usable. • Alter the form of presentation to match the reader’s needs. The controller will ﬁnd that different departments or individuals within departments want to see information presented in different ways. If it does not appear in the format they understand, they may not read it, and almost certainly will not fully understand it. For example, information sent to the shop ﬂoor should be posted on a white board where everyone can read it, because this is the way most information is presented to that group of employees, and they are accordingly used to reading it in that manner. Alternatively, the sales staff may not be in-house very frequently, and so reports must be e-mailed to them. Alternatively, speciﬁc managers may prefer exception reporting, whereas others prefer a complete listing of information. It is the controller’s responsibility to determine the needed formats and to provide them.

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34.2 Rules of Reporting

713

• Standardize reports. Despite the previous discussion regarding altering report formats to match the reader, it is also necessary to standardize reports. This does not conﬂict with the previous rule, because the emphasis here is on consistently delivering the same product, not on issuing a single version of a report. Standardization means that the controller must determine the correct report format for the recipient, and then stick to it. Continual modiﬁcations in the format will only confuse the reader, even if the controller thinks that the modiﬁcations are improvements. Instead, it is best to freeze a report format for a reasonable interval, perhaps a year, and then go over the format with the recipient to determine any changes. Consistency is crucial to a reader’s understanding. Finally, there are several rules that fall under no general category. These are related to the timeliness, accuracy, cost, and usefulness of reports. • Issue reports in a timely manner. Information is not of much use if it is delivered so late that the condition being reported on has already been corrected or has since become signiﬁcantly worse; an employee wants to see information that gives an early indication of trouble, so that corrective action can be taken immediately. For example, a just-in-time (JIT) manufacturing process will spot incorrectly manufactured parts in moments, so that information must be forthcoming on the spot (in fact, most JIT systems move so fast that the accounting staff cannot give them any reports; problems are ﬁxed before the reports can be issued). However, a report showing employee performance review dates may have to come out only quarterly, since the information is not expected to change much in the interim. • Issue accurate reports. The controller must be absolutely certain that the information presented is sufﬁciently accurate to satisfy the purpose of each report. Errors on reports result in a lack of conﬁdence in them and in the accounting department. This may call for a personal review of each report by the controller before it is released, or perhaps some “bombprooﬁng” of each report, so that it is extremely difﬁcult to release inaccurate information. Reports going to top executives should be double-checked, because important policy decisions may be made on the basis of information contained therein. • Ensure that reports are useful. A report may have been useful when it was ﬁrst created, but old reports have a habit of staying the same while operating conditions change, turning them into a waste of paper. To avoid this problem, the controller should periodically review reports with their recipients to ensure that the information and layout are still acceptable. • Verify that reports are cost effective. Some reports are a natural spin-off of accounting operations and require almost no effort to prepare. Others, especially those requiring information that the computer system is not designed to store and disseminate, may require startling amounts of effort to create. When the cost of a report appears to be excessive, the controller should review the situation with the person requesting the report to determine whether the expense is worth the beneﬁt of having the report. Many people asking for special reports have no idea of the effort involved and may cancel their requests once they are provided with this information. Also, expensive reports may be needed only a few times; if so, the controller should periodically check on the most expensive reports to determine how soon they can be terminated. Although there appear to be an excessively large number of rules to follow when creating reports, a controller does not have to consider them every time a report is issued. Instead, it is necessary to review them only when periodically revising or creating a report. Once a report has been set up or revised, the controller has to monitor only its accuracy and timeliness. Also, reports do not last forever, so the controller should set up a calendar that lists a periodic review date for each report. When a review date comes up, the controller can discuss the report with the recipient to determine whether it is still necessary, or if it should be modiﬁed. By following these rules and review dates, a controller can continue to issue a consistently useful set of reports to employees.

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714

Ch. 34 Internal Management Reports

34.3 STATUS REPORTS * Though the ﬁnancial statements are the primary reporting product of the accountant, they are issued only (at most) once a month, which is too long for many managers to go without information about ongoing company performance. Also, much of the ﬁnancial information contained within a ﬁnancial statement is of no use to the typical manager, who is more concerned with operational data. A good alternative to the ﬁnancial statement, both in terms of the frequency of reporting and information presented, is shown in Exhibit 34.1. This exhibit divides key measurements into three ﬁnancial areas and three operational areas. The CFO and treasurer are most concerned with the ﬁrst two blocks of measurements, which describe ﬁve separate components of company cash ﬂow. The third block notes ﬁnancial performance information, while the remaining three blocks of measurements are speciﬁcally tailored to the needs of the managers of the sales, production, and warehouse departments. Another status report is the daily ﬁnancial statement, which can be issued on paper or converted to HTML format and posted to a company’s intranet site for general perusal. The example shown in Exhibit 34.2 contains all of the basic ﬁnancial statement line items. The main difference is that it contains several extra columns that a reader can use to determine the status of the company in reaching its goals. For example, the two columns furthest to the right itemize the actual year-todate results through the preceding month, which are then divided by the total number of months in the year thus far to arrive at the average value per month for each line item. This is a useful comparison to the budgeted amount for the current month, which is located in the third column. Yet another source of information is the forecasted result for the month (in the second column), which is the accountant’s up-to-the-minute estimate of expected results for the current month. Finally, the ﬁrst column contains the most recent actual results for the current month, which contains the least complete information until the month is nearly ﬁnished. By using four different estimates of ﬁnancial results for the current month, the reader can draw his or her own conclusions regarding its most likely outcome. In addition to the monthly information presented in the report in Exhibit 34.2, the information in its ﬁrst few rows details some key accounting measures, such as the volume of invoicing and the cash and accounts receivable balances. Other measures, such as the total backlog, or the dollar volume of orders completed for the month, can also be added here.

34.4 MARGIN REPORTS The status reports just described provide a high level of information to the reader. For a more detailed examination of operating results, it is useful to generate several types of margin reports. One option is noted in Exhibit 34.3, which reveals the gross margin of a series of company products, using their standard costs. This reporting format reveals the gross margin for the sales volumes generated for the year-to-date or month for the listed products. The use of standard costs will reveal accurate margin information, as long as the standard costs are routinely compared to actual costs and adjusted to yield a close approximation to them. By using standards, many computer systems can automatically access all of the listed information and create the report with no human intervention.

*. Reprinted with permission from Chapter 11 of Steven M. Bragg, Accounting Reference Desktop (Wiley, Hoboken, NJ: 2002).

Black process 45.0° 133.0 LPI

Black process 45.0° 133.0 LPI

Available Debt (000s) Overdue Accounts Receivable (000s) Overdue Accounts Payable (000s)

K EY C OMPANY M EASUREMENTS

Backlog for Next Month Backlog for Month After Next Backlog for Two Months After Next Backlog, Total (000s)

E XHIBIT 34.1

Sales

Break-Even, 2 Mo. Rolling (000s) Net Proﬁts Before Tax (000s)

Financial

Days Accounts Receivable Days Total Inventory

Working Capital

Cash

$1,419 $459 $14 $1,892

— —

48 52

$1,350 $257 $129

Week 5

$1,450 $403 $0 $1,853

— —

46 60

$1,300 $215 $153

Week 4

$1,479 $419 $0 $1,898

— —

42 54

$1,150 $289 $114

Week 3

Current Month

K EY C OMPANY M EASUREMENTS

$1,520 $425 $0 $1,945

— —

44 52

$1,250 $305 $105

Week 2

$1,724 $461 $9 $2,194

— —

46 49

$1,500 $388 $114

Week 1

$1,922 $652 $296 $2,870

$1,430 $30

43 61

$1,400 $315 $276

Apr.

34.4

715

$1,651 $491 $358 $2,500

$1,450 ($60)

51 46

$1,200 $269 $401

Feb.

Margin Reports

$1,708 $505 $202 $2,415

$1,440 ($33)

41 52

$1,300 $312 $312

Mar.

34_controllership.fm Page 715 Monday, December 8, 2003 5:04 PM

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Ch. 34 Internal Management Reports

E XHIBIT 34.1

$2,534 $482 $530 $1,522 70%

74% 82% 2% —

Week 5

K EY C OMPANY M EASUREMENTS (C ONTINUED )

$$$ of Total Inventory (000s) $$$ of Finished Goods (000s) $$$ of Work-in-Process (000s) $$$ of Raw Materials (000s) Inventory Accuracy

Warehouse

Machine Utilization % Order Line Items Shipped on Time % Actual Labor Hrs over Standard Scrap Dollars (000s)

Production

716

$2,605 $505 $517 $1,583 66%

79% 86% 14% —

Week 4

$2,658 $510 $529 $1,619 65%

75% 85% 23% —

Week 3

Current Month

K EY C OMPANY M EASUREMENTS

$2,791 $525 $566 $1,700 62%

82% 80% 9% —

Week 2

$2,604 $536 $566 $1,502 56%

80% 83% 17% —

Week 1

$2,644 $496 $680 $1,468 68%

70% 79% 23% $46

Apr.

$2,352 $454 $555 $1,343 80%

67% 73% 40% $51

Mar.

$2,273 $668 $362 $1,243 71%

66% 64% 25% $54

Feb.

34_controllership.fm Page 716 Monday, December 8, 2003 5:04 PM

Black process 45.0° 133.0 LPI

254,900

Sales, Expected this Month

Total Projected Sales

E XHIBIT 34.2

D AILY F LASH R EPORT

Interest expense

Insurance

Dues & Publications

—

354

Copiers

—

6,869

100

7,223

200

Bank charges

Depreciation

1,000

7,223

90%

100%

Advertising

Expenses:

Gross Proﬁt %

Gross Proﬁt

10,661 230,392

Commissions 254,900

13,846

Cost of Sales

254,900

— —

Sales, Month-to-Date

62,203

161,311

192,697

— —

926,547

Accounts Receivable

—

New Business Invoiced

This Month’s Forecast

—

6,925

400

7,875

700

185

2,500

90%

245,006

19,678

6,770

271,454

—

—

—

—

This Month’s Budget

D AILY F LASH R EPORT

Cash

9,424

This Month’s Invoicing

Month-to-Date Actual Results

—

6,925

400

652

700

185

2,500

—

9,894

19,678

6,770

(16,554)

—

—

—

—

Variance from Budget

34.4

717

1,104

6,869

115

6,248

617

242

121

90%

181,821

8,414

10,927

201,162

—

—

—

—

Average for Prior Months

Margin Reports

4,416

27,477

459

24,992

2,468

968

485

90%

727,283

33,655

43,709

804,647

—

—

—

—

Year-to-Date for Prior Months

34_controllership.fm Page 717 Monday, December 8, 2003 5:04 PM

Black process 45.0° 133.0 LPI

581

Proﬁt (Loss)

E XHIBIT 34.2

D AILY F LASH R EPORT (C ONTINUED )

5,000 4,500 194,602 $ 35,790

41 3,970 29,866 $ 225,034

Travel

Other expenses

1,000

500

2,350

4,000

350

120,000

6,000

10,788

2,000

550

Trade shows

Training

1,129

Supplies

10,788

Telephone

Soza/GSA commissions

Salaries

Reserve for cancel. Subscr.

Rent

Recruiting

Postage/Deliveries 1,094

1,055 10,500

Outside services

Payroll taxes

1,150

Meals & Entertainment

50

4,563

This Month’s Forecast

$ 20,994

224,012

2,265

6,000

—

1,250

2,800

2,500

—

150,773

2,032

10,788

5,000

750

13,119

2,500

1,500

2,500

150

1,500

This Month’s Budget

D AILY F LASH R EPORT

4,500

477

4,563

Month-to-Date Actual Results

Marketing

Licenses & Fees

Legal & Accounting

Ch. 34 Internal Management Reports

Total Expenses

718

$ 204,040

194,146

(1,705)

5,959

—

1,250

2,219

1,371

—

150,773

2,032

—

3,906

750

13,119

2,023

1,500

2,500

150

(3,063)

Variance from Budget

$ 16,586

710,697

13,120

18,379

3,990

5,400

7,257

39,229

1,975

422,280

21,527

43,151

8,469

2,202

39,949

4,221

4,598

360

150

13,175

Year-to-Date for Prior Months

$ 4,147

177,674

3,280

4,595

998

1,350

1,814

9,807

494

105,570

5,382

10,788

2,117

551

9,987

1,055

1,150

90

38

3,294

Average for Prior Months

34_controllership.fm Page 718 Monday, December 8, 2003 5:04 PM

34_controllership.fm Page 719 Monday, December 8, 2003 5:04 PM

34.5 Cash Reports

719

Margins also can be presented by customer, as shown in Exhibit 34.4. This format is about the same as the one shown in Exhibit 34.3, but is summarized by customer. Many accounting systems that are integrated with the production system can automatically provide this information, too. Note, however, that this report does not contain any of the additional sales, packaging, shipping, and customer service costs that are needed to maintain proper relations with customers. These added costs are not normally accessible through a standard costing system, and must be separately derived through an activity-based costing system and then manually added to this report format. A more complex margin analysis is shown in Exhibit 34.5. This format divides the margins of all customers into high or low margin, with an arbitrary cutoff between the two of 30 percent. It also splits customers into high- or low-revenue volume, with an arbitrary cutoff at $100,000 per year. The exact cutoff will vary greatly by company, with the intention being to give management a good feel for which customers provide a combination of the highest margins and volumes (located in the upper-right corner) and which are the least proﬁtable ones (in the lower-left corner). Also, all of the customers shown in the high-volume categories on the right side of the exhibit have their individual margin percentages listed next to them, for easy reference. Each of the four segments also contains a small block of information that lists the number of customers located within it, the total proportion and dollar amount of sales that they represent, and their combined gross margin. Though this is a labor-intensive report to create, it presents a great deal of information to management regarding which customers to cultivate, which ones to drop, which ones require a price increase, and which ones require additional sales efforts. Many managers do not know the sales level at which their companies will reach a proﬁtability break-even point. This point will vary somewhat every month, as margins and ﬁxed costs change. The report shown in Exhibit 34.6 can keep this information squarely in front of managers by itemizing the current gross margin level (second column) and the current level of ﬁxed costs (fourth column) to arrive at an expected level of loss or proﬁt, depending upon the exact revenue level reached. In the example, a wide array of revenue levels are itemized in $50,000 increments, which happens to be useful for the small business for which this analysis was constructed. Businesses of other sizes would use revenue ranges that more appropriately ﬁt their high-low range of possible revenue levels.

34.5 CASH REPORTS One can determine the accuracy level of a cash forecast on a weekly basis in order to see if the assumptions or data used in the forecast must be changed to make it more accurate. An example of this reporting format is shown in Exhibit 34.7. This report lists the actual cash balance at the end of each week for the last few months, showing alongside each item the cash forecast that had been made one month prior to each actual cash balance. The dollar and percentage amount of each variance are then listed, as well as an explanation of any especially large variances. This can be a most instructive exercise, as the accountant will initially ﬁnd signiﬁcant variances between forecasted and actual cash balances; continual examination of the underlying problems that caused the variances is needed in order to eventually arrive at a more accurate cash forecasting system. The most likely source of large changes in cash requirements tends to come from working capital, simply because of the large investment that is typically required in this area. To see how the main categories of working capital will vary over time, one can set up a combination of numerical and graphical information, as shown in Exhibit 34.8, that not only shows monthly totals for accounts receivable, accounts payable, and inventory, but also the trend line for working capital levels. This is a most useful tool for determining the existence of any problems related to a company’s investment in working capital.

Black process 45.0° 133.0 LPI

Black process 45.0° 133.0 LPI

5,000

1,150

332,640

20,000

1,741

1,710

7,000

96

5,000

65,000

643

3,016

3,500

Qty Sold

BY

OF

88

460

365

44,906

2,000

378

13,595

525

144

580

9,165

10,057

2,413

0.033

0.104

0.067

0.040

0.093

4.304

0.023

1.032

0.066

0.110

14.364

0.930

0.002

Unit Cost Material

G OODS S OLD S ORTED

Total Revenue

P RODUCT

0.092

0.317

0.135

0.1

0.217

7.95

0.075

1.5

0.116

0.141

15.64

0.8

0.025

Unit Price

S TANDARD C OST

G OODS S OLD R EPORT

14026.1 OF

Remote control case

Medicine spoon

14037.01

S TANDARD C OST

Food storage tray

12006

E XHIBIT 34.3

Ruler, 6"

Baby potty

12320.001

Terminal block

Key pad

14003.201

14003.352

Pail, 5 gallon

11706

14039.02

Baby bath

Magnet cover

Cradle rocker

12350.001

14003.501

Bolster arm cover

12231

12200.7

Light diffuser

14003.221

Item Description

Ch. 34 Internal Management Reports

Item No.

720

M ARGIN %

0.015

0.061

0.015

0.026

0.054

1.357

0.032

0.109

0.027

0.024

1.077

—

0.032

Unit Cost Labor

BY

166

120

22,230

795

162

7,360

158

99

329

7,119

9,236

2,805

9

Total Cost Material

72

70

5,064

522

95

2,321

225

10

136

1,555

692

—

113

Total Cost Labor

48.1%

47.9%

39.2%

34.1%

32.1%

28.8%

26.9%

24.0%

19.8%

5.4%

1.3%

–16.3%

–38.5%

Margin

221

175

17,612

683

121

3,914

141

34

115

491

128

–392

–34

Total Margin $

34_controllership.fm Page 720 Monday, December 8, 2003 5:04 PM

Black process 45.0° 133.0 LPI

Coin holder

Gasket, 35mm

LCD support bracket

S TANDARD C OST

14025.02

14003.28

14003.77

E XHIBIT 34.3 OF

Retaining strip

14010.096

Light pipe

14003.76

Water bottle cap

Battery case

14001.03

Gasket, 23mm

Battery holder

14003.64

14025.046

Key case

14052.01

Water bottle

14026.07

Item Description

14052.021

Item No.

BY

0.023

5,124 $ 1,763,913

0.006

0.041

0.054

0.017

0.024

0.015

0.722

0.018

0.014

0.034

Unit Cost Material

225

7,011

1,236

19

2,046

3,045

8,679

308

4,704

2,100

Total Revenue

P RODUCT (C ONTINUED )

0.244

0.09

0.271

0.412

0.179

0.093

0.145

2.009

0.123

0.084

0.105

Unit Price

G OODS S OLD R EPORT

21,000

2,500

25,872

3,000

106

22,000

21,000

4,320

2,500

56,000

20,000

Qty Sold

0.025

0.017

0.031

0.057

0.044

0.008

0.037

0.106

0.039

0.027

0.017

Unit Cost Labor

$ 861,868

481

16

1,063

161

2

529

316

3,120

44

790

684

Total Cost Material

$ 231,180

525

44

788

170

5

179

776

457

98

1,492

337

Total Cost Labor

34.5

721

$ 670,866

4,118

166

5,161

905

13

1,337

1,953

5,103

165

2,422

1,079

Total Margin $

Cash Reports

$ 38.0%

80.4%

73.6%

73.6%

73.3%

66.0%

65.4%

64.1%

58.8%

53.7%

51.5%

51.4%

Margin

34_controllership.fm Page 721 Monday, December 8, 2003 5:04 PM

Black process 45.0° 133.0 LPI

Bolster arm cover

Cradle rocker

Baby bath

Mophead

Magnet cover

Pail, 5 gallon

Key pad

Baby potty

Ski tip

Daiper pail

Ruler, 6"

Terminal block

Ski tail

Food storage tray

Remote control case

12231

12350

12201

13250

14004

11706

14003

12320

13222

12300

14039

14003

13207

12006

14037 OF

BY

6.019

0.500

6.396

0.800

3.970

13.870

25.670

0.250

0.230

0.141

43.600

56.680

0.250

0.350

25.070

24.830

Unit Price

3.6483

0.0671

3.4643

0.9300

3.9700

7.8078

11.8078

0.0505

0.0424

0.1095

27.5402

33.2162

0.0113

0.0255

18.1019

18.1537

Std Material Cost

S TANDARD M ARGIN

C USTOMER

127,737

10

84,090

3,016

3,016

1,022

3,146

53,500

45,000

320,869

17,800

378

25

20

4,327

2,762

YTD Units

G OODS S OLD R EPORT

Backman Services

Backman Services

Backman Services

Backman Services

Backman Services

Backman Services

Anterior Designs

Anterior Designs

Anterior Designs

Anterior Designs

Exceptional Child Inc.

Exceptional Child Inc.

Exceptional Child Inc.

Exceptional Child Inc.

Exceptional Child Inc.

Exceptional Child Inc.

Customer Name

S TANDARD C OST

Light diffuser

14003

E XHIBIT 34.4

Item Description

Ch. 34 Internal Management Reports

Item No.

722

0.6593

0.0544

0.9171

0.0000

0.0000

0.5974

8.1774

0.0381

0.0283

0.0239

5.7876

5.7876

0.0435

0.0435

2.0184

2.0184

1.687

0.019

1.769

—

—

2.516

2.516

0.057

0.042

0.052

5.012

5.012

0.015

0.015

0.661

3.198

0.328

0.000

0.227

—

—

0.202

0.202

0.000

0.000

0.000

4.162

4.162

0.000

0.000

1.457

1.457

Std Assembly Machine Overhead Cost Cost

C USTOMER R EPORT

Std Labor Cost

BY

768,849

5

537,840

2,413

11,974

14,175

80,758

13,375

10,350

45,243

776,080

21,425

6

7

108,478

68,580

Total Revenue

807,653

1

536,270

2,805

11,974

11,369

71,427

7,769

5,074

59,446

756,524

18,211

2

2

96,225

68,575

Total Expense

(38,804)

4

1,569

(392)

—

2,806

9,331

5,606

5,276

(14,203)

19,556

3,214

4

5

12,253

6

Total Margin

28%

76%

31%

–16%

0%

39%

22%

65%

69%

5%

24%

31%

78%

80%

20%

19%

Direct Std Margin

–5%

72%

0%

–16%

0%

20%

12%

42%

51%

–31%

3%

15%

72%

76%

11%

0%

Total AllInclusive Margin

34_controllership.fm Page 722 Monday, December 8, 2003 5:04 PM

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BY

7.290 7.950 20.320 6.237 0.200 15.730 8.915 7.976 5.984 1.951 13.748 3.017

Unit Price 4.5440 4.3039 13.9105 2.5694 0.0282 14.3636 6.2670 4.6375 4.4709 0.6697 9.3296 1.5511

Std Material Cost 0.6593 1.3573 2.3731 0.8685 0.0218 1.0766 0.4943 0.9292 0.6200 0.2208 1.5807 0.3698

Std Labor Cost

C USTOMER (C ONTINUED )

7,232 4,050 24,614 43,228 12 3,630 25,500 32,142 42,571 11,881 1 3,026

YTD Units

G OODS S OLD R EPORT

Diversiﬁed Products Diversiﬁed Products Diversiﬁed Products Diversiﬁed Products Diversiﬁed Products Diversiﬁed Products Diversiﬁed Products Automotive Designs Automotive Designs Automotive Designs Automotive Designs Automotive Designs

Medicine spoon Water bottle Key case Battery holder Battery case Light pipe Water bottle cap Gasket, 23mm Retaining strip Coin holder Gasket, 35mm LCD support bracket

S TANDARD C OST

Customer Name

Item Description

E XHIBIT 34.4

Item No. 14026 14052 14026 14004 14001 14004 14052 14025 14010 14025 14003 14004 1.816 5.570 0.947 3.863 0.032 1.650 0.897 2.842 1.768 0.431 0.309 0.525

0.328 0.470 2.429 0.190 0.000 0.583 0.291 0.263 0.381 0.000 0.972 0.000

Std Assembly Machine Overhead Cost Cost

53,138 47,387 483,908 323,832 1 64,152 202,724 278,748 308,191 15,703 12 7,400

Total Expense

(417) (15,188) 16,248 (54,241) 1 (7,052) 24,599 (22,383) (53,438) 7,477 2 1,728

Total Margin

34.5

$ 4,142,090 $ 4,238,522 $ –96,432

52,721 32,199 500,156 269,591 2 57,100 227,322 256,365 254,753 23,180 14 9,128

Total Revenue

723

–2%

–1% –47% 3% –20% 59% –12% 11% –9% –21% 32% 11% 19%

Total AllInclusive Margin

Cash Reports

29% 29% 20% 45% 75% 2% 24% 30% 15% 54% 21% 36%

Direct Std Margin

34_controllership.fm Page 723 Monday, December 8, 2003 5:04 PM

Black process 45.0° 133.0 LPI

Annual Margin = 47% AMG Industries Audabon Park Boulder Technology Brindle Corporation Bucktooth Inc. Bushmaster Weaponry Chemical Devices Corp. Convertible Devices Corp. Dutch-Made Devices Englewood Instruments Great Peaks & Sons On Top Gourmet Foods SMC Corp.

Annual Sales = $531K

Percent of Sales = 5%

No. Customers = 30

Ch. 34 Internal Management Reports

High Margin

724

C USTOMER M ARGIN A NALYSIS Huntington Brickworks No. Customers = 10 Initial Response Units Percent of Sales =42% International Clearance Co. Annual Sales = $4,313K Mann’s Cutlery Material Upgrade Company Annual Margin = 37% Newco Pottery Oliphaunt Fencing Peak Industries Acme Quorum Software Best Western Champion Estes Door Frames Gates and Fencing Int’l Hudson River Upholstery Killer Kitchen Products Monster Equipment Sudden Coffee Venture Home Foods

Annual Dollars $607,600 $134,200 $154,900 $340,400 $129,800 $1,586,200 $964,400 $423,300 $440,100 $139,500 $ 4,312,800

Margin 33% 39% 43% 38% 39% 35% 39% 32% 41% 41%

34_controllership.fm Page 724 Monday, December 8, 2003 5:04 PM

Black process 45.0° 133.0 LPI

C USTOMER M ARGIN A NALYSIS

Low Margin

E XHIBIT 34.5

Annual Sales = $493K

Percent of Sales = 5%

No. Customers = 19

Annual Margin = 11% Aston Davidson Aerospace Backup Services Brush Logic Defensive Innovations Entirely Upscale Renderings Fashionable Furniture Gecko Lawn Furnishings Halston Oil & Gas Immediate Response Co. Jervis Book Binders

30%

Low Revenue

Poly Cracker Bird Supply Primary Rescue Services Rocky Mountain Oil Scott Primary Services Sun Tanning Oil Co. Tofu Deluxe

$100K

Anterior Designs Bombproof Draperies Early Research Corp. Engineered Solutions Highland Scots Kanberra Koala Optimum Energy Terrible Trouble Kid Stores Vertical Drapery Company

Annual Margin = 22%

Annual Sales = $4,871K

Percent of Sales = 48%

No. Customers = 9

34.5

Cash Reports

725

$204,000 $130,900 $925,000 $256,400 $146,500 $1,559,500 $904,500 $548,300 $196,000 $ 4,871,100

29% 14% 24% 25% 26% 19% 22% 16% 24% High Revenue

Annual Dollars

Margin

34_controllership.fm Page 725 Monday, December 8, 2003 5:04 PM

34_controllership.fm Page 726 Monday, December 8, 2003 5:04 PM

726

Ch. 34 Internal Management Reports

B REAK -E VEN A NALYSIS (2 M ONTH A VERAGE ) Revenue

Gross Margin

Fixed Cost

Net Proﬁt (Loss)

950,000

34.0%

323,124

545,000

–221,877

1,000,000

34.0%

340,130

545,000

–204,870

1,050,000

34.0%

357,137

545,000

–187,864

1,100,000

34.0%

374,143

545,000

–170,857

1,150,000

34.0%

391,150

545,000

–153,851

1,200,000

34.0%

408,156

545,000

–136,844

1,250,000

34.0%

425,163

545,000

–119,838

1,300,000

34.0%

442,169

545,000

–102,831

1,350,000

34.0%

459,176

545,000

–85,825

1,400,000

34.0%

476,182

545,000

–68,818

1,450,000

34.0%

493,189

545,000

–51,812

1,500,000

34.0%

510,195

545,000

–34,805

1,550,000

34.0%

527,202

545,000

–17,799

1,600,000

34.0%

544,208

545,000

–792

1,650,000

34.0%

561,215

545,000

16,215

1,700,000

34.0%

578,221

545,000

33,221

1,750,000

34.0%

595,228

545,000

50,228

1,800,000

34.0%

612,234

545,000

67,234

1,850,000

34.0%

629,241

545,000

84,241

1,900,000

34.0%

646,247

545,000

101,247

1,950,000

34.0%

663,254

545,000

118,254

2,000,000

34.0%

680,260

545,000

135,260

2,050,000

34.0%

697,267

545,000

152,267

2,100,000

34.0%

714,273

545,000

169,273

2,150,000

34.0%

731,280

545,000

186,280

2,200,000

34.0%

748,286

545,000

203,286

2,250,000

34.0%

765,293

545,000

220,293

2,300,000

34.0%

782,299

545,000

237,299

2,350,000

34.0%

799,306

545,000

254,306

2,400,000

34.0%

816,312

545,000

271,312

E XHIBIT 34.6

Black process 45.0° 133.0 LPI

Margin

B REAK -E VEN A NALYSIS

34_controllership.fm Page 727 Monday, December 8, 2003 5:04 PM

34.5 Cash Reports

727

C ASH F ORECASTING A CCURACY R EPORT

Week

Actual Cash Balance

Forecast 1 Mo. Ago

7-Jan

2,275

2,075

200

9%

14-Jan

2,150

2,109

41

2%

21-Jan

2,425

2,581

–156

–6%

28-Jan

2,725

2,843

–118

–4%

4-Feb

3,125

3,000

125

4%

11-Feb

3,225

3,305

–80

–2%

18-Feb

3,495

3,450

45

1%

25-Feb

3,445

2,942

503

15%

4-Mar

3,645

3,751

–106

–3%

11-Mar

3,555

3,500

55

2%

18-Mar

3,604

3,209

395

11%

25-Mar

3,704

3,589

115

3%

1-Apr

3,754

3,604

150

4%

8-Apr

3,879

3,802

77

2%

15-Apr

3,939

3,921

18

0%

22-Apr

3,864

3,900

–36

–1%

29-Apr

4,264

3,781

483

11%

6-May

4,464

4,351

113

3%

13-May

4,434

4,031

403

9%

20-May

4,188

4,000

188

4%

27-May

4,339

4,503

–164

–4%

Variance

Percentage Variance

Note: Explanatory Notes Included if Variance Greater than 5%.

E XHIBIT 34.7

Black process 45.0° 133.0 LPI

C ASH F ORECASTING A CCURACY R EPORT

Explanatory Notes DEF customer paid early

ABC customer paid late

Bank error in recording check

Paid for capital expenditures

Customers took 2% early payment discount Customers took 2% early payment discount

34_controllership.fm Page 728 Monday, December 8, 2003 5:04 PM

728

Ch. 34 Internal Management Reports

Accounts Receivable

Total Working Capital

Accounts Payable

Inventory

9/03

2,028,000

9/03

1,839,000

9/03

1,604,000

9/03

2,263,000

10/03

1,663,000

10/03

1,614,000

10/03

1,423,000

10/03

1,854,000

11/03

1,498,000

11/03

1,784,000

11/03

933,000

11/03

2,349,000

12/03

1,664,000

12/03

1,932,000

12/03

942,000

12/03

2,654,000

01/04

2,234,000

01/04

2,007,000

01/04

1,152,000

01/04

3,089,000

02/04

2,450,000

02/04

2,273,000

02/04

1,862,000

02/04

2,861,000

03/04

2,042,000

03/04

2,419,000

03/04

1,671,000

03/04

2,790,000

04/04

3,036,000

04/04

2,715,000

04/04

2,575,000

04/04

3,176,000

05/04

2,998,000

05/04

2,588,000

05/04

2,585,000

05/04

3,001,000

Today

2,875,000

Today

2,976,000

Today

2,606,000

Today

3,245,000

E XHIBIT 34.8

W ORKING C APITAL T REND L INE

34.6 CAPACITY REPORTS The extent to which a company is utilizing its assets tends to be one of the least reported by the accountant, even though it represents one of a company’s core drivers of overall proﬁtability. There may not be any systems in place that track the time during which a machine is being used, but some simpliﬁed measure usually can be derived, even if one must back into the number by calculating backward from production volumes the amount of machine time that must have been used to conduct the required manufacturing operations. The result can be plotted graphically, as shown in Exhibit 34.9. This exhibit shows the percentage of utilization for a series of plastic injection molding machines. The calculation of capacity should include a notation regarding the number of hours per day that are used for the measurement—otherwise, management may feel compelled to purchase more equipment if the calculation is based on an eight-hour shift, rather than a 24-hour day.

Black process 45.0° 133.0 LPI

34_controllership.fm Page 729 Monday, December 8, 2003 5:04 PM

34.6 Capacity Reports

Blow Mold 100% Blow Mold

50% 0%

Feb. Mar. Apr. 5/2– 5/9– 5/16– 5/24– 6/1– 5/8

5/15 5/31 5/31

6/7

55-100 Ton 100% 80% 60% 40% 20% 0%

55-100 Ton

Feb. Mar. Apr. 5/2– 5/9– 5/16– 5/24– 6/1– 5/8

5/15 5/31 5/31

6/7

150-200 Ton 100% 150-200 Ton

50% 0%

Feb. Mar. Apr. 5/2– 5/9– 5/16– 5/24– 6/1– 5/8

5/15 5/31 5/31

6/7

300-400 Ton 100% 300-400 Ton

50% 0%

Feb. Mar. Apr. 5/2– 5/9– 5/16– 5/24– 6/1– 5/8

5/15 5/31 5/31

6/7

450-500 Ton 100% 80% 60% 40% 20% 0%

450-500 Ton

Feb. Mar. Apr. 5/2– 5/9– 5/16– 5/24– 6/1– 5/8

5/15 5/31 5/31

6/7

700-950 Ton 100% 80% 60% 40% 20% 0%

700-950 Ton

Feb. Mar. Apr. 5/2– 5/9– 5/16– 5/24– 6/1– 5/8

5/15 5/31 5/31

6/7

Total 100% Total

50% 0%

Feb. Mar. Apr. 5/2– 5/9– 5/16– 5/24– 6/1– 5/8

E XHIBIT 34.9

Black process 45.0° 133.0 LPI

C APACITY U TILIZATION

BY

5/15 5/31 5/31

M ACHINE

6/7

729

34_controllership.fm Page 730 Monday, December 8, 2003 5:04 PM

730

Ch. 34 Internal Management Reports

The capacity planning report can also be used in the service industry, with the chargeable hours of individual employees or departments being substituted for machines. Another way to present capacity utilization measurements is to focus solely upon the key bottleneck operation that drives the overall level of production of an entire manufacturing line or facility. Since even minor ﬂuctuations in the production level at this point can have a major impact on the volume of units produced, such an analysis should delve into the speciﬁc causes of even the smallest production variances from the maximum theoretical production level, so that they can be addressed and eliminated.

34.7 SALES AND EXPENSE REPORTS When actual sales differ from expectations, the accountant needs a report format that reveals exactly where the variance arose. The format shown in Exhibit 34.10 is a good way to show, customer by customer, the cause of the variance. This report shows both the monthly and year-to-date variance by customer. However, many organizations do not budget their sales by speciﬁc customer, unless there are ongoing orders from each one that are easy to predict. If so, this format can be reduced to a smaller number of line items that reveal variances only for speciﬁc market segments or groups of customers. A similar type of format can be used for expense control. Exhibit 34.11 contains an expense control report that is sorted by responsible party within each department. By using this approach, the report can be distributed to department managers, who can then issue it to the individuals within their departments who are responsible for speciﬁc expense line items. Of particular interest in this report is the last column, which notes the full-year budget for each expense line item. This number is placed next to the year-to-date actual expense and variance numbers, so that managers can see exactly how much allocated funding is still available to them for the rest of the year.

34.8 PAYROLL REPORTS The largest expense item in many organizations is payroll, which exceeds even the cost of materials. Proper control of this cost requires a detailed report that lists the salary or wage cost of each employee in comparison with the original budget. Such a format is shown in Exhibit 34.12. In the exhibit, employees are grouped by department, with the budgeted salary or wage level for each person noted in bold. Actual pay on an annualized basis is then shown for each successive month of the year. This format gives an extremely detailed view of exactly where a company is investing its payroll dollars. If there are too many employees to make the report easily readable, they also can be summarized by job title within departments, or simply by department, though some of the effectiveness of the report will be lost with the higher degree of summarization. The report in Exhibit 34.12 may not include the overtime pay for nonexempt employees, since this information could skew the annualized payroll information shown in the report. If overtime is a signiﬁcant proportion of payroll, then it can be shown separately, as in the report format noted in Exhibit 34.13. This report assumes that payrolls are completed once every two weeks, and itemizes the percentage of overtime paid by person within each department. This is most useful if issued to department managers immediately following each payroll, so that they can see who consistently works excessive amounts of overtime.

Black process 45.0° 133.0 LPI

Black process 45.0° 133.0 LPI

E XHIBIT 34.10

F ORECASTED

Customer Name AC Dingo Admedix Best Eastern BonaLisa Case Western Champion Systems Easy Go Services EMC Engineered Skating Products Estep Industries Gates Plastics Great Plains Software Great Deal Foods Hudson & Sons Hunter Stevenson Innovative Boulder Tech. Inovonics Intermediate Diverse Foods Kountry Kitchen Magma Volcanic Gear Martin Stevenson SALES VS .

A CTUAL S ALES R EPORT

YTD Forecast 58,000 285,000 32,000 48,000 26,000 24,000 45,000 1,779,396 47,000 26,000 40,000 6,600 0 525,000 9,000 22,000 9,000 72,000 350,265 0 9,000

S ALES , F ORECASTED VS . A CTUAL YTD Actual Variance 73,506 15,506 738,205 453,205 45,886 13,886 44,453 –3,547 74,513 48,513 24,493 493 45,589 589 2,488,239 708,843 58,800 11,800 83,858 57,858 42,630 2,630 2,854 –3,746 25,678 25,678 409,968 –115,032 38,139 29,139 44,970 22,970 30,173 21,173 83,417 11,417 371,051 20,786 4,620 4,620 11,647 2,647 Month Forecast 21,000 85,000 15,000 8,000 8,000 0 15,000 723,878 25,000 12,000 14,000 2,200 0 300,000 3,000 14,000 3,000 24,000 138,795 0 3,000

34.8

25,678 91,459 6,983 15,001 8,386 13,920 66,964 4,620 3,975

Month Actual 8,417 178,489 13,041 10,868 13,147 11,480 17,548 1,094,675 18,074 26,539 12,395

Payroll Reports

Variance –12,583 93,489 –1,959 2,868 5,147 11,480 2,548 370,797 –6,926 14,539 –1,605 –2,200 25,678 –208,541 3,983 1,001 5,386 –10,080 –71,831 4,620 975

731

34_controllership.fm Page 731 Monday, December 8, 2003 5:04 PM

Black process 45.0° 133.0 LPI

E XHIBIT 34.10

Totals

F ORECASTED

SALES VS .

YTD Forecast 80,000 75,000 390,000 27,000 3,600 5,000 25,000 0 30,000 0 210,000 8,000 0 0 4,000 9,000 60,000 41,000 46,000 0 $ 5,920,162

10,831 177,399 118,023 2,889

A CTUAL Variance 36,002 –72,840 33,465 1,063 –2,600 7,348 –18,598 7,387 28,475 810 –26,257 9,197 2,500 431 4,348 –9,000 –49,169 136,399 72,023 2,889

VS .

$ 1,493,301

S ALES , F ORECASTED YTD Actual 116,002 2,160 423,465 28,063 1,000 12,348 6,402 7,387 58,475 810 183,473 17,197 2,500 431 8,348

A CTUAL S ALES R EPORT (C ONTINUED )

$ 4,426,861

Ch. 34 Internal Management Reports

Customer Name Mile High Sun Systems Miscellaneous Optimus Stoves Polyseasonal Designs Prime Target Company Product Design Assoc. Progressive Ancillary Co. Ryco Boxes Scott Paper Company Sensory Deprivation Co. Superior Furnishings T. Rex Eatery T-Pastry Company Teneriﬁc Kid Toys Toxonomical Products Tranway Tristar Airways Vendomatic Machinery Volway Distribution Westway Oil & Gas

732

$ 1,718,073

Month Forecast 30,000 25,000 120,000 5,000 1,200 5,000 0 0 0 0 60,000 0 0 0 0 3,000 20,000 20,000 14,000 0 $ 2,030,414

8,244 99,641 27,947 1,445

100,274 7,244 1,000 4,020 5,561 3,381 36,468 810 49,493 3,839 2,500 431

Month Actual 36,457

$ 312,341

Variance 6,457 –25,000 –19,726 2,244 –200 –980 5,561 3,381 36,468 810 –10,507 3,839 2,500 431 0 –3,000 –11,756 79,641 13,947 1,445

34_controllership.fm Page 732 Monday, December 8, 2003 5:04 PM

Black process 45.0° 133.0 LPI

E XHIBIT 34.11

Admin Admin Admin Admin Admin Admin Admin Admin Admin Admin Admin Admin Admin Admin Admin Admin Admin Admin

Administration

Department

E XPENSE C ONTROL R EPORT

Grand Total

Accounting & Tax Advertising Auto Expense Bad Debt Charitable Consultants Keyman Insurance Legal Liability Insurance Maintenance Other Expense Phones Postage Salaries Supplies Taxes Training Travel

Description Underhill, David Morris, William Morris, William Underhill, David Morris, William Underhill, David Morris, William Morris, William Underhill, David Underhill, David Underhill, David Underhill, David Underhill, David Underhill, David Underhill, David Underhill, David Underhill, David Morris, William

Responsible 2,500 833 4,316 1,000 1,250 2,000 1,333 666 3,500 2,812 1,500 4,750 1,270 39,215 3,541 166 291 3,750 $ 74,693

$ 79,703

April Budget

2,500 1,680 1,435 3,000 — 6,363 1,337 688 3,500 256 161 6,341 740 48,803 1,668 (465) 1,437 259

April Expense

E XPENSE C ONTROL R EPORT

$ (5,010)

— (847) 2,881 (2,000) 1,250 (4,363) (4) (22) — 2,556 1,339 (1,591) 530 (9,588) 1,873 631 (1,146) 3,491

April Variance

$ 269,985

11,832 4,959 7,823 6,849 179 17,415 4,659 982 13,001 5,406 3,881 25,854 3,719 151,656 1,749 (1,399) 6,215 5,205

$ 291,690

10,000 3,332 17,264 4,000 5,000 8,000 5,332 2,664 14,000 11,248 6,000 19,000 5,080 156,860 7,082 664 1,164 15,000

34.8

733

$ 896,316

30,000 9,996 51,792 12,000 15,000 24,000 15,996 7,992 42,000 33,744 18,000 57,000 15,240 470,580 42,492 1,992 3,492 45,000

Full Year Budget

Payroll Reports

$ 21,705

(1,832) (1,627) 9,441 (2,849) 4,821 (9,415) 673 1,682 999 5,842 2,119 (6,854) 1,361 5,204 5,333 2,063 (5,051) 9,795

YTD Expense YTD Budget YTD Variance

34_controllership.fm Page 733 Monday, December 8, 2003 5:04 PM

Black process 45.0° 133.0 LPI

E XHIBIT 34.11

Assembly Assembly Assembly Assembly Assembly Assembly Assembly Assembly Assembly Assembly

Manufacturing

Monahan, Delaney Monahan, Delaney Monahan, Delaney Monahan, Delaney Monahan, Delaney Monahan, Delaney Monahan, Delaney Monahan, Delaney Monahan, Delaney Monahan, Delaney

Responsible

E XPENSE C ONTROL R EPORT (C ONTINUED )

Grand Total

Building Maintenance Building Rent Liability Insurance Maintenance Other Expenses Rentals Salaries Supplies Training Travel

Description

Ch. 34 Internal Management Reports

Department

734

— 17,100 500 1,200 — 1,400 23,197 200 116 200 $ 43,913

$ 62,045

April Budget

2,434 17,100 500 1,235 144 1,767 33,445 2,303 — 3,117

April Expense (2,434) — — (35) (144) (367) (10,248) (2,103) 116 (2,917)

April Variance

$ (18,132)

E XPENSE C ONTROL R EPORT

$ 186,596

5,284 57,670 2,000 3,122 402 7,430 97,245 9,182 — 4,261

$ 167,404

— 57,000 2,000 4,400 — 4,600 92,788 5,700 116 800

$ (19,192)

(5,284) (670) — 1,278 (402) (2,830) (4,457) (3,482) 116 (3,461)

YTD Expense YTD Budget YTD Variance

$ 526,956

— 205,200 6,000 14,400 — 16,800 278,364 2,400 1,392 2,400

Full Year Budget

34_controllership.fm Page 734 Monday, December 8, 2003 5:04 PM

Black process 45.0° 133.0 LPI

28,752

None

Maintenance Maintenance Process Tech Process Tech Process Tech

Henderson, Alex

Norris, Aaron

Allen, Mark

Phorest, Michael

E XHIBIT 34.12

A NNUALIZED P AY L EVELS R EPORT

Maintenance

Delany, Eric

Short, Bob

40,992

Logistics

Wallace, Loretha

55,116

40,992

35,880

35,880

35,880

25,392

25,392

Logistics Logistics

25,392

48,456

48,456

39,996

43,260

Stewart, Thomas

Logistics

Linger, Lowell

Budget 28,752

Rose, Jim

Engineering Engineering

Open

Assembly

Zwonter, Steve

Mayes, Dennis

Assembly Assembly

Monfort, Pat

Assembly

Bowery, Dan

Johnson, Gregory

Department

Name

30,000

30,555

38,972

50,960

49,321

29,500

30,966

33,058

53,200

39,750

0

36,504

47,788

46,521

33,052

19,524

Jan

32,000

30,706

39,067

50,960

50,721

29,500

30,966

31,954

54,990

39,250

0

36,504

47,788

46,521

33,052

19,524

Feb

A NNUALIZED P AY L EVELS C OMPARED TO

32,000

30,541

38,555

50,960

49,384

34,320

30,966

32,058

54,990

39,500

0

36,504

47,788

46,521

33,052

19,524

Mar

B UDGET Apr

32,877

29,185

41,574

50,960

51,155

33,839

30,966

34,359

54,990

39,000

0

36,504

47,788

47,060

34,944

20,267

May

34.8

Jun

26,018

30,145

44,630

67,227

29,264

32,020

23,870

29,571

55,000

41,550

0

38,000

36,078

47,060

32,272

20,216

Payroll Reports

32,071

31,434

33,618

54,379

49,348

34,320

24,115

30,888

54,990

36,595

0

36,504

45,019

47,060

32,968

20,267

735

34_controllership.fm Page 735 Monday, December 8, 2003 5:04 PM

Black process 45.0° 133.0 LPI

Production Mgmt Production Mgmt Production Mgmt Production Mgmt Quality Assurance Quality Assurance Quality Assurance Quality Assurance Quality Assurance S, G & A S, G & A S, G & A S, G & A

Graham, Lee

Honest, Darrell

Lawrence, Michael

Summers, Theresa

Bella, Donna

McDonald, Robert

Mills, Alan

Smith, George

Walmsley-Dunnet, Al

Bossy, Frank

Gainer, George

Hammit, Robert Spudsit, Jeffrey

Jan

45,240 82,550 $ 1,345,230

$ 1,323,872

125,008

82,004

26,000

18,538

49,998

25,386

24,031

36,010

47,996

70,798

32,000

110,000

46,056 75,000

124,992

84,456

None

24,996

50,004

24,996

24,996

42,996

42,996

70,800

42,996

110,000

Budget

$ 1,349,874

45,240 82,550

125,008

82,004

26,000

18,538

49,998

25,971

24,258

36,010

47,996

70,798

32,000

110,000

Feb

A NNUALIZED P AY L EVELS C OMPARED

A NNUALIZED P AY L EVELS R EPORT (C ONTINUED )

Production Mgmt

E XHIBIT 34.12

Department

Anderson, Carl

Ch. 34 Internal Management Reports

Name

736

TO

$ 1,355,128

45,240 82,550

125,008

82,004

26,000

18,538

49,998

25,069

24,258

36,010

47,996

70,798

34,996

110,000

Mar

B UDGET Apr

$ 1,362,140

45,240 82,550

125,008

82,004

26,000

18,538

49,998

24,063

23,465

36,010

47,996

70,798

34,996

110,006

May

$ 1,347,713

45,916 82,550

125,008

82,004

26,000

18,528

49,998

30,069

24,258

36,010

47,996

70,798

34,996

110,006

Jun

$ 1,339,420

46,000 89,196

125,000

82,000

26,000

18,538

50,000

27,585

22,381

36,000

48,000

70,799

35,000

110,000

34_controllership.fm Page 736 Monday, December 8, 2003 5:04 PM

34_controllership.fm Page 737 Monday, December 8, 2003 5:04 PM

34.9 Graphical Report Layouts

737

34.9 GRAPHICAL REPORT LAYOUTS Many of the preceding reports can be modiﬁed to ﬁt into a more easily readable graph format, of which there are many varieties. Six possible graph types are shown in Exhibit 34.14. The formats presented in the exhibit are: 1. Pie chart. This graph is shown in a three-dimensional format, and also can be presented in a two-dimensional layout (especially when there is more information to pack into the chart). It is best used to show the proportion of parts to the whole amount, and cannot be used to show more than a half-dozen items without severely cluttering the graph. 2. Bar chart. Immediately below the pie chart is a bar chart, also in three-dimensional format. It can be used to compare the amount of a similar item for different entities (in the exhibit, it compares the travel cost for different corporate facilities), and also can be used for a limited amount of trend line analysis. However, similar to the pie chart, it can easily become overloaded if too many data items are presented. 3. Scattergraph. The scattergraph is below the bar chart. It is very useful for pattern analysis, since a large number of data points can be entered into the graph, and then ﬁtted with a trend line that is a “best ﬁt” based on the positions of all data items. As shown in the graph, the slope formula for the line also can be shown within the graph. 4. Trend line. This graph is below the scattergraph. It is heavily used to reveal patterns that occur over time, such as expense levels over multiple periods. It is best not to clutter this graph with too many lines; rather, create a separate graph for each trend in order to more clearly present the data. 5. Bubble chart. The bubble chart is at the top of the second page of graphs. This format is more rarely used, since it is designed speciﬁcally to reveal market share information. 6. Area chart. This graph is located at the bottom of the second page of graphs. It resembles a bar chart, in that data can be stacked on top of each other, while also presenting the stacked information over a series of time periods, as is done by a trend line. It is useful for seeing changes in the proportions of revenues or expenses over time. However, it is easily cluttered if too many data items are stacked on top of each other, and so should be used with care.

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E XHIBIT 34.13

O VERTIME R EPORT BY

15% 0%

15% 0% E MPLOYEE

13%

5% 31% 23%

15% 11% 19%

6%

1/18

8%

0% 11% 25%

Mold Shop Davidson, Raymond Miller, Jerry Stallsworth, Delbert

Process Technicians Allen, Aaron Barron, Alejandro Estrada, Steve Michels, Shayne Reynolds, Mike Sherman, William

31% 0% 15%

Maintenance Delatore, Alex Hansen, Erik Lage, Laurence

1/4 23%

Ch. 34 Internal Management Reports

Engineering Nelson, Mark

738

11%

11%

28%

0% 10% 19%

13% 16% 13%

15%

2/1

O VERTIME R EPORT

E MPLOYEE

0%

11%

21%

5% 9% 34%

24% 41% 26%

10%

2/15

BY

40% 14% 8% 36% 11% 11%

13% 20% 14%

16% 39% 39%

18%

3/01

30% 54% 11% 25% 34% 11%

6% 25% 30%

26% 32% 21%

15%

3/15

0% 44% 10% 33% 11% 5%

10% 16% 28%

8% 31% 24%

0%

3/29

21% 0% 9% 11% 14% 0%

8% 25% 26%

15% 28% 4%

6%

4/12

11% 15% 11% 34% 10% 11%

18% 11% 30%

36% 41%

18%

4/26

34_controllership.fm Page 738 Monday, December 8, 2003 5:04 PM

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E XHIBIT 34.13

O VERTIME R EPORT

11%

E MPLOYEE (C ONTINUED )

10%

13%

6% 14% 6%

13% 6% 9%

45%

0% 28% 13%

17%

BY

9% 1% 9%

33%

14% 8% 13%

2/15

Average of all Overtime

8% 3% 4%

0%

0% 14% 13%

2/1

13% 18% 8%

Courtney, Debbie Martin, Beverly Newby, Ginger

10%

11% 10% 0%

1/18

Assembly Bowden, Greg Jackson, Mike Williams, Rosa

SG&A

Logistics Chhoeung, Lin Gage, Clarence Jacques, Kum Stewart, Loretha Webber, Ricky

Quality Assurance McDonald, Theresa Reidenbach, Donna Smith, Jacqueline

1/4

17%

5% 16% 3%

5% 4% 11%

20%

0%

25% 30% 13%

3/01

17%

3% 8% 11%

13% 0% 10%

23%

0%

6% 9% 13%

3/15

34.9

13%

29% 6% 0%

13% 0% 9%

0% 9% 29% 53% 1%

0% 25% 0%

4/12

23%

40% 33% 74%

8% 0% 15%

13% 41% 30% 46% 0%

10% 24% 13%

4/26

Graphical Report Layouts

17%

23% 21% 20%

6% 3% 9%

0% 39% 51% 26% 0%

13% 19% 13%

3/29

739

34_controllership.fm Page 739 Monday, December 8, 2003 5:04 PM

34_controllership.fm Page 740 Monday, December 8, 2003 5:04 PM

740

Ch. 34 Internal Management Reports

E XHIBIT 34.14

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E XAMPLES

OF

G RAPHICAL R EPORT F ORMATS

34_controllership.fm Page 741 Monday, December 8, 2003 5:04 PM

34.9 Graphical Report Layouts

E XHIBIT 34.14

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E XAMPLES

OF

G RAPHICAL R EPORT F ORMATS (C ONTINUED )

741

34_controllership.fm Page 742 Monday, December 8, 2003 5:04 PM

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35_controllership.fm Page 743 Monday, December 8, 2003 5:08 PM

CHAPTER

35

REPORTS TO SHAREHOLDERS 35.1

INTRODUCTION 743

35.2

PURPOSE OF THE ANNUAL REPORT TO SHAREHOLDERS 744

35.3

CONTROLLER AND THE ANNUAL REPORT 744

35.4

GENERAL CONTENTS OF THE ANNUAL REPORT 744 (a) Highlights or Summary Page 747 (b) Management Analysis of Operations and Financial Condition 747 (c) Financial Statements 747

35.5

REPORT OF MANAGEMENT’S RESPONSIBILITIES 755 (a) Other Disclosures 757 (b) Summary Annual Reports 757

35.6

IMPORTANCE OF FORM 757

35.7

STANDARDIZATION IN ANNUAL REPORTS 758

35.8

OTHER REPORTS TO SHAREHOLDERS 758

35.9

INFORMATION FOR SECURITY ANALYSTS AND INVESTMENT ADVISORS 759

35.1 INTRODUCTION Chapter 34 on internal management reports focused on providing all management levels with information to assist in running the business. That audience already possesses an intimate knowledge of those segments of the entity to which they direct their attention. But there is another large group that also has an interest in the business, but has somewhat limited knowledge of many aspects. It, too, needs reports providing essential information. This group is the shareholders or potential shareholders, and perhaps customers and the general public. Then, there are creditors, government agencies, stock exchanges, and others who would like information about the company. Reporting to each group poses separate problems and has been addressed in separate chapters. The primary means of communicating with this group of owners or potential owners includes: • The annual report (along with the Form 10-K and the proxy statement) • The published quarterly report • Other written materials issued by the company • Other investor relations activities, including periodic meetings, special announcements. These matters, with emphasis on annual reports and quarterly reports to shareholders, are reviewed in some detail, and format examples of excellent present practices are provided for convenience. (It is suggested that the controller peruse available reports to shareholders when reading this chapter.) There are questions being raised about the extent of ﬁnancial disclosure—a subject with which the controller should be concerned. Accordingly, given a changing environment, some observations, suggestions, and criticisms from various professionals are brieﬂy provided in the latter part of this chapter for the thoughtful consideration of the reader.

743

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744

Ch. 35 Reports to Shareholders

35.2 PURPOSE OF THE ANNUAL REPORT TO SHAREHOLDERS The annual report to shareholders serves several purposes. It is an accounting of stewardship to owners and an assessment by management of the ﬁnancial condition and potential of the company. It is also a compliance with Securities and Exchange Commission (SEC) reporting requirements. It is, or should be, a means of permitting a discerning reader to analyze the operations and form a considered opinion of the current and possible future worth of the securities. An important related purpose of the annual report is to secure and hold venture capital. It is a selling device in attracting this capital from prospective shareholders. There are other purposes to be served and should be considered during the preparation. Employees and prospective employees have a keen interest in the ﬁnancial affairs of the company and the future. Customers generally desire to have an insight into the company. If the annual report is well done it can be used to improve civic relations and build goodwill with the general public.

35.3 CONTROLLER AND THE ANNUAL REPORT Preparation of the annual report calls for the cooperation of several executives or departments. The ﬁnancial staff must furnish the ﬁnancial information and supervise its use. Those handling public relations or advertising must see that the report is attractive, understandable, and consistent with published utterances. The industrial relations department may contribute data regarding labor matters. Legal counsel should check the report for legal aspects. The chief executive and top management will give the report a general review and make certain policy decisions. Each of these groups, and others, can and should make a contribution to the corporate annual report. However, the foundation of the annual report is the ﬁnancial statements and the interpretation thereof. This basic information must come from the controller’s ofﬁce—from the accounting and statistical records of the business. For this reason, and because its managerial and accounting aspects are too important or too technical to be satisfactorily handled by others, the report should be the product of the controller’s ofﬁce in close cooperation with the operating and management staff. It should not be turned over to the advertising or public relations department. Although capable advertising people can do an outstanding job in many ways, there is often a tendency for them to make the annual report a somewhat blatant and obvious sales or advertising tool. As a result, the document’s real purpose as a report of stewardship is somewhat obscured. Under the circumstances, it is believed the talents of these departments should be put to work for the controller and not the controller put to work for them. Another question arises about the responsibility and liability of the controller to the shareholders, the directors, and the public. Although such matters have not always been clearly deﬁned, there has developed an increased sense of responsibility by controllers for the published reports of their company. As a member of management the controller cannot escape a share of responsibility for those actions that come within his sphere of activity. Quite naturally, ﬁnal responsibility for adequate disclosure must rest with the directors and ofﬁcers of the company. But it is nevertheless the duty of the controller to make the facts known to management and to press for sufﬁcient disclosure of information. If he ﬁnds that the wishes of management and the board of directors are substantially adverse to his sense of professional ethics, and the subject is material, then he probably will have to resign.

35.4 GENERAL CONTENTS OF THE ANNUAL REPORT In considering the content and form of annual reports, the controller should be cognizant of the speciﬁc requirements of the SEC, the Financial Accounting Standards Board (FASB), the New York Stock Exchange, state legal requirements, and other federal regulations. For example, Rule 14c-3 states that annual reports furnished to shareholders in connection with the annual shareholder meeting should include the following information:

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35.4 General Contents of the Annual Report

745

Audited Financial Statements • Balance sheets as of the two most recent ﬁscal years • Income statements for each of the three most recent years • Statement of cash ﬂows for each of the three most recent years Rule 14c-3 also requires that the following ﬁnancial information as speciﬁed in Regulations S through K be included in the annual report: • Selected quarterly ﬁnancial data • Selected ﬁnancial data for the last ﬁve years • Segment information • Management discussion and analysis of ﬁnancial conditions and results of operations • Disagreements with accountants on accounting and ﬁnancial disclosure • Listing of company directors and executive ofﬁcers • Market price of company’s common stock for each quarterly period within the two most recent years It is apparent that in structuring the report, recognition should be given to all the requirements. Also, if more than one report is prepared, the controller should ensure that they are conformed. The kind and amount of information to be presented will depend on the type of industry and the speciﬁc company. A manufacturing company may ﬁnd it appropriate to discuss new products or increasing productivity. A high-technology company will include comments on the applications of new technologies. A section of the report should be devoted to telling the reader about the industry, products, and type of business. Management should include those facts that will inform the shareholders and provide them with an understanding of the business. The annual report is an opportunity to create a broader and more fundamental understanding of the company. Discussion of the future, new ventures, research and development (R&D), foreign business, growth prospects, and management principles are topics of interest to the shareholder. A review of many annual reports will indicate that most companies’ reports do not change much from year to year. Changes are generally brought about by new reporting requirements or by recommendations from innovative ﬁnancial or other management personnel. The operating departments should be contacted for ideas and suggestions for improvement. Consultants should also be considered and used, particularly for ideas to improve the readership of the report. The controller can also contribute new ideas by researching new techniques and applications. After the general theme, content, and format have been established, top management should review and approve. A well-balanced report provides meaningful information to the shareholder and sufﬁcient facts to meet the needs of the professional reader. One means to accomplish this is to provide highlighted or condensed information with brief analytical comments. In another section of the report, detailed facts and ﬁgures can be presented that are used by ﬁnancial analysts to formulate an investment opinion. An outline of some of the more basic contents of an effective, easy-to-read annual report follows: 1. Highlights or summary page. Usually, a presentation of fundamental and comparative data on ﬁnancial results. Examples are: (a) (b) (c) (d) (e) (f) (g) (h)

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Sales Net income Earnings per share (EPS) Cash dividends paid per share Investments in property, plant, and equipment Long-term debt Book value per share Number of stockholders

35_controllership.fm Page 746 Monday, December 8, 2003 5:08 PM

746

Ch. 35 Reports to Shareholders

(i) Number of employees (j) Return on shareholders’ equity 2. Letter to the shareholders. An opportunity for the chairman of the board or president or both to provide their comments on the company with regard to challenges, strengths, overview of operations, and goals and plans for the future. Generally, in this letter facts and ﬁgures are not included but are presented elsewhere in the report. 3. Review of operations. This section of the report describes the business and can be considered a corporate review. The product lines are normally described and illustrated by the use of photographs, charts, and graphs. Included in the commentary are the markets, customers, productivity, new products, and the future. 4. Management’s discussion and analysis (MD&A) of the summary of operations and ﬁnancial condition. As required by the SEC to be included in the annual report, management should analyze and discuss the reasons for basic changes between the current year and the previous year. Also, the prior year should be compared to its previous year. The information presented should not be boilerplate or mechanistic. Data disclosed should be useful, meaningful, complete, and accurate so that the shareholder can make an informed investment judgment. The MD&A has become a focal point of the ﬁnancial section of the annual report. 5. Financial statements. Comparative ﬁnancial statements, including appropriate footnotes and the independent accountants’ reports. 6. Report of management’s responsibilities. A report of management’s responsibilities for ﬁnancial statements and the system of internal control must be included in the annual report. It also provides management’s assessment of the current effectiveness of the internal control system. Finally it includes management’s response to signiﬁcant recommendations made by its auditors, both internal and independent, concerning the controls. 7. Supplemental information. There are other annual report requirements for data, such as unaudited quarterly information—sales, operating margin, net income, EPS, dividends per share, and the high and low stock prices. Each year new disclosure requirements may be added or old ones eliminated. The controller must be aware of such changes and incorporate them into the annual report. Recent examples of additions are disclosures on income taxes, consolidated ﬁnancing companies, pension plans, and other postretirement beneﬁts, while the requirement for disclosing the effects of general inﬂation was dropped. The independent public accountants should be a useful resource to identify or conﬁrm changing requirements. 8. Other data. Certain additional information is useful to the shareholders in evaluating and keeping informed on the company. Such information includes: (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m)

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Members of the board of directors and their afﬁliations Corporate ofﬁcers Board committees and members Functions of board committees Division and subsidiary ofﬁcers Registrars Transfer agents Outside counsel Independent accountants Stock exchanges where stock is listed and traded Locations of principal ofﬁces and operating units Statement of management responsibility Summary of signiﬁcant accounting policies

35_controllership.fm Page 747 Monday, December 8, 2003 5:08 PM

35.4 General Contents of the Annual Report

747

(n) Notice of annual meeting of shareholders (o) Table of contents for reference (p) Historical statistical data The controller, as the chief accounting ofﬁcer, is encouraged to review annual reports of the industry and of leading companies in other industries to be aware of trends in ﬁnancial reporting. An excellent source of information is Accounting Trends & Techniques, published each year by the American Institute of Certiﬁed Public Accountants (AICPA). It includes a compilation of data obtained be surveying annual reports to shareholders. It points out signiﬁcant accounting trends, and the techniques discussed are illustrated by excerpts from the annual reports. Another source of ideas about ﬁnancial reporting is the Corporate Information Committee Report, published each year by the Financial Analysts Federation. It has subcommittees, composed of experts in various industries, evaluate and rank the ﬁnancial reporting practices of the companies in the industry. The strengths and weaknesses of each company are described in the hope that the preparers will have a better understanding of what investors want to know and why. The controller is also advised to keep informed on the various dates annual reports are required to be ﬁled with concerned agencies and provided to the shareholders. (a) HIGHLIGHTS OR SUMMARY PAGE. In presenting ﬁnancial information to the shareholders, as well as to professional analysts, it is useful to provide a quick review of salient facts concerning operations. Usually, the ﬁrst page or inside front cover of the annual report is a convenient place to present the highlights. Although the amount of information provided will vary, depending on the company, an effective presentation by The Dow Chemical Company for a recent year is shown in Exhibit 35.1. A company should consider what information is most useful to the shareholder in a highlight form. Normally, it should be comparative and presented graphically as well as in tabulated form. (b) MANAGEMENT ANALYSIS OF OPERATIONS AND FINANCIAL CONDITION. Management’s discussion and analysis of the results of operations and the liquidity and ﬁnancial condition of the business has become one of the most important parts of the ﬁnancial section of the annual report. Several years ago, there were perhaps one or two pages used to present management’s explanation and clariﬁcation of what the ﬁnancial statements, primarily the income statement, reﬂected. A review of annual reports will reveal that some companies are using up to twenty pages to provide the readers with comprehensive explanations, of each of the ﬁnancial statements. The average number of pages for the MD&As of large companies probably range between ﬁve and ten. While there is no set rule for how long this section should be, it clearly must be sufﬁcient to enable investors to appraise the quality of earnings and to evaluate the ﬁscal soundness and ﬁnancial potential of the company. It is an opportunity for management to clarify ambiguities and spell out subtleties. Each company will have to decide how much explanation is needed for their readers to have enough information to make informed decisions. An example of a concise MD&A is shown in Exhibit 35.2. This brief discussion by Kellogg Company for a recent year reviews strategic and ﬁnancial objectives, global marketplace results of operations (two years), liquidity and capital resources, the future outlook. (c) FINANCIAL STATEMENTS . The ﬁnancial statements are the primary section of an annual report to shareholders. Obviously, the requirements of the stock exchanges and SEC and generally accepted accounting principles must be satisﬁed. Annual reports contain: 1. 2. 3. 4.

Statement of earnings Statement of ﬁnancial position Statement of cash ﬂows Statement of shareholders’ equity

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748

Ch. 35 Reports to Shareholders

E XHIBIT 35.1

F INANCIAL H IGHIGHTS P AGE C OMPANY

FROM

R ESULTS

OF

2005 A NNUAL R EPORT

OF

T HE D OW C HEMICAL

O PERATIONS

Overview

Kellogg Company operates in a single industry—manufacturing and marketing grain-based convenience food products, including ready-to-eat cereal, toaster pastries, frozen wafﬂes, cereal bars, and bagels, throughout the world. The Company leads the global ready-to-eat cereal category, with an estimated 39% annualized share of worldwide volume. Additionally, the Company is the North American market leader in the toaster pastry, cereal/granola bar, frozen wafﬂe, and pre-packaged bagel categories. During 2005, the Company returned to growth in earnings per share (excluding unusual items, discussed below), as management continued with its global strategy of brand-differentiated pricing, investment in new product research, brand-building marketing activities, and cost structure reduction initiatives. Results for 2005 were signiﬁcantly improved over 2004, a year in which earnings were negatively impacted by competitive conditions in the Company’s major markets. For the full year of 2005, Kellogg Company reported net earnings and earnings per share of $546.0 million and $1.32, respectively, compared to 2004 net earnings of $531.0 million and E XHIBIT 35.2

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M ANAGEMENT ’ S D ISCUSSION A NNUAL R EPORT

AND

A NALYSIS

FROM

K ELLOGG C OMPANY 2005

35_controllership.fm Page 749 Monday, December 8, 2003 5:08 PM

35.4 General Contents of the Annual Report

749

net earnings per share of $1.25. Net earnings and earnings per share for 2003 were $490.3 million and $1.12, respectively. (All per share amounts reﬂect the 2-for-1 stock split effective August 22, 2005. All earnings per share presented represent both basic and diluted earnings per share.) During the current and prior years, the Company reported nonrecurring charges and other unusual items that have been excluded from all applicable amounts presented below for purposes of comparison between years. Additionally, results for 2005 are presented before the cumulative effect of a change in the method of accounting for business process reengineering costs. Refer to the separate section below on non-recurring charges and other unusual items for further information. 2005

COMPARED TO

2004

Excluding nonrecurring charges and other unusual items, the Company reported 2005 earnings per share of $1.70, an 11% increase over the prior-year results of $1.53. The year-over-year increase in earnings per share of $.17 resulted from $.12 of business growth, $.03 of common stock repurchases, and $.04 of favorable tax rate movements, partially offset by $.02 of unfavorable foreign currency movements. The business growth was principally attributable to cereal volume growth in the Company’s U.S. and Latin American markets, continued double-digit growth in other convenience foods volume, and reductions in manufacturing and marketing costs. Foreign currency movements negatively impacted earnings by 2% in Europe, 3% in other non-U.S. areas, and 1% on a consolidated basis. The negative impact on 2005 earnings per share due to results of the Lender’s Bagels business, acquired in December 2004, was approximately $.05. The Company achieved the following volume growth during 2005:

Change Global cereal

+ 3.4%

U.S. cereal

+ 3.9%

Global total

+ 11.3%

Global total excluding Lender’s (a)

+ 5.0%

(a) Lender’s Bagels business acquired in December 2004.

Within the U.S. market, the Company recovered cereal volume declines of the prior year, and slightly exceeded 2003 results. Growth in most other non-U.S. cereal markets offset softness in the Company’s United Kingdom, Canada, and Australia volume. The Company’s Latin American region achieved record annual volume results. Other convenience foods volume continued to increase at a double-digit rate, even after excluding sales from the Lender’s Bagels business. On an annualized basis, regional volume share of the ready-to-eat cereal category remained strong during the year, at approximately 34% in North America, 44% in Europe, 43% in Asia-Paciﬁc, and 60% in Latin America. Consolidated net sales increased 2% for 2005. The favorable impact of strong volumes was partially offset by unfavorable pricing and product mix movements, and a negative foreign currency impact of 2%. Excluding the Lender’s business, consolidated net sales were even with the prior year. On a geographic basis, net sales versus the prior year were: E XHIBIT 35.2

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M ANAGEMENT ’ S D ISCUSSION AND A NALYSIS A NNUAL R EPORT (C ONTINUED )

FROM

K ELLOGG C OMPANY 2005

35_controllership.fm Page 750 Monday, December 8, 2003 5:08 PM

750

Ch. 35 Reports to Shareholders

N ET

SALES BY GEOGRAPHIC AREA —2005 VS .

Business Foreign currency impact Total change

2004 %

CHANGE

U.S.

Europe

All other

Consolidated

+5% — +5%

+2% –5% –3%

+6% –4% +2%

+4% –2% +2%

2005

2004

Change

52.1% – 34.6% 17.5%

53.2% – 36.8% 16.4%

– 1.1% + 2.2% + 1.1%

Margin performance for 2005 was:

Gross margin SGA%(a) Operating margin

(a) Selling, general, and administrative expense as a percentage of net sales.

Gross margin performance for 2005 beneﬁted from volume increases and year-over-year operational cost savings. However, these favorable factors were outweighed by the negative impact of prior-year pricing actions. The improvement in SGA% primarily reﬂects reduced promotional spending in the U.S. market, in line with the Company’s integrated pricing strategy. Operating proﬁt results on a geographic basis were: O PERATING

PROFIT BY GEOGRAPHIC AREA —2005 VS .

( MILLIONS

2005 operating proﬁt as reported Non-recurring changes 2005 operating proﬁt excluding non-recurring charges 2004 operating proﬁt as reported Non-recurring charges 2004 operating proﬁt excluding non-recurring charges

2004

OF DOLLARS )

U.S.

Europe

All other

Consolidated

$706.8 35.2

$158.9 119.1

$143.4 29.8

$1,009.1 184.1

$742.0 $611.2 24.1

$278.0 $204.4 76.5

$173.2 $143.3 35.5

$1,193.2 $ 958.9 136.1

$635.3

$280.9

$178.8

$1,095.8

+1% –4% –3%

+ 11% – 2% +9%

% change - 2005 vs. 2004 excluding non-recurring charges: Business Foreign currency impact Total change

+17% — +17%

+3% –4% –1%

Gross interest expense, prior to amounts capitalized, increased 70% versus the prior year to $117.9 million. The higher interest expense resulted from increased debt levels to fund the Lender’s Bagels business acquisition and the Company’s common stock repurchase program. Excluding the impact of non-recurring charges and other unusual items, the effective income tax rate was 35.3%, 1.5 percentage points lower than the prior-year rate. The lower effective tax rate is primarily due to enactment of a 2% statutory rate reduction in the United Kingdom, effective April 1, 2005, as well as favorable adjustments in other jurisdictions. The effective income tax rate based on reported earnings (before cumulative effect of accounting change) was 37.6% in 2005 and 38.2% in 2004. For both 2005 and 2004, the higher reported rate (as compared to the rate excluding the impact of unusual items) primarily relates to certain non-recurring charges for which no tax beneﬁt was provided, based on management’s assessment of the likelihood of recovering such beneﬁt in future years. E XHIBIT 35.2

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M ANAGEMENT ’ S D ISCUSSION AND A NALYSIS A NNUAL R EPORT (C ONTINUED )

FROM

K ELLOGG C OMPANY 2005

35_controllership.fm Page 751 Monday, December 8, 2003 5:08 PM

35.4 General Contents of the Annual Report

751

The Statement of Financial Position is shown for the past two years; the other three statements present a three-year comparison. In addition to these statements, a ﬁve-year summary of selected ﬁnancial data is also shown. Some companies expand that presentation and show ten or more years as a convenient source for investors and analysts or to keep the information and/or certain trends from being misleading. As mentioned earlier, selected quarterly data for the most recent two years is also included in the annual report. The controller should ensure that the statements presented are consistent and in accordance with the terminology and requirements of the rule-making bodies of accounting. (i) Statement of Earnings. The accounting profession has made considerable progress in the simpliﬁcation of statements of earnings or the income statement. A very readable Consolidated Income Statement for Kimberly-Clark Corporation and Subsidiaries for a recent year is illustrated in Exhibit 35.3.

(Millions of dollars, except per share amounts) Net Sales Cost of products sold Gross Proﬁt Advertising, promotion and selling expenses Research expense General expense Restructuring and other unusual charges

Year Ended December 31 2005 2004 2003 $12,546.6 $13,149.1 $13,373.0 7,972.6 8,241.4 8,828.1 4,574.0

4,907.7

4,544.9

1,937.2 211.8 640.7

2,029.7 207.9 616.4

2,080.9 207.2 603.8

—

1,440.0

481.1

Operating Proﬁt Interest income Interest expense Other income (expense), net

1,303.2 31.4 (164.8) 17.7

107.2

103.6

Income Before Income Taxes Provision for income taxes

1,187.5 433.1

2,002.3 700.8

104.4 153.5

754.4 157.3

1,301.5 152.4

(49.1) 113.3

Income (Loss) Before Equity Interests Share of net income of equity companies Minority owners’ share of subsidiaries’ net income Income Before Extraordinary Gains Extraordinary gains, net of income taxes

2,053.7 28.1 (186.7)

(27.7)

213.0 33.3 (245.5)

(50.1)

(31.0)

884.0 17.5

1,403.8 —

$

901.5

$ 1,403.8

$

33.2

Income before extraordinary gains

$

1.59

$

2.49

$

.06

Net income

$

1.62

$

2.49

$

.06

Net Income

33.2 —

Per Share Basis Basic

E XHIBIT 35.3

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C ONSOLIDATED I NCOME S TATEMENT FOR K IMBERLY- C LARK C ORPORATION S UBSIDIARIES 1997 A NNUAL R EPORT

AND

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Ch. 35 Reports to Shareholders

Year Ended December 31 2005

2004

2003

Diluted Income before extraordinary gains

$

1.58

$

2.48

$

.06

Net income

$

1.61

$

2.48

$

.06

See Notes to consolidated financial statements

E XHIBIT 35.3

C ONSOLIDATED I NCOME S TATEMENT FOR K IMBERLY- C LARK C ORPORATION S UBSIDIARIES 1997 A NNUAL R EPORT (C ONTINUED )

AND

(ii) Statement of Financial Position. The titles used for this statement are usually Statement of Financial Position, Balance Sheet, or Statement of Financial Condition. The most commonly used title is Balance Sheet. Formats will vary, but the account form of assets on the left-hand side equal to the sum of liabilities and stockholders’ equity on the right-hand side is commonly used. The Consolidated Balance Sheet of Kimberly-Clark Corporation for a recent year is shown in Exhibit 35.4. December 31 (Millions of dollars)

Assets

Current Assets Cash and cash equivalents Accounts receivable Inventories Deferred income tax beneﬁts Prepaid expenses and other Total Current Assets Property Land and timberlands Buildings Machinery and equipment Construction in progress Less accumulated depreciation Net Property Investments in Equity Companies Assets Held for Sale Goodwill, Net of Accumulated Amortization Deferred Charges and Other Assets

Current Liabilities Debt Payable within one year Trade accounts payable E XHIBIT 35.4

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2005

$

90.8 1,606.3 1,319.5 341.6 130.8

2004

$

83.2 1,660.9 1,348.3 327.4 119.4

3,489.0

3,539.2

202.0 1,472.6 7,715.0 366.6

291.9 1,807.8 9,234.0 593.5

9,756.2 4,155.6

11,927.2 5,113.9

5,600.6 567.7 280.0 594.8 733.9

6,813.3 551.1 — 262.0 680.1

$ 11,266.0

$ 11,845.7

$ 663.1 747.1

C ONSOLIDATED B ALANCE S HEET OF K IMBERLY- C LARK C ORPORATION S UBSIDIARIES FROM 1997 A NNUAL R EPORT

$ AND

576.5 849.8

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35.4 General Contents of the Annual Report

December 31 2005 2004 302.3 269.5 1,445.6 1,460.1 416.8 401.3 131.4 129.7

Liabilities and Stockholders’ Equity Other payables Accrued expenses Accrued income taxes Dividends payable Total Current Liabilities Long-Term Debt Noncurrent Employee Beneﬁt and Other Obligations Deferred Income Taxes Minority Owners’ Interests in Subsidiaries Stockholders’ Equity Preferred stock—no par value-authorized 20.0 million shares, none issued Common stock—$1.25 par value—authorized 1.2 billion shares; issued 568.6 million shares at December 31, 2005 and 2004 Additional paid-in capital Common stock held in treasury, at cost—12.3 million and 5.2 million shares at December 31, 2005 and 2004, respectively Unrealized currency translation adjustments

3,706.3 1,803.9 887.1 580.8 162.6

3,686.9 1,738.6 926.1 762.3 248.7

—

—

710.8 113.3

710.8 136.7

(617.1) (953.2) 4,871.5

(214.4) (656.8) 4,506.8

4,125.3

4,483.1

$ 11,266.0

$ 11,845.7

Retained earnings Total Stockholders’ Equity

E XHIBIT 35.4

753

C ONSOLIDATED B ALANCE S HEET OF K IMBERLY- C LARK C ORPORATION S UBSIDIARIES FROM 1997 A NNUAL R EPORT (C ONTINUED )

AND

(iii) Statement of Cash Flows. Statement of Financial Accounting Standard No. 95, Statement of Cash Flows superseded APB Opinion No. 19, Reporting Changes in Financial Position and requires a statement of cash ﬂows classifying cash receipts and payments as to whether they result from operating, investing, or ﬁnancing activities. The Consolidated Cash Flow Statement of Kimberly-Clark Corporation and Subsidiaries for a recent year, commencing with the net income shown in Exhibit 35.3 is reﬂected in Exhibit 35.5.

Year Ended December 31 (Millions of dollars)

2005

2004

2003

$ 901.5

$1,403.8

$ 33.2

2005 and 2003 Charges, net of cash expended

689.7

—

1,353.8

Extraordinary gains, net of income taxes

(17.5)

—

—

Depreciation

490.9

561.0

581.7

11.2

40.5

(330.0)

Operations Net income

Deferred income tax provision (beneﬁt) E XHIBIT 35.5

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C ONSOLIDATED C ASH F LOW S TATEMENT

OF

K IMBERLY- C LARK

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Ch. 35 Reports to Shareholders

Year Ended December 31 (Millions of dollars)

2005

2004

2003

(8.4)

(75.1)

(118.5)

(62.1)

(100.2)

(57.6)

27.7

50.1

31.0

Increase in operating working capital

(576.9)

(141.6)

(527.9)

Pension funding in excess of expense

(34.2)

(28.2)

(89.0)

Other

(15.3)

(36.1)

54.9

Gains on asset sales Equity companies’ earnings in excess of dividends paid Minority owners’ share of subsidiaries’ net income

1,406.6

Cash Provided by Operations

1,674.2

931.6

Investing Capital spending

(944.3)

(883.7)

(817.6)

Acquisitions of businesses, net of cash acquired

(82.2)

(223.6)

(76.1)

Proceeds from disposition of property and businesses

779.6

455.4

336.1

Other

(58.9)

18.9

3.8

(305.8)

(633.0)

(553.8)

(530.6)

(461.5)

(348.2)

Net increase (decrease) in short-term debt

355.3

(348.8)

(25.2)

Increases in long-term debt

107.5

75.8

80.7

Decreases in long-term debt

(253.8)

(321.2)

(944.0)

49.2

207.9

121.4

(910.6)

(348.8)

(137.8)

89.8

17.0

(40.9)

Cash Used for Investing Financing Cash dividends paid

Proceeds from exercise of stock options Acquisition of common stock for the treasury Other Cash Used for Financing Increase (Decrease) in Cash and Cash Equivalents

(1,093.2) $

7.6

(1,179.6)

(1,294.0)

$ (138.4)

$ (916.2)

See Notes to Consolidated Financial Statements

E XHIBIT 35.5

C ONSOLIDATED C ASH F LOW S TATEMENT

OF

K IMBERLY- C LARK (C ONTINUED )

(iv) Statement of Shareholders’ Equity. This statement presents an analysis of the changes in each caption of the shareholders’ equity presented in the balance sheet. It is in the form of a reconciliation of the beginning balance to the ending balance for each period for which an income statement is presented. The amount of dividends paid for each share and the aggregate for each class of shares is also stated. It is presented in differing formats. Exhibit 35.6 for a recent year for Colgate-Palmolive Company provides the data in two segments: a Consolidated Statement of Retained Earnings and a Consolidated Statement of Changes in Capital Accounts to identify the changes in the other shareholders’ equity accounts.

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35.5 Report of Management’s Responsibilities

C ONSOLIDATED S TATEMENT

OF

755

R ETAINED E ARNINGS

Balance, January 1

2005

2004

2003

$2,731.0

$2,392.2

$2,496.7

740.4

635.0

172.0

3,471.4

3,027.2

2,668.7

20.6

20.9

21.1

.5

.5

.5

Add: Net Income Deduct: Dividends declared: Series B Convertible Preference Stock, net of income taxes Preferred stock Common stock Balance, December 31 C ONSOLIDATED S TATEMENT

OF

C HANGES

Common Stock

Balance, January 1, 2003 Shares issued for stock options, net Treasury stock acquired Other Balance, December 31, 2003 Shares issued for stock options, net Treasury stock acquired Other Balance, December 31, 2004 Shares issued for stock options, net Treasury stock acquired Other Balance, December 31, 2005 E XHIBIT 35.6

IN

312.3

274.8

254.9

333.4

296.2

276.5

$3,138.0

$2,731.0

$2,392.2

C APITAL A CCOUNTS

Additional Paid-in Capital $ 837.2

Treasury Stock

Shares 288,808,474

Amount $366.4

Shares 77,618,116

Amount $1,462.4

2,309,312 (37,600) 627,558 291,707,744

— — — 366.4

13.7 — (.4) 850.5

(2,309,312) 37,600 (627,558) 74,718,846

(16.8) 1.2 (5.0) 1,441.8

2,206,216 (688,800) 1,042,476 294,267,636

— — — 366.4

44.4 — 23.5 918.4

(2,206,216) 688,800 (1,042,476) 72,158,954

22.0 27.4 (22.4) 1,468.8

3,163,141 (2,795,926) 767,844 295,402,695

— — — $366.4

64.2 — 44.8 $1,027.4

(3,163,141) 2,795,926 (767.844) 71,023,895

54.4 175.1 (18.0) $1,680.3

C ONSOLIDATED S TATEMENT OF R ETAINED E ARNINGS AND C ONSOLIDATED S TATEMENT OF C HANGES IN C APITAL A CCOUNTS FOR C OLGATE -P ALMOLIVE C OMPANY FROM 2005 A NNUAL R EPORT

35.5 REPORT OF MANAGEMENT’S RESPONSIBILITIES This report by management is required by the SEC. It states that the integrity of the ﬁnancial statements and information included in the Annual Report is management’s responsibility. It further describes the accounting control system on which the statements are based and the audit activities used to test and verify compliance with procedures and adequacy of policies. It highlights the role and makeup of the audit committee of the board of directors, addresses signiﬁcant audit recommendations made during the year and evaluates the effectiveness of the overall accounting control system at the end of the year. An illustrative statement of management’s responsibilities for the

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Ch. 35 Reports to Shareholders

E XHIBIT 35.7

S TATEMENT ON M ANAGEMENT ’ S R ESPONSIBILITY FOR F INANCIAL S TATEMENTS , AND R EPORT OF I NDEPENDENT A CCOUNTANTS , FROM E ASTMAN C HEMICAL C OMPANY 2005 A NNUAL R EPORT

ﬁnancial statements, covering a recent year, for Eastman Chemical Company, together with the related Report of Independent Accountants, is shown in Exhibit 35.7. A key factor in evaluating the ﬁnancial performance of a company is the accounting policies that were followed. APB Opinion No. 22, Disclosure of Accounting Policies, concludes that information about the accounting policies adopted by a reporting entity is essential for ﬁnancial statement users and should be included as an integral part of the ﬁnancial statements. The disclosure should identify and describe the accounting principles followed and the methods of applying those principles that materially affect the determination of ﬁnancial position, changes in ﬁnancial position, or results of operations.

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35.6 Importance of Form

757

Paragraph 13 of APB No. 22 states: Examples of disclosures by a business entity commonly required with respect to accounting policies would include, among others, those relating to basis of consolidation, depreciation methods, amortization of intangibles, inventory pricing, accounting for research and development costs (including basis for amortization), translation of foreign currencies, recognition of proﬁt on long-term construction-type contracts and recognition of revenue from franchising and leasing operations. This list of examples is not all-inclusive.

With regard to format and location, there is ﬂexibility as long as the disclosure is an integral part of the ﬁnancial statements. In most cases the disclosure is a separate summary of signiﬁcant accounting policies preceding the notes to ﬁnancial statements or as the initial note. (a) OTHER DISCLOSURES. The matter of how much information should be included in the report to shareholders is a combination of required disclosures (SEC regulations, FASB Standards, etc.), and management judgment. Much of the supplemental information now included in notes to the ﬁnancial statements is mandated, for example, disclosures in connection with leases, segments, pensions, consolidations, and taxes, in addition to previously mentioned accounting practices, quarterly data, and selected ﬁve-year data. These requirements are added to, reduced, and/or modiﬁed on an ongoing basis and the controller must be aware of developments in this area. New disclosures often require a lot of preparation, for example, new accounts, in order to be able to comply with them. Insofar as other disclosures are concerned, the authors believe that the annual report should bring to the owners and investors attention any signiﬁcant trends or developments that affect their equities. Matters such as interest rates, labor problems, sales trends, inventory levels, industry uncertainties, stock repurchase plans, mergers, and capital planning are all of potential interest. Again, the primary objective is to state the facts so clearly that the chance of misconception is reduced to a minimum. As with the growth in the size and importance of the MD&A, the notes to the ﬁnancial statements have also continually increased and now take up ten to twenty pages of most annual reports. There are innumerable ﬁnancial factors that should be considered for inclusion in the annual report. It takes innovative thinking and sound judgment to develop and present in an understandable manner the ﬁnancial information that is relevant to a thorough evaluation of the company. (b) SUMMARY ANNUAL REPORTS. In the last few years, there has been an adverse reaction by some management to the large amount of required supplemental information. They have instead chosen to issue a condensed or summary annual report. In this approach, the full ﬁnancial disclosure is detailed in the 10-K and proxy statement while the annual report presents only certain limited information. Generally, the companies who have prepared summary annual reports have eliminated almost all the footnotes and much of the MD&A. While it varies, most summary reports still present the primary ﬁnancial statements and refer the reader to 10-K/proxy for full disclosure. As a result, the ﬁnancial section of the annual report has been substantially reduced. It should be noted that the SEC’s guidance on preparing summary annual reports requires that the proxy be sent at the same time as, or before, the summary annual report. Therefore, the preparation of all ﬁnancial information must be completed in about the same time frame as before, but now a new set of statements must also be prepared for the summary report. The extra work along with concerns about shareholder perception and confusion seems to be deterring companies from trying this summary approach. So far, only a handful of corporations are using it. It is an available option, however, and each controller should evaluate if it is right for his or her company.

35.6 IMPORTANCE OF FORM The annual report should effectively explain the ﬁnancial statements and provide any additional data or analyses that will clarify any signiﬁcant item, trend, or issue. It is up to the accountants and the accounting profession to develop ﬁnancial reporting principles that keep the shareholder fully informed.

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Ch. 35 Reports to Shareholders

The data that is included in the annual report is certainly important, but how it is presented has much to do with getting the message understood. Summarized next are some comments on various aspects of the physical form of the report that, if needed, may assist in getting the document read: • Language. Short sentences and a simple and brief conversational style have been found most effective. Appeal to the reader level; avoid legalistic phrases. • Arrangement. A summary presented at the beginning is helpful. Distinctive headings and subtitles make reading easier. A division of the report into technical and nontechnical sections can be helpful. • Illustrations. An increasing use of photography or illustrations is being made to get and hold attention. These devices relieve the monotony of a page, and they may be excellent for illustrating the use of the product. • Graphs. Graphs can be important time-savers and are an easy means of illustrating trends. Supporting tables are desirable. • Cover. The cover preferably should identify the company and indicate the contents to be the annual report. The name of the corporation should be easily readable and perhaps placed against an effectively colored background. Application or uses of the company’s product may be effectively illustrated. • Repetitions. Avoid giving the same information several times in the report. • Information. Tell readers what they do not know, not what they already know. Be careful about the extent of promotional material as compared to answers. • Size. Most annual reports are 8 1/2 × 11 inches, and it is more convenient if all the reports are the same size.

35.7 STANDARDIZATION IN ANNUAL REPORTS It is evident that the annual report should be clearly identiﬁed with the company and its products. This requires independent thinking and an individual approach to the preparation of the annual report. New ideas are refreshing and will create an interest in the company. There are, however, certain areas that can be standardized. The accounting rules that have been promulgated have to a great extent standardized ﬁnancial reporting requirements. This will tend to promote a better understanding of the ﬁnancial data. As the ﬁnancial accounting and reporting principles are more reﬁned and standardized, it will be easier for the shareholder to compare the results of different companies and make informed judgments about them.

35.8 OTHER REPORTS TO SHAREHOLDERS Providing the owners of the business with adequate information requires some consideration of frequency. The annual report issued only once a year, and perhaps several months after the ﬁscal period has ended, can hardly be said to inform the shareholders on current operations. There are several means of contact with the shareholders. Some of the more commonly used devices include: • Quarterly report to shareholders • A letter of welcome to new shareholders • Minutes of the annual shareholders’ meeting • News releases • Communications included with the dividend check • Special-occasion material, such as an anniversary • Advertising in periodicals and newspapers • Reprints of speeches by executives

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35.9 Information for Security Analysts and Investment Advisors

759

Obviously, the most common is the quarterly report to shareholders, since it has been a ﬁnancial reporting requirement of the New York Stock Exchange and the SEC. The quarterly report is simple and not as elaborate as the annual report; however, in recent years, it has become more valuable in keeping shareholders and analysis informed on a current basis. Some of the information typically included in quarterly reports to shareholders follows: • Financial highlights • Letter to shareholders • Consolidated condensed statements of income • Other ﬁnancial data • Management’s discussion and analysis of operations and ﬁnancial condition • Selected industry segment information • Consolidated condensed statements of ﬁnancial position • Consolidated condensed statements of cash ﬂows • Consolidated condensed statements of shareholders’ equity • Notes to consolidated condensed ﬁnancial statements. Given the information technology changes, the cost of mailing quarterly statements, and the need to provide information to the shareholders on a timely basis, some companies are changing the way they communicate to their shareholders. There is a trend to either a substantial reduction in the size of the quarterly statement or an attempt to replace the routine mailings entirely. ARCO of Los Angeles, California, has evaluated the best ways to make current information available quickly and economically to all shareholders. Instead of mailing quarterly shareholders reports either directly or with the dividend checks, these investor information telephone services have been initiated: • Fax requests. To request quarterly results and other current news directly to a facsimile machine, a free-of-charge, 24-hours-a-day, seven-days-a-week Fax number is provided. Earnings information is to be available on the day it is announced. • Mail requests. Quarterly earnings, as well as the quarterly and annual results ﬁled with the SEC (Forms 10-Q and 10-K) will be mailed on request. Additionally, to keep shareholders up to date on the progress of important projects, the company sends to the owners an abbreviated midyear report that will supplement the annual report received with the proxy each Spring.

35.9 INFORMATION FOR SECURITY ANALYSTS AND INVESTMENT ADVISORS Much of the preceding commentary has related to, or emphasized, simpliﬁed reporting to the owners of the business. Yet, the fact remains that the material must usually serve also as a contact document with the security analysts and investment advisors. And ordinarily such professionals desire a great deal more information than the shareholder wishes or is capable of understanding. One means of solving the problem is to provide, on request, a ﬁnancial and statistical supplement for this group. It could contain more analyses of the type requested by these professionals. In addition, a knowledgeable ﬁnancial executive should be designated as a contact point for the ﬁnancial analysts; someone they can call for answers to questions they may have. The analytic information to be given to this professional group should be disseminated equally and fairly. Top management, the chief executive ofﬁcer (CEO), and chief ﬁnancial ofﬁcer (CFO), working with the controller, should choose what data will be released. Examples of supplemental information that may be made available are:

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Ch. 35 Reports to Shareholders

1. Sales analyses. Perhaps for several years to show trends as: (a) (b) (c) (d)

By product By division By major program By industry segment

2. Income analyses. (a) (b) (c) (d)

By product By division By major program By industry segment

3. Expense analyses. (a) By type in relationship to sales (b) Identiﬁed types of expenses, such as employee beneﬁts, pension costs, advertising, R&D (c) Industry comparisons 4. Selected ratios. Many can be calculated from available data in the annual report. (a) (b) (c) (d) (e) (f) (g) (h) (i)

Return on capital employed Return on common shareholders’ equity Proﬁt margin, before and after taxes, as a percent of sales Percentage of net income paid in dividends and retained in business Current ratio Turnover of working capital Turnover of receivables Turnover of inventories Special statistics applicable to an individual industry

For analysts to arrive at investment decisions, they usually need more information than what is included in the interim and annual reports. Their interests are more detailed and concern other areas such as market share, technological changes, program production schedules, political and economic environment, backlog analyses, and industry statistics. The controller can provide a valuable service to the ﬁnancial analysts, shareholders, and the company by being innovative in developing the information needed about the company to make informed investment decisions. Chapter 11 has some suggestions about the role of the controller in investor relations.

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CHAPTER*

36

SECURITIES AND EXCHANGE COMMISSION 36.1

INTRODUCTION 761

36.2

SECURITIES ACT OF 1933 762

36.3

SECURITIES EXCHANGE ACT OF 1934 762

36.4

PUBLIC UTILITY HOLDING COMPANY ACT OF 1935 763

36.5

TRUST INDENTURE ACT OF 1939 763

36.6

INVESTMENT COMPANY ACT OF 1940 764

36.7

INVESTMENT ADVISORS ACT OF 1940 764

36.8

REGULATION S-X 764

36.9

REGULATION S-K 767

36.10 REGULATION S-B 768 36.11 REGULATION FD 768 36.12 SEC FORMS 769 36.13 EDGAR FILING SYSTEM 773 36.14 GOING PRIVATE TRANSACTION 775

36.1 INTRODUCTION The Securities and Exchange Commission (SEC) was created as a direct result of the stock market crash of October 1929. Given the massive loss of net worth as a result of the plunge in stock market prices at that time, the federal government felt that a considerable degree of regulation over the securities industry was necessary in order to ensure that the resulting increase in public conﬁdence in the markets would eventually draw them back to it. After a series of hearings to determine what speciﬁc forms of regulation would meet this goal, Congress passed the Securities Act and the Securities Exchange Act in 1933 and 1934, respectively. As noted next in this chapter, the two Acts were designed to greatly increase the information reported by an entity issuing securities (especially the nature of its business and any associated investment risks), as well as the amount of oversight by the government. The oversight function was centered on the regulation of the markets in which securities were sold, as well as the brokers and investment advisors who worked with investors to buy and sell securities. The reporting of information by securities issuers has blossomed into a key function of the SEC, which requires timely ﬁlings to it of all material ﬁnancial information by issuers, which it promptly makes available to the public through its EDGAR on-line database (see Section 36.13.) Congress created the SEC as part of the 1934 Act to administer the new Acts. Its powers later increased as other Acts were also passed, eventually giving it regulatory authority over public util-

*Descriptions of the SEC, securities acts, and regulations in this chapter were adapted with permission from Chapter 6 of Steven M. Bragg, Accounting Reference Desktop (Wiley, Hoboken, N.J.: 2002).

761

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Ch. 36 Securities and Exchange Commission

ity holding companies and mutual funds, too. It has a signiﬁcant amount of enforcement authority to back up its regulatory oversight function, typically bringing about 500 civil enforcement actions per year against any person or business entity that breaks the securities laws.

36.2 SECURITIES ACT OF 1933 The Securities Act of 1933 requires companies issuing securities for public purchase to issue ﬁnancial and other signiﬁcant information to investors, while also prohibiting fraud or misrepresentations of ﬁnancial information. The issuance of information is accomplished through the registration of information about the securities with the SEC, which will review submitted information to ensure that disclosure requirements under this Act have been met. A key item is that this Act is primarily concerned with the issuance of information related to the initial offering of securities only, rather than with ongoing updates to securities-related information (which is covered by the Securities Exchange Act of 1934). There are a few instances where the mandated disclosure requirements do not have to be met. If a securities offering is of a limited size, it is issued by a municipal, state, or federal government, or if the offering is limited to a small number of investors, then it is exempted from registration with the SEC. The information sent to the SEC provides essential details about (1) the issuing company’s properties and business, (2) securities available for sale, (3) information about the management team, and (4) audited ﬁnancial statements. If the information provided by the issuing company can be proven by an investor to be incomplete or inaccurate, then investors may have the right to recover their invested funds from the company.

36.3 SECURITIES EXCHANGE ACT OF 1934 This Act created the SEC, giving it authority to regulate many players in the securities industry, such as stock exchanges (e.g., the New York Stock Exchange and National Association of Securities Dealers), clearing agencies, brokerage ﬁrms, and transfer agents. The Act requires these market players to register with the SEC, which involves the ﬁling of regularly updated disclosure reports. It prohibits the trading of securities on unregistered exchanges. Also, self-regulatory organizations (such as the National Association of Securities Dealers) are required to set up rules under which they can ensure that investors are adequately protected while conducting transactions with members of the self-regulatory organizations. The Act requires ﬁrms with more than $10 million in assets, and whose securities are held by greater than 500 investors, to ﬁle both annual reports and a variety of other supplemental reports. The Act also requires anyone who wishes to acquire more than 5 percent of a company’s securities by tender offer or direct purchase to disclose information to the SEC (this provision was added through a 1970 amendment to the Act). The Act also creates rules for the types of information included in proxy solicitations that are used to obtain shareholder votes regarding the election of directors and other corporate matters. In brief, the solicitations must disclose all important facts regarding the topics about which the shareholders are being asked to vote. It requires that these solicitations be ﬁled with the SEC prior to their issuance to the shareholders in order to ensure that their content complies with the disclosure rules of the Act. The Act also gave the Federal Reserve System’s Board of Governors the power to determine the allowable credit limits that could be used to purchase securities through margin trading. It also requires broker-dealers to obtain the written permission of investors before lending any securities carried on the investor’s account. The intention behind these actions was to avoid the massive loss of wealth that occurred during the 1929 stock market crash, when investors who had purchased heavily on margin lost all of their net worth.

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36.5 Trust Indenture Act of 1939

763

It also prohibits insider-trading activities, which occur when a person trades a security based on nonpublic information, particularly when that person has a ﬁduciary duty to refrain from trading. A 1984 amendment to the Act prohibited the ofﬁcers and directors of a company from short-selling the securities issued by their companies. They are also required to report the amount of securities they hold in their companies, and any changes in those holdings, as long as the amount held is more than 10 percent of the total of registered securities. The Act speciﬁcally prohibits market manipulation through such means as giving a false impression of high levels of trading activity in a stock, issuing false information about possible changes in a stock’s price, price ﬁxing, and making false statements in regard to a security.

36.4 PUBLIC UTILITY HOLDING COMPANY ACT OF 1935 This Act authorizes the regulation of interstate holding companies that are engaged in the retail distribution of natural gas or in the electric utility business, with particular attention to perceived abuses by this type of business. A holding company is deﬁned as one that owns at least 10 percent of a public utility company’s voting stock. A holding company is exempted from this Act only if it operates within a single state, or is an operating public utility company that operates in a single state or in contiguous ones, is not in the public utility business, is a temporary holding company, or is not a public utility business within the United States. One intent of the Act is to conﬁne each holding company to a single integrated public utility system that would keep each company contained within a single geographic region. Also, to keep this type of company from expanding outside the boundaries of that single public utility system, the Act provides that only those nonutility businesses can be bought that are “reasonably incidental or economically necessary or appropriate” to its operations. The Act also provides for the elimination of unnecessary levels of corporate structural complexity, as well as any accumulation of inequitable voting power by certain shareholders. These provisions are designed to keep people with a small number of shares from gaining voting control over a holding company. The Act clearly identiﬁes the types and amounts of securities that a holding company should issue or acquire. Issued securities must correspond to the earning power and capital structure of the holding company. The SEC can authorize the issuance of securities for a holding company only if the proposed issuance has already cleared all hurdles imposed by applicable local state laws. Also, the Act requires holding companies to ﬁrst obtain the approval of the SEC before acquiring any securities, utility assets, or ownership interest in any other business. This restriction includes obtaining SEC approval before becoming an afﬁliate of another public utility company. These companies are also not allowed to borrow from each other. The SEC must also be advised before any sale of assets or securities between holding companies occurs, or any transactions at all between afﬁliates. In addition, any service or construction contracts that holding companies enter into with each other must be fairly priced, so that there is no undue transfer of assets among companies as a result of the contracts. In short, this Act provides signiﬁcant restrictions on some types of public utility holding companies in order to forestall the possibility of monopolies being created or an excessive amount of control over this type of company being gathered by a small number of individuals.

36.5 TRUST INDENTURE ACT OF 1939 This Act applies to debt securities, such as bonds, debentures, and notes that are made available for public sale. These types of securities cannot be offered for sale to the public if there is a trust indenture agreement already in existence between the bond issuer and the bondholder that follows the rules speciﬁed by this Act. The Act also requires that the trustee be a corporation with a minimum amount of capital, that the trustee conform to high standards of conduct, that the trustee not have conﬂicting interests that would interfere with its tasks on behalf of the holders of securities, and that the trustee prepare and send reports to security holders.

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The Act also requires the trustee to maintain a list of securities holders, which must be issued to them at their request. It also stipulates that the securities issuer provide to the trustee all necessary evidence of compliance with the terms and conditions of the trust indenture agreement.

36.6 INVESTMENT COMPANY ACT OF 1940 This Act is designed to regulate those entities whose primary occupation is investing in and trading securities, especially those whose securities are made available to investors. The Act requires these entities to reveal their investment policies, as well as their ﬁnancial condition, to investors—both at the initial sale of securities and at regular intervals thereafter. Other information that should be contained in these disclosures includes the entity’s organizational structure, operations, and investment objectives. The Act does not give the SEC authority to supervise these entities or rate the quality of their investments—only to ensure that they are disclosing the required minimum amount of information to investors. The Act goes beyond the basic information reporting requirements to also prohibit investment entities from signiﬁcantly changing their investment policies or entering into management contracts without shareholder approval. Furthermore, anyone guilty of securities fraud is prohibited from becoming an ofﬁcer of an investment entity, while brokers, underwriters, and investment bankers are prohibited from forming a majority of its Board of Directors. Finally, investment entities are prohibited from cross-ownership of each other’s securities.

36.7 INVESTMENT ADVISORS ACT OF 1940 The Investment Advisors Act of 1940 deﬁnes what constitutes an investment advisor, which (in its amended form) is anyone with at least $25 million of assets under management. The Act then goes on to require these advisors to register with the SEC, as well as conform to a series of rules that are designed to protect investors, such as maintaining their records in accordance with SEC rules, making those records accessible for SEC audits, and clearly identifying any ﬁnancial interest they may have in transactions that they have executed for their clients. Violations of the investment advisor rules fall into the general categories of willful violations of the Securities Act of 1933, the Investment Company Act of 1940, or the Securities Exchange Act of 1934. A violation will also be assumed to have occurred if the advisor has “aided, abetted, counseled, commanded, induced, or procured such a violation by any other person,” or has failed to properly supervise another person who has committed these acts. It also counts as a violation the misstatement or omission of key facts related to a securities ﬁling. Penalties assessed are primarily monetary in nature, as well as cease-and-desist orders, though the SEC will sometimes deny, suspend, or revoke an advisor’s registration if it feels that such action is in the public interest. Beyond these penalties, the SEC can also recommend criminal action to the Justice Department.

36.8 REGULATION S-X This regulation is the principal one used by the SEC to oversee the form and content of ﬁnancial statements submitted by the issuers of securities. It presents a standard format for the presentation of ﬁnancial statements to be ﬁled with the SEC’s various reporting forms, as well as for the dates when these reports are to be ﬁled. This is a very important regulation for a publicly held company; to peruse its entire content, one can access it on the SEC’s web site at www.sec.gov/divisions/corpﬁn/forms. The regulation separately itemizes the ﬁnancial reporting formats for a few niche industries, such as investment companies, bank holding companies, and insurance companies, that for the sake of brevity are not included here. Selected summary descriptions from the more commonly used articles from the Regulation are:

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• Article 2: Qualiﬁcations and reports of accountants. The SEC will not recognize as a CPA any person who is not currently registered to practice in the state where his or her home or ofﬁce is located. It will also not recognize a CPA as being independent if the CPA has a ﬁnancial interest in the entity being audited, or was a manager or promoter of an auditee at the time of the audit. It requires that a CPA’s report be dated and manually signed, state that GAAP was followed, state an audit opinion, and clearly itemize any exceptions found. • Article 3: General instructions as to ﬁnancial statements. Balance sheets must be submitted for the last two year-ends, as well as statements of income and cash ﬂow for the preceding three years. If interim ﬁnancial statements are provided, then standard year-end accruals also should be made for the shorter periods being reported upon. Changes in stockholders’ equity shall be included in a note or a separate statement. The ﬁnancial statements of related businesses can be presented to the SEC in a single consolidated format if the companies are under common control and management during the period to which the reports apply. There are a number of tests to determine whether consolidated results are required, as well as for how many time periods over which the combined ﬁnancial statements must be reported. If a registrant is inactive (revenues and expenses of less than $100,000, and no material changes in the business or changes in securities) during the period, then its submitted ﬁnancial statements can be unaudited. There are also special reporting requirements for foreign private issuers, real estate investment trusts, and management investment companies. • Article 3a: Consolidated and combined ﬁnancial statements. For ﬁnancial statement reporting purposes, a registrant shall consolidate ﬁnancial results for business entities that are majority owned, and shall not do so if ownership is in the minority. A consolidated statement is also possible if the year-end dates of the various companies are not more than 93 days apart. Intercompany transactions shall be eliminated from the consolidated reports. If consolidating the results of a foreign subsidiary, then the impact of any exchange restrictions shall be made. • Article 4: Rules of general application. Financial statements not created in accordance with GAAP will be presumed to be misleading or inaccurate. If the submitting entity is foreignbased, it may use some other set of accounting standards than GAAP, but a reconciliation between its ﬁnancial statements and those produced under GAAP must also be submitted. Footnotes to the statements that duplicate each other may be submitted just once, as long as there are sufﬁcient cross-references to the remaining footnote. The amount of income taxes applicable to foreign governments and the U.S. government shall be shown separately, unless the foreign component is no more than 5 percent of the total. There must also be a reconciliation between the reported amount of income tax and the amount as computed by multiplying net income by the statutory tax rate. This article also contains an extensive review of the manner in which oil and gas ﬁnancial results must be reported. • Article 5: Commercial and industrial companies. This article describes the speciﬁc line items and related footnotes that shall appear in the ﬁnancial statements. On the balance sheet, this shall include the following items: Cash Marketable securities Accounts and notes receivable Allowance for doubtful accounts Unearned income Inventory Prepaid expenses Other current expenses Other investments Fixed assets and associated accumulated depreciation

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Ch. 36 Securities and Exchange Commission Intangible assets and related amortization Other assets Accounts and notes payable Other current liabilities Long-term debt Minority interests (footnote only) Redeemable and nonredeemable preferred stock Common stock Other stockholder’s equity

On the income statement, this shall include the following items: Gross revenues Costs applicable to revenue Other operating costs Selling General and administrative expenses Other general expenses Nonoperating income Interest Nonoperating expenses Income or loss before income taxes Income tax expense Minority interest in income of consolidated subsidiaries Equity in earnings of unconsolidated subsidiaries Income or loss from continuing operations Discontinued operations Income or loss before extraordinary items Extraordinary items Cumulative effect of changes in accounting principles Net income or loss Earnings-per-share data

• Article 6A: Employee stock purchase, savings, and similar plans. These types of plans must present a statement of ﬁnancial condition that includes the following line items: Investments in securities of participating employers Investments in securities of unafﬁliated issuers Other investments Dividends and interest receivable Cash Other assets Liabilities Reserves and other credits Plan equity and close of period

These plans must include in their statements of income and changes in plan equity the following line items: Net investment income

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Realized gain or loss on investments Unrealized appreciation or depreciation on investments Realized gain or loss on investments Contributions and deposits Plan equity at beginning of period Plan equity at end of period

• Article 10: Interim ﬁnancial statements. An interim statement does not have to be audited. Only major line items need be included in the balance sheet, with the exception of inventories, which must be itemized by raw materials, work-in-process, and ﬁnished goods either in the balance sheet or in the accompanying notes. Any assets comprising less than 10 percent of total assets, and which have not changed more than 25 percent since the end of the preceding ﬁscal year, may be summarized into a different line item. If any major income statement line item is less than 15 percent of the amount of net income in any of the preceding three years, and if its amount has not varied by more than 20 percent since the previous year, it can be merged into another line item. Disclosure also must be made in the accompanying footnotes of any material changes in the business since the last ﬁscal year-end. • Article 11: Pro forma ﬁnancial information. Pro forma information is required in cases where a business entity has engaged in a business combination or roll-up under the equity method of accounting, or under the purchase or pooling methods of accounting, or if a company’s securities are to be used to purchase another business. It is also required if there is a reasonable probability of a spinoff, sale, or abandonment of some part or all of a business. The provided information should consist of a pro forma balance sheet, summary-level statement of income, and explanatory notes. The presented statements shall show ﬁnancial results on the assumption that the triggering transaction occurred at the beginning of the ﬁscal year, and shall include a net income or loss ﬁgure from continuing operations prior to noting the impact of the transaction. • Article 12: Form and content of schedules. This article describes the format in which additional schedules shall be laid out in submitted information, including layouts for valuation and qualifying accounts. It also itemizes formats for the display of information for management investment companies, which include the following formats: investments in securities of unafﬁliated issuers, investments in securities sold short, open option contracts written, investments other than securities, investments in and advances to afﬁliates, summary of investments, supplementary insurance information, reinsurance, and supplemental information.

36.9 REGULATION S-K This regulation contains the instructions for ﬁling forms with the SEC under the rules set by the Securities Act of 1933, the Securities Exchange Act of 1934, and the Energy Policy and Conservation Act of 1975. It concentrates primarily on the content of the nonﬁnancial statements that must be ﬁled, dwelling in particular on the following topics: • Description of the general development of the business during the past ﬁve years. • Financial information and a narrative description about individual segments of the business for each of the last three years. • Financial information about geographic areas for each of the last three years. • The general types of property owned by the company, as well as where it is located. • Estimates of oil or gas reserves. • Any legal proceedings currently under way, either at the company’s initiation or to which it is subject. • The primary markets in which each class of the company’s common stock is being traded.

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• The approximate number of holders of each type of common stock. • The amount and timing of the cash dividends declared on each class of common stock for the last two years. • Description of all securities to be offered for sale. • Key ﬁnancial information in a columnar format for the last ﬁve years. • Selected quarterly ﬁnancial information for the last two years. • Management’s discussion of liquidity, capital resources, and the results of operations. • Material changes during interim reporting periods. • Any change in the outside auditing ﬁrm in the last two years. • The market risk associated with trading instruments, as well as how these risks are managed. • Terms and information about derivative ﬁnancial instruments. • The name, age, and position of each company director. • The name, age, and position of each executive ofﬁcer. • The compensation of the CEO and the four most highly paid individuals besides the CEO (but only if their total pay exceeds $100,000). This statement shall separately itemize salary, bonus, option, and pension remuneration. The regulation also sets forth the reporting requirements for a prospectus, and cross-references a series of industry guidelines that detail additional, and more speciﬁc, reporting requirements. The industry guidelines are for the oil and gas, bank holding company, real estate limited partnership, property-casualty underwriting, and mining businesses. Regulation S-K provides the foundation for much of the information reporting requirements that publicly held companies must ﬁle, and so should be perused in detail by those entities.

36.10 REGULATION S-B This regulation is similar to Regulation S-K in that it lays out the speciﬁc information that issuers must periodically send to the SEC. However, this regulation has a somewhat reduced set of ﬁling requirements that are targeted at small companies that cannot afford the more in-depth ﬁling requirements of S-K. As a qualiﬁed small business issuer, a company will ﬁle its registration statement under Form SB-2 or Form 10-SB. order to qualify for these reduced requirements, a company must have revenues of less than $25 million, be an American or Canadian-based issuer, and not be an investment company. Also, if it is a subsidiary, its corporate parent must also qualify as a small business issuer. Furthermore, its market capitalization must be no more than $25 million, based on the price of its securities within 60 days of its most recent ﬁscal year end. Finally, the business must meet these requirements for two consecutive years before qualifying as a small business.

36.11 REGULATION FD The SEC recently released a new regulation, which is the Regulation Fair Disclosure (Regulation FD). The new regulation is designed to curb the disclosure of material information by companies to selected individuals, such as securities analysts, that is not revealed to the general investing public. The regulation will also supposedly reduce a security analyst’s incentive not to disclose this information to the general public (on the grounds that the analyst might no longer be given the privileged information). By imposing Regulation FD, this may curb the amount of insider trading that has arisen based on the nonpublic information. In essence, the regulation requires that an issuer of material information must do so publicly, either by ﬁling the disclosure with the SEC, or by some other broad, nonexclusionary method, such as an Internet webcast or press release. If material information is disseminated by mistake, then the issuer must act promptly to publicly disclose the information. The regulation does not

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apply to issuer communications with the press, rating agencies, and communications during the ordinary course of business with business partners, such as customers and suppliers, nor does it apply to any foreign issuers. It does apply to any communications with anyone who is involved with the securities markets on a professional basis, as well as the holders of any securities issued by the company. Also, to keep a company from having to monitor the communications of its entire staff, the regulation applies only to senior management, its investor relations staff, and anyone else who works for the company and who regularly communicates with holders of company securities or anyone involved with the securities markets. If an issuer violates the regulation, the SEC can initiate an administrative proceeding resulting in a cease-and-desist order, or can go further to seek an injunction or even civil penalties. Thus far, public companies have adapted to this regulation in two ways. Under the ﬁrst approach, some companies have reduced the amount of information given out to anyone—analysts or the public—on the theory that no disclosure to anyone will meet the guidelines of Regulation FD. This has been particularly common in regard to no longer giving earnings guidance and in limiting one-on-one discussions with analysts. As an example of this approach, some have imposed a quiet period on the weeks leading up to an earnings announcement, so there is no chance that management will leak the news in advance to anyone. The second approach is to ﬂood the market with information, on the theory that analysts will have so much information available through general disclosures to the public that they will no longer need any additional information, thereby avoiding any chance of one-on-one meetings where the FD guidelines could be violated. This approach has led to the release of far more 8-K reports, detailing all possible items of interest to investors. By doing so, they have certainly increased the volume of information available, though not necessarily the quality. A variation on the two basic approaches has been to have analysts submit questions in writing, with responses to the questions being posted on the corporate web site within a few days. This interesting approach avoids the risk of ever answering a verbal question with more information than would be released to the public by other means, while ensuring that all investors are informed of answers to analyst questions. Without further guidance from the SEC, a controller can take either approach. Given that the supposed need for FD was the curtailment of the ﬂow of restricted information to a small number of analysts, one can take the position that this is best accomplished by not revealing information to anyone, thereby keeping information releases to a minimum. However, in the interests of full and fair disclosure to all investors, the better approach is to pursue a path of full disclosure to all investors, while still retaining enough information to keep competitors from capitalizing on any released information.

36.12 SEC FORMS The SEC requires public companies to ﬁle a variety of forms with it, based on the occurrence of certain transactions. In this section, we will describe the most commonly used forms. This includes a matrix showing what information is required for each form, followed by details regarding the contents of each requirement noted in the matrix. For a thorough treatment of the requirements for these forms, one can access Title 17, Chapter II of the Code of Federal Regulations. This information is available on the Internet at www.access.gpo.gov, and can be downloaded in both text and PDF formats. The Form 10-K is the primary annual reporting form required by the SEC for most companies that have registered securities for public sale under the Securities Exchange Act of 1934. It must be submitted to the SEC within 90 days of a company’s ﬁscal year end, though an amended form can be ﬁled 30 days later. The quarterly Form 10-Q updates changes in a company’s ﬁnancial position, as well as a variety of other events, since the ﬁling of the last Form 10-K, and is due within 45 days of the end of the ﬁrst three ﬁscal quarters. The periodic Form 8-K is ﬁled immediately after any signiﬁcant event occurs, such as a bankruptcy, merger or acquisition, director resignation, change in corporate control, change of auditors, or initiation of a lawsuit. In general, the form should be

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ﬁled immediately after any event occurs that would be of interest to a prudent investor. While the form must be ﬁled within 5 days of a director resignation or a change in the certifying accountants, in most other cases it can be ﬁled within 15 days of the reportable event. A series of S forms are ﬁled in connection with the issuance of securities. The Form S-1 is used by companies selling securities and that have been subject to SEC reporting requirements only for the past three years or less. It is the principal form used for the ﬁling of initial public offerings. The Form S-2 is a short form used for the same reason, but by companies that have reported to the SEC for more than three years and that have voting stock of less than $150 million. The Form S-3 is used if there is voting stock of more than $150 million, or if the company issues $100 million of securities and the annual trading volume is at least 3 million shares. It can be used only for investment-grade offerings exceeding $75 million, for which securities of the same class are already listed on a national securities exchange. The Form S-4 is used when reporting on changes in securities resulting from business combination transactions. The types of information required to be included in each of these forms is noted in Exhibit 36.1. 8-K Acquisition or disposition of assets Bankruptcy Business Capitalization Certain relationships and related transactions Change in certifying accountants Change in corporate control Change in ﬁscal year Changes in and disagreements with accountants on accounting and ﬁnancial disclosure Changes in securities Defaults upon senior securities Description of securities to be registered Determination of the offering price Dilution Directors and executive ofﬁcers Executive compensation Exhibit, ﬁnancial statement schedules, and reports on Form 8-K Experts Financial statements and supplementary data Interest of named experts and counsel Legal proceedings Management’s discussion and analysis of ﬁnancial/operational condition Market for registrant’s common stock and related matters Other information Plan of distribution Principal shareholders E XHIBIT 36.1

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I NFORMATION R EQUIREMENTS

10-K

10-Q

S-1

S-2

S-3

X X X

X X X X

X

X

X

X

S-4

X X X

X X

X X X X

X X X

X X

X X X

X X

X

X

X

X

X

X

X

X

X

X

X

X

X

X X

X FOR

SEC F ORMS

X

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8-K Properties Prospectus summary Resignation of directors Risk factors Sale of equity securities Security of ownership of certain beneﬁcial owners and management Selected ﬁnancial data Selling security holders Shares eligible for future sale Submission of matters to a vote of security holders Transaction terms Underwriting Use of proceeds E XHIBIT 36.1

I NFORMATION R EQUIREMENTS

10-K

10-Q

771

S-1

S-2

S-3

S-4

X

X

X

X

X X X

X

X X X

X X

X

X X

X X X X

FOR

X

X

SEC F ORMS (C ONTINUED )

An overview of the informational requirements noted in Exhibit 36.1 for each of the seven primary SEC reporting forms is given, in alphabetical order, in the following bullet points. These descriptions include only the primary information requirements for each item, so one should consult the exact requirements as listed in the Code of Federal Regulations before completing any of the forms. • Acquisition or disposition of assets. Describe any major asset acquisitions or dispositions outside those enacted in the ordinary course of business. Information provided should include the date and amount of each transaction, the parties involved, the description of the assets being transferred, and the source and use of funds. • Bankruptcy. If the company enters bankruptcy, note the court in which it applied for bankruptcy, as well as all pertinent information about the case. • Business. Discuss the development of the business since the beginning of the ﬁscal year, as well as its ﬁnancial information by industry segment, major products, market areas, competition, customers, supply sources, order backlog, and other information in which a discerning investor would be interested. • Capitalization. Note the structure of the current corporate capitalization, as well as any signiﬁcant new borrowings, or modiﬁcations of existing ﬁnancial arrangements. • Certain relationships and related transactions. Describe transactions and relationships between the company and certain ofﬁcers, directors, and other speciﬁc parties as deﬁned in the S-K regulations. • Change in certifying accountants. Describe the reason why the certifying accountant left, and whether there was any kind of qualiﬁed or adverse opinion issued by that accountant, as well as any other disagreements or reportable events by the accountant within the preceding two years. • Change in corporate control. Note the identity of both the selling and acquiring entities, plus the consideration used to effect the change in control, and its amount. Also include the percent ownership of the new owner, as well as any related-party transactions. • Change in ﬁscal year. Note the date of the new ﬁscal year, when the decision was made to use it, and whether a Form 10-K or 10-Q will be used to describe the results of the remaining portion of the year.

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• Changes in and disagreements with accountants on accounting and ﬁnancial disclosure. Identify changes in independent accountants during the previous two years, along with reasons for the change. • Changes in securities. Disclose any change to any class of registered securities, as well as the impact of the changes on shareholder rights. • Defaults on senior securities. Disclose any default on the interest or principal payments on securities, but only those not ﬁxed within 30 days of the due date. This reporting also applies to defaults on preferred stock dividends. • Description of securities to be registered. Describe all rights associated with the securities to be registered, such as voting rights, dividend rights, preemptive rights, and liquidation distribution rights. • Determination of the offering price. Describe the factors considered in determining the offering price of securities. • Dilution. When equity securities are offered to the public at a price substantially different from the price paid by ofﬁcers, note the net tangible book value per share both before and after the distribution of securities. • Directors and executive ofﬁcers. Provide a list of company ofﬁcers and directors and pertinent information about them. • Executive compensation. Furnish the amount of compensation earned by the CEO and each of the four other most highly compensated executives and report earnings of all other ofﬁcers as a group. The compensation and pension plans of ofﬁcers must be described. • Exhibit, ﬁnancial statement schedules, and reports on Form 8-K. List documents ﬁled as part of the report including ﬁnancial statements, supplemental disclosures, and reference to Form 8-K, if it has been ﬁled. • Experts. Note the names of any third-party experts used to develop or certify information used in the report, and state that management relies on this information. • Financial statements and supplementary data. Include the balance sheet for the past two years, as well as statements for income, cash ﬂows, and shareholders’ equity for the past three years. • Interest of named experts and counsel. Describe the nature and amount of any ﬁnancial interest in the company by anyone certifying information provided by the company to the investing public, as long as that amount exceeds $50,000. • Legal proceedings. Describe any material legal issues to which the company is a party, including the ﬁling date, location, and parties to each litigation case. Brieﬂy note the nature of each dispute and the amount or type of relief sought. • Management’s discussion and analysis of ﬁnancial condition and results of operations. Discuss the ﬁnancial condition, results of operations and changes in ﬁnancial condition, liquidity, signiﬁcant trends, and events that are expected to occur in sufﬁcient detail to provide an understanding of the business. • Market for registrant’s common stock and related matters. Note the company’s types of securities, the markets in which they are traded, and market pricing information during the reporting period. List the total number of holders of each security type, as well as the amount of dividends declared and their frequency and future probability of recurrence. • Other information. Include any information that would otherwise have been reported on a Form 8-K. If reported here, it does not have to be reported again on a Form 8-K. • Plan of distribution. List the names of underwriters accepting securities, as well as the proportion of the total securities offered that they will accept, plus the terms under which they are accepted. • Principal shareholders. List the shares held and proportion of total ownership for all beneﬁcial shareholders of at least 5 percent of company stock, as well as all executive ofﬁcers and directors.

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• Property. Describe the location and nature of the company’s primary facilities, as well as the industry segments for which they are used, and their levels of capacity and utilization. • Prospectus summary. Most parts of the prospectus issued to investors should be included as an appendix to the ﬁled form. • Resignation of directors. Note the circumstances of any director resignation related to disagreements about company operations, as well as the company’s position on the dispute. • Risk factors. Describe all risks to which a securities holder may be subject, which may be caused by such issues as dilution, competitive pressure, reliance on key individuals, product liability, and environmental litigation. • Sale of equity securities. Note the dates on which securities are sold, as well as the type and amount sold, payment received, and the name of the security recipient. • Security of ownership of certain beneﬁcial owners and management. Provide information about ownership of voting securities for directors and certain other owners. • Selected ﬁnancial data. List in columnar format for the last ﬁve years total revenues, proﬁts, assets, debt, and cash dividends declared. Describe all business changes that impact the comparability of the presented information. • Selling security holders. List the name and relationship to the company of any entity selling securities as part of an offering, as well as the amount offered, and the entity’s remaining ownership interest subsequent to the sale. • Shares eligible for future sale. Note the number of shares held and the identities of their owners for all shares that currently cannot be sold on the open market. Also note the dates when they can be sold, the amounts available for sale at that time, and the dilution impact on existing shareholders. • Submission of matters to a vote of security holders. Describe any issues that were submitted to the shareholders for a vote during the reporting period, as well as the results of the vote. • Transaction terms. Describe the number and class of securities sought, the date by which the offer expires, the amount of consideration, the procedure for tendering securities, and the transaction’s accounting treatment and income tax consequences. • Underwriting. List the underwriters handling the stock offering, as well as the number of shares apportioned to each one. Also describe the main points of the agreements signed with these underwriters, as well as the compensation and expense reimbursements the company expects to pay to the underwriters. • Use of proceeds. State in general terms the uses to which management plans to put the proceeds of the offering.

36.13 EDGAR FILING SYSTEM EDGAR is an acronym for the Electronic Data Gathering, Analysis, and Retrieval system. It is the SEC’s primary on-line tool for automating the collection, validation, indexing, and forwarding of forms ﬁled by companies that are legally required to do so with the SEC. Not only does EDGAR nearly eliminate the paperwork burden on the SEC, but it is also a superior tool for investors and analysts, who have almost immediate on-line access to the forms being ﬁled. The rules and guidelines under which companies are required to make submissions to EDGAR are codiﬁed under the SEC’s Regulation S-T. The SEC requires all publicly held companies with more than $10 million in assets and 500 shareholders to ﬁle their registration statements and periodic reports through EDGAR. However, Form 144 (Notice of Proposed Sale of Securities), Forms 3, 4, and 5 (which are reports related to security ownership and transaction reports for corporate insiders), and the annual report to shareholders (except for investment companies) only have to be ﬁled through EDGAR at the ﬁler’s option. Foreign companies do not have to ﬁle forms through EDGAR.

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Ch. 36 Securities and Exchange Commission

Transmissions may be sent to the SEC, either by dial-up modem or directly through the Internet, on any business day except federal holidays and between the hours of 8 A.M. and 10 P.M., Eastern Standard Time. The following types of documents must be ﬁled in an electronic format: • Registration statements and prospectuses • Statements and applications required by the Trust Indenture Act • Statements, reports, and schedules required by the Exchange Act • Documents required by the Investment Company Act • Documents required by the Public Utility Act It is not necessary (or allowable) to make electronic submissions for some documents where paper-based ﬁlings are still necessary. At the moment, these include the following items: • Applications for deregistration, ﬁled under the Investment Company Act. • Conﬁdential treatment applications • Regulation A ﬁlings and any other offering that is exempt from Securities Act registration • No-action, exemptive, and interpretive requests • Shareholder proposal ﬁlings • Litigation information ﬁled under the Investment Company Act If a company is attempting to meet a ﬁling deadline with the SEC, an electronic submission that is ﬁled on or before 5:30 P.M. Eastern Standard Time will be presumed to have been ﬁled on that business day, whereas any ﬁling submitted after that time will be presumed to have been ﬁled on the next business day. However, this assumption shifts to 10 P.M. for the ﬁling of registration statements. Ofﬁcial submissions to EDGAR must be in either HTML (version 3.2 is the standard as of this writing) or plain text. Anyone who chooses to make a submission in the HTML format is allowed to use hyperlinks between different sections of the same HTML document, and may also include hyperlinks to exhibits that have been included in the same ﬁling. One can also include links to other ofﬁcial ﬁlings within the EDGAR database if submissions are made with the new EDGARLink version; however, it is not allowable to include links to documents located outside of the EDGAR database. Hyperlinks are not allowed as a substitute for information that is required to be included in a speciﬁc document, even if the required information could be located through a linkage to another document that is also ﬁled through EDGAR. The SEC does not currently allow video or audio material to be included in submissions to EDGAR, though it is acceptable to include graphic and image material within HTML documents. It is also possible to make a submission in a PDF (Acrobat) format, but this is considered an unofﬁcial ﬁling that must be accompanied by one of the other two formats. If a PDF ﬁle is submitted, only its formatting and graphics may differ from the ofﬁcial ﬁling. If the submitting entity makes an electronic submission that contains errors solely due to errors in the transmission, and if the submitter corrects the errors as soon as possible after becoming aware of the difﬁculty, then there shall be no liability under the antifraud portions of the federal securities laws. In order to protect itself from computer viruses, the SEC will suspend the ﬁling of any document that appears to contain executable code. If such a document is accepted and the code is discovered at a later date, then it may be deleted from EDGAR and the ﬁler will be required to make a new submission of the required data. There are two cases in which a company can plead hardship and avoid making an electronic submission of data. In the ﬁrst instance, Rule 201 of Regulation S-T allows a temporary exemption for an electronic ﬁler that is having unanticipated trouble in submitting a report, such as in cases where the transmitting computer fails. A paper-based ﬁling, using Form TH (Notiﬁcation of Reliance on Temporary Hardship Exemption) is still required in this instance, and must be followed within six days by an electronic submission. In the second case, Rule 202 of Regulation S-T allows

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a permanent exemption for a few cases where the information to be ﬁled is so large that the ﬁler would be caused undue hardship to do so. The ﬁrst case requires no SEC approval, whereas the second case does. The primary document needed for preparing an electronic document for the SEC is its EDGAR Filing Manual. One can download it at www.sec.gov/info/edgar/ﬁlermanual.htm, or order it from the Public Reference Room, Securities and Exchange Commission, 450 5th Street, NW, Washington, DC 20549-0102.

36.14 GOING PRIVATE TRANSACTION If a publicly held company wishes to go private, it must disclose information that is itemized under the SEC’s Rule 13e-3. This rule applies to situations where a company plans to buy back its securities, as described in the next section. The information required under these circumstances must be ﬁled on Schedule 13E-3, to which amendments must be added if there are material changes to the information presented on it. The primary information listed on the schedule includes complete company ﬁnancial statements and various ﬁnancial information on a per-share basis. The company must also include information regarding the identity of the persons ﬁling the schedule, terms of the arrangement, future plans, the reason for going private, and the source and ﬁnancing terms for the funding required to complete the transaction. The SEC’s Rule 13e-3 applies to any transaction where equity securities are being purchased by their issuer, or when a tender offer for those securities is being made by their issuers or an afﬁliate. Such a transaction must result in having less than 300 people hold the equity security or the removal of that class of equity securities from being listed on a national exchange. When an equity security is withdrawn from circulation by the issuer, the rule also states that information about the withdrawal shall not be misleading or attempt to defraud a security holder. The rule requires the issuer to ﬁle Schedule 13E-3 prior to withdrawing a class of securities, as well as to ﬁle amendments to it to reﬂect any material changes in the information itemized in the original ﬁling. These amendments will be concluded with an amendment reporting the ﬁnal results of the withdrawal transaction. The rule further requires that the security issuer disclose to security holders the following information: • A summary term sheet • The purposes, alternatives, reasons for, and effects of the transaction • Fairness of the transaction to the security holder • Reports, opinions, appraisals, and negotiations related to the transaction • Information concerning the rights of the security holders to conduct appraisals • All other information listed in Schedule 13E-3, except for exhibits. A “fair and adequate summary” can be substituted for this information. If there are changes to the information offered to security holders, then the rule requires that these changes be promptly reported to them. In any event, the original set of disclosures must be issued to the security holders no later than 10 business days prior to any withdrawal transaction. If securities are held in trust for securities holders by a broker/dealer, then the issuer must forward these information materials to the broker/dealer, with instructions to forward it to the security holders. These reporting requirements are not required if the issuer offers security holders another equity security in exchange for the one being retired, but only if the replacement security has essentially the same rights as the old security, including voting, dividends, and redemption and liquidation rights, or if common stock is offered. The reporting is also not required if the security withdrawal is already allowed under the speciﬁc provisions itemized in the instrument creating or governing that class of securities.

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PART

COMPUTER SYSTEMS AND RELATED TECHNOLOGY

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CHAPTER

37

SELECTING A FINANCIAL INFORMATION SYSTEM 37.1

INTRODUCTION 779

37.2

REASONS TO PURCHASE SOFTWARE 780

37.3

WAYS TO DEFINE SYSTEMS REQUIREMENTS 780 (a) Questionnaires 781 (b) Executive Interviews 782 (c) Document Reviews 782 (d) Outside Sources 782

37.7

DISTRIBUTION OF THE RFP 786

37.8

REVIEW OF THE VENDOR’S COMPLETED PROPOSAL 788

37.9

REFERENCE CALLS 792

37.4

EXISTING SYSTEM DOCUMENTATION 782

37.11 SITE VISITS 793

37.5

JOINT SESSIONS 783

37.13 FINAL SELECTION 794

37.6

PREPARING THE REQUEST FOR PROPOSAL 785 (a) Cover Letter 785 (b) General Information/Proposal Guidelines 785 (c) Background Material 786

(d) Vendor Questionnaire 786 (e) Vendor Cost Summary 786 (f) System Requirements 786

37.10 DEMONSTRATION 792 37.12 COST OF THE SYSTEM 793 37.14 CONTRACT NEGOTIATIONS 794 37.15 APPENDIX: VENDOR EVALUATION CRITERIA 794 (a) Product Support 794 (b) Reputation and Stability 795

37.1 INTRODUCTION The controller is primarily responsible for seeing that the ﬁnancial information system meets the needs of those who receive and use its output—management, shareholders, creditors, suppliers, customers, government agencies, and stock exchanges, as well as the general public. This chapter contains a proven approach to selecting and implementing an automated ﬁnancial information system (FIS). It includes an overview of reasons why ﬁnancial system software should be purchased instead of developed in-house, how to thoroughly deﬁne systems requirements, an approach to preparing a request for proposal (RFP), and ways to evaluate software, hardware, and the associated vendors. Selection and implementation of an FIS are extremely important to an organization’s ﬁnancial operation. As a result, the organization must be willing to devote a substantial amount of time and effort to these activities, or hire outside consultants to assist in the process. For the purposes of this chapter, it is assumed that the selection process includes both computer hardware and software. Many selecting organizations already have computer hardware in place. However, where possible, it is recommended that an organization select software that best meets its needs without being constrained by the hardware currently in place. 779

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37.2 REASONS TO PURCHASE SOFTWARE In general, it is recommended that software packages be purchased, instead of developed in-house, to meet the needs of an organization’s ﬁnancial operations. The reasons include: • Implementation speed. Packaged software generally can be implemented much quicker than software developed in-house because the software is readily available and the process of designing and coding the systems is not necessary. • Fewer software problems. Packaged software normally has already been thoroughly tested and “debugged” before it is sold. • Lower overall cost. The total cost of packaged software tends to be signiﬁcantly less than the cost of software developed in-house. Software developed in-house normally requires a very signiﬁcant investment of time and human resources. • Software vendor assistance. Most software vendors, especially those in the mid-range (i.e., minicomputer) and mainframe market, provide ongoing support and maintenance for their software. This means that the support required from in-house information systems (IS) staff can be minimized. • Package enhancements. To maintain market position and sales, software vendors generally provide enhanced functionally and new modules. • Documentation. Most software packages come with a variety of manuals including user, technical, and operations. Therefore, the acquiring organization does not have to invest in developing this type of documentation. • Training. The vast majority of software vendors provide a variety of training classes for user and technical personnel. • Research and development (R&D). Software vendors are in the business of selling system solutions. To maintain (and improve) a competitive market position, they must invest a substantial amount of money in research and development. (Most organizations can’t afford to invest substantial sums in improving existing in-house–developed ﬁnancial systems.) • Information systems support. In general, it is much easier to locate personnel who are familiar with packaged software and can support it than with in-house systems. Also, with in-house–developed software, employee turnover presents greater problems. • Prevalence of software problems. Software vendors normally thoroughly test their products before allowing them to be sold. In addition, packaged software is generally used by numerous users in a wide variety of ways. Therefore, software problems (i.e., “bugs”) are likely to appear relatively early in a package’s life cycle. To survive in the long run, the software vendor must correct these bugs as rapidly as possible. This is not necessarily so for systems developed in-house, which are generally used only by the developing organizations. As a result, it may take years before a bug is uncovered. Also, once the bug is found, considerable time may pass before it is corrected. • The user group. Packaged software vendors tend to support and encourage user groups. Participation in these groups can be an effective means of identifying ways in which to more efﬁciently use the system. Also, it tends to be an effective way of encouraging the vendor to improve its software.

37.3 WAYS TO DEFINE SYSTEMS REQUIREMENTS Before software is selected, the speciﬁc requirements need to be precisely deﬁned. The application areas typically included in an FIS are: • Budgeting • Purchasing • Accounts payable and check reconciliation • General ledger

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• Accounts receivable and revenue accounting • Fixed assets • Cost accounting • Inventory • Order entry and billing • Cost accounting If application requirements are not thoroughly deﬁned and documented, the software selected probably will not meet the organization’s needs. It will be useful to a system requirements deﬁnition (SRD) document that: • Serves as the basis for the RFP • Communicates the organization’s requirements to the vendors • Helps the selected software meet the organization’s current and future needs • Enhances the organization’s understanding of each application area (e.g., accounts payable and accounts receivable) and how automation can assist in improving access to information in that area • Prioritizes the application areas to be automated • Matches requirements against the software’s capabilities to determine where it is deﬁcient, and where modiﬁcations must be developed There are a number of approaches that may be used to develop FIS requirements. These approaches include questionnaires, executive interviews, document reviews, and outside sources. (a) QUESTIONNAIRES. Questionnaires may be used to develop a general understanding of an organization, its objectives, and the environment in which it operates. They may also be used to deﬁne major ﬁnancially oriented tasks, analyze transactions, determine major systems interfaces, and assist with the development of FIS requirements. Prior to developing a questionnaire, the individuals preparing it (normally an FIS steering committee or some other such group) need to make sure that they have top management’s support for the selection project. Without this support, it is doubtful that the questionnaire will be returned in a timely manner with complete and accurate responses. The questionnaire should not be so long that it discourages completion. Alternatively, it should not be so brief that it does not identify speciﬁc requirements. Exhibit 37.1 illustrates the types of questions that can appear in the questionnaire. Note that a cover letter should be attached to the questionnaire, clearly deﬁning its purpose, the date it is to be returned, and the importance of complete and accurate responses. Also, the cover letter should be signed by someone with authority, such as the chief ﬁnancial ofﬁcer (CFO), Controller, or the Director of Information Systems.

QUESTIONNAIRE TO DEFINE FIS APPLICATION REQUIREMENTS

1. 2. 3. 4. 5. 6. 7. 8. 9.

What automated system do you currently utilize? What are the primary goals of your job? With what other departments do you interface? What major tasks do you perform? What reports do you prepare? (Please attached a sample of each report.) What forms do you use? (Please attach a sample of each form.) Where do these forms originate? Where do these forms go when you complete them? What ﬁnancial information do you receive from other departments?

E XHIBIT 37.1

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FOR

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Ch. 37 Selecting a Financial Information System QUESTIONNAIRE TO DEFINE FIS APPLICATION REQUIREMENTS

10. What changes do you predict will occur in your job over the next one to three years? 11. What additional information could you use? 12. What automated system do you currently utilize? E XHIBIT 37.1

S AMPLE Q UESTIONNAIRE

(b) EXECUTIVE INTERVIEWS.

FOR

D EFINING A PPLICATION R EQUIREMENTS (C ONTINUED )

The purposes of conducting executive interviews include:

• Developing an overall understanding of the organization—its environment and objectives • Deﬁning executives information needs • Determining the executives opinions on the current system • Identifying the organization’s goals, objectives, and critical success factors • Identifying executives’ system expectations • Predicting growth areas or new needs that must be planned for by IS • Improving executives “buy in” to the selection process Executive interviews should not be designed to elicit detailed information on systems speciﬁcations. Rather, they should help elicit general information needs and strategic goals and objectives of the organization. It is important that the information and reporting needs of executives be emphasized and identiﬁed early in the selection process. Too frequently, only the needs of staff and middle management are incorporated. The resulting FIS frequently does not provide executives with the necessary reports for effectively managing the application areas. (c) DOCUMENT REVIEWS. Another way to develop systems requirements is to review input forms and reports. Doing so provides the organization with a listing of its current data elements and helps to deﬁne the minimum reporting requirements of the proposed FIS. Audit work papers often contain information that may be useful for developing system requirements. The ﬂow charts contained in the work papers frequently provide an overview of how an accounting “system” operates. Also, the work papers often contain volume estimates, such as the number of accounts payable (A/P) checks issued and the number of customers in the accounts receivable ﬁle. (d) OUTSIDE SOURCES. A ﬁnal source of requirements that should be included in an SRD is the environment in which the ﬁnancial organization exists. Economic trends, changes in laws and practices, and revisions to governmental regulations may all affect the reporting requirements of an FIS and, therefore, should be reviewed. There is a cost involved in collecting systems requirements. As a result, an organization should not spend an excessive amount of time documenting them, because it may never get to the point of selecting software.

37.4 EXISTING SYSTEM DOCUMENTATION After the questionnaires and executive interviews have been completed and the other sources of information reviewed, it is critical the existing manual and/or automated ﬁnancial systems be documented. Included in this documentation should be: • Key objectives of the system (e.g., maintain the general ledger and produce ﬁnancial reports) • Who supports the system • Major system inputs, edits, controls, and outputs (i.e., reports) • All system interfaces and special features • Volume of transactions processed by the system • Approximate costs of operating the system

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783

In addition, if the system is automated, it is important to note the hardware platform on which it operates, the language in which it is written, its age, and the approximate amount invested in the system. The main objectives of documenting existing manual and automated systems include: • Ensure the SRD contains, at a minimum, the features currently available, if desired • Identify speciﬁc weaknesses in the current system • Determine what is currently available and what is missing from the existing systems • Document required and unnecessary reports • Highlight procedures that are poorly deﬁned

37.5 JOINT SESSIONS An effective and efﬁcient means of ensuring a thorough system requirements survey is by conducting “joint sessions” with the employees who will be utilizing and supporting the system. The beneﬁts of conducting joint sessions include development of a more complete SRD and an improved user “buy in.” The steps required to conduct a joint session include: • Prepare “straw man” requirements for each application (e.g., A/P). These requirements generally are based on research previously conducted by the organization, information obtained from software vendors or computer-related literature, or IS consultants. • Distribute the requirements document to the employees interested in or affected by the speciﬁc application. (For example, the A/P requirements should be distributed to the A/P supervisor and clerks and other interested accounting personnel.) • Conduct a joint session for each application area. During these sessions, which generally are facilitated by a selection team member or a consultant, the participants are asked to: • Prioritize each requirement (i.e., state whether the requirement is required, desired optional, or not applicable). • Identify additional requirements. After the current ﬁnancial systems are documented and the joint sessions conducted, it is then time to ﬁnalize the SRD. The purpose of the SRD, which will become part of the RFP, is to communicate to software vendors the organization’s systems requirements and allow the vendors to identify software products that can meet those requirements. The SRD should be divided by application area (e.g., general ledger and accounts payable). The application area should be further divided into: • General systems narrative • Processing requirements • Inquiry requirements • Reporting requirements • Data requirements The requirements should be stated as a single sentence. Exhibit 37.2 gives a very abbreviated example of these factors for an accounts receivable system. System requirements documents may be from 5 to well over 100 pages per application, depending on the number and the level of detail desired. Be careful not to overdeﬁne the requirements or make the SRD so general that it allows all software packages to meet its needs. ACCOUNTS RECEIVABLE SYSTEM NARRATIVE

The accounts receivable system should be designed to handle all of the organization’s receivable and collection requirements. The system must interface with both the order entry system, to obtain billing information, and the general ledger system, to post billings, cash receipts, and bad-debt journal entries. E XHIBIT 37.2

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Ch. 37 Selecting a Financial Information System ACCOUNTS RECEIVABLE SYSTEM NARRATIVE

Processing Requirements The accounts receivable system should be able to perform the following functions: Post to different revenue accounts depending on the type of service performed. Enter non-accounting data to the master ﬁle on-line. Disallow the deletion of data with an account balance greater than zero. Interface with the order entry/billing system. Inquiry Requirements The accounts receivable system should include the following inquiry features and capabilities: On-line review of billing and payment history Inquiry as to the status of a bill using a variety of data elements including: • Customer name • Customer number • Invoice number Reporting Requirements The accounts receivable system should produce the following reports: Accounts receivable aging report—a report indicating the amount of time an accounts receivable balance has been outstanding. Frequency: weekly and on demand Cash receipts register—a register containing information on: • Date of receipt • Check number • Customer name and number • Dollar amount • Invoice number applied to • General ledger account posted to Frequency: daily and on demand Data Requirements The Customer Master File should contain the following data elements: • Customer Name—60 alpha/numeric characters • Customer Number—20 alpha/numeric characters • Customer Address 1 —Street—60 alpha/numeric characters —City—20 alpha characters —State—2 alpha characters • Customer Address 2 —Street—60 alpha/numeric characters —City—20 alpha/numeric characters —State—2 alpha characters • Customer Contact 1 —Name—40 alpha/numeric characters —Phone number—9 numeric characters —Street—60 alpha/numeric characters —City—20 alpha characters —State—2 alpha characters E XHIBIT 37.2

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785

After completing the SRD, the prioritization of the applications should be performed. It is vital for an organization to clearly deﬁne each application in the order of importance, to help it evaluate the completed RFP and identify the factors upon which the software selection will be decided. Factors to consider when assigning priorities to applications to be automated include: • The impact of the system on the organization and its customers. How many employees will come into contact with the system? Will the system affect relations with customers (as would a billing system)? How will the system beneﬁt the selecting organization? • The costs and beneﬁts of the system. Will the system affect the organization’s ﬁnancial position? Can the system inﬂuence the organization’s productivity? What are the total direct and indirect costs of the system? • The demand for the system. Are accounting employees requesting a new system? Does senior management support the system? How long will it take to get the system implemented? • The dependence of the system on other systems. Will the implementation of the accounts receivable system, for example, have to be delayed until the billing system is on-line?

37.6 PREPARING THE REQUEST FOR PROPOSAL An RFP is used to effectively communicate the FIS’ requirements to software and/or hardware vendors. It is prepared after the SRD and serves the following purposes: • Communicates the organization’s systems requirements to vendors and facilitates a uniform response to those requirements. • Requests speciﬁc commitments from vendors, such as the system’s functionality, the level of support and documentation provided, the costs, and contractual arrangements. • Serves as a tool for effectively comparing vendors. The RFP should be designed in a way that allows the selecting government organization to easily compare the proposals of various vendors. Depending on the organization’s situation, RFPs may be prepared for software, hardware, or both. However, no matter what the organization selects, the RFP must be well-structured and precise in order to elicit a clear and concise response from vendors. A vague and poorly organized RFP is likely to result in proposals that are too general and difﬁcult to compare and are lacking details in many areas. A typical Contents page for an RFP should contain: • Cover letter • General information/proposal guidelines • Background material • Vendor questionnaire • Vendor cost summary • System requirements (a) COVER LETTER. The cover letter notiﬁes the hardware and/or software vendor that the organization is requesting a proposal for speciﬁc applications and/or hardware. In addition, the cover letter should contain: important deadlines (such as the date of the bidders conference and when the proposal is due) and the projected installation and implementation dates; the overall objective of the RFP; the individual within the organization to contact with questions; and the format and content of the RFP. (b) GENERAL INFORMATION/PROPOSAL GUIDELINES. The general information/proposal guidelines section contains information on how the proposal is to be completed, how the selection process will be conducted, and the importance of a concise and timely response. Also included in this section is whether site visits will be made by the organization, a statement that the

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cost of preparing the proposal is entirely the vendor’s responsibility, that the organization reserves the right to reject any and all proposals, and that the conﬁdentiality of the material contained in the RFP. (c) BACKGROUND MATERIAL. The background material includes information about the organization that is of interest to the vendor. Generally included in this section is a description of the organization’s different business functions currently being performed and by which departments; volume statistics (e.g., the number of payroll and accounts payable checks issued per month and the number of general ledger transactions); the current hardware, ﬁnancial system software and modules, and operating system, if any; and the hours of operation. This information is very useful for vendors when preparing their proposals. (d) VENDOR QUESTIONNAIRE. The vendor questionnaire asks a variety of questions on the vendor’s background, clients, training, and growth; systems reliability, security, and performance; how modiﬁcations are handled; how reports are produced; acceptance testing and implementation schedule; data control; stafﬁng; R&D expenditures; documentation; and hardware proposed, if any. The answers to these questions will assist the organization with determining the ﬁnal vendor. This section must be extremely well-constructed and the questions concisely formulated. (See the appendix at the end of this chapter for examples of vendor evaluation criteria.) (e) VENDOR COST SUMMARY. In the vendor cost summary, the vendor is requested to complete a cost schedule specifying the costs of the proposed FIS. Each vendor generally is asked to provide information on recurring and nonrecurring costs over a ﬁve-year period and supplemental schedules to explain the derivation of all costs and what is included in such items as installation and maintenance fees. An example of a vendor cost summary schedule is shown in Exhibit 37.3. (f) SYSTEM REQUIREMENTS. The system requirements section sets forth the processing, inquiry, reporting, and data requirements developed during the systems requirement deﬁnition process. Each vendor is asked to complete a matrix that contains all application requirements. The vendor is asked to respond to the following categories for each requirement: • Whether the current system can satisfy the requirement. The only acceptable responses are yes or no. • Cross-reference (X-REF)—where in the vendor’s documentation is the requirement described. • Comments—any comments the vendor may have regarding the speciﬁc requirement. • Exhibit 37.4 reproduces a page from an accounts payable information requirements section, together with a possible vendor response.

37.7 DISTRIBUTION OF THE RFP Once the RFP is completed, the organization must determine the vendors to whom it will be sent. With over 50,000 software packages available, narrowing the ﬁeld can be a difﬁcult task. However, there are some basic factors to consider: • Geographic location. The ability to receive timely support is extremely critical. Since many software vendors may not have ofﬁces located near the organization, this factor can be used to eliminate many vendors. • Hardware considerations. Many software programs run only on certain hardware conﬁgurations (e.g., IBM or Hewlett Packard hardware only). Therefore, if the organization owns hardware or has a preference for a certain manufacturer, the software options are signiﬁcantly reduced.

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V ENDOR C OST S UMMARY Year 1

2

3

4

5

Total

$_____

Recurring costs

Hardware CPU lease

$_____

$_____

$_____

$_____

$_____

Terminal lease

_____

_____

_____

_____

_____

_____

Printer lease

_____

_____

_____

_____

_____

_____

Other lease

_____

_____

_____

_____

_____

_____

CPU maintenance

_____

_____

_____

_____

_____

_____

Terminal maintenance

_____

_____

_____

_____

_____

_____

Printer maintenance

_____

_____

_____

_____

_____

_____

Other maintenance

_____

_____

_____

_____

_____

_____

Software license

_____

_____

_____

_____

_____

_____

Software support

_____

_____

_____

_____

_____

_____

Other fees

_____

_____

_____

_____

_____

_____

Software

Supplies Disks, tapes

_____

_____

_____

_____

_____

_____

Ribbons, paper

_____

_____

_____

_____

_____

_____

Other Total

_____

_____

_____

_____

_____

_____

$_____

$_____

$_____

$_____

$_____

$_____

Nonrecurring costs

Hardware CPU purchase

$_____

$_____

$_____

$_____

$_____

$_____

Terminal purchase

_____

_____

_____

_____

_____

_____

Printer purchase

_____

_____

_____

_____

_____

_____

Other purchase

_____

_____

_____

_____

_____

_____

_____

_____

_____

_____

_____

_____

Freight

_____

_____

_____

_____

_____

_____

Cabling

_____

_____

_____

_____

_____

_____

Site preparation

_____

_____

_____

_____

_____

_____

Training

_____

_____

_____

_____

_____

_____

Customization

_____

_____

_____

_____

_____

_____

System initializing

_____

_____

_____

_____

_____

_____

Installation

_____

_____

_____

_____

_____

_____

Software Software purchase Installation

Other Total TOTAL

E XHIBIT 37.3

Black process 45.0° 133.0 LPI

_____

_____

_____

_____

_____

_____

$_____

$_____

$_____

$_____

$_____

$_____

$_____

$_____

$_____

$_____

$_____

$_____

V ENDOR C OST S UMMARY

37_controllership.fm Page 788 Monday, December 8, 2003 5:13 PM

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Ch. 37 Selecting a Financial Information System

C OMPLETED A CCOUNTS P AYABLE S YSTEM R EQUIREMENTS Requirement

Response Yes

1. Enter invoices on-line.

X

2. Enter vendor credit memoranda future payments. 3. Write checks automatically based on invoice date and a predeﬁned pay period (e.g., 30 days from invoice date). 4. Automatically process recurring payments. 5. Process and post manual checks to correct vendor and general ledger account. 6. Automatically interface with general ledger system. 7. Edit for duplicate invoice numbers to the same vendor. 8. Allow for standard discount terms (e.g., 1/10 net 30).

X

E XHIBIT 37.4

User Manual Pg. 5-22 $5,000 additional fee User Manual Pg. 3-22

X

X X X

Comments

No

X

X

X-REF

User Manual Pg. 2-10 User Manual Pg. 3-12 User Manual Pg. 7-12 User Manual Pg. 6-10 User Manual Pg. 3-20

$3,000 additional fee

C OMPLETED A CCOUNTS P AYABLE S YSTEM R EQUIREMENTS

• Organization size. The size of the organization inﬂuences the size of the computer system that must be acquired. Software is generally designed to run on either microcomputers, midrange systems, or mainframes. As a result, the software vendors to which the organization may send the RFP are limited. • Organizational preference. Some organizations prefer to deal with ﬁrms that only develop software. Other organizations prefer to deal with turnkey vendors that supply both a hardware and software solution. The organization’s decision in this area will inﬂuence the number of vendors to which the RFP can be sent. • Vendor characteristics. It is frequently possible to prescreen vendors to determine if it is appropriate to send them an RFP. This can be accomplished by calling a vendor representative, reviewing vendor literature, looking at one of the many software reference manuals such as Datapro or Data Decisions, or discussing vendors with organizations similar to yours. When prescreening a vendor, look at factors such as the vendor’s stability and related experience, list prices, and ﬂexibility. Other means of identifying vendors that should receive the RFP include engaging a consultant experienced in hardware and software selections, reviewing computer-oriented magazines, contacting hardware vendors for lists of potential software suppliers, and networking with other organizations. In general, the RFP should be sent to between ﬁve and ten vendors; any more than that and the process becomes cumbersome; any fewer and the choices become too limited. The vendor should be given sufﬁcient time—three to six weeks—to complete the RFP accurately and thoroughly.

37.8 REVIEW OF THE VENDOR’S COMPLETED PROPOSAL When the proposals are returned, they should be given an initial brief review. This brief review will most likely eliminate the proposals that do not meet the organization’s minimum critical needs.

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37.8 Review of the Vendor’s Completed Proposal

789

In general, systems decisions should be more heavily inﬂuenced by the software, not the hardware. Therefore, the organization should ﬁrst review the software proposed by the vendors. The goal of this review is to determine the two or three ﬁnalists. (The ﬁeld should be narrowed to two or three, because any more makes the ﬁnal selection cumbersome; any fewer leaves the organization in a risky situation. For example, if only one ﬁnalist vendor is selected and it goes out of business, the organization will have to begin the selection process again.) There are two types of software the organization needs to evaluate; application and systems. Application software is the software that performs the functions needed by the end-user, such as generating paying invoices, preparing ﬁnancial statements, and recording cash receipts. It is used to perform speciﬁc processing or computational tasks. Examples of application software include A/P, accounts receivable, and general ledger systems. Systems software makes it possible to utilize the application software. Included in this broad category are operating systems, database management systems, report writers, database compilers, and debugging aids. The system requirements section of the RFP is used to review the vendor’s application software. As previously mentioned, each vendor is asked to respond to each requirement. The selecting organization should tabulate these responses to determine how well the vendor’s software meets the organization’s needs. Use the following guidelines: • Prepare a spreadsheet listing all of the requirements. The spreadsheet should look exactly like the information systems requirement section displayed in Exhibit 37.4. • Determine the number of points a response is worth. For example, a “Yes” response to a “Required” requirement may be worth ten points, but only six points on a desired feature. (A sample scoring scheme follows.) • Tally the vendor’s responses. • Total the score by application area. • Determine the vendor’s total score. Response Yes No

Required 10 0

Desired 6 0

Optional 4 0

The spreadsheet should look exactly like the information systems requirement displayed in Exhibit 37.4. The rating sheet in Exhibit 37.5 can be effective in evaluating the vendor responses. In addition, the organization should review the following characteristics of each vendor’s application software: • Flexibility. Is the software easy to modify? Will it handle the organization’s needs ﬁve years from installation? Is it easy to debug? Flexibility is also an important factor to consider when reviewing systems software and hardware. • Documentation. Is it easy to use? Is it accurate and thorough? Is it regularly updated? Does it describe all error messages? Are all screen formats presented? Does it clearly describe recovery procedures? Are terms deﬁned? Who maintains it? • Controls. Is a clear audit trail of all transactions available? Are data validated before ﬁles are updated? Does password security exist? Are all errors ﬂagged? Is a listing of log-on attempts provided? Are different authorization levels available? Can check digits be used? Are batch totals available? Analyzing systems software can be more difﬁcult than analyzing application software, because it is harder to quantify. However, the following guidelines can be useful: 1. Determine the systems software factors to be evaluated. For example, it is likely that the selecting organization will want to review: The operating and database management system Multiuser capabilities

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Ch. 37 Selecting a Financial Information System

C OMPLETED A CCOUNTS P AYABLE S YSTEM R EQUIREMENTS

Requirement

Required or Desired

Response Yes

1. Enter invoices on-line. 2. Enter vendor credit memoranda on-line and apply credits to future payments. 3. Write checks automatically based on invoice date and a predeﬁned pay period (e.g., 30 days from invoice date). 4. Automatically process recurring payments. 5. Process and post manual checks to correct vendor and general ledger account. 6. Automatically interface with general ledger system. 7. Edit for duplicate invoice numbers. 8. Allow for standard discount terms (e.g., 2/10 net 30). E XHIBIT 37.5

Comments

No

R R

R D

R R R D

A PPLICATION S OFTWARE R ATING S HEET

Programming language utilized Compilation speeds Systems utilities such as ﬁle maintenance programs, backup and restore programs, and

sorting and text editors Systems support software such as ﬁle management processors, password protection, screen formatters, report writers, and print spoolers Compatibility of the system with other software products Interactive and communications capabilities Ease of operation

2. Once the factors have been determined, prioritize and assign numeric values to them. For example, the selecting organization may need a certain type of operating system. Therefore, this would receive a high priority. 3. Review the vendor’s proposal and assign a score to each factor. Assigning scores is a somewhat subjective process. However, it is important that it be performed. 4. Total the vendor’s score in this section. Exhibit 37.6 provides an example of how systems software can be prioritized and scored.As previously mentioned, the software decision usually takes precedence over the hardware decision. However, a thorough review of the proposed hardware is extremely important to ensure that the FIS will meet the organization’s needs. The size of the proposed hardware system depends on a number of factors: • The volume statistics listed in the background section of the RFP • The organization’s projected growth rates • The vendor’s experience with similar clients

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37.8 Review of the Vendor’s Completed Proposal

S CORING

FOR

S YSTEMS S OFTWARE

Systems Software Factor Points Assigned 1. Operating system 18 2. DBMS 12 3. Multiuser capabilities 10 4. Programming language 6 5. Compilation speed 6 6. Systems utilities 8 7. Systems support software 10 8. Compatibility 8 9. Interactive and communications capabilities 10 10. Ease of operations 12 Total Points 100 E XHIBIT 37.6

S CORING

FOR

791

Vendor A Score 16 12 6 6 2 6 7 8 9 8 80

S YSTEMS S OFTWARE

Acquiring a system that meets the organization’s current and future needs is extremely important. Either an in-house IS specialist or an experienced IS consultant must review the capabilities and ﬂexibility of the proposed hardware conﬁguration. Other hardware factors to review include: • Central processing unit • Peripheral devices (such as disk and tape drives) • Remote devices (such as communications support equipment) • Environmental considerations • Flexibility and expandability • Systems reliability Once the hardware evaluation factors have been identiﬁed, they should be prioritized and assigned a numeric value. (This is similar to the method recommended for reviewing systems software.) Then, each vendor’s proposal should be reviewed and assigned a score on each factor. The total score on hardware is then determined. After the hardware and software have been evaluated, the next step is to evaluate the vendor(s). Depending on the system desired, this may involve reviewing a software vendor and a hardware vendor. The primary factors to consider when evaluating a vendor are: • Product support • Reputation and ﬁnancial stability • Experience • Product availability and enhancements • Documentation • Training Once the software, hardware, and vendor have been thoroughly evaluated, the selection of the ﬁnalist vendors can occur. The ﬁnalists are then analyzed further by means of reference calls,

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Ch. 37 Selecting a Financial Information System

attendance at vendor demonstrations, and site visits. Because substantial amounts of time and money are invested in reviewing the ﬁnalist vendors, it is vital that the selecting organization choose vendors who can actually provide it with an FIS that meets its needs.

37.9 REFERENCE CALLS One of the most important aspects of the systems selection process is making reference calls to existing systems users. Reference calls are a means by which an organization can ﬁnd out what a vendor may not want them to know. For example, the organization may discover that a vendor’s documentation and support are not as good as its sales literature claims. Reference calls should be made for all ﬁnalist vendors. The calls should be directed to users with similar hardware and software conﬁgurations to get the most relevant information. Software does not run equally effectively on all hardware platforms. The questions asked during a reference call should be both fact- and opinion-oriented. The users should be asked to list the software implemented and their overall opinion of the software. Topics to cover when making a reference call include: • Type of organization • Volume statistics • Software packages purchased • Software packages implemented • Ease of installation • Operating system • Database management system • Hardware installed • Hardware dependability • Systems security • Response time • Quality of reports

• Approach to system selection • Why vendor(s) were chosen • Ease of operation • Quality of training • Quality of documentation • Modiﬁcations made • Quality of support • Vendor dependability • Unforeseen costs • User group membership/satisfaction • Overall satisfaction • Names of other users

The names of other systems users are important because vendors frequently provide only the names of satisﬁed users. Asking a user for names of other users may lead to one who is not pleased with the system.

37.10 DEMONSTRATION After the reference calls have been completed, the organization should consider attending vendor demonstrations to: • Obtain additional information on the software and vendor. • See how the software operates. • Review the “look and feel” of the system, its ease of use, and the level of complexity. Prior to attending the vendor demonstration, the organization should: • Prepare an agenda for the vendor to follow. • Develop a feedback form for the attendees to rate various aspects of the software and the vendor (e.g., screen layout and ease of use). • Prepare a list of questions and sample transactions for the vendor to enter into the system (e.g., matching a purchase order and invoice). It is important to remember that the vendors obviously will be presenting their software in its “best light.” You must be in a position to evaluate this information.

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37.12 Cost of the System

793

37.11 SITE VISITS After the reference calls have been made and demonstrations attended, the organization should arrange to see the system at a working installation, not at the vendor’s headquarters. The purpose of the site visits includes: • Viewing the system in a “real-life” environment • Answering questions that may have arisen during the selection process • Assisting the organization in deciding whether the system will meet its current and future needs The site visit should take place at a user’s place of business and should be on a “live,” not “demo,” system so that the vendor has no opportunity to manipulate the demonstration to its advantage. Although the majority of vendors are ethical, manipulation of potential customers is not unheard of. The individuals present at the demonstration should include in-house IS personnel; potential system users, such as the accounts payable supervisor; and the IS consultant, if one is being used. The visit should take no more than a day to complete. The selecting team representatives should come prepared with a set of questions to ask the other organization and a feedback form on which to record ratings of the vendor. If possible, the organization should arrange to make site visits within a two-week period to more easily compare the systems.

37.12 COST OF THE SYSTEM The costs of purchasing hardware, software, and implementation support can be a very critical factor in a selection process and should be carefully analyzed. The vendor cost summary portion of the RFP may be used to compare the costs of proposed systems. However, other cost factors need to be clariﬁed before comparing the total costs of the proposed systems. Consider: • What will the proposed enhancements cost? • How will the cost of future enhancements be determined? • Is there an additional fee for installation? • Is there an additional fee for training? • How much does maintenance cost? • Is there an additional fee for 24-hour support? • Is there a charge for system updates? • Will the organization receive a discount if it purchases other applications? • Does the software license allow for the use of the software at multiple sites? If not, what is the charge for the other sites? • How much does the warranty cost and how long is it in effect? • When does the warranty go into effect? (Ideally, the warranty should go into effect on the date the system is accepted, not on the date the system is installed.) • Does the vendor guarantee in writing a full refund if the software does not perform as promised? • Is the price of documentation included in the total price? • Can the organization duplicate the documentation, or must it pay for additional copies? If so, what is the cost for additional copies? • Is the source code (i.e., copy of the programs) included in the system’s price? If not, what is the charge for the source code?

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Ch. 37 Selecting a Financial Information System

37.13 FINAL SELECTION Once the software, hardware, and vendor have been thoroughly reviewed and the reference calls, demonstrations, and site visits completed, the organization is in a position to select the system. If the organization has completed the steps outlined in this chapter, it should ﬁnd itself with an FIS that meets current and future needs. Once the ﬁnal selection has been made, the organization is in a position to begin contract negotiations.

37.14 CONTRACT NEGOTIATIONS After the software and hardware have been selected, preparation for contract negotiations between the organization and the vendor(s) should ensue. The objectives of contract negotiations are: • Deﬁne the organization’s expectations clearly to avoid misunderstandings. • Deﬁne precisely what remedies are available if the vendor fails to perform as promised. • Protect the organization against unexpected occurrences, such as the bankruptcy of the vendor. • Ensure the best terms possible for the organization. Negotiating a contract can be a long and costly process. When negotiating, there are several points to remember: • Do not accept the vendor’s standard contract. These contracts tend to be one-sided in favor of the vendor and to disclaim all responsibility for performance and support. • Negotiate with someone with the authority to bind the vendor. Negotiating with a vendor representative who has no power is useless, because the promises they make may be overturned by their superiors. • Never accept oral promises. • Do not make unreasonable demands. • Obtain advice from a professional experienced in contract negotiations. The organization should not assume it can negotiate a mutually beneﬁcial contract without the help of a professional (e.g., a lawyer specializing in contract law). Four speciﬁc steps are essential for effectively negotiating a mutually beneﬁcial contract: 1. Select a negotiating team to represent the selecting organization, including an IS specialist, an individual who will be using the system, an attorney or consultant with signiﬁcant computer-related contract experience, and a purchasing department representative. 2. Determine the speciﬁc objectives of the negotiations and prepare a plan of action to take if the negotiations fail. 3. Review the standard contract terms offered by the vendor and identify problem areas and points that are missing. 4. Meet with the vendor to negotiate the contract. The contract should clearly specify the costs for hardware, software, maintenance, installation support, modiﬁcations testing, and upgrades. The organization should attempt to ensure it is protected from any price increases without its written consent. The contract should also clearly identify the terms of payment. The organization should hold back a substantial portion of the purchase price (e.g., 10% to 30%) until the system is fully operational for a speciﬁed period of time and has passed all acceptance tests.

37.15 APPENDIX: VENDOR EVALUATION CRITERIA Key factors to consider when evaluating vendors: (a) PRODUCT SUPPORT • Location of nearest sales and support ofﬁce • Size of the support staff at nearest service ofﬁce and their qualiﬁcations

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37.15 Appendix: Vendor Evaluation Criteria

• Availability of remote diagnostics • Availability of 24-hour support and associated cost • Guaranteed response time for system problems • Preventive maintenance approach and policies • Problem resolution procedures • Availability of installation and implementation support • Existence of and level of support of a user group • Existence of complete user and technical documentation • Frequency of documentation and system updates (b) REPUTATION AND STABILITY • Number of years in the computer industry • Number of similar installations of the particular system still operating • Sales growth rate of applications being reviewed • Financial condition of the vendor and/or its parent company • Research and development budget and number of staff

Black process 45.0° 133.0 LPI

795

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CHAPTER*

38

TESTING STRATEGIES FOR FINANCIAL SYSTEMS 38.1

INTRODUCTION 797

38.2

TESTING DURATION 797

38.3

USE OF REAL VERSUS MOCK TESTING DATA 798

38.4

TEST SCENARIOS 798

38.5

SECURITY TESTING 799

38.6

VOLUME TESTING 799

38.7

ISSUE TRACKING AND RESOLUTION 799

38.8

SIGN-OFF CRITERIA 799

38.9

TESTING PARTICIPANTS 800

38.1 INTRODUCTION When implementing a new ﬁnancial system, there are a number of challenges that will be encountered. More often than not, a huge focus surrounds the testing strategy of the system, ensuring the design works correctly and most of all that it has met the business requirements. Testing is so critical that it must be a dedicated phase of any implementation. Integration testing (i.e., ensuring the various applications such as accounts payable and general ledger work well together) is “where the rubber meets the road.” System factors as well as related business operations must be tested in an integrated manner and replicate how the business will operate once the system is live. The following sections provide factors that must be considered in developing an integration testing strategy for implementing new ﬁnancial systems.

38.2 TESTING DURATION What is the right amount of time for testing? Unfortunately there is no mathematical answer. A number of factors will inﬂuence the duration of the testing: • Complexity of the functionality being implemented • The number of interfaces, conversions, and reports that have been developed as part of the design • The amount of customization of the base package • The level of process reengineering that has been made • The amount of user involvement in testing. (The more user involvement, the more knowledge transfer from the implementation team to the user community is required.) • The number of testing cycles required to satisfy sign-off criteria. (The more speciﬁc the test sign-off criteria are, the more testing time required.)

*This chapter was authored by Tanya Whiteing, Senior Manager, Deloitte Consulting, Foster City, California.

797

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798

Ch. 38 Testing Strategies for Financial Systems

38.3 USE OF REAL VERSUS MOCK TESTING DATA In developing an integrated test strategy, many would argue for the use of real data as opposed to developing “mock” or test data. The use of real (i.e., “production” data) allows the testers to observe how the new system will behave once it goes live. The strategy taken in many implementations is to initially test interfaces, conversions, and transactions with mock data, as they are often easier to create, as opposed to waiting for production data to be available. Once there is conﬁdence that the design is working, then production data should be used where possible. The beneﬁt of using the latter is that production data often contain real-life scenarios that the testers would not have thought of creating. The downfall of using production data is that they usually require signiﬁcant coordination of legacy test systems and setting up the type of technical environment necessary to support this type of testing. As a result, it is often an area that is underestimated within the project workplan. However, if it is decided to continue to use mock data in testing then this will also require some intense preparation. Additional time will be taken to create mock data so that they closely reﬂect the production data with the necessary varied combinations to challenge the system. Some testing, especially that related to interfaces and conversions, requires high transaction volume, resulting in additional setup time. In testing ﬁnancial systems, the preference is to use production data to simulate a month-end close and consolidations processing (if applicable). The additional beneﬁt is to create an environment for testers to be able to perform a detailed level of ﬁnancial reconciliations to prove that ﬁnancial reporting will not be misstated. Using production data will assist in achieving these goals.

38.4 TEST SCENARIOS Test scenarios represent the various conditions that must be thoroughly tested during the integration testing phase. The selection of scenarios for testing is usually dictated by the functionality being implemented, criticality, and difﬁculty of the design, as well as the sign-off criteria. For ﬁnance organizations, scenarios related to month-end close, consolidations, reporting, and reconciliations should be apparent throughout the testing phase. Examples of ﬁnancial reconciliation scenarios include: reconciliation of interfaces to ensure that data passed from a legacy system are accepted within the new system without duplication or missing records, and reconciliation during month-end close to ensure that legal and management reports are still intact, and reconciliation during the consolidations process to ensure the roll-ups of the ﬁnancial transactions are posted to the correct consolidated accounts. The challenge for ﬁnancial scenario testing is the dependency of transactional data being created by other functional areas. This waiting game is often experienced in ERP system implementations where ﬁnancial transactions are produced as a result of executing a transaction in the operations area. Some examples include creating and receiving against a purchase order, creating and processing of a production order for product costing purposes, and so on. This is truly integration testing at a transaction level. Unfortunately, month-end close testing cannot commence until these types of transactional testing are completed. Financial testers must be involved in testing and understanding the scenarios of other integrated functions. This will enable validation that the correct ﬁnancial postings are being created as and when the operational tests occur, as well as ensuring that the variety of scenarios required to test downstream ﬁnancial scenarios exist. The business organizations must participate in the development and/or review of the test scenarios. This will ensure that the test scenarios represent realistic business situations. Test scenarios should represent not only situations that frequently occur but also those that occur on an exceptional basis. This approach will challenge the design of the system and whether it is robust enough to handle all types of situations. An additional advantage of involving the users is that they will represent a process view rather than just a transactional focus. This will ensure complete end-toend testing.

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38.8 Sign-Off Criteria

799

38.5 SECURITY TESTING An important part of any new system is maintaining the security and integrity of the data and controlling access to the data. The goal of testing security proﬁles is to prove that users have the appropriate access to transactions once the system goes live. Security testing should include reviewing the audit restrictions of certain combinations of transactions to ensure that there are no breaches (e.g., no one individual can both enter purchase orders and invoices and perform payment transactions). In addition to this, testing security of certain sensitive information should also be performed (e.g., particular ﬁnancial statement and employee information). Full security testing should not occur until there is an assurance that the actual design is operational. If security testing is performed too early, then there is a risk that when errors occur it will be difﬁcult to assess whether it is the user’s security preventing execution or some error in the conﬁguration setting.

38.6 VOLUME TESTING Another series of tests that should be performed is related to volume, better known as performance/stress testing. It is imperative that high-volume or critical transactions are tested, as once the system goes live, slow-performing systems will cause issues. These types of issues can hinder month-end close activities and reporting. Volume or performance testing usually commences after integration testing. It ﬁrst must be established that the system is operational; otherwise, one will spend more time correcting functional issues than concentrating on its performance. This part of the testing phase is usually led and managed by the technical team as they have the necessary skillset to assess areas of ﬁne tuning.

38.7 ISSUE TRACKING AND RESOLUTION Integral to any testing methodology is the ability to track all testing errors that are incurred as well as their resolution. This provides a solid audit trail of the testing history but also creates documentation for personnel such as those in the production support organizations in case the issue repeats itself once the system goes live. Upon identiﬁcation, issues must be prioritized and it must be determined whether testing can continue or should be halted until the error is resolved. Tracking of related test scenarios that are dependent is also crucial, otherwise the management of the testing phase could be in jeopardy. Testing is one phase of the project that contains unpredictability and as a result must be tightly managed but with extreme ﬂexibility. Testing participants must have the appropriate expectations, including maintaining a positive attitude throughout the testing phase, especially when times are tough.

38.8 SIGN-OFF CRITERIA Sign-off criteria must be developed so that the project team understands how to assist in the measurement of testing success. Some obvious measurements include the number of issues identiﬁed, issues resolved, and how many test scenarios can be executed error free. However, the fact that the system successfully performs its functions does not mean that it has been designed to achieve the business needs. Sign-off criteria should reﬂect precise goals that the testing phase should meet, including some speciﬁc goals around business requirements that were expected to be achieved as a result of the implementation. Some examples of sign-off criteria include; interfaces can be executed with no errors, month-end close processing can be completed within a ﬁve-day timeframe, and account reconciliations match expected results or contain explainable differences that are acceptable to the business. Sign-off criteria must be evaluated throughout the testing phase to ensure testing progress is being made. There is little point evaluating the sign-off criteria at the end of the testing phase and realizing that some cannot be met. This will merely extend the length of testing and question the

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Ch. 38 Testing Strategies for Financial Systems

conﬁdence the business organizations may have in the new system. At the end of the testing phase, a meeting should be conducted with project management and major stakeholders to review the sign-off criteria and make a decision as to whether the system is ready for production.

38.9 TESTING PARTICIPANTS The project team members are likely to be the key participants in testing, as they are the most familiar with the new system and as a result are the ﬁrst point of contact when errors are identiﬁed. Other participants should include users from the various business organizations with a stake in the new system. To accommodate the participation of users, a separate testing cycle is often dedicated to this and is commonly referred to as “user acceptance testing.” This not only facilitates knowledge transfer to the business (prior to end user training) but also encourages buy-in from the user community, which will assist with the sign-off process. Involving the business in testing will ease the training effort required. For ﬁnancial end users, it is extremely critical to have their involvement in the testing phase as they must become familiar with analyzing new reports and transactions. Finally, production support personnel also should be involved in testing in preparation for the ﬁnal cutover.

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CHAPTER*

39

SOFTWARE TESTING 39.1

INTRODUCTION 801

39.2

TESTING CONSIDERATIONS 801 (a) Importance of Testing 801 (b) Cost of Testing 802

39.3

TESTING PACKAGED FINANCIAL SYSTEMS 802

39.4

TEST STRATEGY 803 (a) Test Stages and Approach 804 (b) High-Level Test Work Plan 807 (c) Test Resource Requirements 807 (d) Test Roles and Responsibilities 808 (e) Test Management Process 809 (f) Test Stage Completion 812 (g) Automated Test Tools 812

39.1 INTRODUCTION Software testing is one of the most important aspects of implementing a new ﬁnancial system, yet many organizations consider testing as an afterthought. As a controller, it is important to ensure that all ﬁnancial systems within the organization are defect-free and conform with the company’s accounting policies and procedures. In this chapter, we have outlined the key considerations for testing a ﬁnancial system in a proactive and cost-effective manner.

39.2 TESTING CONSIDERATIONS (a) IMPORTANCE OF TESTING. Software testing is one of the most important components of implementing a new ﬁnancial system, yet it is often overlooked, underemphasized, understaffed, or unorganized. The amount of planning and resources that should be invested in testing depends on the importance of the system to the organization. The accuracy of a ﬁnancial system may not be as critical as the accuracy of a medical system used to operate laser brain surgery equipment. Financial systems are, however, considered essential to an organization, and therefore, a signiﬁcant investment in planning and executing testing activities is warranted to ensure a robust, defect-free system. Software testing should not be a discrete process that occurs at the end of the software development life cycle but rather should be considered a continuous process that occurs throughout the life cycle. The earlier a defect is discovered, the less expensive it is to correct. For example, a defect discovered during design is much simpler to correct than a defect discovered in your production environment. A common mistake made with software testing is that it is not planned until development is near completion and is not executed until after all development has been completed. A robust testing approach focuses on identifying errors early in the development life cycle and pro*This chapter was authored by Karen L. Bassett, Manager, Ernst & Young LLP, Denver Office, and Jill M. Weisbrod, Senior Consultant, Ernst & Young LLP, Denver Office.

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vides for quality throughout the development process. This reduces the cost inﬂation associated with discovering errors later in the implementation process. (b) COST OF TESTING. A signiﬁcant portion of the cost of implementing a new system can be attributed to software testing. Financial systems are no exception. According to a survey published by the Quality Assurance Institute, an average of 24 percent of the total project budget is consumed by testing. Individual responses ranged from 5 percent to 50 percent.1 If a packaged software solution is being implemented, these percentages can be even higher due to the reduced development costs. There should be a balance between the cost of testing and the beneﬁts achieved: “The risk of undertesting is directly translated into system defects present in the production environment. The risk of overtesting is the unnecessary use of valuable resources and time in testing systems that have no ﬂaws or so few ﬂaws that the cost of testing far exceeds the value of detecting the system defects.”2 The actual level of testing should be determined based on the criticality of the ﬁnancial system to your organization, the stability of the ﬁnancial package being implemented, and the number of customizations being made to the ﬁnancial package.

39.3 TESTING PACKAGED FINANCIAL SYSTEMS Most organizations elect to implement a packaged ﬁnancial system solution rather than build a custom application because of the risks, costs, and time associated with implementing custom-built ﬁnancial systems. In addition, ﬁnancial packages often incorporate industry best practices, allowing the organizations implementing them to achieve signiﬁcant process beneﬁts. It follows that testing a packaged ﬁnancial system entails less risk, cost, and time than does testing a custom-built application. Rather than testing every screen, program, and report in a custom-built application, the testing effort for a packaged system focuses on customizations that are being made to the package. Exhibit 39.1 demonstrates where a packaged system may be customized. Customizations may include: • Interfaces between the new ﬁnancial package and other legacy systems within your organization. For example, an accounts payable module of a ﬁnancial package may receive nightly vendor updates from a purchasing system. • Converted data from systems that are being replaced by the ﬁnancial package. For example, if your ﬁnancial package is replacing an existing accounts payable system, unpaid invoices may be translated into a recognizable format and loaded into the new system. • Supplemental screens, programs, and reports that are added on to the package. For example, an entirely new report that is not delivered with the package may be required by your organization. • Modiﬁcations to the delivered screens, programs, and reports that cannot be addressed by supplemental screens, programs, or reports. For example, the general ledger module of a ﬁnancial package may require changes to record additional information about certain transactions that are speciﬁc to your industry or organization. Of course, it is still necessary to validate that unmodiﬁed screens, programs, and reports integrate properly with the customizations and your business processes; however, the effort is signiﬁcantly less than the effort required for a custom-built application.

1. Quality Assurance Institute, 1994 Survey Results on Software Testing, 1994, pp. 1-7. 2. William E. Perry, Effective Methods for Software Testing (Wiley, 1995), p. 14.

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39.4 Test Strategy

E XHIBIT 39.1

803

C USTOMIZED P ACKAGED F INANCIAL S YSTEM

39.4 TEST STRATEGY One of the ﬁrst and most critical steps in the testing process is to deﬁne the test strategy. The test strategy, which documents the testing approach and the resources involved, should be written and approved well before any customizations to the package are designed. The test strategy enables the project team to visualize each testing stage before developing detailed test designs. The test strategy should be deﬁned early so appropriate resources can be allocated in advance of testing stages. This strategy also helps in developing a project schedule that is driven by the system’s readiness for production rather than being driven by a speciﬁc implementation date. According to a survey published by the Quality Assurance Institute, “the dominant factor for determining the readiness of a software for production remains the date of implementation. Sixty-ﬁve percent of respondents said that release of software was time driven. Reasons stated for this situation included tight schedules, test plans altered to ﬁt dates, scheduling conﬂicts, and lack of planning.”1 A thorough and timely test strategy should alleviate many of these problems or at least make the project team aware of them before it is too late. Speciﬁcally, the test strategy deﬁnes: • The overall test process, including the major test stages • A high-level test work plan • Resource requirements for testing, including people, hardware, and software • Test roles and responsibilities • The mechanisms that will be used to report test status • The process that will be used to track and report defects discovered during the various test stages • The usage of automated test tools The remainder of this chapter describes each of these items in further detail.

1. Quality Assurance Institute, 1995 Survey Results on Software Testing, 1995, p. 2.

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Ch. 39 Software Testing

(a) TEST STAGES AND APPROACH (i) Test Stages. Testing is sometimes erroneously considered a discrete event in the system development life cycle. However, in order to detect and correct defects early, testing should be a continuous, integral part of the design, development, installation, and maintenance system development life cycle phases. Exhibit 39.2 describes the relationship of testing stages to the system development life cycle phases. Delivered Package Test. The delivered package test stage focuses on the functionality of the software package as delivered by the vendor. Its purpose is to ensure that the package will assimilate into the corporate environment and to determine whether the package can be used as delivered or whether modiﬁcations or additions need to be made to the package before it can be put into production. Delivered package testing is part of the design phase in the software development life cycle. The outcomes of this testing stage are functional requirements for customizations to the software package and revised system and manual processes. Unit Test. The unit test stage focuses on the functionality of individually developed modules or customizations. No unit testing is performed on unmodiﬁed package modules. Unit testing is the ﬁrst “line of defense” in the testing process. The purpose of conducting unit tests is to uncover defects as early on as possible. It provides modules that, when tested individually, behave as designed when moved to the integration test stage. It also veriﬁes that the application has achieved the intent of the functional requirements and detailed designs for each customization. Unit testing occurs during the development phase of the software development life cycle. Integration Test. The purpose of the integration test stage is to uncover defects introduced by combining individually unit-tested modules with unmodiﬁed package modules. Integration testing looks at complete end-to-end transactions for this purpose. Its focus is not on functionality but rather on technical integration. Integration testing may be compared to a long, thin pipe. Individual fragments are strung together to form the pipe. Integration testing uncovers blockages or leaks in the newly made pipe. Integration testing occurs at the end of the development stage and ensures that the system is stable and ready to proceed to the system test stage.

E XHIBIT 39.2

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T EST S TAGES

AND

S YSTEM D EVELOPMENT L IFE C YCLE P HASES

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39.4 Test Strategy

805

System Test. The system test stage is the most comprehensive test of the system’s functionality, performance, and ﬁt. It demonstrates that the system meets the original objectives and requirements and that it works within the deﬁned constraints for performance, security, and recovery. Typical types of system tests include usability testing, security testing, stress and volume testing, recovery testing, and documentation and procedures testing in addition to functional testing. System testing is one stage of the test phase of the system development life cycle. Acceptance Test. Acceptance testing is the next stage of the system development life cycle test phase. This user-run test stage demonstrates the application’s ability to meet the business objectives and requirements. In this respect, it is like system testing. Unlike system testing, however, the acceptance test is the responsibility of the users and affected information systems (IS) personnel. The objective of acceptance testing is to validate that the system ﬁts into the real-world business environment in which it will be used and that it is acceptable to those who will be using it to perform their jobs. Acceptance test criteria—the critical requirements that the system must meet successfully before it is considered ready to be put into production—must be deﬁned before any customizations are designed. This will help to ensure that customizations are designed, developed, and tested to meet the acceptance test criteria. Installation Test. The objective of installation testing is to validate that the customized and tested package was successfully installed in the production environment. This is particularly important if the ﬁnancial package will be installed at multiple locations or on multiple platforms. During installation testing, validation is performed on ﬁnal data converted from any legacy ﬁnancial systems being replaced by the package. Regression Test. In addition to the test stages described above, regression testing is used to evaluate whether recent changes in one part of the application have adversely affected other portions of the system. Regression testing focuses the retesting effort on the areas of the system that are impacted by the change. Regression testing is used throughout the testing process as defects are identiﬁed and corrected. It continues to be used after the system is in production as additional enhancements are made to the system functionality or as vendor upgrades are applied to the base package. (ii) Test Design. Approach. For any testing stage to be successful, it must be organized and deﬁned prior to the beginning of test execution. In addition to the overall test strategy for the project, each test phase should have its own test plan and approach. The test plan describes the objectives of the test stage, the business requirements and processes being tested, and the completion criteria. Completion criteria help to determine when an acceptable level of quality has been achieved during each stage, allowing the team to proceed to the next test stage or to production. As previously discussed, each test stage focuses on testing speciﬁc aspects of the system. During each stage, the base package and all customizations are tested to varying degrees of intensity as depicted in Exhibit 39.3. A well-deﬁned test plan for each test stage ensures that all requirements are adequately tested and that defects are identiﬁed and corrected early in the life cycle, well before the ﬁnancial system is put into production. Acceptance criteria should be deﬁned during the delivered package test and design of any customizations so the customizations can be developed and tested against these criteria throughout all test stages. These criteria should focus on the business processes and performance measures critical to your ﬁnancial processes and procedures. Testing should focus on rigorously testing critical business processes and acceptance criteria since testing resources are limited and not every aspect of the system can be exercised exhaustively. Financial analysts and users of the system should be involved in the test plan and the design of the individual tests, called test cases, to ensure that all critical ﬁnancial processes are identiﬁed and adequately tested. Test Cases. Test cases are detailed instructions on how to execute business transactions to determine whether a speciﬁc business objective is met correctly. A test case is designed to simulate realistic business transactions and speciﬁes the exact steps to be executed by the tester, the expected results of each step, and the data required to execute the cases. Test data should be realistic and developed speciﬁcally to ﬁt the test case and test conditions. An example of a test case for a ﬁnan-

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Ch. 39 Software Testing

E XHIBIT 39.3

T ESTING I NTENSITY

BY

S TAGE

AND

C USTOMIZATION T YPE

cial system accounts payable module is invoice entry. The test case veriﬁes that the invoice can be entered and saved in the system and that requirements speciﬁc to your organization, such maximum dollar amounts per line item, function properly. Test cases generally focus on a speciﬁc business transaction. In order to test a complete business process or thread of functionality, individual test cases are grouped together into test cycles. Test cycles aid in verifying system ﬁt to business processes and the accuracy of integration between individual modules. For example, a test cycle could include the following test cases: invoice entry, invoice approval, and payment processing. These test cases would be grouped together in sequential order to test the process. Some steps to consider in developing robust test cases are: 1. Make test cases repeatable. When a defect is identiﬁed and corrected, it can be easily retested. 2. Develop test cases robust enough to thoroughly test the software yet understandable to other testers in order to allow the test designer and test executor to be different resources. 3. Clearly deﬁne expected results. 4. Test conditions that will make the transactions succeed as well as conditions that make the system fail, to verify that the system works gracefully under each set of conditions. 5. Avoid random testing. You will miss something, and tests are not repeatable. 6. Deﬁne likely places where there will be errors and test these extensively. (iii) Test Execution. Once test cases have been developed, they can be executed in the appropriate test stage. Often test cases developed for an earlier test stage can be used as the basis for test cases in a later test stage by adding functionality and conditions to the test case. Typically, a subset of system test cases are used during acceptance testing. The test cases are grouped into test cycles and scheduled for execution. All customizations are ﬁrst tested in the unit test stage by the development staff. When all customizations have been developed and unit tested, the test team tests the customizations and unmodiﬁed package sequentially through the integration and system test stages. Integration testing

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807

ends when all major end-to-end business transactions can execute smoothly. System testing ends when the system successfully meets all functional and performance objectives. Finally, the users and affected IS personnel test the system in acceptance testing. Defects identiﬁed in any of these testing stages are corrected and retested in the unit test, then proceed through the integration, system, and acceptance tests sequentially, as indicated in Exhibit 39.4. Each test stage should be executed using its own installation of the customized software package and data. It is extremely important that test procedures and standards be in place to track test case status and the identiﬁcation and correction of defects throughout the test process. (b) HIGH-LEVEL TEST WORK PLAN. Testing is interdependent with many other project activities. Therefore, it is imperative that the test work plan be tightly integrated with the overall project work plan. Critical path dependencies should be highlighted so the impact of project delays on testing and implementation can be seen immediately. Ideally, the project schedule is driven by the system’s readiness for production rather than by a speciﬁc implementation date. (c) TEST RESOURCE REQUIREMENTS (i) People. The test strategy will estimate the number of technical and functional resources required for each test stage. Once test design begins for each test stage, and the actual number of test cases to be created becomes known, a reﬁned estimate should be provided for the remainder of the test design and the subsequent test execution. (ii) Hardware. The test strategy should outline all types of hardware that will be required to conduct each test stage. For a client-server ﬁnancial package implementation, hardware can

E XHIBIT 39.4

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P ROGRESSION

THROUGH

T EST S TAGES

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Ch. 39 Software Testing

include personal computers, the server that will run the package, and any additional hardware required for special test tools. Some additional considerations include: • Tester workstations will require network connectivity. • The server should be large enough to accommodate multiple installations of the ﬁnancial package for development, integration testing, system testing, and acceptance testing. This will allow defects that are discovered during testing to be corrected in development and pass through the subsequent testing stages. (iii) Software. The test strategy should also outline the software required for each type of hardware speciﬁed. Some considerations include: • Tester workstations should have the operating system, test tools, and packagespeciﬁc software (for client-server) or terminal emulation software (for centralized processing) installed. • The server should have the package software and database software installed. (iv) Facilities. Integration testing, system testing, and acceptance testing should be conducted in one facility capable of housing all full-time testers. This facility should provide network connectivity to the server where the package is being run. (d) TEST ROLES AND RESPONSIBILITIES. Testing is the culmination of many prior project activities, and as a result, a cross-functional team must be formed to execute it successfully. Exhibit 39.5 depicts the overall relationships of this cross-functional team. (i) Test Team Responsibilities. There should be one test team responsible for all testing activities. This team deﬁnes the test strategy for the project and implements the supporting tools and infrastructure.

E XHIBIT 39.5

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T EST R OLES

AND

R ESPONSIBILITIES

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39.4 Test Strategy

809

(ii) User Team Responsibilities. Before development can begin, the user teams are responsible for the delivered package test design and the delivered package test execution. These deliverables verify that the unmodiﬁed package is conﬁgured according to the organization’s requirements and that there are no vendor defects within the package. Users should also be involved in validating the results of the unit test execution, ensuring that customizations meet original functional requirements. During integration, system, and acceptance testing, they are responsible for resolving any defects that are assigned to them. It is imperative that selected members of the user teams become full-time members of the test team during integration, system, and acceptance test design and execution. These users should be very knowledgeable in the conﬁguration of the unmodiﬁed package as well as the functional requirements for all customizations. This will provide robust tests that should validate functional requirements. Ideally, integration, system, and acceptance test designs should be performed by a mix of technical and functional resources, with varying degrees of knowledge about the package. If only IS resources or uninformed users are assigned to the test team, critical business requirements may not be tested properly or may be overlooked entirely. However, a tester with little knowledge in the business requirements can be more objective and may be able to uncover defects that an experienced user would not stumble upon. (iii) Development Team Responsibilities. Before integration testing can begin, the development teams mmust create and unit test all programs pertaining to package customizations. During integration, system, and acceptance testing, they are responsible for resolving any defects that are assigned to them. It is imperative that the development team produce their unit-tested code according to the project work plan and correct defects in a timely manner in order for testing and implementation to proceed as planned. (iv) Joint Team Responsibilities. During integration, system, and acceptance testing, the test team and designated members of the development and user teams are responsible for test case execution, defect tracking, and defect prioritization, and for determining whether the package is stable enough to proceed to the next test stage. (e) TEST MANAGEMENT PROCESS. The ﬁrst step in managing the test process is planning the design and execution of test cases. This entails deciding the scope, order, and timing of test case execution. To gauge progress, it is necessary to track how many test cases have been designed, how many test cases have been executed, and how many have passed, and to identify the defects that were discovered during execution. An electronic, shared medium for communicating and tracking the status of test cases and defects will enable the team to evaluate and report the progress of testing stages and extrapolate when they will be completed. (i) Test Case Status. Exhibit 39.6 demonstrates how a test case status database could be used to report test progress and extrapolate when the test phase will be ﬁnished. For example, if the difference between the number of test cases designed and executed over time is wide it implies that there are not enough testers. If the difference between the number of test cases executed and completed is wide, it implies that the number of developers correcting defects is insufﬁcient. All of the curves can be tracked relative to the projected number of tests planned as well as the scheduled completion date.1

(ii) Defect Prioritization and Resolution. The most important cross-team interaction is the prioritization and resolution of defects that are uncovered during testing. If the appropriate

1. Software Testing Concepts Monograph, Ernst & Young Navigator Systems Series, Release 3.0, Ernst & Young International, Ltd., 1995, ch. 4, p. 9.

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Ch. 39 Software Testing

E XHIBIT 39.6

T EST C ASE S TATUS

Source: Software Testing Concepts Monograph, Ernst & Young Navigator Systems Series, Release 3.0, Ernst & Young International, Ltd., 1995, ch. 4, p. 9.

resources are not available from the user, development, and test teams to keep this process moving, testing (and therefore implementation) will be slowed. This is especially important during the integration and system testing stages. A standard defect management process is featured in Exhibit 39.7. A description of each step in Exhibit 39.7 follows: 1. Test application. The test team tests the application during integration, system, or acceptance testing. 2. Identify defect. A defect is identiﬁed during testing or from another source such as a developer or user in the development or training environments. 3. Log defect into system. The person who discovers the defect logs it into the defect-tracking database. 4. Review defects. A designated person or group reviews all defects to determine whether the defect must be ﬁxed immediately for testing to continue. It is important that the reviewer have the authority and make timely decisions, or the progress of testing and thus implementation will be slowed. 5. Disposition. The reviewer decides to accept, reject, or defer the defect. 6. Assign and set priority. The defect is prioritized and assigned to a developer (technical defect) or user (conﬁguration or process defect) for correction. 7. Correct defect. The assignee performs all steps required to correct the defect. This includes overseeing the timely resolution of any issues that are identiﬁed as a result of analyzing the defect. 8. Unit test module(s). Any changes made by the assignee to modules are thoroughly unit tested. 9. Test change in integration/system test environment. The test team retests all defects in the integration or system test environment.

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39.4 Test Strategy

E XHIBIT 39.7

811

D EFECT T RACKING P ROCESS

10. Fixed? If the tester determines that the defect has been ﬁxed and the defect was discovered in integration or system testing, this is the last step of the defect-tracking process. The tester closes the defect. If the tester determines that the defect has been ﬁxed and the defect was discovered in acceptance testing, the tester proceeds to step 11. If the defect has not been ﬁxed, the tester returns the defect to the assignee for recorrection. 11. Discovered in acceptance test? If the defect was discovered during acceptance testing, it must be retested in the acceptance test environment. Note that this is in addition to the previous retest that was completed for the defect in the integration/system test environment. If the defect was not discovered during acceptance testing, no further action is required. 12. Test in acceptance test environment. The users involved with acceptance testing retest all defects in the acceptance test environment. 13. Fixed? If the user determines that the defect has been ﬁxed, the defect is closed. If the defect has not been ﬁxed, the user returns the defect to the assignee for recorrection. 14. Close defect. During various points of the defect-tracking process described above, a defect can be rejected or closed. Pertinent information about each defect that should be tracked in the database includes: • Number (unique number to identify the defect) • Status (new, assigned, ﬁxed, closed) • Severity (how major is the defect?) • Priority (how soon does it need to be corrected?) • Description (including error messages and screen prints)

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Ch. 39 Software Testing

• Detected by (person who discovered the defect) • Detected in version (version of the software where the defect was discovered) • Detected on date (date the defect was discovered) • Test case (name of the test case that discovered the defect, if applicable) • Test stage (integration, system, acceptance) • Assigned to (person correcting the defect) • Date ﬁx required • Target release (version the defect is targeted to be ﬁxed in) • Estimated ﬁx time • Actual ﬁx time • Date closed • Developer comments (description of changes made, including any information required for retest) • Functional area of defect • Source of defect (area of the application where the defect exists) • Module IDs (names of modules that were updated to correct the defect) • Cause of defect (reason why the defect occurred) • Closed in version (f) TEST STAGE COMPLETION. A test schedule should be driven by quality, not be the project work plan. Quality is based upon the rate of defect discovery and the severity of those defects. For example, if the project team has planned one month for system testing and the month has been consumed, this does not necessarily mean that the system is ready to proceed to acceptance testing. If there are major defects that should not be presented to the end user, you may wish to delay acceptance testing until they are corrected. Likewise, if the projected work plan indicates that the system should be put into production on a certain date, but the rate of defect discovery has not leveled off and the defects are signiﬁcant in nature, the system is not ready for production. Putting the system into production under this scenario is likely to result in end users discovering signiﬁcant defects in your production environment and could lead to the corruption of critical data. This would be undersirable because of the cost of correcting these defects and because of the organizational impacts. This approach to test stage completion highlights the importance of tracking defects and their severity. By tracking this information, decisions on whether the system is ready to proceed to the next test stage or to production will be greatly facilitated. It is important that this approach be communicated to project management when the overall project work plan is created to convey the expectation that estimated test stage completion dates are not set in stone. (g) AUTOMATED TEST TOOLS. Automated test tools can be a valuable asset in the testing process. They can reduce the number of people required to execute testing, increase the quality, and decrease the overall cost and time associated with testing. Test tools fall into four major categories: regression-testing tools, performance-testing tools, analysis tools, and status-tracking tools. (i) Regression-Testing Tools. Regression-testing tools allow electronic storage and reexecution of test cases, automating the comparison of actual test results to expected test results. The advantage of regression tool usage is the ability to automatically retest the software after changes are made without signiﬁcant human intervention. The disadvantage is the high degree of setup and maintenance associated with the use of these tools. The use of a regression tool initially requires a great deal of overhead. The beneﬁts occur after the system is in production and changes or new modules are added. A cost-beneﬁt analysis on the use of an automated regression test tool should be performed as part of the test strategy.

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(ii) Performance-Testing Tools. Performance-testing tools simulate multiple users performing simultaneous, realistic transactions on the system and allow the capture and evaluation of application performance metrics such as response time. The cost of using automated performance test tools can be high; nevertheless, the beneﬁts can be signiﬁcant. If an automated performance test tool is used, only one person is needed to simulate many users on the system and there is no need to develop custom programs. Without such a tool, executing these tests requires more time and resources (people, hardware, and software). In addition, using a tool exposes the organization to less risk because performance testing is not limited by the number of available test resources and because the system can be loaded to its saturation point. All major transactions can be tested, as opposed to a select few. Opportunities to tune the database can be pinpointed rather than being stumbled upon. Tests are easily repeatable, and results can be compared to determine whether performance has improved or declined. A cost-beneﬁt analysis on the use of an automated stress/volume test tool should be performed as part of the test strategy. Additionally, server and database performance monitoring tools can be used to capture other performance metrics. (iii) Analysis Tools. Analysis tools evaluate code without actually executing the code. Analysis tools can validate software logic and help to optimize the code so that processing occurs most efﬁciently. Code analysis tools can be extremely valuable if considerable customizations of the ﬁnancial package are being made. (iv) Status-Tracking Tools. A database should be used to track the status of all integration, system, and acceptance test cases. The database should also track all defects discovered during these tests. All members of the team involved with testing should have access to the database.

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CHAPTER

40

IT SUPPORT MODELS FOR FINANCE ORGANIZATIONS

40.1

INTRODUCTION 815

40.7

40.2

INADEQUATELY TRAINED END USERS 815

COMPLICATED SYSTEMS ARCHITECTURE 817

40.8

40.3

NEED FOR MIXED SKILL SETS 816

LACK OF AN ESTABLISHED ESCALATION PROCESS 817

40.4

GEOGRAPHIC CHALLENGES 816

40.9

LACK OF DOCUMENTATION 818

40.5

MONTH-END CLOSE SUPPORT 816

40.6

STAFF RETENTION 816

40.10 CHANGING MANAGEMENT REPORTING REQUIREMENTS 818

40.1 INTRODUCTION Does your ﬁnancial organization experience difﬁculty in getting the appropriate level of support from the information technology (IT) organization? If the answer is yes, then your IT organization may be experiencing a series of challenges that are affecting its ability to service its customers. Expectations of support models include, but are not limited to, ongoing maintenance of the current productive system, timely resolution and escalation of production issues, and completion of system enhancements and/or upgrades. The following discussion focuses on some of the challenges (and potential solutions) that IT support models face in servicing organizations, particularly ﬁnancial departments.

40.2 INADEQUATELY TRAINED END USERS A common problem that is experienced when a system goes live for the ﬁrst time is that the end users are not properly trained, nor has the appropriate knowledge transfer occurred to allow them to accept the system and use it in the manner that it was designed. As a result, there is a heavy emphasis placed on the support organization not only to address production issues but also to train end users. This end-user training should have occurred during the implementation. To combat this type of situation, ensure that key end users are involved early on in the implementation, especially in crucial activities such as requirements gathering, system design, and integration testing. Key end users will not only become advocates of the system but will be better equipped to assist in the training of their organizations on how to use the system. Also, it will provide increased opportunities to transition certain types of support activities to the business itself.

815

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Ch. 40 IT Support Models for Finance Organizations

40.3 NEED FOR MIXED SKILL SETS In today’s systems environment, a stronger emphasis is being placed on mixed skill sets that incorporate a level of both technical and business process knowledge. It is particularly important to emphasize the need for some ﬁnancial knowledge within the IT support model so there is an appreciation of the critical ﬁnancial processes, such as month-end closing. A mixed skill set will also assist the IT department with their ability to quickly react to production issues as many of these require a sufﬁcient understanding of the ﬁnancial process in order to solve the problem.

40.4 GEOGRAPHIC CHALLENGES The challenge of effectively supporting ﬁnancial organizations spanning across multiple countries and time zones is prevalent in large organizations. The IT organization’s obvious objective is to ensure that there is a seamless ﬁnancial process that has ongoing IT support regardless of the country or geography. A decision must be made on how IT resources should be located. Resources can be centrally located or they can be dispersed to many locations. Both situations contain a variety of cost and beneﬁts and will often be a function of how the organizations are structured and company policy. Regardless of where the IT organization is physically located, it must have the ability to provide the necessary support for all users during critical periods such as month-end and year-end close.

40.5 MONTH-END CLOSE SUPPORT The bulk of ﬁnancial processing occurs during month-end close. Large volumes of online transactions occur during the day, and critical programs are executed via batch processing in the evening. (Batch processing is usually triggered in the evening to lessen the impact on system resources during the working day.) In order to react quickly to problems that may occur during month end, many IT organizations provide 24 hour by 7 day (247) support or “on call” support to ensure that problems are resolved and processing is successful.

40.6 STAFF RETENTION Another challenge of any IT organization is the ability to retain knowledgeable employees who will continue to support the system. IT support models for ﬁnance organizations are not immune to this. The problem is that once staff are fully trained and knowledgeable in supporting the system, they tend to become disinterested with their assignments. Suggestions on how to minimize the impact of staff turnover include: • Ensure that critical support roles have both a primary and a back-up contact. • Cross-train staff in other aspects of the support model. This not only increases their understanding of other areas but will also keep them engaged. • Rotate staff on a regular basis to ensure that they gain exposure to other areas of the support model. Although this option contains some powerful beneﬁts, it also presents some costs to the support model. Newly transitioned staff do not possess the same knowledge as their predecessors, thus taking more time to resolve issues, which can be costly during critical periods. • Involve staff in projects that include upgrading and/or enhancing the system. If additional projects are undertaken, IT organizations need to ensure that the support model is appropriately staffed. • Keep support documentation current in order to facilitate knowledge transfer.

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40.7 COMPLICATED SYSTEMS ARCHITECTURE In today’s environment, generally there is not one organization maintaining a single system that performs all of its transactional processing, ﬁnancial consolidations, and reporting. A multisystem environment contains integration challenges with a heavy emphasis on the need for interface programs, reconciliations, and synchronization of data. Strict processes and procedures must be established within the business itself as well as within the IT support organization to ensure that all systems are well understood and functioning correctly. Clear ownership of each system (both business and technical) must be established. In addition to this, there must be a well-deﬁned and accepted process for evaluating requests for system changes. This will reduce some of the delays and confusion that can be found in some organizations, especially when changes to multiple systems are required at the same time.

40.8 LACK OF AN ESTABLISHED ESCALATION PROCESS When a production issue is identiﬁed, it is imperative that the issue be logged through the appropriate mechanisms so it can be tracked and escalated through the support model. Within any support model, there should be a number of levels of support, depending on the nature of the problem. The ﬁrst level of support should have the ability to address simple functional and system-related issues. When this level of support cannot address an issue because of its complexity, then the problem should be escalated to the next support level where additional investigation is required (see Exhibit 40.1).

E XHIBIT 40.1

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S UPPORT M ODEL L EVELS

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Ch. 40 IT Support Models for Finance Organizations

To complement the multilevel support model, clear roles and responsibilities must be deﬁned at each level. There must be a balance between technical and functional resources involved in the problem resolution, especially if the issues are complex in nature. A smooth escalation process also requires an effective tool that can track the progress of an issue and facilitate communication among various parties. An effective tool will also enhance the ability to build a knowledge management system of production issues and in a proactive manner identify areas that require attention (i.e., improved training, functionality upgrades, etc.).

40.9 LACK OF DOCUMENTATION One of the areas that is always last to be completed and detested by those who have to produce it is documentation. Documentation plays an important role within the support model and serves two important functions. First, documentation provides an audit trail and details the reasons why certain decisions were made. Second, documentation facilitates knowledge transfer. The challenge with documentation is ensuring that it is kept up to date, which is especially difﬁcult in an environment where enhancements are frequent. Each document should have a designated owner who is responsible for updating if it is necessary. Align ownership of documentation with relevant system or process responsibilities. Updates to documents should not be made without strict version control procedures. Finally, store documents in a repository that is easily accessible by others.

40.10 CHANGING MANAGEMENT REPORTING REQUIREMENTS Some IT organizations are responsible for developing and maintaining management reporting systems catering to the reporting needs of ﬁnancial organizations. The challenge with this activity is that reporting requirements often change, and some are routinely impacted by company reorganizations. Management reporting systems, commonly referred to as data warehouses, must be designed and implemented to allow ﬂexibility in the areas of reporting layouts, metrics, and organizational structures. These types of changes must be thoroughly tested prior to implementation to ensure that reporting tools are robust enough for the end user.

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CHAPTER

41

HOW MUCH IS TOO MUCH? ASSET LEDGER DETAIL IN ERP

41.1

INTRODUCTION 819

41.3

41.2

ERP SYSTEMS 819

41.4

INTEGRATION OF THE ERP AND EAM SYSTEMS 820 GROUPING APPROACH 821

41.1 INTRODUCTION In today’s world of technical possibilities, the allure of systems that provide controllers with detailed ﬁnancial reporting ﬂowing seamlessly from activities performed over the course of normal business operations would appear to be obvious. A detailed, line-by-line auditable ﬁxed-asset ledger that does not require any back-ofﬁce entry by the accounting department seems like it would be a fairly straightforward proposition when compared to the ﬂow-through from customer orders to inventory to accounts receivable that many companies enjoy. However, despite the power of today’s relational database management systems, which serve as the foundation for most popular enterprise resource planning (ERP) systems, it is not practical—or in some cases possible—to maintain a deep level of detail.

41.2 ERP SYSTEMS Companies began implementing ERP systems throughout the 1990s for a variety of reasons, including the advantages provided by the close integration between modules and compliance with year 2000. This implementation wave was fueled by the hope and promise of shortened close cycles and more accurate information as a result of systematic efﬁciencies, enforced data integrity, and tightly integrated modules. As such, ERP systems have become the de facto standard for core accounting applications such as general ledger, accounts payable, purchasing, accounts receivable, and ﬁxed assets. The ﬁxed-asset module in the ERP typically provides the requisite tools to calculate depreciation for generally accepted accounting principles (GAAP), taxation, and management reporting purposes. To do this effectively, key information about each asset, such as basis, acquisition and in-service dates, and location, needs to be captured. Two signiﬁcant problems are encountered by the ERP when trying to capture this information by the appropriate resource, at the correct time, and when the ﬁxed-asset module is ready to receive:

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Ch. 41 How Much Is Too Much? Asset Ledger Detail in ERP

• The receipt of capital equipment and the installation of the equipment are often performed by two different areas of the organization, both apart from the accounting department. These groups are typically responsible for communicating where the equipment is located is when it was placed in service. • To accurately determine the depreciable basis for equipment, ﬁxed-asset modules often rely on the invoice. Equipment is often received and placed in service well before the invoice is received.

41.3 INTEGRATION OF THE ERP AND EAM SYSTEMS A popular solution to these problems is augmenting the ERP with the implementation of an enterprise asset management (EAM) system. The EAM is developed with a focus on the operational processes associated with asset management versus the ﬁnancial focus brought by the ERP. With the ability to put tools such as bar code scanners, work planners, spares and warehouse managers, and service delivery tools directly in the hands of the operational personnel who perform equipment-handling tasks, the EAM offers a sureﬁre way of ensuring that key data is captured by the right people at the right time. Once an EAM is properly implemented with an appropriate complement of process and change management, the organization has a powerful transaction-processing engine. With some additional investment, the EAM can often be integrated with the ERP and serve as the engine that drives the data needed by every imaginable GAAP, tax, and ﬁnancial management requirement. With the decision to link these two enterprise systems comes one of the most important decisions: What level of detail should be maintained in the ERP’s ﬁxed-asset module—line-by-line or summary? Determination that a “line-by-line” level of detail in the ERP equal to that in the EAM requires no special discussion on the approach as the one-to-one matching of EAM to EPR detail is relatively straightforward. However, several problems associated with this approach are worth mentioning. • Unlike the ERP, the EAM presents users with a far more efﬁcient mechanism for performing transactions. For example, a technician using a bar code scanning device can capture hundreds of transactions related to the location of components in a single day. Each one of these transactions may provide operational value but have no ﬁnancial impact whatsoever. Moving each of these transactions into the ERP suggests a potentially huge volume of transactions to be interfaced and stored in the ERP. • Rapid on-line response to user queries and data entry is an essential requirement in an ERP environment. Maintaining an acceptable performance level is a constant challenge for system and database administrators. One of their greatest weapons in this effort is controlling the demands placed on the ERP’s batch processing requirements and data volumes. Depreciation can be an intensive data processing task for even the largest and most powerful computers. For each depreciable asset in the ERP, depreciation may be calculated in multiple ways (e.g., GAAP, federal tax, state tax, etc.). The processing time required to perform this period task is directly proportional to the volume of assets on which it is to be performed. • As with many data processing systems, maintaining a master system of record is imperative to ensuring data integrity. In the presence of an EAM and an ERP, the EAM typically takes precedence as the system of record for key asset information. When this information is duplicated into the ERP, if nothing else, a temptation to manipulate the data in the ERP is created. If one were to perform a transaction in the ERP, the related data in the EAM would now not jibe, resulting in data integrity issues. Integrating the EAM with the ERP at the summary level can signiﬁcantly reduce the impact of these problems and provide a streamlined approach to data management. The challenge in summarizing asset transactions is in determining the appropriate grouping of transactions for the summarization. The goal is to create the fewest number of groups possible to meet the various ﬁnancial reporting requirements. Property and state tax reporting may require a group for each of taxing

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jurisdiction while federal tax reporting may require a group for each legal entity. From a timing perspective, Securities and Exchange Commission (SEC) ﬁlings may require that groups be identiﬁable on a quarterly basis while tax requires only an annual perspective.

41.4 GROUPING APPROACH Let’s look at an example of a company’s asset base and reporting requirement to determine a grouping approach for ﬁnancial asset summarization. XYZ is a wireless communications company with operations throughout the United States. They have installed thousands of base stations and central switching stations, each containing hundreds to thousands of pieces of equipment, resulting in several million asset records in their EAM. Forcing all of these EAM asset records into their ERP is not considered a desirable option. Therefore, XYZ has elected to group their assets for ﬁnancial reporting purposes. The following variables inﬂuence the number of groups XYZ will need to create in their ERP: • XYZ is a publicly held company that ﬁles a quarterly report (10Q) to the SEC. • XYZ is legally organized in four companies, each of which prepares separate unconsolidated tax returns. • XYZ is separated into two regions, the Northern region and the Southern region, and is internally managed on a region-by-region basis. • Depreciation is not a factor in regional proﬁt-and-loss (P&L) performance. • Within the asset locations, there are three different classiﬁcations of equipment, each having a different useful life and depreciation method. Giving consideration to these variables, XYZ will need to create 24 (i.e., 4 legal entities 2 regions 3 equipment classiﬁcations) ERP ﬁxed-asset groups to accommodate integration with the EAM. Each of these 24 groups will need to be created each quarter that individual EAM assets are added to the asset base. The integration/interface programs developed to support this integration would increment the respective group for every new equipment addition, transfer in, and cost addition to equipment. Similarly, each respective group would be decremented for every equipment retirement, transfer out, and cost reduction to equipment. Over the course of any year in operation, instead of having hundreds of thousands to millions of transactions residing in both the EAM and ERP for ﬁxed assets, the ERP will contain a maximum of 96 detailed asset records.

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CHAPTER*

42

SYSTEMS PERFORMANCE MANAGEMENT 42.1

INTRODUCTION 823 (a) Why Management of Performance Is Important to the Controller 823 (b) Performance Management 823 (c) Performance Problems 824 (d) Understand the Business Requirements of the Organization 824

42.2

DEFINE YOUR ORGANIZATION’S PERFORMANCE METHODOLOGY 824 (a) What Is Performance? 824 (b) Performance Criteria 825

42.3

(b) Establish the Performance Objectives 826 (c) Determine the Performance Measurements Needed 826 (d) Measure the System Periodically 827 (e) Evaluate the Measurements 827 (f) Obtain Feedback and Make Key Decisions 827 42.4

PERFORMANCE DETAILS 827 (a) Components of Performance 827

42.5

FLOW OF PERFORMANCE INFORMATION WITHIN THE ORGANIZATION 828 (a) Be Careful in the Translation of Performance Data from the Tech to the Executive 829 (b) Managing Expectation 829

SIX ESSENTIAL STEPS: A PERFORMANCE METHODOLOGY 825 (a) Understand the Business Requirements 826

42.1 INTRODUCTION (a) WHY MANAGEMENT OF PERFORMANCE IS IMPORTANT TO THE CONTROLLER. It is important, as a key member of your organization’s management team, that the controller understand the components of performance and how they affect companies. Systems performance can affect all aspects of an organization’s operations. However, it is not always obvious how your company is being adversely affected by bad systems performance. This chapter will help you identify the components of performance, the presence of performance problems, and the adverse effects of such problems on your business. The chapter will also explain the terminology and associated methodologies that are necessary to help you to control and manage your company’s systems performance. (b) PERFORMANCE MANAGEMENT. Performance management is the ongoing process of ensuring a business’ work is done on time and within budget. As part of that process, performance

* This chapter was authored by Alan R. Arnold, a manager in the IT Management Consulting group at Ernst & Young’s Irvine, California, office.

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Ch. 42 Systems Performance Management

management takes into account that business volume, needs, and available resources may vary from one time to another. A good performance management program helps a company prevent surprises by providing criteria for estimating in advance what resources are needed and then periodically giving you updated information to ensure that you do not exceed your estimate. Performance management is a continuous process and not something you do only as a reaction to performance problems. It is important that someone within the organization be focussed on performance management issues. Performance management is an important element in managing any business’ dataprocessing resources. It maintains business efﬁciency, provides a smooth transition when business conditions change, increases user satisfaction, improves change management, and provides rapid response time. As the controller, it is usually not within the scope of your day-to-day responsibilities to directly manage performance issues. However, it is important to realize that you must set, or help the information systems department set, the organization’s performance objectives, which must be managed. (c) PERFORMANCE PROBLEMS. Performance problems affecting your organization occur in a number of different ways. For example, there may be a user or group of users who consistently experience wait time between each key stroke. This wait time could be translated as lost productivity. If your company has hundreds, or even thousands, of users, this little problem of poor response time just became an exponential problem of thousands of lost hours of productivity. Continuing this example, what if while your user was waiting on the system, he or she in turn had a customer waiting for a response on an inquiry. The time the customer spends waiting could lead to low customer satisfaction with your company. How many times have you called a customer service agent for a company and been asked to please be patient while the person waited for the system. It is almost an acceptable excuse, like being late for a meeting in Los Angeles because of trafﬁc. As competition continues to strive for better customer service and responsiveness, this excuse will continue to be less and less acceptable. (d) UNDERSTAND THE BUSINESS REQUIREMENTS OF THE ORGANIZATION. Besides the customer satisfaction issue, there is also a productivity issue involved with this second scenario. The company could probably hire fewer customer service agents if the existing agents were more productive, which could be helped by a more efﬁcient response time.

42.2 DEFINE YOUR ORGANIZATION’S PERFORMANCE METHODOLOGY As the controller, you have to assess your own performance situation and help your information systems department develop a performance plan by which you can judge how well your system is meeting your organization’s needs. The organization must do more than monitor performance, it must manage it. The objectives managed must be set by the senior business managers within the information systems group. (a) WHAT IS PERFORMANCE? The question, “What is performance?” can be answered several different ways. Performance means different things to different people and may mean something different to a single person at different times. It is hard to pin down “good” performance for a single system because performance varies in a nonlinear fashion as the system load increases; that is, performance can get very bad, very rapidly. The most concrete, practical answer to the question is that a system’s performance is based upon a system’s productivity and speed. Furthermore, criteria such as response time, throughput, batch work, capacity, and resource use must all be included. To get good performance, a company must make the most of each of the following criteria, each of which requires a different deﬁnition of performance.

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(b) PERFORMANCE CRITERIA (i) Minimizing Response Time. On many systems, interactive response is typically the primary criterion for deﬁning and measuring performance. The system must respond fast enough that users do not perceive delays. Because of this requirement, it is important that the highest priority be assigned to highly visible interactive functions, such as customer service. (ii) Maximizing Throughput. A system must respond fast enough for each user to complete a speciﬁc amount of work in a certain period. For example, a customer service agent working telephones does not want customers to experience long waits while the system is verifying their customer information. A system can be conﬁgured (most of the time) to ensure that every transaction gets into the system and starts working immediately, even though interactive work already in progress is using the available central processing unit (CPU) and storage. In some cases, the deﬁnition of performance is maximizing throughput. (iii) Maximizing Batch Work. Most companies have an end-of-day processing requirement (as, for example, an insurance company will run their ﬁle updates and policy-generating jobs), and their primary performance concern might be maximizing the batch work. The time necessary for batch jobs to run is often directly proportionate to the amount of interactive work that preceded it. This is especially true when the interactive work being done during the day becomes the input to the batch processing done at night. You will normally become concerned with the management of batch work only when it is not ﬁnishing in its allotted time. For example, you would have a problem if your end-of-day batch cycle takes ten hours to ﬁnish and you have only four hours to run it. The extra six hours may affect your interactive availability window or not allow your company to ﬁnish its backups, which are also usually run in the evenings. (iv) Ensuring Adequate Capacity. An insurance company, for example, can expect that, on unpredictable occasions (such as after earthquakes and hurricanes), its system must handle unusually high claims-processing loads and still maintain an adequate level of throughput and a satisfactory response time. To prepare for acceptable performance in the aftermath of disasters, the insurance company must give its system more resources than it needs for its regular workload. In such cases, the deﬁnition of performance is adequate capacity and preparation at all times. By helping your organization prepare for unexpected high-capacity periods, you can ensure that the company will be able to handle the workload. (v) Maximizing Resource Use. Some systems stay busy at all times and use all resources to their fullest to maximize the use of expensive computer hardware components. Such demands probably are not a problem if the workload is consistent from one day to the next and if all users are satisﬁed. However, if the workload grows or the processing varies from day to day, continually operating on the edge is a dangerous proposition. For example, when data are not in main storage, the processor (the most expensive component of any system) may have to wait for the data to be brought in from disk (the least expensive component). In this situation, the system makes run-time adjustments to move data quickly in and out of main storage to keep the processor working as close to capacity as possible.

42.3 SIX ESSENTIAL STEPS: A PERFORMANCE METHODOLOGY Every organization should develop a standard performance methodology that will be used to manage performance and performance expectations. In Exhibit 42.1, we are showing the six steps that make up a good performance methodology. As an executive, it is critical that you be involved with steps one and six. In these steps, you help deﬁne and interpret the results of the performance data. The following discussion deﬁnes the six steps.

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Ch. 42 Systems Performance Management

E XHIBIT 42.1

S TEPS

IN

G OOD P ERFORMANCE M ETHODOLOGY

(a) UNDERSTAND THE BUSINESS REQUIREMENTS. You must understand the business requirements the system is meant to address. Besides these requirements, no doubt your system’s operation must stay within certain constraints, such as budget limitations. These business requirements and constraints have a direct relationship with system requirements. Any change to the requirements will have an impact on information system requirements. You need to understand the business requirements to establish system performance objectives and to understand your options for meeting those objectives. (b) ESTABLISH THE PERFORMANCE OBJECTIVES. Setting objectives for your organization establishes (or deﬁnes) a set of goals and expectations for measuring system performance. The objectives should focus on a particular issue. A typical performance objective may deﬁne average or maximum response times or transaction throughput rates. For example, if your users are getting ﬁve-second response times and you want subsecond response times, your performance objective would be subsecond response time. It is extremely important that you establish these objectives in writing. When a performance objective is deﬁned, it should be as speciﬁc as possible. It is also important that these decisions be made by a team that includes the information systems organization and key users as well as you, the controller. Performance objectives for an organization become moving targets unless you have agreement from everyone involved. You do not want your organization to start out trying to get better interactive response time and end up on some different, endless performance tangent in which nothing seems to get accomplished. You will avoid this situation by getting agreement to a documented set of performance objectives. Once your organization has identiﬁed performance objectives, it is well on its way to solutions. (c) DETERMINE THE PERFORMANCE MEASUREMENTS NEEDED. After you have set your objectives, determine how you are going to collect performance data to track the objectives. There is a direct relationship between your performance objectives and the way your company will collect performance data. Your information systems data collection options are going to be determined by the platform your company is using and by the performance tools installed.

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(d) MEASURE THE SYSTEM PERIODICALLY. You need to measure the way your system is performing. A simple set of graphs showing systems resource usage and workload will help you track your progress. Based on your organization’s deﬁned objectives, you can ﬁnd out how often you will need to see measurements. Measurements can be as simple as a print screen produced by an operator once an hour or as detailed as a performance monitor run by your performance analyst, with speciﬁc collection periods. (e) EVALUATE THE MEASUREMENTS. The evaluation of the performance measurements is the analysis part of the performance methodology. The analysis work is based on the type of data collected and the volume of data collected. This work must be done by a trained performance expert who is familiar with your company’s computer platform. The majority of large companies have a performance analyst who can perform this work. Smaller companies usually need to hire a consultant to help with this part of the performance methodology. Performance data should be kept for an extended period of time so that long-term performance analysis, referred to as trending analysis, can be done. (f) OBTAIN FEEDBACK AND MAKE KEY DECISIONS. When the analysis work is completed, it is vital to use the ﬁndings to make decisions that will improve the organization’s performance. Documentation of the decisions is key to this step. It is critical that your technical staff, or consultant, present the analysis data in a manner with which you are comfortable. If you are delivered a stack of detailed reports that you cannot understand, return them to the source and ask for a translation in a format that you can understand. In this ﬁnal step of the performance methodology cycle, decisions that may require ﬁnancial expenditures need to be based on facts. There is no room for misinterpretation of the data. Large decisions, such as a decision to buy new hardware to ﬁx performance problems, should usually be veriﬁed by more than one source. It is important that the decisions be based on the performance facts and be consistent with the organization’s strategic goals, and not be based on some group’s alternative political agendas. Once you ﬁnish the performance methodology cycle, you sometimes discover that your objective in step one was not the correct objective. You have to redeﬁne the objective and repeat the performance methodology cycle. It is not uncommon to repeat this cycle many times, depending on what is uncovered during the analysis step. For example, you may decide that once you have better interactive performance, you need to work on the performance of your batch jobs. Once you get batch and interactive under control, you may decide to work on your remote users. Therefore, you may have to repeat your six performance steps often until all of your organization’s performance objectives are satisﬁed.

42.4 PERFORMANCE DETAILS (a) COMPONENTS OF PERFORMANCE. A computer system’s performance is made up of different components. Although you are more than likely not managing these detailed systems components, it is important for you to understand each of these components and what part they play in the performance equation. Most organizations have an analyst or team of analysts who focus speciﬁcally on performance issues. All user requests, both interactive and batch, use system resources. Interactive requests require CPU time, main storage space, and usually disk input/output (I/O) resources. In addition, some communications line time and I/O processor resources are necessary to enter the request and to communicate the results back to the user. For batch processing, you can consider a request to be the time between successive reads of a primary input ﬁle. These requests also require CPU time, main storage space, and disk I/O resources. With this view of what makes up interactive and batch work, you can consider all work on the system as comprising multiple transactions. The total time each transaction takes to complete consists of blocks of time spent waiting for or using a speciﬁc system resource. Because the system generally services multiple transactions concurrently, a transaction often spends time waiting for

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Ch. 42 Systems Performance Management

an unavailable system resource. Such resources include communications line resources, processor resources, disk access, and memory. You can think of these components as services that a transaction needs to do the requested work on the system. You can appreciate the many factors that inﬂuence transaction response time if you consider the components as servers and realize that contention exists for the services because of multiple concurrent transactions. Transaction response time depends on how long it takes to acquire and use each server. This amount of time, in turn, depends on how many servers there are, how fast each server is, the arrival rate for the server, and how the requests are selected for the service. Each performance component has its own characteristics in connection with these factors. Let’s look at some of the details of these components. (i) Line Component. Communications requires special performance considerations. Line speed, communications I/O processor utilization, device-controller and line utilization, and line errors all affect how much time is necessary for a transaction to get through the line component. (ii) Processor (CPU) Component. All users of a system compete for CPU time. The system grants CPU time in a priority sequence. Once the system gives the CPU resource to a transaction, no other transaction may share that CPU resource until the transaction waits on another resource. This is a simplistic overview of how a transaction requests the CPU resource. Most systems work differently; thus, if you wish to understand exactly how a system allocates CPU resources, you will have to talk to the information systems professionals at your organization. (iii) Disk Component. When a transaction needs access to a disk, several considerations come into play. The time to process a disk request depends on disk I/O processor usage, drive usage, type of operation, arm contention, disk protection schemes (Mirroring, RAID, etc.), ﬁle placement, and cache hit ratios. (iv) Memory Component. A transaction requires memory to contain the necessary programs and data for the CPU to work with. If these requirements are in main memory, the memory server does not delay the transaction. However, a transaction that needs memory has to wait while the system allocates memory and brings the objects into memory from disk. Different computer systems use their own methods to optimize moving objects between memory and the CPU. These techniques are beyond the scope of this chapter.

42.5 FLOW OF PERFORMANCE INFORMATION WITHIN THE ORGANIZATION The ﬂow of performance information within the organization is important. The larger the organization, the more formal the performance information communication process must be. Exhibit 42.2 shows an example of a performance information ﬂow for an organization. In Exhibit 42.2, we are showing a group called performance management. This group is where the performance expert(s) are located within the management information systems (MIS) department. All performance information for the organization ﬂows through this group. The end-user groups communicate all performance issues directly to the performance management group. In turn, the performance management group returns trending/capacity information, performance problem statistics, and problem determination information back to this user group. If your company has an application development group, it is important that programs being placed into your company’s production environment meet certain minimum performance objectives. For example, a performance problem may result when an application program is changed. If a customer service program is producing subsecond response time, and a change to the program creates ﬁve-second response time, your programmer has just created a new application performance problem. Your performance management group can avoid these kinds of application performance problems by benchmarking before and after performance of applications. It is also a good idea for the performance management group to be proactive about performance management, to set minimum guidelines for application performance for the organization, and to educate the application development staff on optimized programming methods.

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42.5 Flow of Performance Information within the Organization

E XHIBIT 42.2

F LOW

OF

P ERFORMANCE I NFORMATION W ITHIN

THE

829

O RGANIZATION

The executive management group must set the corporate performance objectives and supply business growth estimates so that the performance management group can ensure sufﬁcient capacity for the systems to handle the company’s growth. As part of the capacity planning for the organization, the executive management group must work closely with the end-user groups to understand, or drive, their growth plans for the future. In turn, it is important for the performance management group to validate all modeling and trending information and report this information back to executive management. This performance information must be presented in a manner that is understood by executive management, which usually means graphs and summarized performance numbers should be used. (a) BE CAREFUL IN THE TRANSLATION OF PERFORMANCE DATA FROM THE TECH TO THE EXECUTIVE. It is extremely important that the actual performance data of a system be presented accurately to the executive management of an organization. All information that is subjective in nature should be fully explained to management. Performance analysts sometimes make assumptions based on their own personal understanding of an organization and not on the true organizational objectives. We have also seen performance management groups that chose to interpret the results of performance tests to help justify their own political agenda. For example, a group may prefer a certain operating system, software package, or hardware platform that can be justiﬁed in performance benchmarking. All performance data should be explained in a clear and concise manner. If executives do not understand what is being presented to them, the analysis is not effective for making critical organizational decisions. (b) MANAGING EXPECTATION. One last point about the ﬂow of performance information within your organization: It is important that performance expectation get managed correctly. As performance information is communicated between the groups of your organization, it is important to keep the information focused for the group that is going to use it. Technical groups, based on our experience, will sometimes set a higher level of expectation than is realistic. User groups are especially susceptible to being “oversold” on a project’s or projects’ results. Executive management must understand enough of the details to help set the expectation level of the managers within the user groups of the organization.

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CHAPTER*

43

INFORMATION SECURITY SYSTEMS 43.1

INTRODUCTION 831 (a) Deﬁning Information Security 832 (b) Corporate Spending on Information Security is Increasing 832

43.2

TYPES OF SECURITY THREATS 832

43.3

BASIC SECURITY PRINCIPLES 833 (a) Goals and Objectives 833 (b) Risk-Driven Security Approach 834

43.4

COMPONENTS OF AN EFFECTIVE SECURITY PROGRAM 834 (a) Security policy 834

(b) Security Management 837 (c) Technical Security Measures 838 (d) Nontechnical Security Measures 839 43.5

ENTERPRISE SECURITY STRATEGIES 840 (a) Client-Server Systems 840 (b) Networks and the Internet 840 (c) Interconnected Customer and Vendor Systems 840

43.6

CONTROLLER’S ROLE IN INFORMATION SECURITY 841

43.1 INTRODUCTION In survey after survey, information security—protection against unauthorized use of computer systems—shows up as a top concern of controllers and information technology (IT) managers. While other security issues, such as physical plant security, remain the domain of corporate security ofﬁcers, why does information security so often make it onto the radar screen of controllers and chief ﬁnancial ofﬁcers? One reason is the tremendous potential for loss of critical business data; the very data of greatest concern to ﬁnancial professionals are stored in computer systems. This makes the controller or chief ﬁnancial ofﬁcer (CFO), as the “owner” of these data, ultimately responsible for their protection. Another reason for heightened concern is the rapidly changing nature of the information security landscape. Traditional security techniques based on controlling physical access do not translate well to distributed networked computing systems where physical access to the data repositories is largely irrelevant. Whatever the reason, controllers should expect to be confronted with decisions regarding information security. This chapter presents some essential information that will enable these decisions to be informed ones. Often, the controller’s role as decision maker is one of choosing between security alternatives—perhaps between the highly secure but expensive and disruptive option, and cheaper, more convenient alternatives. There is really no such thing as an “unbreakable” security system; the entire security profession is oriented around managing risk—reducing risk to an acceptable level. As with other forms of risk that the controller manages, some security risks should be eliminated, while others are best accepted because it is too expensive or limiting to mitigate them. As an evaluator and accepter of risk, controllers should ensure they have sufﬁcient information at their disposal to make informed risk management decisions.

* This chapter was authored by E. Edward Bassett III, Senior Systems Security Engineer, Denver Technological Laboratories.

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Ch. 43 Information Security Systems

(a) DEFINING INFORMATION SECURITY. The ﬁeld of information security covers all aspects of protecting computer-based processes and business information stored in computer systems and networks. This growing ﬁeld has been variously called computer security, ADP (automated data processing) security, and AIS (automated information system) security. Every company deﬁnes the boundary between information security and other corporate security functions differently. In some cases, all security functions are consolidated under a common corporate security ofﬁcer. Often information security is separately managed because of its “high-tech” nature. Whatever it is called, expect information security to include a whole gamut of security measures to protect computing systems and the information they process and store. These measures generally include technical measures, such as password protection of log-ons, and nontechnical measures, such as conﬁguration management policies. Physical protection of the computer systems and the rooms that house them is optionally considered part of information security or included with overall plant security. Likewise, personnel security measures for key information systems people, such as background checks, can be included in an information security program or they may be part of a general security effort. (b) CORPORATE SPENDING ON INFORMATION SECURITY IS INCREASING. There are several key factors that have motivated increased spending on information security in recent years. The most signiﬁcant of these factors is a move toward highly networked distributed computing systems. Another important factor is the ever-increasing number of mission-critical business functions that rely on automation. Where a company of some years ago would rely on mainframe computers to handle mainly batch (or non–real-time) “back ofﬁce” processing, today’s organizations rely on complex networks of real-time and near–real-time computers for critical front-line functions as well. This increased complexity and increased reliance have made information security a front-burner issue throughout IT organizations. With this increased reliance on computers and networks for day-to-day operations, companies cannot afford the risk of lax security. Computer failures caused by teenage hackers, corporate spies, disgruntled employees, human error, or even unreliable hardware or software can cost thousands or millions of dollars per incident. The 1996 Information Week/Ernst & Young Information Security Survey found that 78 percent of respondents had suffered a measureable ﬁnancial loss related to information security in the past two years. Although some of this risk can be mitigated by insurance, much of the potential loss cannot, especially intangible costs such as loss of customer satisfaction and conﬁdence if the company has unreliable or inaccurate computer records. Nearly everyone has experienced the modern-day phenomenon of calling a customer service representative and hearing the response, “I can’t help you now; our computers are down.” Even short disruptions of these types of systems cost money in terms of lost orders, unhappy customers, and idle front-line employees. The solution to these types of problems—the ones that insurance alone cannot compensate—is a comprehensive information security program designed to minimize computer system disruptions while balancing cost and other operational factors. The information security industry has responded by producing more sophisticated and more affordable security technology. The use of ultra–high-tech protection mechanisms such as the use of encryption to create protected networks within the main corporate network—known as virtual private networks—has become widespread just in the past two years. Other advances, such as more ﬂexible and reliable access controls to replace clumsy passwords, are just now emerging and will likely be integrated into a large number of corporate networks in the near future.

43.2 TYPES OF SECURITY THREATS The common view of information security is that it is focused on preventing “hacker attacks.” Intrusions by teenage “whiz kids” into important government and corporate computers receives a lot of attention in the media. Computer virus “infection” is another topic that has received

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wide coverage in the mainstream media. Information security covers a broader range of threats than these news stories might imply. The types of threats that information security focuses on stopping fall into two main categories: intentional and unintentional. Both types can have signiﬁcant detrimental effects on computer systems, but they require different types of protections and are, therefore, considered separately. Some examples of intentional threats are: • Unauthorized access by an outsider. This is the classic “hacker” attack: Someone outside the organization uses computer networks or dial-in lines to access a computer system for which they have no authorized access. The motivation for this type of attack can range from “intellectual curiosity” to industrial espionage. In the former case, the intruder is likely to make a big splash (so as to draw attention to their accomplishment) but do little actual damage. In the latter case, the intruder will take much more precaution to be surreptitious but will likely steal or destroy valuable business information. Recent years have seen a dramatic increase in attacks by “professional” hackers. • Unauthorized access by an insider. The most common type of “intrusion” is that perpetrated by someone who already has some access to company systems: employees, vendors, or contractors. The classic example of this type of intrusion is a student entering school administration computers to change grades or account information. Another example is a disgruntled employee who destroys critical records or steals valuable intellectual property to “get back” at his or her employer. This type of attack is often overlooked, but it is the most signiﬁcant threat to most systems. It is also a very difﬁcult type of attack to prevent since the insider, by deﬁnition, requires access to the system. • Malicious software. Viruses and trojan horses are the two most prevalent forms of malicious software. A virus is self-replicating software that spreads from computer to computer by attaching itself to other ﬁles. A trojan horse is software that appears to be a desirable program but actually contains some hidden malicious instructions. Either of these threats can be used in a targeted attack to damage speciﬁc computer systems. Viruses, though, are more generally spread in a nontargeted fashion. Their authors let them replicate “in the wild,” spreading to any system they can. Malicious software can perform very serious destruction or, in the case of some viruses, merely annoy users. Some examples of unintentional threats are • Hardware or software failure. Unreliable hardware or software can cause system outages or corrupted data. Outright failures are always easy to detect and, if proper preparations are made, can be relatively easy to recover from. Data corruption is a much more subtle problem that can be difﬁcult to detect. • Human error. For critical business systems that rely on the accuracy of information, errors made during data entry can propagate and affect key business decisions. Errors in customer records, for example, can cause signiﬁcant expense in correcting them as well as creating customer dissatisfaction.

43.3 BASIC SECURITY PRINCIPLES (a) GOALS AND OBJECTIVES. in three ways:

The goal of information security is to protect systems and data

1. Conﬁdentiality. Information that represents trade secrets, intellectual property, personal information, or other sensitive data must be protected so that only authorized people can read or copy it. In addition to the obvious category of proprietary information, many companies also must protect private customer information, such as credit card numbers, that they are entrusted with.

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Ch. 43 Information Security Systems

2. Integrity. Information that is relied upon to make business decisions must be accurate. Protecting the integrity of data involves controlling both who can enter and change data and how they can change it. For example, an accounting clerk might be allowed to change data in the current quarter, but changes to previous quarters might require a second person’s authority. 3. Availability. Systems that provide critical business functions must be available when they are needed. This is an especially critical factor for real-time or near–real-time systems that are used in front-line operations and production systems. Back-ofﬁce systems can often tolerate a longer period of unavailability, but even these systems can generally not be “down” for longer than a day or so without causing considerable disruption and expense. The security measures that are employed to achieve these three protection goals can be selected based on their beneﬁt to the organization. Cost-beneﬁt analysis can be applied to determine when the cost of securing a system is less than the risk of loss. (b) RISK-DRIVEN SECURITY APPROACH. As was mentioned, there is no such thing as perfect security and no such thing as an unlimited security budget. To make the most effective use of limited dollars, many organizations use a risk-driven approach to select the optimal mix of security features. This approach involves analyzing security risks using qualitative or quantitative approaches to determine where the highest potential of loss exists. Security measures can then be applied to these high-risk areas. The goal of this approach is to avoid buying security for the sake of security (or because of some unbased fear). There are a variety of security risk analysis tools available to assist in this process. Although they vary in detail, they generally use quantitative methods to calculate “annual loss expectancies” that are essentially the annual probability of a loss multiplied by the value of an asset being protected. Security measures can then be applied that reduce the probability of loss for the assets that have the most “exposure.” As an alternative to this quantitative technique, many security practitioners use qualitative techniques to identify the most signiﬁcant risks based on an analysis of the threats and vulnerabilities of a system. Exhibit 43.1 shows a typical risk analysis process that is used to assess risk and select countermeasures (safeguards) for an information system.

43.4 COMPONENTS OF AN EFFECTIVE SECURITY PROGRAM An information security program includes several functions performed by participants from many organizational elements. Exhibit 43.2 depicts the basic information security functions (boxes in the center of the exhibit) and shows their interactions with the system/software development life cycle (lower row of boxes). In order to effectively document information security decisions, several key documents are required. Exhibit 43.3 shows an example of the document tree for an organization with a relatively formal information security program. Of particular interest to the controller will be the Organization Statement of Direction for Security, which will establish the overall goals and objectives of the information security program. Also of interest as it relates to key ﬁnancial systems will be the Risk Assessment Guideline and Incident Response Plan. The following four sections describe the main components of an information security program: security policy, security management, technical security measures, and nontechnical security measures. (a) SECURITY POLICY. At the top level, information security is driven by corporate policies that determine what is to be protected and what level of protection is required. In some cases, there are legal requirements for protection of information. In other cases, companies want to restrict access to information because it is proprietary or because it is critical to an important business function.

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E XHIBIT 43.1

T YPICAL R ISK A NALYSIS P ROCESS

RISK ACCEPTANCE

Non–IT Staff

(Data & System Owners)

P

Decisions

O

Recommendations

L

RISK MANAGEMENT

I C

IT Management Staff

RISK ASSESSMENT

Y & S T A N

DESIGN INPUT

SECURITY DOCUMENTATION

SECURITY TEST

Integrate Requirements

Establish Baseline

Verify Compliance

OVERSIGHT

Audit, Exception Response, Config. Checks

IT Security Staff

D A R D S

E XHIBIT 43.2

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DESIGN

DEVELOPMENT

B ASIC I NFORMATION S ECURITY F UNCTIONS

OPERATIONS & MAINTENANCE

IT Technical Staff

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Ch. 43 Information Security Systems

E XHIBIT 43.3

I NFORMATION S ECURITY D OCUMENTATION

Security policy should be written so as to clearly deﬁne the categories of information and systems needing protection. Many companies have adopted a system of “levels” of data in which more important information is more tightly protected. Because protection costs money, a system of levels can ensure that the most extensive protection is reserved for only that small amount of information that is truly sensitive (e.g., trade secrets, safety-critical systems, etc.). Some typical levels of information are: • Restricted. Access is controlled on a by-name basis to a select group of people. Use of this category is generally limited to the most sensitive information whose unauthorized release would cause serious loss of competitive advantage. For example, details of an upcoming product or acquisition might be protected at this level. • Company conﬁdential. Access is limited to trusted employees who have signed nondisclosure agreements. This category is often used for trade secrets or other proprietary information for which the company must enforce protection vigorously to maintain the legal status of the information as proprietary. This level of protection also provides some legal basis for action if employees violate their conﬁdentiality agreements. • Internal use only. Access is limited to employees and often contractors, vendors, and others who play an integral role in the business operations of the company. This information is to be provided only to those with a bona ﬁde business reason to have the information. Often future planning and operations details are protected at this level, unless a higher level is warranted by the potential for loss of competitive advantage if the information is released. This level represents a “default” protection that employees will apply to company information that has not been designated as falling to another category. • Public. This information has been approved for release to the public, generally by the public relations staff. It is given freely to customers, shareholders, and the media. Another tool that many companies use is “classes of service” for their various systems and applications. This scheme allows various systems to be categorized based on their relative importance to day-to-day operations. It provides a basis for decisions about integrity and availability security decisions, whereas the levels of information described previously are more useful as a basis for conﬁdentiality security decisions. Some typical classes of service are: • Production—mission critical. Systems that perform mission-critical business functions will require the most rigorous security measures. Generally, their conﬁguration is tightly controlled and monitored. Although these systems generally have a large number of users, the

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type of access the users have is strictly limited. A system for taking customer orders would be an example of such a system. Another candidate would be widespread services, such as email, wherein failure could have pervasive impacts on business operations. • Production—non-mission critical. Support systems and other less critical systems may require less strict security. However, production systems are generally held under tight conﬁguration control. • Development. Development systems are very difﬁcult to conﬁguration control because they are constantly changing as development progresses. However, access to these systems is generally restricted to a relatively small number of developers. It is wise to perform development on systems separate from production systems to ensure that errors in development do not propagate to production systems. • Experimental/prototype. These systems generally have minimal security controls to allow maximum ﬂexibility and speed of development. However, they should be isolated from mainstream systems for two reasons: ﬁrst, to keep malfunctions in experimental systems from affecting operational systems; second, to limit access to sensitive or proprietary software being developed in the experimental system. Another factor that should be considered in deﬁning an information security policy is legal “standards of care” that are required for certain types of information. Especially in industries that act as custodians for privileged personal information, such as the medical and legal professions, certain standards of care must be applied to this information. Trade secrets and other intellectual property may also require protection to maintain their legal status. Legal counsel should be consulted to determine the appropriate information security protection to be applied to information in these categories. In addition to categories (or levels) of information sensitivity and classes of service, a company information security policy will include an overall protection philosophy, establish rules for “acceptable use” of corporate computers (for example, whether employees may use company email for personal messages), and deﬁne user responsibilities. The use of a “user agreement” that users sign as a condition of access to computer systems is a recommended way of enforcing compliance with the information security policy. (b) SECURITY MANAGEMENT. Traditionally, security functions have been centralized within an organization. Often security is separate from the normal organizational structure, reporting directly to upper management. As the “gatekeepers” of the organization, it follows that security should maintain “independence.” Information security organizations, however, have found it impractical to follow this model. Often, information security requires specialized technical expertise spanning all the computer systems and applications used throughout the organization. Additionally, IT systems tend to be very fast moving, making it difﬁcult for security to keep up unless the security staff is tightly integrated with the IT organization. It is important to maintain the balance between integration and independence. In particular, it is important to avoid the all-too-common situation in which a new type of system is understood by only one or a few “gurus” who make, implement, and enforce their own security policies. A successful information security program must include many security management functions to ensure that security is consistently applied and that lapses in security are identiﬁed and corrected quickly. The key functions of the security management staff are: • Risk management. This is the process of assessing risk and implementing security safeguards to mitigate the risk to an acceptable level. • Input to system design. Security is a critical component of most system and application designs. Although many systems come with security features, deciding how to use these features to the best advantage of the company is an important part of the system/software development process.

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Ch. 43 Information Security Systems

• Security testing. Security features are often subjected to rigorous tests that include both positive tests (conﬁrm the security features work as required) and negative tests (conﬁrm that the security mechanisms cannot be bypassed or defeated). • Audit/oversight. Periodically, security features should be checked for proper conﬁguration. Audit records should be checked to ensure security procedures are being followed. This function is often combined with other audit functions. • Training and user awareness. Many security mechanisms rely on trusted employees using the correct procedures. Also, many types of security problems, from break-ins to reliability problems, can be spotted by vigilant users if they know what to look for and how to respond. A formal training program for both users and system administrators is an important step to ensure security awareness in the organization is high. • Incident response. Early detection and quick reaction to information security breaches is vital to limit the damage caused by the incident. Formal response procedures and a trained incident response team are being used by many companies to reduce their security-related losses. (c) TECHNICAL SECURITY MEASURES. Technical security measures are the computer-based safeguards. They include a range of mechanisms; some are very common and are included in nearly all computer systems, others are fairly esoteric and are employed only by systems that require a high degree of protection. Some of the types of technical security measures in use today are: • Access controls. Various mechanisms are used to identify users and determine their privileges. Nearly all systems and networks have some form of access control. Desktop PCs are an exception, but many newer desktop operating systems now have access controls. The most common types of access controls are: • Passwords/personal identiﬁcation numbers (PINs). This is the most common form of access control. A user has a “secret” word or number that is used to gain access. • Biometrics. Physical properties, such as ﬁngerprints, retinal patterns, or a signature, are used to identify users. This technique is generally used only for very-high-security systems. • Smart cards. Users carry a “token” that is inserted into a reader to gain access. Smart cards come in many varieties and are gaining popularity, especially for remote access to corporate networks. • Certiﬁcates. Users present digitally signed credentials to gain access. Certiﬁcates use encryption to create hard-to-forge digital “passports.” They are being deployed widely to enable Internet commerce where two parties with no prior relationship must reliably identify each other and communicate securely. • Dial-back modems. Some remote access systems use special modems that call the remote user back at a predetermined number. This prevents intruders from calling in from unauthorized locations. • Encryption. Both hardware-based and software-based tools are available to “scramble” data while they are being transmitted across networks or while they are stored in a computer. Encryption can be used to keep data “private” by preventing eavesdropping. It can also be used to check the integrity of data and to perform a digital “signature” analogous to a written signature that guarantees the authenticity of information. • Firewalls. Many corporate systems now have connections to their vendors, suppliers, and customers that use private network connections or the Internet. Special gateways called ﬁrewalls are used to monitor the communications with external systems to prevent intrusion into internal systems. • Intrusion detection. Many vendors make software tools that monitor network and computer system activity to detect behavior that might indicate a break-in attempt. These tools use

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rules, artiﬁcial intelligence, and knowledge of common intrusion techniques to spot suspicious activity and sound an alarm. • Audit. Most systems have a feature to keep tamper-resistant records of system activity. These “audit trails” can be used to detect unauthorized activity and catch the perpetrator. • Virus detection. Tools that monitor desktop systems for infection by known viruses are widely deployed. These tools scan ﬁles to ﬁnd viral “signatures.” Most also allow the user the option of cleaning their system to remove the virus. • Backup. Most systems include a tool for creating copies of the data on the system. These backup copies are often stored on magnetic tape or on large archive servers. Backups are important for rapid recovery from system failure or data corruption. Backups represent a very low cost way of mitigating the damage that might be caused by a wide range of threats. • Uninterruptible power supply. Special power supplies that allow graceful system shutdown in case of a power failure allow ﬁles to be saved and prevent the data corruption that is common if systems are allowed to “crash.” Some high-reliability systems use alternative power sources, such as generators, to allow continued operation even if commercial power is lost for an extended period. Most systems use a mixture of various technical security measures as well as the nontechnical measures described in the next section. Technical security measures provide very robust, reliable security because computer hardware or software is being used to enforce the security. Technical measures also tend to be more expensive to implement than nontechnical measures. (d) NONTECHNICAL SECURITY MEASURES. Nontechnical security measures are those safeguards that primarily rely on some action by human users to protect the system. The most common nontechnical measure is a “security procedure.” This is some step-by-step process that users must follow to prevent security breaches. Some examples of nontechnical security measures are: • Software use policy. Many companies restrict users from installing software that is not authorized by the company. This is a good method of keeping malicious software such as viruses and trojan horses off company computers. It is also a good way to avoid software licensing violations. • Incident response procedures. Rapid detection and decisive response to intrusions and other unauthorized use are important to limit or prevent losses due to security breaches. • Acceptable use policy. A policy that deﬁnes how employees are allowed to use company systems is valuable to prevent overuse of resources and to limit potential liability for actions that are taken with company computers. • Least privilege. Employee privileges are generally limited to only those privileges needed to do their job. Also, certain privileges are often identiﬁed as mutually exclusive, meaning the same employee cannot perform both functions. This technique is especially useful in ﬁnancial systems where a system of checks and balances requires two or more individuals to perform certain functions. • Physical protection of computer resources. Nearly all technical security measures can be bypassed if an intruder has physical access to the computer system. Security measures such as guards, door locks, desktop and notebook computer locks, and intruder alarms are valuable to prevent someone from simply stealing the computer hardware and the data along with it. • Desktop computer security. Most desktop computers have few technical security features. End users must follow speciﬁc procedures to ensure their desktop computers are properly secured. These procedures can include not storing passwords on the local disk, making backups of important ﬁles, and frequent ﬁle saving to prevent data corruption due to power loss.

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Ch. 43 Information Security Systems

• Employee security. Background checks, drug screening, and other safeguards are used to determine and monitor the trustworthiness of key IT personnel. • Insurance coverage. Some types of security-related loss can be recovered by having proper insurance coverage. • Disaster recovery. Rapid system recovery in case of a major disaster is critical to limiting the ﬁnancial loss due to these events. Most computer systems should be covered by a disaster recovery plan that will restore the system within a time frame dictated by the type of processing the system performs. Although disasters happen very infrequently, they can occur at any time. Periodic testing of the disaster recovery plan is essential to a successful recovery in case of a real disaster. Nontechnical security measures, by deﬁnition, are not enforced by an automated mechanism. In general, this makes nontechnical measures less robust than comparable technical measures. However, they can be relatively inexpensive and quick to implement. Nontechnical measures are often used as a stopgap while technical measures are being developed.

43.5 ENTERPRISE SECURITY STRATEGIES (a) CLIENT-SERVER SYSTEMS. The move to more distributed client-server systems has brought new information security challenges. Mainframe systems generally have a uniﬁed set of security mechanisms that interoperate to provide ﬂexible, robust protection of the information on the mainframe. Obtaining this same level of protection in a client-server environment requires the careful coordination of security features on several systems and in several software packages. In a typical client-server system, security features of the server operating system, database management system, application software, client operating system, and interconnecting network must all be designed to apply a consistent security policy. Several security solutions designed to provide end-to-end enterprise security are emerging. These solutions involve the establishment of a security infrastructure that is used to protect many different applications. Kerberos and the Distributed Computing Environment (DCE) are examples of these types of security solutions. (b) NETWORKS AND THE INTERNET. The percentage of company networks connected to the Internet has risen dramatically in the past few years. The addition of Internet connectivity to corporate networks has added a new security exposure to sensitive and mission-critical internal systems. Specialized security products have been developed to prevent unauthorized entry into corporate systems. The most common solution is a “ﬁrewall”—a specialized security gateway designed to limit the access that outsiders have to internal systems. Because Internet connectivity also provides an inexpensive option for remote access by branch ofﬁces and telecommuters, many companies also utilize remote access products that allow remote users to access internal systems securely. These products provide features to reliably identify the remote user as well as a capability to encrypt, or “scramble,” the transmissions to preclude eavesdropping. The use of encryption to create a private link across a public network such as the Internet is known as “virtual private networking.” This can be a very efﬁcient way of connecting remote employees by using low-cost public networks. (c) INTERCONNECTED CUSTOMER AND VENDOR SYSTEMS. Internetworking technology has made it possible to share information with suppliers, customers, and partners quickly and efﬁciently using electronic data interchange (EDI). The information security challenge is to create these interconnections in a way that permits the free exchange of some information but does not expose other information that is not being shared. Encryption techniques—in particular, public key certiﬁcates and digital signatures—are emerging that will allow these interconnections to be

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protected. This technology is replacing the need for mutual trust between the owners of the interconnected systems.

43.6 CONTROLLER’S ROLE IN INFORMATION SECURITY The controller’s role in information security includes several areas: • Establishing top-level information protection goals for the information and business processes he or she controls. • Monitoring compliance to security standards and policies, perhaps as part of the overall audit function. • Assessing risk to mission-critical systems and balancing the cost of risk mitigation against the potential for ﬁnancial loss due to security breaches. • Participating in the investigation of security incidents, including the evaluation of the loss or impact of an incident.

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CHAPTER*

44

ENFORCING INFORMATION SYSTEM SECURITY POLICY 44.1

INTRODUCTION 843

44.4

44.2

CREATING AN ENFORCEABLE INFORMATION SYSTEM POLICY 844

44.3

IMPLEMENTING INFORMATION SYSTEM SECURITY POLICY 845

AFTER AN INFORMATION SYSTEM SECURITY INFRACTION OCCURS 846 (a) Initial Steps upon Discovery of an Infraction 846 (b) Whom to Call to Investigate a Security Infraction 848

44.1 INTRODUCTION We execute commerce in a wired age. Business, military, government, academic, and personal systems are all interconnected through the Internet. Virtually every employee interacts with corporate data on some type of computing device. Every day, criminal actions—from stealing design documents from a PC to initiating large-scale currency transactions internationally—are occurring. A large portion of many information systems (IS) department budgets has been spent on security devices such as ﬁrewalls, password inspectors, tripwire systems, and system security management, but what consideration has been given to the actions that occur after someone has committed a crime? The primary deterrent to criminal actions is the threat of prosecution. Imagine if there were no law against robbing a bank. An industrious individual could assemble a good set of safe-cracking tools and, with enough time and effort, break into virtually any bank vault in the world. The technology built into bank vaults and alarm systems may slow down, but will not stop, a criminal. Similarly, the security built into corporate business networks may slow down, but will not stop, an intruder. What makes the average individual think twice about robbing the local bank is 20 years of maximum security time in a prison. The same logic applies to corporate information systems. The IS policy a company deﬁnes must be serious, and the employees and all external entities that interact with the company’s business systems must know what they can or cannot do before the FBI will be contacted. The capability of enforcing a security policy is what makes it effective, just as it is the capability to enforce the laws of our society that makes them effective. The following sections describe the key components of an enforceable security policy, how to implement that policy, what to do if a criminal act is suspected, and whom to call when a crime has been committed. In order to facilitate this discussion, there are a few terms that need to be deﬁned: • Incident. An incident is any unusual occurrence within the information system that warrants recording for later review. It may be caused by hardware failure, a software bug, or an intruder altering data ﬁles. * This chapter was authored by David Drach, Director of Business Analytics, FRx Software Corporation.

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Ch. 44 Enforcing Information System Security Policy

• Infraction. An infraction is an action taken within or upon an information system that is clearly deﬁned as prohibited in corporate IS policy and, if appropriate, municipal, state, or federal law. • Policy violation. A policy violation is an action taken that is inconsistent with clearly communicated IS policies (for example, writing a password on a sticky note and placing it on your desk for reference). This is not a criminal act, but the IS policy was violated and the employee needs to be instructed on the proper procedure.

44.2 CREATING AN ENFORCEABLE INFORMATION SYSTEM POLICY The IS policy itself and how it is communicated to the employees of the company are critical to the success of potential criminal prosecution. A law enforcement agency will not support an investigation unless the following components of an adequate security policy have been put in place and are actively communicated to employees: • Scope of corporate policy. What is accepted behavior on the corporate computing systems and networks should be explicitly itemized. For example, the policy should state that computer workstations, networks, and servers are for corporate use only. Explicit statements covering external connections and e-mail should be included and reviewed by legal counsel. Most computer crimes occur through these two avenues. • Balance enforcement with technology limits. Although it would be most secure to turn on every security device in the corporate network and monitor every action, this is not practical. The computing resource would be consumed in tracking every action and not in executing the company’s critical business transactions. There is a balance between the level of security that is needed and the technical feasibility of automating technology management. Work with the IS organization or qualiﬁed security consultants to deﬁne this balance and then deﬁne an implementable IS security policy that is consistent with the deﬁned level of technology. • Deﬁne actions to take if a policy violation occurs. The IS policy should deﬁne actions that will be taken if the policy is not implemented properly or if the policy is violated. The level of action and those responsible for executing the actions should be clearly deﬁned. Some policy violations may result in a reprimand from a supervisor; other infractions may result in criminal prosecution. These appropriate actions should be clearly spelled out in the security policy document. • Deﬁne escalation procedures. Many security infractions are identiﬁed by line employees executing their day-to-day activities on corporate systems. They need to have an easy-to-follow chain of command to go through if they discover what they suspect is a security infraction. There is no one best approach. Some corporations request that security issues be brought to the attention of the immediate supervisor, who then contacts a security ofﬁcer or a designee in the IS department. Others have an incident-reporting number that the employee can call directly if there is a problem. The important element is to deﬁne who to contact and how the information ﬂows to the proper authorities. External agencies who also need to be contacted should be deﬁned in the security policy. • Deﬁne a clear acceptable use policy. The acceptable use policy must be read and signed by every user of the corporate systems prior to allowing access. Unless an employee has signed this policy statement, and this statement can be provided upon request to law enforcement agencies, it is very unlikely that a criminal case can be built around the security breach. Examples of legal acceptable use policies can be found on the Electronic Frontier Foundations Web site at http://www.eff.org. Elements of a good acceptable use policy include: • Statement of responsibility for data stored in the user’s account. • Policy on reading, copying, and updating ﬁles that are not the user’s own, but that are accessible.

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• Rights to make copies of programs, computer conﬁguration data, and application data. In some cases, a special use policy would be drafted for individuals in system administration or development roles. Rights to access other computer servers and their data. Policy on shared accounts. Accounts are often shared for certain administrative activities. The procedures for managing these accounts should be clearly deﬁned. Policy for installing and copying copyrighted software. Policy for using electronic mail inside the company and outside through Internet gateways. Policy should be very clear, stating that corporate systems are to be used in executing corporate business and that e-mail may be monitored at any time. Legal counsel should review wording with respect to e-mail monitoring. Internet news groups (bulletin boards) and World Wide Web access. Once again, a policy of use for business purposes only should be clearly stated. Also, the employee should be notiﬁed that Web access can be monitored at any time. Legal counsel should review wording with respect to Internet news access and Web access. Policy on who can publish Web content and create Web servers is also essential. • Notiﬁcation of proprietary nature of systems. With the current popularity of intranets, it is essential that all intranet Web pages clearly identify that the material is for internal viewing and is proprietary. Without such obvious notiﬁcation, an intruder can infer that the intranet seemed to be simply a series of Web pages meant for public viewing. In addition, any terminal access should display a banner message describing the proprietary nature of the systems and stressing that unauthorized access will be prosecuted. These statements are essential to creating a valid criminal case. Monitoring policies should also be stated on system banners. • Action to take if intrusion is suspected. There are many tools that can be applied to more effectively monitor a potential intruder. Many such tools are too costly to enable on a ongoing basis, but if an intruder is suspected, a policy for enabling these tools should be ready to facilitate the collection of evidence. Some key tools and activities are listed below:1 Turn audit trails on. Audit trails provide a variety of tracking information depending on

the type of system being used. Monitor keystrokes. Make sure the table use policy and system banners notify the user of the potential for being monitored if this tool is to be used. Request trap and tracing from the local phone company. Most computerized phone switches can provide extensive information on the timing and source of speciﬁc calls. Use caller ID. Installing caller ID on all modem dial-in accounts is prudent and may provide all the information needed to intercept an intruder. Deﬁne a security investigator. This individual is responsible for investigating security infractions and maintaining evidence that is collected. This individual should also network with other security managers or investigators both regionally and nationally.

44.3 IMPLEMENTING INFORMATION SYSTEM SECURITY POLICY The only effective security policy is an active policy. Many organizations hire a security consultant who comes in and performs an audit of the system. Numerous security holes are often found, and software and hardware are implemented to remove these potential security hazards. The IS director provides a report to management and shows them the glossy report. The report is passed to the system administrator, who is told it is his or her job to implement security; the problem is solved, or at least senior management thinks that the problem is solved. In a matter of months, employees gain access to the system without signing an acceptable use policy statement. Some 1. From the Federal Bureau of Investigation National Computer Crime Squad Web site, http://www.fbi.gov/programs/compcrim.htm.

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users discover the ease of publishing Web pages and post internal ﬁnancial statements on their own PC using Microsoft Excel. They ﬁgure nobody browsing the Web in New York would be able to see these pages, except that one of the many Web search engines just cataloged their little site last night. The next time an individual types the company’s name and a request for ﬁnancial information into a major Web search engine, up pops the Excel spreadsheet from the intranet (what was thought to be on an intranet is now on the Internet). These data may not have been ready for public consumption, and repercussions for a publicly traded ﬁrm could be severe. The IS policy has been innocently circumvented. IS security policy implementation should be reviewed on a quarterly basis. Due to the current rate of change for technology, the originally authored procedures should be reviewed no less than twice a year. Consultants may not be required for every review, but unless the internal IS department is very competent in the latest technology, the use of consultants is highly recommended. IS policy should be carefully implemented at all levels, from senior management to individual employees. Senior management must be comfortable with the escalation process and prepared to perform damage control after an infraction occurs. The actual implementers of the security policy, those whose task it is to execute the security policy, should be tested on a quarterly basis. Implementation of a solid IS security policy should become part of the culture of a company. All levels of management should be briefed in the current IS security policy. They will very likely be the ﬁrst who are made aware of a potential problem with the systems. IS personnel will typically get involved after line management has indicated a problem. As discussed later in this chapter, the evidence that the manager initially collects is critical to the investigation of a possible security infraction and the potential criminal prosecution that may ensue. All employees who use the internal information systems for any aspect of their job, including e-mail and PC local area network (LAN) access, must review and sign an acceptable use policy. Not taking this basic step makes prosecution of any wrongdoing by an employee virtually impossible. It may even make company-based disciplinary actions difﬁcult or even illegal to execute. In addition, employees should be trained in data backup procedures, password management, terminal access control, and data media storage. Any external entity, such as a business trading partner, must also review and sign an acceptable use policy. Many companies are implementing Internet-based trading activities, such as ordering through e-mail messages, Web access, and so forth. If an external entity that was not covered by the employee policies requires access to the corporate information systems, its representative should sign an acceptable use policy drafted for that purpose. Practice is the most effective means of testing a security policy. A mock security infraction should be executed periodically. This tests the implementation of the policy and the escalation procedures, and, if taken through to contacting the local law enforcement ofﬁcials, it may identify key changes in the policy that are essential to making the policy more enforceable.

44.4 AFTER AN INFORMATION SYSTEM SECURITY INFRACTION OCCURS Unfortunately, virtually every manager who is responsible for a large information system will encounter some level of information system security infraction in their lifetime. A security infraction may be as simple as an employee e-mailing proprietary corporate information to a competitor, or as severe as an intruder from an external system altering critical ﬁnancial information. The infraction may vary from the inappropriate use of corporate resources to a federal offense involving large-scale monetary transactions. Often, once a security infraction has been discovered, the damage is not clear until further investigations have been completed. Thus, every security infraction must be investigated pragmatically to ensure the integrity of the key corporate systems. (a) INITIAL STEPS UPON DISCOVERY OF AN INFRACTION. If an infraction is suspected, it should be reported to the nearest manager and then passed along to the corporate security ofﬁcer.

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In the physical world, the severity of a crime is very easy to discern. If a cash box was stolen, the value of the contents can be readily estimated. Like a crime scene in the physical world, the evidence surrounding the infraction must be preserved for later investigation. In addition, by carefully recording the events surrounding an infraction and preserving an image of the systems after the infraction occurred, the systems can be restored to their normal operating capacity as quickly as possible. An infraction may not always be discovered by the IS department or the system administrator. A severe infraction may often be discovered by an accounts payable clerk who notices that data are changing in an inconsistent manner or by a billing supervisor who notices strange billing dates. The evidence that initiated an international spy hunt in the book The Cuckoo’s Egg, by Clifford Stoll, was an accounting error of just a few cents. • Document the circumstances surrounding the discovery of an infraction. The initial manager who is contacted by an employee with information about a suspected infraction should carefully note all information that led to that employee’s suspicions. Immediate action is essential so that the current state of the system can be recorded most effectively. The initial facts surrounding the infraction are perhaps the most crucial to the follow-on investigation. This information will be the basis of the initial report ﬁled with the proper law enforcement agency. Ask questions such as: When did you ﬁrst discover a discrepancy in the data? Did you leave your terminal unattended for any period of time prior to this discrepancy

being discovered? When was the last time that you saw the data with no discrepancy? What is the impact of these data not being correct? Is there any identiﬁcation of who modiﬁed these data? Have you noticed any unusual behavior in your applications?

• Deﬁne the suspected bounds of the infraction. The next step is to quickly assess the scope of the problem. For example, if the employee who raised the issue suspects that someone has tampered with their Excel spreadsheet, and that spreadsheet resides on the personal computer’s hard disk, then the scope of the problem can be narrowed down to the individual’s personal computer. If that spreadsheet was on a corporate ﬁle server, then the scope encompasses the ﬁle server infrastructure as well. The local system administrator or help desk support representative may be able to help identify where key data ﬁles are located and assess the scope of the infraction. Based on the best information available at the time, the manager must contact the corporate security ofﬁcer, or designated security representative to move to the next step, because now it starts to get expensive. • Do not contact the suspect. If the preliminary assessment of the infraction reveals a speciﬁc suspect or group of suspects as possible perpetrators of what could be a criminal act, do not approach that individual or that group. If the suspect has been contacted prior to contacting the proper law enforcement agency, the suspect may have the opportunity to tamper with critical evidence. Many law enforcement agencies will not even pursue an investigation if the suspect has already been contacted. Not contacting the suspect is especially difﬁcult if the suspect is an employee, but is absolutely critical if there is going to be any chance of criminal prosecution. • Create backups within the bounds of the infraction. At this point, if the infraction appears to be severe, and further investigation is warranted, users must be restricted from the systems in question, and a full backup of all data within the bounds of the infraction must be created. Once these backups have been created, users can continue interacting with the system, as long as the infraction has not caused irrecoverable damage to the data on the system. This system backup is essentially a picture of the crime scene. Without the timely creation of this backup, critical evidence that may be submitted during criminal prosecution may be lost. Depending on the systems being used and the scope of the infraction, this backup process

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Ch. 44 Enforcing Information System Security Policy

may take as little as an hour or as long as 24 hours. All evidence must be immediately secured in a locked cabinet with access only by the designated security ofﬁcer to ensure the integrity of the evidence. • Ensure the integrity of the system. Once the evidence has been recorded on backup tapes, the system should be audited in order to assess the overall integrity of the currently running applications and data. The system administrator and the local IS department should be able to execute a series of routines to provide this information. Once this assessment is made, a decision can be made to either continue processing without interruption or to recover to a previous backup of the data. Although the most conservative approach may seem to reinstall all of the applications and roll back to a safe set of data, the investigation of what really occurred around an infraction can proceed much more effectively if the compromised system is left intact for a short period of time while the investigation takes place. If the integrity of the applications—especially the operating system—is suspected, then these applications should be reinstalled from their source media, which should be read-only tapes or CDs. • Assess the damage. At this time, users should have access to their critical business systems, and the security ofﬁcer or designee can begin to investigate what damage occurred during this infraction. Assessment of the damage is extremely important. If there is an intent to pursue criminal prosecution of whoever caused the damage, the damage must be quantiﬁable in realistic business terms, preferably monetary terms. The effort required to pursue criminal prosecution through conviction is tremendous. If the damage is not too severe, technical or procedural changes may prevent future infractions. The infraction should be logged in a series of incident reports, typically managed by the corporate security ofﬁcer or the IS department. These infractions, combined with other incidents, may provide evidence toward a much greater problem. • Approach law enforcement authorities. If the damage is severe, or if the information seems to be of a criminal nature,2 the proper authorities should be contacted. Whom do you contact? In any case, contact your local police department. They are most familiar with the laws in the state and municipality where the infraction occurred. They can also direct you to experts who deal with high-technology crimes. The local district attorney’s ofﬁce can also help with respect to local laws and often can supply investigative support. At the time of this publishing, only two police departments have a high-tech crime unit that deals with computer security infractions—San Jose, California, and Austin, Texas. Refer to the next section for details on whom to contact. (b) WHOM TO CALL TO INVESTIGATE A SECURITY INFRACTION. There are a variety of agencies who can assist in the investigation of an infraction and the follow-on actions. These agencies range from the proactive distribution of information on security incidents and the legal nature of system security policy to the enforcement of speciﬁc local and federal laws. Key agencies are described below: • High Technology Crime Investigation Association (HTCIA). HTCIA is a consortium of local police and district attorney ofﬁces who have published information on how to create enforceable IS policies, key laws covering privacy, case studies, and links to additional Web sites with security information. Contact their Web site at http://htcia.org. On this Web site you can ﬁnd references to local chapters in your area. • Forum of Incident Response and Security Teams (FIRST). FIRST is an industry consortium that provides an Internet-based repository of security incidents. Contact their Web site at http://www.ﬁrst.org to see the latest security incident information and get additional information on joining the consortium. FIRST is not a law enforcement agency. 2. In one case, an employee had sent an e-mail describing in great detail how he was going to commit a murder. A murder was committed that matched the description, and the e-mail was eventually submitted as supporting evidence.

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• Computer Emergency Response Team (CERT). CERT is afﬁliated with Carnegie Mellon University and is the oldest computer emergency response team. They typically deal with large-scale security incidents that cover many companies, but also have a electronic repository of incidents that may help an investigation. Their library of documents can be reached at ftp://cert.org. • Law enforcement agencies. Which agency is contacted depends on what you suspect the criminal act involves. The local police department with jurisdiction over the area where the infraction occurred should always be contacted, preferably before any additional actions. The best electronic criminal investigation service is the Federal Bureau of Investigation (FBI) Computer Crime Squad, which has matured dramatically over the last several years. Any crime that crosses interstate boundaries (which covers most Internet-based attacks) would fall in the jurisdiction of the FBI. Due to the constrained resources of the FBI, the crime will need to be signiﬁcant, in either monetary value or the proprietary nature of the data, to enlist the Computer Crime Squad’s serices. Exhibit 44.1 lists other key law enforcement agencies and when they should be notiﬁed.

Security Issue

Agency

Phone

Web Site

Registering a criminal complaint

Local Police Department

Look it up; do not dial 911

Any crime dealing with interstate commerce or a felony act Any crime dealing with large monetary cases

FBI

(202) 324-9164 Computer Crime Squad Contact local ofﬁce

Any crime dealing with international money transfers or currency exchange Any crime dealing with stolen trade secrets

U.S. Customs Service

Contact local ofﬁce

www.ustreas.gov/ treasury/bureaus/usss/ usss.html www.customs.ustreas.gov

U.S. Commerce Department

Contact local ofﬁce

www.doc.gov

E XHIBIT 44.1

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W HOM

TO

U.S. Secret Service

C ONTACT

AFTER AN I NFRACTION

www.sjpd.com (San Jose Police Dept) www.ci.austin.tx.us (Austin Police Dept) www.fbi.gov

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CHAPTER

45

E-COMMERCE SECURITY 45.1

INTRODUCTION 851

45.2

E-COMMERCE ARCHITECTURES 851 (a) Traditional Architectures 851 (b) Demilitarized Zone 852 (c) Layered Architectures 853 (d) Secure “Insider” Access 853

45.3

CRITICAL SECURITY MEASURES 854

(a) (b) (c) (d) (e) (f) (g)

Firewalls 854 Intrusion Detection and Response 855 Encryption 856 Authentication 857 Access Control 857 Host Hardening 858 Vulnerability Testing 858

45.1 INTRODUCTION The rapid growth of electronic commerce (e-commerce) over the past few years has enabled many businesses to greatly improve the speed, efﬁciency, and productivity of their relationships with customers, suppliers, and business partners. For the most part, these improvements have been achieved by creating Internet World Wide Web (or simply “Web”) interfaces to key business systems. When a business contemplates adding Web interfaces to its mission-critical systems, signiﬁcant security questions often arise. Many of the “back-end” systems that are being connected to the Internet were originally designed as internal systems and have security features commensurate with operating in a relatively “protected” environment. Current best practices dictate a range of security features de-signed to protect sensitive data and systems from the relatively constant barrage of attacks on the Internet. This chapter will outline both the types of system architectures and speciﬁc security components needed to build robust e-commerce systems today.

45.2 E-COMMERCE ARCHITECTURES (a) TRADITIONAL ARCHITECTURES. Traditional (pre-e-commerce) system architectures generally had a single enterprise network fabric interconnecting all systems, including backofﬁce mainframes and servers, ﬁle servers, and desktop systems. Security measures were, for the most part, implemented as “user ac-counts” and “ﬁle permissions” on individual host systems. There was no real segregation or partitioning of assets by the network itself. As the Internet became an important resource for employees, most companies installed an Internet connection and an Internet ﬁrewall to protect their corporate network from hackers. This type of architecture, shown in Exhibit 45.1, was adequate for “Web surﬁng” and e-mail uses, but is not sufﬁciently robust for e-commerce.

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Ch. 45 e-Commerce Security

E XHIBIT 45.1

S INGLE -R EGION S ECURITY A RCHITECTURE

(b) DEMILITARIZED ZONE. The ﬁrst challenge to be addressed in creating a secure environment for e-commerce applications is the creation of a layered network architecture that provides adequate isolation from the Internet. At the minimum, this involves creation of a perimeter region, dubbed a “de-militarized zone” or DMZ. The DMZ, similar to the boundary regions near contested political borders for which it is named, provides a heavily defended region that acts as a protective buffer in front of the main corporate network, which is less well secured. The DMZ is formed by creating a separate local area network (LAN) that contains the Web servers, and possibly other servers, that are “exposed” to the Internet to conduct business. The isolation between the Internet, the DMZ, and the main corporate network is enforced by a ﬁrewall that restricts the communication between the zones. This is shown in Exhibit 45.2. To take full advantage of the protection provided by the DMZ, it is best to limit the types of systems placed in the DMZ to those directly interacting with the Internet. Other servers, such as application servers and database servers, should be placed in the secure zone further to the rear. The hosts in the DMZ, generally small in number, should be individually “hardened” (see Section 45.3(f)) against an Internet attack since they are exposed to direct connections. Applications should be designed so that the DMZ servers provide only basic services (e.g., Web servers, ﬁle transfer protocol [FTP] servers, e-mail gateways) and do not host databases that store sensitive information (e.g., credit card numbers, customer account databases, etc.).

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45.2 e-Commerce Architectures

E XHIBIT 45.2

853

M ULTILAYERED S ECURITY A RCHITECTURE

(c) LAYERED ARCHITECTURES. As e-commerce applications have become more sophisticated, and as they have expanded to encompass more and more systems within an enterprise, the security infrastructure has also grown more sophisticated and all-encompassing. From an architectural perspective, what started as a single point of protection (the Internet ﬁrewall) and expanded into an appendage on the enterprise network (the DMZ) has now become a fundamental restructuring of network architectures to enable and secure e-business applications. The current state of the practice includes a multilayered network architecture, an example of which is shown in Exhibit 45.3. In this architecture, ﬁrewalls are deployed both at the Internet point of entry as well as internal to the enterprise to create zones representing different security “levels.” As before, the zone containing servers that offer services directly to Internet users are located in a DMZ and an Internet ﬁrewall is used to restrict connection attempts to approved protocols. Additional ﬁrewalls are used to create the boundary between the DMZ and rearward secure zones. By employing separate ﬁrewalls, this architecture eliminates the possibility that a person could “penetrate” the Internet ﬁrewall and thereby gain direct access to sensitive databases. This layered architecture works much like the traditional physical security systems in which a combination of defenses were set up such that an intruder would have to break through each one in sequence. A layered approach avoids the classical “weakest link” problem wherein a chain is only as strong as its weakest link since the tension on the chain exerts on each link equally. In a layered security architecture, the effort required to break in is equal to the sum of efforts required to break each layer in turn. (d) SECURE “INSIDER” ACCESS. Also shown in Exhibit 45.3 are architectural accommodations for secure administrative access where remote users on the corporate network must pass through a ﬁrewall in order to access any of the e-commerce servers in the other regions. This addi-

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tional security layer represents two trends: (1) the trend toward increased remote access by developers, testers, and system administrators to facilitate telecommuting and participation by technical personnel not physically located at the data center hosting an e-commerce application; and (2) a trend toward not considering all company employees to be “trusted” with access to all assets within an enterprise network. Surveys have shown that many security attacks are perpetrated by or involve participation by insiders, that is, company employees or contractors who have some form of legitimate access to company systems. By placing a ﬁrewall between the secure region and the corporate computing region, it is possible to restrict and monitor the access to mission-critical production systems. In effect, the “insiders” are now considered to be coming from an “untrusted” source and their identity and privileges are checked by the ﬁrewall before access is permitted.

45.3 CRITICAL SECURITY MEASURES (a) FIREWALLS. Firewalls were originally invented to provide protection of Internet connections. By funneling all communications to and from the Internet through a single gateway, it is possible to have one device protect a great many relatively unsecure inside systems. This concentration of security services is still the primary purpose of ﬁrewalls, although vendors have recently added many other valuable security functions to their ﬁrewall products. These enhanced ﬁrewalls are the building blocks of e-commerce security architectures since, unlike other network components, they are designed speciﬁcally to perform a security function. Namely, the creation of “boundaries” within networks. Notice in the architecture diagrams in the previous section that each of the dotted lines representing zone boundaries passes through a ﬁrewall device. There is no way for data to ﬂow from one zone to another without passing through a ﬁrewall device and, in general, communications are allowed only between adjacent zones.

E XHIBIT 45.3

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M ULTILAYERED S ECURITY A RCHITECTURE

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The ﬁrewall performs this boundary function by restricting trafﬁc ﬂow based on various criteria. While an unprotected network connection—essentially a wire—between two zones would allow any type of information exchange, a ﬁrewall intentionally restricts data ﬂow based on certain rules of acceptable and unacceptable communications. Because the type of communication that is required between zones varies greatly from system to system, all ﬁrewall products are highly conﬁgurable and are typically customized with a “security policy” that deﬁnes the source, destination, and type of trafﬁc that can ﬂow through them. For example, if a ﬁrewall were protecting a DMZ containing a Web server, the ﬁrewall would be conﬁgured with an access rule that permitted inbound requests from Web browsers anywhere on the Internet and the associated reply. This rule would allow the Web server to receive and respond to Web requests as it is designed. This ﬁrewall would also likely have a rule that denied all other trafﬁc. If a person on the Internet attempted, say, an administrator login to the Web server, the ﬁrewall would recognize that this type of connection request was not permitted to come from the Internet and would reject the request. In this scenario, the Web server is protected because it would not even see the administrator login request because it would be blocked by the ﬁrewall. A ﬁrewall can enforce a complex set of such rules based on the source of the request, the destination (target) of the request, and the type of request (e.g., Web page request, ﬁle transfer request, login request). Some ﬁrewalls can also make decisions based on application-speciﬁc information (e.g., for a Web request, restrict based on the speciﬁc page requested). Because ﬁrewalls are devices that “expect” to be attacked, they are designed with various security features to detect and repel many common forms of attack. For example, most ﬁrewalls can recognize incorrectly formed requests as being potential attacks and deny, log, or ignore those requests. The ﬁrewall itself must, of course, be built on a secure host computer to ensure that an attacker does not defeat the ﬁrewall by attacking the computer on which the ﬁrewall software runs. Some ﬁrewalls today are “appliances,” meaning they are dedicated hardware/software combinations built solely for the ﬁrewall job. Other ﬁrewalls are software packages that run on general-purpose computer systems. (b) INTRUSION DETECTION AND RESPONSE. Shortly after government computer systems ﬁrst began being connected to the public Internet (or rather, when the government networks ﬁrst began being interconnected with public networks), surveys found that a large number of host systems were vulnerable to attack. More shocking, though, was that an even larger number could not detect that they were being attacked. There is a saying in the computer security community that if your system has never been attacked, then you must not have any intrusion detection software installed, meaning that it probably has been attacked but no one noticed. Internet-connected systems are typically probed on a daily basis. While not an all-out attack, these probes are typically information-gathering precursors to a break-in attempt. Many hackers will use automated scanning tools to search for vulnerable systems that they can then go back and penetrate. Intrusion detection software is designed to recognize both the precursor probes and actual attacks. In all cases, intrusion detection software will alert a network administrator or monitoring service as to the presence of an attack. Some products can go a step further and will block the intruder’s access to the network. There are two types of intrusion detection products on the market today: network-based and host-based intrusion detection. Both serve useful and complementary functions and are often used together to provide “complete” visibility of potential attacks. Network-based intrusion detection products work by “watching” all the data that ﬂow into or out of a network. These products are typically placed at an Internet point of entry where they can observe all trafﬁc between the Internet and corporate network (e.g., the DMZ). Each “packet” of data is compared against a database of known attack “signatures,” and matches are ﬂagged as possible attacks. This type of intrusion detection product is especially useful against previously known forms of attack, but is not effective against disguised or new attacks. Like virus detection

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Ch. 45 e-Commerce Security

software, the attack signature database must be frequently updated to include the latest forms of attack. Host-based intrusion detection products are deployed directly on servers and are conﬁgured to watch critical operating system parameters and system log ﬁles (e.g., security logs or application logs) for conditions that might indicate an attack on that host. These products typically leverage security features built into many operating systems, such as logging of failed login attempts, and can detect a wide range of attacks including both remote attacks over a network and direct attacks (e.g., from the server’s console keyboard). Like network-based products, host-based products rely on advance knowledge of what constitutes an attack. Host-based products can typically be customized with respect to both what parameters are being monitored and the thresholds that would be sufﬁcient to sound an alarm. For example, if the product were monitoring critical system ﬁles, any change may be cause for alarm. However, if it were monitoring failed login attempts, a typical conﬁguration would allow a few attempts before sounding an alarm. Intrusion detection products provide great visibility into both network and host activity that is difﬁcult to obtain otherwise. In doing so, they generate large amounts of event data and voluminous reports that can often overwhelm an organization that has not previously had a source for this information. In conjunction with deploying intrusion detection software, companies must establish a process for dealing with the attacks, potential attacks, and precursor events that are detected by the software. This process is known as incident response and encompasses several important activities: • Assessment of event data to determine if it is an actual attack and, if so, the severity of the threat • Investigation of an incident to determine the source of the attack, whether or not it was successful, and, if successful, the extent of damage • Mitigation of damage by limiting or blocking access by intruders before they succeed in completing their attack • Collection and preservation of evidence that may be useful in a disciplinary action, criminal investigation, or legal proceeding (c) ENCRYPTION. Encryption, the mathematical scrambling of data, and decryption, the unscrambling of that same data, have long played a part in protecting communications over unsecured mediums. In the context of Internet e-commerce, the communications are typically privileged to the parties at each side of the transaction but must be communicated over a very public and not very secure Internet. Although there are many different encryption methods that can be used over the Internet, the most widely used for e-commerce is the Secure Sockets Layer (SSL) protocol. The SSL protocol is not, per se, an encryption protocol. Rather, it is an information tunneling protocol that provides privacy (encryption), integrity (message content authentication), and authentication services that enable both sender and receiver to have high conﬁdence that: • Their messages are not intercepted by eavesdroppers. • Their messages have not been tampered with or modiﬁed en route. • The person(s) with whom they are communicating is the in-tended party(ies). SSL provides these services through use of several encryption techniques, including public key encryption (see Chapter 46) for more information). SSL allows the selection of various encryption algorithms and encryption strengths (determined by the length of the encryption key) to accommodate different security levels (e.g., stronger security for highvalue transactions). SSL is also designed speciﬁcally for the type of ad hoc transactions common in e-commerce wherein neither party is known to the other at the start of thetransactions. Another important use of encryption for e-commerce, digital signatures, is discussed in Chapter 46.

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(d) AUTHENTICATION. One of the most difﬁcult challenges in e-commerce is providing positive identiﬁcation of a person or company that is not physically present when conducting the transaction. Various techniques are employed by e-commerce applications to obtain the identity of “clients” who access the application, and, correspondingly, to assure the client that they are, in fact, accessing the correct application. Sometimes the parties of the transaction are well known to each other and have a preestablished relationship. In these cases, authentication is generally accomplished by means of a “shared secret.” For example, a bank, after having established an account relationship with a customer by obtaining his or her physical signature on various documents, may provide that customer with an account number and a personal identiﬁcation number (PIN) that can be used to access the bank’s automated teller machines (ATMs) or e-banking Web site to conduct transactions. Similarly, an employer may provide an identiﬁcation “token” that employees use whenever they want to access the company intranet Web site. In these cases, the preexisting relationship provides a good basis for the e-commerce relationship. Logistically, it is relatively easy for the parties to exchange this shared secret. Legally, both parties can agree in advance, under the authority of a recognized legal signature, on the terms and conditions of their e-commerce relationship. More commonly in the e-commerce world, the parties are not known to each other outside of the e-commerce relationship. In these cases, all necessary authentication of identify must be performed “in band”—that is, totally within the e-commerce information exchange. This represents a much more difﬁcult problem. Organizations that are transacting business over the Internet need assurances against fraud and abuse. Most consumer-oriented applications place a high value on ease of use and therefore typically choose the traditional username/password method of identifying users. Often, a new account can be set up on the ﬂy by a consumer. This method is not highly secure, but is generally considered adequate for low-value and mid-value transactions. For applications that require a higher assurance of the true identity of users (e.g., high-dollar-value business-to-business transactions), technologies such as digital certiﬁcates and hardware tokens can be used. The other side of the authentication equation is that the client that is accessing an e-commerce application must have assurance that they are not dealing with an imposter. For example, a consumer booking airline tickets through an online travel agency would not want to provide his or her credit card and other personal information to anyone other than the reputable travel agency selected. This authentication is called server authentication and for Web applications is provided by digital certiﬁcates. Businesses that run e-commerce Web servers purchase “server certiﬁcates” from trusted third parties known as certiﬁcate authorities. These certiﬁcates are a form of digital passport—difﬁcult to forge and easily recognizable. During the initiation of an SSL connection between a Web browser and a Web server, the server sends its digital credentials to the client browser. The browser checks these credentials to be sure they are valid and that they correspond to the Web site requested by the user. For example, if a consumer points his or her browser to www.onlinestore.com, the browser will check the digital certiﬁcate received from the server to be sure it belongs to www.onlinestore.com. If it does not, the consumer is warned that he or she may have been redirected to a different site than intended. The browser also checks the certiﬁcate to be sure a known trusted certiﬁcate authority issued it. Web browsers have a database of certiﬁcate authorities whose certiﬁcates they will recognize automatically. As was mentioned previously, digital certiﬁcates can be used in a similar manner to identify clients. Web browsers provide this capability, but most consumers do not have digital certiﬁcates today. Although this is likely to change in the future, today e-commerce applications that wish to use digital certiﬁcates for client authentication must make provisions to issue the certiﬁcates (or have a trusted third party issue them) to their users. (e) ACCESS CONTROL. E-commerce applications provide a gateway or portal to information that is to be exchanged between parties. These applications must contain access control mechanisms to ensure that each party has access to only the appropriate functions and data. These controls can be based on the identity of the client. For example, an online retail store must ensure that

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Ch. 45 e-Commerce Security

each consumer can affect the status of only his or her own orders. This type of site will usually identify each customer by name and/or account number. Access controls can also be based on the role/status of the client. For example, a software vendor’s support site may permit anyone who can demonstrate that he or she has a valid software license to download upgrades or patches. This type of site may not identify users by name, but rather simply require users to enter a license number embedded in the software to prove that they possess a copy. Most e-commerce applications contain a customizable mechanism to permit access to various functions within the application based on user identity. These mechanisms are analogous to the “permissions” associated with user accounts on typical computer systems. These mechanisms provide the primary control over user access to data, and will often be subjected to attacks that attempt to circumvent the security controls. Consequently, they must be well designed and well tested to be sure no weaknesses can be found. (f) HOST HARDENING. The servers that host e-commerce applications must be sufﬁciently robust to withstand attack from the Internet. In particular, Web servers that accept connections directly from the Internet must be very well protected. It is not sufﬁcient protection that the system is “behind a ﬁrewall.” If the ﬁrewall is conﬁgured to permit access to the system (as must be the case for a Web server if it is to do its job), then some types of attacks will pass right through the ﬁrewall. Fortunately, the commercially available operating systems commonly used as servers all have sufﬁcient security measures that they can be conﬁgured securely for Internet e-commerce. Unfortunately, none of these systems are secure “out of the box” as delivered by the vendor. All must be explicitly “hardened” to add to the default security. This process involves several conﬁguration items that are usually performed by systems administrators or technical security personnel: • Removal of all unneeded services and protocols • Elimination of unneeded user accounts or privileges • Enabling audit logging • Installing upgrade patches to ﬁx known security vulnerabilities • Setting of various operating system parameters to a secure setting Host hardening is done for each host that is directly exposed to the Internet and may be done, generally to a lesser degree, on back-end systems such as database servers. Many companies perform host hardening of all production systems, even if not Internet accessible, to protect against insider attack. (g) VULNERABILITY TESTING. E-commerce systems, as previously mentioned, endure a continual stream of probes and, especially if they display vulnerabilities, possible attack. To greatly lessen the likelihood that an attacker would succeed, companies perform vulnerability testing before new systems “go live” and periodically thereafter. These tests simulate the type of probing commonly performed by hackers to see, before they do, any vulnerabilities of the system. Testers use commercial vulnerability scanning tools and even some of the “hacker tools” available on the Internet. All operating systems, Web server software, and application development software have known vulnerabilities that have been discovered and reported on the Internet. These ﬂaws range from minor problems to major ﬂaws that would permit an attacker to obtain full access to a server and the data stored by the server. In most cases, software vendors respond by issuing patches—software upgrades that ﬁx the problem—or by issuing instructions on how to conﬁgure their software to avoid the problem. Although there are databases of these known vulnerabilities available on the Internet, it is generally not practical for system administrators to manually check each of their systems for each of the multitude of vulnerabilities that have been discovered. Instead, they will employ vulnerability

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scanning tools to automatically check many systems against a database of literally thousands of possible security ﬂaws. When vulnerability testing discovers a ﬂaw in a system, it means that hackers could identify the same ﬂaw using their tools and, depending on the nature of the vulnerability, exploit it to gain unauthorized access. For e-commerce systems, it is necessary to search out and implement ﬁxes to any discovered vulnerabilities. For systems that are not directly accessible from the Internet, many companies ﬁx only the most serious ﬂaws since for more minor ﬂaws the cost to ﬁx the problem outweighs the likelihood that someone would ﬁnd a way to exploit it.

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CHAPTER*

46

DIGITAL SIGNATURES 46.1

INTRODUCTION 861

46.2

DIGITAL SIGNATURE TECHNOLOGY OVERVIEW 862 (a) Cryptography 862 (b) Digital Certiﬁcates 864 (c) Risks of Forgery, Impersonation, and Falsiﬁcation 865

46.3

DEMAND FOR DIGITAL SIGNATURE TECHNOLOGY 866

(a) Market Forces Driving Electronic Commerce 866 (b) Digital Signatures Enable Electronic Commerce 866 (c) Occasional or One-Time Customer Applications 866 (d) Recurring Customer Applications 867 (e) Internal Employee Applications 867 (f) Business Partner Applications 867 46.4

LEGAL ISSUES 867

46.1 INTRODUCTION The explosive growth of the Internet and the availability of inexpensive wide-area digital networks have caused many companies to move toward electronic solutions for a wide variety of business transactions. As these electronic transactions increasingly involve mission-critical functions such as the transfer of money, controllers and chief ﬁnancial ofﬁcers (CFOs) need these transactions to be as reliable as traditional paper transactions. Speciﬁcally, they need to be able to verify the source and validity of any particular transaction. In the case of an order, for example, what was ordered and who signed the order? A relatively new technology has been developed to provide this service. Typically called “digital signatures,” this technology is based on data encryption techniques and can be used to provide a variety of assurances on an electronic transaction: validation of content, identity of sender, and nonrepudiation. This chapter examines the business forces that may be driving a company to adopt digital signature technology, describes the basic technology being used, explains the way it is used to provide assurances that are analogous to paper transaction mechanisms, and looks at some issues that will be of concern to controllers and CFOs as use of this technology increases. In their simplest form, digital signatures are a replacement for a handwritten signature on a paper document: a relatively difﬁcult-to-forge mark that identiﬁes the originator of a document. In practice, though, both handwritten and digital signatures have several forms with a range of assurances. At the lowest end of the assurance spectrum, a paper document may have a preprinted “rubber stamp” type signature. At the higher end, notaries and other third parties are used to verify the identity of the person afﬁxing the signature. Similarly, digital signatures can range from simple identiﬁers that are not very trustworthy to high-assurance signatures that provide a high conﬁdence of both the identity of the originator and the contents of the document. Exhibit 46.1 shows this spectrum of assurance and examples of analogous written and digital forms of signature. The methods used to create digital signatures with varying levels of assurance are described later in section 46.2. * This chapter was authored by E. Edward Bassett III, Senior Systems Security Engineer, Denver Technological Laboratories.

861

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Ch. 46 Digital Signatures

Digital documents are, by nature, more subject to alteration and forgery than paper documents. The storage medium—electronic bits—does not show signs of tampering as readily as paper. Also, the transmission mechanisms generally involve reproducing the electronic image from one place to another rather than physically moving the document such as is often done with paper documents. The notion of an “original” is largely irrelevant in the electronic document world. Digital signature technology takes these characteristics into account and provides for the veriﬁcation of both the identity of the sender and the contents of the document. When a paper signature is “checked” by a recipient, that person looks for obvious signs of forgery or alteration on the paper document. In higher assurance situations, the recipient may compare the signature to a validated signature kept on ﬁle. They may also require an original document with an original signature to provide further assurance that no alteration has occurred. When a digital signature is veriﬁed, computer software can verify the origin of the credentials used to sign the document as well as verifying that the document has not been altered in transmission from when it was signed.

46.2 DIGITAL SIGNATURE TECHNOLOGY OVERVIEW (a) CRYPTOGRAPHY. In an effort to add security features to the relatively unsecure Internet, technologists have looked primarily to cryptography for answers. For many centuries, cryptography—scrambling messages into unintelligible codes—has been used as a way to send private messages over otherwise not-so-private channels. Military commanders used cryptography to encode messages sent by messenger and, later, radio to avoid interception by enemy spies. James Bond types use cryptography to send secret messages from hotel rooms, pay phones, or whatever communications means are available. Now, cryptography is the solution of choice for sending business transactions of all kinds. Cryptography has traditionally been used to make messages “secret,” that is, to protect them from eavesdropping. While this is important for many business transactions (such as those involving trade secrets), for many others the issues are integrity and source veriﬁcation. It is more important, for example, that we know that an order for goods is accurate and who sent it than that we keep it concealed from outsider observers. Fortunately, cryptography can be used to accomplish these things as well. Digital signatures use a form of cryptography known as “public key cryptography” in which encryption (scrambling a message) and decryption (returning the message to its original form) are accomplished by two separate “keys.” Think of this as a door which is locked by one key and unlocked by another. These keys work as a pair and are generally managed so that one of the keys is kept private and known only to one person while the other key in the pair is made public and known to everyone.

E XHIBIT 46.1

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S IGNATURE A SSURANCE S PECTRUM

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863

This scheme allows a “signature” function to be performed easily. The document originator uses his/her private key to encrypt the document and then he/she transmits it to the recipient(s). Upon receiving the encrypted document, the recipient decrypts the document with the originator’s public key. If the document decrypts properly, the recipient is assured of two things: the document was created (or at least encrypted) by the originator who holds the corresponding private key; and the document was not altered during transmission. It is important to note that this type of encryption does not provide any privacy for the transaction. Because the decryption key is public (i.e., available to anyone), it would be possible to anyone who intercepted the message to decrypt it and read its contents. Encryption can also be used to provide privacy; in fact, that is its traditional use. By combining both privacy encryption and digital signature techniques on the same message, both privacy and integrity can be achieved. The technique described above—encrypting the entire document—is a fairly expensive way of creating a digital signature since the encryption process requires a good deal of computation. It also requires the recipient to decrypt the entire document to read any of it at all. Just as in the paper world we sometimes read a document without verifying—or even looking at—the signature at the bottom, there are many times when it is appropriate to read a digitally-signed document without verifying the signature. To solve both these problems, digital signatures use a technique called a “message digest.” A digest is a small but unique ﬁngerprint of the document. Using computational techniques, a ﬁxed-sized digest can be easily created from a document of any length. This is a one-way operation: Anyone can create the digest from the original document, but it is impossible to recreate the document from the digest. The digital signature is created by encrypting the message digest with the sender’s private key as shown in Exhibit 46.2. It is then sent along with the original document to the recipient(s). The recipient(s) can then read the document right away, ignoring the signature if that is appropriate. When a recipient wants to check the validity of the signature, all he/she needs to do is decrypt the message digest, recreate another message digest from the document, and compare the two digests as shown in Exhibit 46.3. If they match, the recipient can be sure that the document was not altered en-route (if it had been altered, the digest would be different). The recipient can also be sure that the signature was created by the person holding the private key corresponding to the public key that he/she used to decrypt the digest (if it had been created using a different key, the digest would not decrypt properly). In cases where a document must be signed by multiple parties (e.g., contract or agreement), each party would encrypt a message digest with their private key and all the signatures would be transmitted together with the original document. Any recipient could then verify any or all of the signatures.

E XHIBIT 46.2

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C REATING

A

D IGITAL S IGNATURE

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Ch. 46 Digital Signatures

E XHIBIT 46.3

C HECKING

A

D IGITAL S IGNATURE

(b) DIGITAL CERTIFICATES. The previous section described how encryption keys are used to create and to check signatures. This process is fairly straightforward to implement. However, for a signature to have meaning in the business world, it must be readily apparent (and not open to challenge) whose signature it is. Anyone can generate and distribute cryptographic keys. The challenge is to associate those keys with speciﬁc people so that recipients can rely on a signature as deﬁnitely belonging to that person. Just as in the paper world, a signature standing alone cannot be trusted very much—a digital signature could just as easily be forged. To obtain high assurance of the validity of a signature, the paper world uses mechanisms such as signature cards (a sample signature to which later signatures can be compared to verify they were made by the same person) and notaries (a trusted third party who checks the signer’s identity and witnesses their signature). Likewise, digital signatures require similar mechanisms. Recipients need a way to know the identity of the person applying the signature, and they need some assurance that the sender really is who he claims to be. Much of the challenge of using digital signatures in the real world involves the management of the keys so that the meaning of a signature—the identity of the person creating the signature—can be relied upon. Cryptographically, it is nearly impossible to “forge” the actual digital signature by creating a document that appears to have been signed by a particular key unless one actually possesses that key. The problem, then, becomes one of controlling the relationship—the “binding” in computer-ese—between humans1 and their keys. This is accomplished by a mechanism called “digital certiﬁcates.” A certiﬁcate is analogous to a passport: It is relatively difﬁcult to forge, it is issued by a trusted third party, and it unambiguously represents the identity of its holder. When someone presents a passport to you, and they look like the picture on the passport, you can be pretty sure their name and nationality are the ones shown on the passport. The passport binds a physical appearance to a name—if you possess the physical appearance matching the likeness in the photo in the passport, then you are the person named on the passport. A digital certiﬁcate, similarly, binds a public–private key pair to a name—if you possess the private key matching the public key in the certiﬁcate, then you are the person named in the certiﬁcate. If someone presents you with a certiﬁcate and can sign (encrypt) documents that can be decrypted with the public key contained in the certiﬁcate, you can be pretty sure he is the person named on the certiﬁcate. 1. In this discussion, we focus on signatures affixed by individual humans to documents they create, as analogous to traditional paper documents. However, digital signatures are also useful for instances when machines and software need to identify themselves to humans or to other machines. For instance, when you present your credit card payment to an Internet-based merchant, you want to be sure the machine to which you are giving your card number is, in fact, owned by the actual merchant and not an imposter.

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Exhibit 46.4 shows the contents of a typical certiﬁcate. The purpose of the certiﬁcate is to provide a binding between an identity (as indicated by the name on the certiﬁcate) and a key pair (the public half of which is included in the certiﬁcate). The certiﬁcate also contains an expiration date and, optionally, some information about how the certiﬁcate was issued. This is usually a reference to a set of policies used by the issuer of the certiﬁcate. By reviewing these policies, a recipient can determine the rigor of the identity veriﬁcation practices used by the issuer and decide if they are sufﬁcient to trust the certiﬁcate. Finally, the certiﬁcate contains the digital signature of the issuer. The issuer of the certiﬁcate is known as a certiﬁcation authority (CA) because they certify that the person named in the certiﬁcate does indeed own and control the private key that matches the public key contained in the certiﬁcate. The CA is a trusted third party separate from the sender and receiver who are communicating. If you believe the CA has done a good job of identity veriﬁcation when issuing the certiﬁcate, then you can also believe that signed documents you receive whose signatures match (i.e., can be decrypted by) the public key in the certiﬁcate were, in fact, signed by the person named in the certiﬁcate.

E XHIBIT 46.4

C ONTENTS

OF A

D IGITAL C ERTIFICATE

(c) RISKS OF FORGERY, IMPERSONATION, AND FALSIFICATION. Certainly, there is the possibility of false credentials in the digital signature world just as there is in the paper world. The quality of the binding created by a digital certiﬁcate or a passport is only as good as the identity veriﬁcation procedures used by the trusted third party that issues the certiﬁcate or passport. Just as you would have better luck getting through customs with a passport issued by the State Department than with an employer-issued ID card, some digital certiﬁcates are better than others. Some issuers only verify your e-mail address (which can be falsiﬁed fairly easily). Others perform an in-person identity check (perhaps using your passport or another form of ID to verify identity) before issuing a certiﬁcate. Another issue that must be considered to determine the reliability of credentials is the control of the private key. If someone wants to impersonate you using your passport, they must steal your passport and mimic your appearance. To use someone else’s digital credentials, you need merely gain control of his private key. Here, the passport analogy starts to break down. People only have one passport. They do not give it (or a copy of it) to anyone. They only show it to other people long enough to establish their identity and otherwise it is in their personal possession. A digital certiﬁcate, on the other hand, is copied every time you present it to another person to establish your identity. You give them, and they retain, a complete copy of the certiﬁcate that is indistinguishable from the original. While you cannot control whether someone mimics your physical appearance, you can control whether someone gains control of your digital signature key. Typically, the private key is stored in an encrypted form, protected by a password known only to the owner of the key. It can also be stored on a tamper-resistant smart card or other device which makes it difﬁcult for someone to steal it. As we mentioned before, digital signatures and digital certiﬁcates are extremely difﬁcult to forge in the traditional sense. The larger risks are impersonation (stealing someone’s private signature key) and falsiﬁcation (tricking a certiﬁcate-issuing authority to grant you a certiﬁcate with a false name on it).

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Ch. 46 Digital Signatures

46.3 DEMAND FOR DIGITAL SIGNATURE TECHNOLOGY (a) MARKET FORCES DRIVING ELECTRONIC COMMERCE. A large number of business transactions can be accomplished in less time and at lower cost using electronic means. This includes placing orders, issuing bills, accepting payments, and, in some cases, delivery of products and services over electronic information networks. Most companies do their internal processing of transactions electronically and incur a large cost to convert to and from paper form at the interfaces with external companies and customers. Early work in electronic commerce was labeled electronic data interchange (EDI). EDI efforts focused largely on the sharing of technical data—engineering drawings, for example. For this type of data, generally large and complex, there were signiﬁcant savings to be achieved by eliminating the electronic-paper-electronic conversion cycles that were common as information was passed from vendor/supplier to integrator/manufacturer to customer. Unfortunately, EDI standards were slow in coming and were far from ubiquitous. The technology did not lend itself to transactions between unacquainted parties and was therefore only useful for established, long-term business relationships. The rise of the Internet to the status of ubiquitous communications medium in the mid-1990s meant that virtually everyone—vendors, suppliers, manufacturers, distributors, retail outlets, and, increasingly, consumers—could communicate readily and cheaply. One key characteristic of the Internet that has fueled the growth of electronic commerce is that messages can be sent instantly to anyone connected, with no need to preestablish a communications circuit. Granted, extremely large volume transactions (such as are typical of EDI applications) are still better served by dedicated high-bandwidth communications circuits. The Internet, though, is perfectly suited to relatively small, occasional transactions such as ordering, billing, payments, order status checking, delivery scheduling, and a host of other similar business functions. Perfectly suited, that is, with one exception: security. (b) DIGITAL SIGNATURES ENABLE ELECTRONIC COMMERCE. The Internet was not designed with business transactions in mind. It was designed as a scientiﬁc research and development network favoring the easy exchange of information; little emphasis was placed on security issues such as privacy or integrity. With the development of digital signature and other security technology for the Internet, businesses have begun to see it as a viable place to conduct business. Digital signatures provide three very important pieces of information about a document to the recipients: • Authentication of identity: Recipients can be sure the document was signed by the person who claims to have sent it since the signing key is bound by the certiﬁcate to a particular individual. • Integrity of contents: Recipients can be sure the document has not been altered since it was signed since any change would cause the message digest comparison to fail. • Nonrepudiation: The signer cannot deny having signed the document since the signature is unique to that person. The combination of these three services provides a very powerful and versatile set of protections that are being used for a wide variety of applications. As mentioned earlier, digital signatures do not require a preexisting formal relationship between sender and receiver. This makes them ideal for occasional or ad hoc transactions, such as between customers and retailers. However, they are also useful for business-to-business transactions as well. The following paragraphs explore some of the popular applications for digital signatures. It is important to remember that this technology has recently emerged and will likely be integrated into more and more business applications over the next few years. (c) OCCASIONAL OR ONE-TIME CUSTOMER APPLICATIONS. In a scenario where a business wishes to use digital signatures for verifying the source of orders, customers may obtain certiﬁcates from public certiﬁcate issuers and present them to the company at the time the order is

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placed. Similar to the customer signature on a credit card slip, this digital signature is used primarily to ascertain the customer’s identity in case of a later dispute about the purchase. A company may choose to accept certiﬁcates issued by a number of different issuers, as long as they use identity veriﬁcation policies that are substantial enough to beneﬁt the company in case of a dispute over the signature. In this case, there is no need for a prior relationship between the company and the customer. A good example of this type of application would be an Internet mail-order operation where a customer submitted its order, a credit card number, and a digital certiﬁcate. Several banks, credit card companies, and software vendors have endorsed a new standard called secure electronic transaction (SET) protocol that is targeted on this type of transaction. (d) RECURRING CUSTOMER APPLICATIONS. Businesses that have established relationships with their customers are using digital certiﬁcates to protect transactions such as billing, payments, orders, and even delivery of goods and services. In cases where the relationship between the customer and vendor is well established, the company may issue its own “private label” certificates. These certiﬁcates are generally used by the customers only for their transactions with the company. A good example of this type of application is bill payment by a utility company. If customers pay their bills by sending a digitally signed payment order to the company authorizing the company to debit their bank account, the digital signature assures the company that the customer is actually authorizing the payment. The customer cannot later deny having made the payment order or dispute its contents, since its signature is attached to the order. (e) INTERNAL EMPLOYEE APPLICATIONS. Digital signatures are very useful for internal workﬂow applications, where forms that require approving signatures can be handled electronically. By creating a digital signature of a form and storing the signature with the completed form, personal accountability for actions can be stored in an easily audited form. Similar to employee identiﬁcation badges that are used for facility security purposes, digital IDs can be issued by a company to its employees. (f) BUSINESS PARTNER APPLICATIONS. Transactions between business partners can be protected by digital signatures to ensure that the source of information is known. The signing of technical speciﬁcations or other business documents protects against tampering and provides a lasting record of the document’s origin. This can be very useful in partnerships that exchange vital information over public communications media (such as the Internet) so that the source and integrity of a document can be well known.

46.4 LEGAL ISSUES Paper signatures have been used to verify the authenticity of documents throughout the ages. Our legal system recognizes them as legally binding and has a well-established basis of law for handling disputes and for determining which types of signatures are acceptable for different applications. Digital signatures are just beginning to achieve the status of “legally binding.” Utah has pioneered the area of digital signature law, and now most states have passed or are considering legislation that recognizes digital signatures. The references section provides a pointer to an Internet Web site that contains up-to-date information on this dynamic topic. A number of legal issues surrounding digital signatures have not been worked out as of yet. Many of the digital signature concepts do not have a direct corollary in paper signatures, most signiﬁcantly the role of the certiﬁcation authority. These new concepts are being addressed by state and federal legislators, but for now many uses of digital signatures are breaking new ground. In advance of clear legal precedents, companies deploying digital certiﬁcates should consider these issues:

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• Control of private keys. The private keys used to create the signatures must be kept under the sole control of the person whose signature they represent. The responsibility for protection of the private keys, actions necessary in case they are lost or stolen, and liability in case of compromise should be well-established by policy. • Policies for issuing certiﬁcates. The certiﬁcate authority should be following a clear policy for identity veriﬁcation. The policy (or contract in cases where this function is outsourced to a trusted third party) followed by the CA should cover issues such as responsibility for handling errors and liability for improperly issued certiﬁcates. • Acceptance of certiﬁcates from unafﬁliated third parties. In cases where a company accepts certiﬁcates issued independently (as by public certiﬁcation authorities), the company should consider issues of liability if it relies on certiﬁcates that turn out to have been issued in error.

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CHAPTER*

47

CHANGE MANAGEMENT 47.1

INTRODUCTION 869

47.2

DEFINING THE CHANGE MANAGEMENT CHALLENGE 870 (a) Implementation History 870

(b) (c) (d) (e)

Competing Projects 871 Degree of Disruption 873 Cost of Failure 873 Change Management Risks 874

47.1 INTRODUCTION Most companies are undergoing signiﬁcant change. Much of this change is dictated by business environments because companies must respond to competitors’ improvements. The need to change has not escaped the Controller Division. It is now very common for the Controller Division to have several signiﬁcant initiatives underway simultaneously, such as the implementation of a new ﬁnancial system, a new chart of accounts, a new purchasing process, and the like. Information technology (IT) is an area in which organizations are making changes to enhance their competitive position in today’s volatile business environment. Frequently, companies are disappointed with the results of their projects. In fact, research has shown that the majority of projects fail to achieve their objectives on time and within budget. Some projects fail because they are abandoned before they can be installed. However, even if the project is completed, unless the original schedule and budget are achieved, the beneﬁts expected from the project have eroded—perhaps seriously. Why do major projects fail to achieve their full potential so frequently? Most of the time, the identiﬁed solution is adequate for addressing the problem or opportunity that exists. Consequently, a search for a “better solution” is not likely to improve implementation. Instead, most failures are directly attributable to the implementation of the solution. Most major projects involve changes to technology and business processes. These changes will affect the way people do their work—what they will do and how they will do it. Implementing a new ﬁnancial system, for example, may require people to use new equipment, understand and navigate new software packages, handle transactions in a different way, and use new types of information or report formats. In implementing a project such as this, careful consideration is typically given to the hardware platform, data and reporting requirements, interfaces, and the like. Although a high degree of care is devoted to this type of technical requirements, typically less than 5 percent of effort on projects is devoted to managing the effects the technical changes will have on the people. Transition is uncomfortable; for organizations, it is also costly. One recent study shows that, during transition, productive time is consumed by a large increase in both social/gossip time and

* This chapter was authored by Sara Moulton-Reger, e-Business Strategy Consultant, IBM Global Services, Denver, Colorado.

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retraining requirements. This study showed that productive time can be as little as 25 percent of its regular levels during transition. The data clearly shows how important it is to manage transition issues so that regular productivity can be achieved as quickly as possible. The practice of managing the human elements associated with projects is known as change management. Most companies struggle with change management; consequently, most projects fail to achieve their objectives on schedule and within the originally established budget. Although there may be some comfort in being part of the majority, a competitive opportunity exists for the companies that can increase their effectiveness in this difﬁcult area.

47.2 DEFINING THE CHANGE MANAGEMENT CHALLENGE Ernst & Young, LLP, has identiﬁed several change management principles that have been shown to lead to successful project implementations. These principles have been developed through their experience managing numerous major implementation projects and through the contributions of companies such as ODR, Inc. These guiding principles can be used to increase the likelihood of success on any project implementation. The most important initial step in successfully managing a project is to deﬁne the change management challenge. In other words, how much time and attention needs to be devoted to managing the difﬁcult transition period so that people can reach full productivity under their new job requirements? Understanding the change management challenge is important to the development of a realistic schedule and budget for any project. There are several factors that can help a management team to deﬁne the change management challenge. When a project sponsor, perhaps with the assistance of the next tier of management, carefully and candidly considers these areas, a picture of the likelihood of project success will begin to emerge. The most important thing is to consider these factors very early in the life of the project when there is time to devote attention to the human aspects of the project’s implementation. A complete list of change management factors is beyond the scope of this text. However, several important factors that can help an organization to deﬁne the change management challenge are: • Implementation history • Competing projects • Degree of disruption • Cost of failure • Change management risks (a) IMPLEMENTATION HISTORY. Organizations, like people, tend to follow the patterns they have established in the past. Consequently, a careful review of a company’s implementation history is valuable for understanding the challenges faced by the current project. The most applicable patterns emerge when the current project is compared to recent projects that involved the same types of changes and/or the same groups of people. In considering the organization’s implementation history, it is important to identify facets that were effective as well as facets that were ineffective toward achieving project success. After this, the reasons behind effective and ineffective results should be explored. Both pieces of information are valuable. Overcoming past weaknesses is frequently an important key to achieving success on the current project. In addition, each organization has its own reasons for success, and these strengths should be used to fullest advantage. In considering implementation history, start by identifying the past projects that can provide valuable “lessons learned” for the current project. Then categorize these projects by the level of success achieved. The categories may include projects in which: • Objectives were achieved on schedule and within budget. • Objectives were achieved, but somewhat off schedule and/or over budget. • Objectives were achieved, but signiﬁcantly off schedule and/or over budget.

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• Objectives were not achieved, although the project was implemented. • Project was scrapped before installation. After categorizing the projects, look for patterns to emerge in the way the project’s implementation effort was managed. Ask tough questions, such as: • How realistic were the implementation budgets and schedules? • What support, in addition to training, was given to the people who had to do their work differently as a result of the project? • How much notice was given before the change took place? • Were people given adequate time to learn their new activities while balancing regular work responsibilities? • How much communication was done, and what types of communication methods appear to have been the most effective? • In what ways were middle and lower level employees involved in the decision-making process? • How were people held accountable for performing the new job requirements? • How were people rewarded for adequately performing the new job requirements? • How effectively were the projects managed? • How were unexpected events handled during implementation? • How well did the organization focus on the project when day-to-day problems competed for people’s attention? • What are people’s perceptions about the overall effectiveness of the organization’s implementation history, and how could this perception positively or negatively affect the current project? Although the exercise of considering past successes and failures can be difﬁcult and humbling, it can give the management team insight into the speciﬁc actions that should be managed for the current project to be successful. If the organization has a troubled implementation history, it is important to recognize that this can be extremely difﬁcult to overcome. However, overcoming a troubled history is possible when the organization devotes itself to the extraordinary effort and attention that will be necessary to overcome the deﬁciencies of the past. In critically assessing their implementation histories, some companies discover that their employees have very long memories. Even problems that occurred many years ago can taint people’s opinion as to their organization’s ability to be effective. As it assessed its implementation history, one private utility company had to deal with employees surfacing problems from nearly a decade earlier. To put a positive light to these long memories, the president reached back to a time when the organization was held in high respect by its employees. Members of the project team received pins that portrayed the company’s logo from that positive time in its history. These pins brought prestige to the project and the members of the team. However, much more important than this symbol, the “hands-off ” president stayed actively involved in project activities. This demonstration of sponsorship and support was viewed very positively as a step toward overcoming some of its more recent troubled implementations. (b) COMPETING PROJECTS. Many companies are pursuing a large number of initiatives at the same time. Aside from the resource drain and coordination problems that often exist, this agenda of initiatives frequently impacts the same groups of people with little, if any, relief between project implementations. Too much change too quickly can leave people feeling “shell shocked,” which reduces productivity even beyond that normally expected during transition. People who feel overwhelmed are less productive, more prone to conﬂict, more likely to miss work, and the like. To make this concern even greater, it is important to remember that changes happening at work are only one type of change going on in a person’s life at any given time. A person

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within the controller’s division that is attempting to learn the new ﬁnancial system may also be dealing with the birth of a child, an illness in the family, or a divorce. To gain an appreciation for the total amount of change the organization is requiring of its people, it is important to take a full inventory of projects. It is not unusual for this exercise to produce an amazingly long list of projects. These projects may be analyzed from several perspectives: • How well does each project support the strategic direction of the company and/or the long-term goals of the division or department? • Are the strategic direction and long-term goals made clearer to the organization as these projects are rolled out? • How well do the projects relate to and support each other? • Do certain projects detract from other projects or from the goals of other departments or groups? • Are there adequate connections between related projects? • Are all impacted groups adequately represented in the project teams or management advisory groups? • Who are the people to be impacted by each project and how signiﬁcant will the impact be? • What is the timing of the impact? Are there overlapping impacts and time frames that should be managed or reconsidered? • Who will perceive that they “win” something as a consequence of the project? Who will perceive that they “lose” something? Armed with this information, the management team needs to make the following determinations: • What are the project priorities? • What projects can be delayed or scrapped? • What are realistic time frames for implementation taking all projects and their overlapping impacts into consideration? These are especially important questions. Often organizations consider each project to be of equal importance. This is neither realistic nor effective. One of the critical elements to focus the attention of the organization and effectively use scarce resources most advantageously is to look at each project and how it supports the over-all strategy and goals of the organization. Also, note that business conditions are constantly changing, so project priorities may require periodic reassessment. • How should projects with overlapping impacts or time frames be managed to help reduce the potential of overwhelming the people? • How should project priorities and other important information such as strategic direction be communicated throughout the organization? It is important to acknowledge that people have only a ﬁnite ability to accept change over a given period of time. When this ability is not adequately considered, the company will pay a price in lost productivity that exceeds what is necessary. One company chose to implement a fully integrated information system at the same time that its industry was deregulating and jobs were changing signiﬁcantly to accommodate the industry changes. The system changes were signiﬁcant, but when it was added to the simultaneous job and departmental changes, the near term effect was nearly disastrous. At one point, nearly half of the organization was involved in the Employee Assistance Program for problems such as severe stress, alcoholism, and the like. To assist with these problems, the company chose to employ change management activities in conjunction with documenting and conﬁrming the processes required by the new system. Although the problems were smoothed out over time, the near-term situation could have been made less painful, and less costly, for the organization and its employees if change management assistance had been employed before, rather than after, the system implementation.

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(c) DEGREE OF DISRUPTION. Most people are startled to discover that people actually do not resist change. Instead, people resist the disruption that change brings. This is an important distinction because people may resist projects that they believe in and want to see implemented because they fear change. Consequently, measuring the degree of disruption is the ﬁrst way to start predicting the degree of resistance expected from the project. Measuring the degree of disruption caused by a project is not especially easy, nor are there exact quantitative means to do it. However, there are several speciﬁc questions that help to deﬁne the degree of disruption: • How signiﬁcantly will the project affect the way that people do their work? • How easy will it be for people to understand the project and accurately predict how it will effect them? • How much of the necessary knowledge and skills do the people presently possess? • How much will daily routines differ after the project is implemented? • How will the project impact the organization’s power and inﬂuence structures? • How much change has been expected of the people in the past, and how willing have they been to embrace it? In deﬁning the degree of disruption, management frequently underestimates the degree of disruption a project will create in the lives of the people who are impacted. For this reason, it is valuable to ask the people that will be impacted for their answers to the same questions. In deﬁning disruption, two related considerations can be helpful. First, the organization’s history with regard to change can help to deﬁne people’s expectations about change. Some organizations have had to accommodate greater amounts of change due to industry factors, company growth, and the like. Companies that expect change on the basis of their history may ﬁnd smaller amounts of change to be less disruptive. One fast-growing high-technology organization described itself as “good at change.” In assessing the challenge posed by a signiﬁcant process reengineering effort, the organization admitted that the amount and types of revisions required by the project differed from its experience. For this reason, change management activities were used to support achievement of the reengineering project. Second, organizations that have work-forces who feel a high degree of time pressure may ﬁnd virtually any change to be disruptive. The reason for this is that the people understand the energy and effort it will take to make the change and may feel that there is simply no way to “ﬁt it in.” Frequently, these organizations need to carefully prioritize competing initiatives and make tradeoffs that allow people more time to cope with change. (d) COST OF FAILURE. When a project fails, there are costs that will be paid by the organization. The most obvious ones include wasted time, money, and effort, and the fact that little or nothing was accomplished in addressing the problems and opportunities that launched the project. However, these costs actually may have less impact on the organization than the costs that may seem less obvious. In addition to the ﬁnancial costs associated with failure, there are costs that are harder to deﬁne in ﬁnancial terms. These costs include the potential for decreased morale, especially for the people who worked on the project and those who were highly committed to the project goals. Also, people may begin to doubt the organization’s leadership. Ultimately, the people may learn to ignore directives, believing that new projects will fail like ones in the past. These nonﬁnancial costs can have devastating effects on the ability to start and sustain projects. The management team needs to carefully consider what would happen if the project were to fail to achieve its objectives on schedule and within budget. During this analysis, it is especially important to assess the nonﬁnancial costs because they can have the longest impact on the organization. Since some projects are much more important to the organization than others, this type of analysis can help determine the projects that warrant the greatest degree of care, especially in the area of managing the “people” risks.

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Once the costs associated with failure are considered, a very important question needs to be asked: Can the organization afford the cost of failure? • If so, there may be more important initiatives that warrant increased emphasis and attention. • If not, it is important to ensure that realistic schedules and budgets are produced and that signiﬁcant effort is devoted to managing the human aspects of the project. In one organization undertaking a signiﬁcant reengineering initiative, the ten members of the executive staff were asked questions in the area of failure costs. Then each executive was asked whether or not the organization could afford to fail at the effort. The results indicated that six of the executives felt that the project was “mission critical” and that they could not afford to fail. The other four, while believing the project was very important, felt that the project was not critical to the organization. The “correct” answer was not as important as getting these key sponsors to agree as to the criticality of the project. In this instance, these differences of opinion had begun impacting the project schedule and quality. The executives who believed that the organization could afford to fail with the project were devoting resources that were inadequate to achieve the schedule and budget that had been approved. Surfacing these types of differences early in the project life cycle allows for reconciliation so that there will be minimal impacts to project objectives, schedules, and budgets. (e) CHANGE MANAGEMENT RISKS. There are a series of elements that can help to deﬁne a project’s risk from a change management perspective. Research has shown that active management of these risks is very beneﬁcial for achieving project objectives on schedule and within budget. Applying the practices known to be associated with successful projects, as well as avoiding the mistakes others have made, can greatly enhance the potential for success on any project. The full list of these risk elements is rather lengthy, but making an effort to manage the following factors can be of great beneﬁt: • Adequacy of sponsorship. • Adequacy of the motivation. • Vision clarity. • Degree of resistance. (i) Adequacy of Sponsorship. Sponsorship is the single most important change management risk factor. Without sponsorship that is adequately demonstrated, the project is virtually certain to fail to achieve its objectives on schedule and within budget. Most people within organizations know the importance of sponsorship, but it is difﬁcult for many people to deﬁne whether or not it will be effective. When considering a project’s sponsor, most people think of a member of top management or, perhaps, the person responsible for the day-to-day management of the project. In fact, to be successful, there needs to be a network of sponsors that moves down the entire management chain starting at the individual or group of people who have the organizational power to start and stop the project. Managers and supervisors of in-scope personnel must also sponsor the project because they have direct access to the people who need to change as a result of the project’s requirements. Managers and supervisors can also send strong messages about the project’s importance by using managerial decisions such as promotion/advancement, compensation, and rewards to motivate people toward achievement of the project objectives. Although it is important to have a network of sponsors, sponsorship emanates from the top. The speciﬁc deﬁnition of “top” depends on the project and the departments that will be impacted by it. In determining who needs to be the ultimate sponsor of the project, it is often valuable to draw a picture of all the groups of people to be impacted, their management chain, and especially inﬂuential people within those groups. The purpose of this picture is to determine how the project will actually unfold in the organization so the formal and informal inﬂuence networks need to be added to the picture. Although it may be valuable to use an organization chart in beginning to draw this

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picture, the end result will not look like the organization chart if the informal network is adequately considered. For instance, there may be inﬂuences that cut beyond departmental boundaries due to historical or personal circumstances, as well as individuals with speciﬁc expertise that will apply to the project. This picture should be drawn starting from the bottom of the organization. As the picture moves up through the organization, it is important to look for the ﬁrst place that the in-scope groups come to a common manager. This may be the ultimate sponsor of the project. However, it is important to consider whether or not this manager has the authority to stop the project unilaterally. If not, considering this question may help to determine the ultimate sponsor(s). Most people in the organization know the people who have the speciﬁc authority to make these types of decisions for any given project and to believe that the project has the needed sponsorship to be successful, they must see that the project is truly the priority of these people. The ultimate sponsor needs to work with his or her direct reports and other inﬂuential people within the organization to help them to understand the reasons for the project and its importance to the organization. Depending on the way the project was identiﬁed and launched, there may be the need to educate the ultimate sponsor in this important area. The ultimate sponsor also needs details about the vision. This is the ﬁrst step in building the network of sponsors necessary to make the project successful. A common misconception about sponsorship is that it can be delegated to others. Unless it is absolutely clear and believed, that the project “belongs to” the person or people who have the authority to start and stop it, it is possible for people to give the project less priority and support than it needs to be successful. For this reason, sponsorship cannot be a “spectator sport”; it must be demonstrated by the right people to be effective. The following are some characteristics of effective sponsors: • Effective sponsors devote adequate time and attention to communications about the project, its importance, the objectives, and status. This time is spent both with groups and one-on-one with key people on speciﬁc issues. The more time that is devoted to the project by the key sponsors, the more credibility the project will enjoy. • Effective sponsors make sacriﬁces to increase the likelihood of success for the project. These sacriﬁces may including postponing or slowing initiatives that compete for the same resources, devoting extra personal effort, or allowing near-term ﬁnancial shortfalls for the sake of achieving the project objectives. • Effective sponsors ensure that adequate resources are dedicated to the project and maintain these resources throughout the project. These resources include the time of speciﬁc key individuals from the organization, even if this choice impacts other priorities. Sponsors who devote resources that are available rather than the best resources are sending a signal to the organization that the project is not especially important. In addition to dedicating speciﬁc key individuals, effective sponsors ensure that the budgets and time frames are adequate for enabling the project to be successful. • Effective sponsors are willing to make difﬁcult stafﬁng and personnel decisions, but only after they have empathetically considered the impact to the individuals and the organization. Frequently, sponsors must spend a great deal of time with speciﬁc individuals to help them to understand the importance of the project and what these individuals need to do—and not do—to make the project successful. Even the most resistant of people can frequently be brought around to support a project after the sponsor has devoted adequate time and attention to gaining their support. However, if the project is jeopardized by the resistance, or inappropriate actions of speciﬁc individuals, stafﬁng and/or job changes may be required. These decisions can be especially tough because changes may be needed among key contributors to the organization’s past successes. In making these decisions, it is valuable to weigh the trade off between making the difﬁcult personnel decision versus accepting the risk that the project may fail to achieve its objectives on schedule and on budget if a personnel change is not made.

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Finally, sponsors need to be aware that people “listen” to several things. First, they listen to what sponsors say and how they said it. Also, they “listen” to what the sponsors did not say. Finally, they “listen” to what the sponsors do, which has the strongest impact because it indicates the sponsor’s true intent. In sponsoring a project, it is most important to carefully consider every action and make sure that people perceive these actions as consistent with achievement of the project objectives, schedule, and budget. (ii) Adequacy of the Motivation. Transition is uncomfortable. In particular, transition attacks a person’s feelings of conﬁdence, competency, comfort, and control by replacing the known and familiar with the unknown and unfamiliar. It takes signiﬁcant emotional and mental energy to learn new things and gain new habits. Consequently, people do not willingly initiate change if it does not appear necessary, or if the beneﬁts do not outweigh the effort that will be required to make the transition. The more signiﬁcant the transition will be, the more motivation a person will need to initiate and move through that transition. Motivation is created by an understanding of problems that need to be addressed or opportunities that can be used advantageously. These problems or opportunities may either exist in the present or be expected in the future. For many people, problems create more motivation for change than opportunities. Also, existing conditions tend to be more motivational than anticipated conditions. However, adequate motivation can be created even for anticipated opportunities. The key to creating motivation is focusing on the reasons for making the change. In other words, what are the beneﬁts to be gained by implementation of the project? Conversely, without implementation of the project, what would be lost? Frequently, communications about projects focus almost exclusively on details about the solution and neglect to build adequate motivation among the people to make the transition to that solution. As unusual as it sounds, to motivate people to change it is necessary to help them to feel dissatisﬁed or uncomfortable with the way things are today. If people are comfortable with the way things are, they have little or no motivation to go through the discomfort of transition. Creating adequate motivation is a matter of helping people to see and feel how unacceptable it would be to maintain the status quo. Building adequate motivation starts by an understanding of what the organization perceives about its current state. If people are dissatisﬁed with the way things are today, the necessary motivation may already exist. If, however, there are some people who are resistant to the project, a good ﬁrst step in dealing with that resistance is to test their level of motivation: • Do people really understand what will happen if the project objectives are not achieved in a timely, cost-effective manner? Do people understand how they might be impacted if the project were to be unsuccessful? Creating this level of understanding requires time, often one-on-one with people. • For example, will current problems reach a level where the systems, processes, and work schedules will break down? Will the company lose market share, industry position, or its customer base? Will competition catch up or pull ahead of the company? Will employment and/ or advancement opportunities be negatively effected? • Do people really believe that the project will happen? What speciﬁcally can be done to overcome any skepticism that may exist? • Are people getting consistent messages from all levels of management and from different departments about the importance of the project? Some activities that organizations have used to raise the degree of motivation toward a project include: • Establishment of a standing agenda item for staff meetings to discuss the project status and development of periodic update packages for managers to present during these staff meetings. • Periodic executive/top management departmental visits for question and answer sessions.

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• Distribution of regular project updates to management and employees through a variety of different media, such as newsletters, memos, phone messages, etc. • Executive/top management one-on-one meetings with speciﬁc important, inﬂuential, and/or resistant individuals. (iii) Vision Clarity. Once people are adequately motivated to achieve a project’s objectives, they need to see that the project’s vision represents an answer to the problems or opportunities that make up their motivation. Feeling motivated to take action without knowing what to do gives people a hopeless or frustrated feeling. In essence, without a clear vision, people are being asked to move toward something that they do not understand nor believe will bring the relief they seek. In this situation, most people will do nothing, but some people will take action to relieve the anxiety they feel. However, without a vision to guide them, it is very unlikely that even the people who do move forward will arrive at the desired end. Most people understand the need to provide a vision to their people. However, where most project visions fall short of their goal is in providing people with a clear picture of what the future will look and feel like. In other words, what will be each person’s daily working conditions once that vision is fulﬁlled? Frequently, visions contain lofty concepts, platitudes, and “politically correct” language. Although few people would disagree with these types of visions, even fewer people know how to create and work toward them. Effective visions are built with an understanding that their purpose is to target people’s actions. This requires visions to be clear and actionable. Creating an effective vision requires time. It also must involve the sponsors of the project to a heavy extent to ensure that the visionaries behind the project are revealing their expectations and ideas about the future. The vision needs to answer several important questions, such as: • What are the objectives this vision seeks to achieve? • What are the detailed changes that will occur, and what is the timing/staging of these changes? • What are the requirements to achieve the vision? • What will be the daily working conditions for speciﬁc job categories after implementation of the vision? For example: What equipment and procedures will people use? What types of decisions will they make? How will they need to interact with others to perform their job requirements? How will their performance be evaluated, compensated and rewarded? How will the departments, groups, and teams be structured? What knowledge and skills will be necessary to perform the work?

Evaluating these questions in detail among the sponsors and project team is an important clariﬁcation step in any project. One project team discovered ﬁrsthand the importance of taking the time to clarify its vision in this manner. After presentation of the vision to the sponsors, the vision had been approved. The team carefully documented its approved vision, primarily to enable easy communication of the vision to groups that had not been involved in the vision’s development. However, when presented in the new written format augmented with more details, the vision was found to differ from the expectations and understanding of the sponsors. This problem was discovered and corrected quickly, and the potential for wasted effort was avoided. After the vision is documented, it needs to be communicated so that people understand it and its impact. One way that organizations have used to communicate their visions is to give their employees “day-in-the-life” information. In other words, describe what life will be like for certain departments or jobs using ﬁctitious newspaper articles written for the future, role plays, prototype tools, and so on. Also, recognize that effectively communicating a vision requires repetition using multiple means because communication mechanisms are not equally effective, nor do they all reach the intended audience with the desired message.

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One ﬁnal note about communicating a vision: As people begin to understand the future, they will also begin to understand the disruption it will cause. Until a vision is fairly well understood, it is common for very little resistance to be felt from the organization. However, once the vision and its corresponding disruption is understood, the organization frequently displays resistance for the ﬁrst time. This can leave the sponsors and project team wondering if there is something wrong because things may have seemed relatively smooth up to that point. This is an important time to carefully distinguish between real objections based on content versus the objections that represent resistance to the disruption and manage each accordingly. (iv) Degree of Resistance. To repeat an important concept: People do not resist change; rather they resist the disruption caused by the change. This concept is important in explaining why people will resist a change that they view positively, and perhaps even initiated themselves. For this reason, resistance must be expected and planned for because it cannot be avoided. It is also important to note that resistance is not necessarily an indication that something is wrong. Instead, it is frequently an indication that the person understands what they are being asked to do, and correspondingly, what it will take for the project to be accomplished. From this perspective, resistance may be a good indication that effective communication has taken place. Resistance has a variety of causes. Some of the most common ones are: • Confusion about the project vision. • Inadequate motivation. • Unclear or inconsistent messages from sponsors and other key individuals about the importance of the project (e.g., changing or conﬂicting priorities). • Poor implementation history. • Lack of adequate time to respond to and absorb the changes. • History of failing to deal adequately with people who ignore project directives. It is important to create an environment that resistance can be expressed openly without fear of retribution. Suppressed resistance will still negatively affect the project’s goals, but will be much more difﬁcult to surface and manage. Resistance is addressed by ﬁrst identifying its source. One source of resistance is lack of knowledge and skills to perform to the new expectations. This contributes to the person’s feelings of inadequacy and incompetence. Addressing this type of resistance is through education and training. A “just-in-time” philosophy to education and training is especially effective because it enables the person to use the knowledge and skills soon after learning them. The second source of resistance comes from a lack of willingness to perform the project’s requirements. Addressing resistance from this source involves several steps: • Does the person really understand the need for the change? (see Adequacy of the Motivation). • Are there any inconsistencies that need to be corrected? (see Adequacy of Sponsorship and Vision Clarity). • Are there adequate rewards for performing to project requirements and consequences for neglecting or performing poorly against those same requirements? The ﬁnal step requires that speciﬁc measures to assess project progress and individual achievement of project expectations be developed. Then, achievement against those measures needs to be assessed periodically. This step also requires a commitment to following up with people on the results of those assessments—either by giving them rewards that are valuable to them or consequences that will be motivational toward improvements in the future. This type of program can be difﬁcult to administer because it involves the distinct possibility of having to confront nonper– formance, which most people ﬁnd unsettling. However, if the project is truly important to the organization, allowing people to resist willingly and successfully invites a project’s failure.

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CHAPTER*

48

PROJECT RISK MANAGEMENT 48.1

INTRODUCTION 879

48.2

PROJECT RISK CATEGORIES 880

48.3

PROJECT RISK MANAGEMENT APPROACH 881

(a) (b) (c) (d) (e) (f)

Identify the Relevant Risks 882 Evaluate the Risks 883 Assign Risk Owners 884 Address Key Risks 884 Revisit the Project Plan 885 Manage and Track the Risks 885

48.1 INTRODUCTION The controller’s division is not immune from the business pressures that are causing organizations to undertake numerous performance improvement projects. These projects may take a variety of forms: reengineering, systems enhancement, and reorganization, to name a few. In addition to these potential changes, the controller’s division frequently lends its expertise to other projects within the company through a variety of roles, such as providing ﬁnancial analysis and participating on project teams. Unfortunately, in many companies, management is frequently disappointed with project results because these results often fall far below original expectations. Although the reasons for these failures vary, there is one common denominator: earlier in the life of the project, these reasons were risks to the project. Over the past few years, many organizations have concentrated on building the specialized skills and deﬁned methods that are necessary to effectively manage projects. In their processes and procedures for project management, it is common for companies to carefully track and manage the issues that have begun to negatively impact the project. However, it is important that these processes and procedures be augmented by an effective process for identifying and addressing project risks before these risks become issues. Most of the issues that arise on projects could have been foreseen and probably were anticipated by one or more people close to the project. Fully leveraging this early foresight offers the project team a variety of options. For example, priorities or schedules may be changed, key decisions may be escalated to higher levels of management, activities may be added or enhanced, and additional (or different) resources may be obtained. For these reasons, it is valuable to include an approach for managing project risks in the overall project management process. Project risk management is a method for addressing project risks in a proactive manner. In addition to reducing the overall risk of projects, project risk management beneﬁts projects in other ways, by, for example:

* This chapter was authored by Sara Moulton-Reger, e-Business Strategy Consultant, IBM Global Services, Denver, Colorado.

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Ch. 48 Project Risk Management

• Ensuring that project plans are realistic, with corresponding improvements in the overall business case and deﬁnition of project net beneﬁts. • Enhancing management’s understanding of the project’s implications during the early stages of the project, which can reduce unwelcome surprises and perhaps even lead to an appropriate “no go” decision before signiﬁcant resources are wasted. • Providing the opportunity to identify and consider a broader range of options than may be possible when the risk has become an issue, which can conserve resources. • Allowing more time to be made available to address the risks in a careful and well-planned manner. This chapter describes a framework that companies can use to identify and manage project risks at the earliest possible stage in the life of a project.

48.2 PROJECT RISK CATEGORIES Before beginning the process of managing project risk, it is important to understand the distinction between issues and risks: • Issue: A current problem that is negatively impacting a project. • Risk: A possible occurrence that would expose a project to potential failure in some or all respects. In some instances, a risk is an issue that will happen in the future. However, not all project risks become issues. In addition to understanding the distinction between issues and risks, categorizing project risks can be valuable in assisting a project team to identify and consider the potential risks the project may face. Four categories of common project risks are project management risks, technical risks, human risks, and business risks. 1. Project management risks. Potential for unmet requirements in areas such as project management capabilities, project planning, and resource requirements. Some examples of project management risks include: Inadequate project management processes, procedures, or skills Incomplete planning assumptions Overly aggressive time, budget, or beneﬁts estimates Inadequate project resource commitments (e.g., departmental representation, participation

of individuals with key knowledge or skills, percentage of time, or dates of availability) Resource coordination difﬁculties (e.g., geographical distances) Failure to coordinate intraproject linkages and relationships 2. Technical risks. Potential for unmet requirements in terms of project designs, delivery schedules, information availability, and the like. Some examples of technical risks include: Inadequate deﬁnition of future state requirements Designs that do not address the full scope of objectives Hardware or software incompatibility Design incompatibility between interdependent project components Missed delivery schedules Scheduling problems between interdependent project components

3. Human risks. Potential for various human dynamics to impede project objectives or to reduce or negate beneﬁts. Some examples of human risks include: Sponsorship that is inadequate to legitimize and sustain the project Inadequate support from middle or lower levels of management

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Differing or inadequate motivation toward the project or speciﬁc components of the project Differing or unclear understanding about the project scope or impacts Inadequate or ineffective communication Incompatibility between the project and facets of the existing organizational culture Lack of alignment between project requirements and facets of the existing management

support structure (e.g., performance measurement, compensation and rewards practices, or organizational structure) Ineffective anticipation and management of resistance Project overload (e.g., too many projects running concurrently or too little time since another difﬁcult project) Residual issues from previous project implementations (e.g., expectations that the current project will fail because previous attempts have also failed or unresolved conﬂict between departments or key individuals) Changes in key sponsors or project personnel during the life of the project

4. Business risks. Potential for occurrences external to the organization, or in other parts of the organization, that could negatively impact the project. Frequently, these risks fall outside the control of the project team. Some examples of business risks are: Strikes Competitor actions Legislative or regulatory changes Signiﬁcant problems or opportunities that redirect executive attention and/or funding

These project risk categories and examples are not intended to be an exhaustive listing but rather an illustration of the various types of risks that projects face. In implementing project risk management, it may be valuable for each company to develop categories, descriptions, and examples that are speciﬁcally applicable to itself and to its project experiences.

48.3 PROJECT RISK MANAGEMENT APPROACH Project risk management is an iterative process and should be directly tied into the process for managing and tracking issues throughout the life of the project. An effective approach for managing project risks involves six steps; as noted in Exhibit 48.1: 1. 2. 3. 4.

Identify the risks that are relevant to the project. Evaluate the risks to determine which risks deserve the most attention. Assign people to “own” the key risks. Address the key risks through containment or contingency plans (prepared before the risk becomes an issue to the project). 5. Revisit the project plan for adjustment or enhancement if the plan has already been prepared. 6. Manage and track the risks throughout the life of the project. Risk management is especially important during the initial stages of a project. However, it is appropriate to consider project risks at other times as well, such as: • After achievement of key project milestones • Before beginning new project phases • When relevant information is received (e.g., knowledge about changes in business conditions, announcement of organizational changes, or announcement of or discussion about changes in a project sponsor or project member) If a project is underway and its risks have not been identiﬁed and evaluated, it is advisable to begin the risk management process without delay.

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E XHIBIT 48.1

P ROJECT R ISK M ANAGEMENT A PPROACH

(a) IDENTIFY THE RELEVANT RISKS. When identifying risks, it is valuable to brainstorm and consider a wide variety of potential negative impacts to the project. The best approach to identifying risks depends on the size and importance of a project. In some cases, facilitated sessions are warranted. In other cases, it may be appropriate to seek input in writing. However, in all circumstances, it is beneﬁcial to seek contribution from a variety of sources. Key contributors to this process may include project sponsors, project team members, and people with related expertise or experiences. In preparing to identify project risks, a few prerequisites are necessary: • The project objectives must be clear. • Proposed targets for schedule, budget, and resource requirements need to be understood. • Other relevant information should be understood, such as: Implementation history for similar projects Planning assumptions Dependencies with related projects and/or other parts of the business Project organization, and roles and responsibilities1

After these prerequisites have been met, the ﬁrst activity in the project risk management process is to develop a list of relevant project risks. Depending on the nature and size of the project, a variety of methods exist for developing this list, such as ad hoc requests or surveys. If the project warrants a facilitated session, it is helpful to collect a draft list of risks prior to holding the session. Once the essence of each risk has been identiﬁed, risk statements should be developed. Examples of risk statements for each category of risk are: • Project management risk. “There is a risk that key individuals will be pulled from the project too soon to complete some of the reporting reﬁnements.” 1. Ensuring clarity around the project objectives and needed resources is an extremely important ingredient to project success. Many organizations initiate projects before the project vision and its business case have been established. Projects that begin in this manner may run the biggest risk of failure.

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• Technical risk. “There is a risk that the pricing module will be delayed and that this delay will impede the ability to begin the new marketing programs as scheduled.” • Human risk. “There is a risk that users will reject report formats and schedules.” • Business risk. “There is a risk that funding may be jeopardized by problems in manufacturing.” During this ﬁrst step, it may be valuable to use the risk categories to prompt the contributors to consider additional areas. Also, it may be helpful to encourage contributors to review the inputs of others. However, it is important to note that the objective of this step is to create a list of relevant risks that should be tracked and managed. When the contributors believe that the list contains these relevant risks, it is time to move on to the next step in the process.2 (b) EVALUATE THE RISKS. The second step involves evaluating the risks in preparation for taking appropriate actions. Depending on the nature of the project and the culture of the organization, this step may involve the entire project team or may be designated to speciﬁc sponsors and project team personnel only. There are several ways to evaluate the list of project risks. Some ways are: • By the probability of occurrence • By the potential for negative impact to the project, in terms of: Unmet project objectives Missed schedules Budget overruns • By the degree to which the project team is able to control the risk or take action to reduce the probability and/or impact of that risk The ﬁrst step in evaluating project risks involves determining which risks warrant the most attention. This step involves analyzing each risk on two dimensions. The ﬁrst dimension is the probability of that risk occurring. The second dimension is the potential for negative impact if the risk were to become an issue. These two dimensions can be plotted onto a matrix to determine the overall severity of each risk, as shown in Exhibit 48.2. The second evaluation step involves identifying the appropriate manner in which to address the risks, which is the subject of Step 4 in the project risk management process. The severity of each

E XHIBIT 48.2

D EGREE

OF

R ISK S EVERITY

2. It is not uncommon to encounter “naysayers” who will voice negative views about a project and its potential for success. Project risk management can be a way to assure these people that their views have been captured and will be tracked throughout the project, which may help to diffuse the potential for conflict.

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Ch. 48 Project Risk Management

risk is an important element in making this evaluation. The second element involves the degree to which action can be taken on that risk. Although the project team may not have direct control over the risk, it is often possible for tasks to be undertaken that will reduce the probability of occurrence and/or decrease the negative impact if the risk becomes an issue. For some risks, however, there are no actions that are appropriate prior to the occurrence of the issue. An example of a nonactionable risk may be the risk of losing resources and momentum due to the possibility of a strike. In this case, the potential for a strike may be out of the control of the project team, and it is likely that no direct actions are appropriate unless the strike does occur. In identifying the appropriate manner in which to address the risks, another matrix may be valuable. This matrix evaluates risk severity against the degree to which action may be taken (see Exhibit 48.3). Containment plans include actions that will be taken and consequently need to be included in the overall project plan. Contingency plans are preparations for actions to be taken in the event that a key nonactionable risk becomes an issue. The tracking list is a mechanism to document the identiﬁed risks for monitoring and future consideration. The actions identiﬁed through the use of this matrix guide the actions to be taken in Step 4 of the project risk management approach. (c) ASSIGN RISK OWNERS. By this step in the risk management process, the key risks for the project are known and understood, so it is an opportunity to assign a person to “own” each key risk. This helps to ensure that the key risks are managed and tracked adequately. For very high and high severity risks, risk owners are necessary. Also, depending on the importance of the project, it may be valuable to assign owners to risks that are moderately severe. Risk owners are accountable for: • Preparing the containment or contingency plans • Monitoring changes in the probability and/or impact of the risk and notifying the project manager and team of any signiﬁcant changes • Taking the lead in initiating and managing the containment or contingency plans, as appropriate The risk owner may look to others for assistance with these activities, especially if it is deemed appropriate for one individual to own several risks. (d) ADDRESS KEY RISKS. At this point in the process, the actions appropriate for each risk begin. The risk management actions matrix from Step 2 showed three types of actions for the project team to undertake:

E XHIBIT 48.3

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R ISK M ANAGEMENT A CTIONS

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885

1. Containment plans. These plans involve speciﬁc actions that will be taken to: Reduce the probability of the risk turning into an issue Reduce the negative impact to the project if the risk becomes an issue

Containment plans might include the following types of actions: Negotiating ﬁrm commitments for individuals with critical knowledge or expertise Involving additional (or different) people in important roles, activities, or pivotal decisions Lengthening schedules for certain activities Obtaining additional budget and/or time to expand the scope to address important link-

ages between project components or among related projects Narrowing the project scope to make the project more manageable Enhancing communication activities Adding education and follow-up support mechanisms to existing plans for training (e.g.,

mentoring, “chalk talks,” or single subject short courses) 2. Contingency plans. These plans involve preparation for actions to be taken in the event that a nonactionable risk becomes an issue. Contingency plans might include the following types of actions: Identifying and preparing backup resources for critical activities or areas Distinguishing between vital project components that need to be continued and compo-

nents that could be delayed with the least overall impact to the project Purchasing insurance

3. Tracking list. This list is a mechanism to ensure that the identiﬁed project risks are retained and tracked as the project moves forward. Although no immediate action may be warranted, periodic review of the risks on the tracking list will assist the project team in “keeping their eyes on the horizon.” The frequency of reviewing the list depends on the project, but it is valuable to specify the dates for these reviews in the project plan to ensure that they are not overlooked. (e) REVISIT THE PROJECT PLAN. Many project plans are prepared before the project risk management process has begun. If this is the case, it is important to revisit the original project plan after the containment and contingency plans have been prepared. A common problem that has been traced to many project failures stems from project plans that were unrealistic given the conditions. The information available at this point in the risk management process allows the original plan to be evaluated carefully for additional actions and trade-offs that will make the plan more achievable. (f) MANAGE AND TRACK THE RISKS. As the project progresses, the risks that have been identiﬁed need to be: • Managed carefully in the case of risks for which containment plans were created • Monitored closely for indications of changes in probability and/or impact in the case of risks for which contingency plans were created • Tracked for changes in probability and/or impact in the case of the remaining risks. If changes in the probability and/or impact of these risks increase the severity of the risk, containment or contingency plans should be created using the same criteria employed earlier in the process. It is best to include steps to review and oversee the project risk management activities in the project plan. The frequency of these steps depends on the nature of the project. Projects that represent major change for the organization (e.g., involve signiﬁcant disruption to present processes or power bases within the organization or require cross-functional cooperation to a greater extent than normal) will beneﬁt from fairly frequent and close review of the identiﬁed risks.

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CHAPTER*

49

EFFECTIVE PROJECT COMMUNICATIONS 49.1

INTRODUCTION 887

49.2

COMMUNICATION PROGRAM OVERVIEW 888

49.3

COMMUNICATION STRATEGY 888 (a) (b) (c) (d)

Communication Principles 889 Audience Deﬁnition 889 Communication Roadmap 890 Communication Media Deﬁnition 891

49.4

COMMUNICATION CAMPAIGN DEFINITION 891 (a) Communication Objectives 892 (b) Audience Requirements 893 (c) Message Deﬁnition 894

49.5

COMMUNICATION PLAN 895 (a) Communication Delivery Planner 896 (b) Work Plan 897 (c) Budget 897

49.1 INTRODUCTION This is an age of unprecedented challenge for most companies. In response to these challenges, most companies are undertaking a variety of improvement projects. The controller’s division is frequently involved in these projects, and often takes the lead with system implementations and other changes that impact both its own division and other organizations within the company. Most companies have experienced the disappointment of a failed project. Although there are many reasons for project failures, a common one is inadequate communications. Although project managers agree that effective communications are necessary, communication efforts often fail to achieve targeted results for a variety of reasons. For example, many communication efforts lack consistent focus and adequate attention, particularly when the project gets into later stages and other priorities seem to be more pressing. Also, the communications may fail to address the need for multiple communication media and message repetition. Most people are surprised to ﬁnd out that it may take nine or more separate communications of a single message to ensure that the target audience has received the message. In addition, many of today’s projects impact groups of people who are geographically dispersed. This raises the challenge of being effective with communications, especially when the project crosses national boundaries. The people who need to do their work differently as a consequence of the project need to prepare for the changes the project will entail. Project communicationsare one important ingredient to this preparation. Also, if the communications are done in an effective manner, other beneﬁts will be achieved:

* This chapter was authored by Sara J. Moulton-Reger, e-Business Strategy Consultant, IBM Global Services, Denver, Colorado. Sara J. Moulton-Reger and Joseph Potter of the IBM Consulting Group developed the referenced methodology.

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Ch. 49 Effective Project Communications

• Sponsorship for the project can be clearly demonstrated through careful consideration of the proper people to deliver key communications. • Reasons for the project and expected beneﬁts can be communicated, which can be important factors in building adequate motivation toward the project. • The project vision can be repeated with increasing levels of detail so that it becomes well understood and actionable. • Speculation and gossip may be reduced when people are conﬁdent that the formal communications will be complete and timely. Also, since many companies have not communicated effectively on previous projects, an effective communication campaign on a new project may signal a positive change to the people within the organization. This change may help to overcome organizational inertia caused by previous implementation problems. Project communications need careful planning, development, and delivery to be an effective response to the organization need for awareness, understanding, and preparation for action. This chapter describes a framework that companies can use to develop an effective communication program for implementation projects.

49.2 COMMUNICATION PROGRAM OVERVIEW Effective communications are built upon a solid foundation that will provide consistency throughout the project. They are also tailored to the communication requirements, which differ depending on the phase of the project. Finally, effective communications are planned and managed in the same manner as other elements of the project. To achieve these objectives, the components of a complete communication program are: • Communication strategy. The communication strategy deﬁnes the overall approach to the Communication Program in terms of lasting principles and approaches to be used throughout the Program. It is likely that few, if any, changes to the Communication Strategy will be needed throughout the performance of the Program. • Communication campaign deﬁnition. The communication campaign deﬁnition clariﬁes the different phases of communications to be rolled out during the communication program. Some of the key components of the communication campaign deﬁnition are deﬁnition of the objectives for each campaign, identiﬁcation of the information requirements for each audience, and development of the key messages to be delivered in the campaigns. This document is relatively stable throughout the communication program, but is subject to clariﬁcation and other modiﬁcations throughout the performance of the program, particularly for later campaigns. • Communication plan. The communication plan is the document that deﬁnes the workplan and other details for accomplishing the identiﬁed communications. This document is subject to modiﬁcations for additional detail and changes necessary to achieve the campaign objectives throughout the program and ensure that the communications are well coordinated with other aspects of the project. The detail and examples contained in this chapter represent the degree of speciﬁcity and effort appropriate to a relatively signiﬁcant project. Although there may be instances when more communication effort would be required than is shown here, it is more likely that some of the components may be scaled back and still meet the project’s communication requirements.

49.3 COMMUNICATION STRATEGY The purpose of a communication strategy is to deﬁne the overall approach that will be used in conducting the communications activities for a particular project. The Communication Strategy is prepared as the ﬁrst stage in the communication process because it is used to guide development of

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49.3 Communication Strategy

889

the communication campaign deﬁnition and the communication plan. It contains a deﬁnition of communication principles, audiences, campaigns, and media. If carefully prepared, these elements should remain relatively stable during the communication process. A communication strategy contains: • Communication principles. The communication principles are a series of decisions used to guide the development and delivery of the communication activities. • Audience deﬁnition. The audience deﬁnition identiﬁes the groups of people who will need various types of information during the communication program. • Communication roadmap. The communication roadmap is a deﬁnition of the campaigns to be employed and their timing during the communication program. • Communication media deﬁnition. Communication media deﬁnition is an identiﬁcation of the communication mechanisms to be used during the communication program and the campaign(s) most appropriate for each mechanism. (a) COMMUNICATION PRINCIPLES. Communication principles are a means to ensure consistency and effectiveness in the communication process. A complete communication process can be lengthy and may involve the efforts of several people. Communication principles can provide the direction needed to effectively manage communications under these circumstances: • Communication delivery will be done by the most credible source(s) for that particular message. This will require the involvement of executives and other members of the management team. • When executives or members of the management team are needed for speciﬁc communication activities, they will receive at least two weeks’ notice and will be supported by the prepared materials and brieﬁngs necessary for a successful communication delivery. • To ensure managers at all levels feel they are well informed about the project and ready to answer employee questions, communications to managers will precede communications to the people who work for them. • Each campaign will be based upon speciﬁc objectives. At the end of each campaign, these objectives will be evaluated. If the objectives have not been adequately achieved, appropriate follow-up measures will be taken. This follow-up may involve additional communications to be added to the next campaign or a delay in the next campaign to allow for additional communications to achieve the unmet objectives. • Each campaign will focus on delivering a relatively small number of key messages multiple times through multiple communication media. The speciﬁc number and type of communications will be mapped to the audience, in consideration of the importance of the message, the size of the audience, and the difﬁculty of ensuring that the audience has been reached. The communication program will focus on delivering critical messages up to nine times to large groups of affected people. No message will be delivered to any audience less than three times. • The campaign messages will be written to honestly portray important information, even if it will be viewed negatively. Also, when the message is particularly important or complex, multiple types of wording will be used to indicate what will and what will not happen to enhance the effectiveness of the message delivery. • As the communication plan progresses, more “personal” types of communication media will be used (e.g., staff meetings and one-on-one communications rather than memos and voicemail messages). (b) AUDIENCE DEFINITION. It is apparent that different groups of people need different types of information for a particular project. During the development of a communication strategy, it is important to identify all of the groups of people that will need communications over the life of the communication program. This information can then be used to develop the audience

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requirements for individual campaigns. In developing the list of appropriate audiences, several considerations are valuable: • Identify groups of people that have similar information requirements and consider whether they can be combined into one audience. Segmenting the audiences into too many groups can complicate the communication process with relatively little enhanced value. • Recognize that the audience groupings are likely to change between campaigns due to changing needs for information. An opportune time to evaluate this type of change is when considering the campaign objectives and the best ways to achieve these objectives. • Remember to consider audiences that are external to the organization that need information about the project. See Exhibit 49.1, Audience Deﬁnition Example. These groups can include suppliers, customers, unions, governmental organizations, and the like.

Groups Directly Impacted

Groups Indirectly Impacted

Finance and Accounting Information Services Sales and Marketing Field Service

Manufacturing Human Resources Legal Corporate Strategy Union

E XHIBIT 49.1

Groups Needing Information Only Corporate Communications Customers Suppliers Engineering

A UDIENCE D EFINITION E XAMPLE

(c) COMMUNICATION ROADMAP. The communication roadmap deﬁnes the speciﬁc campaigns to be conducted during the communication program and the relative timing of each of these campaigns. This roadmap provides a degree of clarity necessary for beginning the communication campaign deﬁnition. One particularly effective way to develop and deploy communications is to map the communication campaigns to the stages in which commitment toward the project will be developed. One model of the stages of commitment is shown below in Exhibit 49.2. This model shows the progressive nature of the commitment process. When viewed from this perspective, it is easier to target the communication process toward the needs of the audiences during that particular stage of the project.

E XHIBIT 49.2

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C OMMITMENT M ODEL

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49.4 Communication Campaign Definition

891

There are other advantages to using this model. First, using this commitment model will make it easier to identify the most appropriate communication media for a particular stage in a project. It is common for certain types of communications to be overused due to the ease of development and/or deployment. For example, it is common for “nonpersonal” types of communication (e.g., memos, voicemail, and newsletters) to be used when more “personal” types of communication (e.g., one-on-one conversations and staff meetings) would be more appropriate for achieving the speciﬁc objectives for that communication. Also, using this commitment model may make it easier to explain the goals of the communication program. This can be valuable when seeking buy-in from the people who need to deliver more “personal” types of communications, such as executives and other high-level managers (see Exhibit 49.3).

Campaign

Dates

Awareness and Understanding

7/1/03 to 10/15/03

Understanding and Positive Perceptions

10/16/03 to 4/31/04

Installation (“Go Live” date is 10/15/04)

5/1/04 to 12/31/04

Follow-up

1/1/05 to 3/31/05

E XHIBIT 49.3

C OMMUNICATION R OADMAP E XAMPLE

(d) COMMUNICATION MEDIA DEFINITION. As with consideration of audiences, a deﬁnition of the types of communication media to be used is important during development of the communication strategy. An effective communication program will use a variety of “personal” and “nonpersonal” communications, as appropriate to each campaign and its speciﬁc objectives. The ﬁrst step in the media deﬁnition process is to identify and evaluate the communication media available at the company. Then the speciﬁc types of communication media to be used may be targeted. As the communication program progresses, this information may be modiﬁed to reﬂect ﬁndings from actual experiences with the media. The communication media deﬁnition is an opportune time to consider communication media that are new for the organization. Posters/banners, fortune cookies, pocket information cards, “our future looks bright” sunglasses, “quiz your manager about the project” games, and other nontraditional mechanisms may be valuable for gaining attention to the communication messages (see Exhibit 49.4).

49.4 COMMUNICATION CAMPAIGN DEFINITION The purpose of the communication campaign deﬁnition is to provide methods, processes, and tools for further development of the planned communications. It builds on the contents of the communication strategy and serves as a bridge to the communication plan. A communication campaign deﬁnition guides the development of a set of messages designed to help the speciﬁed audiences move through one or more of the stages of commitment as identiﬁed in the Communication Strategy. For example, the campaigns chosen for a particular project may be: • Awareness and understanding campaign • Understanding and positive perceptions campaign • Installation campaign • Follow-up campaign

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Ch. 49 Effective Project Communications

Communication Media E-mail Voicemail Newsletter Memo/letter Presentations and staff meetings “Ask Your Question” voicemail box Management scripts Intranet One-on-one conversations “Day in the Life” video Education and training sessions Mentoring and coaching Performance expectation setting Performance reviews Rewards and recognition E XHIBIT 49.4

Awareness and Understanding Campaign √ √ √ √

Understanding and Positive Perceptions Campaign

√

√ √ √

Installation Campaign

√ √

√ √

Follow-Up Campaign

√

√

√

√ √

√ √

√ √ √

√

√

√

√

√ √

√

√

√

√

√ √ √

C OMMUNICATION M EDIA D EFINITION E XAMPLE

A communication campaign deﬁnition contains: • Campaign objectives. The campaign objectives guide development of the communication campaigns and establish criteria for measuring the success of each campaign. • Audience requirements. The audience requirements identify the communication topics applicable to each group identiﬁed in the communication strategy. Also, by identifying common requirements, it may be possible to consolidate identiﬁed groups into a smaller number of audiences for the purpose of minimizing the complexity of the communication campaign. • Message deﬁnition. Message deﬁnition speciﬁes the key messages or primary category of messages to be delivered for each of the campaigns. Also, the message deﬁnition details the audiences that will receive the message, and the communication media, frequency, and timing for the message. Typically, the message deﬁnition is subject to the most revision and clariﬁcation as the communication program progresses. (a) COMMUNICATION OBJECTIVES. Communication objectives specify the overall goals of each communication campaign. At the end of each campaign, these objectives will be used to determine if the Campaign has been successful. If the objectives have not been achieved, a plan to remedy this issue can then be implemented early enough to ensure that the next campaign builds upon a ﬁrm foundation. Two likely remedies for missed objectives are: 1. To include additional communications in the following campaign 2. To delay the following campaign while the missed objectives are addressed

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The following 13 objectives are examples for four communication campaigns: 1. Campaign: Awareness and Understanding One hundred percent of directly impacted personnel will be aware of the activity-based costing project. The majority of directors and managers will be able to explain the ABC project and its objectives in their own words. One hundred percent of executives and directors of indirectly impacted organizations will be aware of the ABC project. 2. Campaign: Understanding and Positive Perceptions The majority (over 60%) of the directly impacted personnel will be able to explain the ABC project and its four objectives. The majority of executives and directors will view the project as necessary to the long-term competitive positioning of the organization. Forty-ﬁve percent of impacted personnel will have voluntarily participated in at least one brown-bag lunch presentation about the ABC project by March 31, 2005. 3. Campaign: Installation One hundred percent of directly impacted personnel know the required training schedule applicable to their position. Eighty percent of all inbound communication are answered within two business hours. One hundred percent of impacted personnel know that a help line exists. 4. Campaign: Follow-Up The majority of directly impacted personnel can describe at least one beneﬁt or success story associated with the ABC project. One hundred percent of directly impacted managers are aware that a performance appraisal guideline document is available for their use in setting next year’s employee performance goals. One hundred percent of all inbound communications are answered (or acknowledged, if the answer must be researched extensively) within two business hours. One hundred percent of directly impacted managers are aware of the additional training possibilities for new employees or people who need to learn additional system functionality. (b) AUDIENCE REQUIREMENTS. The audience requirements portion of the communications campaign is a means to speciﬁcally consider the needs of each audience grouping. Notice that the deﬁnition of audiences and Audience Requirements are speciﬁc to a particular campaign. The audience requirements are helpful in: • Consolidating groups of people into a single audience to simplify the communication process • Ensuring that the messages for that campaign will be adequate to achieve the communication requirements for all audiences • Identifying common communication requirements that may be appropriate for mass communication media, such as newsletters and memos In identifying audiences, the following characteristics apply: • Members of an audience need the same kinds of information. • Members of an audience may be impacted in a similar way during that particular stage of the project. • Members of an audience may have similar responsibilities toward the project at that particular stage.

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Ch. 49 Effective Project Communications

Campaign Awareness and Understanding General Information Requirements

Speciﬁc Information Requirements

Executives

• Overview of project • Project goals and timing

Directors (for directly impacted areas)

• Overview of project • Project goals and timing

Managers and Supervisors (for directly impacted departments)

• Overview of project • Project goals and timing

Employees (for directly impacted departments)

• Overview of project • Project goals and timing

Union for Employees (for directly impacted departments)

• Overview of project • Project goals and timing

• Interrelationship and/or impact on other corporate initiatives and ﬁnancial position • Project priority • Project leadership and stafﬁng • Project status and issue discussion • Their personal and departmental responsibilities • Impacts on their department and timing • Impacts on their personnel and timing • Who to contact for answers • Their personal and departmental responsibilities • Impacts on their position and timing • Impacts on their department and timing • Impacts on their personnel and timing • Who to contact for answers • Impacts to their position and timing • Who to contact for answers • Positions to be impacted

Audience

• Impacts on the positions and timing • Ways they will be informed and involved Directors and Managers (for indirectly impacted areas)

• Overview of project • Project goals and timing

Customers

• Overview of project • Project goals and timing

E XHIBIT 49.5

A UDIENCE R EQUIREMENTS E XAMPLE

To help correlate the message to each audience, Exhibit 49.5 provides general and speciﬁc information needs for some sample audience deﬁnitions. (c) MESSAGE DEFINITION. Each campaign will focus on delivering a relatively small number of key messages. Different messages will be applicable to different audiences at separate times on

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49.5 Communication Plan

895

the basis of their information requirements. Also, the messages will naturally lend themselves best to certain types of communication media. For this reason, it is important to speciﬁcally consider the messages for each campaign along with the applicable audiences, media, frequency, and timing. One way to perform this deﬁnition is shown below. Note that the messages in Exhibit 49.6 are worded in complete sentences. In the development of the actual messages, concise wording is appropriate as long as the essential points are conveyed to the people who must prepare the messages. 1. XYZ Corp. is implementing a new system for customer service within the 123 division. The name of this project is CSI—Customer Service Integration. The goals of this project are to enhance customer satisfaction and to reduce transaction costs through a “one call does it all” strategy. The project timeline is from 7/03 through 12/04, when the package will be fully implemented and all impacted personnel will have fulﬁlled applicable training. 7/03 Executives Directors (impacted)

7/03–8/03

Managers and supervisors (impacted)

8/03–9/03

Employees (impacted)

8/03–9/03

Union (impacted)

8/03–9/03

Directors and managers (nonimpacted)

8/03–10/03

Customers

10/04–12/04

Media: Memo, E-Mail (2), Voicemail (2), Newsletter (2), Intranet, Staff meetings, Management scripts, Customer letter 2. Although productivity enhancements are expected, this project will not result in lay-offs. 7/03 Executives Directors (impacted)

7/03–9/03

Managers and supervisors (impacted)

7/03–9/03

Employees (impacted)

8/03–11/03

Union (impacted)

8/03–11/03

Directors and managers (nonimpacted)

10/03–11/03

Media: Memo, E-Mail (2), Voicemail (2), Newsletter (2), Intranet, Staff meetings, Management scripts 3. To accomplish the CSI project objectives, corporate funding priorities for some projects will be revised. Also, headcount reallocations will be necessary. Details about the headcount reallocations will be announced when the process changes are identiﬁed. 7/03–8/03 Executives Directors (impacted) Media: Memo, E-Mail, Staff meetings E XHIBIT 49.6

7/03–9/03

C USTOMER S ERVICE C AMPAIGN E XAMPLE

49.5 COMMUNICATION PLAN The communication plan is the document used to direct the actual preparation and delivery of communication materials. It deﬁnes the speciﬁc communications to be prepared and delivered, the timing for each communication, and the budget for the overall communication program and/or campaign. There are three elements in the communication plan: 1. Communication delivery planner. The communication delivery planner builds upon the detail developed in the message deﬁnition. For each campaign, the communication delivery

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Ch. 49 Effective Project Communications

planner identiﬁes the communication media, timing, applicable messages for that media, and audiences to be targeted. This information will be used predominantly by the person who prepares the communication materials. 2. Work plan. The work plan will be used to schedule the production and delivery of communications. The work plan is a Gantt chart for the overall communication program. It contains the following information: Detailed communication activities for the current communication campaign Summary information for later communication campaigns Preparation and delivery responsibilities Completion dates Time line showing elapsed time 3. Budget. The budget is used to determine the total cost of developing and delivering all the communications speciﬁed in the communication plan. The budget should meet the content and format speciﬁed by the organization. It may reﬂect only incremental or cash expenses (such as video production costs) or it may also include costs for resource time and the like. (a) COMMUNICATION DELIVERY PLANNER. The communication delivery planner (see Exhibit 49.7) is a means to consolidate messages by media, which is needed to facilitate effective preparation of the messages identiﬁed in the message deﬁnition. The communication delivery planner also allows for a review of the key message delivery to ensure that the targeted number of repetitions is accomplished. Note that although there may be media delivering the same messages multiple times, these are not meant to be mere duplication of the same materials. Instead, each iteration of the same media needs to include additional information relevant to the key message(s) and valuable to meeting the campaign objectives.

Media

Timing

Messages

Audiences Executives and directors (impacted) All audiences except customers All audiences except customers All audiences except customers All audiences except customers All audiences except customers Directors (impacted and nonimpacted), managers, and supervisors Executives Directors (impacted and nonimpacted) Managers and supervisors (impacted) Employees (impacted)

Memo to executives and directors

7/03

#1, #2, #3

Memo to all employees

7/03

#1, #2

E-mail (2)

7/03, 9/03

#1, #2

Voicemail (2)

7/03, 9/03

#1, #2

Newsletter (2)

7/03, 9/03

#1, #2

Intranet

7/03

#1, #2

Management scripts

8/03

#1, #2

Staff meeting—executives Staff meeting—directors

8/03 8/03

#1, #2, #3 #1, #2, #3

Staff meetings—managers and supervisors Staff meetings—employees

8/03

#1, #2

8/03

#1, #2

E XHIBIT 49.7

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C OMMUNICATION D ELIVERY P LANNER E XAMPLE

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49.5 Communication Plan

897

(b) WORK PLAN. The work plan is the document that contains the activities, responsibilities, and timing of the overall communication program. It enables the communication effort to be integrated into the overall project management approach. In evaluating the success of speciﬁc campaigns, the work plan and communication objectives are key inputs. The work plan is a meaningful way to portray the communication effort to others and ensure that the ﬂow of the communication program is consistent with the timing and sequencing of the project it supports. Also, it is a means of identifying the required communication resources and the support that will be needed from others during the communication process. Finally, the work plan is an important input to the budget development. The work plan may be created using a spreadsheet or project planning software to enable revisions as the communication Program progresses (see Exhibit 49.8).

E XHIBIT 49.8

W ORK P LAN E XAMPLE

(c) BUDGET. The ﬁnal piece of the communication plan is a budget for the communication program. The budget should follow the typical format and content requirements speciﬁed by the organization. When developing the budget, the following costs may be applicable: • Material costs, such as paper, video tapes, and so forth • Printing charges for newsletters, posters, and the like • Programming costs for placing communications on the intranet or other electronic media • Video production, duplication, and distribution charges • Postage • Costs associated with any rewards or special recognition procedures • Costs for personnel time for preparation and/or delivery of communications • Fees for external resources involved in preparation and/or delivery of communications

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CHAPTER*

50

HOW TO IMPLEMENT A SUCCESSFUL CRM SOLUTION 50.1

INTRODUCTION 899

50.2

DEFINE A BUSINESS CASE TO DRIVE SHAREHOLDER VALUE 900 (a) How Can a Company Build a Strong Case to Justify the Project’s Shareholder Value? 900 (b) Interrelated Projects Require a Portfolio View 900

50.3

CLEARLY COMMUNICATE THE CHANGE IMPERATIVE 900 (a) Winning Support from Division Heads 900 (b) Communicating a Sense of Urgency to Change 901

50.4

BUILDING A WINNING T EAM 901

50.5

PREPARE FOR THE WORST 902

50.1 INTRODUCTION In the past decade, enterprise-wide application has proliferated into corporate America at a pace that is almost unseen in the software application industry. Customer relationship management (CRM) is among the “inventions” that have profoundly transformed how American corporations do business. Based on the successful marketing efforts of software application vendors, most business executives are convinced that these applications are “silver bullets” with the capabilities to solve all customer relationship problems they may encounter. Consequently, we have witnessed a big rush of investment to implement these applications by companies, big and small, across all industries. Unfortunately, most are still struggling to receive the anticipated return on their investments. While software gathers transaction data, people build customer relations. To ensure that money is spent wisely, executives need to know the strengths and limitations of various programs in relations to their business objectives, and how to strategically complement these applications with the human workforce to deliver the best relationship management outcomes. A veteran management consultant with a wealth of experience in enterprise application, Fong has personally managed numerous successful implementation projects and unfortunately, has also witnessed a wide range of failure stories. This chapter discusses the four key areas a company should look out for when implementing a CRM program to help ensure the return on its investments: 1. 2. 3. 4.

Deﬁne a business case to drive shareholders’ value Clearly communicate the change imperatives Build a winning team Prepare for the worst

*This chapter was authored by Pak Fong, Senior Manger, Deloitte, San Francisco, California.

899

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Ch. 50 How to Implement a Successful CRM Solution

50.2 DEFINE A BUSINESS CASE TO DRIVE SHAREHOLDER VALUE Regardless of the size of the company, rolling out a major CRM project is often a big commitment; given a typical CRM application usually involves a multi-million dollar cash outlay. Executives need to build a strong business case with clearly deﬁned beneﬁts to justify the huge investment. For public companies, it also means the urge to translate the expected beneﬁts into obvious shareholder value. A typical CRM implementation project usually lasts between 9 and 12 months. In most cases, beneﬁts of the implementation, if deﬁned, are not seen until toward the end of the project. Experience indicates a 9- to 12-month time frame is not an issue in times of a good and robust economy. However, during a weak economy, projects without clear shareholder beneﬁts can hurt the company’s competitiveness. As such, a strong business case that ties the business beneﬁts to shareholder value is critical. (a) HOW CAN A COMPANY BUILD A STRONG CASE TO JUSTIFY THE PROJECT’S SHAREHOLDER VALUE? Fundamentally, shareholder value will only be realized by an increase in corporate earnings over the long term. For example, if Company A is considering building a CRM application to enhance its sales force effectiveness, it should consider how sales force effectiveness could be tied to long-term shareholder value. Company A may decide that the project will help tighten the company’s account management capability, cross-sell its services, and improve customer retention, all of which would have a positive impact on the customer’s wallet share. Once the shareholder value drivers are identiﬁed, the company should begin to baseline relevant business metrics that will allow for measuring long-term improvements after implementation. The company also needs to make sure the scope, timing, and budget of the project are well aligned with the beneﬁt assumptions. Traditional IT and ﬁnancial metrics for scope, timeline, and implementation cost will need to be monitored throughout the implementation. (b) INTERRELATED PROJECTS REQUIRE A PORTFOLIO VIEW. What may complicate the achievement of shareholder value is the lack of coordination among smaller implementations going on simultaneously across departments. It is not uncommon for a company to have multiple application projects, initiated by individual departments, taking place at the same time. Though these projects may accomplish minor savings on a department level, a portfolio view is required to identify and realize shareholder beneﬁts. The company will need to clearly deﬁne integration points and value drivers across these projects in the entire portfolio. When viewed together, companies may be compelled to shut down non-value-added projects and/or change directions of individual ones to ensure that consistent and complementary value drivers can be used to enhance the value of the overall investments.

50.3 CLEARLY COMMUNICATE THE CHANGE IMPERATIVE A successful system implementation requires whole-hearted support by employees who are willing to change the way they work because of the new application. Are users convinced of the need for change? Most people tend to resist change, at least initially, partially due to inertia. Ofﬁce politics and myopic views usually also play a part as individual divisions may want to insist on their own way as a symbolic gesture to secure their power. How to clearly communicate the change imperative is thus another crucial step to ensure a successful CRM implementation. (a) WINNING SUPPORT FROM DIVISION HEADS. To implement a company-wide application often results in a standardized system that requires changes by individual departments. Securing buy-in from senior executives representing all major divisions is thus very essential. Clearly, there are individuals who will insist on running the business the way they have been. Individual departments will demand to have the application conﬁgured to their desired speciﬁcations, usually with no concern of cross-business and functional impacts. They may also refuse to fundamentally change their practices for the company’s future beneﬁt. With visible high-level support

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from each individual division, it helps to convey a strong message that complance with the new requirements by all is a “must” rather than an “option.” (b) COMMUNICATING A SENSE OF URGENCY TO CHANGE. Equally important is to convince people the change is for the better. A clearly deﬁned business case itself is not enough since people rarely are motivated by analytical thoughts, but rather by emotional feeling. Promoting feelings that help facilitate desired changes with as much concrete evidence as available will help overcome the hurdle. Research suggests that faith and trust are among the emotions that help facilitate changes in people’s behaviors. Leadership ﬁrst needs to identify problems that the application is designed to correct or improve. The next step is to show the problems to people in ways that are as emotionally engaging and compelling as possible, or simply speaking, to make people see the issues. That may involve a wide range of creative methods, for instance, from distributing customer complaint letters to showing video recordings of angry customers in all-hands meetings. These efforts will help create a sense of urgency among people, and ultimately, make them realize the need to change.

50.4 BUILDING A WINNING T EAM Now, with the business beneﬁts identiﬁed and change imperatives clearly communicated, which set the implementation foundation, the next step is building the right implementation team. The winning team will be composed of the following elements: • Effective project management • In-depth functional and process knowledge • Extensive application and IT knowledge • Continuous change leadership (i) Effective Project Management. The ﬁrst question a company should ask is: How complex is the project? Is the scope wide ranging, cross businesses, cross functional, and cross geography? If this is the case, project leaders need to know how to work across complex organization boundaries. In addition, complex implementations require rigorous system integration. The methodology provides a roadmap for the project. Without it, the project team could easily get lost in non-value added and irrelevant activities. Identifying people with the necessary background and expertise to lead the project is essential to its success. (ii) In-Depth Functional and Process Knowledge. Another important element is in-depth functional and process knowledge. This normally is achieved by bringing in people with a user perspective. The right candidates need to have a good understanding of the business problems that the application is trying to solve. They will have good intuition on why current processes fail to deliver the value the company is trying to achieve. They will also have a good vision of how to translate the shareholder value drivers into application functionality. A winning team needs to be represented by people who possess detailed knowledge and a high-level understanding of the business process. A balance between the two helps keep the project team to stay focused without losing sight of practical issues. (iii) Extensive Application and IT Knowledge. Does the company have enough necessary in-house application knowledge? The desired ratio between internal IT personnel and outside experts is signiﬁcantly inﬂuenced by the project timeline. If required knowledge doesn’t exist, will there be sufﬁcient time for the internal IT resources to accumulate the knowledge? One typical way companies often employ to lower delivery cost is to outsource the development effort to offshore. While this may reduce the overall cost structure, the project team needs to have a rigorous design methodology to ensure the design expectations are clearly communicated to the offshore developers.

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Ch. 50 How to Implement a Successful CRM Solution

(iv) Continuous Change Leadership. Another important component of a winning team is a continuous change leadership with the credibility, skills, connections, and authority required to make change happen. This change team will help translate the business case into conviction for the company. They will be involved in ongoing communication with the rest of the company of the vision, strategies, and short-term gains of the project. Making people feel the progress along the change process will further build up momentum. Another critical aspect of change leadership is to ensure that appropriate training materials are developed. Frequently, training materials are too technical and irrelevant for the users. The solution is to ensure that training and process experts collaborate to create effective training materials.

50.5 PREPARE FOR THE WORST A successful implementation also requires a contingency plan, with a stabilization period built in, which helps prepare the company for the unexpected in case things don’t go as smoothly as planned after the system goes live. The project team, with a sigh of relief, may start to congratulate each other for a job well done. The ﬁrst few days are typically noneventful. Users are still trying to ﬁgure out how to use the system. They will get lost in their supposedly newer and better application, trying to recall the stepby-step instructions for various activities in the training guidebook. Then, trouble may strike. All of a sudden, as users begin to ﬁnd out the intricacies of how the applications really work, they will also discover that everything they used to know won’t work anymore. Even with all the training and change management communications, people will get frustrated. They will start to lose conﬁdence in the value of the application. The project team will be working day and night again to resolve the user issues. Let’s face it. Things don’t always happen perfectly the ﬁrst time around. Throughout the implementation life cycle, trade-offs may be made to keep focused, to make the deadline, or to stay within budget. These seemingly wise trade-offs at the time of development may have unintended consequences in the business operations. These issues may result in backlog of orders, loss of efﬁciency, or reduction of customer satisfaction. Sometimes, things may even get worse before they will get better. Therefore, it is essential to have a stabilization period built in after the system goes live. Best practice suggests that, depending on the complexity of the new system and the success of user training, the stabilization will typically last for two to six months. It will take that long before the users ﬁnally learn to undo their old habits, and conduct business the way the new system is designed. After the new system is ﬁnally stabilized, the company should start measuring the business metrics identiﬁed in the business case. The metrics will help determine potential problem areas, either in the system or in the company. It is a prudent strategy to have a follow-up budget, typically ranging from 5 to 20 percent of the original, to ﬁx the newly discovered issues.

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CHAPTER*

51

ORGANIZATIONS LARGE AND SMALL EMBRACE SHARED SERVICES 51.1

INTRODUCTION 903

51.5

IMPLEMENTATION 906

51.2

EXECUTIVE SUMMARY 904

51.6

OPERATIONS 908

51.3

ABOUT THE SURVEY 904

51.7

CUSTOMER RELATIONS 908

51.4

BUSINESS CASE 905

51.8

NEXT STEPS 911

51.1 INTRODUCTION In the midst of the slowest economic recovery in years, companies are constantly asking: • How do we decrease operating costs and increase the value we provide to our customers and shareholders? • How do we get better control of our autonomous operating units? And operate in a consistent manner, or operate like one company? • How can we improve the reliability of our ﬁnancial results? • How do we improve the operating performance of the divisions that we acquired in previous mergers and at the same time position ourselves for future growth? Companies have pursued numerous strategies to realize operational effectiveness including rationalizing product lines, consolidating operations, and merging with competitors. Many organizations have turned to Shared Services as the strategic path to achieve long-lasting and meaningful results. The use of Shared Services allows organizations to pursue process standardization, higher automation, and increased control for highly transactional, repetitive processes while reducing costs and providing accountable ﬁnancial results. The concept of Shared Services structure also enables organizations to deliver on the promised synergies from past acquisitions and provides signiﬁcant opportunities for growth through quicker integration of future acquisitions. Shared Services allows decentralized organizations to place increased visibility and control over selected processes, and by segregating noncore processes, it enables business units to focus on core business activities.

* To find out more information or to obtain a copy of the survey results, please contact Susan Hogan in Atlanta at (404) 631-2166 or Kevin Church in San Francisco at (415) 783-4518. For more information on Deloitte, visit our website at http:\\www.deloitte.com.

903

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904

Ch. 51 Organizations Large and Small Embrace Shared Services

While Shared Services is often more visible in times of ﬁscal restraint, many organizations have also pursued the concept as a means of growth. Operational effectiveness is essential to support increased product sales, new product launches, and corporate expansion driven by mergers or acquisitions. To clarify and document our observations on how organizations are currently leveraging Shared Services and to identify future trends, Deloitte Consulting surveyed 70 Shared Services leaders from around the globe. The survey follows the journey that most organizations face while implementing Shared Services including the challenges that take place once the Shared Services Center (SSC) is operational. The majority of participants were leaders in the Shared Services arena, coming from established Shared Services operations with 82 percent of respondents having been operational for more than one year and 37 percent operational for more than ﬁve years. Participants represented all major industry groups including: manufacturing, consumer business, healthcare, ﬁnancial services, utilities, public sector and telecommunications. Most of the organizations were signiﬁcant in size with 35 percent having revenues greater than $15 billion and 60 percent having revenues greater than $5 billion.

51.2 EXECUTIVE SUMMARY The survey validated that Shared Services is being embraced by organizations both large and small and that the concept has provided signiﬁcant beneﬁts for those that have undertaken the journey. Highlights from the survey include: • Survey participants represented seven major industry groups across the globe, with 37 percent having their SSC operational for more than ﬁve years. • The organizations actively pursued Shared Services to realize both ﬁnancial and strategic beneﬁts, and 74 percent of respondents indicated that the beneﬁts met or exceeded expectations. • Highly transactional ﬁnancial processes are the one most frequently included in Shared Services; however, 53 percent of the organizations also included supply chain processes. • Thirty-ﬁve percent of the participants indicated that their organization currently outsourced at least one function or process and 14 percent were pursuing additional outsourcing in the future. • Respondents’ implementation timelines varied dramatically based on functional, geographical, and technical scope. • The level of effort needed to address people challenges during implementation was the most often underestimated. • Over 50 percent of the respondents felt that service level agreements (SLAs) are an important tool for connecting with customers; however 74 percent of them were struggling to make SLAs effective. • Increased process standardization, expansion of services, and enhanced automation were the top three next-focus areas.

51.3 ABOUT THE SURVEY The survey was structured to reﬂect the path most organizations follow while undertaking a Shared Services journey including Business Case, Implementation, Operations, Customer Relations, and Next Steps. • The Business Case section reviews the drivers, costs, and beneﬁts that companies identify while assessing the opportunities of migrating to Shared Services. • The Implementation section looks at many of the decisions and challenges that companies face during the implementation. • The Operations section compares how companies set up their Shared Services structure and how they deal with the issues that they face as they try to optimize the center’s performance.

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51.4 Business Case

905

• The Customer Relations section identiﬁes how companies best connect with customers and how they help their associates maintain customer focus. • The Next Steps section collects what organizations are planning to implement to improve, expand, and reduce the costs of their Shared Services Center.

51.4 BUSINESS CASE The business case is imperative to help organizations drive change and provide the measurements that will be used to gauge the SSC success over the life of the implementation. The business case is critical for documenting the baseline, and without that documentation it is impossible to measure progress. With this much emphasis on a single document, it is also very important to update the business case of the project on a regular basis. In many of the organizations surveyed, updating the business case was as important as creating one. Both tangible and intangible business drivers had signiﬁcant inﬂuence on the decision to pursue Shared Services. While most organizations have cost cutting objectives, with headcount reduction often identiﬁed as one of the primary drivers, most respondents stated that their strategy for implementing Shared Services extended beyond headcount reductions to adding “value” to the organization. As one Shared Services leader from a chemical processing company noted, “We decided to pursue Shared Services for more strategic reasons than just reducing processing clerks.” Over 80 percent of survey respondents started their Shared Services journey with a business case and 95 percent felt that their implementation was successful. Survey respondents reported an average headcount reduction of 29 percent and a projected ROI of approximately 20 percent. The top three ways that organizations were expecting Shared Services to add value included standardizing processes, improving processes, and improving service levels (see Exhibit 51.1). Respondents who did not feel that their implementation was successful reported that the number one reason was due to lower-than-expected headcount reduction (see Exhibit 51.2). Organizations that built a business case typically had a more realistic headcount reduction expectation and were more likely to have achieved their targets.

E XHIBIT 51.1

T OP B USINESS D RIVERS

Source: 2003 Global Shared Services Survey—Deloitte Consulting

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906

Ch. 51 Organizations Large and Small Embrace Shared Services

E XHIBIT 51.2

B USINESS C ASE C OMPONENTS M OST I NACCURATELY E STIMATED

Source: 2003 Global Shared Services Survey—Deloitte Consulting

Tracking business case results is a very important part of the change management process. Being able to accurately communicate the savings and other beneﬁts that have been accomplished is a vital exercise to keep the organization committed to the Shared Services journey. Fifty-four percent of respondents reported that they updated their business case at least once and 30 percent update it regularly. Business case shortfalls resulting from overestimated headcount reductions are often a result of organizations not fully understanding the true drivers that inﬂuence the ability to reduce stafﬁng levels. Organizations also struggle to achieve targeted headcount reductions as a result of not having the executive commitment required to work through an organization transformation. It is critical for the executive team to understand the tough stance it needs to take to maximize the Shared Services beneﬁts. As one Shared Services manager described it, “We did not achieve our desired headcount reduction because Senior Management would not draw a hard line when it came time to make the difﬁcult decisions at the division level.” Organizational buy-in is very important but senior management commitment is critical to the success of the implementation. Including business unit and corporate representation on business case development teams builds stronger support and establishes a more accountable environment to ensure that targets are met. It is also very helpful to set business case metrics in anticipation of being operational so that they can be easily integrated into future measurement systems.

51.5 IMPLEMENTATION Determining the scope of the Shared Services Center is often dependent on the sponsor of the project. With the majority of the implementation ﬁnance-driven, highly transactional ﬁnancial processes dominated the SSCs of the respondents surveyed. Many organizations tend to expand their service offerings after they’ve realized their initial ﬁnancial and strategic beneﬁts and add other transactional components of their businesses. Targeted processes include supply chain, customer service and human resource functions (see Exhibit 51.3).

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51.5 Implementation

E XHIBIT 51.3

T OP F UNCTIONS

IN

907

S HARED S ERVICE C ENTERS

Source: 2003 Global Shared Services Survey—Deloitte Consulting

Eighty-nine percent of respondents have implemented Shared Services for ﬁnancial processes. Fifty-three percent have implemented Shared Services for supply chain processes, with 70 percent for human resources. And another 42 percent have completed implementations for IT and 44 percent for administrative functions. Shared Services centers typically expand their scope of offerings once the concept is proven and accepted within the organization. As one executive from a consumer goods company commented, “Our organization expanded our Shared Services offerings to include higher-value activities as a result of our initial success with back-ofﬁce processes.” Once the concept is proven, business units are less afraid to consider other transactional activities as possible Shared Services candidates. Implementation timelines varied dramatically across respondents based on functional, geographical and technical scope. From project approval to initial go-live, 25 percent of respondents indicated the total time to complete their SSC implementation was less than two years, while 43 percent took between two and three years. Thirty-one percent claimed that it took more than three years to implement their SSC. Respondents indicated that people/change leadership components were the most underestimated aspects of their implementation (see Exhibit 51.4). In any organization transformation project, Shared Services included, the people related components require signiﬁcant attention. It is critical to provide timely communication, training and additional support throughout the transition for those going through the change. Shared Services’ impact is far reaching, so communication needs to be consistent, timely and meaningful. Many organizations underestimate the importance of a change management plan to manage the people components of the project. One respondent commented, “When our project budget got cut, we made the mistake of removing resources focused on change activities. Do not make the same mistake. Instead of saving us money, that decision cost us more.” A detailed plan is critical for focusing executive sponsorship and to align the executive team. It is also very helpful to predict communication requirements and timing well in advance of the need for the material.

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908

Ch. 51 Organizations Large and Small Embrace Shared Services

E XHIBIT 51.4

U NDERESTIMATED L EVEL

OF

E FFORT

Source: 2003 Global Shared Services Survey – Deloitte Consulting

51.6 OPERATIONS Typically, the majority of Shared Service Centers serve at least 75 percent of their organization. This ﬁgure partially reﬂects that 18 percent of the respondents had been operational for less than one year but many of the organizations struggle to get all of their remote operations fully implemented. Thirty percent of respondents are so well-tuned that they are able to provide services for other organizations However, 92 percent of respondents have been unable to achieve standardized processes across all locations served. Increasing process standardization is the number one initiative that respondents are undertaking to improve SSC performance. As Shared Services organizations become more mature, so does the pricing of services. In the ﬁrst year of operation, many of the respondents indicated that their SSC started with a ﬁxed fee for each location serviced. Respondents typically charged for their services on a monthly basis and renegotiated on an annual basis. Thirty-ﬁve percent of respondents said that they do not charge’s for their services. Many of the more signiﬁcant challenges that Shared Services leaders face are related to their people (see Exhibit 51.5). Due to the repetitive nature of transaction processing and relatively ﬂat organization structures, maintaining a motivated workforce can be extremely difﬁcult. The character of the Shared Services leader is extremely important as a means of mitigating the people challenges. The leader of the SSC is primarily responsible for maintaining the operational effectiveness of the center, but instilling the customer service mindset and building a talented team can often be the more daunting challenges.

51.7 CUSTOMER RELATIONS Building and maintaining strong relationships with the customers of the Shared Service Center can be a very difﬁcult task. Strong leadership is critical for preventing the “brick wall” from forming between the center and its customers and for establishing an environment of continuous

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51.7 Customer Relations

E XHIBIT 51.5

909

SSC P EOPLE C HALLENGES

Source: 2003 Global Shared Services Survey—Deloitte Consulting

improvement. Having the center positioned as an equal to its customers can be a very effective way to stay connected to the locations being serviced. Many actions can and should be taken to prevent a “brick wall” from forming between the SSC and its customers, such as: • Active issue management • Effective service level agreements • Joint leadership meetings • Continuous process improvement and goals • Retraining and recommunication on problem areas • Performance measurement, tracking, and reporting • Informational newsletters Respondents used a variety of mechanisms to stay connected to their customers (see Exhibit 51.6), and the most effective method was through joint continuous improvement objectives. Service level agreements ranked second as a communication tool, and site visits and joint leadership meetings were also effective. Interactions with the customers of the center are typically the most effective way to stay integrated. Many Shared Services Centers are initially not trusted by their customers until they are able to provide demonstrated beneﬁts. Joint efforts that work on common objectives and provide operational efﬁciencies for both parties go a long way to building customer relationships. Over 50 percent of the respondents felt that service level agreements (SLAs) between the Shared Services Center and customers are an important tool for connecting with customers, and over 75 percent of the respondents had implemented or are implementing SLAs. Many respondents felt that SLAs helped drive standardization, efﬁciency, and improved customer service. However, 74 percent of them were struggling to make SLAs effective (see Exhibit 51.7).

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910

Ch. 51 Organizations Large and Small Embrace Shared Services

E XHIBIT 51.6

C ONNECTING

WITH

C USTOMERS

Source: 2003 Global Shared Services Survey—Deloitte Consulting

SLAs are an effective tool to stay connected with customers but they often become overly complicated and fail. The biggest challenge when developing the SLA is that if roles aren’t clearly deﬁned, trust between the SSC and the locations they service is often not established. As one SSC director described it, “We went a couple of years before we implemented SLAs. In retrospect, I wish that we had implemented them right from the very beginning. Roles and responsibilities were so unclear that we were in constant battles with the plants over who was dropping the ball.” As a result, many organizations focus the content of the SLA on responsibilities and not services; thus the SLAs lose the purpose that they are intended to serve. Being able to keep them simple and build in mechanisms for issue resolution and continuous improvement is how best practice companies leverage this tool. One organization even changed the name to partnership agreement to emphasize that it was more about working together.

E XHIBIT 51.7

E FFECTIVENESS

OF

SLA S

Source: 2003 Global Shared Services Survey—Deloitte Consulting

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51.8 Next Steps

911

51.8 NEXT STEPS In order to improve the efﬁciency of Shared Services Centers, survey respondents have implemented several automation tools that improve both efﬁciency and customer service. Most commonly used tools include electronic funds transfer, call center technology, electronic data interchange, performance reporting, direct deposit, document imaging, data warehousing, procurement cards, and employee self service. Respondents of mature SSCs indicated a higher use of call centers than did newer SSCs. Many organizations are utilizing imaging as a means to get rid of paper handling and to enable automated workﬂow processes. Sixty-two percent of respondents from mature SSCs use imaging. However, only 25 percent of the SSCs under development are implementing imaging. Increased process standardization, expansion of services, and enhanced automation were the top three next-focus areas of the established SSCs (see Exhibit 51.8). This truly indicates that respondents had embraced the concepts of Shared Services and planned to continue to grow their centers.

E XHIBIT 51.8

N EXT S TEPS

FOR THE

SSC

Source: 2003 Global Shared Services Survey—Deloitte Consulting

Respondents indicated a continued progression toward higher levels of automation, with many of the tools respondents planned to implement leveraging web-based technologies. Any time new automation or tools can be implemented in the SSC, service levels typically improve. Reducing the number of times information is touched also allows for further FTE reductions and lowers the cost of providing the service. One hundred percent of respondents indicated that continuous improvement was very important and was a true sign that organizations were continuing to place signiﬁcant emphasis on Shared Services concepts. There was limited interest in outsourcing with the survey respondents and, in fact, several companies had started bringing some activities back in-house under the belief that they could provide the service at lower cost. As a result, the majority of the organizations that participated in the survey have committed to their Shared Services journey and outsourcing would most likely be considered only once the center was fully optimized.

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PART

7

SOME ADMINISTRATIVE AND SPECIAL ASPECTS OF THE CONTROLLER’S DEPARTMENT

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CHAPTER*

52

FINANCIAL PLANNING AND ANALYSIS FOR ACQUISITIONS, MERGERS, AND DIVESTMENTS 52.1

HISTORY OF ACQUISITIONS AND MERGERS 916

52.13 MULTINATIONAL BUSINESS VALUATION 939

52.2

RELATION OF ACQUISITIONS TO CORPORATE OBJECTIVES 916

52.14 LEVERAGED BUYOUTS (LBOS) 941

52.3

REASONS FOR DIVESTMENTS 917

52.4

AN OVERVIEW OF THE ACQUISITION CYCLE 917

52.15 ACCOUNTING FOR A BUSINESS COMBINATION: PURCHASE METHOD 943

52.5

ACQUISITION CRITERIA 919

52.6

SOURCES OF ACQUISITION INFORMATION 920

52.7

ACQUISITION TEAM 921

52.8

EVALUATING THE PROSPECT: IN-DEPTH ANALYSIS 922

52.9

OBJECTIVES OF FINANCIAL ANALYSIS 928

52.10 IMPACT OF DIFFERING ACCOUNTING POLICIES 929 52.11 VALUATION OF AN ACQUISITION 929 (a) Book Value 931 (b) Market Value 931 (c) Capitalized Earnings (P/E Multiples) 931 (d) Appraised Value 931 (e) Discounted Cash Flow (DCF) 932 (f) Present Value of Future Cash Flows 932 (g) Internal Rate of Return 935 (h) More About Discounted Cash Flow 935 52.12 COMPARING THE VALUES 938

52.16 TAX CONSIDERATIONS IN ACQUISITIONS AND MERGERS 947 (a) Asset Acquisition 947 (b) Section 338 Transaction 947 (c) Stock Acquisition 948 (d) Type A Reorganization 948 (e) Type B Reorganization 948 (f) Type C Reorganization 949 (g) Taxes: A Summary 949 52.17 FINANCIAL IMPACT OF AN ACQUISITION 949 (a) Earnings Per Share 949 (b) Impact of Product Line Growth Rates 949 (c) Impact of Differing Packages of Cash/ Securities 950 52.18 FINANCIAL REPORT ON A POTENTIAL ACQUISITION 950 52.19 MISTAKES BY MANAGEMENT 962 (a) Diversiﬁcation away from the Core Business 963 52.20 EFFECTIVE INTEGRATION 964 52.21 DIVESTMENTS 965

* Section 52.15 is reprinted with permission from pp. 470–474 of Steven M. Bragg, Accounting Reference Desktop (Wiley, Hoboken, NJ: 2002).

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916

Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

52.1 HISTORY OF ACQUISITIONS AND MERGERS A review of U.S. business history of the last three quarters of a century will reveal recurring cycles of industrial combinations and acquisitions. The principal manner by which this may be accomplished may change periodically—for example, from a predominance of large, horizontal, multiform consolidations to conglomerate acquisitions of relatively smaller companies. Styles and types of consideration and amounts paid relative to market price of the stock may change (e.g., from negotiated agreements to contested tender offers, from a package of securities to largely cash, from small premiums above stock market price of the acquired to substantial premiums). Given the decline in the value of the dollar, the rapid rate of inﬂation with consequent high facility replacement costs, and the greater potential stability in the United States, there has been more merger activity in the late 1980s than in some of the earlier periods. Greatly increased levels of activity tend to create a seller’s market and consequently to put added value on sound analysis. The number of acquisition candidates that are available at prices to permit the acquiror to earn a fair return on investment is limited; therefore, the buyer presumably will be more discerning than otherwise. In the late 1990s, there was an acceleration of acquisition activity. The characteristics of that current wave, which are discussed later in this chapter, include: • Mergers of groups already large in their own right, which are measured in the billions of dollars • Exceedingly high initial bids as compared to market value of the stock of the target (or its book value) • Securing a much stronger place in the highly competitive national or international market for companies that are already large • Achieving a better degree of vertical integration • A reduction in the number of highly leveraged buyouts wherein the cash ﬂow of the target pays for the acquisition and many divisions of the acquired group are sold to reduce the excessive or heavy debt This chapter reviews the reasons for acquisitions, as well as divestments, and discusses some sound acquisition procedures, including valuation techniques.

52.2 RELATION OF ACQUISITIONS TO CORPORATE OBJECTIVES Corporate objectives may be achieved by several means, and effective planning must consider alternative routes available to any given company. Corporate goals of growth in earnings may be attained by internal means, but such growth may take many years and in fact may involve more cost and risk than acquiring a suitable existing company. Consequently, as discussed in Chapter 12, it is understandable that some ﬁrms will look to acquisitions or mergers to achieve some of the corporate objectives. In any given time, there are several ﬁnancial or operating reasons for which a corporation may wish to acquire another active business. Some of these are: • Diversiﬁcation for growth • Diversiﬁcation by market or customer to offset seasonal factors, to counteract a declining product market, and so forth • Broadening, completing, or complementing product lines • Acquiring needed research and development (R&D) capabilities • Creating or acquiring new product lines • Integrating or otherwise securing an adequate supply of critical materials or parts

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52.4 An Overview of the Acquisition Cycle

917

• Broadening markets, including previously untapped foreign markets • Improving management by ﬁlling voids in talent or aging capabilities • Acquiring modern manufacturing or research facilities • Providing additional working capital or other funds • Achieving the maximum permitted advantage of tax, or other, laws • Investing idle capital • Increasing the market value of the stock • Providing customers with new services • Improving the corporate image and reputation Financially speaking, these may be summarized in large part as meeting a long-range objective of increased earnings and higher market value of the stock, based on improved or superior service and/or products for the customer.

52.3 REASONS FOR DIVESTMENTS Just as there are good reasons why the acquisition route may be used as the strategy of attaining a corporate objective, so also there are valid arguments for selling a business or parts thereof. For example, an entity may acquire a company and dispose of some segments in order to raise cash to reduce heavy indebtedness; or, especially, privately held entities may be sold for a variety of good reasons. Whatever the reason in a speciﬁc case, a number of causes for divesting a business include: • Need to reduce excess indebtedness • Need to diversify an estate • Management or owner dissension • Incomplete product line • Lack of required funds, or means of securing them, for necessary R&D or market penetration • Lack of management succession • Declining or inadequate rate of proﬁt • Inability of the management to cope with new technology, foreign competition, or other major market changes • Pending unfavorable legislation or regulations (air pollution, antitrust developments, etc.) • Failure of management to understand foreign marketing, and presence of a buyer especially knowledgeable in this area • Probability of adverse income tax developments The amount and type of ﬁnancial analysis desirable when disposing of a business is covered in Section 52.22.

52.4 AN OVERVIEW OF THE ACQUISITION CYCLE Having discussed the reasons for acquisitions, it may be helpful to get an overview of the acquisition cycle before considering in detail any of the steps. A successful acquisition cycle is depicted in Exhibit 52.1. Finding a suitable acquisition candidate is not, or should not be, a haphazard event. It should be part of a carefully planned process. And, of course, determining that the acquisition route, rather than self-growth of the business, is the proper method of entering a business area, is a component of the strategic planning process discussed in Chapter 12.

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Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

E XHIBIT 52.1

A CQUISITION C YCLE

Some brief comments on the acquisition steps listed in Exhibit 52.1 follow: 1. Strategically plan the type of acquisition needed. The acquisition cycle in fact commences when the strategic decision is made to pursue the acquisition route. 2. Establish suitable criteria. Initially, it may appear that any number of acquisition candidates may meet the business need. However, certain aspects, such as insufﬁcient present sales volume, may prove to be unsatisfactory. Therefore, to conserve management time and to assist in getting one of the most suitable candidates, it is helpful to establish certain acquisition criteria.

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52.5 Acquisition Criteria

919

3. Make a diligent search for potential candidates. Although members of top management, or the acquisition team, may have some logical candidates in mind, it is probably worth the special effort to develop a creditable and adequate list of potential candidates. 4. Screen the acquisition candidates. When the list of potential candidates is completed, each should be judged against the criteria established for the acquisition. Those appearing less suitable should be put aside. 5. Make a preliminary analysis of the candidates. This review can be performed using public information, such as annual reports, 10-K reports, industry data, and so forth, without the need of contacting the target. Such analysis probably will bring out facts that will eliminate some candidates from further discussion, or will identify the better ones. 6. Perform an in-depth analysis and evaluation of the apparently most suitable candidate or candidates. This will necessitate contact with the potential acquiree and extensive in-depth reviews if the candidate is agreeable. 7. Negotiate suitable purchase agreement. This will involve considering the wishes of the selling candidate and the most mutually acceptable method of structuring the acquisition. 8. Acquire the candidate. The terms of purchase and sale are carried out. 9. Integrate the acquiree. Careful attention must be paid to how the candidate is integrated into the new group. Lack of follow-up and consideration of the viewpoint of the acquiree ofﬁcers and employees often has caused an acquisition to be an economic disappointment. 10. Finally, the acquisition should be periodically evaluated. How the acquiree performs versus expectations should be reviewed. It usually cannot simply be left on its own. Guidance, and sometimes modiﬁcation of operative conditions, etc., may be necessary.

52.5 ACQUISITION CRITERIA Usually, it is prudent to set criteria for acquisitions and generally to adhere to them. Too many exceptions could lead to unsatisfactory combinations. Thus, management time is limited, and acquiring little companies could lead to excessive time demands by the smaller operations, usually to the detriment of more important matters. Hence, a minimum sales volume requirement could well be one of the criteria. Each industry has factors that are critical to success, as does each company. These matters may inﬂuence the criteria. Examples of some commonly used constraints in acquiring businesses include: • Type of Business Relation to a speciﬁc business need Line of business (SIC codes) Ease of entry Competitive posture • Sales Sales volume Share of market Market growth rate Share of foreign business Share of U.S. government sales volume • Financial/Economic Capital intensiveness Capital structure (amount of debt) • Proﬁtability Percent return on sales Percent return on assets

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920

Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments Percent return on equity Minimum absolute amount

• Other Quality of management Speciﬁc management capabilities (e.g., sales manager) Physical location Patent protection Management compatibility

In summary, proper guidelines or criteria can increase the chances of making a successful acquisition.

52.6 SOURCES OF ACQUISITION INFORMATION Whether in the search for potential candidates, or for data in the preliminary analysis, or the in-depth review, there are a reasonable number of public information sources which may be helpful. These may relate to the economy, the industry, or speciﬁc competitors or companies. To be sure, some useful leads or data may be secured from such sources as trade meetings, informal social events, investment bankers, and so on. Written data are available from a variety of sources (and there are helpful retrieval systems on particular subjects): 1. State of the economy (a) Annual Statistical Abstract of the United States provides information on a variety of economic factors, such as employment, prices, business, and income. (b) The monthly Survey of Current Business is a source of statistical summaries about various business or economic matters. (c) Periodic Bureau of the Census reports can be very helpful. Included are: Census of Manufacturers Census of Wholesale Trade Census of Retail Trade Census of Selected Services (d) Business newspapers and magazines, such as The Wall Street Journal, Business Week, Fortune, Forbes, and Barron’s, contain information on company and industry matters. (e) Trade and industry associations usually publish informative industry data. (f) Numerous other publications from the Superintendent of Documents, U.S. Government Printing Ofﬁce, Washington, D.C., are a good source of documents. (g) Summaries and other data from stock brokerage houses, ﬁrms of Certiﬁed Public Accountants, or consultants, or, for a fee, public data from ﬁrms specializing in providing data on selected topics can be helpful. (h) Dun & Bradstreet directories or other publications providing data based on SIC codes may be useful. 2. Industry data (a) The quarterly Standard & Poor’s Industry Surveys provides industry and selected comparative information. (b) Some ﬁnancial services such as Value Line Investment Survey provide industry summaries as well as data on speciﬁc companies. (c) The Directory of Companies Required to File Annual Reports, by the Securities and Exchange Commission (SEC), contains listing of companies required to ﬁle reports, arranged alphabetically and by industry groups.

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(d) The Annual Statement Studies by Robert Morris Associates provides ﬁnancial statistics by companies and by industry. (e) Almanac of Business and Financial Ratios, also published by Robert Morris Associates, contains useful data. 3. Competitors and/or speciﬁc companies (a) Annual Reports, or Form 10K, or 8K, usually can be obtained from the investor relations department or secretary of the company itself—or from ﬁrms who specialize in providing ﬁnancial information. (b) Moody’s Manuals and related updates and Standard and Poor’s Stock Reports provide speciﬁc data on many businesses and industries. (c) The SEC can be a source of information about selected public companies. See the Directory mentioned above. Usually, personnel of libraries, such as public libraries or the Library of Congress or those of various schools of business, will be most helpful in locating data or suggesting sources of information.

52.7 ACQUISITION TEAM A knowledgeable in-depth analysis of a suitable acquisition candidate is a complex task. While the ﬁnancial aspects certainly are important, the analytical process is not a matter of simply projecting earnings, cash ﬂow, and ﬁnancial condition. In fact, the authors would state that an acquisition ordinarily should not be made only for apparently sound ﬁnancial reasons. Rather, the entire business must be carefully examined: the manufacturing operations and facilities; the marketing organization, and marketing policies and procedures; the research capabilities; the general management group; and so on, ad inﬁnitum. Because the in-depth analysis is so critical, and because correct conclusions often rest on the perception and intuition of the acquisition team, its composition and method of operation merit special attention. The acquisition team, sometimes also called the due diligence team, is assigned the responsibility for making the investigations. Its responsibilities may extend from the establishment of criteria, through the selection of potential candidates, the preliminary analysis, the in-depth review, and the negotiations, to the actual acquisition. Some general observations that may be worth thinking about are: • The person who will manage the target company after the acquisition should be considered for the position of team leader (although many times the team leader is a senior member of the acquiring company’s ﬁnancial management). • Team membership may extend from the executives and employees of the acquiror to such outside sources as certiﬁed public accountants (CPAs), lawyers, specialized appraisers, or knowledgeable individuals (including investment bankers). Of course, some of these noncompany specialists may supply their expertise on an as-needed basis only. • In any event, the acquisition team should include members with appropriate expertise. (See the listing later in this section.) • Team members should be aware of the buyer’s reason for the proposed acquisition—the need it is expected to ﬁll. • Each team member should be aware of the key factors in his area of expertise that should be analyzed and understood in the appraisal of the function, or product, or relevant asset or liability. • Team members should be in communication with each other rather frequently, so that (a) any overlapping is eliminated, and (b) ﬁndings in one area that signiﬁcantly impact the work effort or conclusions of another team member are made known to him.

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• Nonﬁnancial team members who gain important knowledge that will impact the ﬁnancial results or conclusion should make such information available to the ﬁnancial executive where it is relevant to his work effort and conclusions. • Each team member should be fully aware of what data or information must be reviewed as to his assigned area of responsibility so that proper conclusions may be drawn as to the activity or condition. The examination should be carefully planned, including the use of checklists, so that all relevant facets are examined and proper conclusion drawn. So people knowledgeable in what areas should be represented on the team? That depends, of course, on the needs of the speciﬁc case: the present knowledge of the acquiror about the candidate, the suspected or known weaknesses of the potential acquiree, the reasons why the sellers are willing to sell, the success factors in the business generally, and so on.

52.8 EVALUATING THE PROSPECT: IN-DEPTH ANALYSIS Evaluating a company is no easy task. The matching of values of two businesses to determine an equitable exchange of equities or other suitable consideration requires special and careful analysis. Although one ﬁrm may have a less favorable earnings history than another, certain franchises, or patents, or production facilities may be of special importance to the acquiring company. One corporation may own a modern plant and be well located with respect to raw materials and markets but may lack sales know-how. In contrast, another business may possess a superb nation-wide sales organization and an excellent product but be burdened with obsolete manufacturing facilities. Still another company may have acquired an excellent research organization, and the question arises about how this is evaluated. Much judgment is required to weigh earnings against assets and organization. When this stage is reached, much analysis must be undertaken. The kinds of information to be gathered will depend on the particular situation. Many labor hours ordinarily will be spent in collecting and organizing all the pertinent facts that are considered necessary to arrive at a fair estimate of the value of the business. The company to be acquired may be seeking the same data with respect to the acquiring company. Although each acquisition team should develop its own approach to an analysis of the business, the following outline indicates the many aspects to a complete study: A. Industry Overview 1. 2. 3. 4. 5.

What is the size of the industry? How is the industry segmented? What is the industry’s projected growth and proﬁtability? What are the factors affecting growth and proﬁtability? What are the trends in the number of competitors and their size, product innovation, distribution, ﬁnances, regulation, and product liability?

B. Corporate Overview 1. 2. 3. 4. 5. 6. 7.

When and where was the company founded, and by whom? What is its history of product development? What is the history of the management team? Has the corporate location changed? Have there been ownership changes? Have there been acquisitions or divestitures? What is its ﬁnancial history?

C. Organization and General Corporate Issues 1. Obtain the articles of incorporation and bylaws. Review for the existence of pre-emptive rights, rights of ﬁrst refusal, registration rights, or any other rights related to the issuance or registration of securities.

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2. Review the bylaws for any unusual provisions affecting shareholder rights or restrictions on ownership, transfer or voting of shares. 3. Review the terms associated with any preferred stock or unexercised warrants. 4. Describe any antitakeover provisions. 5. Obtain certiﬁcates of good standing for the company and all signiﬁcant subsidiaries. 6. Obtain the minutes from all shareholder meetings for the past ﬁve years. Review for proper notice prior to meetings, the existence of a quorum, and proper voting procedures; verify that stock issuances have been authorized; verify that insider transactions have been approved; verify that ofﬁcers have been properly elected; verify that shares are properly approved and reserved for stock option and purchase plans. 7. Obtain the minutes of the Executive Committee and Audit Committee for the past ﬁve years, as well as the minutes of any other special Board committees. Review all documents. 8. If the company is publicly held, obtain all periodic ﬁlings for the past ﬁve years, including the 10-K, 10-Q, 8-K, and Schedule 13D. 9. Review all annual and quarterly reports to shareholders. 10. Obtain a list of all states in which the company is qualiﬁed to do business and a list of those states in which it maintains signiﬁcant operations. Determine if there is any state where the company is not qualiﬁed but should qualiﬁed to do business. 11. Review the articles of incorporation and bylaws of each signiﬁcant subsidiary. Determine if there are restrictions on dividends to the company. For each subsidiary, review the minutes of the Board of Directors for matters requiring disclosure. Also review each subsidiary’s legal right to do business in each state in which it operates. 12. Review the company’s correspondence with the SEC, any national exchange, or state securities commission, other than routine transmittals, for the past ﬁve years. Determine if there are or were any enforcement or disciplinary actions or any ongoing investigations or suggestions of violations by any of these entities. 13. Review all corporate insurance, using a schedule from the company’s insurance agency. If there is material pending litigation, determine the extent of insurance coverage and obtain insurance company conﬁrmation. 14. Review all pending and threatened legal proceedings to which the company or any of its subsidiaries is a party. Describe principal parties, allegations, and relief sought. This includes any governmental or environmental proceedings. Obtain copies of existing consent decrees or signiﬁcant settlement agreements relating to the company or its subsidiaries. 15. Review the auditors’ letter to management concerning internal accounting controls and procedures, as well as any management responses. 16. If there has been a change in accountants during the past ﬁve years, ﬁnd out why. 17. Review any reports of outside consultants or analysts concerning the company. 18. Review any correspondence during the past ﬁve years with the EPA, FTC, OSHA, EEOC, or IRS. Determine if there are any ongoing investigations or suggestions of violations by any of these agencies. 19. Research any press releases or articles about the company within the past year (see Bloomberg.com, NEXIS, Equifax, etc.). 20. Review all contracts that are important to operations. Also review any contracts with shareholders or ofﬁcers. In particular, look for the following provisions: (a) Default or termination provisions (b) Restrictions on company action

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(c) (d) (e) (f) (g)

Consent requirements Termination provisions in employment contracts Ownership of technology Cancellation provisions in major supply and customer contracts Unusual warranties or the absence of protective provisions

21. Review any required regulatory compliance and verify that necessary licenses and permits have been maintained, as well as ongoing ﬁlings and reports. 22. Review all current patent, trademark, service mark, trade name, and copyright agreements, and note renewal dates. 23. Review all related party transactions for the past three years. 24. Review the terms of any outbound or inbound royalty agreements. 25. Was any company software (either used internally or resold) obtained from another company? If so, what are the terms under which the code is licensed? Are there any associated royalty payments? 26. Review all legal invoices for the past two years. 27. Obtain a copy of any factoring agreements. 28. Obtain copies of all outsourcing agreements. D. Capitalization and Signiﬁcant Subsidiaries 1. Review all Board resolutions authorizing the issuance of stock to ensure that all shares are validly issued. 2. Review debt agreements to which the company or any subsidiary is a party, as well as all debt guarantees. Note any restrictions on dividends, on incurring extra debt, and on issuing additional capital stock. Note any unusual consent or default provisions. If subordinated debt securities are being issued, compare new subordination provisions with the provisions for other agreements for compatibility. Review the latest borrowing base certiﬁcates. Inquire whether there are any defaults or potential defaults. 3. Review any disclosure documents used in the private placement of securities or loan applications during the preceding ﬁve years. 4. Review all documents affecting ownership, voting, or rights to acquire the company’s stock for required disclosure and signiﬁcance to the purchase transactions, such as warrants, options, security holder agreements, registration rights agreements, shareholder rights, or poison pill plans. E. Employees 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Obtain copies of any employment agreements. Obtain copies of any noncompete agreements. Obtain copies of any salesperson compensation agreements. Obtain copies of any director compensation agreements. Obtain copies of any option plans. Summarize any loan amounts and terms to ofﬁcers, directors, or employees. Obtain any union labor agreements. Determine the number of states to which payroll taxes must be paid. Obtain a copy of the employee manual. Obtain a list of all employees, their current compensation, and compensation for the prior year. 11. Summarize the names, ages, titles, education, experience, and professional biographies of the senior management team.

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12. Obtain copies of employee resumes. 13. What has been the employee turnover rate for the past two years? 14. Obtain a copy of the organization chart. F. Revenue 1. 2. 3. 4. 5. 6. 7. 8. 9.

Summarize sales by customer for the current and past year. Summarize sales by product for the current and past year. Summarize the backlog by customer. Summarize the backlog by custom work and standard products. Determine how much stafﬁng is required to complete the existing backlog of custom work. Determine the seasonality of revenue. Determine the amount of ongoing maintenance revenue from standard software products. Obtain copies of all outstanding proposals, bids, and offers pending award. Obtain copies of all existing contracts for products or services, including warranty and guarantee work.

G. Assets 1. Obtain copies of all asset leases, and review for term, early payment, and bargain purchase clauses. 2. Obtain copies of all ofﬁce space lease agreements, and review for term and renewal provisions. 3. Review the title insurance for any signiﬁcant land parcels owned by the company. 4. Obtain current detail of accounts receivable. 5. Obtain a list of all accounts and notes receivable from employees. 6. Obtain a list of all inventory items, and discuss the obsolescence reserve. 7. Obtain the current ﬁxed asset listing, as well as depreciation calculations. 8. Review the bad debt reserve calculation. 9. Obtain an itemized list of all assets that are not receivables or ﬁxed assets. 10. Obtain any maintenance agreements on company equipment. 11. Is there an upcoming need to replace assets? 12. Discuss whether there are any plans to close, relocate, or expand any facilities. 13. Itemize all capitalized R&D or software development expenses. H. Liabilities 1. Verify wage and tax remittances to all government entities, and that there are no unpaid amounts. 2. Obtain a list of all accounts payable to employees. 3. Review the sufﬁciency of accruals for wages, vacation time, legal expenses, insurance, property taxes, and commissions. 4. Review the terms of any lines of credit. 5. Review the amount and terms of any other debt agreements. 6. Review the current accounts payable listing. 7. Obtain copies of all unexpired purchasing commitments (purchase orders, etc.). I. Financial Statements 1. Obtain audited ﬁnancial statements for the last three years. 2. Obtain monthly ﬁnancial statements for the current year.

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Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

3. 4. 5. 6. 7. 8.

What are the revenues and proﬁts per employee? What is direct labor expense as a percentage of revenue? Obtain copies of federal tax returns for the last three years. Verify the most recent bank reconciliation. Determine proﬁtability by product, by customer, and by segment. Obtain a copy of the business plan and budget.

J. Internet 1. Does the company use the Internet for internal use as an interactive part of operations? What functions are used in this manner? 2. Has the company’s ﬁrewall ever been penetrated, and how sensitive is the information stored on the company network’s publicly available segments? 3. Does the company provide technical support information through its Web site? 4. Are Web site usage statistics tracked? If so, how are they used for management decisions? 5. In what way could operational costs decrease if the company’s customers interacted with it through the Internet? K. Software Development 6. Who are the key development personnel involved with the creation, coding, and evaluation of software products? What is their tenure and educational background? 7. How much money is invested annually in development? How much is invested as a proportion of sales? 8. What is the strategic plan for the development of new products? What is the timeline for their introduction? To what markets are they targeted? 9. How many patches were required to make the last major software release stable and commercially viable? 10. What was the average time required to resolve customer software problems? 11. How many customer accounts have been lost due to a software upgrade? What reasons did they give for dropping maintenance? 12. What operating system platforms are the target for the company’s software products? Is there a plan to port any company products to other platforms? For what proportion of existing products has this been done? 13. Does the company use structured programming techniques that allow for easy software updating, maintenance, and enhancement? 14. What development languages and tools does the development staff use now? Are there plans to change to other languages and tools? 15. What are the attributes that make the company’s products unique? 16. What is the company’s strategy in designing new products (e.g., quality, support, special features)? L. Marketing 1. 2. 3. 4. 5.

What types of advertising and promotion are used? Does the company have a Web site? Who owns the site and how is it hosted? Does the company use e-mail for marketing notiﬁcations to customers? What are the proportions of sales by distribution channel? How many customers can the company potentially market its products to? What would be the volume by customer? 6. What is the company’s market share? What is the trend? 7. Are there new markets in which the products can be sold?

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M. Sales 1. What is the sales strategy (e.g., add customers, increase support, increase penetration into existing customer base, pricing, etc.)? 2. What is the structure of the sales organization? Are there independent sales representatives? 3. Obtain the sales organization chart. 4. How many sales personnel are in each sales position? 5. What is the sales force’s geographic coverage? 6. What is the sales force’s compensation, split by base pay and commission? 7. What was the sales per salesperson for the past year? 8. What was the sales expense per salesperson for the past year? 9. What is the sales projection by product for the next 12 months? 10. Into what category do customers fall—end users, retailers, OEMs, wholesalers, and/or distributors? 11. Who are the top ten customers, based on sales volume? 12. What is the historical sales volume to all customers for the past three years? 13. How many customers are there for each product, industry, and geographic region? 14. What is the average order size? 15. Does the company have an Internet store? Does the site accept on-line payments and orders? What percentage of total sales come through this medium? 16. How many customers have current subscriptions or maintenance for the company’s software? What is the dollar amount per customer? What is the growth rate in the number of customers? 17. What is the structure of the technical support group? How many people are in it, and what is their compensation? 18. Obtain a list of all customers who have stopped doing business with the company in the last three years. N. Intellectual Property 1. List all patents and pending patent applications. Verify that all maintenance fees have been paid, and prosecution of all pending applications is current. 2. Is there a procedure for disclosing and recording new inventions? 3. List all trademark and service mark registrations and pending applications for registration. Verify that all afﬁdavits of use and renewal applications have been ﬁled, and prosecution of all pending applications is current. 4. List all unregistered trademarks and service marks used by the organization. 5. Collect and catalog copies of all publications and check for unlisted trademarks and service marks, and proper notiﬁcation. 6. List all copyright registrations. 7. List all registered designs. 8. Does the organization have any information that provides a competitive advantage? If so, verify that the information is marked as “Conﬁdential.” 9. Have all employees executed Invention Assignment and Conﬁdentiality agreements? 10. Obtain copies of all licenses of intellectual property in which the organization is the licensor or licensee. 11. List all lawsuits pertaining to intellectual property in which the organization is a party. O. Other 1. Discuss revenue recognition policies. 2. Construct a cash forecast through the end of the year.

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3. Obtain a copy of the chart of accounts. 4. Determine risk management strategies and insurance coverage. 5. Is there a 401(k) plan? any company contribution? Who manages it? Are contribution payments current? 6. Evaluate the company beneﬁt plan to determine its cost, as well as the amount of employee participation. 7. Is there a General Services Administration schedule? When does it come up for renewal? 8. Obtain a list of all signiﬁcant accounting policies. P. The Purchase Transaction 1. If the transaction involves the issuance of stock, are there sufﬁcient authorized shares for the offering, including any conversion rights, taking into account any shares reserved for issuance pursuant to outstanding options, warrants, convertible securities and employee beneﬁt plans? With the continual changes in the competitive marketplace, in tax law, in antitrust emphasis, and so forth, the checklist would need to be updated periodically. Additionally, it should be mentioned that some of the leading public accounting ﬁrms have excellent, and extensive, checklists that might be available.

52.9 OBJECTIVES OF FINANCIAL ANALYSIS In a volume whose principal audience is likely to be ﬁnancially oriented, discussion of the purpose of ﬁnancial analysis would be expected. A soundly conceived acquisition screening procedure will require extensive analysis by various disciplines. To be sure, the ﬁnancial review is but part of the total analysis. But it is an important one in looking to the potential ﬁnancial impact of the acquiree on the acquiror. An indication of the objectives of the ﬁnancial analysis as part of the acquisition study may be gained from this listing: 1. Determination of existing ﬁnancial condition of selling company and impact on the combined ﬁnancial position 2. Determination of present earning power, using the acquiring company accounting practices 3. Identiﬁcation of income-producing segments: Product lines Geographical areas Customers

4. Determination of major ﬁnancial strengths and weaknesses: Product sales trends Margin trends Commitments and contingent liabilities Nature and magnitude of investments

5. Identiﬁcation of potential synergisms of the two companies, when integrated 6. Estimation of earning power and related cash ﬂow from operations 7. Estimating an acceptable price range 8. Consideration of the best ﬁnancial method of acquiring the company—tax impact considered 9. Securing appraisal of the potential acquiree’s ﬁnancial staff 10. Review of “control” aspects of the acquiree versus the acquiror The chief purpose is to focus on all those ﬁnancial matters that should be known by the management of the acquiror. Some of the forementioned items may require elaboration.

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52.10 IMPACT OF DIFFERING ACCOUNTING POLICIES Even given the use of generally accepted accounting principles, there can be signiﬁcant differences in ﬁnancial condition and earnings by reason of differences in accounting policies. It is presumed that an acquired company will report its ﬁnancial results on the basis of the accounting of the acquiring corporation. Hence the ﬁnancial statements of the company under examination should be restated on such a basis. Differences in accounting practices in terms of inventory valuation, depreciation, pension funding, fringe beneﬁt accruals, and so on, may cumulatively have a signiﬁcant impact on reported earnings. A comparative analysis of the income statement is shown in Exhibit 52.2. The comparative data and reﬂections in market value of the stock are summarized here: Using Acquiror Policies

Using Present Accounting of Acquiree

Reported net income

$ 675,000

$ 1,335,000

Number of shares outstanding

$ 550,000

$

550,000

EPS

$

1.23

$

2.43

Earnings decline due to accounting changes

$

1.20

Market value At P/E ratio of 10 At P/E ratio of 12 At P/E ratio of 15

$ $ $

12.30 14.76 18.45

$ $ $

24.30 29.16 36.45

Failure to bring these differences to the attention of management could result in disappointing future earnings. When making estimates of future earnings, and the impact on the acquiror, it may be desirable to present three levels: 1. The candidate, with its present practices, both accounting and operating. 2. The candidate, with the acquiror accounting and operating practices (where applicable). 3. The candidate, with synergisms and acquiror practices.

52.11 VALUATION OF AN ACQUISITION There is, of course, a direct relationship between the results of the ﬁnancial analysis of a potential acquisition and the price to be paid, as well as the method by which the transaction will be accomplished. A sound in-depth ﬁnancial analysis should yield these results, as well as provide data on operating results, margins by product lines, and on speciﬁc assets and liabilities and so forth: • Heighten management’s awareness of the ﬁnancial impact—both operating results and ﬁnancial condition—of the acquisition on the ﬁnancial statements of the acquiror. • Identify the advantages and/or disadvantages of using differing means of affecting the acquisition—more debt or less debt, a taxable versus a tax-free transaction, impact of using various packages of securities and so on. • Clarify the tax impact of the proposed acquisition, and the preferred method, tax wise, of consummating the transaction. • Alert management as to the areas of risk and the amount thereof, as well as the earning potential and cash ﬂow of the candidate. • Identify segments, if any, of the potential acquiree that should be considered for sale.

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C OMPARATIVE S TATEMENT OF I NCOME AND E XPENSE D IFFERING A CCOUNTING P RACTICES ( DOLLARS IN THOUSANDS )

WITH

Y C OMPANY Using Acquiror Company Accounting

Net Sales Comparable costs Cost of goods, sold Selling, general, and administrative expenses Subtotal Accounting differences Inventory— last in, ﬁrst out vs. ﬁrst in, ﬁrst out Depreciation, straight line vs. double declining balance Moving expenses Research expenses Pension costs Deferred compensation

Using Present Accounting

Amount

% Net Sales

Amount

% Net Sales

$10,000

100.0%

$10,000

100.0%

5,000

50.0

5,000

50.0

2,000

20.0

2,000

20.0

7,000

70.0

7,000

70.0

400

4.0

—

400 150 300 200

4.0 1.5 3.0 2.0

100 70 100 50

1.0 .7 1.0 .5

200

2.0

10

.1

1,650

16.5

330

3.3

Total costs Income before taxes Income taxes

8,650

86.5

7,330

73.3

1,350 675

13.5 6.8

2,670 1,335

26.7 13.4

Net income

$ 675

Total

E XHIBIT 52.2

I MPACT

OF

6.7%

$ 1,335

D IFFERING A CCOUNTING P RACTICES

ON

13.3%

N ET I NCOME

• Provide valuable information useful in strategic and short-term planning. • Provide the basis of determining the fair market value of the enterprise. The purchase price of the acquisition, including the stock exchange ratios, or package of securities used, and so forth, will be determined largely by negotiation. However, the ﬁnancial analysis will provide data about the impact on future earnings of changes in accounting policy, future earnings potential, different valuation bases, the market value of assets, the extent of actual and contingent liabilities, and other subjects that could serve as a starting point in setting a price. Several methods are in use for determining the value of an enterprise. Some are simple and easily applied; others are more sophisticated and of greater worth in determining a possible price. A few applicable comments are made on these commonly used methods: • Book value • Market value • Capitalized earnings (P/E multiples) • Appraised value • Discounted cash ﬂow

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931

(a) BOOK VALUE. To some owners, book value per share (common shareholders’ equity divided by the number of shares outstanding) with or without adjustments arising from the ﬁnancial analysis, is indicative of the relative worth of the company. For them, it is a measure of the reasonableness of the stock exchange ratio, or perhaps of the cash value of the acquiree. This measure may be used alone or in combination with other methods. Many of us are aware that book value relates to original costs and past earnings, and is not necessarily an indicator of future earning power or cash ﬂow or market value of ﬁxed assets, and so on. (b) MARKET VALUE. For a publicly traded company stock, the market price, along with the related aggregate value, is a measure of worth. If a stock exchange is to be made, the market price (before the news leaks out about the possible merger or combination) may be an important determinant. In many instances the market price plus a substantial premium of, say, 25%, 50%, or even 100%, may be employed to entice the owner to sell. So market value, with or without adjustment, may be an indication of worth of the stock. (c) CAPITALIZED EARNINGS (P/E MULTIPLES). Another method of determining worth is to capitalize earnings, or its equivalent, the application of a P/E ratio to a stream of earnings, to arrive at a market value. This has validity in that acquiring a business entity is for the purpose of securing a stream of future earnings (or cash ﬂow). This technique has at least two variants: (1) to apply the P/E to a stream of historical earnings, either weighted or unweighted, for, let us say, a ﬁve-year period, or (2) to apply the P/E to projected earnings. More than a single year is used to avoid the risk of an abnormal year, or to give recognition to the trend of earnings. Exhibit 52.3 shows the applications on both a simple and a weighted basis, for a historical ﬁve-year period with a rate of return equal to 8.5% (a P/E of 12) for the limited risk. Recent years are given a greater weighting. The illustration reﬂects the inﬂuence of the earnings trend—with company A producing an increasing return per year, and company B showing a decreasing trend on identical total earnings. These earnings can be adjusted to reﬂect any accounting differences. Application of the method to projected earnings is shown in Exhibit 52.4. In this illustration, the stream of earnings as estimated by the seller is adjusted by the buyer to reﬂect any relevant changes. In this example, the earnings of the candidate seller are adjusted for: • Use of differing accounting principles (depreciation and retirement plan provisions—ﬁve years instead of ten) • Expected cost level reductions to be initiated by the buyer • A difference in judgment of buyer and seller as to the 15% growth rate foreseen by the seller to a 10% rate anticipated by the buyer It should be noted that the compounding effect of a lower growth rate in earnings is substantial. The P/E ratio employed by this capitalized earnings method may be one of several: • A P/E representative of the industry • The current P/E at which the seller stock is being traded—if a public company • A P/E ratio representing the acquiring company’s required rate of return. If, for example, the acquiror desires a 20% net after-tax rate of return, then an equivalent P/E of 5 is applicable • A rate mutually agreed upon between buyer and seller (d) APPRAISED VALUE. The appraised value is determined by an independent appraisal of the property by a knowledgeable person usually hired by the prospective buyer (perhaps with the consent of the seller). This method often is used when the transaction is to be a purchase of assets (not stock). An appraisal of each asset may be useful for tax purposes. This method assigns replacement cost or market value to every piece of property. It can be used in allocating

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932

Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

O N B OTH

A

C APITALIZED E ARNINGS (H ISTORICAL ) S IMPLE (E QUAL W EIGHTING ) AND W EIGHTED B ASIS C OMPANY A ( DOLLARS IN THOUSANDS ) Company A

AND

C OMPANY B

Company B

Year 20X1 20X2 20X3 20X4 20X5

Weighting Factor 1 2 3 4 5

Earnings $ 10,200 11,600 13,300 15,600 17,100

Weighted Earnings $ 10,200 13,200 39,900 52,400 85,500

Earnings $ 17,100 15,600 13,300 11,600 10,000

Weighted Earnings $ 17,100 31,200 39,900 46,400 51,000

Total

15

$ 67,800

$ 201,200

$ 67,800

$ 185,600

Average earnings (ⴜ 5) Weighted average earnings (ⴜ 15) Capitalized earnings (P/E of 12) E XHIBIT 52.3

$ 13,560

C APITALIZED E ARNINGS —S IMPLE

$ 13,560

AND

$ 13,413

$ 12,373

$ 160,960

$ 148,480

W EIGHTED

the purchase price to each such asset and goodwill but may bear little relationship to the productivity of the particular asset. This method is a check against other appraisal bases, and may be useful in assigning value to patents, or completed research, and so on. (e) DISCOUNTED CASH FLOW (DCF). Finally, a method widely used for years in evaluating capital expenditures, that is, expenditures for plant and equipment now is being applied to acquisition or divestment transactions. It involves discounting a future stream of cash to the present time. The principle is employed in two ways: A speciﬁed interest rate (discount factor) is applied to the estimated cash stream to determine its net present value (NPV) or worth. In another application where a purchase price for a business is proposed or used, this outﬂow of cash, together with the future needs or sources of cash of the business, to arrive at the rate of return expected to be earned over the life of the project—the internal rate of return (IRR). An application of each technique is discussed next. (f) PRESENT VALUE OF FUTURE CASH FLOWS. Because the discounted cash ﬂow method is technically correct in that it recognizes the time value of money, a somewhat more lengthy explanation of its use—both the NPV and IRR application—may be helpful. Since the price to be paid for an acquisition will be arrived at by negotiation, the present value amount is a point of reference. If the discount factor used is the minimum rate of return that a management must earn, then the NPV is the maximum price that the purchaser will pay and still attain its expected rate of return. If the discount factor is a rate greater than the minimum (thereby decreasing the amount to be paid) expected rate of return, then it may be regarded simply as a reference point. The procedure to arrive at this present value of future cash ﬂows (NPV), illustrated in Exhibit 52.5, is: 1. Determine the probable income after taxes of the target operation for a given period into the future (say 5 to 10 years; column 1). Preferably, this should be on the acquiror’s basis of accounting—not that of the selling company.

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670) (730) (750)

($25,557)

(25,557)

($ 1,230) (2,769) (4,673) (7,013) (9,872)

—

— — —

Judgmental

540 (769) (2,353) (4,623) (6,512)

(2,150)

670) (730) (750)

($ 15,867)

(13,717)

($

Increase (Decrease) Total

E XHIBIT 52.4

C APITALIZED E ARNINGS B ASED

52.11

$ 29,935

$ 239,483

177,043

28,830 31,766 35,062 38,407 42,978

62,440

$ 17,930 20,660 23,850

Earnings as Adjusted

A DJUSTED P ROJECTIONS

$ 239,483

28,830 31,766 35,062 38,407 42,978

$ 17,930 20,660 23,850

Equal Weighting

Earnings

115,320 158,830 210,372 268,849 343,824

17,930 41,320 71,550

Valuation of an Acquisition

933

170,555

34,111

$ 1,227,995

$

Weighted

$ P ROJECTED L EVELS

$ 16,660

16,660

$ 2,540 2,920 3,300 3,450 4,450

—

— — —

Cost Level Changes

ON

$

ON

($ 6,970)

(4,820)

190,760 $ 255,350

(770) (960) (980) (1,060) (1,090)

(2,150)

($

Accounting Differences

28,290 32,535 37,415 43,030 49,490

64,590

$ 18,600 21,390 24,600

Earnings Estimated by Seller

Adjustments

J EFFREY C OMPANY , I NC . M AXIMUM P URCHASE P RICE TO Y IELD 20% N ET B ASED ( DOLLARS IN THOUSANDS )

Capitalized earnings (P/E of 5)

36

4 5 6 7 8

1 2 3

Weighting Factor

OF

Weighted average earnings (ⴜ 36)

Average earnings( ⴜ 8)

Total

Subtotal

200E

200A 200B 200C 200D

Projected

Subtotal

1998 1999 2000

Actual

Year

C ALCULATION

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P RESENT V ALUE OF

OF

$366,263

$ 18,419 21,181 24,359 27,802 32,119 37,047 42,015 47,568 54,300 61,451

A

$27,840

— $ 980 1,960 2,100 2,000 2,700 3,000 3,500 4,600 7,000

Working Capital (4)

$6,360

— $1,100 1,400 — 2,230 840 — 790 — —

Fixed Assets (5)

OF

R ETURN

$573,410

$ 332,063

$ 18,419 19,101 20,999 25,702 27,889 33,507 39,015 43,278 49,702 54,451

Net Cash Flow (6)

17% R ATE

Additional Investments

T HE J EFFREY C OMPANY F UTURE C ASH F LOWS B ASED ON ( DOLLARS IN THOUSANDS )

Operating Cash Flow (3)

F UTURE C ASH F LOWS

$35,313

$330,950 Estimated going value (10X)

Total (NPV)

$ 2,119 2,436 2,802 3,012 3,610 4,262 4,312 4,210 4,440 4,110

Depreciation (2)

$ 16,300 18,745 21,557 24,790 28,509 32,785 37,703 43,358 49,862 57,341

Estimated Net Income (1)

P RESENT V ALUE

Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

E XHIBIT 52.5

10

0 1 2 3 4 5 6 7 8 9

934

.208

.208

.855 .731 .624 .534 .456 .390 .333 .285 .243

17% Interest Factor (7)

$ 250,322

119,269

$ 15,748 13,962 13,103 13,725 12,717 13,068 12,992 12,334 12,078 11,326

Percent Value (8)

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52.11 Valuation of an Acquisition

935

2. Convert this net income to cash ﬂow from operations by adjusting for the noncash items (columns 2 and 3). Usually the only noncash item is depreciation or amortization of ﬁxed assets. 3. Further adjust the cash ﬂow to recognize additional cash needs, if any (columns 4 and 5). Typically, as the business grows, additional funds will be required for working capital and plant and equipment. These adjustments should then produce year by year the net cash generation or need for the period of the projection (column 6). 4. Determine the going-concern value, or salvage value, of the business at the end of the planning period. Typically, this is a multiple of earnings (10 × or 8 ×, etc.) if sold as a going concern, or the cash value if sold on a liquidating basis (receivables, inventory, and ﬁxed assets; shown at the bottom of column 6). 5. Apply a discount factor taken from present worth discount tables (column 7) to arrive at the present value (column 8). This represents the maximum amount that can be paid to purchase the future stream of cash and still earn the designated rate of return. In the illustration, Exhibit 52.5, the sum of $250,322,000 can be paid for the Jeffrey Company and yield the desired 17% rate of return after taxes. This assumes that the premises as to earnings and cash ﬂow are correct. (g) INTERNAL RATE OF RETURN. In some acquisition situations (a) the seller speciﬁes a desired price and (b) the buyer has a minimum desired rate of return (the IRR). This may represent the return that may be earned on other projects, or it may be the cost of capital, adjusted for risk and so forth. In any event, the task is to determine if the speciﬁed selling price will enable the buyer to earn the desired rate of return on the investment. The procedure is quite similar to that of determining the present value, in that the stream of future cash ﬂow by years and the liquidating value must be estimated. But the discounted rate of return is the unknown. Reference to Exhibit 52.6 will help in understanding the process: • The requested price is treated as an outﬂow of cash in year 0—$12 million in the illustration. • The future cash generation is determined as explained in Exhibit 52.4. • By trial and error and the use of present value tables, the rate of return is calculated. Basically a “guess” is made as to the rate of return, and this tentative rate (discount factor) is applied to the stream of cash. When the sum equals zero, the discount rate at which this occurs is the IRR. If the sum is greater than zero, then the earning rate is more. Then a higher rate is used until a negative position results. The applicable rate between the two discount factors is arrived at by interpolation—shown at the bottom of the exhibit. If the calculated rate of return is at least the minimum set by the buyer, then the quoted price is deemed acceptable, or is the basis for further negotiation. This same technique may be used for alternative calculations. Thus, if borrowed funds are to be used in the acquisition, the impact of leverage on the buyer’s investment may be determined. Exhibit 52.7 reﬂects the same transaction as Exhibit 52.6 except that the buyer uses borrowed funds of $9,600,000 for the initial investment (out of a gross price of $12 million) and, in later years, an additional $2,250,000 of interim borrowed funds to ﬁnance the purchase. The net result, after interest payments, is a return of 41.9% on the buyer’s equity investment. (h) MORE ABOUT DISCOUNTED CASH FLOW. These comments may be helpful in understanding some of the characteristics of the discounting process: • The importance of the discounted cash ﬂow technique lies in the fact that it recognizes the time value of money (i.e., if cash is received earlier rather than later, it can be invested to produce more earnings).

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E XHIBIT 52.6

Total

Sale of business (net of tax)

6 Subtotal

D ETERMINING

($13,500)

1,500)

($12,000)

(

Permanent

0 1 2 3 4 5

THE

400) 300) 300)

460 890 1,340 1,460 1,510 1,670

490 610 540 470 420 400

$ 2,930

$

Depreciation (DDB)

OF

R ETURN

Discount rate of return: 9% 1%

$ 7,330

$

Proﬁt after Taxes and Depreciation

D ISCOUNTED C ASH F LOW R ATE

($ 1,000)

( ( (

$

Working Capital

Investment

950 1,500 1,880 1,930 1,930 2,070

9.9%

11,850 $ 7,610

( 4,240)

$(12,000) 950 — 1,480 1,630 1,630 2,070

Cash Generation (Requirement)

514 --------------------------------514 ( 51 )

$10,260

$

Cash Flow

D ISCOUNTED C ASH F LOW G ROSS I NVESTMENT ($000)

Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

Year

936

.596

7,063 $ 514

1,224

.596

Amount $(12,000) 871 — 1,142 1,154 1,060

1.000 .917 .842 .772 .708 .650

Factor

.564

.564

1.000 .909 .826 .751 .683 .620

Factor

6,683 ($ 51)

1,167

$(12,000) 864 — 1,111 1,113 1,011

Amount

Discounted at 10%

Discounted Cash Flow Discounted at 9%

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0 1 2 3 4 5

($14,500)

A DJUSTING

Total

E XHIBIT 52.7

—

($12,000) — ( 1,500) (400) (300) (300)

Year

6 Subtotal Loan repayment Sale of business (net)

Gross Investment

THE

2,930

7,330

288) 303) 328) 344) 352) 178)

(1,793)

( ( ( ( ( (

( 6,033)

(12,000) 662 ( 303) 1,152 1,286 1,278 1,892

Gross Cash Generation (Requirement)

5,817 (11,850)

11,850 (11,850)

OF

R ETURN

FOR

B ORROWED F UNDS

41.9%

5,817

11,850

( 2,400) 662 1,047 1,512 1,556 1,548 1,892

Net Cash Generation (Requirement)

9,600 — 1,350 360 270 270 —

Borrowings

47 Discount rate of return: 41% 1% --------------------------47 ( 5 )

10,260

950 1,500 1,880 1,930 1,930 2,070

D ISCOUNTED C ASH F LOW R ATE

490 610 540 470 420 400

460 890 1,340 1,460 1,510 1,670

Proﬁt after Interest Taxes and Depreciation Expense Depreciation (DDB) Cash Flow (Net)

D ISCOUNTED C ASH F LOW I NVESTMENT N ET OF B ORROWINGS ($000)

52.11

1.000 .709 .503 .357 .253 .179 .127

Factor

1.000 .704 .496 .349 .246 .173 .122

Factor

($

937

5)

( 5)

$(2,400) 466 519 528 383 268 231

Amount

Valuation of an Acquisition

47

47

(2,400) 469 527 540 394 277 240

Amount

Discounted at 42%

Discounted Cash Flow Discounted at 41%

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Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

• The discount factor, representing a given rate of return, to use in arriving at NPV is already established in the discount tables. It merely needs to be applied to the stream of cash. This rate can be used as a starting point for the trial-and-error approach of calculating the actual or precise IRR. The company may have a minimum IRR as a cut-off point for acquisition (or capital assets). Additionally, software packages are available to determine NPV or IRR using a personal computer. • The interest factor—the discount rate—declines very rapidly so that events transpiring after ﬁve to eight years have very little impact because of the relatively low discount factor. • Because the assets of the acquiree at the end of the planning period should have value, this salvage value or going-concern value should not be overlooked in the NPV or IRR calculation. • The method implicitly assumes that the cash ﬂows each years can be invested at the discount factor (interest rate).

52.12 COMPARING THE VALUES When the value of a target company is determined by several methods, and they are all in the same general “ballpark,” this probably is an indication that the determination is realistic. Quite often, it is desirable to summarize the results of the various measures of worth. Such a schedule, based on assumed values, is:

COMPARATIVE FACTORS IN PROPOSED MERGER Company A

Company B

Relationship Ratio/Share

Five-year average earnings/share

$ 3.60

$ 3.90

.92 to 1

Five-year average dividends/share

$ 1.80

$ 1.90

.95 to 1

Market price (recent before merger inﬂuence)

$ 52.00

$ 51.40

1.03 to 1

Present worth of future cash ﬂows

$ 46.00

$ 42.80

1.07 to 1

Book value/share

$ 11.37

$ 17.89

.64 to 1

Net current assets/share

$ 8.96

$ 7.12

1.26 to 1

Evidence of Value

These are the factors usually taken into account in arriving at a stock exchange ratio. The weighting, a matter of judgment and bargaining power, depends on the opinion of both buyer and seller. In the foregoing example, if earnings, market price, and net current assets are the important factors in the eyes of both buyer and seller, there is a strong probability that one-for-one will be the stock exchange ratio. In the process of valuation, several scenarios may be developed, using varying assumption about growth rates or target rates of return. While the management of the buyer may not be interested in the details, a sense of the impact of various assumptions or discount factors may be useful. Thus, in Exhibit 52.8, the rate of return estimated for some selected offering prices is presented. Exhibit 52.9 provides the rate of return for several scenarios—most likely, conservative and optimistic—and at differing offer prices.

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52.13 Multinational Business Valuation

E STIMATED R ATES

OF

939

T HE J OHNSON C OMPANY R ETURN , N ET OF T AXES , F OR THE E LECTRONICS A RM , I NC . AT S ELECTED O FFERING P RICES Scenario (%)

Offering Price ($ Millions) 100 95 90 85 E XHIBIT 52.8

R ATES

Most Likely 14.75 15.50 16.75 18.00 OF

R ETURN B ASED

ON

Conservative 13.35 14.25 15.50 17.00

Optimistic 16.25 17.00 18.25 19.10

S ELECTED O FFERING P RICES

M AXIMUM C ASH O FFERING P RICE T O A CHIEVE I NDICATED R ATE OF R ETURN FOR T HREE S CENARIOS Target Rate of Return Scenario A. Most likely Aggregate price ($ millions) Per share price B. Conservative Aggregate price ($ millions) Per share price C. Optimistic Aggregate price ($ millions) Per share price E XHIBIT 52.9

14%

16%

18%

$ 276 $ 138.00

$ 244 $ 122.00

$ 212 $ 106.00

$ 252 $ 126.00

$ 220 $ 110.00

$ 195 $ 147.50

$ 305 $ 152.50

$ 265 $ 132.50

$ 235 $ 167.50

M AXIMUM C ASH O FFERING P RICE

52.13 MULTINATIONAL BUSINESS VALUATION With the trend to globalization, there is a need to understand some of the complications of considering a foreign acquisition. While the same basic principles and procedures used in evaluating a domestic entity are employed in appraising a foreign operation, several additional factors should be considered: • Translation of the foreign currency or currencies • Restrictions on currency transfers • Differences in foreign tax and accounting regulations or purchases • Impact of transfer pricing on earnings and taxes • Lack of adequate and relevant data about markets, competitive activity, and so on • Need to evaluate political risk • Impact of foreign exchange (FX) hedging on value • Determining the appropriate cost of capital Some of these subjects are discussed in the following sections. It is assumed that the valuation basis is the DCF method. Representative cash ﬂows of a U.S. domiciled parent, with a wholly owned subsidiary domiciled in England, is shown in Exhibit 52.10.1 In this example, the English subsidiary receives reve1. From Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies (New York: Wiley, 1990), p. 282. Used by permission.

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940

Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

nues from both France and England, buys raw materials supplied from Denmark, incurs costs for labor and materials in England, and borrows funds from Switzerland as well as England. Further, it receives capital and raw materials from its U.S. parent, and provides cash ﬂow to its parent in the form of both dividends and license fees. These many sources and uses of cash must be properly accounted for. The steps in valuing a foreign subsidiary are reﬂected in Exhibit 52.11.2 The starting point is to estimate or forecast the free cash ﬂow in each foreign currency. English revenues are estimated in pound sterling and French revenues are estimated in Euros. Next the nonsterling cash ﬂow is converted into pound sterling by using forward FX rates. When the estimated cash ﬂows are converted to pounds, they are discounted at the English cost of capital. This sterling value is then converted to U.S. dollars, the home currency, using the spot FX rate. In forecasting free cash ﬂow, the political risks, convertibility restrictions, withholding taxes, proper transfer prices, and the estimated inﬂation rate must be considered. A key point in foreign acquisition analysis is to focus on the cash available to the parent. Impediments to cash ﬂow from the subsidiary to the parent might be:

E XHIBIT 52.10

C ASH F LOW

FOR A

U.S. C OMPANY ’ S F OREIGN S UBSIDIARY

• Currency restrictions • Exchange rate ﬂuctuations • Withholding taxes. You may wish to review Chapter 10 of the reference in footnote 2 as well as Section 11.8. Because of the changing tax regulations and political risks, it might be appropriate to seek the assistance of knowledgeable counsel when evaluating a speciﬁc foreign acquisition prospect.

2. Ibid., p. 283. Used by permission.

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52.14 Leveraged Buyouts (LBOs)

941

1. Forecast free cash ﬂow in the foreign currency Use nominal foreign currency cash ﬂow Make accounting adjustments for FX translation, foreign accounting standards, and for “hidden assets” Use foreign inﬂation predictions Estimate the effective tax rate Use appropriate transfer prices Use forward FX rates to convert cash ﬂow to subsidiary’s domestic currency Predict forward FX rates Translate foreign-denominated cash ﬂow to subsidiary’s domestic currency 2. Estimate the subsidiary’s cost of capital Estimate subsidiary’s capital structure Estimate cost of equity Estimate after-tax cost of debt Use the after-tax weighted average cost of capital to discount cash ﬂows 3. Estimate the subsidiary value in your domestic currency Discount the translated foreign currency free cash ﬂow at the subsidiary’s cost of capital Translate the subsidiary value to your currency using the spot FX rate E XHIBIT 52.11

S TEPS

IN

V ALUING

A

F OREIGN S UBSIDIARY

52.14 LEVERAGED BUYOUTS (LBOS) Other than brieﬂy discussing the economic effect of differing cash/securities packages in evaluating a particular acquisition candidate, we have not attempted to explain the mechanics of how an acquisition should be accomplished. Thus, such matters as hostile tender offers or leveraged buyouts have been avoided. But the number of LBOs and their dollar value in the late 1980s and early 1990s have been so high—reaching $60 billion in 1988 alone—and the later heavy defaults and discounts on junk bonds have been so disastrous in some cases—that some general comments on this popular acquisition procedure are warranted. As the LBO method is also a study in managing liabilities (or not properly managing them) some facets of the subject are discussed in Chapter 32. First, let us review what the procedure is, and why it is so popular. The three basic steps in a leveraged buyout are: 1. A company with the desired characteristics (discussed later) is purchased (often by the management). 2. Most of the funds needed for the purchase are borrowed. 3. Unwanted assets are sold. The funds from such sales, plus the cash ﬂow, are used to service the large debt and to pay down the indebtedness to reasonable levels as quickly as possible. In a typical LBO, the transaction is ﬁnanced with these securities:

Security Secured senior debt

50–60

“Junk” bonds-unsecured, less-than-investment grade junior bonds-carrying a very high interest rate

30–40

Preferred stock and common stock

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Share of Capitalization (%)

10

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Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

Why have LBOs been so popular? Among other reasons, if the candidate is well selected, properly managed, and successful, the return on the investment is very high. Additionally, the incentives paid to the investment bankers for corralling the funds is lucrative. And the rewards to a successful management are bountiful. On the other hand, the risks to the equity holders (and junk bondholders) are great when the venture is ill-planned and/or ill-managed. In the event of an economic downturn, the results can be disastrous—restructuring or insolvency. What are some of the desirable characteristics for a leveraged buyout? They include many of these attributes: • A heavy and stable cash ﬂow • Segments or businesses that can be sold without negatively impacting the remaining operations • A relatively low debt-to-equity ratio • Stable working capital requirements • Stable capital expenditure needs • Preferably, management continuity • A noncyclical business pattern • Sizeable cash dividends The essence of an LBO is the payment for the entity from its future earnings and from proceeds arising through the sale of assets. A highly leveraged LBO forces the management to focus on effectively and efﬁciently running the business—or the management will not have a business to run. Some of the techniques or methods of achieving a successful operation include: • Emphasizing cash ﬂow. The need to reduce debt (and interest expense) causes a focus on increasing cash ﬂow and cash availability. How can the investment in receivables be reduced? Through JIT techniques, can we lower inventories? • Relating compensation to cash ﬂow and/or proﬁtability of operation. • Motivating the ofﬁcers and managers through stock ownership. Heavy stock ownership can stimulate an entrepreneurship attitude—and more aggressive action. • Involving the board of directors. The outside directors, frequently investors also, often have good ideas which are listened to. • Communicating effectively and frequently with employees. The fact that they are “wired in” and kept informed motivates them. They feel they are “part of the team.” • Focusing on the “critical success factors”—the essentials. These elements, and the reasons for their importance are communicated to the managers. They thus know where their attention should be directed. Proper emphasis is given to matters such as: Customer satisfaction Improved quality The sales organization Renegotiating contracts Reducing non–value-adding activities Keeping research and development effective Expanding product uses and the like

• Involving all of management in the annual planning process. When the managers have a say in the annual plan, then it becomes “their” plan—not that of the chief ﬁnancial ofﬁcer (CFO) High rewards can carry high risks. Some unpleasant LBO results are discussed in Chapter 32.

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52.15 Accounting for a Business Combination: Purchase Method

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52.15 ACCOUNTING FOR A BUSINESS COMBINATION: PURCHASE METHOD In brief, the purchase method of accounting for a business combination assumes that the acquiring company spreads the acquisition price over the assets being bought at their fair market value, with any remaining portion of the acquisition price being recorded in a goodwill account. The company being purchased can be bought with any form of consideration, such as stock, cash, or property. There are three primary steps involved in accounting for a purchase transaction. The ﬁrst is to determine the purchase price, the second is to allocate this price amongst the various assets of the company being purchased, and the third is to account for the ﬁrst-year partial results of the purchased entity on the buyer’s ﬁnancial statements. The issue with the ﬁrst step is that the purchase price is based on the fair market value of the consideration given to the seller. For example, if the purchase is made with stock, the stock must be valued at its fair market value. If Treasury stock is used as part of the consideration, then this must also be valued at its fair market value. If the buyer’s stock is thinly traded or closely held, then it may be necessary to obtain the services of an investment banker or appraiser, who can use various valuation models and industry surveys to derive a price per share. The second step in the purchase method is to allocate the purchase price amongst the acquired company’s assets and liabilities, which are then recorded in the buyer’s accounting records. The method of valuation varies by line item on the acquired company’s balance sheet. Here are the key valuation rules: • Accounts receivable. Record this asset at its present value, less the allowance for bad debts. Given the exceedingly short time frame over which this asset is outstanding, there is generally no need to discount this valuation, unless there are receivables with very long collection terms. Also, since the acquisition transaction is generally not completed until several months after the acquisition date (given the effort required to make the accounting entry), the amount of the allowance for bad debts can be very precisely determined as of the acquisition date. • Marketable securities. These assets should be recorded at their fair market value. This is an opportunity for the buyer to mark up a security to its fair market value (if such is the case), since GAAP normally only allows for the recognition of reductions in market value. For this reason, this is an area in which there is some opportunity to allocate an additional portion of the purchase price beyond the original cost of the asset. However, since most companies only invest in short-term, highly liquid securities, it is unlikely that there will be a large amount of potential appreciation in the securities. • Inventory—raw materials. These assets should be recorded at their replacement cost. This can be a problem if the acquiree is in an industry, such as computer hardware, where inventory costs drop at a rapid pace as new products rapidly come into the marketplace. Consequently, the buyer may ﬁnd itself with a signiﬁcantly lower inventory valuation as a result of the purchase transaction than originally appeared on the accounting records of the acquiree. • Inventory—ﬁnished goods. These assets should be recorded at their selling prices, less their average proﬁt margin and disposition costs. This can be a difﬁcult calculation to make if the ﬁnished goods have variable prices depending upon where or in what quantities they are sold; in such cases, the determination of selling price should be based on a history of the most common sales transactions. For example, if 80% of all units sold are in purchase quantities that result in a per-unit price of $1.50, then this is the most appropriate price to use. This rule can be avoided, however, if the acquiree has ﬁrm sales contracts as of the date of the acquisition with speciﬁc customers that can be used to clearly determine the prices at which the ﬁnished goods will actually be sold.

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If the acquirer had been using a last-in, ﬁrst-out (LIFO) inventory valuation system, then the newly derived valuation for the ﬁnished goods inventory shall be used as the LIFO base layer for all inventory obtained through the purchase transaction. • Inventory—work-in-process. These assets receive the same valuation treatment as ﬁnished goods, except that the cost of conversion into ﬁnished goods must also be subtracted from their eventual sale price. • Property, plant & equipment (PP&E). These assets should be recorded at their replacement cost. This can be a difﬁcult task that lengthens the interval before the acquisition journal entry is completed, because some assets may be so old that there is no equivalent product currently on the market, or equipment may be so specialized that it is difﬁcult to ﬁnd a reasonable alternative on the market. This valuation step frequently calls for the services of an appraiser. • Property, plant & equipment (PP&E) to be sold. If the buyer intends to sell off assets as of the acquisition date, then these assets should be recorded at their fair market value. This most accurately reﬂects their disposal value as of the acquisition date. • Capital leases. If the acquiree possesses assets that were purchased with capital leases, then the accountant should value the asset at its fair market value, while valuing the associated lease at its net present value. • Research & development (R&D) assets. If any assets associated with speciﬁc R&D projects are part of the acquiree, the accountant should charge these assets off to expense if there is no expectation that they will have an alternative future use once the current R&D project has been completed. The precise allocation of assets to expense or asset accounts can be difﬁcult, since the existing projects may be expected to last well into the future, or the future use of the assets may not be easy to determine. Consequently, one should carefully document the reasons for the treatment of R&D assets. • Intangible assets. These assets are to be recorded at their appraised values. If the buyer cannot reasonably assign a cost to them or identify them, then no cost should be assigned. • Accounts and notes payable. Accounts payable can typically be recorded at their current amounts as listed on the books of the acquiree. However, if the accounts payable are not to be paid for some time, then they should be recorded at their discounted present values. The same logic applies to notes payable; since all but the shortest-lived notes will have a signiﬁcantly different present value, they should be discounted and recorded as such. This treatment is used on the assumption that the buyer would otherwise be purchasing these liabilities on the date of the acquisition, not on a variety of dates stretching out into the future, and so must be discounted to show their value on the acquisition date. • Accruals. These liabilities are typically very short-term ones that will be reversed shortly after the current accounting period. Accordingly, they are to be valued at their present value; discounting is rarely necessary. • Pension liability. If there is an unfunded pension liability, even if not recognized on the books of the acquiree, it must be recognized by the buyer as part of the purchase transaction. • Stock option plan. If the buyer decides to take over an existing stock option plan of the acquiree’s, then it must allocate part of the purchase price to the incremental difference between the price at which shares may be purchased under the plan and the market price for the stock as of the date of the acquisition. However, if the buyer forced the acquiree to settle all claims under the option plan prior to the acquisition, then this becomes a compensation expense that is recorded on the books of the acquiree.

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52.15 Accounting for a Business Combination: Purchase Method

945

If the acquiring company (Charleston Corporation) buys the acquiree’s (Denton Corporation) stock with $500,000 of cash, the entry on Charleston’s books would be: Debit

Credit

Investment in Denton Corporation Cash

$500,000 $500,000

Alternatively, if Charleston were to make the purchase using a mix of 20% cash and 80% for a note, the entry would be: Debit

Credit

Investment in Denton Corporation Cash Note payable

$500,000 $100,000 400,000

Another approach would be to exchange 5,000 shares of Charleston’s $1 par value stock for that of Denton as a form of payment. Under this method, the entry would be: Debit

Credit

Investment in Denton Corporation

$500,000

Common stock—par value

$5,000

Common stock—additional paid-in capital

495,000

The result of all the preceding valuation rules is shown in Exhibit 52.12, where we show the calculation that would be required to adjust the books of an acquiree in order to then consolidate it with the results of the acquiring company. The exhibit shows the initial book cost of each account on the acquiree’s balance sheet, followed by a listing of the required valuation of each account under the purchase method, the adjustment required, and the new account valuation. The new account valuation on the right side of the table can then be combined directly into the records of the acquiring company. Under the “Purchase Method Valuation” column, a designation of “NPV” means that the net present value of the line item is shown, a designation of “FMV” means that the fair market value is shown (less any costs required to sell the item, if applicable), “RC” designates the use of replacement cost, “SLM” designates the use of sale price less the gross margin, and “AV” designates an asset’s appraised value.

Acquiree Records

Account

Purchase Method Valuation

Required Adjustment

Adjusted Acquiree Records

$0 0 (CR) 264 (CR) 13 (CR) 3 (DB) 34 (DB) 79 (DB) 1,490

$1,413 4,000 808 490 918 429 950 7,495

Assets

Cash Receivables Receivables, long term Marketable securities Inventory—raw materials Inventory—WIP Inventory—ﬁnished goods Property, plant, & equipment E XHIBIT 52.12

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A DJUSTMENTS

TO THE

$1,413 4,000 1,072 503 921 395 871 6,005

$1,413 4,000 (NPV) 808 (FMV) 490 (RC) 918 (SLM) 429 (SLM) 950 (RC) 7,495

A CQUIREE ’ S B OOKS

FOR A

P URCHASE C ONSOLIDATION

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Acquiree Records

Account

Purchase Method Valuation

Required Adjustment

Adjusted Acquiree Records

Assets

Equipment for sale Capital lease assets Goodwill Investment in acquiree Intangibles Total Assets

803 462 0 0 593 $ 17,038

(FMV) (FMV)

745 500 0 0 650

(CR) 58 (DB) 38 (DB) 4,677 (CR) 14,600 (DB) 57

745 500 4,677 –15,000 650

$18,398

(CR) $8,563

$ 8,075

$0 350 0 50 0

$ 3,992 2,950 325 400 408

$400

$ 8,075 $0 0 0

(AV)

Liabilities

Accounts payable Notes payable, long term Accrued liabilities Capital lease liabilities Pension liability

$

Total liabilities

$

3,992 3,300 325 450 408

$3,992 (NPV) 2,950 325 (NPV) 400 408

8,475

$8,075

4,586 100 3,877

— — —

(DB) 4,586 (DB) 100 (DB) 3,877

(DB) (DB) (DB)

Shareholder’s Equity

Common Stock Paid-in capital Retained earnings Total equity

$

8,563

—

(DB) $8,563

$

Total liabilities & equity

$ 17,038

—

(DB) $8,963

$ 8,075

E XHIBIT 52.12

A DJUSTMENTS

TO THE

A CQUIREE ’ S B OOKS

FOR A

0

P URCHASE C ONSOLIDATION

In the exhibit, debits and credits are speciﬁed for each adjusting entry listed in the “Required Adjustment” column. The amount of goodwill shown in the “Required Adjustment” column is derived by subtracting the purchase price of $15,000 from the total of all fair market and other valuations shown in the “Purchase Method Valuation” column. In this case, we have a fair market valuation of $18,398 for all assets, less a fair market valuation of $8,075 for all liabilities, which yields a net fair market value for the acquiree of $10,323. When this fair market value is subtracted from the purchase price of $15,000, we end up with a residual of $4,677, which is listed in the goodwill account. Please note that the “Adjusted Acquiree Records” column on the right side of the exhibit still must be added to the acquirer’s records to arrive at a consolidated ﬁnancial statement for the combined entities. The third step in the acquisition process is to account for the ﬁrst year partial results of the acquired company on its books. Only the income of the acquiree that falls within its current ﬁscal year, but after the date of the acquisition, should be added to the buyer’s accounting records. In addition, the buyer must charge all costs associated with the acquisition to current expense—they cannot be capitalized. These acquisition costs should be almost entirely for outside services, since any internal costs charged to the acquisition would likely have been incurred anyways, even in the absence of the acquisition. The only variation from this rule is the costs associated with issuing equity to pay for the acquisition; these costs can be recorded as an offset to the additional paid-in capital account. An additional item is that a liability should be recognized at the time of the acquisition for any plant closings or losses on the dispositions of assets that are planned as of that date; this is not an expense that is recognized at a later date, since we assume that the buyer was aware at the purchase date that some asset dispositions would be required.

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If the acquirer chooses to report its ﬁnancial results for multiple years prior to the acquisition, it does not report the combined results of the two entities for years prior to the acquisition. A reverse acquisition is one where the company issuing its shares or other payment is actually the acquiree, because the acquiring company’s shareholders do not own a majority of the stock after the acquisition is completed. Though rare, this approach is sometimes used when a shell company with available funding buys an operating company, or when a publicly held shell company is used to buy a non-public company, thereby avoiding the need to go through an initial public offering (IPO) by the non public company. In this case, the assets and liabilities of the shell corporation are revalued to their fair market value and then recorded on the books of the company being bought.

52.16 TAX CONSIDERATIONS IN ACQUISITIONS AND MERGERS One corporation may acquire another through either a taxable or nontaxable transaction. Moreover, under either method a sale of assets or a sale of stock may be accomplished. It is quite obvious that the tax consequences may be of particular interest to either buyer or seller. It usually is an important factor in properly structuring the transaction, and, of course, on the price to be paid. The controller should be generally aware of the tax aspects, and in any proposed purchase or sale, the tax consequences for the company (and sometimes as to the other side) should be calculated. This, of course, should be determined with knowledgeable assistance, whether from the tax manager or the ﬁrm of independent accountants or tax counsel or legal counsel. Because tax law changes frequently, only a general background is provided herein. With a case in hand, the controller will want to be updated on the current laws. Basically, there are six ways of making an acquisition under U.S. law, and some have several variations. The primary methods are: 1. An asset acquisition 2. A Section 338 transaction 3. A stock acquisition 4. A Type A reorganization 5. A Type B reorganization 6. A Type C reorganization The ﬁrst three usually are considered to be taxable. Type A, B, or C reorganizations generally are tax free, under Internal Revenue Code (IRC) 368; they ordinarily should not have income tax consequences for the parties involved. A few brief comments are made on each method. (a) ASSET ACQUISITION. In this type of acquisition the acquiring party purchases all or a part of the assets of the target company for cash, stock, or other considerations. Payment is made by the acquiring entity to the target company and the latter remains in existence. The transaction is viewed by the Internal Revenue Service (IRS) as a taxable sale of assets. However, if the target company, pursuant to a plan of liquidation distributes all of its assets, there is no tax payable by the selling entity. But the owners of the latter must recognize gain or loss upon distribution of the proceeds. (b) SECTION 338 TRANSACTION. Under this type of acquisition, the acquiring company purchases the stock of the target company from its shareholders for cash, stock, other securities, or other consideration. Pursuant to IRC 338, by the ﬁfteenth day of the ninth month after the month of acquisition, it elects to treat the transaction as if the target sold its assets for a price equal to

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Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

their fair market value. Such a series of transactions is considered by the IRS as a taxable sale by the shareholders of the target. (c) STOCK ACQUISITION. Under this type of acquisition, the acquiring company purchases the stock of the target for cash, stock, other securities, or other consideration. The transaction is regarded by the IRS as a taxable sale by the shareholders of the target. (d) TYPE A REORGANIZATION. Under the general category there are four types of Type A reorganization: (1) Type A statutory mergers, (2) Type A statutory consolidations, (3) Type A subsidiary mergers, and (4) Type A reverse subsidiary mergers. All are regarded as nontaxable. A brief explanation of each follows: 1. Type A statutory merger. This kind of reorganization occurs when two corporations, pursuant to a state statute, combine in such a manner that one company remains in existence and the other disappears. In the eyes of the IRS, the merged company is considered to have exchanged its assets for the stock of the surviving—the acquiring—company. The acquired company distributes the stock of the acquiring corporation to its shareholders in exchange for the stock of the target company. Thus, a nontaxable stock exchange takes place. 2. Type A statutory consolidation. A Type A statutory consolidation occurs when two or more corporations are combined into a new corporation. In the eyes of the tax law, the combined corporations are viewed as having exchanged their assets for the stock of the new corporation. These combined corporations, upon receiving the stock of the new corporation, distribute it to their shareholders in exchange for their shares in the combining company. 3. Type A subsidiary merger. A Type A subsidiary merger, also referred to as a standard triangular merger, occurs when the target company merges into a controlled subsidiary of the acquiring corporation in exchange for the stock of the acquiring company. The acquiring entity must acquire substantially all of the assets of the target company. Also, no stock of the subsidiary may be given to the shareholders of the target entity. The merged (target) company is considered to have exchanged its assets for stock. The target company then distributes its newly acquired stock to its shareholders in exchange for its stock held by them. 4. Type A reverse subsidiary merger. In such a transaction, a controlled subsidiary of the acquiring company merges into the target corporation—by reason of a legal need for the target to remain in existence. The shareholders of the target company receive the stock of the acquiring corporation, and the acquiring entity receives the stock of the target. When this transaction is completed, the target corporation must hold (a) substantially all of the assets is held before the transaction, and (b) substantially all of the assets of the subsidiary merged into it. (e) TYPE B REORGANIZATION. This type of reorganization usually may be accomplished in one of two ways: (1) stock of the parent is exchanged for stock of the target company, or (2) subsidiary stock is exchanged for stock of the target company. When the ﬁrst of the two methods is undertaken, the acquiring company must exchange its voting stock for stock of the target in a sufﬁcient amount to control the target (i.e., 80% of the combined voting power of all voting stock and at least 80% of all other categories of target stock). Thus, in effect, the target becomes a subsidiary of the acquiring corporation. In the second variation of a Type B reorganization, the acquiring entity may use its own stock or that of its subsidiary in an exchange—but not both. The acquiring company may pass its stock down to the subsidiary, which exchanges that stock for the stock of the target company. As an alternative, the subsidiary may issue its own stock in exchange for the stock of the target. Thus, in effect, the target becomes a subsidiary of the acquiring company’s subsidiary. These Type B reorganizations are nontaxable.

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949

(f) TYPE C REORGANIZATION. This type of reorganization may be effected in one of two ways: (1) an exchange of parent stock for assets, or (2) an exchange of subsidiary stock for assets. In the ﬁrst instance the acquiring corporation exchanges its voting stock for substantially all of the assets of the target. In the second case, the subsidiary (of the acquiring company) exchanges its own voting stock, or voting stock of its parent, for substantially all of the assets of the target. In a Type C reorganization, the acquiring corporation or its subsidiary usually does not recognize any gain or loss. On the other hand, the target company and its shareholders recognize no gain or loss if only voting stock is received. However, when the target is liquidated, its owners takes a tax basis in the acquiring company common stock equal to that of their target company stock. If “boot” is part of the transaction and is distributed to the target company shareholders, it is taxable to them. (g) TAXES: A SUMMARY.

These further comments are helpful:

• From the standpoint of the buyer, the objective is to select an acquisition method that represents the most advantageous or least-cost type that is negotiable. • To reiterate, tax laws and their interpretation change. So the ﬁnancial ofﬁcers of the acquiring company (or the acquired) must secure the best up-to-date tax advice possible before their company consummates a transaction. • This tax consideration discussion has focused on federal taxes. However, the impact of state and local taxes, which may be considerable, also should be carefully examined.

52.17 FINANCIAL IMPACT OF AN ACQUISITION A great many factors must be weighed, and alternatives considered—both ﬁnancial and nonﬁnancial—when a potential acquisition is under study and/or discussion. What these factors are depends on the circumstances, of course, and the particular interests of the management and board of directors of the acquiring entity. In the ﬁnal analysis, a most important subject is the impact on earnings. Most readers may be aware of these inﬂuences, but we will brieﬂy comment on three aspects: • Earnings per share (EPS) • Impact of product line growth rates • Inﬂuence of differing cash/securities packages as consideration These matters are in addition to subjects already discussed, including whether a taxable or tax-free transaction should be used in a particular transaction, and whether a pooling of interests or purchase accounting may be most advantageous. (a) EARNINGS PER SHARE. The ﬁnancial community and many chief executives pay a great deal of attention to earnings per share, or more speciﬁcally to growth in EPS. An increase in this ﬁnancial measure can be accomplished by several means (see Chapter 33), including buy-back of outstanding shares, more intensive use of debt instead of equity to ﬁnance growth, as well as a real increase in annual earnings. Of course, if an acquisition is made at a lower price-earnings (P/E) ratio than the acquirer has achieved, the EPS may increase. Aside from this relative P/E factor, usually management expects an acquisition to improve the EPS ultimately, if not immediately. Some acquisitions, however, do dilute earnings for a period of time. In any event, the ﬁnancial executives should be sensitive to EPS and include commentary on this fact in the acquisition report. It may be a simple comparison, as shown in Exhibit 52.13. (b) IMPACT OF PRODUCT LINE GROWTH RATES. Another phenomenon that impacts earnings and EPS is the growth rate of any or all product lines. The impact on earnings of a different growth rate in the presumed sales, and therefore earnings, of a proposed acquisition was illustrated by the judgmental adjustment of projected earnings in Exhibit 52.4 for differences of opinion

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Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

between buyer and seller. In any event, the impact on earnings for different assumptions as to growth rate (of an acquisition) might be graphically presented in the acquisition analysis as illustrated in Exhibit 52.14. E STIMATED I MPACT

ON

T HE J OHNSON C OMPANY P ER S HARE E ARNINGS OF A CQUIRING S UPERTECHNOLOGY C ORP . I NC .

200R

Johnson Company EPS without the Acquisition

Supertechnology Earnings Expressed in Johnson EPS*

Adjusted EPS

$ 6.40

(.82)

$ 5.58

200S

$ 7.02

1.02

$ 8.04

200T

$ 7.71

1.70

$ 9.41

200U

$ 8.60

2.40

$11.00

200V

$ 9.75

2.90

$12.65

200W

$10.80

3.78

$14.58

200X

$11.96

5.06

$17.02

200Y

$12.14

5.75

$17.89

200Z

$12.60

6.25

$18.85

*Allowance made for interest expense at 10.25% per annum on estimated borrowing of $40 million.

E XHIBIT 52.13

I MPACT

OF

A CQUISITIONS

ON

EPS

(c) IMPACT OF DIFFERING PACKAGES OF CASH/SECURITIES. One of the tasks of the ﬁnancial ofﬁcer of the acquiring company should be to explore the impact on earnings and earnings per share of differing combinations of the consideration, for example, varying amounts of cash and common stock and/or preferred stock. Again, a graph can effectively portray the impact of various packages, and might be included in the acquisition report. (See Exhibit 52.15.)

52.18 FINANCIAL REPORT ON A POTENTIAL ACQUISITION When the in-depth acquisition analysis is complete, when the nonﬁnancial executives and ﬁnancial executives have reviewed, discussed, and generally agreed upon any operating matters that will have a signiﬁcant ﬁnancial impact (sales volumes, terms of sales, rates of growth, product margins, manufacturing costs, marketing expense levels, research and development, new facility requirements, to mention a few) and when these conclusions are reﬂected in the relevant sales volumes, costs and expense levels, and asset levels of the ﬁnancial statements, together with ﬁnancial-type decisions as to sources of cash, accounts receivable levels, and so on—then the ﬁnancial segment of the acquisition report can be prepared. The ﬁnancial commentary and tabulations often comprise one segment—albeit an important one—of the acquisition report. As to this review, it is the responsibility of the ﬁnancial ofﬁcers, sometimes primarily the controller, to summarize and interpret the actual and projected ﬁnancial statements for the beneﬁt of all of top management, including the board of directors. The purpose should be to communicate all signiﬁcant ﬁnancial facts about the proposed acquisition and the ﬁnancial impact on the acquiring company. An informed conclusion on these matters and the best manner, ﬁnancially speaking, of consummating the acquisition—if it is to be acquired—should be reached by the ﬁnancial ofﬁcers and communicated to the management and the board of directors. This group of presumably largely nonﬁnancial executives should not be inundated with excessive detail. While a certain amount of relevant detail may be included in an appendix, the summarized ﬁnancial data should simply and clearly explain and support the recommendation. Again, the exact format and content will depend in part on the interests of the audience and the important facts that must be communicated. Though an oral presentation (with graphs) may be highly desirable, some suggested written commentary and related tabulations to be part of the content are:

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52.18 Financial Report on a Potential Acquisition

E XHIBIT 52.14

I MPACT

OF

951

P RODUCT L INE G ROWTH R ATES

S UMMARY Brief tabulation or graphs, perhaps extending over ﬁve to ten years, as appropriate, showing: • Basic assumptions • Net sales • Earnings and rate of growth • Earnings per share and impact of acquisition (dilution or accretion) • Return on investment (DCF) • Return on shareholders’ equity • Cash ﬂow from operations • Condensed ﬁnancial condition, showing sources of funds (necessary borrowings), and debt capacity • The proposed consideration (package of cash, stock, etc.) • Financial risks of the acquisition

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Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

E XHIBIT 52.15

I MPACT

OF

D IFFERING C ASH /S ECURITIES P ACKAGES

The summary, if appropriate, could include some alternative scenarios such as most probable, pessimistic, and optimistic results or conditions. Depending on circumstances, certain supporting data might be presented (or be available): N ET S ALES • Growth by area or market • Competitor status and/or actions • Impact of alternative growth rates (see Exhibit 52.14) E ARNINGS • Basic company planned earnings, acquiree earnings, and combined earnings • Inﬂation impact • Adjustments to seller data

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953

• Impact of accounting changes (acquiror vs. acquiree) • Anticipated savings or synergisms • Growth rates • Earnings of target by signiﬁcant segments C ASH S OURCES

AND

U SES

• Segregation as between target, basic company, and combined • Signiﬁcant new equity issues, if any • Signiﬁcant borrowings • Dividend payments • Capital expenditures (basic company and target, each separate) F INANCIAL P OSITION • Condensed statements (most likely) of both basic company, target, and consolidated (perhaps also the worst-case scenario when discussing risks) • Key ﬁnancial ratios, with target, and without, related to credit agreement requirements • Tax status of transaction • Contingent liabilities, basic company, target, and consolidated • Return on assets—with and without target • Analyses of shareholders’ equity—showing earnings of target, and basic company; dividends status and growth; return on equity (with and without the acquisition) P ROPOSED A CQUISITION P ACKAGE • As recommended including impact on EPS • Alternatives (see Exhibit 52.15) O THER • Basic assumptions • Extent of ﬁnancial risk—amount, probability of occurrence, and period of greatest exposure In summary, the major ﬁnancial points should be communicated. There should be available, if appropriate, further detailed results by year and perhaps by line of product. Naturally, the ﬁnancial ofﬁcers should be prepared to answer any and all ﬁnancial questions directed to them. Hopefully, the presentation will have anticipated most questions. An illustrative condensed ﬁnancial report on selected phases of an acquisition is presented in Exhibit 52.16, largely in the form of a short narrative. It is designed to indicate that a meaningful ﬁnancial presentation can be made without reams of detailed ﬁgures. If, on the other hand, management is highly analytical, and ﬁgure oriented, then supporting data to the commentary could be attached as an appendix, as shown in Exhibit 52.17, Exhibit 52.18, and Exhibit 52.19. TO:

CEO

FROM:

Controller

SUBJECT: Acquisition of Supertechnology, Inc You have asked for a concise report on the ﬁnancial impact on our company of the proposed acquisition of Supertechnology, Inc., with information as to net sales, net income, earnings per share, and dividend-paying ability for the next ﬁve years. You have also requested a succinct statement on the proposed package to be issued in payment for the acquisition, and the resulting return on the company’s gross investment in Supertechnology, Inc. The summarized data is presented below. E XHIBIT 52.16

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954

Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

N ET S ALES Based on discussions with the vice-president-marketing regarding the sales outlook, by detailed product lines, we are of the opinion the following sales pattern represents the most likely combined result for the next ﬁve years (dollars in thousands): Year

Parent Company

Supertechnology, Inc.

Combined

$ 128,00

$ 35,000

$ 163,000

Historical Last year This year (est.)

131,500

40,250

171,750

Total

$259,500

$ 75,250

$ 334,750

200R

$138,075

$ 46,290

$ 184,365

200S

144,980

53,235

198,215

200T

152,230

61,220

213,450

200U

159,840

70,405

230,245

200V

167,830

80,965

248,795

$762,955

$312,115

$1,075,070

Projected

It is estimated that the parent company sales will continue to increase, but only at about 5% per year. On a most probable basis, the sales of Supertechnology, Inc., will increase about 15% per year to a level of $80,965,000 for the year 200V. Thus, by that year combined sales of the companies will approach $250 million. A very conservative forecast would see Supertechnology, Inc., sales increase at about 10% to a level of $67,774,000 by 200V. In contrast, an optimistic sales estimate reﬂects a potential of 20% per year growth—or a level of $95,990,000 by 200V. NET INCOME Using the net income of our ﬁve-year plan, and income and expense levels estimated for Supertechnology, Inc., and agreed to by the functional managers of both companies, the most likely consolidated net income, in comparison with the past two-year actual or expected net income, is as follows (dollars in thousands): Year

Parent Company

Supertechnology, Inc.

Combined

$ 7,680

$ 4,200

$ 11,880

7,890

4,830

12,720

$15,570

$ 9,030

$24,600

200R

$ 8,285

$ 5,555

$ 13,840

200S

8,700

6,388

15,088

200T

9,134

7,346

16,480

Historical Last year This year (est.) Projected

200U

9,590

8,450

18,040

200V

10,070

9,715

19,785

$45,779

$37,454

$83,233

E XHIBIT 52.16

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52.18 Financial Report on a Potential Acquisition

955

The parent company earns 6% on net sales, whereas Supertechnology is expected to secure a 12% return on a most likely basis (even after making certain interest expense adjustments— discussed later). With this rate of return on sales, the parent company is expected to earn $10,070,000 in 200V, whereas, Supertechnology probably may achieve earnings of $9,715,000 in the same year—a combined total of $19,785,000. This compares with expected net income of the parent company only approximating $7,890,000 this year. On even a pessimistic scenario, Supertechnology is estimated to earn $7,290,000 in 200V; and the optimistic forecast of net income for this potential subsidiary is $12,630,000 in this same year. EARNINGS PER SHARE Based on the above net income, the estimated earnings per share of common stock to be contributed by Supertechnology, Inc., and the combined results are as follows: Year

Parent Company

Historical Last year This year (est.) Projected 200R 200S 200T 200U 200V *

Supertechnology, Inc.

Combined*

$2.780 3.194 3.673 4.225 4.857

$ 6.92 7.54 8.24 9.02 9.89

$3.840 3.945 4.140 4.350 4.567 4.795 5.035

After providing for interest on newly borrowed funds.

These earnings per share are based on 2 million shares of outstanding common shares. It is not expected that either additional common shares or any preferred shares will need to be issued for this acquisition. DIVIDENDS ON COMMON SHARES At the present time the company follows a practice of paying out about 40% of the estimated sustainable earnings level. The dividend on the common stock presently is at the rate of $1.50 per share annually. Even after providing for the interest expense on some planned borrowings, if the board of directors approves, annual dividends per share could rise to the following level and still not exceed the 40% payout ratio: Year 200R 200S 200T 200U 200V

40% Payout $ 2.77 3.02 3.30 3.61 3.96

With a planned accelerated repayment of a term loan over the next ﬁve years, it is not recommended that the full 40% payout ratio be reached over this time period. E XHIBIT 52.16

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956

Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

PURCHASE PRICE FOR SUPERTECHNOLOGY, INC. The owners of Supertechnology, as a nonpublic company, initially quoted an asking price of $80,000,000 payable in 2,000,000 shares of our common stock or a new convertible preferred for 100% of the stock of their company. However, in examining (a) the impact of doubling the existing number of shares, and possibly raising problems of management control; (b) the seller’s intention to dispose of most of the stock; (c) the seller’s need for cash; (d) certain advantageous investments in municipal bonds for the aging sellers; (e) the tremendous impact on earnings per share of doing a cash transaction and avoiding dilution; and (f) the sizable amount of cash and temporary investments held by our company, your three principal ofﬁcers convinced the sellers to immediately accept a cash counteroffer of $65,000,000. So, if you and the board of directors agree, the transaction will call for a payment of this sum, with no issuance of stock. The impact of this transaction, if the estimated earnings and cash ﬂow materialize, is a rate of return of 18.2% after taxes. This is somewhat higher than our internal target of 15% calculated on a discounted cash ﬂow basis. IMPACT ON FINANCIAL POSITION The current ﬁnancial position of the company, as of September 30, 199Q, is summarized on Exhibit 1, attached. We propose to borrow $15,000,000 as a term bank loan, payable in 7 years, with interest at two percentage above the prime rate. At the present time, the interest rate would be 12.5% per annum. The company would be permitted to prepay any part of this loan at any time without penalty. Accordingly, a share of the earnings from the Supertechnology operations, after a provision for “dividends” (to 40% or less), would be applied to pay down the bank loan of $15,000,000. It is estimated that the term loan would be repaid in ﬁve years, from the Supertechnology earnings, as shown on Exhibit 2, attached. The chief ﬁnancial ofﬁcer of the company is of the opinion that the cash available will be greater than this estimate in that (a) the earnings estimate is reasonably conservative because expense levels have been estimated on the high side; (b) the investment in receivables, inventory, and ﬁxed assets for Supertechnology included above, amounting to $17,580,000 probably is 25% greater than actually needed; (c) probably the dividend payout ratio will be kept below 40% for perhaps three years to assure ourselves that the earnings level is attainable. These further comments apply as to the company’s ﬁnancial position: 1. As you know, we have been keeping funds available for a possible acquisition, so that the use of $50 million of the $54,400,000 still leaves ample cash for our operating needs. 2. The company capitalization now, and with the term loan, would be as follows ($000): At Present Amount Long-term liabilities Shareholders’ equity Total

$30,000

Percent 32.00%

64,200

68.00

$94,200

100.00%

With Term Loan Amount

Percent

$ 45,000

41.00%

64,200 $109,200

59.00 100.00%

In the opinion of our investment bankers and commercial bankers, the long-term debt as a percentage of total capitalization, with the proposed borrowing, or the long-term debt to E XHIBIT 52.16

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52.18 Financial Report on a Potential Acquisition

957

equity ratio is reasonably conservative in our industry—especially in view of the company’s tract record. We believe the company has additional borrowing capacity—which we do not plan to use. I hope these comments answer your questions. Please call me if you have any more. J.J.J. Controller

EXHIBIT I—to letter dated October 14, 199Q Re: Acquisition of Supertechnology, Inc. Impact on Financial Position ($000) Assets Current Assets Cash and temporary investments

$ 54,400

Other current assets

24,800

Total current assets

$79,200

Fixed Assets Property, plant and equipment

44,000

Total assets

$ 123,200 Liabilities and Shareholders’ Equity

Current Liabilities Accounts payable

$ 13,600

Accrued items

15,400

Total current liabilities

$ 29,000

Long-Term Liabilities (insurance loan)

30,000

Total liabilities

59,000

Shareholders’ equity

64,200

Total liabilities and shareholders’ equity

$ 123,200

EXHIBIT II—to letter dated October 14, 199Q Re: Acquisition of Supertechnology, Inc. Impact on Financial Position ($000) Investment Net of Depreciation (B)

Net Cash Flow (C)

Less Applicable “Dividend” (D)

Available for Loan Payment (E)

Amount to Prepay (F)

Year

Earnings (A)

200R

$ 5,555

$ 5,855

$ 2,342

$ 3,513

$ 3,000

200S

6,388

( 280)

6,108

2,443

3,665

3,000

200T

7,346

(1,070)

6,276

2,510

3,766

3,500

200U

8,450

(2,000)

6,450

2,580

3,870

3,500

200V

9,715

(2,530)

7,185

2,874

4,311

2,000

$

300

200W

11,172

(2,700)

8,472

3,389

5,083

—

Total

$48,626

($8,280)

$40,346

$16,138

$24,208

$15,000

A–B=C D=40% of net cash ﬂow

E XHIBIT 52.16

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20X1 20X2 20X3 20X4 20X5 Total Average

E XHIBIT 52.17

193,243

107,660 108,320 107,899 113,660 117,432 554,971 110,994

208,310 216,990 226,300 239,800 253,670 1,145,070 229,014

C OMPARATIVE S ALES , E ARNINGS ,

Southern Manufacturing Company Actual 20X4 20X3 20X2 20X1 20X Total Average

Forecast

184,216 189,817 190,066 197,430 204,684 966,213

AND

C ASH F LOW D ATA

1.96 .61 — 5.34 3.32 — 2.29

1.77 4.17 4.29 5.97 5.78 — 4.28

2.72 3.10 .10 3.87 3.67 — 2.64

FOR

8.00 8.71 8.32 9.56 8.78 — 8.68

10.00 10.50 10.50 11.00 11.00 — 10.62

10.08

9.90 9.74 9.41 10.29 10.96 —

4,218 4,706 4,491 5,403 5,011 23,829 4,766

15,415 16,057 16,746 17,745 18,772 84,735 16,947

13,611 13,809 12,202 14,666 16,427 70,715 14,143

M ERGER S TUDY — IN S UBSTANTIAL D ETAIL

8,612 9,430 8,976 10,866 10,311 48,195 9,639

20,831 22,784 23,762 26,378 27,904 121,659 24,332

18,230 18,493 17,894 20,311 22,430 97,358 19,472

3.92 4.34 4.16 4.75 4.27 — 4.29

7.40 7.40 7.40 7.40 7.40 — 7.40

7.39 7.27 6.42 7.43 8.03 — 7.32

A PPENDIX I W ESTERN M ANUFACTURING C ORPORATION AND S OUTHERN M ANUFACTURING C OMPANY S ALES , E ARNINGS , AND C ASH F LOW F OR THE Y EARS 20X4 T HROUGH 20X5 (D OLLARS IN T HOUSANDS ) Net Sales Pretax Earnings Net Income Amount % Increase Preceding Year Amount % Net Sales Amount % Net Sales

Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

Western Manufacturing Corporation Actual 20X4 20X3 20X2 20X1 20X Total Average

958

6,318 6,988 6,619 7,562 7,184 34,671 6,934

32,288 33,633 35,077 37,169 39,319 177,486 35,497

28,319 29,877 28,067 31,412 33,660 151,335 30,267

5.87 6.45 6.13 6.65 6.12 — 6.25

15.50 15.50 15.50 15.50 15.50 — 15.50

15.37 15.74 14.77 15.91 16.44 — 15.66

Cash Flow* Amount % Net Sales

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20X1 20X2 20X3 20X4 20X5 Total Average

20X4 20X3 20X2 20X1 20X Total Average

20X1 20X2 20X3 20X4 20X5 Total Average

327,290 339,810 350,500 368,830 388,280 1,774,710 354,942

291,876 298,137 297,965 311,090 322,116 1,521,184 304,237

118,980 122,820 124,200 129,030 134,610 629,640 125,928

1.61 3.52 3.15 5.23 5.27 — 3.67

2.50 2.15 — 4.40 3.54 — 2.51

1.32 3.23 1.12 3.89 4.32 — 2.73

E XHIBIT 52.17

C OMPARATIVE S ALES , E ARNINGS , AND

C ASH F LOW D ATA

* Net income, plus depreciation, depletion, and amortization, if applicable.

Projection

Merged Companies Historical

Forecast

FOR

9.45 9.96 10.15 10.49 10.48 — 10.12

9.20 9.37 9.02 10.02 10.16 — 9.57

8.50 9.00 9.50 9.50 9.50 — 9.21

20,415 21,337 22,336 23,550 24,827 112,465 22,493

17,829 18,515 16,693 20,069 21,438 94,544 18,909

5,000 5,280 5,590 5,805 6,055 27,730 5,546

6.24 6.28 6.37 6.39 6.39 — 6.34

6.11 6.21 5.60 6.45 6.66 — 6.22

4.20 4.30 4.50 4.50 4.50 — 4.40

52.18

39,428 41,123 42,652 45,039 47,529 215,771 43,154

34,637 36,865 34,686 38,974 40,844 186,006 37,201

7,140 7,490 7,575 7,870 8,210 38,285 7,657

12.05 12.10 12.17 12.21 12.24 — 12.16

11.87 12.37 11.64 12.53 12.68 — 12.23

6.00 6.10 6.10 6.10 6.10 — 6.08

959

Cash Flow* Amount % Net Sales

Financial Report on a Potential Acquisition

M ERGER S TUDY — IN S UBSTANTIAL D ETAIL (C ONTINUED )

30,941 33,834 35,562 38,638 40,694 179,669 35,934

26,842 27,923 26,870 31,177 32,741 145,553 29,111

10,110 11,050 11,800 12,260 12,790 58,010 11,602

A PPENDIX I W ESTERN M ANUFACTURING C ORPORATION AND S OUTHERN M ANUFACTURING C OMPANY S ALES , E ARNINGS , AND C ASH F LOW F OR THE Y EARS 20X4 T HROUGH 20X5 (D OLLARS IN T HOUSANDS ) Net Sales Pretax Earnings Net Income Amount % Increase Preceding Year Amount % Net Sales Amount % Net Sales

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Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

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20X1 20X2 20X3 20X4 20X5 Total Average

E XHIBIT 52.18

1,000 1,000 1,000 1,000 — 1,000

2,000 2,000 2,000 2,000 2,000 — 2,000

FOR

90,000 92,706 95,197 98,600 — 95,523

260,719 270,176 280,322 290,867 301,639 — 280,745

S ELECTED D ETAILED S HAREHOLDER D ATA

Southern Manufacturing Company Actual 20X4 20X3 20X2 20X1 Total Average

Forecast

2,000 2,000 2,000 2,000 10,500 2,100

6,600 6,600 6,600 7,200 8,000 35,000 7,000

M ERGER D ISCUSSIONS

90.00 92.71 95.20 98.60 — 95.52

130.36 135.10 140.17 145.43 150.82 — 140.38

2.00 2.00 2.00 2.00 10.50 2.10

3.30 3.30 3.30 3.60 4.00 17.50 3.50

4,218 4,706 4,491 5,403 23,829 4,766

15,415 16,057 16,746 17,745 18,772 84,735 16,947

4.22 4.71 4.49 5.40 23.83 4.77

7.71 8.03 8.37 8.87 9.39 42.41 8.48

A PPENDIX II W ESTERN M ANUFACTURING C ORPORATION AND S OUTHERN M ANUFACTURING C OMPANY S ELECTED S HAREHOLDER D ATA 20X4 T HROUGH 20X5 Earnings Applicable* to Common Equity at Year End Dividends Common No. of Shares Per Amount Per Per Issued† (000) Amount ($M) Share ($) ($M) Share ($) Amount ($M) Share ($) Western Manufacturing Corporation Actual 20X4 2,000 220,000 110.00 6,000 3.00 13,611 6.81 20X3 2,000 227,809 113.96 6,000 3.00 13,809 6.90 20X2 2,000 234,011 117.00 6,000 3.00 12,202 6.10 20X1 2,000 242,077 121.04 6,600 3.30 14,666 7.33 20X 2,000 251,904 125.95 6,600 3.30 16,427 8.22 Total — — — 31,200 15.60 70,715 35.36 Average 2,000 235,160 117.59 6,240 3.12 14,143 7.07

960

31.65 32.97 29.18 37.80 —

7.5 7.0 6.5 7.0 —

9.0 9.0 9.0 9.0 9.0 —

8.0 8.0 8.5 8.0 8.5 —

54.48 55.29 45.75 58.64 69.87 —

69.39 72.27 75.33 79.83 84.51 —

Price Earnings Ratio

Market Price Per Share

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2,600 2,600 2,600 2,600 2,600 — 2,600 2,600 2,600 2,600 2,600 2,600 — 2,600

310,000 320,515 329,208 340,677 353,015 — 330,683 364,330 376,567 389,803 403,653 417,480 — 390,367

119.23 123.28 126.62 131.03 135.78 — 127.19 140.13 144.83 149.92 155.25 160.55 — 150.14

8,000 8,000 8,000 8,600 9,100 41,700 8,340 9,100 9,100 9,100 9,700 11,000 48,000 9,600

E XHIBIT 52.18

S ELECTED D ETAILED S HAREHOLDER D ATA FOR

3.08 3.08 3.08 3.30 3.50 — 3.20 3.50 3.50 3.50 3.73 4.22 — 3.70

M ERGER D ISCUSSIONS (C ONTINUED )

† Exchange ratio of .6 share of Western Manufacturing for each share of Southern Manufacturing.

* For simplicity, illustration assumes no preferred stock issued.

Average

20X1 20X2 20X3 20X4 20X5 Total Average Merged Companies Historical 20X4 20X3 20X2 20X1 20X5 Total Average Projected 20X1 20X2 20X3 20X4 20X5 Total

Forecast

52.18

17,829 18,515 16,693 20,069 21,438 94,544 18,909 20,415 21,337 22,336 23,550 24,827 112,465 22,493

74.58 78.00 85.90 90.06 95.50 — —

Market Price Per Share 37.50 39.60 44.72 46.48 48.48 —

9.5 9.5 10.0 10.0 10.0 — —

961

Price Earnings Ratio 7.5 7.5 8.0 8.0 8.0 —

Financial Report on a Potential Acquisition

6.86 7.12 6.42 7.72 8.25 — 7.27 7.85 8.21 8.59 9.06 9.55 — 8.65

A PPENDIX II W ESTERN M ANUFACTURING C ORPORATION AND S OUTHERN M ANUFACTURING C OMPANY S ELECTED S HAREHOLDER D ATA 20X4 T HROUGH 20X5 Earnings Applicable* Common Equity at Year End Dividends to Common No. of Shares Per Amount Per Per Issued† (000) Amount ($M) Share ($) ($M) Share ($) Amount ($M) Share ($) 1,000 103,611 103.61 2,500 2.50 5,000 5.00 1,000 106,391 106,39 2,500 2.50 5,280 5.28 1,000 109,481 109,48 2,500 2.50 5,590 5.59 1,000 112,786 112.79 2,500 2.50 5,805 5.81 1,000 115,841 115,84 3,000 3.00 6,055 6.06 — — — 13,000 13.00 27,730 27.74 1,000 109,642 109,64 2,600 2.60 5,546 5.55

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962

Ch. 52 Financial Planning and Analysis for Acquisitions, Mergers, and Divestments

A CQUIRING C ORPORATION S UMMARY OF C OMBINED R ESULTS ( DOLLARS IN MILLIONS , EXCEPT PER SHARE ) Year

Buying Company

A. Net sales 20X1 20X2 20X3 20X1–X9 Average B. Net income 20X1 20X2 20X3 20X1–X9 Average C. Earnings per share Number of shares outstanding 20X1 20X2 20X3 20X1–X9 Average D. Rate of return Discounted cash ﬂow basis 20X1–X9 On assets employed 20X1 20X2 20X3 20X1–X9 On shareholders’ equity 20X1 20X2 20X3 20X1–X9 E XHIBIT 52.19

S UMMARY

OF

Selling Company

Combined

$

390 430 450 5,400 $ 540

$

90 120 150 2,320 232

$ 480 550 600 7,720 $ 772

$ 23.4 26.7 28.4 340.2 $ 34.0

$

5.7 7.7 9.7 155.4 15.5

$ 29.1 34.4 38.1 495.6 $ 49.5 10,000,000

$ 2.34 2.67 2.84 34.02 $ 3.40

17.6% 9.8 10.3 10.4 10.6

$ .57 .77 .97 15.54 $ 1.55

16.0% 9.6 9.7 9.8 9.9

24.3 23.7 23.4 23.2

C OMBINED O PERATING R ESULTS

$ 2.91 3.44 3.81 49.56 $ 4.95

17.1% 9.7 10.1 10.3 10.5 24.2 23.9 24.2 25.1

WITH

A DDITIONAL D ETAIL

52.19 MISTAKES BY MANAGEMENT In the past, there have been a high number of successful acquisitions. Yet, there also have been a signiﬁcant share that have not achieved the results anticipated. While expectations may have been too high in some instances, in other cases some seemingly minor oversights led to disappointment by the new owners. A summarization of some causes of failure may be useful: • Failure to respond to customer needs or to emphasize quality. Perhaps the emphasis was on costs or selling prices, while neglecting customer complaints.

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52.19 Mistakes by Management

963

• Failure to properly integrate the acquisition. This aspect is discussed in the next section. • Undue emphasis on labor costs. Some acquirors have focused attention on labor costs, even though, with automation, such costs aggregate less than 15% of total costs. Perhaps more is to be gained by motivating the labor force instead of downsizing. • Focusing attention on the high-margin products while neglecting low-margin items. In some endeavors, such as the commodity business, attention to small but vital upgrades in the high volume products can produce signiﬁcant proﬁt improvement. • Failure to recognize the weaknesses of portfolio management. Some acquiring managements treat each acquisition as a separate investment, emphasizing growth market share and growth rate. It hopes to move each investment into a more favorable cash generator sector. If the management of an acquired business regards itself as a stand-alone or salable business, barriers arise between the two managements, and the exchange of technology or management ideas becomes inhibited. Moreover it may become necessary to match the investment of less diversiﬁed competitors of each such separate businesses—reducing the anticipated rate of return. • Failure to commercialize innovation. Often it is said the Americans invent the product but the Japanese successfully sell or commercialize it. Such mismatching can be reduced in many cases by closely linking R&D, and manufacturing and marketing. U.S. companies perhaps should consider the setting of goals for commercializing of innovation, measuring the development time, and making every effort to shorten it. • Failure to take a long-term view of discounted cash ﬂow analysis. The DCF process gives great weight to the immediate years; but it may be necessary to consider the entire product life cycle. The near-term development years may reﬂect a low DCF rate of return which is more than offset by a very high rate of return in the later years. As someone allegedly has said, “If IBM had demanded as high a rate of return on its early computers as it earned on other products, it might still be making adding machines.” • Acquiring a business the new management did not really understand. This is discussed in the next section. • Failure to spot overvalued assets. Some companies make the mistake of not throughly analyzing the accounts receivable and inventories of the companies they are acquiring, resulting in the realization after the fact that much of these assets must be written off. Accounts receivable may require a write-off if they are unusually old, of course, but management should also look at the volume of invoices that were credited and rebilled to see if there is an underlying billings problem that may result in an exceptionally large number of write-offs. Inventory may require a write-off if the staff of the acquired company cannot readily locate it, or if inventory counts are clearly incorrect. The purchasing company should also conduct price tests on the most expensive inventory items to see if there is any overvaluation. Also, an appraiser can be called in to determine how much of the inventory can be proﬁtably returned to suppliers, or at least to determine the write-off that would be required to return it. Finally, it is useful to examine inventory usage records to determine the age of a representative sample of the inventory, which is a strong indicator of the need to write off inventory. (a) DIVERSIFICATION AWAY FROM THE CORE BUSINESS. As mentioned in Section 52.2, among the reasons for acquiring another business may be diversiﬁcation for growth as well as diversiﬁcation by customer or market to offset seasonal factors or a declining product market. These, indeed, may be legitimate reasons for diversiﬁcation. However, in connection with the environmental analysis desirable in strategic planning, a company management should be aware of the “success” factors, also called “critical success factors” that are responsible for a company’s progress. (See Chapter 12.) It is equally true that in making an acquisition the acquiring company management should really understand the business of the acquiree. Many company managements assume that if they can successfully run one

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business, then they can run any other business. An implicit assumption in this thinking is that it can learn sufﬁcient information about the new business in a timely manner. But the numerous failed acquisitions attest to the fact that the acquiring management simply did not understand the critical success factors. So the generalization can be made that diversiﬁcation into new, unrelated lines carries with it increased risk; and some provision should be made to at least partially compensate for these risks. But how? One well-known authority, in a thought-provoking article has these suggestions for improving the success rate of nonspecialized diversiﬁcation.3 • Choose the right people. Quite often, the people at the top corporate level are those who built the company. They may have strong ideas about changing the method of doing business. Therefore, if a present manager is unable or unwilling to accommodate rapid change, a reassignment of duties may be desirable before attempting to diversify. • Change the environment. Any major change in how business is done usually carries with it a major change in the corporate culture. It may be prudent, therefore, to relocate the company headquarters in an attempt to eliminate the old cultural trappings. • Choose the proper organizational structure. In many old companies there exists strong central control—perhaps too strong. Yet, many successfully diversiﬁed companies are decentralized so as to allow the local business managers to make competitive decisions as to product prices and customers. But, top corporate management continues to plan the general course of the company and to monitor the subsidiary or division businesses it controls. Therefore, two levels of management, physically separated, may be necessary. • Choose the right strategies when diversifying. Quite often, when companies decide to diversify they select the wrong acquisition before considering these four courses of action: 1. Diversify gradually—since assimilation takes time. Don’t attempt to digest too much too soon. 2. Identify the acquiring company’s distinctive capabilities to see if they can be used. These might include special manufacturing know-how, research and development expertise, a marketing organization, or organization strength. 3. Eliminate the (old) industry-imposed restrictions that impede business decisions. 4. Explicity plan for change as distinct from business operational planning. This will include a two-tier planning organization as previously mentioned. • Choose the right timing. As in many actions, the proper timing is important. For example, a growing company in a growing industry would seem to lack a compelling reason to diversify. If the potential acquiree is in decline, the best time to make the purchase may have passed.

52.20 EFFECTIVE INTEGRATION There are situations wherein the product line of the acquired company was superb, the marketing policies and strategies well founded, the manufacturing processes excellent, and the ﬁnancial analysis for the acquisition unsurpassed. Yet the acquisition was basically a failure. Why? Because the target entity was not properly integrated into the acquiring company. The management of the acquired company was left largely alone. It was not guided or given assistance in solving some of its problems. Moreover, the acquiring company’s procedures were forced on it. A successful integration of two cultures involves a mutual educational process. The management of the acquiring company, including the controller and other ﬁnancial ofﬁcers, should give thought to: • The business of the acquired company must be so managed that market share, competitive position, and operating efﬁciency are not lost. To accomplish this may require management

3. Adapted from Milton Leontiades, “The Case for Nonspecialized Diversification,” Planning Review, Jan.– Feb. 1990, pp. 28–32.

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support and ﬁnancial help from the acquiring company. (The required investment should have been provided for in the cash ﬂow estimate.) • The beneﬁts or opportunities foreseen before the acquisition must be pursued so as to be realized. They cannot be left to chance. • The policies and procedures of each company, acquiring and acquired, ought to be examined to see if changes should be made in either segment to beneﬁt the new operations. It well may be that many of the acquired’s practices should be continued and not changed to that of the acquiror. • The organization structure, reporting relationships, and authority and responsibility of each manager should be examined for any desired changes. Each manager should know his status or position in the new scheme of things. He should be made to feel “comfortable” and a part of the organization. • As developments dictate it, new strategies may need to be considered. • Periodically, the actual results of the newly acquired operation should be compared with what was expected to see if any corrective action is required.

52.21 DIVESTMENTS Up to this point, the discussions of this chapter have centered largely on acquisitions. Yet, for whatever reason, divestments often must be considered if the unsatisfactory operations or conditions cannot be corrected, or if the disposal is part of a “bust-up” acquisition. In any event, when it is ﬁnally decided that divestment is the best course, then the controller or other appropriate ﬁnancial ofﬁcer must make an analysis of the divestment candidate so that its fair value is known. Technically, some of the same techniques reviewed earlier for establishing the value of an acquisition can be utilized to determine the value of a divestment candidate. The ﬁnancial analysis should seek to establish these judgments: • The probable future earnings potential of the business segment • The probable future cash ﬂows of the segment • An estimated fair market value • What return can be secured from an investment of the divestment proceeds • Whether or not any minority interest should be retained in the divested segment • The impact on the owning company of the divestment—earnings and ﬁnancial position, including contingent liabilities, possible tax consequences, retirement fund liabilities, and so forth

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CHAPTER

53

ADVANCED ACCOUNTING SYSTEMS 53.1

PROCESS CENTERING 967

53.5

PAPERLESS OFFICE 977

53.2

PARTNERING 969

53.6

ELECTRONIC CASH 980

53.3

INTERNET 973

53.7

VIRTUAL CORPORATION 982

53.4

ISO 9000 976

53.8

DATA WAREHOUSING 984

53.1 PROCESS CENTERING Process centering is a simple concept: Instead of having a large number of people take part in completing a process, as many of the functions as possible should be centered on one person. The reason for this approach is that a very large amount of time is spent moving documents from person to person; all of this movement time can be saved by keeping the work with one person and never moving the paperwork. For example, the insurance industry is famous for taking weeks to process claims that really require only a few minutes of work—the rest of the time is wasted while documents move between various departments and wait in the work queues of each person who takes part in the process. Another reason for using process centering is that information can be lost when it is moved between people. For example, if the paperwork associated with a transaction must be handled by ten people, this represents ten situations in which the information can be lost. By having one person handle a transaction from start to ﬁnish, it can be completed faster while also avoiding the loss of crucial information. There are a number of implementation issues for a process centering system that impact the accounting department. One is that some accounting functions should not be included in the process centering changes because of the potential loss of assets. For example, any staff outside of the accounting department should not be given control over cash. Doing this tempts employees to divert the cash for their own uses, whereas the controls already imposed over cash within the accounting department are sufﬁcient in most cases to prevent signiﬁcant losses of cash. Another area is the write-off of bad debts. This is a function that should be kept within the accounting staff so that the controller can approve speciﬁc credits. Otherwise, employees would be tempted to issue credits indiscriminately and then divert any incoming funds that have been credited to their own uses. Also, issuing credit to customers can be mishandled in a process centering environment, because employees may be tempted to increase sales with no regard to the difﬁculty of collecting the cash once the sale has been made. Finally, there are several areas in which privacy or technical expertise requires that the function continue to be handled by the accounting department; the obvious examples are the preparation of tax returns and the continuing maintenance of the payroll function. In short, there are a large number of accounting functions that should not be dispersed to other parts of the company as part of a process centering system—it is better to leave the accounting functions largely intact. 967

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In some cases, accounting functions will be dispersed to process teams despite the objections of the controller. In these instances, it is extremely important that the employees taking on the accounting tasks be given large amounts of in-depth training, so that they will be able to complete the accounting tasks with a minimum number of errors; an alternative in cases in which there is no time for training is to move former accounting staff onto the process teams, where they will be responsible for completing the accounting tasks. The remaining accounting staff should be available on a continuing basis to provide coaching to the process teams on any accounting-related issues; the staff should also conduct continuing reviews of the transactions being completed by the process teams to see what kinds of problems are arising. A ﬁnal implementation issue is to ensure that anyone using the accounting computer system, no matter where they may be within the company, has access to the system; this may require the installation of additional cabling, more terminals, and possibly even a software license that allows usage by more users. By completing these tasks, moving some accounting functions outside of the accounting department has a greater chance of success. Several key control points can be implemented that will help to reduce the number of errors if any accounting transactions are moved into process teams. One is to have the internal audit department audit the transactions created by the process teams. This action will tell management which employees require further training before they can successfully complete accounting-related tasks. Another approach is to move accounting staff into the process teams, so that an experienced person is available who can complete the accounting transactions. Also, to avoid problems with theft or inadvertently lost assets, two people can be assigned the task of completing any accounting-related transactions—it now requires collusion for theft to occur. The amount of theft can be reduced by allowing process teams to complete transactions only for amounts that are limited by an upper amount; all other larger transactions must be forwarded to the accounting staff for completion. By using an audit team, moving accounting staff to the process teams, having several process team members complete accounting transactions, and limiting the size of transactions, it is possible to reduce the risk of loss when nonaccounting personnel work on accounting transactions. When process teams are allowed to complete accounting work that was previously completed by the accounting department, it is obvious that many inputs into the accounting department will arrive fully completed, which has the signiﬁcant impact of shrinking or eliminating the bulk of the accounting staff’s transaction-related work. It is therefore likely that the number of accounting employees will be reduced. However, some of the displaced staff can still be used to conduct error checks of the incoming transactions. Depending on the amount of training given to the process teams, the number of accounting errors can either increase or decrease as a result of moving the completion of transactions to them. If the new employees are heavily trained or (even better) if accounting personnel are moved to the process teams, there can be a reduction of accounting errors, because fewer people will be involved with each transaction, which reduces the risk of problems arising due to the movement of paperwork. However, with minimal staff training, there can be a signiﬁcant rise in the number of accounting errors, because accounting work requires a signiﬁcant level of experience before all errors disappear from the process. On the whole, it is more likely that the number of errors will increase when accounting functions are shifted to process teams, especially in the short term, when the teams are still acquiring experience. There are several costs associated with moving accounting functions to process teams. The most signiﬁcant cost is training for the team members so that they will be fully qualiﬁed to take on the new tasks. Additional costs are mostly related to giving the process teams access to the accounting computer system, which includes the cost of placing terminals near the process teams, stringing cable to the terminals, and acquiring an accounting software license that covers the additional number of users. A ﬁnal cost is for the accounting staff time needed to research and ﬁx any accounting errors input into the system by the process teams; this cost tends to be very high when tasks are initially given to the process teams and then goes down (but not away) after the process teams learn from their initial mistakes. The primary accounting costs related to giving

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accounting tasks to process teams are for training, computer system extensions, and labor to ﬁx transaction errors. There are several measurements that should be tracked in a process centering environment, because they give management a clear understanding of problems caused by having process teams undertake accounting functions. The measurements are: • Bad debt write-offs. Process teams who are allowed to grant credit to customers may do so with little regard to the credit risk of those customers. This problem is most prevalent in situations in which process teams are rewarded for increasing sales but not for the volume of cash collected. By closely reviewing the amount of bad debt write-offs (which is typically tracked in a separate general ledger account), management can determine whether this is an actual problem. • Payment levels to suppliers. Process teams can shift business to preferred suppliers (possibly owned by the process team members), and end up paying excessively high per-unit amounts to these suppliers, possibly in exchange for kickbacks. By tracking changes in the level of payments to suppliers or sudden changes in the supplier base, management can possibly spot these illicit arrangements. This measurement can be periodically reviewed and compiled by the internal auditing department, which is in the best position to conduct such reviews. • Volume of transaction error rates. When accounting transactions are handed over to process teams for processing, it is likely that these less experienced employees will make mistakes. The accounting staff can track changes in the number of transaction errors, preferably by an individual process team, to determine where additional training is needed to drop the number of errors. This is measured by assigning unique password identiﬁers to each process team, which are linked to each accounting transaction. Then, when the accounting department ﬁnds and must correct a transaction, it can see on the transaction record who originated the transaction, and the error can be charged to that process team. However, many low-end accounting systems do not store information about who entered a transaction, which makes this a difﬁcult performance measure to track with those systems. In short, giving accounting tasks to process teams is generally not a good idea. It avoids a large number of controls that are built into the accounting department, which increases the risk of theft if dishonest employees on the process teams try to shift cash or other assets to themselves. There is also a probable risk of having more transaction errors that must be ﬁxed, while costs must be incurred to train and provide software access to the process teams. (This discussion is oriented more toward showing the controller how to mitigate the risks of using process teams than of trying to present a convincing argument for using them.)

53.2 PARTNERING Partnering sounds simple and logical, but is the antithesis to what most companies practice. Simply stated, partnering is the process of trusting one’s trading partners enough to interlock operations more closely. This is greatly at odds with how most companies treat their trading partners, which is very much at arm’s length and with great distrust. For example, a typical company puts all large purchases out to bid and accepts the lowest bid. This practice requires a large amount of labor and time by the purchasing staff, who must coordinate the bids and issue contracts. In a partnering situation, the company will have only one supplier for each product, which means that there can be no bidding process—the same supplier gets all of the business for a speciﬁc part. The purchasing department turns its energies to winnowing down the supplier base to those few companies that are reliable enough to become sole-source suppliers, and also negotiates year-long blanket purchase orders with the supplier instead of issuing multitudes of purchase orders for single shipments. Also, the companies tend to correspond electronically, using electronic data interchange (EDI) to route orders and other transactions back and forth; setting up these systems can be expensive, so they are more commonly found in partnering situations in which the participants know they will be

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Ch. 53 Advanced Accounting Systems

working together for a long time. A typical company also keeps its product speciﬁcations to itself, whereas companies in partnering situations tend to exchange product information. This is very useful for the company creating the end product, because suppliers can tell the company how to redesign the product so that the component parts will be cheaper, which may yield either higher margins or greater sales (by allowing the company to drop its price). Yet another partnering beneﬁt is that several companies may jointly fund the development of a new product that is too expensive for one company to create, and then share in the resulting proﬁts. Finally, partners who are customers can electronically send orders into the company’s order-entry system, and even go into the company’s computer system to lock in space on the company’s production schedule to produce products for them, which greatly reduces the company’s need to manually input this information. In short, partnering reduces the number of trading partners, eliminates the bidding process, increases the transfer of electronic information, increases the amount of interaction in the design of new products, allows for joint funding of new-product development, and improves the transfer of information from customers. There are a number of implementation issues for a partnering situation that impact the accounting department. One issue is that long-term partners tend to switch away from individual purchase orders to blanket purchase orders, because they are committed to long-term contracts involving buying large numbers of products from each other. The accounting department does not want to lose track of these blanket purchase orders, because they must be used frequently to match to supplier invoices. The best ways to avoid losing them include locking up the master copy and working only from copies, as well as keypunching the blanket order into the computer database, where it cannot be lost unless the computer backup system is not functional. Another problem for the accounting department is the increased use of wire transfers. Longterm trading partners tend to use wire transfers more frequently, because it is worth their time to obtain bank routing information from each other in exchange for quicker cash transfers. Someone in the accounting department must be responsible for logging in these transactions and recording them against accounts receivable. The easiest approach is to give someone access by modem to the company’s transactions at the bank, which can be accessed each day to determine what transfers have arrived. This can also be converted to an interface to the bank that automatically matches wire transfer receipts against accounts receivable. This interface is expensive enough to program that it is usually created only for high-volume wire transfer situations. Another issue is that some of the company’s staff may move to partner locations, which allows them to interact better with their counterparts at those companies. This presents a problem for the accounting department in the payroll area, because it must collect their hourly pay information and somehow route each paycheck to them. The best ways to avoid these problems are to encourage moving these people to salaried status so that no hourly information needs to be collected, and to use direct deposit so that payments are automatically routed to the bank accounts of those employees. Another by-product of partnering is that the accounting department is called on to conduct a somewhat smaller number of credit checks on customers, because a large proportion of customers are so long term that the company already has a good credit history with them. Another issue is that partners may ask to store some of the company’s inventory at their locations, possibly on a consignment basis. The accounting department needs to have some method for tracking this inventory. The most advanced, and least used, method is to locate computer terminals at every consignment location so that the partners can enter inventory transactions online as inventory is received or used. A more common approach is to fax transactions back to the accounting department, which veriﬁes the accuracy of this information with periodic visits by internal auditors. Finally, there may be proﬁt-sharing deals with selected partners, depending in amount on who has committed resources to the various projects. The accounting staff will be called on to calculate and report on the proﬁt splits for various joint ventures and disseminate this information (along with payments) to the various participating partners. In short, there are a large number of implementation issues to consider for the accounting department when partnering arrangements are created. There are a number of control problems that arise when a company sets up partnering agreements with its trading partners. One is that it becomes very easy to forget the terms of pay-

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ment for parts shipped between partners, resulting in incorrect billings and payments. To avoid this problem, the appropriate control point is to store all contract prices in a database that is automatically reviewed by the accounting software when invoices from suppliers are received to see if the billed part prices are correct; any variances from the contract prices will be ﬂagged and automatically brought to the attention of the accounting staff for correction. Partners also tend to send more payments by wire transfer, which can be diverted by a dishonest employee. This problem can be avoided by installing password control over all wire transfers. This control may be a password required to initiate an individual wire transfer, or it may be periodic management review of batches of wire transfers prior to their initiation. In addition, inventories may be stored at partner locations. These can be reviewed by roving teams of internal auditors, which provides an “after-the-fact” control over their use. The auditors should compare actual inventory amounts to the usage records maintained by the partners at each location to determine whether record keeping is accurate and, if not, what transaction errors are occurring that are causing the problem. Finally, blanket purchase orders are used far more frequently in a partnering environment; if these are lost, it is much more difﬁcult to verify the authorization for payment of supplier invoices. To avoid this problem, the easiest control point is to either tightly control a master copy of each blanket purchase order or store the information on all master purchase orders in the accounting database, where it cannot be lost if the system is properly backed up. In summary, control points are needed to ensure that correct contract prices are used, wire transfers are not diverted, off-site inventories are accurate, and master purchase orders are not lost. There are a few changes to the inputs to and outputs from an accounting department when partnering is used. One input change is that more electronic transactions can be expected to arrive from trading partners, usually in the form of electronic interchange transactions or wire transfer payments. This reduces the amount of data-entry work by accounting clerks. Also, because longterm relationships with partners tend to encourage the use of blanket purchase orders, there is a smaller volume of purchase orders to sift through when matching purchase orders to supplier invoices. This change in inputs tends to reduce the amount of accounts payable clerical work. The one change to accounting outputs is that some partners may need periodic proﬁt-sharing reports that show the ﬁnancial results of joint projects and the calculation of how the resulting proﬁts were split. Because there may be a variety of partners cooperating on a large number of projects, this additional reporting may be a signiﬁcant burden on the accounting department, requiring the use of additional ﬁnancial analysts to complete. When partnering is used, inputs shift from being paper-based to electronic, whereas outputs may be expanded to include proﬁt-sharing reports. Partnering typically results in fewer errors in accounting transactions for a variety of reasons. One is that a company usually has fewer trading partners when they are all of the long-term variety, so paperwork does not get lost among the documents for the vast number of other customers or suppliers. Also, partners tend to use blanket purchase orders, which greatly reduces the number of purchase orders and therefore makes it easier to match accounts payable documents. Additionally, partners use EDI more frequently, which means that data can be sent straight into the accounting database with no need for manual rekeying of information and the associated risk of rekeying information incorrectly. The only increased chance of having errors in a partnering situation is a company’s keeping its inventory at a partner location, which may result in lost inventory. In general, accounting errors tend to decline when a company shifts to partnering arrangements with its key trading partners. There are several offsetting cost increases and decreases for the accounting department related to having partnering agreements. One is the additional cost of creating EDI links to trading partners, with attached interfaces that automatically convert incoming transactions into the appropriate format for the company’s computer systems. The cost to program and test an interface tends to be particularly expensive. Offsetting this considerable cost is the reduction in labor for manually entering transactions, because the automated interface now sends a portion of all transactions straight into the accounting database with no need for manual data entry. In addition, because there are fewer transactions that can have data-entry errors, there is also less labor needed for error

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correction work. Thus, the considerable up-front cost of creating automatic interfaces to trading partners is offset over time by the reduced cost of data-entry labor. There are a number of measurements that are useful for tracking the efﬁciency and effectiveness of partnering agreements. Not all of the measurements shown below can be accumulated by the accounting department, but all of the measurements can be collected from other departments and included in the periodic internal ﬁnancial reports issued by the accounting department. The following list of measurements includes a description, how to calculate it, and why it is useful: • Payment terms. This is the number of days allowed to lapse before payment is due and frequently includes an option to pay early while taking a small discount from the total amount due. Payment terms tend to improve when a company has long-term business partners, because they trust each other enough to avoid imposing onerous payment terms such as cash on delivery or in advance. This can be tracked either for each individual trading partner or as an average of the terms for all partners. The average is calculated by converting all of the payment terms ﬁelds in the computer into the number of days until payment is due (which usually requires some custom programming), summarizing the number of these days, and dividing them by the total number of trading partners. • Proportion of sales expense to revenues. This measure shows how much sales-related cost is required to generate a given level of sales. When partnering is used, there tends to be signiﬁcantly less need for a sales staff, because there is no need to prospect for sales or familiarize customers with the company’s products. In addition, electronic purchases tend to bypass the sales force. The net result is that tightly interlocked business partners frequently maintain sales forces only to go after sales to brand-new customers, and have no sales personnel at all for existing, long-term customers. This measurement is calculated by summarizing all of the costs for the sales department as noted in the general ledger (e.g., the costs of salaries, commissions, payroll taxes, telephones, travel, and entertainment) and dividing this amount by total revenues for the same period. • Proportion of purchasing staff to cost of goods sold. This measure shows how much cost is required to negotiate and coordinate the acquisition of materials for a given level of sales. Partnering arrangements tend to require fewer purchasing staff, because there is more use of automatic electronic ordering between business partners, usually using EDI. These transactions can be automatically interfaced into a company’s computer systems, so that there is little manual work to be performed by the purchasing department; thus, some reduction in the number of purchasing staff can be expected. This measurement is calculated by adding up all of the costs in the general ledger related to the purchasing department (e.g., payroll, payroll taxes, telephones, travel and entertainment, and occupancy) and dividing this amount by the total revenues for the same period. • Number of suppliers. This measure shows how many relationships must be maintained with business partners in order to conduct business; a smaller number of suppliers requires less effort by employees to conduct day-to-day operations and is therefore desirable. The easiest way to calculate the total number of suppliers is to print the total number of suppliers as listed in either the accounts payable or purchasing systems (they should reference the same database of suppliers) and adding up the number of suppliers on this list. The list should be updated quarterly and unused suppliers purged from the list so that this listing is an accurate representation of the total number of suppliers currently in use. • Number of inventory turns. This measure shows how efﬁciently the inventory is being used. A low inventory turnover ratio indicates that inventory may include obsolete components or that purchasing systems are ignoring on-site inventories in favor of purchasing new stock; in either case, the company’s investment in inventory is excessive. Turnover is calculated by dividing the average inventory (i.e., the beginning inventory plus the ending inventory, divided by two) by the total cost of goods sold.

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• Target cost variances. This measure shows how well suppliers are meeting their costing targets, as well as the ability of the product design teams to meet their costing goals. Excessive target cost variances show suppliers not being adequately controlled by the purchasing staff, as well as the possibly poor setting of initial target costs or bad engineering team management. To calculate these variances, store the engineers’ target cost information in an empty ﬁeld in the inventory costing database (perhaps in an average cost ﬁeld if that ﬁeld is unused), and then write a custom report that lists the target and actual costs alongside each other and shows the difference in costs between the two numbers. • Proportion of electronic transactions to total transactions. This measure shows how closely the information systems of the company and its business partners are linked. Tightly interlocked systems frequently utilize EDI to move transactions back and forth, which represents a cost reduction in the number of data-entry staff needed to manually keypunch this information. The measurement can be difﬁcult to calculate. The computer system must compile the total number of transactions in one database register, while also summarizing the total number of purely electronic transactions (e.g., with no human interference) in another register. These two numbers can then be compared to determine the proportion of electronic transactions to total transactions. Custom programming is usually needed to obtain this information. • Supplier rating scale. Suppliers can have wildly varying levels of performance. If they consistently do a poor job of delivering quality parts in the correct quantities at the right time, they can have a serious impact on a company’s ability to produce its products on time. Clearly, a supplier’s overall performance must be tracked so that a company can decide if the relationship should be terminated. The rating scale can include a variety of performance measurements. The simplest measurement (and one that can be automatically measured by many accounting systems) is the number of days late on a delivery. The computer system can simply subtract the due date as noted on the purchase order from the actual receipt date to determine the number of days late. This information can then be compiled for each supplier so that an average number of days late can be determined. In addition, the quantity ordered on the purchase order can be compared to the quantity delivered to determine the average amount of short-ships by supplier. Finally, the number of units rejected (which is stored in many receiving databases) can be compared to the total amount received to determine the average percentage of rejections for each supplier. These three measurements can be kept separately or summarized in a variety of ways to arrive at a rating scale for suppliers that gives management a very good understanding of the performance of all suppliers. In summary, partnering involves the closer interaction of a company and its trading partners. This interaction requires the accounting department to handle more electronic transactions, report on proﬁt-sharing splits with partners, use direct deposit for employees located at partner sites, track more off-site inventory, and handle increasing volumes of blanket purchase orders. Control over new partner-related processes will require more review by the internal audit staff, as well as password control over wire transfers and the creation of databases to store information about contract prices and blanket purchase orders. These changes will result in one-time costs related to creating EDI interfaces to the accounting system, plus long-term savings from using fewer data-entry personnel. These changes will result in new measurement requirements, especially for the number of suppliers, a supplier rating scale, target cost variances, and the number of inventory turns.

53.3 INTERNET The Internet is a worldwide cluster of networks that allows users to access and transmit information almost anywhere. A user typically connects to the Internet through a service provider, who maintains an electronic mailbox for the user for a monthly fee. The service provider’s network is linked to a high-speed transmission channel such as a ﬁber-optic cable that allows large

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quantities of data to be transmitted to other network servers who are also tied into this high-speed transmission channel. Some users, such as universities, post information on the Internet for anyone to access. Others, such as online bookstores, have products to sell; their Internet sites allow users to place orders, usually with credit cards that are veriﬁed online by a bank. In these cases, the user typically enters an order directly into the order-entry system of the company maintaining the Internet site, which eliminates the cost and error risk of having a data-entry person perform the same function. Any backlog notiﬁcations are automatically sent to the user by e-mail. Other, more advanced functions include online access to real-time video camera images of many locations around the world, online manipulation of robots, and even telephone calls. In short, the Internet is a vast, interconnected web of networks that allows users to shop, obtain information, or send messages to and from millions of locations around the world. There are a number of implementation issues for an Internet site that affect the accounting department. One is the need to install automatic error-checking routines in the site’s order-entry screen. Customers are entering their own orders into the system, and it is important that they enter all information correctly; if not, the accounting staff may be called on to contact them to ﬁx some incorrect information. To avoid this problem, the accounting staff should be involved in designing error-checking programming for the order-entry screen. For example, the “ship to” address must contain a zip code and a state, each line item must include a quantity, and each part number entered must match a valid part number in the company’s item master ﬁle. Another related problem is that the company may post incorrect product prices on the Internet site, which the accounting staff will have to correct after orders are entered that contain these incorrect prices. The best way to avoid this problem is to have the accounting staff involved in writing the interface that takes product prices from the company’s master pricing ﬁle and automatically updates the Internet pricing ﬁle. This involvement can include testing the interface to ensure that prices are updated regularly and correctly. The site may also have space for posting the company’s ﬁnancial information. If so, the accounting staff will be responsible for manually updating this information, which will require assigning this responsibility to someone on the staff, initiating a review process to verify that the information to be posted is correct, and creating a procedure showing how to post the information. Another issue is that customers may badger the accounting department about late product shipments if their products are not delivered on time. To avoid this problem, there should be a mechanism in the Internet site that sends an e-mail back to the customer that automatically notiﬁes them if products have been back-ordered and how long the wait is estimated to be. By proactively and automatically bringing this information to the customer, there is less need to manually track down the information later when the customer inquires about it. Finally, the accounting department should be involved in the design and testing of all interfaces from the Internet site to the company’s other systems. These interfaces include links to the order-entry system, inventory system, and a credit card veriﬁcation service. If any of these interfaces do not operate correctly, the accounting staff will probably be called on to manually ﬁx information related to customer orders, so it is worthwhile to spend time up front on these issues rather than later on and in larger quantities. In short, the accounting department must be concerned about such Internet implementation issues as interfaces, backlog notiﬁcations, order-entry error checking, pricing updates, and posting ﬁnancial information. Several controls must be implemented to ensure that having an Internet site will not lead to the loss of assets. One control is over the automated credit-granting rules used to issue credit to those customers ordering through the Internet site who are not using credit cards. These rules should be frequently reviewed by the internal audit staff and compared to any trends in credit losses through this sales channel to determine whether there is a need to change to stricter credit-granting rules. Another control is to ensure that all credit card payments are approved by the issuing credit card institution prior to making any shipment to the customer. Otherwise, the payment, as well as the corresponding shipment, may be lost. This control is of particular note for those companies that ship without credit approval in order to achieve a very marginal increase in the speed of shipment to customers. This increase may come at great cost if several credit card payments are rejected by the bank. Another control is needed over the posting of product prices on the Internet. If these

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prices are not updated regularly, customers will pay incorrect (and possibly lower) prices for their orders, which reduces the company’s revenues. This problem can best be avoided by creating an automated linkage between the Internet database and the company’s main pricing catalog, so that any changes to the prices in the catalog will automatically be changed in the Internet database. This interface should be thoroughly tested by the internal audit department when it is created, and infrequently tested for problems thereafter. Finally, the ﬁnancial information posted on the Internet site may be incorrect, which may cause problems (even lawsuits) with investors and analysts. This problem is best avoided by installing a manual control over the information posted on the Internet site. The information should be thoroughly checked and signed off on by a senior ﬁnancial ofﬁcer before it is transferred to the Internet site. Thus, controls over an Internet site are needed to ensure that credit is properly granted, credit cards are authorized, prices are updated, and ﬁnancial information is reviewed. There is one change to the inputs to the accounting function, as well as one change to its outputs when it is linked to an Internet site. The input change is that customer orders will be input electronically by the customers through the Internet site, which avoids the use of accounting clerks to enter orders and issue billings. The output change is that many Internet sites are used to post a company’s ﬁnancial results (especially if it is publicly held). This information is usually manually transferred from the usual printed ﬁnancial statements to the Internet site by an accounting staff person. In short, accounting labor is reduced when customer orders can bypass the order-entry function, whereas some additional labor is needed to provide the new output of ﬁnancial information posted on the Internet site. Accounting error rates tend to decline when customers enter their orders directly into a company’s computer system through an Internet site, because customers know exactly what they want and will enter precisely the correct information. A data-entry or order-taking person may not enter the information correctly. This reduces problems for the accounting department in terms of having to collect payment from customers who received the wrong order, or for having to issue credits for the same reason. However, error rates can rise if the order-entry screen on the Internet site does not have a large number of error-checking routines built into it that prevents customers from making incorrect orders. This becomes more important as the complexity of the order rises, especially if the product being ordered is so complex that changes in the speciﬁcations in one area will affect speciﬁcations in another area. For example, the fan on a personal computer will vary in size based on the power of the microprocessor chip. When different chip sizes are ordered, the order-entry system must know that different fan sizes must be built into the unit. Only when this level of complex error checking is built into the order-entry software will the accounting department receive the beneﬁts of having fewer order-entry errors. There are a number of new costs associated with the implementation of an Internet site that is equipped for commerce. The company must purchase a computer to link to the Internet, as well as Internet software; construct interfaces to the order-entry system, accounting system, and a credit card bank; and pay periodic fees for phone lines as well as for periodic maintenance of the system. In exchange for these costs, there will be some reduced clerical labor in the order-entry area, because some orders will be entered directly by customers through the Internet interface. The other major savings will be through revenues from new sales coming in through the Internet interface. These must be new sales and not sales cannibalized from other sales channels—otherwise, there will be no real increase in revenues to offset the considerable costs of the Internet site. To summarize, when a company creates an Internet site to sell its products, the accounting department must be involved in creating error-checking routines in the customer’s order-entry screen, as well as reviewing a variety of interfaces from the company’s pricing database to the order-entry database and inventory database, and externally to the bank that approves customer credit requests. The accounting staff must also manually update any ﬁnancial information that is posted on the Internet, review credit-granting rules (if any credit is granted), and ensure that goods are shipped only after credit card amounts are veriﬁed by the bank. Once the interface programming and computer hardware and software costs are expensed, the company will also experience some cost savings as order entry is automated. If all of these issues can be successfully

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handled, the company will ﬁnd that it has acquired a new sales channel that takes orders at minimal cost while increasing sales volume.

53.4 ISO 9000 Although an ISO 9000 system has a much greater impact on nearly all other company functions, there are a few accounting issues to point out—primarily those related to implementation, changes to controls, new system inputs and outputs, the impact on accounting transaction error rates and costs, and the need for a few new performance measurements. ISO 9000 is a set of quality standards that a company should follow by documenting related policies and procedures and then ensuring that they are followed. The ISO 9000 standards do not directly relate to the accounting function; instead, they are primarily concerned with the functions of the manufacturing and engineering areas, where a large number of functional areas are required to be documented and implemented. The purpose of the ISO 9000 standards is to force a company to have operations that must follow certain steps that make it more likely for the company to deliver a quality product to the customer. Once a company feels that its policies and procedures are consistent with the ISO standards and that it is following them, it calls in an independent auditor, who reviews the company’s documentation and then compares actual performance to the documents to see if the standards are truly being followed. If they are, the examiner then awards the company with an ISO 9000 certiﬁcation, which the company may use as proof of the quality of its operations with potential or current customers, which may allow it to either maintain or improve the volume of its business. There are a number of implementation issues for an ISO 9000 system that affect the accounting department. One issue is the greatly increased concern with nonconforming parts. Because the receiving department will now be careful to ﬁnd, segregate, and return these parts, the accounting department will probably be called on to measure the amount of them on hand, as well as determine how long they are kept on-site. This will require an inventory database that identiﬁes speciﬁc parts as being nonconforming, assigns a cost to them, and tracks their locations. The best way to do this is to set up a separate warehouse in the inventory-tracking database and have the receiving staff transfer the inventory to this warehouse when nonconforming characteristics are found. Then the cost of this other warehouse can be easily accumulated and audited for period-end ﬁnancial and operational reporting. The same issue arises for customer-supplied parts, which should also be tracked in a separate warehouse or group of bin locations, which allows the accounting staff to easily summarize the information and audit the underlying inventory. In addition, part of the ISO 9000 process is to make sure that purchase orders are fully completed, so that suppliers will know exactly what parts to send to the company. These purchase orders are easier for the accounts payable staff to use when matching them to supplier invoices, which may result in some labor savings in this area. In short, an ISO 9000 system will require the accounting staff to review and summarize the amounts of nonconforming and customer-owned parts, and may result in less document-matching work by the accounts payable staff. When ISO 9000 is installed, the only input change to the accounting system is that purchase order information is more complete; this allows the accounts payable staff to more rapidly match supplier invoices to the purchase orders. The only change in outputs is that the accounting staff may be called on to report on any nonconforming goods that have not been disposed of. This is more of a warehouse reporting issue, but the information may be summarized and reported as a line item in the periodic ﬁnancial reports issued by the accounting staff. Accounting system input and output changes are relatively minor when an ISO 9000 system is installed. The only accounting error that will be reduced when ISO 9000 is implemented is in the accounts payable matching area. A main tenet of ISO 9000 is that a purchase order must be completely ﬁlled out to ensure that suppliers know what products to deliver to the company. When this happens, the purchase order that the accounts payable clerk matches to the supplier invoice and receiving documentation becomes easier to correctly match, because there is typically more information on it. This reduces any errors related to rejecting payments to suppliers because the pur-

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chase order authorization does not appear to support the suppliers’ payment claims. Thus, more accurate purchase order information leads to fewer accounting errors in the accounts payable matching function. The cost of conducting accounting operations tends to be somewhat less when a company is ISO 9000 compliant. This is because one of the ISO 9000 requirements is that the purchase order information be as complete as possible so that suppliers can accurately ship the correct quantities and types of products to the company. Having these more complete purchase orders slightly reduces the workload of the accounts payable staff, who must otherwise try to match supplier invoices to purchase orders that do not contain enough information to identify the items on the supplier invoices. Thus, using ISO 9000 can lead to more efﬁcient matching of accounts payable documents, which reduces the work (and cost) of the accounts payable function. There are very few measurements that are useful for tracking how well an ISO 9000 system is working, short of conducting a full ISO 9000 audit. The following measures are all that concern an accounting department in relation to how it interacts with an ISO 9000 system. These measurements include a description, how to calculate it, and why it is useful. • Percentage of nonconforming items in stock. One aspect of an ISO 9000 system is determining whether received inventory conforms to purchasing speciﬁcations. If not, the received parts probably are of no use in the manufacturing process and must then be returned to the manufacturer. This problem can be tracked by having the receiving department enter conformance information into either a manual or computerized receiving log, which the accounting staff can then review to determine the percentage of receipts that contained nonconforming inventory items. • Percentage of purchase orders with incomplete key ﬁelds. Another ISO 9000 requirement is to issue purchase orders that are complete enough to allow suppliers to determine the correct speciﬁcations of the items being purchased. If these speciﬁcations are not complete, parts may arrive at the receiving dock at the wrong time, in an incorrect quantity, and possibly with the wrong dimensions or other characteristics. The internal auditing staff can track this problem by periodically reviewing a sample of purchase orders and checking for incomplete ﬁelds on each purchase order. In summary, the implementation of an ISO 9000 system requires that the accounting department track or at least report on the existence of nonconforming goods. The accounting department is also likely to experience a slight decrease in data-entry costs and errors in the accounts payable area as a result of having more accurate purchase orders. The department should also track several performance measurements related to nonconforming parts and incomplete purchase order information.

53.5 PAPERLESS OFFICE A paperless ofﬁce is created when all or a majority of documents related to a transaction are digitized with a scanner and stored in a computer storage device, which can then be accessed by employees from computer terminals. These documents are coded for easy retrieval with one or more index numbers that may be related to key information on the document, such as a supplier or customer name, the date of the transaction, or the name of the item being purchased, received, or sold. The digital version of the document is stored in a computer storage device such as a compact disc (CD) jukebox that is capable of storing vast quantities of data, because a digital image requires a signiﬁcant amount of storage space. The related index codes are stored separately in a high-speed computer that is linked to one or more terminals that employees use to access the document. When an employee types in an index code, the computer searches the storage device for the correct document, retrieves it, and sends it to the employee’s terminal. The paperless ofﬁce is usually associated with accounting documents, but is equally useful in other functional areas that handle large quantities of information, such as the legal and engineering departments. Its main beneﬁts are in reducing the storage space needed for paper documents and eliminating the labor

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needed to ﬁle and retrieve those documents. When properly implemented, the paperless ofﬁce can greatly reduce the time and cost related to storing and ﬁnding paper-based documents. There are a number of implementation issues for a paperless ofﬁce system that affect the accounting department. One issue is that digital documents have several index numbers that are used to identify them; these index numbers can be used to match accounts payable documents, such as receivers, purchase orders, and supplier invoices, so that the work of the accounts payable team is vastly reduced. When selecting the paperless ofﬁce software, the accounting staff should insist on software that contains this matching function, because it will nearly eliminate one of their most tedious tasks. Another issue is deciding what to do with stored paperwork. The accounting department should wait until the paperless ofﬁce hardware and software has been thoroughly tested, all paperwork has been digitized, and several months have passed before moving the bulk of its accounting documents off-site. The reason for this delay is that the paperless ofﬁce system must prove to everyone’s satisfaction that it will be functional at all times; if not, it would be foolish for the accounting staff to move its ﬁles off-site, have the paperless ofﬁce system crash, and then be unable to perform its functions while waiting for the system to become operational again. The ﬁnal issue is that the paperless ofﬁce system should be linked to the company’s electronic mail system, so that notiﬁcation of the receipt or movement of an electronic document can be sent to the appropriate employee and backup helper, so that the transaction related to that document can be completed. Otherwise, with no paperwork arriving to signal that work must be done, digital documents can languish in the computer system and never be handled properly. In short, implementing the paperless ofﬁce requires the accounting staff to pay attention to the ability of the new software to automatically match accounts payable documents and send transaction notiﬁcations to employees by electronic mail, and also brings up the issue of when to move the majority of its ﬁles to an off-site location. A large number of controls are needed when a paperless ofﬁce is installed. One needed control is over access to restricted documents (usually in the payroll or human resources areas). Because of the sensitive nature of these documents, a logical control point is to require password access to them, as well as a computerized log of which passwords and terminals were used to access the information (including failed attempts) and the dates and times when these attempts occurred. If sensitive paper documents, such as payroll information, are moved off-site after being digitized and cannot be destroyed due to various legal requirements, it is also necessary to ﬁnd a secure location for these documents, such as a warehouse with access allowed to only those employees on a preapproved list. Also, since essentially all company documents are now stored in an electronic storage medium (e.g., on tape, hard drive, or a CD jukebox), it makes sense to restrict access to and protect this hardware so that there is a reduced risk of damage to the storage media. This control can take the form of locks on the computer room with security card access, automatic nonwater ﬁre extinguishing systems, disaster recovery plans, uninterruptible power supplies, frequent data backups, disk mirroring (i.e., storing information on two different storage media at the same time), and off-site storage of data backups. A combination of many of these forms of protection is usually necessary before the stored information can be considered to be reasonably well protected. Finally, it is possible to lose information in a digital storage system even if the digitized document is actually stored in the system. This problem occurs when an incorrect indexing code is assigned to a document, making it impossible to retrieve the document. One way out of this problem is to convert digitized images into characters that can then be scanned for word combinations that can be typed into the system to ﬁnd the missing document. The other, and more common, approach is to assign multiple index codes to a document, which allows an employee to search for it in several different ways. For example, the index code on a supplier invoice for the supplier’s name may be incorrect, but there are also indexes available for the part numbers ordered and the supplier’s zip code and telephone number, so it is possible for someone to search for these other items and still locate the missing document. In short, controls must be implemented in a paperless ofﬁce that restrict access to sensitive documents and storage media, as well as allow searches on multiple indexes so that digitized documents cannot be “lost in the system.”

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The inputs to the accounting department are drastically reduced in quantity when a paperless ofﬁce is installed. By digitizing all of the incoming documents, there is far less work required to match, ﬁle, or ﬁnd documents. This reduces the amount of clerical help needed in the accounting department. There is no change in outputs from the accounting function as a result of having a paperless ofﬁce. A paperless ofﬁce tends to reduce the number of accounting transaction errors, because it is much more difﬁcult to lose documents when they are ﬁled electronically. For example, a supplier may not be paid on time or a customer billed if the supporting documentation cannot be found. In addition, there tend to be fewer errors related to matching accounts payable documents, because some paperless ofﬁce systems will even search out and match supporting documentation for the accounting staff, which reduces trouble with nonpayments to suppliers because supporting documents cannot be found. By digitizing accounting documents, errors related to missing documents will decline or disappear. The creation of a paperless ofﬁce requires that several new costs be incurred during the system setup, followed by the reduction of other costs once the implementation has been completed. The primary initial hardware costs include purchasing scanners, terminals, a CD jukebox, and an indexing computer. In addition, there will be the cost of the scanning and document storage software, plus a considerable amount of time to scan documents into the new storage system. Once these tasks have been completed, there will be cost savings related to reduced ofﬁce storage space as well as the cost of storage materials (e.g., fewer ﬁling cabinets). However, the major cost savings will be related to the eliminated cost of labor to ﬁle documents and search for documents. The only continuing additional cost is the labor needed to scan new documents into the digital storage system. In short, there are considerable up-front system costs for a paperless ofﬁce, followed by long-term cost reductions in low-end clerical costs; it tends to take a fair amount of time before the paperless ofﬁce pays for its investment. There are several measurements that are useful for tracking the functionality of the paperless ofﬁce. Not all of the measurements shown below can be accumulated by the accounting department, because the management information systems (MIS) department must also be involved in one case, but this measurement can be collected from the MIS department and included in the periodic internal ﬁnancial reports issued by the accounting department. The following list of measurements includes a description, how to calculate it, and why it is useful: • Percentage of ofﬁce space for data storage. Ofﬁce space is extremely expensive to lease and maintain, so it is important to keep the amount of ofﬁce square footage devoted to storage space to an absolute minimum. By reducing the required level of ofﬁce space, the company can reduce its tenancy cost. To measure this information, the building maintenance or engineering staff can periodically measure the square footage of all areas used for storing paperwork and divide this amount by the total ofﬁce space (as shown on the building drawings or rental agreement) to derive the percentage of ofﬁce space used for data storage. • Cycle time to match accounts payable documents. One of the most labor- and time-intensive functions of the accounting department is the matching of accounts payable documents. This function can be almost entirely automated with a paperless ofﬁce, because documents can be digitized and automatically matched. To measure the impact of this change on the accounting department, the cycle time needed to match documents before and after the creation of a paperless ofﬁce should be calculated. This can be done by compiling the total number of supplier invoices arriving in one month (which can be found by adding up the line items in the accounts payable journal for the month) and dividing it by the number of hours spent by the accounts payable staff in matching documents (which requires a time study using time cards for one month). The resulting cycle time is quite reliable, because it is an average of the time needed to process hundreds or thousands of documents. • Cost of ﬁling labor. A typically heavy cost in many accounting departments is the cost of ﬁling away and ﬁnding paperwork. Because a paperless ofﬁce effectively reduces (if not

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eliminates) this cost, it is a reasonable performance measure. When the cost savings are cal-culated, however, the offsetting labor cost needed to digitize images should be subtracted from the ﬁling costs saved to drive the true savings from reducing the ﬁling of paperwork. The cost of ﬁling labor is calculated by determining who does ﬁling, conducting a time study (usually with time cards) to ﬁnd out how many hours per week are related to ﬁling tasks, and multiplying these hours by the cost per hour of each worker. • Jukebox uptime. A paperless ofﬁce is effective only if the computer system holding all of the document images is workable at all times; otherwise, any staff person requiring a document to complete a transaction must wait until the computer system is operating properly. Any lengthy period when digitized documents are not available to employees will result in a severe loss of productivity. This measurement can be tracked by having the information systems department maintain a log of all “downtime” for the portion of the computer system that stores digitized documents (usually a CD jukebox). In summary, the paperless ofﬁce is a signiﬁcant efﬁciency boost for the accounting department. It can be used to eliminate lost paperwork, reduce paper storage space, and even automatically match accounts payable documents. However, in order to realize these beneﬁts, the accounting staff must be able to assign accurate indexing numbers to paper documents as they are being digitized, recognize the beginning of accounting transactions even when there is no paperwork to initiate the transaction, restrict access to conﬁdential electronic documents, protect the storage devices containing the document digital images, and above all convince management that the considerable up-front cost of the paperless ofﬁce computer equipment can be recouped by other savings in the accounting area. If the accounting department can overcome these challenges, the department’s operations will become much more efﬁcient.

53.6 ELECTRONIC CASH Electronic cash is a form of money that can be issued by anyone in exchange for “real” cash and can be redeemed as electronic chits. The way it works is that a company issues an electronic voucher to a user in exchange for cash in advance (usually paid by credit card). The user can then use the electronic cash voucher to buy goods with that same company or with other companies, who then take the electronic voucher back to the originating company for payment in “real” money. Why is this an improvement over credit cards, which do not require the user to pay in advance? Many transactions, especially involving the transfer of information, can be charged for a rate of less than a penny, which can be accomplished only with electronic cash, which can be subdivided into quantities of less than a penny. In short, e-cash is a privately issued cash voucher that can be used only with that company or to purchase goods with other companies if they agree to accept the e-cash, and it is particularly useful for transactions of less than a penny. There are a number of implementation issues related to the use of electronic cash that impact the accounting department. One issue is that, if the company issues its own e-cash, the accounting department must record a liability on the accounting books when it is issued and a sale when it is redeemed. A further problem is when to convert the e-cash liability to a sale when the e-cash is not redeemed but enough time has passed to prove that the e-cash is not likely to ever be redeemed. The e-cash software should summarize the usage of e-cash; the accounting staff can access this information at the end of each month when deriving its journal entries for e-cash. As for determining when an outstanding e-cash balance can be converted to a sale, the e-cash software should be able to generate an aging report that shows how long it has been since any e-cash was withdrawn by a customer. To avoid any reversed journal entries related to having a customer try to use some very old e-cash and ﬁnd that it has been deleted and converted to a sale, the company should make it clear to all customers “up front” that its e-cash does have an expiration date (similar to frequent ﬂier miles that are deleted after a certain number of years have passed). If third- party e-cash is used, the accounting department will need an automated interface to the e-cash provider, so that redeemed e-cash amounts can be sent off to the provider as quickly as possible, thereby ensuring

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quicker receipt of actual cash as reimbursement for the e-cash. If the e-cash provider also charges a service fee, the accounting staff must be able to track this fee and record it as an expense through a journal entry. In summary, the use of e-cash requires the accounting department to track the amount of it used, still available, and so old that it is probably not going to be used, as well as the amount sent to a third-party provider for reimbursement and any service fees charged by that provider. Cash usually requires the largest number of controls to prevent theft, and electronic cash is no exception to this rule. Encryption of e-cash account numbers and passwords are necessary to prevent unauthorized users from obtaining access to this information and using it to spend other people’s electronic cash. Passwords can also be used in addition to encryption as a second line of defense to keep unauthorized users away from the e-cash information. Scrambling information or denying access to it is necessary to prevent the theft of e-cash information. There are a variety of new costs associated with using electronic cash. First and largest is the cost of several interfaces that must be custom programmed: one from the Internet site to the orderentry system to record the customer order; another from the Internet site to a third-party e-cash provider to pay for the transaction; and a third from the Internet site to the accounting software to record the dollar amount of the transaction, either as a back order or as a sale. Second in size is the cost of the Internet site itself, which includes a computer, Internet software, phone lines, e-cash software, and encryption software. Offsetting these costs are, presumably, more sales. For smaller businesses, it is likely that these costs will not be offset by increases in sales, because the ﬁxed cost of setting up the e-cash installation is too large. There are only two measurements related to the performance of electronic cash. Both of them can be tracked, summarized, and reported by the accounting department, because they are purely ﬁnancial measures. The following list of measurements includes a description, how to calculate it, and why it is useful: • Proportion of e-cash to regular cash. E-cash can become a signiﬁcant part of a company’s cash receipts, but it is difﬁcult to determine this amount unless the volume of e-cash is specifically tracked and compared to the volume of regular cash receipts; this information is useful for determining the volume of sales using e-cash; in effect, it also shows the volume of business moving through the electronic sales channel that uses e-cash. The best way to track the volume of e-cash is to record e-cash receipts in a separate general ledger account. This volume can then be compared to the volume of cash received through the company’s bank statement or lockbox statement to derive the proportion of e-cash to regular cash. This information can be tracked over time to see if the level of business related to e-cash is changing. • Aging of unused e-cash. If a company issues its own e-cash and records unused e-cash as a liability, it is useful to track the age of the unused e-cash, because very old e-cash balances can reasonably be considered to be unclaimed and can be converted to a sale and removed from the liability account. Thus, tracking this information can generate additional sales. The best way to track this information is to generate an aging report that is identical to the format used for an accounts receivable aging report—show the amount of outstanding e-cash for each customer, aged by time bucket. Once old e-cash reaches a prespeciﬁed time bucket, that e-cash is converted to a sale and removed from the aging. In short, the use of e-cash requires the accounting department to analyze the age of e-cash vouchers that have not been redeemed and record them as sales if it appears that they will go unused; record journal entries for issued and redeemed e-cash; request payment from third-party e-cash providers; and record service fees (if any) that are charged when third-party e-cash is redeemed. The accounting department should also be involved in the use of encryption and passwords to protect customers’ e-cash balances, as well as measuring the age of unused e-cash and the proportion of e-cash sales to regular cash sales. By offering this additional payment option to customers, a company has a greater chance of retaining its existing customer base, and may even attract a slight increase in sales volume.

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53.7 VIRTUAL CORPORATION A virtual corporation is one that outsources nearly all of its functions to other companies and retains only the core value-added functions that earn it the largest proﬁt. This means that the virtual corporation must select a small number of companies as its long-term partners; these companies may take on the virtual corporation’s manufacturing, marketing, sales, engineering, and accounting tasks, depending on what management feels are superﬂuous functions that should not be maintained in-house. The resulting company must also be able to track the performance of the companies that are handling many of its functions. Because the customer does not know that these functions are being performed by a different company, any poor performance by those companies will be looked on as poor performance by the virtual corporation. If these problems can be managed, the virtual corporation presents a very low-cost approach to forming and continuing a corporation; it employs very few people, has no signiﬁcant capital costs, and therefore has a very low breakeven point. Because of these advantages, it is likely that virtual corporations will be used more frequently in the future. There are a number of implementation issues related to a virtual corporation structure that affect the accounting department. One issue is that payroll may be outsourced. This means that the controller may need to lay off the payroll staff, create a modem linkage to the outside payroll service, send the remaining payroll staff to training so that they will know how to send the detailed pay data to the payroll service, and create new payroll reports based on the payroll service’s report-writing software. Also, the payroll service may not accumulate labor costs against speciﬁc jobs—if not, part of the existing payroll staff may still be employed entering this information into the company’s job costing software while also transmitting more summarized information to the payroll service. Also, tax preparation can be outsourced. It is usually best to combine this function with the company’s auditing ﬁrm, because the work papers needed to complete the tax work are mostly generated by the auditing personnel; thus, keeping both functions at one company allows the tax work to be completed more efﬁciently, because all of the supporting paperwork is located in the same place. In addition, there must be an intensive focus on cost accounting, because nearly all costs are outsourced. If the accounting department does not pay close attention to the costs of the various suppliers, costs can rapidly spin out of control, possibly resulting in losses. Increasing the cost accounting staff is a reasonable option in this situation. Finally, EDI is used more frequently in a virtual corporation, because the company has a small number of high-volume suppliers with whom the company conducts transactions a number of times every day. EDI works perfectly here because it moves transactions back and forth much more quickly than ﬁrst-class mail. EDI transactions arrive by electronic media; therefore, the accounting system needs an automated interface to interpret and input these transactions into the accounting database. In short, the accounting department in a virtual corporation can outsource its payroll and tax preparation work, focus on cost accounting, and automatically accept EDI transactions. Several additional controls are needed when the standard corporate structure switches to a virtual corporation. One control is needed to ensure that the number of units billed from the company’s manufacturer matches the number of units shipped and billed to customers. If these numbers do not match, the internal audit department should be called in to see if excess units are being billed by the manufacturer, or if too many billings are being issued by the shipper. Also, the company should track warranty claims to see if there is an upsurge in claims, which indicates that the manufacturer may be producing the company’s products with insufﬁcient quality controls, which will cause a loss of sales and reduce proﬁts. In addition, the accounting department should track the cost per unit manufactured; if this ﬁgure varies signiﬁcantly and the variation is not explained by a scheduled cost change in a contract with the manufacturer, there is probably an unscheduled increase in the cost of the product that is being billed to the company by the manufacturer. Finally, it is important to maintain control over the dates on which products are shipped to customers. If these dates are signiﬁcantly later than the dates on which deliveries were originally promised, it is likely that customers will not order additional products, resulting in a decline in future revenues. Shippers or manufacturers may have to be changed if this problem persists. Thus, controls are

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needed to ensure that billed costs per unit do not exceed their contractual prices, amounts billed match the amount shipped to customers, warranty claims are not excessive, and products are shipped on their promise dates. A number of errors can occur in the accounting system when a virtual corporation is implemented. One error is a company’s being billed for incorrect unit costs on products produced by its manufacturing partner. This error by the manufacturer requires the accounting staff to research unit costs on every supplier invoice to ensure that the error is caught prior to paying the incorrect (and usually higher) amount. The error checking can be automated by having the computer system check every line-item cost charged by the manufacturer against a standard table of costs that are set out in the company’s blanket purchase order to each manufacturer, which results in a report that shows any variances in billed amounts from the preestablished per-unit costs. Also, an error can occur if a shipping partner sends the company an incorrect shipping date for a delivery to a customer, which the accounting department relies on when billing the customer. This error can result in accounts receivable collection problems when customers are billed when they have not yet even received their shipments. The best way to avoid this error is to have the internal audit department schedule repeated unannounced visits to the shipping location to verify that products are actually shipped on the dates that are reported to the accounting department. Another error relates to processing incorrect payroll hours for personnel who are primarily located off-site at the locations of a company’s trading partners. Collecting their hours worked can be quite difﬁcult and frequently results in entering incorrect hours in their pay; the best way to avoid this problem is to set up as many employees as possible on salaries instead of hourly pay, which avoids all problems with collecting hours worked from a variety of locations. Finally, it is possible to have large numbers of errors in billings to customers if the shipping information received from the shipper is incorrect. This problem can be avoided by setting up a rating scale for the shipper that gives the shipper a score based on the accuracy of its shipping information (as veriﬁed by an internal auditor). If the score drops to an unacceptable level, the company should ﬁnd a new trading partner to ship its goods to customers. In short, there are a variety of errors that can occur when a virtual corporation is implemented, but these problems can be overcome with the increased use of internal auditors and converting off-site personnel to salaries from hourly pay. The primary cost change for the accounting department in a virtual corporation is for the development of an electronic interface to the company’s business partners. This typically requires a custom-designed interface between the accounting software and a standard EDI package that converts incoming transactions into the format used by the accounting software. This tends to be an expensive programming project. As a result of having the interface, the data-entry cost of the accounting department tends to decline, because the electronic transactions go straight into the accounting database without any need for rekeying. In short, there is a one-time cost for creating an electronic interface, followed by continual cost reductions in the data-entry area because of the automated interface. There are two measurements that are useful for tracking the efﬁciency and effectiveness of virtual corporations. Both measures can be tracked by the accounting department, because they involve costing information that can be accumulated through the general ledger. The following list of measurements includes a description, how to calculate it, and why it is useful: • Proportion of commissions to total revenues. A virtual corporation requires very few salespeople, because it has long-standing and largely automated interfaces with its primary customers. Thus, there is little or no need for salespeople in a virtual corporation. The best way to measure the personnel cost of sales is to measure the proportion of commissions paid to salespeople to the total volume of sales. By tracking this percentage over time, it is possible to determine the impact of converting to a virtual corporate structure. The measure is easy to track; just take the revenue and commission dollar amounts from the general ledger each month and divide the commission total by total revenues. • Average margin by sales channel. A company may have a variety of sales channels: electronic, trade show, storefront, distributors, or phone sales. The gross margin, including the

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cost of sales, should be calculated for each sales channel, which may reveal that some channels are so expensive to maintain that they should be discontinued. A virtual corporation tends to use more electronic methods of obtaining sales, so this measurement tends to highlight the proﬁtability of that sales channel. The measurement is determined by storing sales information in a different general ledger sales account for each sales channel; product costs are then offset against these revenues to derive the traditional gross margin. Then the directly identiﬁable sales cost associated with each sales channel is included to derive a reduced margin. The margins for each sales channel should be compared to determine where sales growth should be pushed, and should also be tracked over time to see if there are any problems with reduced margins in particular sales channels. To summarize, a virtual corporation requires a radical shifting of resources within the accounting department, away from data-entry work and toward the analysis of the cost of relationships with the company’s business partners. It also involves sending paychecks to employees located at partner locations, outsourcing tax preparation work, and using electronic interfaces to the computer systems of partner companies. The amount of internal audit work increases drastically, because the company must continually review the accuracy of transactions with its partner organizations, as well as investigate the prices they charge. The accounting staff must also track several performance measurements to verify that the company is proﬁting from the structure of the virtual corporation. If managed properly, these changes allow company management to keep ﬁrm control over the virtual corporation.

53.8 DATA WAREHOUSING A data warehouse is the central repository of a corporation’s information, where it can be accessed by all employees who need the information to make the best possible decisions. This does not mean that all other corporate databases are eliminated; instead, most data warehouses pull in key data from subsidiary databases through automated interfaces. This information resource is of great value for a company’s ﬁnancial analysts and managers, who no longer have to spend excessive amounts of time searching for the information they need before using it to make a decision. With a data warehouse, they just use a report writer to access the information, which is kept in one place for their use. The primary problem with accounting errors in a data warehousing environment is that a data warehouse usually moves information from the subsidiary accounting system to the data warehouse automatically and quite frequently, without previous review of the data by any accounting staff. Accounting information that is incorrect can be quite dangerous if used to make key decisions by other people using information stored in the data warehouse. To avoid this potential error, it is better if information from the accounting system is checked for accuracy ﬁrst through the month-end closing process and then moved to the data warehouse. This means that accounting information will be updated in the data warehouse only once a month, but at least there will be some assurance that the information will be accurate. If management insists that the information be transferred every day, it may be possible to transfer information that will not lead to incorrect decisions even if the information is incorrect, such as accounts receivable or payable agings, ﬁxed assets, or tax information. The information on which incorrect decisions can be made if it is incorrect primarily relate to revenues, the cost of goods sold, and departmental costs, and these should therefore wait until month-end before being transferred to the data warehouse. In short, the accounting department must be able to send error-free information into the data warehouse, which may require once-a-month transfers of information for those data items that absolutely must be checked during the month-end close before it can be issued to other employees through the data warehouse. Other data that are less subject to error or are unlikely to cause bad decisions can be transferred to the data warehouse more frequently even if the information is somewhat incorrect.

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CHAPTER

54

WORLD-CLASS ACCOUNTING SYSTEMS 54.1

OVERVIEW 985

54.2

MANUFACTURING RESOURCE PLANNING 985 (a) Components of an MRP II System 986 (b) Effects of MRP II on the Accounting System 986 (c) Performance Measurements 987

54.3

54.4

INTEGRATED DISTRIBUTION MANAGEMENT 988 (a) Components of an IDM System 988 (b) Effects of IDM on the Accounting System 989 (c) Performance Measurements 991

54.5

54.6

JUST-IN-TIME 993

(a) Components of a JIT System 993 (b) Effects of JIT on the Accounting System 994 (c) Performance Measurements 996 PRODUCT DESIGN 997 (a) Components of a Product Design System 997 (b) Effects of Product Design on the Accounting System 998 (c) Performance Measurements 999 COMPUTER-INTEGRATED MANUFACTURING 1001 (a) Components of a CIM System 1001 (b) Effects of CIM on the Accounting System 1002 (c) Performance Measurements 1003

54.1 OVERVIEW This chapter reviews how a variety of new management systems can change the standard accounting system. The chapter gives an overview of several management systems, such as manufacturing resource planning, integrated distribution management, just-in-time, and computer-integrated manufacturing. The impact of these systems on the accounting function is explored in terms of implementation issues, control points, inputs and outputs, error rates, costs, and new measurements. The chapter is designed to give only a brief overview of each management system; for more detailed information, a separate book on each topic should be consulted.

54.2 MANUFACTURING RESOURCE PLANNING A manufacturing resource planning (MRP II) system greatly improves the accuracy of several key databases (inventory, bills of materials, and labor routings) that can improve the accuracy of some accounting transactions. The system requires additional audit time to ensure that the databases remain accurate over time; otherwise, transaction error rates may increase. Once the system is installed, accounting labor costs should go down slightly, though a moderate amount of accounting labor is needed to assist in the system’s implementation. There are a large number of measurements that can be tracked to verify the performance of the system. Few of these measures can be easily calculated by the accounting department, because they are operational measures that are not accumulated through traditional accounting systems. 985

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(a) COMPONENTS OF AN MRP II SYSTEM. In essence, an MRP II system is a large schedule. The entire production schedule is entered into it, showing the quantities required and planned dates of production. This information is then multiplied by the parts quantities shown in the bill of materials (BOM) for each of the products to be manufactured to derive the total parts quantities needed to produce the items listed on the production schedule. This list is then compared to the amounts of inventory either on hand or on order to derive a reduced list of parts that must be ordered to produce the production schedule. This list of items to be ordered is then sequenced based on the dates of production noted in the production schedule and the lead times required by suppliers, to derive a list of parts to be ordered on speciﬁc days. In addition, labor routings are also matched against the production schedule to determine the amount and skill level of labor required for each day of the production schedule. When armed with this information about labor and materials requirements, a company’s manufacturing function is quite capable of producing the exact quantities of products that are shown on the production schedule, and can do so on the required dates. (b) EFFECTS OF MRP II ON THE ACCOUNTING SYSTEM. (i) Implementation Issues. When an MRP II system is installed, there are several changes that can be made to enhance the existing accounting system. First, the controller can take advantage of the existence of a computerized production schedule to forecast cash requirements, sometimes for several months into the future. This is accomplished by taking the quantities of all items listed on the production schedule and multiplying them by the number of component parts as listed on their bills of materials (which should also be present in the MRP II system). The resulting quantities can be compared to on-hand parts quantities as shown in the inventory records (which are also a necessary part of the MRP II system) to derive quantities that must be purchased. The quantities to be purchased can be spread by date required, as noted on the production schedule, to determine when expenditures must be made. The dates of these expenditures constitute the bulk of the cash expenditures of most companies, since materials costs are still the largest cost in most industries. The same technique can be used with labor routings to forecast hours of labor required by day, which can also be part of the cash ﬂow forecast. By including the expenditures amounts in the cash forecast, the controller can plan cash requirements further into the future and with greater accuracy. Another accounting use for the MRP II system is the derivation of the month-end accounts payable accrual. An MRP II system can only operate if the records of inventory receipts are very accurate, so the controller can rely on its month-end records of receipts as a reliable (and on-line) substitute for a receiving log. This log can be used to derive the month-end accounts payable accrual for items that have been received but for which there is no supplier invoice. In summary, the MRP II system can be used to enhance the accounting system’s capabilities in the areas of cash forecasting and accounts payable accruals. When the MRP II system is implemented, the accounting department will be called upon to perform several tasks. One is a complete review of inventory costs; since having an accurate inventory is a cornerstone of an MRP II system, it is reasonable that part of the review of inventory counts should include a review of the associated product costs. Another time commitment is the training of department personnel in the use of the MRP II software. This training is typically conducted immediately before turning on the software; it is necessary for many accounting personnel to receive this training, because they must have access to inventory counts, BOMs, and labor-routing information. The internal audit staff may also be called upon to assist in testing the MRP II software to verify that key transactions are processed properly and that all necessary control points are being implemented correctly. The MRP II system’s implementation period will require signiﬁcant time commitments by accounting personnel for testing inventory costs as well as for software training and testing. (ii) Control Issues. The internal audit staff should audit the three main databases of the MRP II system. One is inventory, which should be 95 percent accurate. Auditors should test for accurate inventory part numbers, quantities, and locations—any variances should be counted as errors.

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Another primary database is for the bills of materials. Auditors should test for accurate part numbers and unit quantities—a bill should be counted as being incorrect if even one small error is detected within its structure. Finally, labor routings must be reviewed. Auditors should test for accurate amounts of time required for each task, the correct sequence of tasks, and the correct job types for each task. Once again, a routing should be counted as being incorrect if even one of these errors is detected within its structure. Control over the MRP II system is founded upon frequent reviews of its databases to ensure that they are sufﬁciently accurate for the system to operate properly. An MRP II system allows the controller to use a computer interface to access highly accurate inventory and work-in-process information that is stored in the MRP II database. This information is integrated into the periodic ﬁnancial statements, thereby ensuring that the raw materials and work-in-process inventory ﬁgures presented have sufﬁcient supporting detail to withstand any audit test, and giving the controller great conﬁdence in the accuracy of the cost-of-goods-sold expense. The MRP database should be accurate enough to provide high-quality supporting detail for the ﬁnancial statements. (iii) Transaction Errors. Any transaction errors related to inventory, BOMs, or routings should decrease when the accounting system relies on data provided by an MRP II system. This is because these three databases must be very accurate for the MRP II system to function; if their accuracy levels were low, it is unlikely that the MRP II system would be able to function for very long, which would be a clear signal to the accounting department to stop using its databases for transactions. Accounting transaction error rates tend to drop when the accounting system relies on data from a properly functioning MRP II system. (iv) Additional Costs. The cost to the accounting department goes down when an MRP II system is installed, since there is less work needed to track down and ﬁx the smaller number of transaction errors. However, costs can be expected to increase when the MRP II system is installed, since the accounting staff may be called upon to examine and revise inventory unit costs at that time. Also, the cost of the internal audit staff should increase on an ongoing basis, since it will be called upon to conduct reviews of the accuracy of the MRP II database to ensure that minimum levels of accuracy are maintained. (c) PERFORMANCE MEASUREMENTS. There are a large number of performance measurements that can be used to track an MRP II system. However, none of them are ﬁnancial measures, and so it is better for the accounting department to collect the information from other departments and include it in its monthly reports, rather than attempt to measure the information itself. Because many departments end up measuring their own performance (which can lead to skewed measurements that make the departments look better), it is reasonable to have the internal audit department review the measurement results on a regular basis. Some of the more important performance measures are: • Inventory accuracy. This measure is most easily tracked by the warehouse staff. It is measured by selecting a sample of the inventory and counting bad quantities, locations, and part numbers as errors. Poor inventory accuracy means that the production staff cannot rely on inventory records for the kitting of parts stored in inventory for use in the production process. • BOM accuracy. This measure is most easily tracked by the engineering staff. It is measured by selecting a sample of the BOMs and counting bad quantities and part numbers as errors. Poor BOMs mean that they cannot be relied upon for determining what materials are needed to produce products. • Labor-routing accuracy. This measure is most easily tracked by the engineering staff. It is measured by selecting a sample of the labor routings and counting bad hour standards, job levels, and sequences of work as errors. Poor labor-routing accuracy means that routings cannot be relied on for predicting how many staff are needed to produce products.

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• Production plan performance. This measure is most easily tracked by the production scheduling staff. It is measured by verifying that all items listed on the production schedule for the last month were produced on time, to the correct speciﬁcations, and in the correct quantities. Poor production plan performance means either that the production planning process is not doing a good job of predicting actual production output or that the production and materials handling processes are incapable of producing in the quantities and on the dates speciﬁed by the plan. • Supplier delivery performance. This measure is most easily tracked by the purchasing staff. It is measured by verifying that all receipts during the past month were delivered on time and in the correct quantities. Poor supplier delivery performance means that suppliers cannot be relied upon to deliver parts in time for them to be used by the production process for regularly scheduled manufacturing. • Number of schedule changes. This measure is most easily tracked by the production scheduling staff. It is measured by adding up the total number of changes to the production schedule after the “freeze” date, the time at which no further changes to the production schedule are supposed to be allowed. A large number of schedule changes means that expediting costs are probably being incurred to bring in deliveries of parts on “rush” orders at the last moment. • Number of delivery releases with full lead time. This measure is most easily tracked by the production scheduling staff. It is measured by adding up the proportion of production orders that were listed on the production schedule with the full lead time required to procure materials for production without having to incur any expediting costs. A small proportion of delivery releases with full lead times means that expediting charges are probably being incurred to bring in parts in time for the “rushed” orders.

54.3 INTEGRATED DISTRIBUTION MANAGEMENT An integrated distribution management (IDM) system (and especially the warehouses that are managed by the system) requires a number of changes to the traditional accounting system. Some accounting functions may be outsourced, centralized, or decentralized. Tight control over the accuracy of inventory records is needed, which requires additional internal auditing staff to verify. More cost accounting staff will be needed to report on the costs of distribution, warehousing, and ﬁnal assembly. Accounts payable will become more difﬁcult to manage, since crucial matching paperwork can be lost among all of the company locations. Many measurements can be used to track the performance of the various aspects of the IDM system. Nearly every aspect of the accounting system is modiﬁed by the use of an IDM system. (a) COMPONENTS OF AN IDM SYSTEM. There are many deﬁnitions of an IDM system; in essence, it involves the use of tightly linked computer systems to bring products to customers as quickly and cheaply as possible. Though it does not necessarily require the use of a large number of warehouses, the system is typically installed by companies that have many distribution points already in existence. It works by storing all inventory and customer order information on a single database. Customer orders can even be entered into the database by the customers themselves; the computer then scans the database of inventory records to determine where the correct inventory is being held (or is in transit) and quickly routes the correct items to the customer, based on various rules regarding the cost of transport—if an item is stored too far from the customer, it will not be shipped due to the cost that will be incurred to move it. The system requires exceptionally accurate inventory records, not only for each warehouse but also for all inventory being moved between locations by whatever means. More advanced IDM systems also assist in tracking ﬁnal assembly of products at distribution points; this is useful if there are many ﬁnal product conﬁgurations that are too expensive to store in completed form. In short, a centralized database of inventory and customer orders is the key to an IDM system.

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(b) EFFECTS OF IDM ON THE ACCOUNTING SYSTEM. The accounting system must be altered considerably when an IDM system is installed. In short, the elements of the accounting system that will require alterations when an IDM system is implemented include accounts payable processing, payroll processing, the chart of accounts, the inventory database, and the cost-reporting function. • Accounts payable processing. First, it is necessary to decide where accounts payable will be processed. If all accounts payable for all locations are to be processed from a central location, the outlying locations must be trained to send all supplier invoices, purchase orders, and receiving documents to the central location so that these documents can be matched and paid. If the decision is made to disperse the accounts payable function to outlying areas, then those locations must be properly staffed with accounting personnel who can adequately perform this function. • Payroll processing. Second, due to the need to pay local payroll taxes for the many locations required in an IDM environment, it may be easier to outsource the payroll function to a provider who is skilled in calculating, withholding, and paying taxes to all levels of government. If the company needs payroll data to determine job costs, it will need to separately enter this information into the job costing system, since most payroll providers do not accumulate job costing information. An alternative is to keep a centralized payroll system for those company locations for which job costing is necessary, and outsource payroll for those locations (such as warehouses) that are not directly involved in the manufacturing of products. • Chart of accounts. Another issue is that the chart of accounts should be altered to include a location code, but otherwise kept the same for all locations. This change is needed to keep a uniﬁed account code structure, which is necessary for consolidating the accounting information of all locations. If the account codes were to be different for each location, the accounting department would have a difﬁcult time of consolidating the data into ﬁnancial statements. • Inventory database. Fourth, a centralized inventory-tracking database is needed for all inventory stored at all locations. This is necessary so that inventory may be logged out of one location and into another one with one transaction; otherwise, inventory movements between locations can easily be lost on the company’s database, which makes it very difﬁcult for the accounting staff to determine the month-end inventory when the separate inventory databases of each location are consolidated—one untracked truckload of high-value inventory that is between locations can have a signiﬁcant impact on company proﬁtability. • Cost-reporting function. Finally, company management will require a variety of reports to track the cost of each distribution point, the total cost of the logistics function, the cost of transportation (both between company locations and to the customer), and the cost of faster forms of transportation (progressing from ships through trains and trucks, and on to overnight delivery services). All of these reports will require more accounting time to assemble as well as the presence of report-writing software that links to the existing accounting system. (i) Implementation Issues. There are several implementation issues related to an IDM system that have an impact on the accounting department. One is the need to track assets in a variety of locations. There should be either an accounting staff at each location who can do this or a methodology for reporting the acquisition of assets to a central asset-tracking function, where these assets can be entered into a common database. Similarly, there must be a capital-budgeting methodology for gaining approval for the acquisition of these ﬁxed assets; local management must receive instruction regarding the company’s capital-budgeting procedures, or the local accounting staffs (if any) can be responsible for this function. In addition, if the company decides to own a truck ﬂeet, there must be a cost-tracking system that records the permile cost for each truck, maintenance costs (especially if there is an in-house repair facility), and any gains or losses on the sale of truck-related equipment. The largest issue is where accounting transactions will be processed. If all transactions will be completed from a single central location, there must be a mechanism in place for transferring such paperwork as purchase orders, supplier invoices, tax forms, and

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receiving documents to a central location. If a decentralized model is used, provision must be made for the local management of the accounting function and the reporting of ﬁnancial results in a format that is common to all locations. In short, the accounting department must be heavily involved in the implementation of an IDM system, with its involvement ranging from ﬁxed-asset budgeting and tracking through cost tracking and setting up either centralized or local accounting departments. (ii) Control Points. There are several control points that must be added when an IDM system is installed. One is a continual audit of the inventory. This function is very necessary in an environment where inventory is continually moved between a variety of company locations, since it is easy for inventory records to be incorrect simply due to the number of moves. Also, if the ﬁnal assembly of products is conducted at the distribution points, it is important that assembly costs be audited to ensure that the time taken to complete assembly operations is close to anticipated amounts. The internal audit department should regularly travel to the various company distribution points to review both of these control points. A ﬁnal control point is the periodic review of transportation fees charged by outside carriers. These costs can be checked by an outside freight-auditing company, which is compensated based on a percentage of the freight billings discovered that are incorrect. In summary, all of the extra control points needed for an IDM system involve the auditing of ongoing functions. (iii) Additional Inputs. An accounting system will have a large number of additional inputs in an IDM environment. The bulk of these inputs will be related to inventory transactions; this is because there will be a large number of inventory movements to customers as well as between various distribution points, many of which will require an accounting transaction to record. In addition, there will be more bank account reconciliations, since each distribution location will likely require a bank account to handle local cash needs. Finally, there will be a variety of additional taxes to be processed—local payroll and property taxes for each location. A number of new accounting inputs will occur when a company has multiple distribution points, which will result in a need for more accounting labor. (iv) Requests for Reports. The controller can expect a number of requests for reports that company management needs to track the effectiveness of various parts of the IDM system. The most common reports are: • Report on facility costs. This report lists the rent or lease payment for each facility, plus the cost of taxes, utilities, other ﬁxed costs, depreciation, and labor. The report is needed to determine the total cost of each distribution point and is usually combined with a measure of each location’s total inventory movement volume to determine the efﬁciency of each location per dollar expended. • Report on freight costs. This report lists the cost per carrier and is usually combined with the number of shipments for each carrier to determine the average cost per load. The report is used to determine which carriers are most expensive and therefore should be replaced with cheaper competitors. • Report on customer distribution costs. This report lists the cost for each customer of transportation, of inventory storage, and (in some cases) of repackaging products to customer speciﬁcations (this generally applies only to retailers who are reselling the products). These costs can be included with product costs and offset against revenues to determine the true gross margins associated with sales to speciﬁc customers. The intent of the report is to determine which customers’ sales are resulting in poor margins, which will require action by management to improve. • Report on the cost of faster delivery times. This report lists the cost of various types of delivery. It includes the cost of overnight delivery services, of in-house carriers, of contract carri-

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ers, and of customer-speciﬁc distribution points. This information is required by management so that they can decide if it is cost-effective to offer high-speed delivery to customers. All of the above reports are cost related. A multilocation distribution system is very expensive, so careful attention to costs is important to ensure that proﬁt margins do not suffer as a result of having it. (v) Transaction Errors. An IDM system is one of the few management systems that causes more transaction errors in the accounting system. For example, there are more inventory movements throughout the company, and there will be inventory overages and shortages that will result in inaccurate cost-of-goods-sold entries at month-end—these errors must be investigated and corrected by the accounting staff. In addition, there will be problems with shipping products from a variety of locations and then forgetting to invoice customers for the shipments. Also, documents related to accounts payable will be received at a number of locations and not necessarily forwarded to a central accounts payable processing function, resulting in missed payments to suppliers— these typically require last-minute investigations to collect the paperwork and pay irate suppliers. In short, due to the greatly increased number of locations in an IDM system, there will be a variety of additional accounting transaction errors; more accounting labor will be required to ﬁx them. (vi) Additional Costs. The accounting department of a multilocation company incurs many additional costs. One is the cost of local accounting staffs; even if most accounting functions are centralized, there is usually a need to conduct local job costing, prepare local tax forms, and collect and forward documents to the central accounting facility (if any). Also, an expanded internal auditing function is a necessity—it is extremely important in a multilocation environment to constantly send auditing teams to all locations to ensure that all procedures are being followed in a uniform manner and that any exceptions to those procedures are dealt with promptly. Finally, the computer system needed to link the locations together can be a considerable expense. The accounting software part of the system should be on the client-server model, so that the software can run independently at all locations with program sharing, while still being able to periodically link each location’s database to that of all other locations to ensure that inventory and order entry information can be tracked throughout all locations. Such a system requires a computer server at each location, plus full-time communications links between all facilities. An accounting function that must track the activities of multiple locations will incur costs for additional accounting and internal audit personnel, as well as the cost of a distributed accounting computer system. (c) PERFORMANCE MEASUREMENTS. There are a number of performance measures needed to track the effectiveness and efﬁciency of an IDM system. Several can be calculated by the accounting department, but others are operational in nature and are more easily tracked by other departments. The measurements are noted below, along with an explanation of why they are used: • Amount of inventory investment. This measure is most easily tracked by the accounting department, which can accumulate the cost of inventory located at each distribution point as well as the amount in transit between company locations. This measure is useful for determining the company’s working capital investment in various sales regions. When subdivided into inventory investments by product line, it gives management a good idea of its working capital investment at this more detailed level. • Inventory turns. This measure is most easily tracked by the accounting department. By comparing the amount of inventory to the cost of goods sold, this measure shows how efﬁciently inventory is being used to support various sales levels. A high turnover ratio shows that very little inventory is being held in the production system to produce a given level of sales, which indicates that the production process is very efﬁcient. • Cost of transportation per order. This measure is most easily tracked by the accounting department. This is not a measurement that can be tracked for every order on an ongoing basis, since many freight rates are based on bulk transfers of products, not individual shipments. However, it

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is practical to periodically determine the average cost per order. The measure should be subdivided into transportation costs by geographical region, to see if freight rates charged to customers should be varied to offset costs. • Cost of warehousing per order. This measure is most easily tracked by the accounting department, and should be done periodically, perhaps as an activity-based costing project. The total warehousing cost should include all warehouse costs (e.g., taxes, depreciation, facility rent, and personnel costs) and should be divided by the total number of order line items shipped from the warehouse to determine the cost per order. This information is especially useful when tracked by customer, since some customers require local warehouses for their use, which can dig into, if not eliminate, all proﬁts on product sales to those customers. • Facility efﬁciency. This measure is most easily tracked by the logistics department. The square footage of a facility is divided by the number of order line items shipped from that location to determine the amount of activity per square foot. A low activity ﬁgure indicates that the warehouse may be poorly positioned, since there are few deliveries to customers within its geographic area. A low activity ﬁgure may also indicate that the warehouse is stocked with slow-moving products, which requires a change in the product mix kept on hand in order to improve efﬁciency levels. • Proportion of damaged goods. This measure is most easily tracked by the logistics department. The amount of damaged goods should be tracked not only by individual warehouse (which is an indicator of the skill of the warehouse staff ) but also by carrier, which can be used to determine which carriers should be rewarded with more business and (more importantly) who should be dropped based on their lack of care of the company’s products. • Average percentage of order lines ﬁlled on ﬁrst shipment. This measure is most easily tracked by the logistics department. By tracking how much of an order is ﬁlled on the ﬁrst shipment, management has some idea of how well the various warehouses are being stocked. This measure should be tracked by individual warehouse, which gives some indication of the mix of inventory kept at each location. If the percentage of order lines ﬁlled is low while the facility efﬁciency measure (see above) is also low, this is a clear indication that a warehouse may be overstocked with slow-moving items that may require an obsolescence write-down. • Proportion of back orders. This measure is most easily tracked by the logistics or sales departments. It shows management how many order line items end up on back order and is a good indicator of the company’s ability to stock the correct products at its distribution points. • Committed delivery date compliance. This measure is most easily tracked by the logistics or production departments. It reveals a company’s ability to produce a product and deliver it to a customer on a previously agreed-upon date. It is a general measure that may have several underlying causes, since production snafus, rather than any distribution problem caused by the logistics system, may cause a delivery to be late. • Inventory accuracy. This measure is most easily tracked by each warehouse. Any error in a product’s part number, location, or quantity is counted as an error. This is a critical measure, since a company will not be able to reliably promise deliveries to customers from its warehouses if the records of those warehouses are incorrect. • Total cycle time. This measure is most easily tracked by the internal auditing department, since it crosses several departmental boundaries. One of the main reasons for having an IDM system is to push ﬁnished products as close to the customer as possible, which reduces the cycle time needed to service a customer. This is measured by subtracting the shipment date of the ﬁnal order line item to the customer from the date of receipt of the customer order; this measure can be further subdivided to show production and transportation time, as well as wait and queue time.

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54.4 JUST-IN-TIME This section describes the primary components of a just-in-time (JIT) system and how it functions, as well as implementation issues that would have an impact on the accounting department. In addition, it discusses control issues, system inputs and outputs, accounting error rates, costs, and accounting measurements that are related to a JIT system. A JIT system generally has a favorable impact on the costs, reporting requirements, controls, and error rates of the accounting department. The internal audit department will have a large role in this environment, since it must be careful to verify the integrity of the bills of materials records, while also ensuring that the performance measures tracked by the various departments are being calculated accurately. At the end of this section, the reader should have obtained a general knowledge of how a JIT system impacts a traditional accounting system. (a) COMPONENTS OF A JIT SYSTEM. A JIT system, in essence, is a group of techniques that work together to reduce waste in the manufacturing process. There are many types of waste that a JIT system reduces, such as excess inventory, scrap, production capacity, and cycle time. There are many components of a JIT system, not all of which need to be implemented to have a legitimately operational JIT system. The most common components are: • Elimination of bidding. A traditional system requires the procurement staff to obtain a number of bids for every part purchased. This is very wasteful, not in terms of the ﬁnal price negotiated (which tends to be the cheapest available), but because a large amount of time is required to obtain the bids. By eliminating bidding, the overall time and resources needed to build the ﬁnal product are reduced. • Elimination of bulk deliveries. A traditional system requires that parts will be purchased and delivered in bulk, since bulk purchases are cheaper on a per-unit basis and suppliers prefer to deliver in this quantity. This is wasteful, because storage facilities must be purchased for the extra parts that will not be used immediately, personnel must be assigned to track the parts, and some parts will be damaged in storage. By forcing suppliers to deliver on the amount of parts needed immediately for production purposes, all of these costs can be eliminated. • Elimination of receiving. A traditional system requires that all incoming parts be inspected by a receiving staff. This is wasteful, because the company must incur the cost of the receiving crew, which adds no value to the product. A better approach is to certify each supplier for quality with a rigorous quality process inspection, so that all incoming goods are certiﬁed to be of high quality and in the right quantity, and can therefore be delivered straight to the production workstations for inclusion in that day’s production. • Elimination of setup times. A traditional system uses long production runs, because this is the most efﬁcient way to produce goods when equipment setup times are extremely long. This is wasteful, because long production runs frequently mean that excess quantities of parts are being produced, which must then be stored, with all the costs attached to inventory storage. A better approach is to have process teams continually review the work sequence needed to set up equipment, with a goal of reducing setup times to zero. It is common after a series of such reviews to reduce equipment setup times from many hours to just a few minutes or even seconds—this makes it practical to have very short production runs, since the cost of setups has been so greatly reduced. By reducing the size of production runs, there is no need to produce excess quantities of parts, which greatly reduces the cost of excess inventory. • Creation of production cells. A traditional system uses clusters of the same type of equipment, with production then ﬂowing on to the next cluster of the same type of equipment. This is wasteful, because there will be unused or overburdened equipment in each cluster. In addition, no one has complete responsibility for a ﬁnished product, so it is difﬁcult to determine responsibility if there is a ﬂaw in the ﬁnished product. A better approach is to cluster all types of equipment needed to produce a speciﬁc product in a production cell that is serviced by a very small number of employees—perhaps as few as one. This arrangement allows a very

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small number of workers to complete all production steps associated with a part, which results in ﬂaws being spotted immediately and their causes corrected before large numbers of parts are produced—and scrapped. This also ensures that each piece of equipment is used in equal amounts. A ﬁnal side-product of this approach is that the company focuses on a large number of cheaper, manually operated machines, rather than a small number of very expensive, highly automated machines that require large investments. • Creation of subplants. A traditional system uses lots of work-in-process to ﬁll in for any capacity imbalances between machines, so that all equipment can operate at maximum capacity. This is wasteful, since the company must use a large amount of working capital to maintain the high levels of work-in-process. A better approach is to cluster production cells together into what are called subplants; these subplants are designed to pass one part from cell to cell until the ﬁnished product is completed—without the need for large quantities of work-in-process. The elimination of inventory is accomplished by carefully balancing the production capacity of each production cell within a subplant so that there are no cells that produce parts at excessively slow or fast rates, which would introduce either work stoppages or excessive work-in-process into the production process. • Use of Kanbans. A traditional system pushes materials through the production process based on estimated production requirements that are created by the sales department. These production volumes are produced in large batches, even if there is no customer who has clearly committed to purchase the products. Also, each workstation produces the maximum quantity of parts at all times in order to show the most efﬁcient use of the machine in meeting the total production goal, which dumps large quantities of semiﬁnished parts onto the operator of the next machine in the production sequence. This is wasteful, since large amounts of ﬁnished goods may end up in storage for long periods of time and may even have to be written off and scrapped if no buyer can be found. Similarly, a machine malfunction can cause an error in a part that is not discovered until a large number of parts have been produced, and they must then all be scrapped. A better approach is to switch to a pull system that uses a request called a “kanban.” The kanban can be a card, a ball, a light, or any signal that more parts are needed. The equipment furthest down the production process will complete a part and then demand one additional part (or a small number of parts) from the workstation immediately before it in the production chain, using a kanban as a signal. The exact number of requested parts are delivered—no more and no less. Each machine operator in the production sequence uses this same kanban signal to order more parts from the previous workstation, which greatly reduces the amount of in-process inventory and leads to the discovery of ﬂaws in parts more quickly than if they were buried in piles of inventory. This same technique can be used with customers; a conﬁrmed customer order can be treated as a kanban, which “pulls” the exact amount of product needed by the customer from the production process, thereby eliminating any ﬁnished goods inventory and any associated risk of inventory obsolescence. In short, a JIT system works toward the goal of reducing waste through the manufacturing process so that a company can produce goods at the lowest cost and in the shortest possible period of time. (b) EFFECTS OF JIT ON THE ACCOUNTING SYSTEM. (i) Labor Requirements. A JIT system is a great boon to the accounting department in terms of the number of tasks that are no longer required. For example, a JIT system deemphasizes the tracking of direct labor; because labor time is only used on production when production is needed and otherwise stands idle, there is not much point in emphasizing high direct labor utilization. Also, because inventories are reduced to very small levels, it is more efﬁcient to expense inventories as a current expense rather than wasting accounting resources in tracking inventory levels at the end of each reporting period and using this information to derive the cost of goods sold. Also, there is no reason to continue tracking the overhead volume variance, since this might encourage behavior that would increase production volumes solely in order to reduce the overhead variance,

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which would leave excess ﬁnished goods wastefully stored in the warehouse. The payroll function would require less work if piece-rate payments could be discontinued; piece-rate work encourages high-speed production, whereas a JIT system encourages work that is frequently paced slower to ensure that products are manufactured correctly on the ﬁrst try. Also, there is less labor needed to match accounts payable documents prior to issuing payments, because blanket purchase orders are typically used in a JIT environment—and there are fewer blanket purchase orders to compare to supplier invoices and receiving documents. However, an accounting system that does not change to accommodate the large number of small shipments that are an essential part of a JIT system will be “snowed under” by the large number of supplier invoices, receiving documents, and purchase orders that are needed for each delivery. In short, if properly modiﬁed, an accounting system will require much less labor to maintain once a JIT system is installed. (ii) Implementation Issues. There are a few issues to be considered by the controller when a JIT system is installed. One is the possibility of expensing the entire inventory. This is because the amount of inventory may shrink so low that it will be easier to expense it off than to conduct a periodic inventory count. The immediate issue for the controller is that there may be a signiﬁcant charge to the cost of goods sold when the remaining inventory is expensed. One way around this problem is to gradually build up a reserve against the anticipated amount of the write-off, so that the expense can be spread over many accounting reporting periods. Also, the cost accounting function must be sharply reoriented away from direct labor and overhead reporting, and into such areas as target costing and activity-based costing (ABC). This switch may require retraining of the cost accounting staff. The largest implementation issue is how to handle the ﬂood of paperwork associated with the large number of small parts deliveries from suppliers that is a common feature of a JIT system (i.e., just-in-time deliveries). Under the traditional accounting approach, each delivery will have an associated purchase order, supplier invoice, and receiving document—when the number of deliveries increases, so too will the amount of paperwork. This can be avoided by issuing blanket purchase orders for an entire year’s requirements for various parts, which greatly reduces the volume of purchase orders. Another approach is to have suppliers summarize their bills into single monthly statements, which also reduces the volume of paper. Yet another variation is to pay suppliers based on the number of parts received, instead of relying on any supplier invoice at all. All three of these techniques are geared toward a signiﬁcant reduction in the volume of paperwork associated with JIT deliveries. The primary accounting implementation problems to be addressed when a JIT system is installed include the expensing of inventory, the realignment of cost accounting tasks, and a reduction in the paperwork needed to process accounts payable transactions. (iii) Control Points. The accounting control points vary somewhat in a JIT environment. First, there is no need to verify inventory quantities, since inventory amounts are so small that errors in this area would have no signiﬁcant ﬁnancial impact. The prices the company agrees to pay on blanket purchase orders are worth comparing to market rates from time to time, to ensure that the company is not paying excessively high costs by not using competitive bidding. Another control is to compare the prices on blanket purchase orders to the prices actually being paid, to ensure that the company is being billed for the correct amounts. These controls are of the auditing variety—there are no new controls required that are built into the day-to-day accounting transactions. (iv) Inputs and Outputs. When a JIT system is installed, there is a considerable change in the input volumes of receiving documents, purchase orders, and supplier invoices. As previously noted, this input volume can be reduced by using different methods to verify the receipt of goods. On the output side, the accounting department is clearly responsible for less variance reporting. The burden of variance tracking shifts in large part to the production department, which posts this information near each production cell on a minute-to-minute basis and is therefore able to act on the information much more quickly. Thus, the accounting department will experience some change in input volumes and will see a reduction in the amount of internal reporting once a JIT system is installed.

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(v) Bills of Materials Errors. There is a crucial error to watch out for when a JIT system is used. This is any error in a product’s BOM. This is a critical error, because purchases are driven by the quantities shown on the bill; if the bill is incorrect, the accounting department (if it is using the more advanced technique of paying suppliers based on quantities of products produced) will pay suppliers for an incorrect quantity of parts used in the production process. Thus, it is very important that bills of materials be accurate so that accounting errors can be avoided. (vi) Cost Reduction. The cost of running the accounting department should go down once JIT is installed, unless no effort is made to alter the method of paying suppliers for the increased volume of parts shipments received. The impact of this cost reduction will be on the accounts payable staff, where some clerical personnel can be eliminated. Also, there is a possibility of removing some cost accounting labor, since a number of variances will no longer require tracking. Labor costs, both in the clerical and skilled areas, may be reduced once a JIT system is fully implemented. (c) PERFORMANCE MEASUREMENTS. A large number of measurements can be used to track the performance of a JIT system. Only a few of these measurements are most easily tracked by the accounting staff, such as inventory turnover, since most of the measures are operational in nature and are really the responsibility of the engineering and production departments to track. Because these departments are reporting on their own performance, it is important to have the internal audit department cross-check their measurements from time to time to ensure that there is no skewing of measurements that favors those departments. • Materials cost. This measure is most easily tracked by the accounting department. Materials cost is the single largest cost of most products, so a trend line of the unit cost of each product is very worthwhile to track. Any signiﬁcant trend changes in this cost should be brought to the attention of the engineering staff for review. • Cost of scrap. This measure is most easily tracked by the production department, with occasional review by the internal auditing staff. A JIT system should have very minimal scrap levels, so any sudden increase in this measure may indicate that some production process is no longer working correctly, and requires immediate correction. • Production backlog. This measure is most easily tracked by the production scheduling department. A major increase in the backlog may require action by management to increase production capacity, while minimal backlog levels may be an opportunity for the production staff to review production processes and make them more efﬁcient in anticipation of the next surge in orders. • Work-in-process inventory. This measure is most easily tracked by the production department. The amount of work-in-process inventory, especially as a proportion of the cost of goods sold, is one of the most useful JIT measures. It tells management how much inventory “slack” is in the production process. By slowly removing inventory from the production process, management can see that its manufacturing process is slowly being converted from a less efﬁcient job shop environment to a more efﬁcient process ﬂow environment. • Value added by cell per employee. This measure is most easily tracked by the engineering department. Because a JIT system strives to reduce the non–value-added time in the production process, this measure is important; it tells management how much value is being added within each cell by the production workers. The measure should not include those production activities that do not add value, such as moving or stacking parts. • Delivery performance. This measure is most easily tracked by the logistics or shipping departments. A key customer service measure is getting the product to the customer on the originally agreed-upon date. Any variation from this date should be noted. This measure is frequently accompanied by a list of speciﬁc reasons that identify why each order was not shipped on the correct date.

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• Defective parts per million. This measure is most easily tracked by the production department. A JIT system is designed to produce only the exact amount of products needed to ﬁll customer orders, so any defects will interfere with this level of production. Hence, tracking defective parts is one of the most common JIT measures. • BOM accuracy. This measure is most easily tracked by the engineering department. A JIT system must receive only the exact quantities of parts needed to produce a product in order to operate at the most efﬁcient levels. If bills of materials are inaccurate, the needed parts will be ordered in either excessive or inadequate quantities; this severely impacts the timing of the JIT production process. • Supplier delivery performance. This measure is most easily tracked by the purchasing department. Suppliers must deliver parts on time so that the JIT production process can use them immediately. There is no excess parts quantity on hand in a JIT environment to form a buffer against late supplier deliveries, so poor supplier delivery performance can stop the entire JIT production process. • Cell output. This measure is most easily tracked by the production department. It is necessary to periodically compare the size of the backlog to the production capacity of the various work cells within the production line. Any major disparity can signal the company’s inability to clear the backlog within a reasonable period of time and will require the creation of more production cells. • Customer returns. This measure is most easily tracked by the receiving department. This measure should be accompanied by a list of reasons why products were returned. If product defects are a signiﬁcant reason, this information must be fed back to the production staff, who should take steps to eliminate the errors from the production process. • Floor space utilization. This measure is most easily tracked by the engineering department. When a large proportion of the work-in-process has been removed from the production process, there will be a much smaller on-site inventory storage requirement, which should be reﬂected in a considerable reduction in the amount of ﬂoor space used by the production process. This can be measured in square feet of space saved.

54.5 PRODUCT DESIGN A product design process does not have a large impact on the operations of an accounting system. No transaction cycles are signiﬁcantly altered. However, there are some extra reporting requirements related to the cost of product design teams as well as trends in product costs and revenues. Also, comparing target costs to actual costs for products can reduce the chance of having errors related to overpayment, while reporting this information back to design teams is necessary for the teams to investigate and correct any signiﬁcant variances. Finally, the performance measurements for the product design process are primarily collected by the engineering department itself, with only a few additional measures being tracked by the accounting staff. Thus, the accounting department serves the product design process primarily in a reporting role. This section describes the primary components of a product design system and how it functions, as well as any implementation issues that would have an impact on the accounting department. In addition, control issues, system inputs and outputs, accounting error rates, costs, and accounting measurements that are related to an enhanced product design system are noted. At the end of this section, the reader should have obtained a general knowledge of how an advanced product design system impacts a traditional accounting system. (a) COMPONENTS OF A PRODUCT DESIGN SYSTEM. A traditional product design process is sequential—a research group creates a theoretical design that is handed over to another engineering group that creates a detailed product concept. The concept then goes to a prototyping team that creates an operating model of the product. The prototype is then fully documented, including ﬁnal drawings and bills of materials. Suppliers are then selected who can deliver the

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component parts, and equipment is ordered for the production process. Once the production process is operational, the product design process is complete. The problem with this traditional process is that it takes a large amount of time to complete. At any stage in the process, it is likely that a problem will be uncovered that will force the process to shift back to repeat an earlier step, which greatly lengthens the time to market. For example, the prototyping team may ﬁnd that the model has a serious ﬂaw that can be ﬁxed only by the research team. The project must therefore be moved back to the beginning of the process, where the sequence of events begins from scratch. An even more serious problem arises if the production department discovers that it cannot produce the new product due to problems with the product design; this issue typically means that the design team must redesign the product and may even lead to the purchase of different manufacturing equipment. Not only is the sequential design process subject to many expensive iterations, but also it requires large amounts of time to bring a new product to market. A revised product design process shifts away from sequential design and uses parallel design instead. This means that all functions associated with a new product are involved in the process right from the start. This allows prototyping, design, and manufacturing personnel to identify all potential product ﬂaws that will impact their functions right away, so that no critical ﬂaws will be uncovered near the end of the design process, requiring an expensive redesign. This has the greatest impact on the production department, which has input into designing a product that is as easy to manufacture as possible. By giving all concerned groups continual input into product design at all stages of the design process, the associated expenses and time requirements can be greatly reduced. The resources needed to complete the design process can also be improved with a number of other techniques. One is to implement an engineering data management (EDM) system. This system digitizes, indexes, and stores all design drawings, logs drawing approvals, stores bills of materials, and allows users to copy drawings and bills from previous projects into the ﬁles for new projects. The system eliminates the time needed to physically locate ﬁles and reduces the time needed to create new ﬁles by “cannibalizing” old ones. Also, the engineering function can focus on reusing existing parts from other products, which reduces the time needed to develop new products; this can be tracked by measuring the number of old parts used in new products. Also, using the same part in several products means that larger volumes of those parts can be purchased, which improves a company’s ability to obtain quantity discounts. In addition, the time needed to complete the prototyping phase can be reduced by linking a computer-aided design (CAD) computer to stereolithography equipment, which automatically constructs a prototype directly from electronic drawings. The management of the design process can also be changed so that each design team handles fewer design projects at one time—studies have shown that the efﬁciency of project completion is signiﬁcantly improved if each design team works on the minimum number of projects at one time. Another efﬁciency technique is to create a warranty claims database that collects information about speciﬁc customer problems that have been encountered with products. Engineers can review this database to locate design ﬂaws in products that can be corrected during the design of the next product version and that will lead to fewer warranty claims at that time. Finally, the design process can use target costing to hold product costs at predetermined levels. This technique starts with a target total price for a product that is expected to be acceptable in the marketplace; management then determines an acceptable margin, which leaves the cost of the product—the design team then allocates target costs among the various component parts and matches actual costs to the targets. By tightly controlling these costs against target goals, there is a much better chance of ending the design process with the costs that were originally anticipated, as well as of selling a product at a reasonable price with a good proﬁt margin. Obviously, there are a large number of techniques that can be used to reduce the cost and time needed to design a product. (b) EFFECTS OF PRODUCT DESIGN ON THE ACCOUNTING SYSTEM. (i) Implementation Issues. There are several issues associated with the implementation of a product design system that will have an impact on an accounting system. One is the need to track

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the cost of each design team. The accounting department should assist in establishing a budget for each team, tracking actual costs against that budget, and reporting any variances from the budget to company management. Another issue related to accounting is that a design team creates a product based on target costs. These costs should be stored by the accounting department in a database and regularly compared to actual costs so that the design team can determine why costs are varying from expected levels. Also, the revenue generated by each product line should be tracked on a trend line to determine when sales growth is leveling off. This is a sign that the engineering staff must be ready to replace the existing product line with a new one that can create more sales. Finally, the accounting staff should calculate the cost of engineering change notices. These costs can include the expense of throwing away unneeded inventory, changing product brochures, altering production processes, and recalling existing products. All of the above implementation issues require the addition of more cost accountants to fulﬁll the needs of more cost reporting, as well as the creation of cost-tracking systems and databases to store the cost information. Thus, there is a clear additional accounting expense associated with creating a product design process. (ii) Control Issues. The primary accounting control issue related to product design is the comparison of target costs to actual costs to see what component parts of a product are costing more than expected. This represents a control over product costs, which is different from a more typical control that watches over an accounting transaction. However, lack of attention to actual parts costs can lead to considerable monetary losses and is therefore an appropriate control to be managed by the accounting function. (iii) Inputs and Outputs. There are no new inputs to the accounting department when a product design system is installed, but several new outputs are required. One is a report that compares budgeted against actual costs for each design team. Another report should compare targeted product costs to actual costs. This report can be summarized for individual products or product lines. Another report can show the trend in product costs. This report can either show changes in a product’s total cost over time or break down this information further into cost trends for each component part of a product. Finally, a report should be prepared that shows the trend in product revenues—this report can be shown in a variety of ways, such as by individual product, or by product line, or by geographic region. The accounting staff will create a variety of new reports when a product design process is implemented. (iv) Transaction Errors. A product design process has very little impact on any accounting transactions, and so there is no reason for accounting error rates to change as a result of having such a system. However, a by-product of the design process is having a database of target costs for each product. This information can be used by the accounting staff to compare incoming parts costs to expected costs, which can help to avoid any errors associated with paying too much for materials. If this information is used correctly, there should be a drop in any errors related to the payment of excessively large sums for parts. (v) Additional Costs. The only added cost for the accounting department when a product design process is implemented is the labor for inputting time cards from each of the design teams and for the accumulation, summarization, and reporting of information related to the costs and revenues of each product or product line. Unless there are a large number of design teams or products, this should be an insigniﬁcant extra cost for the accounting department. (c) PERFORMANCE MEASUREMENTS. There are a large number of performance measurements that can be used to track the efﬁciency and effectiveness of the design process. However, only a few of these measures are related to costs and revenues and so cannot readily be accumulated or summarized by the accounting department. Instead, the engineering department is the group most likely to originate these measurements. Because this means that the engineering department will be reporting on its own performance, it is important that the internal audit depart-

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ment review these performance measures from time to time to ensure that they are being accurately collected, summarized, and reported. The most important performance measurements related to the product design process are: • Cost of design team. This measure is most easily tracked by the accounting department. The cost of each design team should be periodically compared to a budgeted set of costs, primarily payroll, for each design team. This report is used by management to determine which design teams are using more resources than is considered reasonable to design a product. • Investment in the design process. This measure is most easily tracked by the accounting department. The amount of this investment is not just engineering payroll—it can also include a number of ﬁxed assets such as CAD workstations and high-speed printers for full-size drawings. • Break-even time. This measure is most easily tracked by the accounting department. It tracks the amount of time required to break even on the initial design and tooling investment in a new product. Because many products are obsolete within a year of introduction, this is becoming a more crucial measure of the success of a product design effort. • Trend in sales volume. This measure is most easily tracked by the accounting department. A key indicator of when a product should be replaced is by tracking the growth rate in sales volume. A ﬂattening of this growth rate indicates that the product market is maturing and that a newer product is needed to grow sales further. • Trend in unit cost. This measure is most easily tracked by the accounting department. When the trend of unit costs stops declining, it means that a product’s design team can no longer wring any cost reductions from it; this is a signal for the introduction of a new product, which the design team can cut costs from once again. • Proportion of drawings created on paper. This measure is most easily tracked by the engineering department. When drawings are converted to an electronic format, they can be more easily changed to suit the needs of other design teams for other products, which saves time. Thus, a low proportion of drawings created on paper is desirable. • Number of design revisions after release to production. This measure is most easily tracked by the engineering department. Each design revision after release to production requires a great deal of coordination to ensure that different parts are ordered, old parts are used up or thrown away, user manuals are redesigned, and the production staff is trained in assembling this somewhat different product. It is clear that, due to the effort involved, the number of subsequent design changes must be kept to a minimum. • Proportion of new parts used on a new product. This measure is most easily tracked by the engineering department. New products can be designed, tested, and released to production much more quickly if existing parts are included in their designs, since this eliminates the time needed to design and test new parts. Thus, a low proportion of new parts used on a new product is quite desirable. • Number of iterations of the design cycle. This measure is most easily tracked by the engineering department. The design team’s costs will increase greatly if it must continue to reiterate the design cycle prior to releasing a new product to the production department. By using parallel design efforts that incorporate reviews from all interested parties at every step of the design process, the number of iterations can be reduced, which can greatly reduce the time to market for the new product. • Number of new products per year versus number of new competitors’ products. This measure is most easily tracked by the engineering or marketing department. A company can lose market share if it cannot keep up with the volume of products being introduced by competitors. Of course, the uniqueness of the products being offered is also quite important, but the total number of product offerings is still a clear indicator of a company’s effectiveness in bringing new designs to the marketplace.

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• Proportion of products completed on time. This measure is most easily tracked by the engineering department. In an environment where a delay in product introduction of a month or less can lead to great reductions in market share, it is critical that products be completed on time. This performance measure can be divided into the time required to reach the production phase as well as to reach the market, which narrows the focus of management in determining precisely why products are not reaching the market on the target date. • Number of design projects per product team. This measure is most easily tracked by the engineering department. A product team can mplete design projects if it is focusing on the smallest number of projects at one time. The optimal number of projects to give to a team will vary depending on the type and complexity of the products being produced. Management can gain some understanding of the optimal number of projects by comparing the number of projects for which each team is responsible to the average number of days by which targeted release dates are missed for each team. • Number of engineering changes in ﬁrst year after introduction. This measure is most easily tracked by the engineering department. If there are a large number of engineering changes after a product has been released to the market, this causes problems in a number of areas; by tracking the number of design changes subsequent to release, management can determine the extent of this problem. • Degree of conformance to speciﬁcations. This measure is most easily tracked by the engineering department. Engineering management should compare each completed product to the original speciﬁcations to determine how closely the design team came to the original speciﬁcations. If the ﬁnal product varied considerably from the desired speciﬁcations, this is a clear sign that the management of the project team should be changed for the next design project, since performance against goals is a primary management task.

54.6 COMPUTER-INTEGRATED MANUFACTURING This section describes how a computer-integrated manufacturing (CIM) system operates, what alterations to the accounting system are required to make the accounting system mesh with it as efﬁciently as possible, as well as any implementation, control, input or output, error rate, cost, or measurement issues related to the accounting system. (a) COMPONENTS OF A CIM SYSTEM. A CIM system is founded upon a central database of production information that tracks every movement of a part through the production process from the issuance of a purchase order to a supplier, through the receipt and use of the part, and through to the shipment of the completed product from the shipping dock. This may sound like an MRP II system, but a CIM system goes a step further and links the database to a variety of automated production equipment to produce the products. For example, robots pick parts from a warehouse area and put them on automated equipment-moving devices that bring the correct parts to the correct automated production equipment, where other robots unload the parts and insert them into the production equipment for processing. The parts continue through the production process in this fashion until they reach ﬁnal assembly, which is also conducted automatically, and then they are automatically boxed, put on pallets, and loaded on a truck for shipment to the customer. A fully implemented CIM system can be automated all the way through the production process. The CIM system is of most use for the production of products that are very standardized and that can be produced in large enough volumes to justify the considerable expense of buying and implementing such a system. The CIM system has a dramatic effect on process ﬂow times, since it requires no wait or queue times in the production process. Thus, products can be produced and shipped to customers much more quickly than is the case with a typical production system. The CIM system also produces products with much more precision (assuming that the equipment is properly maintained), which means that any waste due to machine operator errors is eliminated from the system. In short, a CIM system is quite expensive but pays for itself by producing products faster and with less waste.

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(b) EFFECTS OF CIM ON THE ACCOUNTING SYSTEM. (i) Implementation Issues. The major implementation issue faced by a controller when a CIM system is installed is the need to create an interface between the accounting and CIM databases. The CIM database contains a large amount of information that is useful to the accounting system, such as the dates on which parts were received from suppliers, as well as the quantities received; the dates of shipments to customers, as well as the quantities and types of items shipped; and the time each production job spends in each machining center before moving along to the next. An interface can automatically send this information into the accounting database so that the following actions can be taken: • Automatic supplier payments. Electronic receiving log information can be sent to the accounting system, where it is automatically matched to purchase order authorizations to create supplier payments. • Automatic customer billings. Shipment information can be sent to the accounting system and linked to customer bill-to addresses and tax programs to automatically create customer billings. • Automatic job cost roll-ups. The time that a product spends in a machining center can be accumulated in the accounting database and multiplied by the cost per center to determine the total cost assigned to a job. Creating an interface between the CIM and accounting databases creates an automatic ﬂow of information into the accounting database that allows the accounting system to automatically complete a number of important transactions, which cuts or eliminates the labor normally required to handle them. Once an interface is installed between the CIM and accounting databases, there is the possibility of producing daily ﬁnancial statements that are very accurate. This is possible because the CIM system tracks—in precise quantities—the amounts of materials and labor used, receipts and shipments, and exact location of work-in-process in the ﬂow of production. The only remaining costs that are imprecise are mostly of the ﬁxed-cost variety, such as utilities and taxes, or easily averaged over a period of time, such as ofﬁce supplies. By using daily estimates of ﬁxed and other costs and combining this information with the accurate production data supplied by the CIM database, it is quite possible to create daily ﬁnancial statements. The interfacing does not need to stop with the CIM-accounting interface. It is possible to extend the interface via electronic data interchange to the computer systems of other companies, which allows the accounting system to also track the shipment dates of parts from suppliers, which can be used to predict cash ﬂow requirements. These additional interfaces are also useful for collecting orders from customers, billing customers, and issuing bid requests to suppliers. The accounting system does not need all of the information transmitted by these additional interfaces, but some is useful for cash forecasting, rapid billings, and quicker response to customer requirements. (ii) Control Points. The main control point needed when using information from a CIM database is to ensure that the data stored in the CIM database is accurate; otherwise, the information being transmitted from it will result in errors in the accounting database. The best way to implement this control is to have the internal auditing department verify the accuracy of various key data items, such as inventory, labor routings, and bills of materials. This should be a frequent audit item, since a breakdown in the accuracy of any one of these items could have a serious impact on the accuracy of related accounting transactions. (iii) Inputs and Outputs. Several inputs to the accounting system are automated when it is interfaced to a CIM database. All information on the receiving log will automatically be sent to the accounting system, so there is no need for the laborious matching of accounts payable documents to receiving documents. In addition, shipping information is automatically transmitted to

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the accounting system, so there is no need to manually create bills from shipping documents. Also, job costing information related to the amount of time spent on various production processes does not have to be manually entered into the accounting database by clerks; instead, all of this information is transmitted from the CIM database. In short, the volume of manual entry work drops signiﬁcantly when information is automatically imported from the CIM database to the accounting database. When a CIM system is implemented, the only new output required of the accounting system is daily ﬁnancial statements. Because all revenue and cost-of-goods-sold information is being automatically transmitted to the general ledger from the CIM database every day, it is easy to issue ﬁnancial statements down to the gross margin line every day without any new accounting work at all. To extend the ﬁnancial statement “below the line” to sales, general, and administrative costs, it is necessary to make a single journal entry each day to account for the average cost in each category. The accumulation of all these journal entries should approximate the total actual costs compiled by the end of the reporting period. The journal entries are reversed at month-end so that actual costs may be substituted. This costing structure gives management a very good idea of product revenues and costs every day, and will only miss unusual costs “below the line” that have not been incurred before. By incorporating daily infusions of information from the CIM database into the accounting system, it is possible to issue reasonably accurate daily ﬁnancial statements. (iv) Transaction Errors. There should be fewer errors in the accounting database when information is sent to it from the CIM database. This is because of the high level of CIM information accuracy—there simply are no informational errors requiring investigation and correction by the accounting staff. If errors had previously been quite high, the sudden reduction in errors as a result of using CIM database information may even lead to a reduction in accounting staff that had previously been occupied with ﬁxing information errors. (v) Cost Reduction. The primary cost reduction experienced by the accounting department when the accounting system is linked to the CIM database is a reduced need for data entry personnel. This is because a number of transactions related to inventory movements, receipts, and shipments is now automatically transferred to the accounting database without any need for rekeying of the data by clerks. However, this cost reduction must be offset against the considerable programming and testing cost of creating an interface between the accounting and CIM databases. The initial cost of creating the interface will likely outweigh any cost savings, but long-term savings will eventually offset this cost. (c) PERFORMANCE MEASUREMENTS. The primary measurements used to track the performance of a CIM system are noted below. These measures are heavily oriented toward tracking the cost of the system. Because a CIM system is so expensive, it is critical to track the break-even sales level, overhead rate, and debt-equity ratio on a continuing basis so that problems in this area can be spotted and corrected as quickly as possible. Also, there are several performance measures related to the operation of the system—inventory turns, cycle time, square footage used, the proportion of direct labor, and the size of the purchasing department are all impacted by a CIM system, so they should be constantly monitored to ensure that the CIM system is having the anticipated impact on several key company functions. The primary measurements are: • Break-even level. This measure is most easily tracked by the accounting department. A CIM system is very expensive and will therefore increase a company’s ﬁxed costs. It is important to know the break-even point where the CIM costs have been covered by revenues, so that management knows the minimum sales level that must be achieved each month before proﬁts can be earned. • Inventory turnover. This measure is most easily tracked by the accounting department. A CIM system maintains tight control over inventory levels and the amount of work-in-process needed to maintain an efﬁcient production process. A greatly reduced inventory investment is

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a typical result of having a CIM system, so the inventory turnover ratio should increase subsequent to a CIM installation. • Debt-equity ratio. This measure is most easily tracked by the accounting department. A CIM system is so expensive that many companies must take on large amounts of debt to purchase the necessary equipment. It is useful to track the debt/equity ratio both before and after the purchase of a CIM system to determine the amount of additional ﬁnancial risk being incurred as a result of having it. • Total cycle time. This measure is most easily tracked by the industrial engineering department. A CIM system removes most of the queue and wait time from the production process, so the total cycle time required to produce a product should be greatly reduced as a result of having a CIM system. • Square footage utilized. This measure is most easily tracked by the production department. A CIM system can be kept in a smaller facility than a typical production layout, since there is less work-in-process to store, and conveyors are used instead of aisles to move parts between production equipment. Thus, there should be savings from shrinking square footage requirements when a CIM system is installed. • Size of purchasing staff. This measure is most easily tracked by the accounting department. A CIM system can be directly linked to the computer systems of a company’s suppliers for the direct ordering of parts with the electronic data interchange format. When this automated linkage is installed, there is less need for the services of a purchasing department, resulting in some staff reductions in this area. • Proportion of maintenance staff to direct labor staff. This measure is most easily tracked by the accounting department. A large part of a production department’s direct labor force will be redundant when automated production equipment is installed, but there is an increase in equipment maintenance personnel needed to ensure that the CIM system operates properly. This transfer of labor skills is most evident when tracking the proportion of maintenance staff to direct labor staff. • Overhead rate. This measure is most easily tracked by the accounting department. Overhead increases as a proportion of total costs when a CIM system is installed, since there is more depreciation and equipment maintenance, and fewer direct costs such as direct labor. In an activity-based cost environment, the overhead pool may be split up into a large number of smaller cost pools so that costs may be more accurately assigned to various product groups. In summary, a CIM system is a very expensive system that uses a highly accurate database of production information to drive an automated production facility. The data collected and stored by a CIM system must be highly accurate in order to make the production system run smoothly. Because of this high level of accuracy, it is very worthwhile to create a computer interface between the CIM system and the accounting system; this allows the accounting system to automatically bill customers, pay suppliers, and conduct job cost roll-ups for each machining center with only minimal manual data entry by the accounting staff. Due to the high cost of this system, a company’s debt, overhead, and break-even levels should be monitored by the accounting department at all times. Several additional performance measurements should be added that track areas directly impacted by the CIM system, and which should be accumulated and reported by the production department.

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CHAPTER

55

ACCOUNTING BEST PRACTICES 55.1

INTRODUCTION 1005

55.2

SIXTY-SIX BEST PRACTICES 1005

55.1 INTRODUCTION There are many ways to improve the functions of the accounting department. These improvements can be gleaned from textbooks, magazine articles, trade association meetings, or simply invented internally. Whatever the source, they enhance the efﬁciency of the accounting department. When a number of these improvements, or “best practices,” are combined into a department’s operations, its overall performance will vastly increase. Brief descriptions are provided of 66 best practices that a controller can implement in the accounting and ﬁnance areas. The best practices are noted in alphabetical order and give a brief description, as well as the advantages and disadvantages, of each one.

55.2 SIXTY-SIX BEST PRACTICES In this section, a long list of best practices are presented. They are listed in alphabetical order, with the general functional area in which the practice is used being listed at the beginning of each description. For each best practice, there is a short description of the method, followed by a summary of the advantages and disadvantages of using it. 1. Accounts payable, location consolidation. This best practice involves putting all accounts payable processing for a company in a single location. The reason for doing so is that there are major efﬁciencies involved in processing large quantities of accounts payable from a single location. For example, a company can avoid having suppliers send their invoices to the wrong processing location, because there is only one location to send them to. Also, it is cheaper to shut down multiple accounting software packages that process accounts payable, because there are software maintenance fees for each package that can be avoided. Also, there are expensive processing systems that are most efﬁcient when accounts payable are processed in high volume from a single location; these systems include page scanning, digital document storage, and automated electronic payments. On the downside, there is a considerable staff dislocation involved in consolidating processing centers, as well as the risk of not paying invoices in the short term, while the transition takes place. 2. Accounts payable, payment on receipt. This best practice involves issuing a check for each supplier invoice the moment each invoice is received. This approach contravenes the method used by nearly all companies, which is to wait for the maximum time period to expire before paying suppliers. However, one must also consider the effort needed to wait before paying, which includes ﬁling invoices, retrieving them when payment is due, and then ﬁling them 1005

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Ch. 55 Accounting Best Practices

away again once payment is completed. The cleaner approach is to pay for invoices as soon as possible in order to avoid the repeated reﬁling of documents, but this necessitates giving up the interest earned on cash that is being paid to the suppliers. One solution to this problem is to negotiate special advance payment discounts with suppliers that offset the interest that would otherwise be earned on money that is being paid immediately to suppliers. Accounts payable, reduction of number of approvals. This best practice involves reducing the number of approvals needed to process a payment to the absolute minimum. This approach avoids multiple approval situations, such as a manual approval of an invoice, a second review prior to printing checks, and then one or more signatures on the resulting check, before it is ﬁnally put in the mail. Instead, if a purchase order has already been approved by an authorized person, then there is no need for any subsequent approvals, because the approving person has already seen the information once and does not need to see it again. The problem with this approach is that everything being purchased must have an approved purchase order, which can be enforced by having the receiving staff turn away at the receiving dock all items that have no purchase order. Also, if some employees are issuing verbal purchase orders, this can be put down forcefully by management by using various levels of censure. In short, strengthening its control over purchase order approvals allows a company to avoid the need to continually obtain additional signature approvals for payments. Accounts payable, use petty cash as substitute. This best practice involves paying suppliers and employees through the petty cash system, rather than using the more elaborate accounts payable system to cut checks. The petty cash system has far fewer payment steps than a disbursement system that uses checks, so the controller should shift as many payments as possible to the petty cash system. These payments are typically the smaller ones that are too expensive in terms of processing effort to pay for with checks. Though petty cash is typically used only to reimburse employees, it can also be used to pay suppliers on the spot for small amounts; this means that a controller will be using a cash-on-delivery system with some suppliers, but only those involving very small payment amounts. However, paying with petty cash is not a viable alternative for the majority of payments made, because most payments are much too large to be handled in this manner, and also because most suppliers do not show up in person to receive their payments in cash. Still, companies can effectively increase the use of their petty cash systems to some degree. Accounts receivable, elimination of month-end statements. This best practice involves eliminating the printing, envelope stufﬁng, and mailing needed to issue month-end statements. Though statements are used as part of a company’s accounts receivable collection effort, this is not a method that generally results in a considerable improvement in collections, because most people receiving statements simply throw them out. A collections staff can occupy its time more proﬁtably by directly calling customers about overdue accounts. The costs saved by eliminating month-end statements include paper, computer printing supplies, envelopes, postage, and the labor needed to print and mail them. Activity-based costing (ABC). This best practice involves compiling costs by activity center, and then charging out the costs of the activities to those outputs, such as products or services, that use them. For example, a manufacturing facility can compile the complete cost of operating a machine, which may include the cost of electricity, maintenance, capital costs, and supplies. These costs can then be summarized and divided by an activity measure, such as hours. The cost of that machine can then be charged to a product based on the number of hours during which the machine is used to create the product. The concept can be taken a good deal further by forming a variety of cost pools that can be charged out to products and services, using many kinds of activity measures as the basis of allocation. This approach is an excellent tool for clearly deﬁning the costs that activities actually incur. The method is especially useful in low-margin environments, where strict attention to product costs is a primary determinant of success. However, the system can require a considerable investment in time and

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8.

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personnel to implement, so some companies give up during the implementation effort. Also, managers must be taught to understand and trust the resulting cost information, or else the system’s output will not be utilized to its fullest effect. Area concentration banking. This best practice involves automatically shifting funds from a number of bank accounts into a single one, so that all funds are easily accessible for investing. This approach works most easily when a company does business with just one bank, which can automatically do a nightly transfer of cash from a number of lockboxes into a single investment account that bears interest. The approach is most useful for companies that must have a number of bank accounts, and which accordingly has cash spread out in so many locations that it cannot track all of its cash without a considerable effort. The only disadvantage of this system is cost, because the bank will charge for each cash sweeping transaction into the investment account; however, this expense is usually easily offset by the corresponding increase in investment income. Balanced scorecard reporting. This best practice involves switching from the traditional set of purely ﬁnancial reporting measures to one that combines measurements for a company’s ﬁnancial, customer-related, internal operations, and learning and growth activities. This approach is based on the belief that a company’s ability to grow and perform is based on far more than just ﬁnancial measures, and that these additional factors should be included in the standard accounting reports, so that management focuses on those issues that are central to this belief. The exact measurements used will vary by company, because they must correlate to a company’s strategy. For example, a company that is targeting growth by increasing its share of the market will use a measure such as customer retention, whereas one that focuses on proﬁtability through enhanced asset utilization will be more interested in working capital ratios and employee retention. It can take a great deal of time for the management team to determine which measures it wants in the balanced scorecard, and it may change them from time to time as corporate strategy changes, so the controller must be prepared to alter the data collection systems needed to create measurements. Also, some measurements are difﬁcult to compile, because they do not fall within the usual accounting data collection systems. For example, measuring customer satisfaction may require an entirely new data collection system before the accounting staff can produce reliable information. Budget, automated link to purchasing approvals. This best practice involves creating an automated link between the ﬁle in the computer system that stores the budget, the general ledger, and the purchasing software, so that any new purchase order is automatically compared to the amount of budgeted funds still available, and the purchase order is accepted or rejected based on that information. More speciﬁcally, when an account number is entered for each line item in a purchase order, the computer system should compare the amount being purchased to the net amount of budgeted expense still available (which is done by comparing the original budgeted amount to the amount of expense already noted in the general ledger). This approach keeps a company from overriding the budget and enforces a great deal of ﬁscal discipline. However, many software packages do not contain this feature, so a company must pay for customized programming to install it. Budget model simpliﬁcation. This best practice involves using a number of minor techniques to reduce the size and complexity of the budgeting model, while clarifying the procedures used to channel updated budgeting information into it. The following list describes the various components of this best practice: Create a budgeting manual to deﬁne the exact dates when inputs are due, and note who is

responsible for supplying this information. Switch from a monthly to a quarterly budget layout to reduce the volume of numbers to review. List expenses as a percentage of sales, so that they change automatically as revenues change.

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Ch. 55 Accounting Best Practices Reduce the number of accounts listed in the budget by consolidating small-dollar line

items. Color code data entry cells in the model, so there is no question about what information

needs to be changed. Cluster all key variables at the beginning of the budget model, so managers can easily

access them for experimenting with different scenarios. 11. Budgeting, activity-based. This best practice involves setting up a budget that is centered around activity costs, rather than departmental costs. For example, a traditional production department can instead be budgeted into a variety of cost pools that feed into a number of activity centers, which can then be allocated out to a variety of company outputs. This approach allows a company to far more accurately determine the extent of its costs for each activity, which gives it greater control over them. However, this approach is usually severely criticized by managers, who have a hard time understanding who is responsible for which costs, and who is responsible for each activity center. Also, since this method requires a complete demolition of the old budgeting system, an incorrect implementation of the new one may leave a company with no effective budget at all. Finally, each line item in the budget must be aligned to the chart of accounts, so that a budget can be noted next to each actual cost in the periodic ﬁnancial statements; this may require signiﬁcant alterations to the chart of accounts. 12. Budgeting, ﬂex. This best practice involves setting expense line items in the budget as a percentage of sales or some alternate measures of activity, so that the budgeted expense changes if the level of activity changes. This approach keeps the budget from diverging away from reality if the amount of volume handled by the business varies signiﬁcantly from expectations. In the real world, this level of variation is more common than not, so a ﬂex budget is of great use to many organizations. It is also useful for gaining the attention of managers who have gotten used to blaming an unrealistic budget for a variety of problems, and who now ﬁnd that it is much more accurate than was previously the case. On the downside, any changes to the level of activity will alter budgeted expenses, which means that the new budget numbers must be punched into the general ledger, so that the budget can be compared to actual expenses; this can be a substantial amount of extra data entry work. 13. Budgeting, on-line. This best practice involves storing the budget model on a computer network, where users can easily access the model and make changes to areas for which they are responsible. This approach greatly reduces the time needed to complete the budget model, because it avoids the extra effort needed to manually enter budget changes onto a paperbased model, send it to the accounting department, wait for someone to enter the changes, and send the modiﬁed budget back to the person making the changes, to ensure that the modiﬁcations were made correctly. The main problem with this approach is if someone accesses conﬁdential information, such as payroll data, that is part of the budget model, or if portions of the model are accidentally destroyed by a user. These problems can be avoided by using password access to some or all portions of the budget model, as well as by keeping backup copies of the model in a separate location. 14. Budgeting via videoconferencing. This best practice involves using video-conferencing to avoid the time and expense required to bring people together from many company locations to discuss budget issues. This approach involves using desktop conferencing systems, or more advanced room-sized systems, that allow video image transfers at minimal expense. By doing so, a company can avoid the travel expense of moving employees to budget meetings, while also avoiding the expense of lost productivity by the same employees while they are traveling. This best practice can be supplemented by keeping key budget documents in a central data storage facility that is easily accessed by employees located in many facilities, so that there is no need to travel to view the documents, either. However, videoconferencing can be too expensive if a room-sized conferencing center is created just for budget meet-

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ings; instead, the expense should be shared with other departments, or an off-site facility can be rented. Of course, there is no need for this best practice if there is only a single facility. 15. Chart of accounts, identical for subsidiaries. This best practice involves issuing duplicate charts of accounts to all corporate subsidiaries, so that they all report numbers to the parent in the same format. This approach makes it much easier for ﬁnancial reporting personnel to consolidate company-wide results into a single, combined general ledger. The reduced effort can also contribute to a shorter time period in which to issue ﬁnancial statements. However, some subsidiaries may have such disparate operations that it is difﬁcult to shoehorn their operating results into a single general ledger format; in these cases, a controller must either choose between risking having expenses and revenues itemized in the wrong accounts or expanding the general ledger to include extra accounts to accommodate each operating unit. 16. Chart of accounts, reduction. This best practice involves consolidating general ledger accounts to the greatest extent possible. By doing so, the general ledger accountant has less account reconciliation work to perform. This also makes it easier for a company’s external auditors, since they can spend less time researching the year-end balances in a smaller number of accounts. However, there is a balance to be struck here, for an excessively small number of accounts will require the general ledger accountant to deal with too much data being stuffed into too few accounts. For example, it is difﬁcult to reconcile an accounts receivable account that includes not only all regular accounts, but also all employee receivables and miscellaneous items. In these cases, it is best to judiciously make use of a small number of additional accounts. 17. Closing activities, accelerated. This best practice involves shrinking the time required to complete the closing activities needed to produce ﬁnancial activities. There are a variety of steps that are a part of this best practice: Accrue estimated charges and income that cannot otherwise be determined during the

closing period. Create a process ﬂowchart. Defer routine accounting tasks during the closing work. Develop allocation bases in advance for the distribution of costs. Distribute a detailed list of closing activities that describes all tasks to complete deadlines

and responsibilities. Eliminate duplicate activities. Prepare closing forms in advance. Replace physical inventory counts with perpetual tracking systems. Review bank statements after the close is completed. Review preliminary month-end reports in advance in search of errors. Review the shipping log in advance to ﬁnd items possibly not billed. Set investigation levels, below which variances are ignored. Use intensive reviews of each closing process to determine where the process can be improved in the future. Use the receiving log to anticipate and accrue for supplier invoices that have not arrived. Utilize automated journal entries for recurring items.

All of these methods combine to create a vastly reduced time frame in which accurate and reliable ﬁnancial statements can be produced. There are no disadvantages to this approach; instead, a continuing emphasis on reducing the production time will inevitably lead to an overall reduction in the total time needed to produce the statements, which leaves more time for other activities. This best practice should top the “to do” list of any controller who wants to improve the performance of the accounting staff.

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18. Collection call database. This best practice involves using a general data ﬁeld in the accounting software for recording information about collection calls to customers. This approach allows a collections person to keep all relevant contact information about an invoice in a single storage location, so that the information is easily accessible when making or researching collection calls. This method greatly reduces the time needed for each customer, thereby creating more time for either additional calls or other accounting activities. The problem with this method is that software customization is frequently necessary to create a data ﬁeld alongside invoice information in the accounting database, which can be an expensive proposition. 19. Collection call stratiﬁcation. This best practice involves sorting through the accounts receivable aging to pick out the largest overdue balances and making calls to those customers before making any to customers owing smaller amounts. By doing so, a company will collect the largest proportion of its overdue accounts, thereby enhancing its cash ﬂow. Many companies do not use this approach, instead favoring a top-to-bottom sequential approach to making collection calls; they start at customer names beginning with A and work their way through to Z, irrespective of the size of the amounts that are overdue. The only risk to using this method is that, if there is not a sufﬁcient number of collection people on hand, some of the smaller accounts may never be reached, resulting in the eventual write-off of their overdue balances. 20. Collections, automatic write-off of small balances. This best practice involves setting a predetermined write-off level for old accounts receivable, below which invoices are automatically written off without any further collection efforts. This approach is very useful if the collections staff is burdened by a disproportionate number of small accounts that are interfering with its ability to call those customers with large outstanding balances. The exact amount of the write-off level will vary by company, depending on the cost to make a phone call (which is driven by the presence of customers for whom long distance phone calls must be made), and the average amount of time needed to complete a collection call. The only danger to using this method is the possibility of customers learning that they can simply wait until the cutoff period is reached and then never pay. Reducing customer credit levels after a write-off will solve this problem. 21. Commissions, simpliﬁed. This best practice involves adopting a simpliﬁed commission structure that is so simple to calculate that the accounting department does not have to devote a large part of its resources to calculating commission payments each month. For example, a typical commission structure splits commissions between a number of people, such as the salesperson and the sales manager, adds in splits in case sales are to multiple sales territories, and then throws in a commission rate difference depending on the volume of sales for the year to date, plus a quarterly commission override if the quarterly sales goal was reached. A more simpliﬁed structure merely pays out a ﬁxed commission on each invoice at the time the invoice is billed. The main problem with the simpliﬁed format is that commission structures are sometimes designed to modify the behavior of salespeople, and so require somewhat more complexity than a controller would like. The extent of simpliﬁcation is usually the result of negotiations between the controller and the sales manager. 22. Contract terms database. This best practice involves consolidating the payment and receipt terms on all contracts into a single database that the accounting staff can reference to see when contract terms change, when billings or payments are due, and how to calculate them. This avoids the typical mess in most accounting departments, where no one has a ﬁrm grasp of this information, because the data is spread through dozens of ﬁles. Having a contract terms database avoids a great deal of trouble in ensuring that incoming payments arrive in a timely manner, that billings to customers are done on time and in the right amounts, and that no time is wasted in following up on errors that were caused by changes to contract terms. There are no disadvantages to this approach.

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23. Customer credit, preapproved. This best practice involves identifying prospective customers in advance, checking their credit histories, and setting up credit levels for them in the computer system before the potential customers have even been contacted about a possible sale. The advantage of this approach is that new customer orders can be processed much more quickly (since there is no need to wait for a credit check). Also, it avoids the rush that the sales department typically puts on the credit granting work, which avoids any risk of granting an incorrect credit level due to not having time to thoroughly research a new customer. However, this approach does not work well in an environment where there is little preplanning of new sales leads, because there is no advance notice regarding which new customer orders are likely to arrive. 24. Customer credit, reporting of. This best practice involves sending the sales staff a daily listing of the available credit for existing customers. This approach keeps the sales staff from wasting time trying to obtain orders from customers who have already maximized their credit with the company, while highlighting those customers who still have room left in their credit limits for additional sales. The report can also be issued in an electronic format, so that sales staff who are not on the premises can still access the report by electronic mail. 25. Customer order exception tracking. This best practice involves creating a report that lists all customer orders for which the company has not yet issued an invoice. This report will list all current orders in-house, as well as those orders that are overdue, indicating that the order was lost once it was initially entered into the computer system. When the report is sorted by order entry date, the missing orders will be listed at the top of the report. This report is useful only if orders are immediately entered into the computer system on arrival at the company; if orders are handled through a manual instead of a computerized system, this report will not generate any relevant information. 26. Digital signatures. This best practice involves creating a digital signature that certiﬁes the validity of electronic documents that are sent to trading partners. This approach involves adding an encrypted identity code to all electronic transactions, that, when decrypted by the user, reveals a company-unique authorization certifying the validity of the received electronic document. The system is useful for using electronic transactions to place orders, send billings, or deliver electronic services. It avoids any problems with deceptive information being sent, because the recipient can be sure of the identity of the sender. Finally, the recipient does not have to worry about the sender repudiating the contents of the electronic document, because the signature is unique to the sender. 27. Document imaging. This best practice involves scanning accounting-related documents into a central database, accompanied by several indexes that make it easy to access the documents. Employees can then access the digital images of the documents from any connected workstation. This approach eliminates the need to search for (and later replace) documents, avoids the risk of misﬁling a document, and reduces the time needed to call up a ﬁle. It also reduces the need for ﬁling space in an ofﬁce. However, this approach requires a modest investment in scanning equipment, as well as workstations, a ﬁle server, and a CD jukebox storage system. In addition, a controller must pay for clerical assistance to scan documents into the system. 28. Electronic data interchange (EDI) transaction processing. This best practice involves exchanging information with business partners by electronic media. This approach most commonly involves sending invoicing and purchase order information to and from suppliers and customers by EDI. In an EDI system, a company encodes a transaction into a very speciﬁc format and then sends the e-mail message to a third-party processor, which stores the message in an electronic mailbox. The recipient then polls the mailbox from time to time and extracts the message, which it processes. By using EDI, a company avoids any paper-based transactions, avoids the time wasted when a document is mailed through the postal service, and avoids the time and effort needed to transcribe a transaction into the accounting system of the recipient. A key factor when using an EDI system is that it is no

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more efﬁcient than a simple fax machine, if transactions are manually keyed into and out of the EDI format at either end of the transaction. Instead, there should be automated interfaces at both companies that automatically create transactions and send them out, as well as automatically receive them into the recipient’s computer system. By using these automated interfaces, a company can avoid the risk of incorrectly transcribing a transaction, or of losing one completely. The downside of EDI is that it is so expensive to set up that few companies attempt to use EDI with all of their business partners; instead they use it only with the few with whom the company has a high volume of transactions. 29. Electronic funds transfer. This best practice involves sending and receiving cash payments electronically, by routing payments directly to and from a company’s bank account. The approach eliminates the need to generate paper-based checks or the extra time to have them signed, and also eliminates the mail ﬂoat that occurs when a check must negotiate the postal system. However, there can also be a disadvantage if a company sends wire transfers, because it loses the use of its money much sooner than would be the case if it mailed a check. Also, there is a signiﬁcant wire transfer fee that is charged by the bank. Finally, this method requires some setup time to acquire information about the bank routing number and account number of the recipient, and set up this information in the computer system for transfer; consequently, given the amount of setup time, it is most common for electronic funds transfers to only take place between long-term trading partners. 30. Expense reporting, automated. This best practice involves having employees directly access an expense reporting system in the company’s computer that allows them to enter all relevant information from their expense reports. The program will tell them what expenses are allowable, and will automatically tell employees which receipts must be sent to account-ing to complete their expense reports and process them for payment. Each employee then mails the required receipts to the accounts payable staff, accompanied by a routing number that the accounting staff uses to attach the receipts to the appropriate expense report document that was already entered into the computer system by the employee. Once the receipts are received, the computer system automatically issues a direct deposit payment to the account of the employee who ﬁled the expense report. To ensure data integrity, the internal audit staff can review a selection of receipts. This entire process drastically cuts the time an accounting staff needs to process an expense report, and also reduces the time period that an employee must wait to receive his or her reimbursement. However, such systems are entirely custom-built, and so they are cost effective only if there is a large processing expense that a controller is trying to reduce. 31. General ledger, use as a data warehouse. This best practice involves using the statistics ﬁelds in the general ledger to store large quantities of additional information about company operations. This approach is useful for companies that want to store information about key operations, want to retain it for long periods of time, and need to access it with a report writing tool for easy access. Though most companies store such information in a separate facility called a data warehouse, it is possible to use the general ledger, which is already present, and a much cheaper storage medium, to perform the same job. For the general ledger to perform well in this role, there should be automated interfaces to other company systems, so that key information is automatically extracted from those systems and forwarded to the general ledger from time to time. Also, greater access to the general ledger will have to be given to employees, so that they can make use of the new information stored in it; when this extra access is given, the controller should be careful to limit access to the more sensitive ﬁnancial information that is also stored in the general ledger. The downside of using the general ledger in this role is that there is a signiﬁcant programming cost required to modify it. 32. Inventory, cycle counting. This best practice involves conducting a continuous series of inventory counts, covering contiguous blocks of storage locations. When consistently applied, this technique allows the warehouse staff to rapidly compare the actual inventory to

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computer records to determine the extent and nature of any quantity, unit of measure, or location errors. If the warehouse manager corrects the underlying problems causing these errors, the average accuracy of the inventory records will gradually improve, until they reach a point where there is no need to conduct a periodic physical inventory. However, cycle counting does require a continuing investment in the labor of a cycle counting team. Once the management team realizes the extent of the improvement in operations that is caused by increased inventory accuracy, it will not mind the extra labor expense. Inventory, move to shop supplies. This best practice involves reviewing the list of inventory on hand to determine which items fall into the categories of ﬁttings and fasteners, and then moving these items out of inventory, to be expensed as shop supplies. Although there is an immediate expense that is charged to shop supplies, this move can greatly reduce the number of items in stock, frequently by more than one half, so that the controller has a much smaller number of inventory items to worry about tracking for the next physical inventory count. The problem with this approach is that, by moving items out of inventory, it is more difﬁcult to determine when it is time to reorder parts; this problem can be circumvented by creating visual tracking methods, such as bin level indicators, that take the place of automated reordering systems. Inventory, tracking accuracy of. This best practice involves the use of a simple methodology to audit the accuracy of inventory, which provides a standard measure that can be used to show changes in the ability of the warehouse staff to accurately control its inventory. This approach is extremely useful for a controller, because a high level of inventory accuracy means that there are fewer inventory variances that the accounting staff must investigate. By posting the results of periodic inventory audits, employees will see that this is a key item to improve, which leads to additional enhancements. In addition, continuing accuracy reviews can point toward any problems that may result in year-end inventory write-offs; by spotting problems in advance, a controller can adjust the accounting records earlier in the year, thereby leaving fewer adjustments at the year-end close. To be effective, this review should be conducted weekly, which means that a controller must invest the time of some staff person on a regular basis in order to arrive at the needed accuracy information. Invoicing by e-mail. This best practice involves sending an invoice to a customer by electronic mail. This approach avoids the time delay of creating and mailing an invoice, and also avoids all mailing costs. If acted upon promptly by the recipient, it can also reduce the time period before a payment comes back to the company. This approach varies somewhat from EDI, because it does not use a rigidly formatted invoicing form, nor does it park transactions in the computer of a third party’s computer, where the transaction languishes until the recipient chooses to access its mailbox for incoming EDI transactions. The main disadvantage of this approach is that there is no record of the transaction, so it is easy to lose. Invoicing, hand delivery of. This best practice involves not only giving an invoice to a customer at the point of delivery, but even creating the invoice at that time. This approach requires the delivering person to either have a preprinted invoice in his or her possession at the time of delivery, or to have the capability, probably with a computer and printer, to create and issue an invoice “on the spot.” This approach allows a company not only to eliminate the mail ﬂoat associated with mailing an invoice, but also to agree with the recipient on the correct quantity that has been delivered, and match the invoiced quantity to that amount; by doing so, a company not only receives payment faster, but there are also fewer disputes with customers over the exact amount to be paid. The disadvantage of this approach is that the delivery person may not be well enough trained to create an invoice, the customer’s receiving staff may lose the invoice, and that the company must pay for a computer and printer for each delivery person if they are to create invoices at the point of delivery. Invoicing, intercompany, replaced by operating transactions. This best practice involves substituting simple warehouse transactions for the invoices that are frequently used to record movements of stock between companies that are owned by the same corporate parent. This

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approach avoids the need for a reconciling entry that reverses sales and cost of goods sold for these inventory movements; because these reconciling entries are always manually calculated by the accounting staff, it makes sense to completely avoid them in order to reduce the amount of work by the accounting staff. Instead, a company can opt to record a simple transfer of materials between different warehouse locations (which works only if all subsidiaries are operating on the same computer system), or create a journal entry to a special intercompany holding account, which can then be quickly summarized by the accounting staff at month-end for rapid conversion into an intercompany reversing entry. Journal entries, automated recurring. This best practice involves setting up journal entries that do not change from month to month, so that the accounting system automatically creates the same entries over and over again, without operator intervention. The concept can be extended to an automated reversal of journal entries in the following period, for those entries that need this treatment. This approach reduces the time needed to close the books at the end of each reporting period, while also ensuring some consistency, since there is no risk of an entry not being recorded. The main risk of this approach is that most journal entries must be terminated at some point in the future, so there should be a periodic review of all automated entries to ensure that the amounts and accounts used are still accurate. For example, a bad debt accrual may need to be changed once a year, based on an occasional review of a company’s experience with accounts receivable write-offs. Lockbox collections. This best practice involves having customers send their payments to a mailbox that is directly accessed by a company’s bank; the bank opens the mail and deposits the checks, thereby saving a day of mail ﬂoat. This approach allows a company to invest its money more quickly, which yields a larger amount of interest income. The system can also be expanded to different areas of the world, so that lockboxes are set up in all areas where there are concentrations of customers; this keeps the total mail ﬂoat to an absolute minimum, no matter how far-ﬂung customers may be. The downside of this best practice is that it takes a considerable effort to get customers to change their mailing addresses to a lockbox, either because of inertia or because they realize that they will lose the use of funds by handing it over to the company that much sooner. Consequently, some payments will always come to a company’s main address, no matter how hard it tries to divert payments to its lockboxes. Outsourcing, collections. This best practice involves shifting the burden of collection calls to an outside agency. This approach is normally only used for the most difﬁcult-to-collect accounts, when there is nothing more that the internal staff can do to collect the money and must resort to other means to obtain the funds. This approach has the advantage of using the more experienced staff of a collection agency to bring in accounts receivable that would otherwise have to be written off. However, an agency normally keeps up to one half of the amount it collects, so the expense is considerable. Also, if the collection problem was caused by an internal error in billings, the collection agency is unlikely to relate this data back to a company’s billings staff, so it is possible that the same type of error will occur again. Outsourcing, internal audit. This best practice involves having an outside auditing group perform all of a company’s internal auditing tasks. The advantages of doing so are that the outside auditors are heavily trained in reviewing systems, that they are a variable cost that goes away when there is no auditing to do, that it eliminates the ﬁxed cost of having an internal auditing group, and that different people with differing levels of expertise can be brought in to deal with internal audit tasks that require special skills. In addition, if those auditors performing the internal audit are the same ones that conduct the year-end audit of the ﬁnancial statements, this extra work gives them a better knowledge of the company, which contributes to a more efﬁcient year-end audit. On the downside, outsourcing the internal audit eliminates the internal expertise of the internal audit staff, introduces the higher variable cost of the outside auditors, and removes a department that may have previously been used as a training ground for junior-level company managers.

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42. Outsourcing, payroll. This best practice involves shifting the processing of payroll to an outside service bureau, such as Automated Data Processing (ADP), Paychex, or Ceridien. These services allow a company to enter payroll information on-line into their databases, where checks are cut, signed with digital signatures, stuffed into envelopes, and delivered back to the originating company the next day. In addition, these suppliers automatically withdraw tax payments from a company’s account and forward them to various taxing authorities, send direct deposit payments straight to employee accounts, and issue year-end W-2 statements to employees. In short, they take the most complex payroll processes away from a company, thereby reducing its workload and the risk of fouling up key payroll transactions. However, the transition to a payroll supplier is usually only doable on the ﬁrst day of the calendar year, since there are tax reporting records that are best initiated on that date, which makes it difﬁcult to convert to outsourced payroll at any other time of the year. Also, suppliers charge relatively high prices for their payroll services, which generally exceeds the cost of processing payroll internally. 43. Outsourcing, tax form preparation. This best practice involves handing over all tax form preparation to an outside agency. This approach allows a supplier to avoid hiring expensive tax specialists, and instead incur only the expense of the services of experts who are likely to be very well trained and experienced, while at the same time only using their services during those hours when they are speciﬁcally working on company-related tax issues. Thus, tax preparation costs can be converted from a ﬁxed cost to a variable cost. However, there are very few tax preparation suppliers who are skilled in local taxation issues (e.g., enterprise zones, city or county reporting), and so a controller typically retains a sufﬁcient amount of help internally to deal with these issues. 44. Payments based on purchase orders. This best practice involves using a purchase order as the primary form of authorization for paying suppliers. This approach improves the efﬁciency of the accounts payable department, for it can immediately match an incoming invoice to an existing ﬁle of purchase orders (either on-line or from a paper-based ﬁle), rather than having to send out individual invoices to managers for an approval signature. By avoiding sending out invoices for approval signatures, the accounts payable staff does not run the risk of losing invoices that are never returned by managers. In addition, performing an immediate match to a purchase order vastly reduces the cycle time needed to complete processing of each invoice; this also keeps the amount of currently open work to a minimum. The only downside to this method is that the managers must be trained to issue purchase orders in advance before authorizing suppliers to ship in products or perform services. For an autocratic manager who does not like paperwork, this can be quite a problem. 45. Payments based on receipt. This best practice involves automatically paying a supplier as soon as its shipment is logged in at the receiving dock. This approach requires a computer system that links a purchase order database to the receiving dock, so that a receiving person can enter the purchase order on a received shipment to the computer and match it to a purchase order. The computer system then automatically schedules the purchase order for payment without the need for any supplier invoice. This approach eliminates the majority of accounts payable labor, because there is no longer a need to manually match supplier invoices to receiving documents and purchase orders. However, making a payment without a supplier invoice means that the computer system must be able to generate its own sales tax information for payment, which is normally supplied by the vendor under a more traditional system. 46. Payroll cycles, minimum number of. This best practice involves shrinking the number of different payroll processing cycles processed by the payroll personnel. This approach greatly reduces the amount of time required to process the paychecks of employees. For example, a company can reduce payroll processing time by consolidating the payroll runs for its hourly and salaried personnel into a single batch. It can save even more time by lengthening the pay periods; it takes four processing runs per month if there are weekly pay periods, but

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only one processing run if paychecks cover one-month periods. Though the accounting labor savings is considerable, there can be resistance from the staff, especially if it has gotten used to more frequent payment periods. This is a particular problem for those people living from paycheck to paycheck, who do not have enough ﬁscal control to last for an entire month on one paycheck. For these people, the company has the option of either extending advances (which creates lots of extra work) or of directing them to an outside lending agency to procure enough funds to last them until the next paycheck. Payroll forms, automatic fax back. This best practice involves setting up a computer that is activated by digital tones from a touch-tone telephone; employees call a phone number that leads them through a series of prompts to order standard payroll forms, which are stored in the computer and automatically faxed out by it to a caller-speciﬁed fax number. This approach allows the payroll staff to avoid the drudgery of continually locating and mailing out payroll forms, allowing it to concentrate on more important tasks. It is best used for companies with widely scattered locations that do not all have their own local payroll departments. However, the expense of the system does not make it worthwhile for companies with a single location or a small number of employees. Payroll, consolidate all payroll systems. This best practice involves combining the data in all of a company’s payroll databases into a single one, which eliminates a number of problems. This approach is a good one for companies with many subsidiaries, each with its own payroll system. When the corporate parent moves employees among different subsidiaries, it must delete employees from the database of the old company, and shift this information over to the system of the new one; this presents a potential problem with causing errors in payroll data as it is rekeyed, and also does a poor job of tracking employee seniority (which is needed to determine vesting in 401(k) and other pension plans), since each payroll system will record an incoming employee as a new hire with no seniority. By combining data into a single payroll system, these problems are eliminated. Offsetting these beneﬁts is the considerable conversion cost of combining all the disparate payroll systems. Payroll, direct deposit. This best practice involves issuing payroll payments directly to employee accounts, rather than manually issuing them a paycheck. The advantage of this approach is that there is no need to track down employees in order to pay them, which is a major problem for employees who work off-site, such as traveling salespeople. This is also a beneﬁt to employees, who no longer have to go to a bank to cash their checks. However, this feature is not available to employees who do not have a bank account into which funds may be sent. Also, there is a charge, usually of about one dollar, to send each direct deposit payment to an employee, so there is some added expense when using this method. Payroll, direct employee access to deduction changes. This best practice involves allowing employees direct access to their deduction records in the payroll system, so that they can modify their own deductions as they deem necessary. This approach is useful when employees are taking up a large part of the payroll staff’s time to continually make these changes. The access can be given by constructing a special interface to the deduction ﬁle in the payroll system, either directly through a company’s computer network, or through a touch-tone phone interface. No matter what the means of access, a company’s programmers must restrict access by means of a password, so that only employees can change their own deduction information. A key feature of the deduction access system is to give employees a total amount of payroll deduction that will result after they change their beneﬁts; this information should be provided before employees are asked to “lock in” their new beneﬁts; this keeps employees from being surprised by the size of changes to their net pay that result from their deduction changes. The main downside to this best practice is that it requires a considerable programming expense to create the interface to the payroll system. Payroll, disallow prepayments. This best practice involves creating a policy not to issue any advances on paychecks. In many companies, there are a signiﬁcant number of employees who live from paycheck to paycheck, and who sometimes cannot quite make it to the next

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one. When this happens, they request a small advance to tide them over for a few days. When they ask for the up-front payment, the accounting staff must cut a manual check, and then manually add the amount of the advance to the payroll system, so that it can be deducted from each employee’s next regular paycheck. Both of these manual steps can interfere signiﬁcantly with the smooth operation of the payroll cycle, and cuts into the efﬁciency of the accounting department. Instead, employees requesting an advance can be directed to any of a variety of local banks or other lending agencies, where they can apply for a loan. The only disadvantage to this approach is that it may gain the ill will of employees, especially when the policy is ﬁrst put in place, or if they have gotten used to a liberal advances policy in the past. 52. Payroll, honor system for tracking vacation and sick time. This best practice involves eliminating any formal method for tracking the vacation and sick time of salaried personnel. Instead, these employees are responsible for tracking their own time off. This approach reduces the amount of paperwork reaching the payroll person, who must otherwise store time-off request forms, as well as enter this time into the payroll system. The overall reduction in time by the payroll person is offset by the risk that some employees will abuse the system and take extra days, but individual supervisors can avoid this problem by keeping time-off records for each of the people reporting to them. An additional consideration is that the honor system works best if a company does not roll forward its accrued unused vacation and sick time to future years; this eliminates any difﬁculty with employees appearing to pile up enormous accrued time-off balances over many years, when in fact they do not have the time, because the result of the honor system is that time used is not offset against the accrual in the payroll system. 53. Payroll, link the payroll and human resources databases. This best practice involves merging the separate databases for payroll, beneﬁts, and human resources into a single one. The payroll database typically contains an employee’s name, address, Social Security number, deductions, and pay information for the current year. The beneﬁts database is usually kept manually and includes an employee’s name, address, Social Security number, and listing of current beneﬁts selected. Finally, the human resources department maintains a database of an employee’s name, address, Social Security number, contact information, pay history, job classiﬁcation, race, and history of work-related accidents. When maintained separately, there is a strong likelihood that multiple addresses, deductions, and even pay amounts are being stored, because not all of the data is updated when a change is made. The obvious solution is to combine the databases, so that only one update is required to change information. This reduces the time spent by the accounting and human resources departments in updating employee information. However, when combining information into a single database, it is possible that the database structure selected will not have enough ﬁelds to contain the information from the disparate databases, which may call for either a modiﬁcation of the underlying database structure or the discarding of some information. 54. Payroll, prohibit deductions for employee purchases. This best practice is a simple prohibition of payroll deductions for employees who are purchasing goods through a company. Since each deduction represents a manual transaction for the payroll staff, it is best to avoid the deduction entirely by prohibiting company purchases on the behalf of employees. An alternative that may be more palatable to employees is to allow purchases, but only if employees pay for the full amount of the transaction in advance, or at the time of delivery. In either case, there is no deduction for the payroll staff to track. Though an easy best practice to implement, this one can cause dissatisfaction by employees, especially in a company where there is a long tradition of allowing gradual paybacks by employees for purchases. 55. Payroll, send remittance advices as e-mail messages. This best practice involves linking the payroll system to a company’s e-mail system, so that the remittance advices for paychecks are sent electronically to employees. This approach eliminates the time and effort needed to manually distribute pay information to employees, and sends the data to them instantly. It

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56.

57.

58.

59.

Ch. 55 Accounting Best Practices

also eliminates the postage cost of mailing the information. However, this approach does not work for any employees who receive a paycheck instead of a direct deposit, since the paper check must be given to them; it also does not work for employees who do not have access to electronic mail. Finally, the interface between the payroll and e-mail systems must be created in-house by a company’s programming staff. Payroll, switch to salaried positions. This best practice involves moving as many hourly people as possible to salaried positions. The reason for doing so is that there is much more work by the payroll staff in tracking the hours of people who are paid per hour than there is to pay a salaried person. For example, a salaried person is paid the exact same amount of money during every payroll, which means that a payroll clerk sets up this person in the computer system to be paid the same amount indeﬁnitely, and then forgets about doing any further work. However, a payroll clerk must review the hours accumulated by an hourly person, go to a supervisor to gain approval of any overtime worked, and then punch this information into the computer system for tax calculations and payment. Even when there is a computerized time clock that automatically accumulates hours worked, there is still more work for a payroll clerk, because there are inevitably going to be times when an employee punches in but not out, which requires manual intervention by a payroll clerk to correct. The only downside of this approach is that there are legal requirements for what constitutes a salaried position (which varies by jurisdiction), which one must be mindful of when converting employees over to salaried status. Purchasing cards. This best practice involves issuing special credit cards to employees that can be preprogrammed to only accept a certain dollar amount of purchases per day or reporting period, and only at suppliers in certain lines of business. The monthly report issued to the company by the credit card issuer also categorizes purchases by various identiﬁcation numbers. These special features not only make it easier for the accounting staff to determine the expense accounts to which charges should be coded, but also eliminate a large number of smaller purchases that are now paid for with a single credit card payment. The restrictions on periodic payments and types of purchases also represents some control over unauthorized purchases. The only downside of this technique is that most credit card issuers are not willing to issue purchasing cards unless a company is willing to purchase a minimum of one million dollars’ worth of goods or services per year with the cards; otherwise, there is no payback to the issuer, given the extra expense of setting up the credit card account. Purchasing, blanket purchase orders. This best practice involves issuing a single master purchase order once a year to each supplier, against which all purchases are authorized. This approach allows the accounting staff to keep a minimal number of purchase orders on ﬁle, so that there is less paperwork to sort through when matching incoming supplier invoices to purchase order authorizations prior to paying suppliers. A side beneﬁt is that there are far fewer purchase orders for the purchasing staff to track, as well as fewer purchase order records occupying space on the hard drive of the computer system. Purchasing, direct interface for ofﬁce supplies. This best practice involves using either a paper-based or electronic form for ordering supplies from an ofﬁce supply dealer. This approach eliminates the need to ﬁll out a requisition for common ofﬁce supplies and give it to a purchasing person, who then selects a supplier with the best price and issues a purchase order. Instead, anyone who needs ofﬁce supplies ﬁlls out a standard form that lists the most common ofﬁce supplies, and either faxes or e-mails it to a preselected ofﬁce supply company, which then delivers it to the company the next day. Any request for unusual ofﬁce supplies can still go through a purchasing agent. The advantages of this approach include less time required by the purchasing staff, less matching of supplier invoices to purchase orders for the accounts payable people (since the ofﬁce supply store is given a blanket purchase order), and faster supplies ordering by anyone in the company who needs supplies. The only disadvantage is when someone incorrectly orders large quantities of supplies, but this can be tracked after the fact by reviewing quantities invoiced, investigated, and stopped.

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60. Reporting, on-line. This best practice involves moving accounting reports to employees through the computer system. This approach avoids the need for paper and increases the speed with which reports are delivered. It is particularly effective for delivering information to employees in outlying locations, who can access their email in moments, but who might have to wait for a week or more to receive the same information by mail. The most common use of this approach is daily reports rather than the full ﬁnancial reporting package. The advantage of delivering a daily report is that such a report is relatively short, contains fresh information, and can easily be packaged into a single ﬁle for easy transmission. The approach does not work as well for a full monthly reporting package, because there may be several ﬁles in different ﬁle formats, which makes the information more difﬁcult to read when presented in this manner. 61. Reporting, simpliﬁed. This best practice involves shrinking continuing accounting reports to the minimum level required by management to run a business. This approach involves reviewing ﬁnancial and operating reports with management on a regular basis to determine their reporting needs, and paring down the reporting output to match those needs. The process needs to be continuous, for requests for information will change regularly, as a business changes, and old reporting requirements fall by the wayside and new needs arise. It is particularly important to share with managers the cost of obtaining some kinds of information; when they learn that a seemingly minor request actually involves a major effort by the accounting staff, they frequently withdraw the request. This seems like an obvious best practice; however, most companies do not schedule regular reviews of their reports, resulting in statements that have not changed in many years and that are no longer in touch with management’s informational needs. The minimal cost of conducting regular reviews is easily offset by the reduced cost of compiling accounting information. 62. Signature plate. This best practice involves using a signature plate or stamp to afﬁx an authorized signature to all company checks. This approach has the advantage of avoiding the time needed to track down an authorized check signer. Not having a check signer on hand can be a particular problem if there is a very immediate need for a check, and there is no check signer on the premises at all, such as when a package arrives that has cash-on-delivery terms. The cost of creating a signature plate is minimal. The only signiﬁcant risk is that someone will gain access to the signature and incorrectly afﬁx it to checks that have not been authorized with a purchase order; this problem can be avoided by keeping the stamp locked up in a secure location, along with the check stock. 63. Target costing. This best practice involves adding a cost accountant to all new product development teams to assist in setting up cost targets for new products in advance. The team then allocates portions of the total estimated cost to speciﬁc sections of new products, with portions of each team working on driving down the cost of their assigned components. If the team cannot devise a product that meets its target cost, then the product design is dropped. If the team can meet its cost target, then it is the cost accountant’s job not only to compile and report on these costs, but also to follow up on changes in costs subsequent to the release of the product to the production ﬂoor, to ensure that there are no cost changes that will impact product margins. This approach is very useful for ensuring that products are not created that have such high costs that a company cannot charge competitive prices for them and still earn a good proﬁt. The only added cost is that of assigning a cost accountant to each design team, but the savings from having tight cost management during the design phase should easily overcome this cost. 64. Time clock, bar-coded. This best practice involves giving employees plastic time cards that are encoded with employee-speciﬁc data, which they swipe through an electronic time clock. This approach replaces the traditional time clock that required the accounting staff to decipher time punches and encode time worked into the payroll software for processing. Not only does this best practice do away with all of the keypunching of hours worked, it also allows the time clock to invalidate time punches for employees who arrive late for

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Ch. 55 Accounting Best Practices

work, requiring a supervisor to arrive and punch in an override code before the truant employee can enter his or her time into the system. This clearly brings a new level of control to management, though the hourly staff may not appreciate the change. Also, because the system automatically summarizes time worked, there is less risk of incorrectly paying an employee the wrong amount for time worked. However, bar-coded time clocks can meet with some employee resistance, because they are not given a paper-based record of the time they worked, which was the case with old, manual time punch systems. 65. Vacation accruals, automatic. This best practice involves including an automatic vacation accrual adjustment in the periodic payroll calculation, which is then printed on each employee’s pay stub. Not only does this approach eliminate the need of the payroll staff to make periodic vacation calculations, but it also eliminates visits from employees who want to know how much vacation time they have left to use—they can now refer to their pay stubs for this information. The only downside to this approach is that it is common to make a number of mistakes when the accrual is ﬁrst set up, because employees may have undocumented special vacation deals that must be researched and then put into the payroll system; this process can take some time before the accruals are accurate and running correctly. 66. Variance analysis, reduced. This best practice involves setting minimum dollar or percentage limits for variance analysis. For example, a 10 percent limitation will keep the ﬁnancial analysis group from working on the underlying detail for any general ledger account for which actual results vary from the budget by 10 percent or less. This approach allows a controller to avoid a considerable amount of analysis work when creating the ﬁnancial statements. However, the limitation may need to be combined as both a percentage and dollar limit, because some accounts, such as materials or direct labor, should not be off more than one or two percent. Otherwise, these accounts have such a large amount of expense ﬂowing through them that a variance of only a few percent will have a major impact on the amount of reported proﬁts.

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CHAPTER

56

REPORTING PERIOD AND HOW TO CLOSE IT 56.1

INTRODUCTION 1021

56.6

HOW TO ACHIEVE A FAST CLOSE 1025

56.2

SELECTING THE FISCAL YEAR 1021

56.3

SELECTING THE NUMBER OF INTERIM REPORTING PERIODS 1022

56.7

TYPICAL FAST CLOSING SCHEDULE 1029

56.4

REASONS FOR ACCELERATING THE CLOSING PERIOD 1024

56.8

56.5

VALUE OF INTERIM REPORTS 1024

RECONCILING ACCURATE REPORTING AGAINST A FAST CLOSE 1033

56.1 INTRODUCTION One of a controller’s principal functions is providing timely ﬁnancial information to management. Two of the most basic issues a controller must consider are when to issue ﬁnancial statements and how fast it is practical to do so. Historically, many companies have automatically chosen the calendar year as their ﬁscal year, and the calendar month as their reporting month. Also, most companies sacriﬁced the speed of ﬁnancial reporting in favor of later statements that were more accurate. However, these time-related issues have changed as the business environment has become more sophisticated. Many companies are changing their ﬁscal years and interim reporting periods in an effort to obtain more accurate and comparable information, while management is placing greater pressure on the controller to generate ﬁnancial statements as soon as possible, so that it has more rapid feedback about its performance. These trends raise several key issues for the controller: what is the proper ﬁscal year, how many reporting periods should there be, how to more rapidly issue ﬁnancial statements, and how to do so while retaining a high degree of accuracy. This chapter provides the answers.

56.2 SELECTING THE FISCAL YEAR Although controllers are not faced with the selection of a ﬁscal year very often, they should consider whether the present basis used is the most suitable. The most common accounting year is the calendar year, which ends on December 31. An alternative is a company’s natural business year, which is the period of twelve consecutive months that ends when business activities have reached the lowest point in their annual cycle. This section describes how to identify the natural business year, as well as the advantages of using it as the ﬁscal year. The natural business year terminates when business is at an ebb. This means that inventories are at the lowest levels, the peak volume of sales have passed, and receivables are declining. For the same reason, borrowings and other liabilities are at a minimum or are being reduced. The natural year end is easily determined by listing the dollar values for each item (e.g., inventory, sales, 1021

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Ch. 56 Reporting Period and How to Close It

receivables, borrowings, and other liabilities) for each month of the year and in total. Conversion of the amounts to percentages of the total for each factor may more clearly indicate the ﬂuctuation. The more important factors should be considered, and the trend checked over several previous years. Once the natural business year is known, the question arises about how it should be adopted. Some businesses, convinced of the advantages, have hesitated to make the change because of possible complications in connection with the tax laws. However, procedures involved in adopting the natural business year are few and simple. For existing corporations desiring to change their ﬁscal year, it is important to obtain approval from the Internal Revenue Service (IRS) to effect the change. Normally, permission is granted when based on sound reasons. Similar permission may be required from state or other authorities, or, at a minimum, a notiﬁcation of the change or special reporting may be required. In establishing a new corporation, the desired ﬁscal year is simply written into the bylaws. The advantages of adopting the natural business year lie in facilitating certain operations essential to the conduct of the business. The following are indicative: • Annual audit. If the work of public accountants were spread more evenly throughout the year, through companies having different ﬁscal year ends, they could give more attention to the individual needs of each client. Also, public accountants have slow periods during the year, and a different ﬁscal year may allow a company to negotiate reduced audit fees by having audits conducted during one of those slow periods. • Formulation of policies. Closely related to the foregoing is the general consideration of policies. When business is slack, the executives have more time to consider information and develop new programs and policies. Not only is the information available, but the time is more likely to be propitious. • Inventory taking. Physical inventories can be taken at a lower cost and with fewer interruptions in normal activities. Smaller stocks mean that the count can be taken, checked, and summarized more easily. The smaller scope of the job perhaps signiﬁes also a smaller margin of error in valuing the inventory. Further, with other activities at a lower ebb, regular employees are available to assist in the inventory taking. • Preparation of more accurate ﬁnancial statements. Financial statements are always a combination of facts and opinions. With smaller inventories and accounts receivable, there is less need for estimates or arbitrary provisions. Valuation reserves are lower because of such lower values. • Preparation of more informative statements for planning and control purposes. New policies and goals are often introduced at the beginning of the natural business year. Financial statements prepared at the end of such a period, reﬂecting as they do a complete annual cycle of operations, provide management with a better check on the effectiveness of these new policies. • Securing credit. Lenders prefer statements at the end of a natural year because they may better appraise the business. The statements contain more facts and fewer estimates, and a more accurate opinion may be formed about liquidity. It is usually to the advantage of the company if the ﬁnancial statements show its most liquid condition. A controller should switch over to a natural year from a calendar year; it is a very easy process to do so.

56.3 SELECTING THE NUMBER OF INTERIM REPORTING PERIODS Most companies use the calendar month as a basis for summarizing and reporting operating results within the ﬁscal year. There are a number of advantages to using this method. Executives frequently think in terms of calendar months, and statistics relative to business are generally expressed for such periods. Many charges, such as salaries and wages, are based on the calendar

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month and are frequently set on a monthly basis; in addition, billings to customers are sometimes made monthly. Relations with customers and suppliers are likely to involve the calendar month as a basis of calculation. There are, however, some objections to using a calendar month as an accounting period, principally from the standpoint of comparability. Because the calendar month seldom contains the same number of respective days of the week as did the same month in the preceding year, or as did the preceding month, the sales or expense statements for a given month may not be comparable with these preceding periods. Yet comparison is a common practice; consequently, at least mental adjustments, if not detailed analyses, must be made for the total number of days in the month and also for the number of working days in the month. Where such variations signiﬁcantly affect the value of comparisons, alternatives are available, such as a thirteen-month ﬁxed calendar and a thirteen-period year. Each of these alternatives are noted below: • The thirteen-month ﬁxed calendar. The thirteen-month calendar consists of thirteen months of 28 days each, which accounts for 364 days. The extra day, called “year day,” is not in any month, and “leap day” is similarly treated. Each month within a year would start on the same day of the week, and each would so close. For example, the ﬁrst day of every month might begin on Sunday and end on Saturday. The campaign to adopt this calendar has been proceeding for many decades, but there is no indication that it will be accepted in the foreseeable future. • The thirteen-period year. A plan adopted by some companies is to split the present calendar into thirteen periods, each with 28 days. The extra day, or two days in a leap year, may be treated in one of three ways: 1. Accumulate the extra day, and insert a week every ﬁve or six years. An advantage is that every period would begin on the same day of the week. The longer period would not be strictly comparable with the others. 2. Include the extra day or days in the thirteenth period. Most of the periods would be comparable. 3. Exclude January 1, which is a holiday, from the calendar. Only the leap day is added. The thirteen-period calendar gives the advantage of better period-to-period comparability, with the resulting greater usefulness of the data for control purposes. In some instances, because of the avoidance of partial work activities, accounting and clerical costs may be reduced. Also, the lapsed time between summary periods is shorter. However, there are also disadvantages to using the thirteen-period calendar: • Periods still not comparable. Although it adjusts for the total number of days in a period, it does not adjust for legal holidays or plant-wide vacation periods. Consequently, the number of workdays will often differ from period to period. • External reporting varies. It is adaptable only for internal accounting purposes. When monthly or period statements are prepared for stockholders or the government, adjustments must be made to conform to the calendar periods. This will usually require additional work by the accounting staff. • More periods to close. It results in one added closing, increasing from the usual twelve periods to thirteen. • Expenses do not match the period. Fixed charges create a problem. When contracts require payment on a calendar basis, or where salaries are paid monthly, some periods could receive an extra charge. This objection can be overcome by revising contracts, depreciation calculations, and other adjustments. One should realize that the choice of an interim accounting period has no direct connection with the selection of the ﬁscal year. Each is a separate problem with different considerations.

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Ch. 56 Reporting Period and How to Close It

56.4 REASONS FOR ACCELERATING THE CLOSING PERIOD It is essential that management be provided with summarized information for the various operating periods such as month, quarter, and year. Management decisions to a large extent are based on past performance, trends, and actual results relative to the budget. The more current the information is, the better are the chances for taking effective and prompt action. In today’s business environment of close competition, it is a major advantage if management receives immediate feedback on company activities from the accounting staff. Besides this most obvious reason for prompt reporting, the following points should also be considered: • Better control. When the ﬁnancial statements are available so fast, the controller has more time available to examine the results of the statements, resulting in quicker action to ﬁx control problems. • Better process focus. An accounting staff that focuses on shortening the time needed to deliver ﬁnancial statements will also ﬁnd that this focus on examining and improving the underlying process can be carried over to other activities, resulting in greater efﬁciencies throughout the function. This has a particular impact on such key areas as the speed of billings and collections. • Improved morale. The accounting staff will experience an improvement in morale because it has worked together to improve the speed of ﬁnancial statement delivery. Successfully implementing such a signiﬁcant improvement task invariably leads to greater pride, which commonly has the favorable by-product of reduced staff turnover. People like to work in a successful department. • More time for other activities. When the accounting staff rapidly issues ﬁnancial statements, this removes a large activity from the staff’s work list for the month, thereby creating lots of time for other activities. In particular, management will ﬁnd that the accounting staff has more time to handle any information requests, resulting in a faster turnaround of reports. Thus, accelerating the production of ﬁnancial statements not only improves the ﬂow of information to management, but also has a major positive impact on other factors in the accounting department. It is an excellent starting program for improving the entire area.

56.5 VALUE OF INTERIM REPORTS Before a controller turns all department resources into a campaign for shortening the time needed to production ﬁnancial statements, it may be of use to inquire further as to the reasons for doing so. If the primary cause of this activity is a request by management for quicker reporting, the controller may ﬁnd, upon further investigation, that management wants only certain parts of the ﬁnancial statements. If so, the controller can provide interim reports to management that are much easier to produce in a short time period than a complete set of ﬁnancial statements. The most commonly asked-for information, and the pitfalls a controller must be aware of when supplying it, are discussed in this section. The information that management needs immediately after the end of a reporting period varies by the type of industry, the growth path of the company, and the motivation of management. For example, a company in the telecommunications industry may focus most tightly on its return on assets deployed (since the industry is asset intensive). Alternatively, if management is forcing a company along a very rapid growth path, its focus will be on revenue growth, probably in great detail by territory, salesperson, and product. If management is motivated by stock options, its focus will be on proﬁtability, so the controller will be called on to provide information on product margins and any out-of-the-ordinary expenses. Consequently, the information that management will require of the controller will vary considerably, depending on a variety of factors. The information requested by management will vary greatly, as just noted, but there are several broad categories into which most information requests fall:

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1025

• Revenues. This can be sales volume as compared to the budget or the previous year, or in greater detail by salesperson, product, or territory. • Operating margins. This can be by major product line or subsidiary, or in greater detail, such as for individual products or jobs. • Financial factors. This varies in accordance with the management focus, such as the return on assets or investments, the production backlog, or the amount of capital expenditures. • Cash ﬂow. This varies in accordance with a company’s ﬁnancial position. Those with little cash focus on projected cash requirements more than other measures. Once the controller has worked with management to determine the appropriate mix of ﬁnancial information needed, it is a simple matter to assemble a short report, usually of only one page, that itemizes the required data. A controller can use exception reporting when issuing reports to management. This type of report shows only items that are outside of expected levels. For example, the amount of overdue accounts receivable will not be reported if it is minimal, but will be shown if it exceeds 10 percent of the total accounts receivable balance. This is a very good way to reduce the amount of information that management must review, allowing it to focus on only the most critical items. Also, because the controller is only reporting on exceptions, he or she will be more likely to cross-check the information being presented; one reason for the amount reported being so far away from expectations is that the accounting staff may have compiled it incorrectly. Thus, an alternative to reporting a standard set of information is to report only amounts that require correction, which leads to greater management attention to the report, as well as more accurate reporting by the controller. There is a major pitfall that a controller must be aware of before issuing an interim report to management; issuing a report containing information that the controller later changes on the ﬁnal ﬁnancial report for the same period. There is nothing more irritating for management than to make decisions based on preliminary information that turns out to be incorrect. A controller can always issue disclaimers regarding the accuracy of initial information, but this is hardly a good way to run a business. Management relies on the controller for quality information, and the controller has an obligation to provide it. A vastly better approach is for the controller to carefully examine the processes resulting in the information reported in any interim reports, and to “bombproof” this information with extra controls, so that the likelihood of its being incorrect is vastly diminished. For example, if management wants to know the exact cost of all assets at the end of the month, the accounting staff can conduct a continuing audit of the most expensive assets every few months, to ensure that the reported cost cannot be too far off. Similarly, the amount of revenues can be veriﬁed in advance with an audit of selected invoices, while the computer system can conduct an automated comparison of invoiced items to the shipping log to determine whether there are any discrepancies. Accordingly, bombprooﬁng the data reported to management in interim reports prevents a controller from having to explain subsequent changes to the information. There are many reasons why a controller can ﬁrst use interim reports to satisfy management demands for information before having to accelerate the issuance of periodic ﬁnancial statements. The usual categories of information that management wants to see in these reports was discussed, as well as the dangers of reporting information that may not be completely accurate and how to guard against this problem. This is a step that a controller should strongly consider before engaging in a year-long project to speed the delivery of ﬁnancial statements, because this option gives management key information well before such a long project could be completed.

56.6 HOW TO ACHIEVE A FAST CLOSE If the controller ﬁnds that management is not content with interim reports and wants the entire set of ﬁnancial statements as soon as possible, it is time to undertake an orderly process of discovering how the current system works and then implementing a number of alterations that will compress the statement preparation time down to a minimum. This section takes the controller through the

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Ch. 56 Reporting Period and How to Close It

1 List & send consignment inventory quantities (3 days)

4 Summarize all inventory quantities (1 days)

2 List inventory quantities (1 days)

5 Multiply quantities by unit costs (2 days)

3 Send to corporate HQ (4 days)

6 Create inventory journal entry (.2 days)

E XHIBIT 56.1

F LOWCHART

necessary steps. A key issue to consider when reviewing this information is that the controller cannot achieve a fast close by himself—it is a team effort, for everyone involved in the closing process may have valuable suggestions for improving it. Also, because changes to the process directly impact their work schedules, it is critical to obtain buy-in from these people; employees who understand why a process is being changed are more likely to support the changes. The key steps a controller should follow when compressing the ﬁnancial statement closing schedule are: 1. Clear out the junk. The process is similar to cleaning out your garage. The ﬁrst step is throwing out the trash so you can have a better look at what is left. In this case, try: Eliminate items that require multiple approvals; once should be enough. Eliminate items, such as many copies of invoices, that must be ﬁled multiple times (e.g.,

alphabetically, numerically, by state); once should be enough. Clean the accounting area; if it is inundated in paper, then either ﬁle the paper away or

(even better) review its usefulness and then (hopefully) throw it away. 2. Document the process. Do not implement solutions without ﬁrst reviewing the process in detail, because further review may reveal that the solutions are not the best ones. Here are several ways to document the process; the controller should use all of these techniques before continuing: Create a process ﬂowchart. This is a quick way to determine how a process ﬂows. There

are few symbols to remember; just list the process sequentially. In addition, include the time required to perform each step, as well as the time needed to go between steps. An example of this ﬂowchart is shown in Exhibit 56.1.

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56.6 How to Achieve a Fast Close

Consignees

1 List & send consignment inventory quantities (3 days)

Subsidiaries

1027

Corporate HQ

2 List inventory quantities (1 days)

3 Send to corporate HQ (4 days)

4 Summarize all inventory quantities (1 days)

5 Multiply quantities by unit costs (2 days)

6 Create inventory journal entry (.2 days) E XHIBIT 56.2

F UNCTIONAL F LOWCHART

Create a functional ﬂowchart. This shows how a process moves between departments, or

between personnel within departments, and is very useful for pinpointing where time accrues during the process. An example of this ﬂowchart is shown in Exhibit 56.2. Create a geographic ﬂowchart. This shows where paper travels during a process and

where wasteful travel occurs. A geographic ﬂowchart is shown in Exhibit 56.3. The ﬂowchart shows that the controller should swap the locations of the accounts receivable clerk and the cost accountant in order to reduce the accounts receivable clerk’s travel time to the fax, copier, and storage room. 3. Eliminate duplication. Duplication typically occurs in two places during the closing process. First, information compiled at a subsidiary location is cross-checked at the consolidating location. Second, a subordinate’s work is reviewed by a supervisor. Using the ﬂowcharts developed during the preceding stage, highlight these duplications and eliminate them. This is not easy if the cross-checking is done to ﬁx numerous mistakes. The process must ﬁrst be

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Ch. 56 Reporting Period and How to Close It

1

2

3

Receivables Clerk

Conference Room

Payables Clerk

4

5

6

Controller

Fax/Copier/ Storage Room

Cost Accountant

Get overdue receivables information Copy invoice for collection letter Send fax to late-paying customer

E XHIBIT 56.3

4.

5.

6.

7.

G EOGRAPHIC F LOWCHART

made errorproof so that errors are impossible. For example, staff can receive better training, and tasks can be either automated or simpliﬁed. Defer routine work. Take note of those items being performed during the closing process that are unrelated to it and can be deferred until a later date. For example, performing a budget versus actual expense analysis on janitorial supplies is not crucial unless the variance is enormous, and can wait until the ﬁnancial statements have been completed. Automate standard items. Prepare certain accounting entries on a standard basis and adjust periodically as in the case of depreciation and insurance. This is a common area for errors, because standard entries eventually change, and the changes are frequently missed. To avoid these mistakes, the underlying documents that show change dates should be attached to the journal entry documents. For example, a lease payment amount changes once a year; rather than ﬁling the change schedule separately, either attach it to the journal entry or conspicuously note the change date on the journal entry form. Set investigation levels. If variances are minor, their impact on the accuracy of the ﬁnancial statements will be minimal. Investigation of these minor items can safely be done after the ﬁnancial statements have been issued, with any adjustments appearing in the statements for the following period. Move activities into the previous month. Many tasks associated with the closing can be performed prior to the end of the period, thereby avoiding the bottleneck period when there are too few people to complete all necessary closing tasks. For example: Prepare forms in advance. If journal entries or other forms are included in the closing

process, then complete as much information as possible in advance, such as descriptions, account names, budget data, and prior period ﬁgures. Anticipate problems. Be aware of areas where problems may develop and do as much analysis and reconciling as possible prior to closing. This could be the case when intercompany transactions are extensive and reconciliations are difﬁcult. Develop distributions. Create as many needed factors as possible before the end of the reporting period. Allocation bases and certain ratios for cost distributions may be determined in advance. One way to avoid last-minute calculations is to use allocation bases and ratios from one or more months in the past, or even a rolling average that does not include the last month. This allows the controller to ﬁnalize these ﬁgures prior to month end. 8. Reduce cycle time. Cycle time is the total time required to complete a process. It is common for the actual processing time for any function to be quite minimal, while the wait time before processing begins is very long. By targeting these wait times and reducing them, a controller can greatly reduce the time needed to complete closing processes. 9. Automate manual processes. After reviewing cycle times, ﬁnd the processes that take the largest amount of time to complete, and automate all or portions of them. For example, counting inventory and extending unit costs to derive a total inventory valuation is very time

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consuming. However, by switching to a perpetual inventory system (see the inventory tracking chapter) and automatic collection of unit costs through the accounts payable system, this activity can be reduced to a few keystrokes on the computer. 10. Replace serial activities with parallel activities. Based on the ﬂowcharts developed earlier, identify those steps that are currently performed in sequence, but which could be performed in parallel, and then convert them to parallel processing. This shortens the time needed to complete all activities, for several can be completed at once, rather than waiting for another task to be completed ﬁrst. For example, when the information on a report is needed by three people in order to generate their closing reports, do not wait for them to pass it along from one person to the next; instead, give copies to all three so that they can process the information in parallel. 11. Create a calendar. There must be a ﬁrm schedule of dates by which each member of the accounting staff should have completed each task that is needed to complete the ﬁnancial statements. One of the controller’s primary tasks in the closing is constantly going over this schedule with the staff to ensure that the close is completed by the expected date. The controller should review this schedule with the staff before it is ﬁnalized to ensure that everyone fully understands the closing process. Any period-speciﬁc problems, such as vacations, should be incorporated into the schedule at this time. 12. Rearrange work space. Alter the accounting department’s work area to minimize paper movement and cut the level of nearby trafﬁc (which reduces interruptions). Also, shift nearby fax machines and copiers closer to the work area to reduce travel time to that equipment. 13. Train the staff. The accounting staff must be well trained in the closing procedures. Cross-training the staff will minimize the problem of peak loads, trouble spots, and absenteeism. Training related to the closing processes should include: Tasks to complete Exact times and dates by which tasks must be completed Speciﬁc cutoff dates by subsystem

The training should not only include indoctrination in existing closing procedures, but also continuing training in how to review business processes and improve them even more. 14. Do it again. The controller must lead the constant revision of the closing process. Continual revisions of the closing procedure are needed to ward off the creeping effects of bureaucracy, while there are always technological advances that can further improve the process. Constant attention to the procedure also has a positive impact on the accounting staff, whose morale improves when there is continual positive attention by the controller. For a fast close to be successful, the controller must provide good leadership, with a tight focus on the process as well as the teamwork that makes the process function properly. The step-by-step guidelines noted in this section give a controller a basis upon which to accelerate the production of ﬁnancial statements.

56.7 TYPICAL FAST CLOSING SCHEDULE This section contains a closing schedule that can be used to achieve a one-day close. The list assumes a single company location, as well as an accurate inventory that does not require a recount at the end of each reporting period. The author has used this schedule to routinely issue 20-page ﬁnancial statements at the end of the ﬁrst business day following the end of each reporting period. The required tasks are split into three categories: for activities that can be completed in advance, those that must be done on the closing day, and clean up or improvement tasks that can be delayed until a later period. They are:

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Ch. 56 Reporting Period and How to Close It

(i) Activities to complete in advance. The bulk of the activities required to close the books can be completed prior to the end of the reporting period, as the following list will demonstrate. The author ﬁnds that the accounting department must begin to address these issues about 21/2 business days prior to the end of the reporting period in order to devote sufﬁcient time to the completion of all activities. The actual time required will vary substantially by type of business and the number of accounting staff available for this work. Here are the speciﬁc activities one can complete in advance: • Accrue bad debt reserve. If the collections staff is contacting customers regularly about overdue invoice payments, then the controller should have an excellent idea of the size reserve required for bad debts. This reserve can be adjusted well before the close to match expected losses. • Accrue bonuses. If bonuses are based on operational issues that can be determined prior to the end of the reporting period, or if they are paid only once a year and so require an incremental accrual of the expense, then accrue them early. If bonuses are paid frequently or are based on ﬁnal monthly results, then the accrual will probably have to wait until after the period is completed. • Accrue interest expense. If there is no expectation of altering debt levels substantially in the last day or two prior to the close, then the projected interest expense can be calculated with great precision. Even if there are some last-minute debt changes, an early estimate of interest expense should be relatively accurate. • Accrue royalty payments. If royalties are paid to another entity based on a company’s use of a resource, one can usually make a reasonable advance estimate of the amount of royalty owed. However, this will not work if the royalty must be paid based on actual sales activity, in which case it is moved to the “During the closing day” list of activities. • Accrue unpaid hourly wages. If all employees are salaried, then there is no need for an unpaid hourly wages accrual. In the more likely event that some employees will be paid on an hourly basis, one can use the maximum number of hours that each of these people should work during the ﬁnal few days of the reporting period, given their past history of hours worked. Though the actual number of hours worked during this accrual period will likely vary somewhat from the estimate, it should not be sufﬁciently large to impact the reported proﬁt level in the ﬁnancial statements. • Accrue unused vacation time. Even in the absence of a vacation time tracking system, one can use a monthly company calendar of events to determine who has taken vacation time, and use this information to derive an approximate vacation time accrual. This chore is made easier if the company enforces a “use it or lose it” policy, since the vacation accrual can then match the highest allowable amount of carryforward vacation time allowed by the policy. Under this scenario, the controller has only to adjust the accrual downward from the maximum allowable amount to account for those employees who are most aggressive in using their earned vacation hours. • Allocate rent. If rent is being charged to multiple departments, verify that the allocation has occurred immediately after all rent payments have been made, rather than waiting for the end of the period to make the entry. • Complete daily bank reconciliations. Daily reconciliations can be completed if the accounting department has on-line access to bank information. By making an incremental daily reconciliation, there is little chance that any signiﬁcant entries must be made once the bank statement arrives in the mail a few days after the period-end. Some banks offer a PDF-based bank statement that arrives via e-mail, but this format will still arrive too late to be used in the closing process. Instead, any remaining minor adjustments based on the bank statement should be included in the ﬁnancial statements for the following reporting period.

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• Record depreciation. Though some capital purchases may be recorded in the last day or two of a closing period, the overall impact on depreciation expense will be minimal. Thus, it is reasonable to record depreciation in advance of the closing day, and complete the depreciation on any new assets in the following period. • Review billable hours. If employee hours are billed to customers at the end of the reporting period, it is useful to review their hours charged through the reporting period thus far to see if hours are missing, appear incorrect, or are charged to the wrong job. By ﬁxing these errors in advance, there is much less of a rush to make changes after the period has closed. • Move cafeteria money and reconcile account. If the company has a cafeteria plan, one can shift funds withheld from employees into the cafeteria plan account as soon as the amount withheld can be reasonably determined. Also, as was the case for the regular bank account, it should be possible to reconcile the cafeteria bank account prior to the end of the period. • Enter commissions through current date. Salespeople usually earn commissions based on individual invoices billed, so verify the allocation of invoices to individual salespeople in advance to ensure that invoices are being credited to the correct sales staff. If separate spreadsheets are used to accumulate commission information, be sure to complete these spreadsheets for all invoices issued up until the last day prior to the period-end close, so only invoices issued on the ﬁnal day of the close must be added to the schedules on closing day in order to determine commission totals. • Review department ﬁnancials for errors. Given the high volume of transactions ﬂowing through the accounting system in any reporting period, it is very likely that a few transactions will end up being charged to the wrong accounts, resulting in inaccurate ﬁnancial statements. The vast majority of these problems can be spotted by printing out the statements the day before the closing date and reviewing them for errors. By doing so, only errors occurring during the closing process will still appear on the ﬁnancial statements once the period has been completed. • Complete supporting schedules in advance. Most ﬁnancial statements include a set of attached statements containing information on a variety of operational and ﬁnancial topics. In many cases, some or all of these statements can be at least partially completed prior to the closing day. At a minimum, one can reset column headers and dates, thereby saving a small amount of time when the statements must be completed at a later date. • Reconcile prepaid accounts. Be sure to examine all prepaid accounts in detail to see if any items should be shifted to an expense account. • Review inventory extensions. If there are errors in inventory balances, a good way to ﬁnd them is to print a fully priced inventory report, sorted in declining order by dollar totals, and see if any items appear to have unusually high or low dollar totals. Investigate and correct any unusual items. • Discuss inventory closing transactions with the warehouse staff. Meet with the warehouse manager to reinforce the need for the proper cutoff of inventory transactions, as well as the time of day by which all period-end inventory transactions must be completed. • Compile reimbursed expenses. If customers have agreed to reimburse the company for expenses incurred, be sure to examine these items in advance to verify that expenses to be reimbursed fall within the acceptable range of expense types authorized by customers. Also ensure that all supporting documentation is properly organized; otherwise, this item can require a great deal of time to invoice. • Verify customer sales tax codes. One can avoid the risk of not collecting sales taxes by reviewing the customer database periodically to ensure that the correct sales tax codes are listed. If there are not too many customers, the closing process is a good time to do this, thereby ensuring that any billings sent out at the end of the reporting period will be properly taxed.

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Ch. 56 Reporting Period and How to Close It

(ii) Activities to complete during the closing day. The activities left for the accounting staff on the day of closing are primarily related to ﬁnal customer billings and any expense calculations that depend upon those billings. These tasks are as follows: • Verify that all employee hours are recorded. This step is especially important in service businesses where employee hours are billed to customers, and can be the bottleneck step that interferes with the completion of the ﬁnancial statements. Be sure to tackle this step early on the closing day. • Verify that all deliveries have been shipped. Go to the shipping dock and verify that all scheduled shipments have been completed, and that the associated transactions have been entered into the computer system. This is also a bottleneck activity, and so may require the presence of an accounting staff person on-site until all paperwork is complete. • Accrue revenue. If revenue is recorded on the percentage-of-completion basis, then create these calculations and record the related revenue amounts. • Complete invoicing. Complete all invoices based on the shipments and hours billed information. If some are unusually large or complex, it may be useful to have someone review them for accuracy. If customers want to see them at once, then convert them into Adobe Acrobat PDF format and e-mail the invoices to them. If invoice errors are found by customers, the error corrections should be recorded in the following reporting period. • Complete commission accruals. Add any ﬁnal invoicing to the schedule of commissions earned, and e-mail the commission statements to the sales staff for review. Though the sales staff may modify the commission statements later by splitting commissions or shifting them to different people, the commission total should not vary appreciably, and so can be booked at once. Subsequent changes that impact commission totals can be booked into the next reporting period. • Complete bonus accruals. Complete any bonus accruals that could not be ﬁnished earlier in the closing process. • Conduct ﬁnal ﬁnancial statement review. Print the ﬁnancial statements and compare the resulting amounts not only to the budget, but also to the results from the last reporting period in order to spot any unusual changes in account balances. Investigate and correct only the largest variances. Smaller items that have no appreciable impact on the reported level of profitability can wait until after the close to be ﬁxed. • Record income tax liability. Once the income ﬁgure on the income statement is ﬁnalized, record an accrued income tax liability. This should be the last journal entry made, since any other adjustment to the income statement will have an impact on this amount. • Tie detail to balance sheet. Compare all balance sheet accounts to supporting detail to ensure that all account balances can be supported. If accounts have been tracked properly, this should take only a few minutes. If there are small differences between the detail and summary-level balances, one can wait until after the close to correct them. • Convert ﬁnancial statements to PDF format. Use Adobe Acrobat to convert the ﬁnancial statement package into PDF format, including accompanying commentary and spreadsheets. It is generally best to convert all statements into portrait mode, since Adobe has difﬁculty printing a mix of portrait and landscape pages. • Issue ﬁnancial statements by e-mail. Company managers, investors, and creditors may be scattered in many locations, so that ﬁnancial statements take a long time to reach them. By converting the statements to PDF format and attaching them to e-mail messages, one can ensure that all recipients have access to the statements at once. (iii) Activities to complete subsequent to the closing. Once the ﬁnancial books have been closed and ﬁnancial statements issued, there are still a few steps to complete, primarily related to the further improvement of the closing process the next time it is performed. Subsequent steps are as follows:

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56.8 Reconciling Accurate Reporting against a Fast Close

1033

• Organize the closing binder. Journal entries and related documents should be kept on ﬁle for future reference, in case the controller needs to determine the calculation or reasoning for the use of a speciﬁc entry. Once the closing is complete, the controller should organize these entries in a closing binder, preferably stored behind a checklist (such as this one) to ensure that all entries were made, and that they are kept in the same order for easy reference. • Update procedures. Review the accounting staff’s policies and procedures manual, making updates as needed to improve the efﬁciency of the closing process. If there are changes, issue the revised manual to the staff, and inform them of any changes. • Request new programming. There are many cases where programming changes to corporate computer systems can result in enhanced levels of efﬁciency in the closing process. The controller should obtain the opinions of the accounting staff about possible changes following each closing, and write them down in the closing binder. She can then use this list to keep track of completed programming changes over time. There are so many variations on accounting systems at companies that any controller will be forced to modify this checklist in order to achieve an optimum close. Also, the checklist will constantly vary to accommodate ongoing alterations in business systems and requirements. Because of these changes, one should expect to alter the checklist after almost every close.

56.8 RECONCILING ACCURATE REPORTING AGAINST A FAST CLOSE Top management insists that a controller issue ﬁnancial statements as fast as possible, so that it can determine the ﬁnancial results from the previous period and make any adjustments to ensure continued proﬁtability and growth. However, ﬁnancial statements tend to be more accurate if the controller waits longer to see if extra supplier invoices come in that relate to the previous reporting period, as well as to see if collections of company invoices for the previous period reveal any invoicing problems that may result in credits. Also, it is helpful to wait for the bank statement to arrive so that any extra expenses revealed by that document can be added to the ﬁnancial statements. Finally, it may be necessary to count the inventory every single month to ensure that the reported cost of goods sold is accurate. All of these tasks lengthen the time needed to produce accurate information. How does a controller reconcile top management’s need for quality information as fast as possible, when producing the best information takes extra time? This section describes a way out. A controller cannot possibly cut the time required to produce ﬁnancial statements from, for example, several weeks to a few days without ﬁrst setting up a large number of supporting systems. The controller must make it quite clear to management that, although the objective may be to produce ﬁnancial statements a day or two after the end of the month, this remains an objective and not a reality until the controller can set up enough systems to make this possible. In short, the controller’s ﬁrst step is to set expectations for how long it will take to achieve rapid reporting and make sure that this expectation is stretched out for a number of months. The next step is for the controller to identify those costs that are not readily available at the end of the month, and which therefore require extra time to obtain. These costs include supplier invoices for services or goods delivered at the end of the month, and for which the controller does not expect an invoice for several extra days. This may also include periodic costs such as semiannual property tax invoices or quarterly trash-hauling bills. In addition, the controller should review any costs that are charged through journal entries, such as accrued commission or royalty payments. By laying out these costs, the controller has a basis on which to review how to receive accurate costs earlier in the closing process. Revenues can also delay the closing of the ﬁnancial statements. The controller should determine the average amount of invoicing that occurs at the end of the month and how long it takes to complete this invoicing.

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Ch. 56 Reporting Period and How to Close It

Once the controller has a good idea of what information about costs and revenues is delaying the production of ﬁnancial statements, it is time to determine the predictability of that information. For example, the bank statement may reveal a fairly standard banking services fee every month, with only a minimal amount of variability. Similarly, tax invoices or billings for continuing services do not normally show much variability. For these types of expenses, the controller can safely accrue an estimated expense and adjust the next month for any variations from the expected expense that were subsequently discovered. These accruals can usually be investigated and completed very quickly. Other expenses cannot be predicted with accruals. Chief among these are supplier invoices that arrive late, and which apply to the previous month. The best approach here is for the controller to insist on using purchase orders for all major purchases. Then, the controller can compare the receiving log from the last week of the last reporting period to received invoices to determine which receipts do not yet have an accompanying invoice, and go to the related purchase orders to derive a cost that should be very close to the actual expense. A good accounting software package can automatically perform this function, saving the accounting staff a great deal of effort. This process eliminates the time needed to wait for incoming invoices. Another problem is missing check payments that are uncovered only when the bank statement arrives and a bank reconciliation is completed. The controller can avoid this issue in two ways. One is to have the bank statement delivered early, so that it cuts off a few days prior to the end of the month; this makes the bank reconciliation slightly more difﬁcult but allows it to be completed at the end of the month. The problem with this approach is that there is still a risk that checks issued near the end of the month that were not recorded on the company’s books will not be discovered until the following bank statement. This approach also will not work at the end of the ﬁscal year, when the auditors will insist on a bank statement with a cutoff date that matches the ﬁscal year end. The other way to avoid waiting for the bank reconciliation is to obtain on-line access to the bank’s records of cleared checks, which gives a company the capability to run an ongoing reconciliation as frequently as every day, thereby allowing it to catch any checks that were not expensed. Either approach results in good accuracy without lengthening the ﬁnancial statement reporting period. The biggest problem is late invoicing. Many companies ship the bulk of their products near the end of each month, resulting in an invoicing jam that can seriously prolong the time needed to complete the ﬁnancial statements. There is no way to legitimately accrue for estimated deliveries, because generally accepted accounting principles clearly state that a company record as revenues only what it has actually shipped. Consequently, the controller must concentrate on accelerating the period-end billing process. The solutions will vary by the type of system, but some solutions include stacking extra personnel on this function at the end of the period, requiring overtime to complete the billings, and investigating the process ﬂow to see where the cycle time can be compressed. This may take some months of work before the invoicing period is signiﬁcantly shortened. In summary, there are a variety of expenses and revenues whose accuracy depends on waiting extra days to complete the ﬁnancial statements. This puts the controller in the position of denying accurate information to management, because extra time is needed to improve the accuracy. The controller can eliminate much of this extra time while still ensuring a high degree of accuracy by using accruals for expense items with highly predictable expense levels, automating other systems, shortening cycle times, and concentrating resources on some tasks. An important point is that this work cannot be completed overnight; a controller must tell upper management that fast ﬁnancial results are possible with high accuracy, but it is a process that can be completed only after a number of months have passed.

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CHAPTER

57

OUTSOURCING THE ACCOUNTING FUNCTION 57.1

INTRODUCTION 1035

57.2

FINDING A SUPPLIER 1035

57.3

GENERAL ADVANTAGES OF OUTSOURCING 1037

57.4

FUNCTION-SPECIFIC ADVANTAGES OF OUTSOURCING 1039

57.5

RISKS OF OUTSOURCING 1040

57.6

CONTRACTUAL ISSUES 1042

57.7

OUTSOURCING COSTS 1044

57.8

PERSONNEL ISSUES RELATED TO OUTSOURCING 1046

57.9

MANAGEMENT OF OUTSOURCING SUPPLIERS 1047

57.1 INTRODUCTION Outsourcing is an increasingly prevalent technique that yields several key beneﬁts, such as improved expertise, less operational risk, and (in some cases) reduced costs. It involves handing over any one of many accounting functions to a supplier, who runs it on behalf of the company. Most controllers have already outsourced some portion of their accounting functions without realizing it, since it is very common to hand over the payroll function to an outside processor, as well as to give the tax calculation and reporting task to the external auditors. The range of functions can be expanded well beyond these two areas to include internal auditing, ﬁnancial statement preparation, check printing, collections, transaction processing, and both cash and pension management. In this chapter, a number of issues surrounding the outsourcing of the accounting function are covered.

57.2 FINDING A SUPPLIER There are a variety of ways to ﬁnd a supplier who is willing to take on some functions of an accounting department. This section describes those methods, as well as how to select the right supplier that will most closely match a company’s needs. There are several ways to ﬁnd a supplier. The following list gives a controller a broad range of search methods. Usually, a combination of these search methods will quickly result in the discovery of a batch of qualiﬁed candidates. The search methods are: • Industry trade journals. One of the most common places for a supplier to advertise is in an industry trade journal. Because suppliers want to target their limited advertising dollars at speciﬁc target groups, advertising in this place gives them good coverage of their target market for each advertising dollar spent. 1035

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Ch. 57 Outsourcing the Accounting Function

• Outsourcing clearinghouse. There is a national clearinghouse for outsourcing services called The Outsourcing Institute (located in Brooklyn, New York) that sells a lengthy list of outsourcing suppliers. It also runs seminars on outsourcing topics. Because its list of suppliers is conﬁned to those suppliers who are paying to be listed in its materials, one should not consider ts lists to be comprehensive. • Personal contacts. Many suppliers have such superb reputations that they do not need to advertise their services. Instead, existing customers drum up business for them by telling their contacts. Thus, a controller can hear about good suppliers through personal contacts, frequently without even asking. • Seminars. Suppliers like to put on seminars, frequently for free, just so that they can use the sign-in list of attendees to call about future business. Even if they do not use this aggressive approach, a controller can easily obtain the business card of a seminar instructor and contact this person later on, either about obtaining services from the instructor’s company, or to get the instructor’s opinion about the best suppliers to use. • They ﬁnd you. If a controller’s company is large enough, there is no need to worry about ﬁnding a supplier—the company is probably near the top of the contact list for every supplier in town, and the controller can comfortably wait for the more aggressive suppliers to make the ﬁrst call. • Trade shows. Suppliers set up booths at trade shows and distribute product and service information from those spots. A controller can garner a large amount of information about suppliers by trolling through a national trade show. • Yellow Pages. Some accounting outsourcing tasks are so common that they have their own heading in the Yellow Pages, allowing a controller to pick from a conveniently summarized list. The only situation in which a controller will have trouble locating a quality supplier is when the company facility is located in such a geographically isolated place that there are no suppliers anywhere in the vicinity. This is not a problem if the service being outsourced is one that requires no direct supplier contact, such as cash management, but it can severely restrict a ’s chances of outsourcing any function that requires repeated supplier access to the facility. In many functional areas, there are a number of suppliers to choose from. To narrow a controller’s range of options, here is a sampling of the market-leading suppliers of services in the more commonly outsourced functions: • Accounts payable check printing. There are very few banks that provide this service yet, so a controller will be limited to the largest and most technologically sophisticated ones. The best known of this group is Chase Manhattan Bank. • Collections. Though there are thousands of small suppliers, the largest supplier by far in this highly fragmented industry is Dun & Bradstreet Receivables Management Services. • Payroll. The main players are Automated Data Processing (ADP), Ceridian, and Paychex. There are many local operators, but these three dominate the industry. • Taxation and internal auditing. The perennial top suppliers in this area are the “Big Four” accounting ﬁrms. All have sterling reputations, so a controller will have a hard time going wrong in selecting any of them. Usually, a selection is based on personal relationships between a controller and a partner at one of these ﬁrms. • Transaction processing. The clear leader in the transaction processing ﬁeld is Accenture. Look for other of the Big Four accounting ﬁrms to enter this ﬁeld in the near future. Once a controller has found a number of potential suppliers, it is time to send out a request for proposals (RFP). This document allows a controller to clearly specify the requirements of the function to be outsourced, and creates a format for how each supplier is to respond to the company’s needs. By standardizing the selection process through an RFP, a controller can force suppliers to respond in a similar format that allows for easy comparison of the services provided by each supplier, which eases the supplier selection task. The RFP should include:

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• Description of the company and its industry • The scope of the work to be provided by the supplier • Key dates for supplier candidates to be aware of, such as the date when all responses must be received, the date for a question and answer session to clarify the RFP, and the date by which a selection decision will be made • The selection criteria (and their relative weighting) that the controller will use when selecting a supplier • Any use of subcontractors that will be allowed by the company to provide services as part of the outsourcing arrangement • Any expected transfer of personnel from the company to the supplier that will result from the outsourcing deal • The performance standards that will be used to measure a supplier’s continuing performance • Any penalties that will apply if a supplier does not meet performance expectations • The conditions under which the controller will terminate the services of a supplier By clearly deﬁning these key points in the RFP, suppliers can more easily create bids, while also determining their risks in providing services to a company. They may even use the RFP to decide that they cannot provide the desired level of services, which allows them to back out of any potential deals, thereby avoiding any future problems with the company due to lack of services, high pricing, or other matters. When reviewing an RFP, a controller should keep a number of points in mind that will lead to the selection of the correct supplier. Some of these points may require additional investigation, since a supplier may not want to list the information in an RFP. One key item is the size of the supplier’s staff. If there is a limited group of personnel available, a company may not experience a very high degree of response time or attention, because the staff may be overwhelmed with work for other customers. Another issue is the distance of the supplier from the company. This may not make a difference if the service provided is totally automated, such as the cash management functions of a bank. However, other services, such as internal auditing, require an extensive amount of on-site support, which is not an easy matter if the supplier is based many miles away. Thus, a deciding factor may be the distance of the supplier from the company, depending on the type of outsourcing. Next, one should note a supplier’s ﬁnancial condition. A supplier will rarely divulge this data (unless it has an unimpeachable reputation), so a controller should obtain a credit report on the supplier’s ability to pay its bills. Any weakness in this area may indicate the potential failure of the supplier, which can have serious ramiﬁcations on the services a company is trying to outsource. In addition, a telling factor is the amount of time a supplier has spent in outsourcing. A long history indicates a heavy experience base, which will probably translate into a good working relationship. Alternatively, a minimal degree of experience should be viewed with some suspicion, unless the supplier staff includes a signiﬁcant proportion of employees who have many years of outsourcing experience with other companies. Finally, a controller should pay a great deal of attention to a company’s reputation in the marketplace. If there are a signiﬁcant number of stories circulating regarding a supplier’s failure to support its client base, there are certainly grounds for further investigation of the rumors, quite possibly leading to the disqualiﬁcation of what might otherwise appear to be a preminent supplier. A controller should carefully weigh all of these factors when picking a supplier to take over an accounting function.

57.3 GENERAL ADVANTAGES OF OUTSOURCING Why outsource an accounting function? Although there are several function-speciﬁc reasons (covered later in section 58-4), there are a variety of general reasons that apply to all functions, and which should be the driving force behind a controller’s decision to outsource some or all portions of the accounting department:

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• Acquire better management. A controller may ﬁnd that an accounting function is not being very well managed, and outsources that function solely to acquire the greater management expertise of a supplier. This can be a radical solution when the only problem is poor management, but it can be a viable alternative if a controller has run through a number of poor managers and does not see any better way to acquire good management assistance. • Acquire new skills. A controller may use the skills of suppliers to improve the functions of various accounting functions. This reason is a common one when a controller ﬁnds that the existing accounting staff is in a rut and can devise no new means for improving the effectiveness and efﬁciency of their jobs. In these cases, bringing in a specialist supplier with an in-depth knowledge of best practices can have a rejuvenating effect on the performance of the accounting function. • Alter the break-even level. A typical accounting department has the same size staff year-round, and this level varies only gradually as sales volume changes. Thus, the typical accounting department can be considered a largely ﬁxed cost. A controller can modify this situation somewhat by using outsourcing. In many cases, such as payroll or transaction processing, a company is charged for a supplier’s services based only on the volume of transactions processed, so that accounting costs will vary with volume. Accordingly, by using outsourcing, a controller can convert some ﬁxed costs over to variable costs, which slightly reduces a company’s break-even point. • Assist high-growth situations. If a controller is struggling to increase the staff size of the accounting department at a rate that matches a company’s growth, a good way out of the bind is to hand over some functions to a supplier, and let it worry about adding a sufﬁcient number of staff to keep up with the rate of growth. By doing so, a controller can ignore stafﬁng problems and concentrate on other issues that may be equally crucial to ensuring that the company continues to grow at a blistering pace. • Avoid investments. A rapidly growing company is one that is frequently short on cash. To keep from spending more of it, a controller can outsource functions that would otherwise require an investment. For example, an in-house payroll processing function might require its own software package and computer, whereas outsourcing it to a supplier results in no investment at all. • Focus on core functions. A primary reason for using outsourcing is to allow a controller to focus on the more crucial core functions of the accounting department. For example, it is common for the main processes to center around billings and payments; if so, a controller does not want to waste time on other accounting tasks, and so will outsource these other functions to suppliers. • Handle overﬂow situations. Though rarely a primary strategic reason for using outsourcing in the accounting arena, it is possible to bring in a supplier just to handle situations where the internal staff is overwhelmed by the volume of work and requires assistance for a short time. For example, the internal auditing staff may not have time to conduct due diligence work on a new acquisition, so the controller brings in a supplier’s auditors to conduct this work instead. By using suppliers strictly for overﬂow work conditions, a controller can keep the core in-house staff levels down to the minimum needed to handle only the most essential tasks. • Improve performance. A controller may simply want to improve the performance of the accounting department, getting more results per dollar expended than is currently the case. Because of their knowledge of best practices and their expert staffs, suppliers can frequently provide the performance improvements that a controller is looking for. There is a broad range of strategic reasons why a controller would be justiﬁed in outsourcing various accounting tasks. These reasons range from acquiring knowledge and experience from a supplier, to reducing ﬁxed costs, avoiding investments, and handling high-volume transaction situations. For nearly every company, there will be a number of situations that beg for the use of outsourcing to improve its operations.

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57.4 FUNCTION-SPECIFIC ADVANTAGES OF OUTSOURCING Besides the general advantages of outsourcing that were mentioned in the preceding section, there are a variety of advantages accruing to the use of outsourcing particular functions of the accounting department. These advantages cover a wide range of functions, from cash management to transaction processing. For each item listed below, covering a separate functional area, there are one or more speciﬁc advantages that will occur as a result of outsourcing a function. • Pension plan administration. By moving the administrative tasks associated with a pension plan to a supplier, a controller can convert the ﬁxed cost of having an in-house staff to the variable cost of the supplier, who only charges a per-participant fee for all administrative work performed. If an accounting department has a large number of ﬁxed costs, this is an ideal way to reduce them. • Cash management. The main advantage of using a bank to automatically sweep cash from various accounts and into investment accounts is that the process is automatic—there is no risk of a manual transfer that will result in excess cash lying in a non–interest-bearing account. In addition, it may be possible to dispense with some of the in-house labor that had previously been employed to track cash ﬂows, but which can now be fully automated. • Collections. Though a collections agency really performs the exact same task as an in-house collections staff, it usually does so with greater energy—after all, its pay is based on its collections success. Consequently, a controller will ﬁnd that a collection agency may have much greater collections success than the in-house staff. • Financial statement preparation. One advantage of having a supplier prepare ﬁnancial statements is that the supplier is usually an audit ﬁrm, which means that it has an outstanding knowledge of the rules and regulations governing the exact layout of and information contained in a set of ﬁnancial statements. There are any number of new Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) rules appearing every year; therefore, this is a valuable service, especially for a publicly held organization that must present its ﬁnancial results in a rigidly predetermined format. Thus, any controller who has a poorly trained staff that is only marginally capable of preparing ﬁnancial statements should consider outsourcing the task to a supplier. • Internal auditing. One advantage of outsourcing the internal auditing function is that a controller obtains a wide range of skilled auditors from the supplier, who can be shifted in and out of auditing jobs, depending on the skill levels needed for each audit. Also, because of its experience in auditing many companies, a supplier has a good knowledge of best practices that it can impart to a company as part of its review. In addition, if the supplier has multiple ofﬁces (as many do), a company can avoid travel expenses by having the supplier assign staff from its local ofﬁces to work on audits of company locations that are near to those ofﬁces. Plus, there are no hiring or training costs associated with outsourced auditors, because these expenses must be supported by the supplier. In addition, there are no downtime costs, since the auditors go back to the supplier as soon as their work is done; this means that the internal audit fees are a variable cost, not the ﬁxed one of having a paid in-house staff. Finally, there is a good chance that the quality of the staff and management provided by the supplier will be superior to that of the in-house internal audit function, because the supplier’s staff has gained a wide range of experience by working for many companies on a variety of extremely diverse audits. • Payroll processing. There are a considerable number of advantages to giving the payroll processing function to a supplier. One is that a company can shift the burden of ﬁling payroll tax payments to the supplier, which also allows it to avoid any penalties associated with not making the ﬁlings in a timely manner. In addition, a company can avoid buying any payroll processing software or making continuing payments on software updates, because the supplier uses its own software. Also, a company no longer has to prepare W-2 earnings statements for all employees at the end of the year, does not have to print paychecks, avoids

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stufﬁng checks into envelopes, and does not have to put a signature on every check—all of these tasks are handled by the supplier. If that is not enough, a supplier can also use direct deposit to shift payments straight to employee bank accounts and mail checks to multiple company locations. Finally, a limited number of suppliers even have 401(k) plan administration linked to their payroll systems, so that a controller can combine the outsourcing of pension administration under one roof with payroll. The large variety of advantages to outsourcing payroll shows why this is one of the most popular outsourcing opportunities. • Taxes. The primary advantage of using a supplier to prepare tax returns is that this is all the supplier does—its staff has great expertise in preparing returns, and can not only do so quicker than an in-house staff that must prepare them only once a year, but also may know of some twists in the tax laws that will save a company money. Consequently, a large proportion of companies resort to outsourcing their tax preparation work. • Transaction processing. One advantage of handing over all transaction processing to a supplier is that an expert supplier can apply a greater knowledge of best practices to the area than could a controller, thereby bringing greater efﬁciencies to the manner in which transactions are performed. In addition, at least some portion of the costs can be converted from the ﬁxed cost of paying for an in-house staff to the variable cost of paying on a per transaction basis. Also, in some cases, a supplier will move the transaction processing function off-site to its own central location, which allows a controller to eliminate some expensive ofﬁce space. Finally, the supplier sometimes uses its own software to process transactions, so it may be possible to stop paying maintenance fees on the software that had been used in-house to process transactions. There are a number of outsourcing advantages that are speciﬁc to certain accounting functions, including internal auditing, cash management, and payroll preparation. When combined with the general advantages noted in the previous section, a controller can make a powerful argument in favor of outsourcing nearly any activity in the accounting area.

57.5 RISKS OF OUTSOURCING For each of the areas in which a controller can use outsourcing, there are risks to consider. This section discusses those risks. In general, the key problem with outsourcing is lack of performance by the supplier. This problem can usually be avoided by carefully attending to the supplier selection process to ensure that the best possible supplier is brought in to meet a company’s needs. If the pension plan administration function is outsourced, there is a risk of poor service by the supplier, which can take the form of delayed, lost, or incorrect changes to employee pension plans. Because this function has heavy interaction with employees, there is a high probability that poor service will cause considerable employee dissatisfaction. The best way to avoid this problem is to carefully review the history and references of any pension plan administration supplier. It may also be useful to incorporate a clause into the company that allows a termination of the supplier for cause, with a modest number of days (such as 90) for the supplier to improve its performance upon written notiﬁcation by the company. By screening out poor candidate suppliers in advance and giving itself a quick way out of a relationship, a company can control its risk in the area of outsourced pension management. If the cash management function is outsourced, a company will have to consolidate its banking services, to a large extent, with the bank that is providing those services; this is because it is much easier to have a single entity conduct automated cash sweeps, rather than use manual transfers between different banks. Consolidating banking activities with one supplier is not necessarily a bad thing and will probably increase the efﬁciency of bank transactions. However, if a banking supplier suddenly decides to increase its fees, there is not a great deal that a company can do, because it is very difﬁcult to shut down all bank accounts, move them to a new bank, and set up the same cash sweeps, zero balance accounts, and lockboxes that were in place at the ﬁrst bank. Thus, the primary risk of outsourcing cash management is that the supplier can raise its prices to a considerable degree without a company being able to respond in a meaningful way.

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If the internal auditing function is outsourced, a company loses a good training ground for its future managers. In many companies, this function is used to cycle promising management candidates through many functional areas. Not only does this approach give management trainees an excellent view of the company, but it also gives existing employees a good view of the capabilities of the candidates. This beneﬁt goes away when the internal audit function is handed over to a supplier. Also, the experience level of the external auditors who are brought in to conduct audits may not be as high as that of the internal auditors they are replacing. One reason is that the internal audit staff knows everyone in the company, and knows its processes, so they are comparatively more knowledgeable than the people brought in to replace them. Also, the external auditor may bring in staff people with minimal skills, because it can charge lower rates by doing so. This can be a major problem if the controller is pushing the supplier to reduce its costs, which forces the supplier to cut costs by using its cheapest, and least experienced, auditors. Thus, a controller should consider the loss of training availability and the potential for lower-quality audits when making the decision to outsource the internal auditing function. If the collections function is outsourced, a controller should be aware that there is some risk of irritating customers. This can happen when an overly aggressive collections supplier goes after customers to make payments. While some degree of aggression is to be expected, it does not help if a company’s customers are being verbally abused over the phone, and can even result in the loss of those customers. Another problem is that collections suppliers expect to keep about one third of the amount they collect, which may be signiﬁcantly higher than the cost would be if the matter were handled internally. A controller can mitigate this cost by negotiating the reimbursement rate downward (though there may be a promise of high collections volume in order to do this), or by reducing the dollar volume of accounts receivable that are turned over to the collections supplier for collection. Thus, using a collections supplier can be expensive and may irritate customers. If the ﬁnancial statement preparation function is outsourced, a controller must be aware that there is a high cost associated with having a supplier either review or prepare a company’s ﬁnancial statements. This work must be completed by supplier personnel with a relatively high degree of experience and training; therefore, their billable rates will accordingly be high. The best way to reduce this cost is to prepare statements internally and have only the supplier review the resulting statements. Another risk is that the supplier will not produce ﬁnancial statements quickly enough to suit the needs of the company. This problem can be mitigated by using a combination of penalty clauses in the contract, under which the supplier pays if a ﬁnancial statement is delivered late, or bonus payments, under which the company pays the supplier for prompt service. Usually, these clauses are sufﬁcient to ensure the rapid delivery of ﬁnancial statements. If the taxation function is outsourced, there is some risk that the supplier will not be completely conversant with some local taxation issues, which may result in the company’s paying a higher tax rate than would be the case if the taxes were calculated by an in-house staff that was more experienced in these matters. The best way to avoid this problem is to keep the calculation of local taxes in-house, and outsource only tax calculations for federal and state taxes. Also, there can be a signiﬁcant time delay if the supplier calculating taxes is not the same one that provides the annual audit service, because paperwork must be exchanged between the two, which takes time. Accordingly, it is common to give the tax work to the external auditors to eliminate this time lag. A controller should be concerned about the accuracy of local tax calculations and the time needed for a nonauditor supplier to complete the company’s tax calculations. If the transaction processing function is outsourced, there can be a considerable increase in the cost of services provided. The cost increase is due to the supplier’s need to earn a proﬁt, as well as by the particular pricing structure adopted. For example, an agreement that incorporates a minimal number of services in the baseline cost must include any remaining services under higher-priced add-on services, which will inevitably increase the total cost of the supplier’s services. To avoid this problem, a controller should pay careful attention to the pricing terms during initial negotiations, and shift as many services as possible into the baseline services portion of the agreement. If the payroll processing function is outsourced, there are several risks, most of which arise during the conversion phase to the supplier. For example, it is an easy matter to incorrectly transfer

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start-up information to the supplier, resulting in an incorrect payroll calculation, which will certainly not be greeted with enthusiasm by employees. In addition, there are many additional services that can be added to the baseline payroll service, such as envelope stufﬁng, vacation accruals, and direct deposit. It is common for problems to crop up when these extra services are used, so it is best to sequentially implement them over time, waiting for all problems to be solved on each one before progressing to the next. In addition, outsourced payroll services cost more than in-house payroll; there is no way around this, so a controller should be aware of this in advance and build the added costs into the budget. Also, an in-house person must still transmit payroll information to the payroll supplier in order to complete the check processing; if this transmission is not made, there will be no payroll. Accordingly, a controller should always designate a backup person to prepare payroll, in case the person with primary responsibility for this task is not available. Thus, there are a number of disadvantages to payroll outsourcing that a controller should guard against. A ﬁnal risk that relates to the supplier of any outsourced function is that of the supplier’s situation changing in the future. This change can take a number of forms, such as a reduced ﬁnancial situation, a takeover by another company, or a change in the supplier’s strategic direction. Any of these changes can have a direct impact on a company, such as a stoppage of service by the supplier, perhaps because it is getting out of the outsourcing business, a change in fees or a reduction in the service level in order to increase its proﬁts, or perhaps a changeover to new supplier personnel. All of these changes can have a serious impact on the cost and quality of services provided by a supplier. In many of these cases, a company will have no choice but to bring a function back in-house or move it to a different supplier. The best ways to guard against this problem are to keep in constant touch with a supplier in order to gain advance knowledge of any impending changes, and also by staying in touch with competing suppliers, so that there will be a shorter required interval to search for and select an alternate supplier. There are a number of risks associated with outsourcing accounting functions, which include supplier nonperformance, high costs, and dependence on sole suppliers. However, many of these risks can be mitigated by proper attention to the supplier selection process, fair pricing, and continual supplier communications.

57.6 CONTRACTUAL ISSUES This section describes a wide range of contractual issues that a controller should keep in mind when negotiating contracts with suppliers. A few of them address contracts with suppliers of any service, but several are targeted speciﬁcally at contracts for speciﬁc accounting areas. A key issue to consider when negotiating any contract for outsourcing services in any area is to beware of incomplete contracts. An aggressive supplier will try to force a company into signing a contract early on in the negotiations, which has two harmful effects. The ﬁrst is that other potential supplier candidates are blocked out of the selection process, which gives a company no alternatives in case negotiations with the primary supplier break down. The second problem is that, by deferring some issues for postcontract negotiation, a supplier can take its time, knowing that all other suppliers have been blocked out, and obtain high pricing for those issues. Thus, prolonging negotiations until all issues are included in the contract not only keeps other suppliers in the running until the last moment, but also gives management a comprehensive view of all costs before they sign the contract. Another contractual item to avoid is the supplier’s contract. No matter what the functional area being outsourced, the contract presented by the supplier was created solely for the beneﬁt of the supplier and contains many clauses that protect the supplier, to the disadvantage of the company. Rather than mull over the supplier’s contract line by line, it is much easier and less risky to simply create a new contract. There are cases, usually involving minor outsourcing deals, where it is not worth the effort to do so, but a controller should rip up the supplier’s contract in most cases and start with a fresh sheet of paper. Some accounting areas, such as internal auditing, tax preparation, and ﬁnancial statement preparation, involve conﬁdential information that could harm a company if it were to get out to the

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public. A controller can avoid this problem when dealing with suppliers by requiring them to sign a conﬁdentiality agreement as part of the outsourcing contract. Then, if it can be proved that a supplier has disseminated crucial information about company operations, a company will have a ﬁrm legal basis for demanding compensation from the supplier. Depending on the application being outsourced, it may be wise to include a clause that allows a third party to review and report on supplier activities from time to time. Though rarely used, this clause gives a company access to an independent outsider who can objectively give a considered opinion regarding the performance of a supplier. A controller frequently picks a supplier based on the quality of the supplier’s staff that is assigned to work on company functions. To ensure that these personnel or ones of similar quality are in fact used on company business, it is useful to include in a contract a clause that severely curtails the use of subcontractors. Bringing in a third party is a common ploy by a supplier to shift work to a lower-cost supplier that has lower operating standards, and that typically does not provide work of the same level of quality. Since there may be valid reasons for using a subcontractor, such as when the subcontractor has a special skill, a controller should at least require approval prior to bringing in a subcontractor. Proper control over subcontractors has a direct impact on the quality of outsourced services. Even if a supplier has a wonderful staff, the relationship may be a sour one if the primary contact person or project manager does not have a good working relationship with the controller. To avoid such a situation, the contract should include a clause that allows a controller to request the removal of the project manager. Though this clause should be used sparingly (to avoid undue strain on the outsourcing relationship), it is useful to have in those rare instances where the working relationship is clearly not working. An extremely useful clause is to require a supplier to actively assist in the conversion to a different supplier if the contract with the ﬁrst supplier is terminated. While it is usually necessary to sweeten this clause with a healthy payment to the outgoing supplier, it is still useful to have a legal recourse if the controller ﬁnds that there is no other way to force a supplier to hand over necessary documentation and provide training to an incoming supplier. So far, general contractual issues have been noted that will apply across the board to all or most accounting outsourcing situations. The following list makes reference to additional contractual issues that will vary by the functional area being outsourced: • Cash management. There are few negotiating points when dealing with a bank. The cash management systems will be highly automated, so there is no need to modify their method of automation from the one already established by the bank. The main remaining point of discussion is pricing, which a bank may alter, especially if the company is a large one that passes a considerable portion of its monetary investments through the bank. For a smaller company, there is not much chance of reducing fees. • Collections. When negotiating a contract to outsource collections, the main point will be the percentage of collections that the supplier gets to retain. The percentage agreed upon can vary considerably if the controller is willing to send a large proportion of a company’s accounts receivables to the collection agency, which allows the agency to make up its proﬁts on volume, rather than on the percentage retained. • Internal audit. When negotiating a contract for internal auditing services, a major task is driving down the audit fees charged by the supplier. In this case, the supplier is frequently a Big Four auditing ﬁrm that is used to charging high fees for its staff’s time. In order to keep rates low, a controller should target those times of the year when the audit ﬁrm is not busy (usually the summer months, unless the ﬁrm audits the health care sector, where summer year-ends are common), which is when audit partners are looking for ways to keep utilization levels high, even at the cost of reducing its billable rates. Another negotiating point is that the controller should have the right to request speciﬁc auditors for the internal audit work, or at least the right to not allow speciﬁc auditors to perform the work. This clause gives a controller great control over the quality of the work performed.

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• Payroll. When negotiating a contract to outsource payroll, the only real negotiating point is the price of the baseline services offered. Most payroll suppliers are quite large, and their systems do not allow for much customization of the deals with different suppliers. The best that a controller can hope for is a percentage discount off the base rate. In isolated cases, it may also be possible to reduce the per-unit rates on add-on fees, as well. • Pensions. It is very difﬁcult to alter the terms offered by pension companies. This is because they are so large that most companies are too small to be worth the effort of a customized deal. However, it is possible to work with most pension companies to create a set of investment alternatives to present to employees. A controller should concentrate on negotiating at least ﬁve investment alternatives, so that employees will have a reasonable set of alternatives to choose from. • Taxes. When negotiating a contract to have a company’s tax forms prepared, the rate per hour is generally negotiable. In addition, one can add a clause that allows the controller to specify who will prepare the tax forms. It does no good to specify in the contract the name of the person who should do the taxes, because employees come and go, but a controller should at least have a right to pick from the available group of supplier employees. • Transaction processing. The best chance for negotiating large swathes of a contract lie in the transaction processing area, because this type of outsourcing involves contracts that are largely customized to the speciﬁc needs of a company. One key area is the number of services included in the baseline monthly fee; the fewer the number of services not included in the baseline fee, the smaller the amount of additional costs. Another contractual item is the minimum time before a supplier can transfer former company employees to its other projects at other client sites; this clause keeps experienced staff on-site to work on company-speciﬁc issues for the longest possible period of time. Also, a controller can require ﬁnal approval of all transactional changes, because these changes may have an impact on the functions of other parts of the company. There are a variety of contractual issues that a controller should consider when negotiating with a supplier for outsourced services. Some pertain to nearly all contractual situations, while others only apply to speciﬁc functions. It is best to be aware of these issues and incorporate them into a contract, in order to avoid legal ramiﬁcations later in an outsourcing relationship.

57.7 OUTSOURCING COSTS This section covers the types of costs that go along with outsourcing, as well as (in a few cases) ways to reduce those costs. The section also discusses how supplier performance varies with excessively low pricing levels. This is a more important area for outsourcing in other parts of a company, where outsourcing deals are more customized. Because most accounting outsourcing situations involve procuring services from large suppliers with ﬁxed contractual terms, it is not likely that a controller can negotiate signiﬁcantly different pricing than what is outlined in this section. The key costing issues are: • Base price plus fees for extras. The suppliers of most accounting services provide a basic level of service, with expensive additional fees for other activities that extend beyond the basic level of support. For example, a payroll supplier will charge a basic fee per person to process payroll data and cut a check. It then adds fees to imprint a signature on each check, direct deposit the money in an employee’s account, and stuff checks into envelopes. These added services are typically quite expensive, because they are where a supplier makes most of its proﬁt. By bidding its initial services based on the baseline fee and nothing else, a supplier appears to be inexpensive, but then the cost escalates dramatically when the extra service costs are added in. To some extent, a controller can mitigate some of these added costs by rolling them into the baseline cost or by negotiating them down in advance. However, for the larger suppliers, only a very large company that can deliver a large volume of business to the supplier will be able to negotiate signiﬁcant changes to the original contract pricing.

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• Cost of living adjustment (COLA). Some suppliers will insist on cost of living adjustments, which usually go into effect annually. This adjustment protects the supplier from any sudden changes in the rate of inﬂation, which may be a major concern if the contract length is so long that there is uncertainty regarding the ability of the economy to avoid inﬂation. The adjustment is particularly common in countries with a long-term history of high inﬂation. A controller can safely avoid this cost if an outsourcing agreement is of such a short length, such as one year, that there will be little risk of inﬂation. However, the cost may be a necessary one for contracts that cover long periods of time. • Compensation based on value provided. Some suppliers are attempting to charge fees based on the value of the services provided. For example, there can be a sharing of savings from reduced transaction processing costs, or from savings in taxes paid. These deals should be avoided, because they are usually a thinly disguised attempt to extract more money from a company than would be the case if a more typical fee structure were used. • Escalation caps. If a controller agrees to a COLA to a contract, for any cost escalation, the agreement should include a cap on the total amount of the increase. For example, a contract can allow for a COLA, but with a maximum allowable increase per year of 7 percent. By including these caps, a controller can transfer the risk of excessive cost increases to the supplier. However, one must be aware that an excessively low cap will transfer so much cost to the supplier that the supplier will have no choice but to reduce its level of service in order to continue to turn a proﬁt; to avoid this problem, a controller should arrive at an escalation cap that is high enough to yield reasonable proﬁts to the supplier, thereby ensuring a higher degree of service to the company. • Milestone award. This is a special award to a supplier that is in recognition of its reaching a speciﬁc milestone. For example, a supplier may be awarded a ﬁxed amount of money for achieving a reduction of transaction processing costs. This award is much more common in other functional areas, such as engineering, where milestones are more easily deﬁned. A controller should agree to a milestone award only if there is a clear cost reduction that will be achieved as a result of the milestone, preferably one that exceeds the amount of the award. • Severance payments to employees. When a functional area is outsourced, some employees may be transferred to the supplier, and others may be let go. For those being released, a controller should budget for reasonable termination payments to assist them in their transitions to new positions. The amount of these payments will vary, but a typical formula is one week of severance for every year worked for the company, with no cap on the size of the payment. This amount may increase based on a company’s generosity or be reduced based on its cash position. Also, there may be a severance payment agreement in the supplier contract that provides for payments to former employees who were transferred to the supplier, but who will be let go if the company prematurely terminates it agreement with the supplier. As long as there is a gradual reduction in the company’s share of this termination payment, it is a reasonable item to put into a contract. • Termination fees. It is common for a supplier to charge a termination fee when its services are terminated, but this usually applies to services provided to other functional areas, where the supplier has made a large up-front investment that has not yet been recouped. In the accounting area, this circumstance applies only to the outsourcing of transaction processing, where a supplier may have made a signiﬁcant investment in creating a separate facility for transaction processing and paid out a large sum to convert a company’s processing capabilities over to that facility. If so, an early termination of the outsourcing agreement should probably result in a termination fee being paid to the supplier. A variation on this payment is a reimbursement for unearned proﬁts; this payment compensates a supplier who has intentionally deferred some portion of its current proﬁts to a later period by scheduling price increases for later in the contract, and who will not earn them because the controller is canceling the contract. If there is a clear deferment of proﬁts that a supplier will not earn, then it is reasonable to pay for some portion of the deferred proﬁts.

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• Variable pricing based on volume. For a limited number of functions, it may be possible to ratchet down pricing based on the volume of transactions handled by the supplier. For example, the price per check processed by an accounts payable check processing center may be reduced after 100,000 checks have been processed. Suppliers may be amenable to this type of fee structure as long as the lower-volume pricing levels are still high enough to cover their costs of doing business with the company; any higher-volume (and cheaper) pricing will then contribute mostly to supplier proﬁts, so there may be more room to negotiate these prices. When reviewing bids from suppliers for outsourcing services, a controller should be as suspicious of low bids as of high ones. The trouble with a bid that is excessively lower than anyone else’s is that the bidder either has not properly priced the services to be provided or else is not planning to provide a very high level of service. If the ﬁrst issue is the case, then the supplier will ﬁnd that the only way to make money on the deal is to provide a low level of service. In short, either circumstance results in the same outcome—poor service by the supplier. To avoid this problem, a controller should contact any suppliers submitting very low bids to allow them the chance to reevaluate their pricing decisions and resubmit bids. If there are still bids that are clearly out of line, a controller should consider the references provided by those suppliers to see if there have been service issues elsewhere, prior to selecting their bids. Thus, a very low supplier bid is not necessarily something that a controller should take as being the best possible deal. A ﬁnal item is that the chart of accounts should be modiﬁed to include separate line items for each outsourced accounting function. By doing so, a controller can easily track the cost of each service and compare costs against a budget, so that any variances from expectations are immediately apparent. If the fees paid are so small that a separate chart of accounts line item is not warranted, an alternative may be to summarize all outsourced accounting services into a single line item; this allows a controller to aggregate all outsourcing costs, so that the cost of using outsourcing in general can still be determined. Separate storage of outsourcing costs in the general ledger provides a greater degree of control over them. In summary, there are a number of outsourcing cost variations that a controller should be aware of when reviewing supplier pricing options. In a few cases, it is possible to gain better control of outsourcing costs by modifying the terms of these pricing options. In addition, it is important not to accept supplier bids that are clearly too low. It is a good idea to use separate chart of accounts line items to more clearly track the cost of each supplier.

57.8 PERSONNEL ISSUES RELATED TO OUTSOURCING When outsourcing part of the accounting department, it is common to run into hard feelings or confusion on the part of the existing staff, who may be replaced by the supplier. Many times, these feelings are justiﬁed. When making the decision to outsource, and following through on it to implement a transition to a supplier, a controller should keep in mind the points noted in this section, in order to keep the level of turmoil to a minimum. An open-minded controller might think it ethically correct to inform the entire accounting staff immediately if there is even a chance of outsourcing some of the department to a supplier. Although it may seem fair to the employees to do this, all it results in is an instant loss of productivity, as all employees who might be impacted start updating their resumes and contacting search ﬁrms. A more realistic approach is to wait until there has been a deﬁnite decision to outsource, and a supplier has been selected, and then to inform the staff. By waiting, a controller can avoid putting the accounting personnel through the uncertainty of whether or not they are to be replaced. In short, if there is no deﬁnitive decision, do not tell anyone. When the controller does talk to the accounting staff, it is very helpful if a team from the supplier is on hand to describe how it will take over the function, what the impact will be on the employees, and to answer any questions that the employees may have. By bringing in the supplier right away, employees receive complete information about the transformation process. If they are to be let go, they ﬁnd out immediately, and if they have any questions about how they are to be

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moved into the employment of the supplier, then these issues can also be answered. If possible, a well-prepared controller can even convert employees over to the supplier’s payroll during this ﬁrst meeting (though some like to let employees think it over for a few days). By giving employees complete information alongside the outsourcing announcement, there is less disruption and uncerainty; by reducing these factors, it is more likely that fewer key employees will leave to work elsewhere. Before letting people go to a supplier, a controller should consider keeping the best employees, if only to provide an in-house backup for the supplier. When a company allows its best talent to be hired away, it no longer has the option to bring the accounting function back in-house (at least not without a considerable cost). In order to keep this as a viable option, it is best to retain a small number of very experienced employees, though this may mean that the accounting payroll will be somewhat higher than is strictly necessary. Also, these people can be used to manage or monitor the supplier’s activities. For example, the former in-house payroll supervisor can now monitor the activities of the supplier and report to the controller when anything goes wrong, so that he or she can take steps to improve the supplier’s performance. Thus, keeping a small number of the best accounting staff has several advantages. For those employees who are hired by outsourcing suppliers, this can represent a considerable opportunity. A person who specializes in a particular accounting activity will now work for a company that does nothing but that activity, has multiple sites through which to rotate its employees for more experience, and probably has a high level of knowledge of best practices with regard to that activity. In short, a supplier can offer a much better learning environment than the original company, so many employees may see the arrival of a supplier as a great opportunity—and it should be presented to them as such. In summary, a controller should keep from talking to any accounting staff about an impending decision to outsource until the agreement has been ﬁnalized. At that time, supplier representatives should be on hand to answer employee questions. These steps keep staff turmoil to a minimum. In addition, a controller should “cherry pick” the accounting staff to keep a few of the most experienced or knowledgeable, in order to provide in-house monitoring and backup of suppliers. Finally, for the remaining staff who are switching to the supplier, this should be presented to them as a signiﬁcant opportunity—the chance to learn from the supplier.

57.9 MANAGEMENT OF OUTSOURCING SUPPLIERS There are a variety of issues related to the management of the suppliers of accounting services. The need for an in-house coordinator to monitor and control supplier activities is discussed in this section, as well as how this person should operate and be supported by other staff. There is a wide range of control points and measurements that can be used to monitor supplier activities to ensure that they are performing in accordance with expectations. No matter how many accounting functions are outsourced to suppliers, there should still be someone in-house who continues to work for the company who can monitor supplier activities, determine their level of service, and modify it as needed. This person needs a strong background in accounting, as well as considerable management skills, especially if there are a large number of suppliers to deal with. The person who most clearly ﬁts this description is the controller. A typical controller has a broad range of knowledge, and has probably been outsourcing a small number of functions, such as payroll and tax preparation, for some time, and so is the clear choice for managing suppliers. For a larger company, the controller may hand off this task to one or more assistant controllers, depending on their levels of expertise. Again, in a larger company, it is common for the treasurer to oversee the activities of some suppliers, usually those that handle cash transactions or pension management. Thus, it is common for the controller, with help from assistant controllers or the treasurer, to manage accounting suppliers. There should be a support staff to assist the person coordinating supplier activities, unless the accounting function is a very small one. These support personnel should be culled from the best of the accounting staff before they are transferred to suppliers as part of the outsourcing process,

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thereby keeping the most knowledgeable staff to monitor and measure the activities of the suppliers. Their role is to review the daily transactions handled by suppliers to ensure that they are handled correctly, as well as to track supplier billings against contractual rates and to measure supplier performance against designated goals. When there are negotiations with suppliers, the support staff should act in a backup role to the controller, supplying this person with information as needed. Thus, an experienced support staff is vital to the success of a controller in managing supplier activities. Besides an accounting support staff, it is also helpful to have an outsourcing committee somewhere in a company that provides support for general outsourcing problems to all functional areas, not just accounting. This committee collects outsourcing information and disseminates it to all departments; for example, it can determine the best way to negotiate contracts with suppliers, based on the company’s experience in many areas, and then summarize this information for use by all departments. The committee may even provide lawyers for negotiations, as well as human resources personnel to handle staff transitions to suppliers. It can also help a controller (or other department head) analyze the pros and cons of using outsourcing and arrive at a reasoned conclusion that is based on more experience than a controller may have. In short, a central outsourcing advisory committee can assist in collecting and disseminating outsourcing information, as well as provide specialized assistance, all of which make it easier for a controller to manage outsourced functions. Even with all of this support, it is still up to the controller to decide which functions are outsourced and which are kept. Usually, the best candidates for outsourcing are those functions that involve large quantities of transaction processing or very specialized knowledge. Common outsourcing areas that have one or more of these attributes are cash management, pension management, transaction processing, and tax preparation. Areas that do not have these attributes are typically those that require company-speciﬁc knowledge or the presence of someone at company locations, such as cost accounting, ﬁnancial analysis, equity planning, and debt management. Though important, these functions do not comprise the majority of the work carried out by the accounting department, so a controller who is strongly in favor of accounting can eventually see the majority of the department disappear, as suppliers take on an abundance of tasks. Having assembled a support team and outsourced a number of functions, a controller must still decide how to monitor supplier activities. There are a number of control points and measurements, as detailed later in this section. It is also useful to enroll the services of both the support staff and the internal auditors to sample a predetermined set of supplier activities to see if they are being handled in accordance with expectations and at budgeted cost levels. Typical items that should be included in these periodic reviews are the hourly, baseline, and add-on rates charged by suppliers, any changes in those costs, and incidental costs. Also, performance should be tracked against a predetermined set of goals that have been agreed to by both the controller and each supplier. It is much easier to keep track of supplier costs if each one is given its own line item in the chart of accounts, so that actual and budgeted costs can be easily compared in the ﬁnancial statements. If a supplier does not meet its cost or performance targets, a controller should make use of penalties to bring supplier performance back into line. Alternatively, there should be a bonus arrangement to award outstanding supplier service. Finally, there should be a schedule of review meetings, so that the controller and supplier management can sit down and talk over performance during the past period, company concerns, and expectations for the future. These meetings should include an agenda and published minutes, in order to keep meetings on track, as well as to provide evidence of the agreements reached during the meetings. Only by taking these steps can a controller adequately manage supplier activities. There must be more than a periodic review of costs and performance to ensure that a supplier is performing its tasks in accordance with the expectations of the controller. In addition, there should be tight control over a small number of checkpoints. These points must be designed to give a controller assurance that the most important tasks are being completed on a continuing basis. For example, it is critical that a transaction processing supplier issue invoices to company customers on a timely basis, so a major control point is a continual review of the daily invoicing run and comparison to the shipping log, to ensure that the supplier is not only issuing billings on time, but also

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creating a billing for every item shipped. Unfortunately, it is impossible to create a complete list of control points for all outsourcing situations, because there are far too many variations in how accounting departments operate. Nonetheless, the following list includes some of the most common control points that will apply to most situations: • Cash management. All cash in lockbox accounts should be completely swept every day, so that all possible cash receipts are earning interest in an interest-bearing account. • Collections. The supplier should be remitting a portion of all cash received to the company. • Financial statement preparation. There should be no material errors in the income statement, balance sheet, and accompanying footnotes that would mislead anyone reading the ﬁnancial statements. • Internal audit. All internal audits should be reviewed to ensure that they are completed with a sufﬁcient degree of thoroughness to spot any control problems in the samples being audited. • Payroll. Payroll taxes should be deposited on time. Paychecks should be given to employees on the date speciﬁed on the check (neither sooner nor later). Payroll changes, such as raises and terminations, should be entered promptly and accurately. • Pension management. All monies transferred to the pension account should be credited to employee accounts as promptly as possible. All investments shall be made to the investment accounts speciﬁed by employees. All investments shall be returned to employees as promptly as possible following their requests for disbursement. • Taxes. There shall be no material errors in tax calculations that would result in a tax penalty, nor shall tax ﬁlings be made so late that they would incur a late fee. • Transaction processing. There should be a purchase order supporting every supplier invoice that is paid. The price paid to the supplier should not vary from the amount on the purchase order by more than a predetermined percentage of ﬁxed dollar amount. In addition, there should be a billing for every shipment noted in the shipping log. In addition, the date on every invoice sent to customers should be no more than one day later than the date listed in the shipping log, to ensure that invoices are sent out on time. A key element of the management function is determining which measurements to use to track the performance of suppliers. There are many to choose from; the following are the most effective ones to use, sorted by the functional area being outsourced: • Cash management. There are several good measures for tracking the performance of a cash management supplier, with the extent of tracking determined by the number of services provided by the supplier. For example, a supplier that does nothing more than automatically sweep cash from a number of lockboxes into a central investment account should be judged by its transaction fee per sweep. However, if the supplier also purchases various investment instruments on behalf of the company, it can also be measured by its brokerage fees as a percentage of the amount invested. If the supplier is also giving advice on the types of investments that a company can make, then another appropriate measure is the earnings rate on investments, although this should be tempered by an evaluation of the risk of those investments. Finally, no matter what the level of cash management service provided, a supplier’s ability to accurately move funds must be measured. To do so, conduct a periodic audit that compares the transfer instructions sent to the bank to the transaction movement records sent back from the supplier to the company. • Collections. There is only one way to measure the effectiveness of a collections agency, and that is its ability to collect money. To measure the percentage collected of dollar volume assigned, divide the cash received from the agency by the total amounts of accounts assigned to it for collection. This proportion will be reduced by the fees an agency takes out of the amounts collected, so the percentage will look lower than the actual amount collected.

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• Financial statement preparation. In this area, one can measure the accuracy and timeliness of the statements produced by a supplier. The easiest measure is the timeliness of ﬁnancial statement preparation, which is determined by tracking the date when ﬁnancial statements are received back from the supplier each month (keeping in mind that the annual statements will usually take longer, due to the extra care required to ensure that they are as accurate as possible). The other measure, involving the accuracy of the ﬁnancial statements, is much more difﬁcult to determine. A good approach is to use a rotating internal audit that checks on the accuracy of speciﬁc portions of the ﬁnancial statements. An inaccuracy that results in a restatement of proﬁts of more than 5 percent is certainly worth an in-depth discussion with the supplier. • Internal audit. In this area, a supplier should be judged on its ability to complete the required number of audits, and to do so in a cost-effective manner. Accordingly, a key measure should be the percentage of audits completed, which is easily measured by dividing the number of completed audit reports received by the total number of audits scheduled. Another measure is the cost per audit, which is measured by dividing the total audit cost for the year by the total number of audits conducted. • Payroll. The key factor in measuring a payroll supplier is cost. Accordingly, one measure should be the transaction cost per person, which is calculated by dividing the total number of employees paid by the total fee charged by the supplier. Another measure is the proportion of fees for extra services, which shows the amount of costs that fall outside the baseline cost provided by the supplier. To measure it, divide the total baseline cost into the remaining cost of other services; these numbers are easily extracted from the supplier’s invoice. Costs can also be impacted if the supplier does not pay payroll taxes on time. The timeliness of tax ﬁlings is easily measured by compiling all tax penalties received by the company that relate to late payroll tax ﬁlings. Finally, there is an employee service element to be considered, which is the ability of the supplier to deliver paychecks to employees (a common problem when the supplier is mailing checks to multiple company locations). To measure it, divide the number of employee complaints about no paycheck receipts by the total number of paychecks delivered. • Pension management. The most common performance measurements in pension management relate back to employee satisfaction, since this supplier is essentially serving a company’s employees, rather than the corporate entity itself. Consequently, one measure should be the time to release funds to employees; this measure is of key importance to those employees who request disbursements, frequently because they are in a rush to receive payment. Another measure is the return on pension investment; again, this measure does nothing for the company, but a great deal for the employees, into whose pockets the increased investments will go. Finally, one can measure the timely release of statements to employees; though a minor issue, some suppliers have difﬁculty getting quarterly statements out to their pension plan participants. All of these measures should be tracked over time to spot developing performance problems. • Taxes. A key factor in tax preparation is completing the work in time to meet the tax ﬁling deadlines of the various government entities to whom the tax reports are sent. The timeliness of ﬁling is an easy one to track, since a late ﬁling fee will arrive in the mail if the supplier does not complete a ﬁling on time. This measure can be tracked another way by compiling the cost of tax penalties, which can be incurred not only for a late ﬁling, but also for improperly completing a ﬁling. • Transaction processing. Since this function covers a wide range of tasks, there are many effective measurements for tracking supplier performance. One is the average cost per transaction. Because many suppliers bill based on this cost, it is easy to calculate—just extract it from the supplier’s invoice and track it over time to spot changes. Another measure is the percentage of payment discounts taken. When properly managed, the accounts payable function should spot all payment discount opportunities and take advantage of them. This

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measure is best made with a periodic audit of invoices paid, with a heavy emphasis on suppliers who are known to offer early payment discounts. Another factor is the timeliness of processing. A periodic audit of transactions may reveal that some key transactions, such as billings, are not taking place as rapidly as one would expect. An internal audit can also be used to discover the transaction error rate as well as the average time to resolve errors, which should be tracked over time to see if there are continuing problems with accurately processing transactions. Finally, a more speciﬁc transaction processing measure is the time to turn around employee expense reports, which reveals the efﬁciency of the accounts payable processing function. The preceding list of measurements is not of much use if a controller does not use some consistency in applying them. First, it is critical to write down the measurement method, so that it is readily accessible every time the measure is used. By carefully applying the same measurement method, a controller can be assured of having a consistent set of measurements that are comparable over time. Second, a controller must use the measurements. If they are simply ﬁled away in a drawer, there will be no change in the performance of suppliers. Instead, the measurements must be sent to suppliers in the form of a report card, with attached comments from the controller. Also, there should be a periodic review meeting with each supplier, in which the measurements are discussed and performance improvement methods agreed upon. Only by using consistency in measurement and active follow-up will a controller make the most proﬁtable use of a comprehensive measurement system. A controller cannot just hand over selected accounting functions to a group of suppliers and forget about both the functions and the suppliers. Instead, the controller must take on the role of a functional coordinator, using the services of a highly qualiﬁed support staff to closely monitor and manage supplier activities, using a variety of control points and measurements. Only by taking these extra steps can a controller wring the highest degree of performance from those suppliers who have taken over a company’s accounting functions.

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CHAPTER*

58

PREPARATION AND MAINTENANCE OF MANUALS 58.1

INTRODUCTION 1053

58.12 MANUAL RETRIEVAL 1066

58.2

WORK STEPS FOR CONSTRUCTING A PROCEDURES MANUAL 1054

58.13 BENEFITS OF USING ELECTRONIC MANUALS 1066

58.3

SUGGESTED LIST OF PROCEDURES 1057

58.14 DISADVANTAGES OF USING ELECTRONIC MANUALS 1068

58.4

MAINTAINING ACCOUNTING MANUALS 1059

58.15 BASIC ELECTRONIC MANUAL 1069

58.5

RESPONSIBILITY FOR MAINTENANCE OF MANUALS 1060

58.6

SPECIFICATIONS FOR MAINTENANCE OF MANUALS 1060

58.17 ELECTRONIC MANUAL WITH ADVANCED INDEXING FEATURES 1072

58.7

PHYSICAL CONSTRUCTION OF THE MANUAL’S BINDER 1061

58.18 ELECTRONIC MANUAL WITH BUILTIN HELP INFORMATION 1073

58.8

CREATION AND STORAGE OF THE MASTER MANUAL COPY 1062

58.19 WRITING TIPS FOR ELECTRONIC MANUALS 1074

58.9

CREATION AND MAINTENANCE OF THE DISTRIBUTION MAILING LIST 1063

58.20 EXAMPLE OF COMPREHENSIVE ELECTRONIC MANUAL FEATURES 1075

58.16 ELECTRONIC MANUAL WITH EMBEDDED HYPERTEXT 1069

58.10 PHYSICAL DISTRIBUTION PROCESS 1064

58.21 USING THE PDF FORMAT FOR ELECTRONIC FILES 1076

58.11 ISSUANCES TO NEW EMPLOYEES 1065

58.22 MAINTAINING AN ELECTRONIC MANUAL 1077

58.1 INTRODUCTION The process of creating an accounting manual does not end with the creation of policies and procedures, for even the best manual will be of no use if it is not properly organized and distributed in such a manner that it is thoroughly readable and instructive. In this chapter, we will review the mechanics of how to construct and physically assemble the accounting manual, why we must keep a master copy of the manual (even for years after it has been superseded), how to determine the

* Adapted with permission from Chapters 3–4 of Steven M. Bragg, Design and Maintenance of Accounting Manuals (Wiley, Hoboken, New Jersey: 2003).

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best possible members for the distribution list, and how to ensure that they receive and understand it. We also deal extensively with the electronic manual, thereby giving a complete view of both the traditional and new approaches for creating and updating manuals.

58.2 WORK STEPS FOR CONSTRUCTING A PROCEDURES MANUAL Constructing a procedures manual is a major project for all but the smallest organizations. The following 18 steps are designed to provide structure to the process and create boundaries over the number of procedures being produced, which will keep the organization from getting bogged down in an endless cycle of procedure creation and updating. 1. Deﬁne the project. The largest single problem with the construction of a procedures manual is that no one knows when to stop. Instead, new procedures keep pouring in from all parts of the company for the most mundane and inconsequential items, resulting in a massive manual that is never truly ﬁnished and is never issued. To avoid this situation, it is very important to deﬁne immediately the company functions for which procedures will (and will not) be written, as well as make a rough guess at the total number of procedures that will be generated. This keeps the project within boundaries that give it a reasonable expectation of completion. 2. Obtain a project sponsor. No project of any size is ever completed unless there is someone in upper management who believes strongly enough in the project to support it through budget battles and the allocation of other scarce corporate resources. The positions that are generally most interested in a procedures manual are the chief ﬁnancial ofﬁcer and chief operating ofﬁcer, so the controller should approach these people ﬁrst. If they are not interested, the controller can be the project sponsor, though this position tends to have less control over other parts of the company, resulting in a manual that covers only the accounting and ﬁnance functions. 3. Determine the size of the project team. The only other item needed prior to making a budget request for funds is to determine the size of the project team, because the main expense is labor. To do so, take the previously estimated total number of procedures, multiply them by a generously estimated number of hours each, and factor in an overage percentage, resulting in an approximate number of person-hours for the work. Then determine the average pay rate per person, and multiply this amount by the total number of estimated hours to determine the total labor expense. It may also be necessary to budget for some travel to outlying company locations, as well as for ofﬁce space for the team and the production and distribution costs of the manual. 4. Obtain an approved budget. Present the proposed budget through the usual budget process, using the project sponsor to obtain approvals when needed. If the approved budget level is inadequate, scale back the number of procedures to be written to reﬂect the number of paid hours available. If a reduction is needed, give feedback to the project sponsor regarding the pared-down size of the manual so there will be no surprises when it is eventually released. 5. Determine the number of procedures to be written. A general estimate of the total number of procedures to be added to the manual was done initially, but now it is time to develop a master list of procedures. To do so, each department should be contacted and asked for a full list of the procedures they would like to have. List all these procedures together and determine the total number in the list. It is almost always far more than the budgeted number. Then work with the department managers to throw out the least important procedures. This can be a time-consuming process; some managers will insist on having more than their share of procedures, so the project sponsor must intervene to decide which departments will be given more or less than their fair share of procedures. When complete, there should be a master list of procedures that the project team uses as its basis for all future planning. 6. Prioritize the procedures. Once the master list of procedures is complete, it is necessary to determine which are the most important. Though all of them may be completed, one should

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always complete a core set of procedures ﬁrst, in case funds are cut off before the project is ﬁnished or a need arises for an advance release of the procedures before they have all been completed. The criteria for establishing importance can vary considerably, such as ranking one department over another if the department’s work is considered more critical. Another method is to complete all of the procedures related to a speciﬁc process cycle, such as order fulﬁllment or purchasing, so that those activities are completely documented. The most common approach is a political one, whereby each department receives an allocation of procedures; though not necessarily the best way to prioritize procedures, this method does allow all departments to participate in the process at about the same time, which increases the degree of user buy-in to the project and gives it a better overall chance of success. 7. Establish a time line. A set of due dates and milestones should be assigned to the project, to establish boundaries for when work is expected to be completed. For example, there should be regularly scheduled review dates to ensure that progress on procedures is acceptable. There should also be milestones for the completion of speciﬁc groups of procedures (usually for easily grouped clusters, such as by department or process cycle). 8. Issue requests for existing procedures. Based on the master list of prioritized procedures, send out requests to all department managers, asking for any existing documentation of targeted procedures. The returned information may include paper-based or electronic procedure formats, and may be in text or graphical mode. Whatever the format, it is wise to collect as much existing procedural information as possible, as this forms a foundation for subsequent interviews and, in many cases, also provides such complete information that there is little additional work to do, except for reformatting the material into a standard procedure layout. 9. Undertake initial interviews. Using any previously collected documentation, go to the departments that need procedures and obtain additional information through interviews. This should include multiple interviews whenever possible so that one can verify information with different people and also have the same interviewees review the interviewer’s written notes for accuracy. As a general rule, the ﬁrst interview will result in erroneous procedural information, so follow-up interviews are necessary to increase the level of information accuracy. 10. Send out preliminary procedures for review. Once the procedures have been completed, send them out to the department managers for review. These people will probably pass along the documents to the experts within their organizations who are most able to determine if there are any inaccuracies in the information. It is helpful to determine in advance if other employees should also review the preliminary procedures. This is a key point for procedures that are used by multiple departments—simply having one of the users review them does not cover the full range of possible users. Also, when sending procedures out for review, it is helpful to attach a review form to them, explaining how to review a procedure, as well as how to note changes to the document. There should also be a control document for tracking when procedures are sent for review, as well as when they were received back and who reviewed them. This document is most useful for determining which reviewers have not returned documents so that timely follow-up to complete the review process can be done. 11. Update preliminary procedures. Once the procedures have been reviewed and returned, input the changes into the procedures database. This step should include an independent review of the updated documents by an experienced editor who can verify that all required changes were made, as well as ensure that the documents use correct grammatical conventions. There should also be a control document for this stage of work, because procedure updates may be performed over a long period of time (depending on how long it takes to recover documents that are out for review), and some updates may be missed. By regularly examining the control document on which are noted the procedures that have been updated, it is an easy matter to track down and update those still requiring this work.

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12. Approve procedures. Approvals should be kept to a minimum. If only accounting information is released, a three-step preparation and approval system generally works best. The system consists of origination, editing for accuracy and consistency, and ofﬁcer approval. Origination is done best at the unit level, such as by the manager of payroll, payables, budgeting, and so forth. The controller should then review the proposed release for consistency and accuracy. Finally, the chief ﬁnancial ofﬁcer’s staff should review the proposed release for possible legal conﬂicts, as well as conﬂicts with the procedures of other company segments. If approved, the procedure is released for general distribution. 13. Assemble procedures manuals. Once the procedures have been approved, they must be formatted properly. The typical format includes a company logo, the date of the procedure, the page number, the version number, and the index number. Once the procedures are formatted, the publisher must be notiﬁed of how many copies to print, which is based on the distribution list (see next item). Also, the type of binder must be determined, which may include inserts on the spine and cover itemizing the contents. Finally, depending on the size of the volume, it may be useful to include index tabs that delineate the procedures of each department. There are a wide range of prices, depending on the layouts, types of binders, inserts, and use of color, so try to match the budget to the options selected. 14. Determine procedures distribution list. Once procedures are completed, it is time to determine who should receive the resulting manuals. This can be as simple as issuing a ﬁxed number of manuals to each department head and giving them the responsibility for handing out the books. However, this tends to result in an uneven distribution of valuable documents, so it is generally best to determine, with the assistance of the department managers and the human resources coordinator, what job titles should receive a procedures manual. This approach makes it a simple matter to distribute manuals based on the job descriptions listed in the human resources database. It is also necessary to determine which parts of the manual go to each recipient. For a very large manual, possibly encompassing a multitude of binders, it can be cost-prohibitive to distribute all of it to everyone, especially those who do not need it. Accordingly, the list of position titles to whom the manual should go must also include a description of exactly what part of the manual is to be sent. 15. Distribute procedures manuals. Once the procedures binders arrive from the printer, it becomes a simple matter to use the distribution list to send out procedures manuals to recipients, either through interofﬁce mail (if there is one location) or the postal service (if there are many locations). If there are multiple locations, it may be necessary to update the distribution list (see the preceding step) with mailing addresses for each recipient. All mailings should include a note asking the receiving organization to return the binder if the recipient no longer works for the company, so these expensive documents can be used elsewhere. 16. Determine frequency of review. Once the initial procedures documentation work is completed, it is time to determine how frequently the process should be repeated. Integral to the frequency question are the funds available, the likely need for additional new procedures (especially common if businesses are being added that are unrelated to existing ones), and the need for rapid updates. This last factor is most important if a company uses its procedures manual as a training tool for employees—if the actual procedure is no longer correctly reﬂected in the written procedures, the binder is of no further use as a training tool. A typical review cycle is once a year, with more frequent updates only if the department needing the update designates it as being on a rush basis. 17. Obtain approval of budget continuations. Once the frequency of procedures updates has been determined, one must make estimates of the continuing staff time and distribution costs that will be needed. Because these are the two main cost drivers for the process, it is then a simple matter to compile a budget request for the upcoming year that should encompass the project requirements. The main variables that may require an increase in funding are requests for a number of new procedures, more recipients of the expensive procedures binders, or the addition of new subsidiaries that also require new procedures writing.

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18. Write a project review. Once the project is complete and the budget request has been submitted for the upcoming year, there is one step remaining—to review the entire process with participants to see whether any problems with the process came up that could be corrected the next time around. This is a frequently ignored step, as everyone involved wants to move on to other work. However, this is a critical step for reducing the work required to produce quality procedures when valuable staff time can be used elsewhere, and costs can be lowered in the future. In short, a carefully reviewed and documented project review is an excellent way to leave recommendations for the next project team assigned to updating procedures, making the process easier and less expensive in the future. The exact process used to create or update a procedures manual will vary from company to company. Some businesses are so small that many of the preceding steps are unnecessary—a few people can gather a sufﬁcient amount of information in a short time to rapidly assemble a reputable procedures manual. Other companies have so many far-ﬂung divisions that the procedures writing chore becomes massive, with a full-time team to research and write procedures and an ongoing staff to handle updates. In this environment, the preceding process steps are clearly not sufﬁcient for timely and successful completion of the project. Instead, these steps are designed to serve the needs of the majority of small- to medium-sized businesses with enough departments and procedures to require a formal documentation process.

58.3 SUGGESTED LIST OF PROCEDURES The exact procedures chosen for documentation will depend upon their criticality within a speciﬁc business, as well as how much they are needed as control points, the amount of resources consumed by them, or the proportion of total time taken by an employee to complete them. Thus, the procedures chosen for inclusion in a procedures manual will vary considerably by company. Nonetheless, a short list of the more common procedures follows, which can be used as the basis for a procedures manual: • Cash Authorize a wire transfer payment Process cash receipts Process credit card payments Process credit card refunds Reconcile bank statement to book balance Reconcile petty cash

• Financial statements Accrue for earned vacation time Accrue for income taxes payable Accrue for unpaid wages Accrue for warranty expenses Calculate earnings per share Calculate overhead costs and application thereof Create journal entries Create the budget Calculate accruals Enter the budget into the ﬁnancial statement report

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• Financing Conduct a daily cash sweep Create borrowing base certiﬁcate Issue capital stock Issue dividends Pay for outstanding debt Prepare a cash forecast Process a letter of credit Request additional debt from a revolving credit line

• Fixed assets Calculate depreciation on ﬁxed assets Conduct inventory of ﬁxed assets Enter ﬁxed asset payments Evaluate capital purchase proposals Record gain/loss on sale of an asset

• Inventory and Purchasing Cycle count inventory Physical count inventory Purchase under economic order quantity calculations Purchase small tools and supplies Receive deliveries from unqualiﬁed suppliers Receive deliveries from qualiﬁed suppliers Track scrap transactions

• Payroll Calculate excess life insurance payments Calculate payroll taxes Calculate proﬁt sharing Process payroll transactions Summarize timesheets

• Payments Calculate commissions Calculate royalties Calculate sales taxes Match receiving, purchasing, and supplier documents Obtain authorization for non-purchase order acquisitions Print 1099 forms Process manual check payments Review expense reimbursements Void checks

• Sales Authorization of bad debts Billings to employees

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Calculation of allowance for bad debt reserve Collection of overdue accounts Create customer invoices Issue credit to customers Record sales returns Record scrap sales

58.4 MAINTAINING ACCOUNTING MANUALS As soon as a new manual has been released, maintenance is not far behind. Accounting manual changes consist of adding or deleting something, changing a record, account, or procedure, or clarifying a previous release. Maintenance of documentation can vary considerably, from a minor change that may affect only a few people to a massive change such as the installation of new systems or major overhaul of existing systems. There are three levels of change and several ways to announce or publish changes. Minor changes, such as adding or deleting one or a few account numbers, income or expense codes, approval authorizations and so on, can be reported by interofﬁce correspondence or memoranda to those departments or employees affected by the change. The memorandum would specify the change and the reason for it; the change would be related to a speciﬁc manual or prior release with enough information to enable the recipient to enter the change in his or her copy of the proper manual. Intermediate changes, such as the replacement of a signiﬁcant portion of a manual, the introduction of a new form, a signiﬁcant change in an existing form, or a policy or procedural change that may affect most operations within the company, are disclosed through the policy/procedure statement (P/PS) system, possibly in conjunction with replacement sections of the manual as attachments. A major change, such as a new accounting system, a new data processing system affecting users, a replacement of several action or transaction forms, and so forth, would require the rewriting and reissuance of the manual, or major sections thereof if the changed affected only one or two separate sections of a manual. Updating manuals is highly judgmental. Indications of the need for the release of new information to the holders of any of the manuals are an increase in transaction errors, a sudden disregard of company policy or procedure, consistently faulty transaction coding indicating the preparer has not been informed of a change in the coding structure, and so on. The preparer of the manuals or systems documentation should maintain a record of the distribution of each type of release if updates and new releases are to be distributed to the original recipients in an orderly manner. The minimum amount of information contained in a distribution record should be: • Name of the released document • Date published • Retrieval number (if any) • Distribution list For small-issue releases, such as the general accounting manual, speciﬁc names and titles may be recorded. For larger, more general releases, the general name of the employee group may be listed. For example, if a P/PS were released to supervisors, department heads and senior management, names would not be needed because the next release, even if it is an update of a previous publication, would be addressed the same way. Large lists of names are difﬁcult to maintain because of employee turnover in most organizations. At all times, the primary objective of releasing information is to get the information to the right department or designated level of personnel. The distribution list should be fairly deﬁnitive. For example, if a P/PS is used to announce a special change in the retirement plan for employees

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over 60 years old, the distribution list should have that description. Maintaining speciﬁc names is not important because it is unlikely that a similar release will be issued to exactly the same employees. Thus, designated group names become an important part of the distribution system.

58.5 RESPONSIBILITY FOR MAINTENANCE OF MANUALS The person selected to document an accounting system should have a fairly comprehensive knowledge of modern accounting practices, some knowledge of the organization, and a strong desire to complete the assignment. In a very large organization, a specialist may be employed in a staff position, reporting to the controller or chief ﬁnancial ofﬁcer. This person should be given as much authority as an internal auditor, with full access to the ofﬁcers and department managers, documents, and the current procedures in use. The position title should indicate the span of authority, such as Director of Systems Documentation. Two speciﬁc employee types immediately come to mind: the recent college graduate with a major or minor in accounting, or an older person within two or three years of retirement—an excellent use of an experienced person with prior management-level experience in the accounting function. In many organizations, the task of documenting accounting systems can be assigned to the controller, who can assign speciﬁc areas or tasks to knowledgeable supervisors reporting to him or her. The controller then becomes the editor, approver, and publisher of accounting manuals. In any case, the assignment should be closely allied with and monitored by the controller’s ofﬁce, for it is here that the highest level of knowledge of the working accounting procedures are controlled, changed when necessary, and maintained appropriately. The following is a job description showing the traits desirable in an employee who will be assigned the writing and compiling tasks, and the criteria for selecting an outside consultant who may be employed to produce speciﬁc accounting manuals: • Documenter Job Description: Degree in accounting Large-company business experience Knowledge of internal accounting controls Good writing ability (style) Desire to spend several years in this job Good interviewing techniques

• Consultant Selection Criteria: Signiﬁcant experience in writing documentation for accounting, data processing, or simi-

lar operations. Well-designed plan to utilize internal employees as much as possible for startup materials. Good, readable writing style. (Review several recent reports or actual documentation pre-

pared by the consultant who will be assigned to the job.) Receive assurance that the consultant understands fully the exact requirements of the speciﬁc manuals that he or she will complete. Determine any other speciﬁc needs such as ofﬁce space, photocopying, printing services, and so on to be provided.

58.6 SPECIFICATIONS FOR MAINTENANCE OF MANUALS There should be printed instructions for maintaining each type of manual. The instructions should include ﬁve categories of information. The ﬁrst category is mechanics, which refers to the size of paper used for different types of forms and reports, as well as the method by which a manual is bound. The second category is content, which refers to the types of forms, tables, poli-

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cies, procedures, and other instructions to be contained within the manual. The third category is updating, which refers to what types of information should be updated on a regular basis. The fourth category is numbering and indexing, which describes the numbering schemes used to identify documents within each manual. The ﬁnal category is normal distribution and retention, which notes who receives each manual and what happens to old manuals when they are replaced by new ones.

58.7 PHYSICAL CONSTRUCTION OF THE MANUAL’S BINDER Before issuing an accounting manual, the subset of policies, procedures, forms, and ﬂowcharts that have previously been developed must be assembled into a cohesive whole. We will address this task in two pieces; the binder in this section, and the contents in the next. This should be a simple enough step—just buy a boxful of binders. However, there are some subtleties to the purchase of a binder that should be considered, which are as follows: • Use a loose-leaf binder. Any accounting manual will start to go out of date the moment it is released for general use, just because a company’s systems are always changing to reﬂect alterations in the business. Accordingly, the accounting manual should be stored in a binder that can be easily opened so that pages can be inserted or removed at any time in the future. • Buy the slant-ring version of the binder. If there is a choice, it is better to purchase binders in the slant-ring style. This is because the slant ring version holds more pages than the standard circular rings, and also tends to result in less page jamming. These features easily outweigh its slight increase in cost. • Buy binders that are too large. When ﬁrst creating an accounting manual, it is quite likely that the number of documents created will not cover all possible topics, if only because there will be pressure to release some sort of document to help the accounting department as soon as possible. The trouble is that the binder purchased for this ﬁrst release may not be sufﬁciently large to encompass the additional pages that will be added during future releases. Accordingly, the binder purchased should be much wider than the size needed to hold the pages produced for the ﬁrst release. • Base binder size on the ring width. Less-expensive binders are likely to cost less because their manufacturer has scrimped on the size of the ring within the binder, while still creating a binder that has an impressively wide spine. A purchaser of such a binder will ﬁnd that the binder will hold fewer pages than expected. A much better way to predict the page capacity of a binder is to base it on the inside diameter of the ring; one inch of ring diameter will hold roughly 200 pages of paper (though this will vary if heavier-weight paper types are used). • Buy a stiff binder. A stiff binder cover is preferred, because this type of binder is more likely to be stood up on end for storage, and so will be more visible to the user. Alternatively, a soft binder is more likely to be stored horizontally, and so may be buried under a stack of other papers, which makes it invisible to the user, and so less likely to be used. • Buy binders with plastic overlay covers. It is not acceptable to issue an accounting manual that is completely unidentiﬁed by any type of marking, since it will certainly be shufﬂed in with other user binders that are similarly unmarked, and will never be used at all. Instead, there should be plastic overlay covers on the front, back, and spine. The exact type of identiﬁcation sheets used within these overlays are up to the manual development team; a suggestion is to use a different color insert for different types of binders. For example, the accounting manual may have a blue cover, while the human resources manual may be red. This makes it easier for the manual development team to differentiate the manuals as it prepares them for delivery to recipients. • Use clearly visible index tabs. Avoid index tabs that are ﬂush with the edge of a page, for these will not be clearly visible to the user. Instead, any type of index tab that stands out clearly is to be preferred. Some users may prefer a particular type that is color-coded by

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topic, but users will probably not understand the color scheme if there are many topics (which require many colors). • Reference procedure numbers on index tabs. It is very common to group procedures by department or function on index tabs. However, this approach may not work if department names or processes change over time, which will require the distribution of new tabs, and possibly a heavily re-organized manual. Instead, the tabs should identify clusters of procedures by the range of their identifying numbers. Though a seemingly minor topic, this section included eight points that primarily targeted the type of binder to use for an accounting manual. These are subtle items, but can make the difference between a professional-looking and heavily used manual and one that is undistinguished and rarely used.

58.8 CREATION AND STORAGE OF THE MASTER MANUAL COPY With all binders completed, it is now necessary to create a complete master document for this issue of the accounting manual. There are several reasons for doing so. One is that the distribution process may take place over several weeks or months, depending upon how the roll-out plan has been developed (such as providing training alongside a new manual, which tends to result in a much slower, though more thorough, rollout). When there is a long interval between the ﬁrst and last mailing, there is some danger that the later recipients will receive documents that contain newer changes than those that were sent to the earlier recipients; this can result in differences in transactional processing throughout the company. Another problem is that the company may choose to bring suit against an employee for improperly completing a procedure or following a policy. If so, the employee may use the defense of having relied upon an earlier or later version of the manual. It is difﬁcult to counteract this defense unless there is a master copy of the manual on hand that relates to the period under discussion. Given these points, one should address the following steps in order to create a master copy of the manual: 1. Assign the same release date to all documents. All new pages that are to be inserted in the manual should be given the expected release date for the manual, rather than the earlier date when they were actually created. This avoids the contention that some other date on a document indicates that there was a separate, earlier release of documents. 2. Update the revision history. If the manual contains a list of dates when each document was updated, be sure to include any new revision dates on this list. This is especially useful for legal reasons, since a company can prove a complete history of when new documents were issued to employees. 3. Verify that old-page versions are replaced. If new versions of documents have been created for this most recent master copy, then verify (several times) that the old pages have been taken out of the manual and replaced with the new ones. It is not acceptable to send out the manual with duplicate or missing pages, since this confuses readers. 4. Create multiple tables of contents. Once all of the pages have been inserted or deleted, create two tables of contents for the manual. One should be in order by the subject topic, as shown in Exhibit 58.1. A reader can look up a topic in this table, and then use the related document number to ﬁnd it within the manual. This is the table of contents that will be used most heavily, and so should be the ﬁrst of the two tables. The second of the tables should itemize the manual’s contents by sequential document number. An example is shown in Exhibit 58.2. This table reﬂects the actual order in which the manual is organized, and so may be of some use to those employees who are already familiar with the general grouping of documents within the manual, and therefore can ﬁnd documents more readily with this type of presentation.

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Document Number C Cash, Petty Cash, Receipts Cash, Reconciliation Cash, Deposits Cash, Electronic Funds Transfer Cash, Wire Transfer

0307 0329 0305 0300 0372 0399

D Deposits, Cash E XHIBIT 58.1

0300

T ABLE OF C ONTENTS S ORTED A LPHABETICALLY BY S UBJECT T OPIC

5. Update the existing tables of contents. If the manual already exists, and is merely being updated, then the previous step can be eliminated. Instead, the document design team needs to verify only that all of the latest document changes have been properly reﬂected in the two tables of contents. 6. Lock up the master copy. Once the set of documents is complete, the primary issue remaining is to ensure that no one changes its contents without formal approval. To do so, the physical copy should be locked up, preferably in a ﬁreproof safe. The electronic copy of the manual should be given password protection in the computer system, so that only authorized personnel can change it. This does not mean that the preceding master copy should be thrown out when the new one is completed. On the contrary, and as noted at the beginning of this section, there are legal reasons for keeping older copies of the manual. Accordingly, older master copies should be clearly labeled with their dates of completion, and kept in storage. The legal department should notify the manuals team of the dates on which these older copies can be safely destroyed.

58.9 CREATION AND MAINTENANCE OF THE DISTRIBUTION MAILING LIST The most expensive way to distribute a manual is to do a bulk mailing to every employee in the organization. This can be prohibitively expensive if there are many employees, and also does not

Document Number

Procedure Description

0300 0305 0307 0329 0372 0399 0423 0569 0721

Cash, Deposits Cash, Reconciliation Cash, Petty Cash, Receipts Cash, Electronic Funds Transfer Cash, Wire Transfer Billing, to Service Customers Collections Finance Charge Deductions

E XHIBIT 58.2

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make much sense from the perspective of subsequently updating the information contained within it, since many employees cannot be bothered with replacing pages in their manuals. As noted in the last section, updating a manual is also an issue from a legal perspective, since there is a risk that employees will base their actions on old versions of a manual. A better and much less expensive approach is to create a list of positions within the company that are most likely to use the manual, and which will be responsible for making its contents available to other employees. This usually means that supervisors are the ones most likely to be on the mailing list for a manual. Once the mailing list has been determined, it can be converted into a matrix, such as the one shown in Exhibit 58.3. This one has converted the names of recipients to their job titles, since employee departures and hires would otherwise render the mailing list obsolete very rapidly. The matrix also lists the type of manual that each person should receive. By subdividing the total number of manuals into subsets for each recipient, a company can reduce the cost of creating an excessive number of manuals. Of particular note is that there is a date listed in the matrix for each manual that has been sent to each person on the mailing list. This is the date of the most recent update sent, and is of great value to the manuals design team in determining who has not yet received the most recent update to a manual. With this mailing list matrix in hand, a company can easily determine what manual has been issued to a speciﬁc job position, as well as the last date on which it was updated, which greatly aids in the process of sending out updated information.

Job Title

Accounting Manual

Recipient

Budgeting Manual

Assistant Controller

11/03

Budget Manager

11/03

03/03

CFO

11/03

03/03

11/03

CIO Controller

Human Resources Manual

Period-End Close Manual 04/03 04/03

08/03

07/03

03/03

08/03

07/03

03/03

08/02

Development Manager

04/03 04/03

07/03

Engineering Manager

03/03

H/R Manager

03/03

08/03

Production Manager

03/03

08/03

E XHIBIT 58.3

Information Technology Manual

08/03

M AILING L IST M ATRIX

58.10 PHYSICAL DISTRIBUTION PROCESS With all of the distribution materials now ready, as well as the list of recipients, how do we go about actually distributing the manuals? The ﬁrst step is to create a cover letter that goes with the manual, describing why the manual is being sent out and what changes have been made to it since the last release. Some time should go into writing this part of the letter, for a vivid description of key changes is the best way to get the reader to immediately review the attached materials. If only a partial release is being issued, then the letter should also include a detailed listing of exactly what pages in the old manual are being replaced. If training classes related to the manual have been developed at this time, the letter should also include a list of training dates and locations. In addition, it should also list the name and phone number of a person on the manuals development team

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who can be called if the recipient thinks there is a problem with it. This letter should be mail merged with the distribution list in order to personalize it with the names of recipients. The manual development team has now completed all of the materials needed to distribute the manuals. At this point it can shift the physical distribution process to the company mailroom, which is better equipped to handle the distribution task. However, many smaller organizations do not have a mailroom, so the development team must handle this chore as well. If so, these four steps should be followed: 1. Match cover letters to manuals. If there are several different manuals, such as an accounting manual and a human resources manual, then the staff must match up the cover letter for each person to the correct types of manuals. This may require double checking to avoid mistakes. 2. Securely package manuals. Internal deliveries may require minimal packaging, especially if the sturdiest possible binders have already been obtained to hold manual documents. However, anything designated for external delivery may receive rough handling, and should be packaged accordingly. 3. Route local deliveries through internal mail stops. If there is an internal company delivery system, then the development team should determine the correct mail stop for each recipient, address the packages to be delivered, and send them on their way. 4. Route external deliveries through a delivery veriﬁcation service. If any documents are being sent outside of the company delivery system, then the development team will want to verify that they were received by the person to whom they were sent. This requires mailing through a service, such as Fedex or United Postal Service, that will record the name of the person to whom a package was delivered. An alternative is to contact all recipients a few days after the mailing date to verify receipt of the package. Since manuals are primarily being sent to people in management positions, it is critical that they share this information with their staffs. Some managers are not good at this task, which results in a group of employees who are not well versed in the most current procedures. There are several ways in which the manuals development team can go straight to the employees to notify them that a new manual has been issued, and that they should see their supervisors in order to review it. One approach is to include this information in a bulletin that can be posted on company bulletin boards and other public places. Another alternative is to include a notice in the company newsletter, such as this: HUMAN RESOURCES EMPLOYEES

A new human resources manual was issued to all managers in the Human Resources department on October 3rd. Since this manual contains extensive updates to existing policies, procedures, and forms, we strongly recommend that you talk to your supervisor about reviewing it. Another alternative is to maintain a copy of the most recent version of the manual in a public place, such as the copy room (convenient for making copies of the most pertinent pages) or the cafeteria. The only problem with this approach is that the manuals can suffer from extensive use, and so should be replaced with great frequency.

58.11 ISSUANCES TO NEW EMPLOYEES New employees may be hired at any time, but it is most unlikely that they will arrive on precisely the same dates when new manuals are released. Consequently, they may be left without any knowledge of a company’s policies and procedures for quite some time. There are several ways to avoid this problem. One approach is to create a form for use by the human resources department, which it forwards to the manuals development group whenever a new employee is hired, which is sufﬁcient notiﬁca-

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tion that a manual should be sent to that person as well as added to the ongoing mail list for future updates. Another approach is to have the human resources staff send a notiﬁcation to the new employee’s supervisor as a reminder to go over the supervisor’s copy of the manual. A further step may be to require the supervisor to sign a document attesting to the completion of such training and then send it back for inclusion in the employee’s ﬁle. Yet another approach is to schedule all new employees for training in the use and contents of company manuals as part of their new employee indoctrination. This may include the scheduling of later classes that cover the manuals in greater detail. If this approach is used, then the human resources staff should also maintain a database that lists who has attended these classes, in case reminder messages must be sent out.

58.12 MANUAL RETRIEVAL Some companies go to great lengths to determine the location of manuals that have been left behind by departing employees, even going to the extreme of either withholding ﬁnal paychecks until the manuals are turned in, or else deducting their cost from ﬁnal paychecks. The reasons given are that the company manual is a conﬁdential document that should not be revealed to outsiders, and that it is a valuable document that is difﬁcult to reproduce. One should seriously discount both of these arguments. If an employee wants to disseminate the contents of a manual to all possible competitors, all that is needed is an hour on the local copier – and there is very little that a company can do to stop this sort of behavior. As for retrieving valuable manuals for later use, how would an incoming employee feel about being given a handme-down accounting manual that is laced with notes and scribbles? It is better to throw out all “preowned” manuals and issue new ones, even if there is a modest attendant cost. The only reason why a manual should be retrieved when an employee leaves is that it is less likely to be maintained with new document updates, and so will eventually contain less-thanaccurate information. Consequently, there should be a notation in the exit interview form that reminds the interviewer to inquire if the manual has been turned in. This is a much more reasonable approach than forcing departing employees to pay for nonreturned manuals.

58.13 BENEFITS OF USING ELECTRONIC MANUALS Why switch to an electronic manual? There are several excellent reasons for doing so that can reduce the cost of preparing, updating, and (especially) distributing accounting manual information to users. In addition, and perhaps most importantly of all, a properly designed mix of electronic presentations can make it much easier for users to ﬁnd the procedural information that they need, which will greatly enhance the overall comprehension and usage of the information contained within the accounting manual. Some of the main beneﬁts are: • Cannot lose the manual. In a large accounting department where there are many potential users of a set of accounting manuals, it is more the rule than the exception for some of the manuals to be missing, since someone has taken them for reference purposes. This is a problem for anyone who needs a quick answer to a procedural problem. However, by using an electronic manual, all users can access the same data all of the time, and the manual cannot be lost. • Faster access to desired information. A traditional accounting manual will contain a table of contents, and in rare cases an index too. These forms of reference may not be sufﬁcient for allowing a user to rapidly locate the precise procedural information needed within a short period of time. An electronic document, on the other hand, may include pull-down help screens that contain needed information, or indexes of related information that can be accessed throughout the document, or imbedded hypertext that can be clicked on in order to shift a user to related information. It may also be possible to conduct searches of the

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entire document based on a few key words. Given all of these alternatives for accessing information, it is much easier for a user to ﬁnd speciﬁc information with an electronic manual than it is with a paper-based one. • Greater frequency of updates. A traditional system for updating documentation will require that changes be gradually accumulated until there are enough to justify the cost of sending out replacement pages to the existing manuals. It may be a number of months before this takes place, so that all procedural changes that have been requested in the meantime will be put on hold. By switching to electronic manuals, this issue is eliminated by making incremental adjustments to the documents at once, and then posting the revised documents for electronic distribution. The only issue here is that users may not know that changes have been made to the electronic documents unless a notiﬁcation, such as an e-mail, is sent to them that describes the change; they can then access the relevant text within the electronic documents and print or download the changes that they need. • Instant data access. When using an electronic manual, the speed with which data can be accessed will usually be an improvement over the use of a paper-based manual. The reason is that a few clicks of a mouse will bring the relevant text to a user’s computer, whereas the user of a traditional manual will have to locate it, refer to its table of contents, and then access the appropriate information, which takes substantially more time. A side beneﬁt of having instant data access is that users will be more inclined to access the information in the manual when they are not certain about a particular procedure, rather than guessing at the correct approach. Thus, greater adherence to corporate policies and procedures becomes more likely. • Provides an additional help capability. A traditional accounting manual tends to be a rather dry collection of policies, procedures, and forms. However, when an electronic manual is used, it is also possible to employ drop-down menus that provide access to help information, as well as hypertext that can send a user to deﬁnitions or examples that are tied directly to the information currently being reviewed. Though adding this feature to an electronic document certainly increases the time required to create it, the enhanced presentation will result in a much higher degree of user comprehension. • Reduced cost of distribution. If documents can be made available for downloading by users, then they can be accessed when needed without any need for expensive shipping and handling charges. The only case where there would still be some cost of distribution is if those employees accessing the information do not currently have any means for computer access to such posted information, and would require computer equipment to do so. • Reduced documentation tracking cost. When a set of expensive paper-based manuals are issued to a user, the issuing entity must keep track of who has received them, so that it can issue revision documents at regular intervals. If there are many such recipients, this can become an administrative hassle, because the recipients will, over time, change their locations within the company, and probably will not always contact the manuals development group to inform them of this fact. However, by switching to electronic manuals, one can avoid the necessity for tracking mailing addresses. Nonetheless, one should still trace the email addresses of clusters of probable users, so that notices can be sent out when changes are made to the electronic documents. This does not mean that the e-mail addresses of speciﬁc individuals be tracked, but rather that the e-mail addresses of all likely users of a manual be clumped together for a group notiﬁcation; for example, all accounts receivable personnel should receive notiﬁcation if a portion of the manual that applies to them is altered, but not any other members of the organization. • Send comments to the maintainer of the manual. Anyone can send a memo back to the documentation design team in regard to suggestions for improvements to the accounting manual—however, it takes time to write a memo and post it through the interofﬁce mail or postal service. Given the effort required, most design teams do not hear back from users of its manuals. However, when an e-mail button is added to the presentation of an electronic manual, it is a simple matter for a user to ﬁre off a request for changes that requires almost

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no time to create. The result is a stream of productive comments from users back to the design team. Many of the advantages listed here are related to logistics—how to get the most recent production (e.g., product updates) to customers (e.g., users of the manuals) with the lowest possible distribution cost. The basic work of collecting information about a process ﬂow and writing procedures about it does not change at all, just the compilation, presentation, and distribution of the resulting information (unless help facilities are added to the basic text).

58.14 DISADVANTAGES OF USING ELECTRONIC MANUALS Though the just-noted advantages of using electronic manuals are powerful ones, there are also several problems that one should be aware of. In some instances, these may be sufﬁciently important to curtail the use of electronic manuals. These issues are: • Cost of reprinting electronic documents. Though the manuals development staff may save a signiﬁcant amount of money from no longer having to print accounting manuals, this does not mean that paper costs are completely eliminated. On the contrary, every user of an electronic manual may feel compelled to print it out, either due to a greater comfort level with paper-based documents or because access to the electronic manual is relatively limited. This may result in a greater reprinting cost on a company-wide basis than was previously the case for the manuals development staff. • Duplicate use of both paper-based and electronic manuals. There may be cases where some use of the existing paper-based manuals must continue, in addition to the use of electronic manuals. One reason for this situation is when long-term employees who use the old manuals are unwilling to try something new. Another reason is that some employees may not have ready computer access to the electronic documentation. Whatever the reason may be, this situation will call for the retention of most existing systems (and costs) required to create, distribute, and update the paper-based manuals, as well as new systems (and costs) for the electronic versions. • More complex formatting requirements. There are a variety of ways in which an electronic manual can be formatted—frequently calling for more than one format at the same time. For example, it may be necessary to insert some procedures into the “Help” ﬁelds attached to the company accounting software, as well as having a separate version that is formatted to be downloaded and printed out by users, while yet a third version is set up with interactive links and on-line demonstrations, with the intention of being used more frequently by ﬁrst-time users. All of the formats have a different use, and may greatly increase the utility of the electronic manual, but also call for a much greater formatting effort on the part of the manuals development staff. • Methods of electronic access required. Though it is increasingly unlikely in today’s interconnected world, some potential users of electronic manuals may not have ready access to the computers or intranet/internet connections that they need to gain access to electronic manuals. If this is a problem, the cost of properly equipping these employees may greatly exceed any beneﬁts that might otherwise be gained from the use of electronic manuals. On the other hand, this may just be one more reason to give computer access to these employees, and tip the scales in favor of doing so. • No access if the computer system is down. Though greater computer reliability makes this an increasingly small problem, there are times when a glitch in the network or a computer will keep users from accessing electronic manuals. The likelihood of this issue can be further reduced with the use of battery backups for all computers and network servers, as well as ﬁber optic cabling in environments where manufacturing emissions can interrupt the ﬂow of data through cables. If this is still a problem, then it may be necessary to add a paper-based manual to the mix of options available to users.

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One of the key problems noted here is that electronic documents may not completely replace the existing paper-based manuals for a variety of reasons, which results in a separate system that is used to maintain the electronic manual, as well as its predecessor. Since this will result in greater costs than was previously the case, a manager should carefully analyze the impact of this conversion to determine if costs will indeed rise as a result of the changeover.

58.15 BASIC ELECTRONIC MANUAL In its most basic form, what is an on-line accounting manual? It is essentially a direct restatement of the existing paper-based manual, with no enhancements such as interactive tutorials, help menus, sound, or video clips. Despite the lack of these additional features, a basic on-line accounting manual can be quite an attractive option, because it requires limited skill to transfer documents to the on-line format. The ﬁles are either posted directly to the company intranet, or else they are incorporated into the help screens used in the corporate accounting software. By using this approach, a company can have its manuals available to the company as a whole with very little effort. In these formats, a user is expected either to download the necessary ﬁles and review them on his or her computer, or else to review them on the screen when accessed through the accounting system. Though this is a reasonable approach to accessing the necessary information, and will present information that is similar to what users have come to expect, it does not result in an enhanced learning environment where new tools are added to the basic manual ﬁles. Consequently, the most rudimentary on-line manual should be treated as a jumping-off point from which many other features can be added to make the electronic manual a real pleasure for users to access and browse through. These additional features are described in some of the following sections.

58.16 ELECTRONIC MANUAL WITH EMBEDDED HYPERTEXT One of the chief advantages of creating an electronic manual is the use of embedded hypertext. This is text located anywhere within a document that contains linkages to other parts of the document, such as help screens and tutorials. By clicking on hypertext, a user can be shifted instantly to related information that is crucial to his or her understanding of the information being reviewed. This greatly enhances the speed with which a user can access the most relevant information pertaining to the issue at hand. An alternative use for hypertext is to send a user to an e-mail screen, so that he or she can send a message directly to the manuals development staff in regard to any issues that should be ﬁxed in the electronic manual. This greatly improves the speed with which feedback about problems will be given to preparers. Another use for hypertext is to send a user to an area of the manual that contains explanations of highly technical information contained within a procedure. For example, the content from a relevant FASB (Financial Accounting Standards Board) pronouncement related to the proper treatment of foreign exchange rates for month-end reporting can be linked via hypertext to a procedure that deals with this issue. It is even possible to have some outside expert maintain the section of the manual that deals with technical issues, and store it on a Web server at some other physical location—the hypertext links will still access the relevant data. This approach is particularly useful in those cases where a company cannot afford to pay for its own staff of in-house experts, and so provides linkages to the data provided by an outside entity instead. The sample text shown in Exhibit 58.5 contains a series of hypertext links, which are noted in bold. Key words that require explanatory deﬁnitions are provided with hypertext links, as are technical topics. At the bottom of the text, the user is also provided with hypertext links to several related topics, plus links that will send the user to an e-mail feedback form or to an interactive tutorial regarding the current topic.

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In order to value inventory, one must establish a clear period-end cut-off, so that transactions occurring after the cut-off are not mistakenly included within the valuation calculation. To aid in this effort, all items on the receiving or shipping docks should be clearly identiﬁed as being either included within or excluded from the counting process. Next, counting procedures must be created for use by counting teams that make use of speciﬁc pre-numbered forms. The count teams must be selected from a group of employees who are knowledgeable in the characteristics of the inventory. The teams must then be educated in the use of count procedures, and then set to count speciﬁc sections within the inventory area. Once the count is complete and audited, the count sheets are entered into the computer system and costed using the existing LIFO cost database. Next, the inventory valuation is sorted by total dollar amount and checked to see if any obvious costing anomalies are present; if so, the unit quantities, units of measure, and costs for these items are reviewed and corrected, if necessary. Next, the inventory is reviewed for obsolescence issues, with the cost of obsolete items being eliminated from the inventory valuation. Finally, lower of cost or market rules are applied to the inventory to further reduce the valuation, if necessary. R ELATED T OPICS • Average Costing Consignment inventory

• FIFO Generally accepted accounting principles Inventory controls Perpetual inventory system Valuation of supplies

• Other Items: Access the Inventory Valuation Tutorial Contact the Manuals Development Team

E XHIBIT 58.4

E XAMPLE

OF

E MBEDDED H YPERTEXT

There are several key issues related to the text in Exhibit 58.5. First, though the topic of inventory valuation is quite a long and complex one, we have reduced it into a very small and readable snippet that provides just a brief overview of the process. By doing so, a reader can easily access the key information related to the topic without having to scroll down beyond a single computer screen of information. Second, the additional information that makes up this topic is accessed through hyperlinks; by using this formatting method, we allow the user to go directly to those related topics that are of most importance, while bypassing all other topics that are of less relevance. Finally, by adding a series of related topics at the bottom, we prevent the user from having to guess at what other information might be available in the electronic manual—instead, the linkages are made available for the easiest possible access. The hypertext linkages noted in Exhibit 58.5 are recreated in graphical form in Exhibit 58.5, where we see that the hypertext links allow a user to switch between several different ﬁles— including ﬁles for forms, deﬁnitions, procedures, tutorials, and accounting rules. Not all linkages are traced to related databases, in order to improve the readability of the presentation. Based on the number of ﬁles shown in Exhibit 58.5, it is evident that hypertext linkages can be an effective way to cross-reference information from a wide variety of information sources. Unfortunately, it is also possible to misuse links, which can add to a user’s confusion, rather than the reverse. For example, an excessive proliferation of links will give a user so many

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choices for where to go for extra information that it takes an excessively long time to explore every possible item of related information. Also, links to only slightly related topics will not assist user comprehension of a topic. This later issue is best resolved through clear writing skills, so that only the most relevant information is included in a manual. The most common problem with hypertext linkages is when they are not adjusted to reﬂect ongoing changes in the documentation. For example, a new deﬁnition that is added to the deﬁnitions database will not be of much use to readers if it is not referenced anywhere with hypertext links, since no one will be aware of its presence. Similarly, if information is deleted, but the related hypertext links are not, then users can become confused. Thus, constant maintenance of hypertext links to reﬂect changes in related information sources is mandatory.

E XHIBIT 58.5

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G RAPHICAL R EPRESENTATION

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H YPERTEXT L INKS

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58.17 ELECTRONIC MANUAL WITH ADVANCED INDEXING FEATURES A standard paper-based manual will assist the reader in ﬁnding information by listing the names of all policies, procedures, and forms in the table of contents—and that is all. A more advanced manual may also list the names of related procedures as part of a cross-references section. However, this may not be sufﬁcient for a user who is trying to ﬁnd the usage for a particular word, or whose concept of a topic is different from the title already given to it. These problems can be avoided through the use of more advanced alphabetical indexes. When used with an electronic manual, there is no reason to create an abbreviated table of contents that may only include a few dozen items. Instead, we can create a much larger version with hundreds of entries. For example, Exhibit 58.6 lists a traditional table of contents for a portion of an accounting manual. These are obviously highly aggregated topics that do not give a user much information about the precise types of information that he or she is searching for. However, an electronic manual can be outﬁtted with a multilevel table of contents that allows for a much greater level of detail. By clicking on one of the major category headings, an additional set of more detailed topics will be revealed beneath it – and even more levels of detail, if necessary. As an example, Exhibit 58.7 shows sublevels of contents for just the “Accounts Payable Processing” category of the table of contents. • Accounts Payable Processing • Billing Processing • Cash Receipts Processing • Financial Statement Preparation • Inventory Valuation E XHIBIT 58.6

T RADITIONAL T ABLE

OF

C ONTENTS

FOR AN

• Accounts Payable Processing Deﬁnitions Discount Electronic Funds Transfer Matching Receiving Documentation Routing Number Vendor Voucher Wire Transfer Flowcharts The Accounts Payable Process Flow Forms Check Request Purchase Order Requisition Three-Way Matching Veriﬁcation Voucher Policies Early Payment Cash Payment Approvals Check Signing Documentation Matching E XHIBIT 58.7

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E XPANDED T ABLE

OF

C ONTENTS

A CCOUNTING P ROCEDURES M ANUAL

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Procedures

Cash Payment Check Payment Credit Memo Processing Documentation Matching Electronic Funds Payment Supplier Invoice Cancellation Supplier Invoice Data Entry Tutorials Documentation Matching Payment Methods Supplier Invoice Data Entry Billing Processing... E XHIBIT 58.7

E XPANDED T ABLE

OF

C ONTENTS (C ONTINUED )

The above list does not have to appear in a massive pull-down table of contents listing on a computer screen. Instead, it is much easier to have only the main categories appear, and then click on each one to drill down to greater levels of detail. Another approach is to set up a search feature that allows a user to type in a few key phrases. The system will respond with a short list of topical entries, possibly drawn from several different parts of the table of contents. For example, an entry of “Documentation Matching” in such a search ﬁeld would result in a list of topics from the policies, procedures, and tutorials sections of the table of contents. The search feature is especially useful when a user ﬁnds that information could be listed under myriad similar headings, and does not want to spend the time manually combing through all of them. The multilayered table of contents, when combined with a data search ﬁeld, allows users to much more rapidly locate relevant information in an electronic manual than can be managed with an identical paper-based manual.

58.18 ELECTRONIC MANUAL WITH BUILT-IN HELP INFORMATION A traditional paper-based accounting manual does not hold out much hope for a user who reads through the standard policy and procedures formats, but simply does not “get it.” They usually have to consult with a more experienced employee who can assist them with overcoming information that is not sufﬁciently clearly presented or for which they do not possess enough background information. However, this can require a signiﬁcant amount of employee time. A better approach is to use some of the help features of an electronic manual. Hypertext itself, as discussed in the previous section, is a tremendous improvement over traditional manuals in that it provides a reader with a multitude of information sources. Simply by making use of all possible hypertext links, a user will be much more likely to ﬁnd the answers to most issues. Another approach is to install a list of frequently asked questions that is linked to each topic in the database. The linkage is through a hypertext connection, and will reference a reader to a separate ﬁle that is constantly being updated with the answers to questions that have repeatedly cropped up in the past. This ﬁle may be updated by the in-house training staff, or can even be a linkage to an Internet site maintained by the provider of whatever software packages a company may be using— and they update the frequently asked questions (FAQ) list based on queries that their customer service staff has received. The use of an on-line FAQ list is highly recommended, for it will cover the vast majority of problems that continually arise with user comprehension. Only a small minority of other user questions will then have to be answered by other means. Another help feature is a comprehensive database of explanations that can be accessed at any time from the menu of the electronic manual. This database can include either a search feature or

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detailed table of contents, as long as it brings a user straight to an explanation of the current problem area. Since much of the information contained within this help database will duplicate the information contained within a well-designed electronic manual with a plethora of hypertext links, many companies will prefer to avoid the expense of creating this feature, and will instead focus their efforts on ensuring that this help information is more fully integrated into the basic manual. This is a valid response, since the creation of a full-blown help database is a signiﬁcant effort, and realistically will be used only by the minority of employees whose questions have not already been answered by the FAQ section of the database. A ﬁnal feature can be added for those users whose questions are not answered through any other feature of the electronic manual. These are usually the most difﬁcult questions that either cannot be anticipated, or that represent such a small minority of issues that it is not worth adding explanatory information to the electronic manual that will address them. In these instances, the manual can include either a phone number to the company help desk (or to the company expert on a speciﬁc informational area) or an e-mail message box that will send the request to an appropriate party, or an e-mail message box that will page the company help desk staff and require them to call the user back at once. Any of these options will allow for a relatively rapid response to the most difﬁcult employee questions. The additional help options noted here will result in an electronic manual that is much more likely to provide users with the explanations they need to increase their comprehension of the information contained within an accounting manual. Even better, it means that users are much more likely to use the manual, because they will come to realize that it is the most complete resource of accounting information for them. This in turn leads to more wide-ranging acceptance of the policies and procedures contained within it, and therefore fewer transactional exceptions.

58.19 WRITING TIPS FOR ELECTRONIC MANUALS The writing format for a traditional paper-based accounting manual does not work well for an electronic manual, because the size of the reading area (the computer screen) is considerably smaller than the printed page. Also, the paper-based format does not take advantage of the many features that can be added to an electronic document, as have been described over the past few sections of this chapter. Instead, some of the following writing tips should be used: • Use a consistent format. There are a great many features that can be added to an electronic manual, such as help buttons, hypertext, references to a glossary, access buttons to send an e-mail to a procedure writer, tutorials, and so on. However, the trouble with this featurerich environment is that the screen can become excessively cluttered. To avoid this problem, the design team should determine a standardized format that it will use for all screens in the electronic manual. By doing so, a user will always ﬁnd the same reference points at the same spot on any screen being viewed. This does not mean that some good potential features must be left out of the standard format, but that the format is constructed in such a way that they are compressed into a readable format that does not excessively clutter the screen. This is a sufﬁciently important topic that the design team should consult with users to see what potential formats yield the greatest beneﬁt to them. • Keep the message short. The electronic manual is ideally suited for delivering short snippets of information to the user – preferably within a single computer screen, so that a minimum amount of scrolling is needed. If the text is excessively long, then users will tend to jump around through the presented material, and will not absorb the presented material so well. Accordingly, the anticipated documentation should be carefully structured in advance, so that topics are kept short and heavy use is made of hypertext, so that users can easily jump to related topics. This can be a difﬁcult transition for a procedure writer to make, and requires a great deal more structure to one’s writing than was previously the case. A good way to truncate the length of presented text is to divide it into segments, each of which only deals with a single main idea. If a secondary idea is also contained within the text, then split it off and cross-reference it with hypertext.

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• Cross-reference heavily. Since one of the main writing tips for the electronic manual is to break down information into a large number of small text messages, it makes sense to spend a great deal of time ensuring that a reader is able to easily collect a sufﬁcient amount of information about a topic through the use of hypertext links. By creating many cross-references, related topics can be easily clustered together for rapid perusal. This is a major part of the work required to create an on-line manual, and is worth the extra effort of having users verify that the cross-references used in the manual are sufﬁciently comprehensive. • Continually review references to new text. When any new information is entered into an electronic manual, no one will know that it is now available until it is added to the on-line help screen, table of contents, and hypertext linkages of the manual. It is essentially invisible and inaccessible knowledge until these changes take place. Consequently, a great deal of attention must be paid to these reference sources. • Avoid dangling hypertext links. Information may be deleted from a manual when it is out of date, no longer relevant, or attached to a process that is no longer in use. When this happens, the manual design team should verify that all hypertext linkages to it have been eliminated, so that users will not attempt to access information that is no longer provided. • Reinforce topics with glossaries and tutorials. Whenever there is the slightest doubt that a reader may not understand the content of a message, add hypertext links to an on-line glossary that explains key words, or provide links to on-line tutorials that will walk an employee through a particularly important transaction. Since these tools are available, use them to the greatest possible extent. The writing tips noted here will result in an electronic document that requires more pre-planning of the ﬁnal document than had previously been the case for a paper-based manual. The reason is that the accounting topic will now be broken down into a much larger number of small topics, which must then be carefully re-assembled into a highly readable presentation structure. This does not mean that the chore of assembling an electronic manual is meant to be a daunting one – only that extra effort in this area will result in a vastly more rewarding experience for anyone using it, and much more so than would be the case for even the most perfectly designed paper-based manual.

58.20 EXAMPLE OF COMPREHENSIVE ELECTRONIC MANUAL FEATURES A number of features have been mentioned in this chapter that can be added to an electronic manual. The exact layout and content of the resulting electronic manual is entirely up to the discretion of the manual development team. Nonetheless, an example of a fully developed format is noted in Exhibit 58.8, more to provide a starting point for further development than as the best possible layout. The exhibit contains the text from Exhibit 58.4 but goes on to surround it with additional linkages to other features of the electronic manual. In Exhibit 58.8, a sidebar has been added that contains a number of links to various types of information, such as the help desk, the table of contents, and a tutorial. They are itemized in order, so that the most commonly used ones are listed at the top. An alternative approach is to list these items in alphabetical order, and let users scan through the list to ﬁnd what they need. It is also possible to include this information in a top bar that contains drop-down menus. The worst place to itemize these linkages is at the bottom of the text, since users may not realize that they must scroll down some distance to gain access to the links, and so may not realize they are available at all. If a particular screen does not contain all of the linkages used in the master layout (for example, there is no tutorial available), then the format should remain the same, for two reasons. First, users should become used to having information available to them in the exact same spots on the screen, every time. Second, there may eventually be a need to include a linkage in the missing location, and leaving it initially blank will allow the development staff to more easily ﬁll in the linkage at a later date.

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• Keyword Search • Table of Contents • Glossary • Help • Tutorial • Contact Help Desk

E XHIBIT 58.8

In order to value inventory, one must establish a clear periodend cut-off, so that transactions occurring after the cut-off are not mistakenly included within the valuation calculation. To aid in this effort, all items on the receiving or shipping docks should be clearly identiﬁed as being either included within or excluded from the counting process. Next, counting procedures must be created for use by counting teams that make use of speciﬁc pre-numbered forms. The count teams must be selected from a group of employees who are knowledgeable in the characteristics of the inventory. The teams must then be educated in the use of count procedures, and then set to count speciﬁc sections within the inventory area. Once the count is complete and audited, the count sheets are entered into the computer system and costed using the existing LIFO cost database. Next, the inventory valuation is sorted by total dollar amount and checked to see if any obvious costing anomalies are present; if so, the unit quantities, units of measure, and costs for these items are reviewed and corrected, if necessary. Next, the inventory is reviewed for obsolescence issues, with the cost of obsolete items being eliminated from the inventory valuation. Finally, lower of cost or market rules are applied to the inventory to further reduce the valuation, if necessary.

I NVENTORY V ALUATION O VERVIEW —F ULL E LECTRONIC F ORMAT

58.21 USING THE PDF FORMAT FOR ELECTRONIC FILES One problem with the use of electronic ﬁles for the distribution of manuals is that users may not have the required type of software to read them. This problem has been avoided by Adobe with its Adobe Acrobat software by making the reader version a free download (available at its www.adobe.com site), requiring one to pay only for the software if it is to be used to create documents. The resulting Portable Document Format (PDF) ﬁle has become an extremely popular electronic document format, for the following additional reasons: • A document can be created in one’s favorite ﬁle format and then be converted into the PDF format with no loss of formatting. • Web pages in the PDF format look exactly line Web pages with the latest Web technology, such as cascading style sheets and Java script. • Text stored in the PDF format can be saved to the Rich Text Format (RTF) for later importing into word processing software for further editing and formatting. • PDF ﬁles can be opened in the Windows, Mac OS, and UNIX operating environments. • A PDF ﬁle is compact in size, so it can be quickly downloaded, frequently faster than the document formats in which they were originally designed. • Such features as text boxes, check boxes, list boxes, radio buttons, digital signature ﬁelds, and more can be added to a document within Acrobat. Additionally Acrobat allows one to develop PDF forms containing ﬁelds that can change depending upon user input. Users can use this feature to ﬁll in information on a PDF form and then submit it electronically. • Reviewers can add comments and position them at the location of the requested changes. Many types of changes can be added, such as electronic sticky notes, text, audio, stamps, graphic or text markups, and attached ﬁles. Also, comments from multiple reviewers can be merged into a single, consolidated PDF ﬁle to facilitate the review process. • A PDF ﬁle can also be set to allow no changes by users to the document.

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• Any links on PDF ﬁle pages are active, so additional Web pages can be downloaded as needed without returning to a Web browser. • A variety of navigational elements allow readers to more quickly locate speciﬁc information within a PDF document, such as Thumbnails (automatically generated miniature page previews), bookmarks, links, and full-text indexes. This wide array of beneﬁts has made Acrobat the preferred software for the development of any document that will be widely distributed electronically.

58.22 MAINTAINING AN ELECTRONIC MANUAL There are several key differences between the maintenance of a paper-based manual and one that is constantly accessed electronically by employees. The differences are: • Constant maintenance. A traditional procedure maintenance system uses batch processing of procedural changes—that is, changes are accumulated until the pile reaches an impressive height, and then all the changes are incorporated at once, resulting in a small number of procedure distributions per year. With an electronic manual, there is no need to wait to make changes, as there is no distribution cost. Accordingly, changes are made to the manual as soon as they are received. This calls for more daily attention to the task, rather than a shortterm project orientation. • Additional training. A small amount of additional training is needed to access the on-line procedure database and alter existing information. Though this is not a major item, some training is required for everyone associated with ongoing procedure maintenance. • Less review time. Because changes can be made to the database at any time, there is some pressure to make immediate changes to the database, though this can result in incorrect procedures (see next bullet point). This is different from the traditional approach, which involves a mass mailing of proposed changes to users, who can comment on them for some time before they are incorporated into the existing manual. • Stratiﬁed review system. Given the high speed of procedure updating, there is an increased need for a stratiﬁed review system, whereby minor changes or any changes to minor procedures can bypass the traditional lengthy review process; larger changes should still be screened before permanent alterations are made. • Database access issues. The procedures staff ﬁnds itself dealing with complaints from users regarding their access to the database. Though the procedures staff has no control over who gets access to the computer network, it will nonetheless ﬁnd itself in the midst of user requests for more access, which it must forward to the computer system department for action, perhaps with recommendations regarding the real need of each applicant for the desired computer workstation. Thus, the administrator of an on-line procedures manual will ﬁnd that changes are made to procedures more frequently. More training and review systems are needed to ensure that the changes are the correct ones and that they are entered correctly. Though it may not seem to be in this person’s job description, issues surrounding user access to the database will occupy a portion of his or her time.

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CHAPTER*

59

RECORDS MANAGEMENT 59.1

INTRODUCTION 1079

59.2

RECORD-KEEPING COSTS 1079

59.3

RECORD-KEEPING POLICIES AND PROCEDURES 1080

59.4

REQUIRED TAX RECORDS 1084

59.5

COMPUTER-BASED RECORD KEEPING 1086

59.1 INTRODUCTION The accountant is responsible for records management in most companies, except those organizations that are so large that this function can be shifted to a full-time staff. The accountant must keep several counterbalancing goals in mind when setting up a records management system. One issue is to minimize the cost of record keeping; however, this goal will conﬂict with the opposing goals of having ready access to necessary information, as well as of retaining documents for periods much longer than is economically the most efﬁcient. Consequently, this is an area that should be governed by a strict set of policies and procedures that are carefully designed to balance the conﬂicting goals of the function. The accountant’s optimum solution then becomes following those policies and procedures in the most effective and efﬁcient manner possible. In this chapter, we will itemize the various costs that are incurred by a record keeping system, so that the signiﬁcant costs associated with this function are clearly understood. We will then proceed to a discussion of the policies and procedures that are necessary for record keeping, and ﬁnish with a short discussion of computerized records management systems.

59.2 RECORD-KEEPING COSTS The costs associated with record keeping are much higher than most people realize. Not only are there the clearly quantiﬁable costs of storage, but also the subjective ones related to lawsuits that are lost for lack of proper record keeping, as well as any forensic accounting needed to reconstruct lost information. Particularly in the case of lost lawsuits, the potential cost of record keeping can be startlingly high. Consequently, a clear understanding of these costs is necessary in order to point out the need for top-notch records management systems, as are described in the following sections. The following points note the most common quantiﬁable costs of record storage, as well as how they should be calculated: • Space rental. Any space taken up by ﬁling cabinets or boxes represents either a direct lease cost or else an opportunity cost for space that could more proﬁtably be put to use for other activities. This is a particularly high cost if records are kept on site, as opposed to a lower-

* Reprinted with permission from Chapter 29 of Steven M. Bragg, Accounting Reference Desktop (Wiley, Hoboken, New Jersey: 2002)

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cost warehousing facility. To determine this cost, summarize not only the space directly taken up by stored records, but also the width of all walkways around them that cannot otherwise be used due to the potential for reduced access to the records. If the facility is entirely company-owned and there is no clear-cut way to sell off the storage space, then the cost of storage can be calculated by determining the costs that would not be incurred if other facilities could be consolidated into the storage space. • Storage equipment. Storage equipment may be as minimal as cardboard boxes, or extend to the use of ﬁreproof safes, storage cabinets, or forklifts. The expense associated with these investments should be added to the overall cost of storage. Be sure to tie the depreciation rate on capital items to their actual usage period (subject to standard depreciation period restrictions). • Fire suppression systems. The local ﬁre warden may require special ﬁre suppression systems for storage areas, which may extend to the use of expensive sprinkler or Halon systems. The cost of this item should also include the periodic cost of system inspections, testing, and maintenance. • Transportation. If ﬁles are stored in other facilities, it will be necessary to move them back to the company’s premises whenever needed. This cost of transport should be easy to calculate if movement is done by a third party, since there will be a billing for each move. If the transport function is kept within the company, then some portion of the moving staff’s wages should be charged to this activity. • Insurance. A modest amount of insurance is required to protect a company from loss of its records. However, there may be additional insurance required that protects the company from the increased ﬁre hazard represented by stored records. • Clerical costs. There is a signiﬁcant cost associated with the personnel who are engaged in ﬁling documents, retrieving them, shifting them to off-site locations, and bringing them back from time to time. If there is a great deal of “churn” in the amount of paperwork that is moved in and out of storage, this can be the largest cost associated with record storage. • Computer systems. Those companies that have shifted over to electronic storage must account for the capital cost of computer acquisitions, as well as ongoing equipment replacement and maintenance costs. This cost should include an apportionment of the time required by the computer services staff to maintain the system. By summarizing all of the preceding costs, many accountants will ﬁnd that the cost of record management is very high. Consequently, there is a positive cost-beneﬁt associated with following the formalized record-keeping systems noted in the following sections, so that the cost of this activity is minimized.

59.3 RECORD-KEEPING POLICIES AND PROCEDURES There are an enormous number of document types that ﬂow through a corporation every year, many of which will be reviewed repeatedly for a number of years thereafter. Without a proper record-keeping system, a company will incur substantially higher costs in the areas noted in the preceding section. The best way to ensure that these costs are minimized is to set up and follow a system of policies and procedures. The following three policies should serve as the groundwork for a complete set of related procedures: 1. Document retention policy. All too often, there is no criterion for how long a record is to be retained, and so documents will tend to pile up in a disorderly manner. To avoid this trouble, there should be a policy that carefully itemizes the number of years that each type of document will be stored before it is destroyed. The number of years for which various types of documents must be retained will, to some extent, be determined by local or federal government regulations. For a detailed listing of recommended storage intervals for documents, one can consult the Guide to Record Retention Requirements, which is published by the U.S. Government Printing Ofﬁce. If there is some expectation or history of lawsuits in certain

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areas of company operations, it may also be necessary to retain selected documents to serve as a possible future legal defense, in which case the statute of limitations will serve as the proper guideline for the date of document destruction. Accordingly, the legal staff should be consulted when this schedule is constructed. If there are contractual agreements with other entities that might result in audits of company records, then the retention period for any related documents should be tied to the termination dates of the contracts; for example, a cost-plus government construction job may require a company to retain all job-costing records for a period of three years after the completion date of the contract. The records most likely to fall into this category are those related to billings, ﬁxed assets, inventory, and manufacturing costs. There will also be a number of documents that should be kept for as long as the company is in existence. These documents include blueprints, formulas, copyrights, patents, trademarks, leases, the certiﬁcate of incorporation, bylaws and constitution, and the Board minute book. If there are other documents for which there are no governmental or legal reasons for retention, then the basis for determining a retention period should be the time period after which there is no reasonable expectation that they will be used. An example of a policy that incorporates these guidelines is shown in Exhibit 59.1. The time periods noted in the table are examples only, and should not be used for an actual document retention policy without ﬁrst being reviewed by legal counsel. Any ongoing changes to this table should be authorized by legal counsel as well as the chief accounting position in the company. Type of Record Advertising, original artwork Advertising, research reports Advertising, tear sheets and proofs Articles of incorporation Audit report, external Audit report, internal Audit workpapers, internal Bank reconciliation Bank statement Bond, ﬁdelity Budget Check, dividend (cancelled) Check, payable (cancelled) Check, payroll (cancelled) Collection notes Contract document Copyright application Cost estimates Credit application, customer Customs paperwork Debit/credit memo Deposit slip Expense reports Financial statements Forecasts Franchise record Guarantees E XHIBIT 59.1

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Retention Period (years) 10 2 Permanent Permanent Permanent 10 4 6 6 10 5 6 6 3 While customer is active 5 years after termination Permanent 5 While customer is active 5 5 6 5 Permanent 5 5 years after termination 5

D OCUMENT R ETENTION T ABLE

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Ch. 59 Records Management

Type of Record Insurance claim, other than employee Insurance claim, workers’ compensation Inventory, cost record Inventory, count sheet Invoice, company Invoice, supplier Journal entry Lease document Ledger, general Ledger, subsidiary License, business Litigation record Minute book Mortgage Note payable Note receivable Overhead allocation calculations Patent application Plan, annual Plan, long-range Proxy Purchase order Receiving record Report, to shareholders Royalty record Security registration Shareholder list Trademark application E XHIBIT 59.1

Retention Period (years) 3 years after completion 3 years after completion 3 3 5 5 10 5 years after termination Permanent Permanent 10 5 years after termination Permanent 5 years after termination 5 years after termination 5 years after termination 5 Permanent 5 5 6 5 5 Permanent 10 Review after 5 years 6 Permanent

D OCUMENT R ETENTION T ABLE (C ONTINUED )

2. Storage area policy. Most records storage areas are located in spare rooms for which no other use can currently be found. No consideration is given to the safety or future condition of the records that will result from such storage. To avoid this problem, there should be a policy that speciﬁes the condition of the designated storage area. This should include criteria for ﬁreprooﬁng, ﬂoodprooﬁng, allowable minimum and maximum temperatures and humidity levels, and records fumigation. 3. Responsibility for record-keeping policy. The preceding policies involve tasks that will cut across the responsibilities of virtually all major company departments, which makes them very difﬁcult policies to administer. Accordingly, a policy should be created that concentrates responsibility for these policies, as well as all attendant procedures, with a speciﬁc job position. The policy should describe the position’s responsibilities in general terms, as well as its reporting relationship. With these three policies in place, we now know which documents to retain, how long to do so, where to store them, and who will manage the process. However, this still leaves a number of unanswered questions at a more detailed level, such as how documents are to be identiﬁed, indexed, retrieved, and destroyed. The following procedures should be created so that guidelines will be available for these tasks:

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• Box indexing procedure. A procedure is needed that will use a standard indexing system to identify each box of records. One possibility is to start an index number with the year to which the records pertain, and then add a sequential number that identiﬁes the speciﬁc box for that year. For example, the thirteenth box of records for the year 2004 would be “200413.” An indexing ﬁle could then be compiled that itemizes each document stored within each of these box numbers. However, a problem with this method is that when the time arrives to destroy records, the entire box may be destroyed, even though some of the records within the box may be scheduled for earlier or later destruction. One way around this problem is to separate documents that are to be kept in a permanent ﬁle, and store them elsewhere (given their nature, these documents should be stored in the highest security environment, and so deserve special handling in any case). Another possibility is to use the same indexing system just noted, but to use the year of document destruction as part of the index, rather than the year of document creation. This makes it much less likely that documents will be destroyed at the wrong time. • Box identiﬁcation procedure. In those instances where documents are kept in storage boxes, there should be a procedure that establishes a standardized type of identiﬁcation, as well as common storage of similarly identiﬁed boxes. For example, the procedure should clarify the exact spot on the box where an identifying index number will be recorded, which should be the end of the box that will be readily apparent to the casual observer if the boxes are palletized, with only one side showing. Otherwise, labels attached to other sides of a box will not be visible, requiring the deconstruction of an entire pallet to ascertain the index number of each box. Another procedural issue is how the index number is to be marked on the box. If a label is used, it may fall off over time. A better approach is to mark the box with indelible ink, even if this means that the box will not be usable for some other purpose at a later date. • Conﬁdential document storage procedure. When most records are ﬁled away for storage, they are kept in open areas that are readily accessible for many employees. However, if the records are of a sensitive nature, such as payroll or legal documents, then a procedure is needed that will segregate these records at once and ensure that they are stored in the most secure location. The procedure should specify, in detail, the documents or document categories that are to be handled in this manner. If there are many documents from a speciﬁc area, such as human resources, that will fall into the conﬁdential category, then it may be easier for the procedure to state that all documents from this area will be conﬁdential, unless speciﬁcally stated otherwise. The procedure should also note the minimum levels of security and document handling that will be required, as well as who is responsible for their safety. For example, the procedure may require off-site storage in containers that are proof against ﬁre damage up to a speciﬁc temperature and for a speciﬁed time period, with access requiring the approval of stated company positions. • Document destruction procedure. The destruction of documents requires special controls, for a company may have to defend this practice in court if there is an appearance of unscheduled document destruction whose use in court might otherwise be damaging to the company. Consequently, a procedure should require the use of a document destruction certiﬁcate, which speciﬁes which documents are to be destroyed, a cross-reference to the company policy that itemizes the duration of document retention prior to destruction, approval signatures, and the signature of at least one person who witnesses the actual document destruction. • Document retrieval procedure. If the corporate staff is allowed full access to all on-site records, it is very likely that the quality of record keeping will decline in short order, for only a trained clerk who is responsible for the records will have any reason to preserve order as documents are pulled and returned, and boxes are shifted about. Consequently, a procedure should specify how documents are to be requested from an authorized clerical staff, which will in turn retrieve the requested records, log them out, and turn them over to requesting employees. This procedure should include the use of a request form, a logout form, and a report that itemizes all withdrawn documents.

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• Document transfer-to-storage procedure. Documents tend to be sent to long-term record storage by dumping them into storage boxes at the end of the ﬁscal year and carting them off. This makes it more likely that different types of documents with different storage requirements will be lumped together, which leads to the risk of their being destroyed after incorrect time periods. To avoid this problem, a procedure should identify how current documents should be segregated and reviewed before they are to be sent to long-term storage. This should include a formal sign-off on the contents of each shipping carton. • Storage area layout procedure. The storage area should not become a large pile of disorganized boxes. Instead, a procedure should be created that outlines how different types of records are to be stored within the area. This may include separate storage for permanent ﬁles and conﬁdential documents, separate storage by the year of document creation, the most recently ﬁled documents in the most accessible area, or some other variations. The procedure may also make some provision for the labeling scheme to be used to identify aisles and bins in a logical manner. The creation of the policies and procedures outlined in this section should be partially based on a cost-beneﬁt analysis. This analysis should compare the expected risk that documents will be needed at some future date to the cost of retaining them. The result of this review may well be a reduction in the storage requirements or locations for some types of records, so that only the most critical documents are retained for long periods in the safest and most secure environment. This cost-beneﬁt review should be conducted periodically, and especially as the nature of the business changes, to see if the perceived risk level for document retention has changed, and with it the need for changes in records management policies and procedures.

59.4 REQUIRED TAX RECORDS Because of the propensity of various government entities to hand out penalties and interest charges when tax ﬁlings are incorrect or late, it behooves the accountant to maintain an especially high level of control over all tax records. Of particular importance is a calendar that itemizes all of the dates when tax forms are due for ﬁling, when payments must be made, and when tax auditors are scheduled to arrive. An example of a tax calendar is shown in Exhibit 59.2. A more advanced format for the tax calendar is to store it in a central database, so that the information contained within it can be readily updated and reviewed by all users who are involved with tax information. With such a system, it may also be possible to have the computer automatically issue e-mails to targeted employees, warning them of upcoming due dates. Record keeping must also be maintained in great detail for all taxes for which a company must ﬁle a return. Failure to do so on the dates required can result in signiﬁcant penalties and interest charges. In a few cases, a missing tax form can even lead to the suspension of a company’s legal right to do business. Consequently, a tax summary table, such as the one shown in Exhibit 59.3, should be constructed. This table should include summary-level information about each type of tax form that a company must complete, including the company locations for which reporting is required, the type of form needed, ﬁling due dates, data sources, and related ﬁle storage locations. It may also be useful to note the size of potential tax penalties if a form is not ﬁled in a timely manner, so that the tax preparation staff can categorize tax form preparations based on which ones could cost the company the most money. As a result, when the tax calendar previously shown in Exhibit 59.2 reveals that a form must be ﬁled in the near future, someone on the tax staff can access the tax summary table for the speciﬁed tax, and have ready access to all of the key information needed to prepare the form. The summary-level information associated with tax forms is by no means stable, so a company should assign someone the task of periodically updating these forms with the most recent information. If there is no staff time available for this, the tasks can also be outsourced to a competent tax review organization, which will send form updates to the company as tax-related changes arise.

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31

30

15*

15

Jun

Jul

Federal excise monthly payment (1st)

E XHIBIT 59.2

T AX C ALENDAR

applicable during tax year.

organization will ﬁle federal, New York, Massachusetts, Washington, D.C., and North Dakota.

***Whenever

**Tax

15

15

extend—not extension of time to pay total tax liability, only extension of time to ﬁle ﬁnal return.

15

Federal excise monthly payment (2nd)

*May

31 31

Federal excise quarterly return

15

30

15

15

15

31

31

30

May

31 31

15

Apr

31

28

15*

Mar

Federal use tax—commercial vehicles***

28

28

Feb

Federal use tax—highway vehicles***

Form 599-1099**

Final analysis of liability account for year-end 20XX

Discuss retirement, 5500 etc. package to be completed

15 31

Preliminary analysis of liability account for ﬁnancial statements

Jan

Mail tax packages to subsidiaries and divisions for year-end 20XX

Tax return for year-end 20XX

Estimated payments for calendar year 2004

Federal (consolidated)

59.4

15

31

Aug

15

31

31

X

Oct

15

30

Nov

Required Tax Records

15

30

15 (Final)

15

Sep

1085

15

31

15

Dec

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Required Information

Colorado Personal Property Tax

Locations for which reporting required Tax form addressee Form name/number Form due date Data sources for form completion General ledger source account Storage index location

Facilities in Centennial, Englewood, and Lone Tree Douglas County Tax Assessor’s Ofﬁce, Colorado Personal Property Declaration Form (92A) 2/28/XX Fixed asset and asset addition/disposal records XX-1400 through XX-1650 Tax permanent ﬁle #12

E XHIBIT 59.3

T AX S UMMARY T ABLE

Record keeping also extends to the working papers created during the process of completing tax forms. Since these documents may be called upon if taxing authorities question a company’s submitted tax forms, there should be a system for organizing these workpapers. At a minimum, each set of working papers should include a copy of the completed tax form, as well as reference notes on the copy that refers back to those portions of the working papers that were used to compile the tax form. If tax research was conducted as part of the tax form preparation, then a copy of the research notes, containing lists of all referenced authorities, should be included in the working papers. If there is any related correspondence with taxing authorities, these letters should also be included in the ﬁle. The complete set of documentation should also be numbered sequentially and indexed, so that it will be obvious if any of the pages are subsequently removed from the ﬁle. Once each ﬁle of working papers is complete, it should be referenced in a master taxation index and stored in a secure location. Since there is some chance of paying additional taxes if a company’s tax position is challenged and it cannot produce the underlying working papers to defend itself, the level of storage security provided must be of the highest order. A ﬁnal record-keeping issue related to taxes is the proper structure of the chart of accounts (COA). If the COA is not properly designed to accumulate information that will feed into speciﬁc line items in various tax forms, the taxation staff must spend an inordinate amount of time in separately compiling the required information. Such information may be incorrect, since it is manually compiled, and is likely to contain errors. It is also difﬁcult to recompile if lost, which makes record keeping for it a particularly difﬁcult task. A better alternative is to construct the COA with the advice of the tax staff, so that it can be properly structured to assist in accumulating tax-related information.

59.5 COMPUTER-BASED RECORD KEEPING One can avoid most manual record keeping problems by digitizing the images of paper-based documents into computer storage. In brief, the system required to do this is a compact disk “jukebox” that has a very high storage capacity (necessary for the thousands or millions of document images that it will store), a high-speed scanner for digitizing images into the jukebox, and a separate computer server with high-speed magnetic disk access, on which an index to all of the documents is stored. A commercial software package is also needed for managing the storage and accessing of these records. Once this system is in place, users can access records from anywhere in the company that has a network connection to the document management system. This system has the unique advantages of allowing for nearly instantaneous access to digitized documents, the complete absence of lost documents (since they are never moved from their storage locations on the CD jukebox), and access by multiple personnel to the same image at the same time. However, these advantages come at a high price. Speciﬁcally, a single digitized image will require at least 100,000 bytes of storage space, and may exceed one million, depending on the denseness of the image. When multiplied by thousands of documents, this will require a very large amount of expensive storage capacity. Also, if there are many potential users, computer access must be arranged for all of them, while an expensive site license must be purchased that will encompass all potential users. Furthermore, ongoing clerical help must be paid for that will input

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all new paper documents into the system on an ongoing basis. Thus, the clear advantages of this system must be offset against a potentially high cost. It is also possible that it will never be cost-effective to store some types of documents in the document management system. For example, some documents may be so old or so rarely used that even the modest cost of scanning them into the system will not be justiﬁed. Also, some documents, such as title to any sort of property, must be maintained in its paper form for legal purposes. For these reasons, even a highly digitized corporation will still ﬁnd that there are a small number of documents for which it must maintain an adequate manual record-keeping system. Another way to implement computer-based record keeping is to not print out documents at all, but rather maintain as many of them as possible within a company’s computerized accounting systems. If anyone needs to locate a record, this is much easier to do through the computer system than through a manual records management system. However, there are a few issues that may make this a less-than-effective solution. One is that many computer systems will automatically delete all records that are more than a preset number of years old. Though it is possible to override this limitation, the result may be either a massive increase in the amount of required storage capacity, or else a slowing down of the computer access speed, because the accounting database must search through a very large set of documents. Another issue is that many corporate documents may fall outside of the accounting system; for example, the purchasing department creates purchase orders, the receiving staff piles up receiver documents, and the shipping staff writes bills of lading. To ensure that these documents are also included in the on-line database, the accounting computer system should be expanded to become an enterprise resources planning (ERP) system, which encompasses virtually all company operations, as well as the paperwork that they generate. However, this is a very expensive proposition. Another issue involving computer-based record keeping is how to store records that arrive electronically through electronic data interchange transactions. These are typically retrieved from a third-party electronic mailbox and transferred directly into the corporate accounting system, without any printout of the arriving transactions ever occurring. In most cases a company will simply store the electronic transaction in the computer system and print it out only when needed. Another alternative is to rely upon the sender of the transaction to also keep a copy of the transaction. It may even be possible to ask the third party that administers the electronic mailbox to keep an electronic copy of every transaction, which could be arranged for an additional fee. However, relying upon another party to store one’s records is not normally a good option, since a company has minimal control over the storage process. The best alternative by far is to maintain a multi-layered offsite data backup facility, so that the risk of losing electronic data interchange transactions is kept to a minimum.

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CHAPTER

60

INVENTORY TRACKING 60.1

INTRODUCTION 1089

60.5

60.2

DIFFERENCES BETWEEN PERPETUAL AND PERIODIC INVENTORY SYSTEMS 1089

PHYSICAL INVENTORY PROCEDURE 1095

60.6

PHYSICAL INVENTORY COMPLICATIONS: THE CUTOFF 1098

60.3

SETTING UP A PERPETUAL INVENTORY SYSTEM 1091

60.7

RECONCILING INVENTORY VARIANCES 1099

60.4

AUDITING AND MEASURING A PERPETUAL INVENTORY SYSTEM 1094

60.8

OBSOLETE INVENTORY 1100

60.9

HOW TO AVOID THE INVENTORY TRACKING PROBLEM 1101

60.1 INTRODUCTION Inventory is the largest investment for many companies. Having an accurate inventory is critical to reporting an accurate cost of goods sold to investors, as well as an accurate borrowing base to lenders. Unfortunately, few companies accurately know the quantities or costs of items in their inventories. At the end of each year, a company shuts down while the staff counts inventory, and if the result approximately agrees with the inventory value on the books, the controller keeps his or her job. If not, and especially if the variance is signiﬁcant, a new person takes over the position. In short, inventory tracking is too critical to a company’s reported proﬁts and to the job security of the controller for it to be ignored. This chapter includes a discussion on how to avoid these problems by setting up and maintaining a perpetual inventory tracking system. In addition, if a controller does not have time to set up a perpetual inventory system before the end of a ﬁscal year, the chapter also notes how to properly administer a traditional physical inventory procedure. Also included is a discussion of several factors that have a signiﬁcant impact on the value of the inventory—period-end inventory cutoffs, reconciling count variances to book records, and what to do with obsolete inventory. It then concludes with a discussion of a controller’s options in pursuing a strategy that gradually reduces the amount of inventory on hand and thereby the amount of work needed to track it. There is enough information to enable a controller to maintain tight control over the inventory.

60.2 DIFFERENCES BETWEEN PERPETUAL AND PERIODIC INVENTORY SYSTEMS A controller must determine the value of the inventory at set intervals, which requires a count of the inventory. The controller can do this either by conducting a periodic count of the entire 1089

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inventory or by maintaining a perpetual inventory tracking system that tracks inventory inﬂows and outﬂows with sufﬁcient accuracy to avoid the need for a periodic count (though many controllers supplement their perpetual inventory systems with a periodic count if they do not think the perpetual systems yield sufﬁciently accurate information). The differences between the two methods, and why a controller might pick one system over the other, are discussed in this section. A controller most commonly uses a periodic inventory count when a company has no history of continuously tracking its inventory balances. This is most common for new companies that lack the materials management expertise to create such a system. It is also common when the perpetual system has so many procedural holes in it that inventory balances are incorrect for a large proportion of the parts. Also, some types of inventory, such as sheet metal, are subject to shrinkage, and so require frequent counts, irrespective of what the computer database may say is on hand. This also applies to any parts for which multiple units of measure are used, such as wire. For example, ten feet of wire may be issued to production, but the warehouse counts the wire in reels, so it is easy for a discrepancy to arise without periodic counts. Finally, there may be a few very expensive items in inventory that can have a major impact on proﬁtability if the reported quantities are incorrect. A controller would be prudent to count these items frequently. Thus, there are a number of situations in which a controller is fully justiﬁed in conducting periodic counts of the inventory. An increasing number of companies are switching from periodic inventory counts to highly accurate perpetual inventory systems that yield extremely accurate inventory balances at all times. The following points justify installing such a system: • Avoid wasted time. Staff time is not being efﬁciently used during a physical inventory count, because they could be involved in other activities. Also, the production facility is usually shut down during a physical count, which may interfere with a company’s ability to ship products on time, which in turn reduces revenues. • Improve product delivery performance. High inventory accuracy allows companies to promise shipments to customers with greater conﬁdence, because products can be built without delays due to missing parts. • Achieve better accuracy than with physical counts. Inventory counts should be done by the experts—the warehouse staff—and should be done at their leisure, which ensures higher count accuracy. If a complete plant-wide physical inventory is performed, then accuracy drops because counts are done by less experienced people from outside the warehouse, and because there is a rush to complete the count within a narrow time window. • Avoid year-end surprises. Many companies have been unpleasantly surprised by unexpected changes in inventory levels at year end. These surprises can be avoided by constantly monitoring inventory levels with a perpetual inventory tracking system. • Use transaction data to reduce the inventory. The transaction history that is a by-product of a perpetual inventory system allows the materials manager to make informed decisions regarding deletions of parts from stock. This is of value to the controller, because cash requirements for additional inventory are reduced and can be enhanced as inventory is sold back to suppliers. As inventory is reduced, the staff needed to track it and the insurance needed to ensure it can both be reduced, thereby improving the company’s cash ﬂow a second time. It is apparent that there are good reasons for using both systems—a periodic inventory count in cases in which inventory records are chaotic or risky to leave inaccurate, or a perpetual system because it is more efﬁcient and yields better data. Of the two systems, the one a controller should strive for is a perpetual inventory system, since it yields better data and is far less disruptive to company operations. However, there are frequently cases in which pockets of inventory within a perpetual system refuse to stay accurate, or are so expensive that a controller cannot afford to have incorrect information. In these cases, a controller is fully justiﬁed in supplementing a perpetual system with physical counts of selected areas, just to be sure that the database is continuing to report accurate information.

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60.3 SETTING UP A PERPETUAL INVENTORY SYSTEM An accurate perpetual inventory system carries with it the considerable beneﬁts of accurate inventory valuations at all times, as well as reliable data for use by the materials management staff when determining what materials to buy, based on what is already in stock. However, there are many steps to complete before a company will have a perpetual inventory system that runs with high accuracy levels. This section contains a sequential listing of the steps that must be completed before an accurate system is achieved. This is a difﬁcult system to shortcut, for missing any of the following steps will have an impact on the accuracy of the completed system. If a company skips a few steps, it will probably ﬁnd that it has not achieved the requisite high levels of accuracy that it wants, and ends up having to backtrack and complete those steps at a later date. Consequently, a company should follow all of the steps needed to create a perpetual inventory system: 1. Create the underlying systems. Perpetual inventory tracking software must be installed and tested before a company proceeds to other steps, because the inventory tracking system will not run without a proven computer system. The required steps are: (a) Select and install inventory tracking software. The primary requirements for inventory tracking software are that it track the frequency of product usage (so one can tell if it can be deleted from stock due to lack of use), update records immediately (because the purchasing staff and cycle counters must rely on up-to-the-minute inventory accuracy), and report inventory sorted by location ﬁeld (because cycle counters can most efﬁciently track inventory when it is sorted by location). (b) Test inventory tracking software. Create a set of typical records in the new system, and perform a series of transactions to ensure that the software functions properly. In addition, create a large number of records and perform the transactions again to see if the response time of the system drops signiﬁcantly. If the software appears to function properly, continue to the next step. Otherwise, ﬁx the problems with the software supplier’s assistance, or acquire a different software package. 2. Clean up and rearrange the warehouse. The warehouse is probably laid out in an inefﬁcient manner and clogged with parts. This situation must be rectiﬁed before proceeding further. The required steps are: (a) Revise the rack layout. It is much easier to move racks prior to installing a perpetual inventory system, because no inventory locations must be changed in the computer system. Create aisles that are wide enough for forklift operation, if heavy-duty picking is anticipated. Cluster together the racks that will contain smaller parts, which results in easier picking. (b) Create rack locations. A typical rack location is, for example, A-01-B-02. The meaning of this coding is: A = Aisle A 01 = Rack 1 within Aisle A B = Level B within rack 01 (numbered from bottom to top) 02 = Partition 2 within level B of rack 01 As one moves down an aisle, the rack numbers should progress in ascending sequence, with the odd rack numbers on the left and the even numbers on the right. This layout allows an inventory picker to move down the center of the aisle, efﬁciently pulling items based on sequential location codes. (c) Lock the warehouse. One of the main causes of record inaccuracy is the removal of items by staff from outside the warehouse. These people are not in the habit of logging out parts from the inventory database, so the database rapidly becomes inaccurate. To stop such removal, all entrances to the warehouse must be locked. Only warehouse personnel should be allowed access to the warehouse. All other personnel

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entering it should be accompanied by a member of the warehouse staff to prevent the removal of inventory. 3. Identify and rearrange the parts. Once the warehouse is set up properly, it is time to do the same to the parts located in it. Otherwise, it is very difﬁcult to ﬁnd or identify them, much less count them on a regular basis. The required steps are: (a) Consolidate parts. To reduce the labor of counting the same item in multiple locations, group common parts in one location. This is not a one-shot process, for it is difﬁcult to combine parts when there are thousands of them scattered throughout the warehouse. Expect to repeat this step at intervals, especially when entering location codes in the computer, when it tells you that the part has already been entered for a different location! (b) Assign part numbers. Have several experienced personnel verify that all part numbers attached to parts are the correct ones. A mislabeled part is no better than a missing one, since the computer database will not show the existence of the correct part. Mislabeled parts also impact the total inventory cost; for example, a mislabeled engine is more expensive than the item represented by its incorrect part number, which identiﬁes it as a spark plug. (c) Verify units of measure. Have several experienced personnel verify all units of measure for all parts. Unless the software allows multiple units of measure, the entire organization must adhere to the concept of one unit of measure for each inventory item. For example, the warehouse may want to count tape in rolls, but the engineering department would rather create bills of materials that list it in inches instead of fractions of rolls. If someone goes into the inventory database to change the unit of measure to suit his or her needs, this will also alter the extended cost of the inventory; for example, when ten rolls of tape with an extended cost of $10 is altered so that it becomes ten inches of tape, the cost will drop to a few pennies, even though there are still ten rolls on the shelf. Consequently, not only must the units of measure be accurate, but the ﬁle that stores this information must be kept off limits. (d) Pack the parts. Pack parts into containers, seal the containers, and label them with the part number, unit of measure, and total quantity stored inside. Leave a few parts free for ready use. Also, open containers only when additional stock is needed. This level of organization makes it much easier for cycle counters to rapidly review the inventory and spot any problems. 4. Count and enter the inventory. After the parts have been organized and identiﬁed, it is time to count and enter them into the inventory tracking database. The required steps are: (a) Count inventory items. Count items when there is no signiﬁcant activity in the warehouse, so that the counts can be completed without interruption. Elaborate cross-checking of the counts, as is done for a year-end physical inventory, is not necessary. It is more important to have the perpetual inventory database operational before warehouse activity increases again; any errors in the data will quickly be detected during cycle counts and then ﬂushed out of the database. The counts must include the part number, location, and quantity. (b) Conduct software training. The warehouse staff should receive software training just before using it, so that they do not forget the training. Since the next step involves the computer, this is the time to do so. The training should include entering all types of transactions that the staff will have to handle on an ongoing basis, such as receipts, picks, and cycle count adjustments. (c) Enter data into the computer. Have an experienced data-entry person input the location, part number, and quantity for each inventory item into the computer. Once the data is input, another person should cross-check the entered data against the original data for errors.

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(d) Quick-check the data. Scan the entered data for errors. If all part numbers have the same number of digits, then look for items with part numbers that are too long or short. Review location codes to see if inventory is stored in nonexistent racks. Look for units of measure that match the part being described. For example, is it logical to have a pint of steel in stock? Also, if item costs are available, print a list of extended costs. Excessive costs typically point to incorrect units of measure. For example, a cost of $1 per box of nails will become $500 in the inventory report if nails are listed in eaches. All of these steps help to spot the most obvious inventory errors. 5. Create control systems. Once all parts are entered into the inventory tracking database, the controller must still ensure that the information remains accurate. This requires several additional steps: (a) Initiate cycle counts. Print out a portion of the inventory list, sorted by location. Using the report, have selected staff count blocks of the inventory on a continuous basis. They should look for accurate part numbers, units of measure, locations, and quantities. The counts can concentrate on high-value or high-use items, but the entire stock should be reviewed regularly. The most important part of this step is to examine why mistakes occur. If a cycle counter ﬁnds an error, the cause of the error must be investigated and corrected, so that it will not occur again. It is also useful to assign speciﬁc aisles to cycle counters, so that the warehouse manager can see who is really performing counts; it is common to ﬁnd that some employees are not suited to this work, so this gives the warehouse manager a basis on which to remove people from this task. (b) Initiate inventory audits. The controller or a subordinate should regularly audit the inventory, perhaps as much as once a week. This allows the controller to track changes in the inventory accuracy level and initiate changes if the accuracy drops below acceptable levels. In addition, frequent audits are an indirect means of telling the staff that inventory accuracy is important and must be maintained. The minimum acceptable accuracy level is 95%, with an error deﬁned as a mistaken part number, unit of measure, quantity, or location. This accuracy level is needed to ensure accurate inventory costing, plus it assists the materials management staff in planning future inventory purchases. In addition, establish a tolerance level when calculating the inventory accuracy. For example, if the computer record of a box of screws yields a quantity of 100 while the actual count shows a quantity of 105, then the record is still considered accurate if the tolerance is 5%, but inaccurate if the tolerance is 1%. The maximum tolerance should be 5%, although it can be reduced for high-value or high-use items for which perfect accuracy is critical. (c) Post results. Inventory accuracy is a team project, and the warehouse staff feels more involved if the audit results are posted against the results of previous audits. Accuracy percentages should be broken out for the counting area assigned to each cycle counter, so that everyone can see who is doing the best job of reviewing and correcting inventory counts. (d) Reward the staff. An accurate inventory saves a company thousands of dollars in many ways, especially in regards to not ordering parts that are already in stock. Therefore, it is cost effective to incent the staff to maintain and improve this accuracy with periodic bonuses based on reaching higher levels of accuracy with tighter tolerances. Using rewards results in a signiﬁcant improvement in accuracy. The long list of requirements to fulﬁll before achieving a perpetual inventory system makes it clear that this is not a project that yields immediate results. Unless the inventory is very small or the conversion project is heavily staffed, it is likely that a company faces many months of work before it arrives at the nirvana of an extremely accurate inventory. Consequently, a controller should set expectations with management that project completion is a considerable ways down the road, and that only by making a major investment of time and resources will it be completed.

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Despite the major effort needed to implement a perpetual inventory system, this is still a most worthwhile project. The controller will have extremely accurate inventory quantities to use in determining the inventory valuation, auditors can review it at any time, there is no need to conduct a year-end physical inventory count, and the materials management staff has a reliable source of information when trying to determine the number of parts it already has in-house. Surely, these are sufﬁcient reasons for embarking on a conversion to a perpetual inventory system as soon as possible.

60.4 AUDITING AND MEASURING A PERPETUAL INVENTORY SYSTEM A vast amount of work goes into establishing an accurate perpetual inventory system. Unfortunately, the initial work to set up the system usually results in an accuracy level of only about 75%, which is not sufﬁcient to give a controller assurance that the inventory value is accurate; nor is it good enough for the materials management staff to rely on when determining how much additional inventory to purchase. When the numbers are this inaccurate, the purchasing staff usually plays it safe and orders extra parts, just to be sure that there is enough on hand for current production needs; this inﬂates the inventory, resulting in a need for more warehouse storage space, more warehouse staff, and extra working capital. In short, the initial system implementation does not result in enough accuracy to signiﬁcantly improve the situation. This section covers the steps a controller must follow to bring the inventory accuracy up to a higher level, where the information in the perpetual database will be of more use to everyone. The ﬁrst step is to create a very public reporting system that shows the accuracy of the inventory records in each section of the warehouse. A typical layout is shown in Exhibit 60.1. This information should be listed on a white board in the warehouse. A cycle counter is assigned to a block of aisle space, as noted in Exhibit 60.1. This person is directly responsible for the accuracy of that section, and indeed has a major impact on it. The format then shows a short-term history of the accuracy of each area, along with the results of weekly audit counts by the controller’s staff. This format is quite effective in determining changes to accuracy that require management attention, and also shows which counter is doing a good job, which can be used as the basis for issuing periodic rewards for accuracy. Once the reporting system is in place, the controller must set up an auditing program that yields the measurements to be recorded in the reporting system. To audit the inventory, the controller should create a computer report that sorts the in-stock inventory by location code. Then the person doing the auditing takes a random sample of parts from the report for the counting area assigned to one of the people shown in Exhibit 60.1. The auditor then veriﬁes the description, unit of measure, quantity, and location listed on the report. If any one of these items is wrong, the entire record is considered incorrect. Also, the auditor should pick an equal number of items from the shelves and trace them back to the computer report; this ensures that all items in stock are being input into the computer system. After completing the audit, the auditor divides the number of correct items by the total number audited to determine the inventory accuracy percentage. This is the typical inventory auditing method.

Aisles

Responsible Person

A–B C–D E–F G–H I–J K–L M–N

Fred P. Alain Q. Davis L. Jeff R. Alice R. George W. Robert T.

E XHIBIT 60.1

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2 Months Ago

Last Month

Week 1

Week 2

Week 3

Week 4

82% 70% 61% 54% 12% 81% 50%

86% 72% 64% 58% 17% 80% 60%

85% 74% 67% 62% 22% 79% 65%

84% 76% 70% 66% 27% 78% 70%

82% 78% 73% 70% 32% 77% 80%

87% 80% 76% 74% 37% 76% 90%

I NVENTORY A CCURACY R EPORT F ORMAT

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The controller should not expect rapid improvement in this area. Even with intensive pressure from management, this is an area that resists immediate perfection. Instead, the controller must get used to a seemingly endless cycle of ﬁnding errors through audits and cycle counts, investigating and correcting the underlying mistakes, and then ﬁnding new mistakes once the old ones have been ﬁxed. Also, the system will never work if there is not a high level of support from the warehouse manager and staff. If this is not forthcoming, top management may be forced to replace any portion of the staff that resists conversion to a perpetual system. Finally, the controller will inevitably notice a drop in accuracy whenever an experienced warehouse person leaves the company and is replaced by an inexperienced one. The best remedy for this is reducing turnover by improving conditions and pay levels for the warehouse staff, as well as intensive training for all incoming employees. It is only after some months of gradually ﬁnding and correcting errors that a controller will ﬁnally succeed in creating a perpetual inventory system with a very high level of accuracy. Continually auditing its accuracy and reporting those results are key to the improvement of the system.

60.5 PHYSICAL INVENTORY PROCEDURE Most companies still use a physical inventory system that only reconciles inventory to actual counts at the end of the ﬁscal year. The controllers of these companies need a reliable approach for organizing the inventory in preparation for a count, creating and managing counting teams, and properly using counting forms and inventory release teams to ensure that counts have been completed as accurately as possible. This section provides that information. As was the case for setting up a perpetual inventory tracking system, a controller needs a speciﬁc set of instructions for organizing the period-end physical count. The following steps reveal how to conduct this count, and are grouped into the major categories of initial inventory organization, team selection and training, counting, and releasing. The steps are: 1. Organize the inventory. It is very helpful to clean up and organize the inventory area prior to starting the physical count. This helps the counting to proceed more smoothly, because it is easier to ﬁnd and identify parts. The steps are: (a) Appoint an organization team. The warehouse manager should appoint a very experienced team to prepare the inventory for counting. This group must have a thorough knowledge of all parts, so they can complete the other organizing steps. There is no way that an inexperienced group can do this. (b) Consolidate parts. The team must locate parts that are scattered in different sections of the facility and cluster them together for easier counting. This is a very difﬁcult task, because there may be thousands of parts, so the team must rely on its knowledge of where parts are located. (c) Assign part numbers. The team must assign valid part numbers to all parts. Without them, the counting teams will have no way of identifying what they are counting. This can be a very involved task, so there should be a large amount of time in the budget to ensure that it is completed. (d) Pack the parts. The team should seal parts into easily countable containers, such as boxes or plastic bags. These should be sealed with the quantity clearly marked on it, so that the counters can later go through the warehouse and quickly count the items. This is a major labor saver during the counting process, although it requires a great deal of preparation. 2. Select and train teams. The time available for inventory counting is usually quite limited, such as an evening or weekend, so it is important that the counting teams are sufﬁciently trained to conduct accurate counts with minimal recounting or other problems that may lengthen the time needed to count. The steps are:

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(a) Select team members. All team members should be very familiar with the parts stored in the warehouse. The counts will be far more accurate if an experienced person correctly identiﬁes the parts being counted. This is a common mistake for many companies, who enroll people from functional areas such as sales and accounting who have no idea of what a part looks like. These people with no experience tend to make many more counting mistakes and should not be included in the counting teams. (b) Prepare forms. The form used for a physical inventory count is the inventory tag (or “count card”). It is afﬁxed to each lot of identical parts counted. The tags are numbered serially in advance; a portion of the tag is left on the stock, which serves as a means of ensuring that all lots are counted. The inventory tag should include space for writing the part number, unit of measure, quantity, location code, and initials of the counter. For work-in-process operations, there should also be a space for listing the last operation performed on the part. (c) Prepare procedures. The controller should prepare a procedure that is handed out to each counting team, telling them how to conduct a count. The procedure will vary by company, but usually contains these basic steps: A team of two people is assigned a block of the warehouse for counting, with one person counting and the other recording the count information on an inventory tag. The person writing on the tag (usually a two-part form) attaches one part of the tag to each lot that was counted, and keeps the other copy. When the team completes its count of the assigned area, it sorts the tags into numerical order (they are numbered serially) and brings them to a data-entry station, where they are reviewed for errors, entered into the computer system, and compared to database records for variances. The team then goes back to recount any variance items. Finally, a supervisor reviews the count area to check for items that may not have been counted. The supervisor signs off on the count area, and the counting team is released from duty. (d) Conduct advance training. The controller goes over the counting procedure and inventory tags with a counting team to ensure that it is understandable, including a practice count of a small area. After making any adjustments to the procedures to correct problems revealed by the practice count, the controller goes over the procedure with all counting teams. Many companies leave this step until just before the count, so that the teams do not forget their instructions. (e) Clarify organizational roles. There are several positions involved with the physical inventory, and the controller must be sure that they all understand their roles. The applicable positions are: Controller. Responsible for complete planning and execution of the physical inven

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tory program. Coordinator. Ensures complete coordination of all inventory activities with all functional heads. Training supervisor. Responsible for training everyone concerned with the inventory taking, including those preparing the areas and arranging stock, as well as the development of a training program and arranging for the proper selection of employees to participate. Counting supervisor. Responsible for the proper identiﬁcation and counting of all materials to be inventories and making sure that inventory cards are properly prepared. Checking supervisor. Responsible for recounting and verifying the accuracy of the counts and ensuring that all items have been counted and tagged. Control supervisor. Responsible for the issuance and control of all inventory cards and tags, analysis of variances, and the preparation and distribution of applicable reports.

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3. Count the inventory. It is quite possible for counting teams to incorrectly count a large part of the inventory, which results in a major effort to recount it during the time that is available for this. The controller can avoid recounts by ensuring that it is done correctly on the ﬁrst pass. The steps are: (a) Issue ﬁnal instructions. Even if the counting teams have been trained at an earlier date, or have done this task for many years, it is still helpful to conduct a brief review of the counting procedure to ensure that everyone is clear about their tasks. These instructions should note all items not to be included in the counts, such as tools, capital equipment, containers, supplies, consignment inventory, and anything marked with a “Do Not Inventory” tag. (b) Schedule counting areas. Issue a master list of counting areas to the counting teams. This list shows the beginning and ending aisle locations that each team is assigned to count. Be sure to highlight the counting area on the sheet for each team, and conduct an immediate check of each counting team’s location as soon as the count begins—no matter how clear this may seem, some teams always end up counting areas to which they are not assigned. (c) Supervise counts. The counting supervisor must be available to the counting teams throughout the counting period, so that they can have a ready source of information. Common problems referred to the supervisor are to determine an appropriate unit of measure, whether to count something, and if an item is actually on consignment, and therefore not to be counted. 4. Release the inventory teams. Once counts are taken, the controller must follow a speciﬁc set of procedures to ensure that all count cards have been collected, and that the counting results meet expectations. If these steps are not completed, the controller faces a long period of recounting inventory and tracking down missing count cards, probably when the company has restarted its operations, which makes it doubly difﬁcult to correct the problems. The steps are: (a) Review count cards. Once counting teams turn in their count cards, a group of reviewers should sort the cards into numerical sequence to ensure that there are no missing cards (if a counting team does not use a card or damages one, it should mark “VOID” on the card and retain it, so that there is no break in the numerical sequence of cards). The review should also include a check for missing part numbers, units of measure, or quantities. If any of these problems are present, the errors should be noted and the cards turned back to the count teams for ﬁxing. (b) Input the count cards. A team of data-entry people, probably from the accounting staff must input the approved count cards into the inventory system. This may require the construction of a bank of computer terminals, so that the group can input data together and mutually resolve any data-entry problems. This usually requires a number of hours to complete. (c) Review count areas. A review team should check a few counts in each area, especially for expensive items, to see if there are obvious errors, such as incorrect part numbers, item numbers, or units of measure. This is also a good time to check on possibly fraudulent activity involving false counts. This can take several forms. One is empty or deliberately mislabeled boxes. Another is diluted liquid inventory (difﬁcult to spot), as well as the presence of customer-owned inventory in the counts. A classic problem is building squares of legitimately ﬁlled boxes to conceal an empty space in the middle that is counted as full. These problems require great diligence by the review team to spot. (d) Check for variances. Once the data-entry team has completed its data-entry work, the controller should run off a report that compares the computer systems; record of quantities on hand to the counted quantities. Any variances must be resolved (see Section 60.7).

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(e) Sign off on count areas. Once the controller is satisﬁed that everything has been counted in each inventory area and that variances have been accounted for, the supervisory group can sign off on the results of each counting area and send home the counting teams. Because the teams may ﬁnish their counts at widely scattered intervals, it is customary to complete the data-entry work on the teams that are ﬁnished earliest, so that those teams can resolve any problems and go home. This reduces a company’s hourly payroll cost devoted to the inventory counting task. A controller can use the steps noted in this section to administer a physical inventory count. There are many steps in this process, requiring a considerable amount of management skill by the controller to accurately complete. Having gone through the physical counting process, a controller should then refer back to the steps required for creating a perpetual inventory system. Many of the steps are the same, yet the perpetual system must be set up only once, whereas the physical count must be conducted at least once a year. This may be a sufﬁcient incentive for a controller to advocate the elimination of physical counts in favor of a perpetual tracking system.

60.6 PHYSICAL INVENTORY COMPLICATIONS: THE CUTOFF The physical inventory counting process is highly dependent on a stationary inventory. This means that there can be no movement of inventory into or out of the warehouse area during the counting process, nor can there be a movement of any related paperwork. If this basic rule is not followed, a controller will have great difﬁculty in determining the true value of the period-end inventory, because the quantities were in a state of ﬂux during that period. This section contains sample procedures that are applicable in most situations for ensuring a proper period-end cutoff of all inventory related transfers. The procedures cover receiving, central stores, and the ﬁnished goods area. They are: 1. Receiving and receiving inspection No paperwork or parts will be forwarded to the central stores area later than 11:00 A.M.,

October 26. This will allow paperwork to be processed and stock put away. Beginning October 15, all receivers processed by receiving inspections must be stamped “Before Inventory.” 2. Central stores Receipts: All paperwork on parts received from receiving inspection must be transferred

to data processing before 4:30 P.M., Friday, October 26. Issues: The paperwork on all issues to open orders and jobs in process must be completed and sent to data processing before 4:30 P.M., Friday, October 26. On issues for sales orders, the issue documents and parts must be in the staging area or shipping area before 3:30 P.M., Friday, October 26. 3. Finished goods area Staging area: These are segregated parts by sales order. If the parts are not shipped before

3:30 P.M., Friday, October 26, they will be retained as part of the storeroom inventory. Receipts into the ﬁnished goods area from order or job number completion must be received and the paperwork sent to data processing before 4:30 P.M., Friday, October 26. The production control assigned representative should make sure that all ﬁnished units are placed in stock and that the paperwork went to data processing before the 11:00 A.M. cutoff. Issues: On issues for sales orders, the issue card and parts must be in the staging or ship-

ping areas before 11:00 A.M., Friday, October 26. For issues to orders and job numbers, all paperwork on issues to work-in-process must be in data processing before 4:30 P.M., Friday, October 26.

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60.7 RECONCILING INVENTORY VARIANCES When a company uses a perpetual inventory system or a periodic physical count, it will ﬁnd some variances between the quantity found in stock and the amount listed in the inventory database. These variances will occur in the best of companies and are caused by a myriad of problems, the most frequent of which is parts being physically added to or removed from the inventory without a corresponding adjustment to the underlying records. When these variances occur, the controller must decide what to do. The controller’s options are discussed in this section. Whenever cycle counts or a periodic physical inventory count are completed, there will probably be some variances between the expected and actual quantities on hand. There may be many of them. The controller must take some action to determine whether the reported variances are correct. There are several steps the controller can follow to do this. Each step is a ﬁlter that blocks out further action at the next step, thereby continually reducing the amount of items to review as the controller reaches each subsequent reconciliation step. The progression of actions is: 1. Accept variances with small dollar values. The bulk of all inaccuracies will be for large quantities of small and inexpensive items, such as ﬁttings and fasteners. These are not worth the trouble of a further review, especially when there is a minimal change in the inventory cost, no matter what the outcome of a recount may be. The controller can safely record the altered count without further action. 2. Recount items with large dollar variances. The obvious next step is to recheck the count to see if there was a counting error. If this does not resolve the problem, it is sometimes useful to recount the items in adjoining inventory locations, in case there is a problem with a part having shifted over to the next location. This recount can also be extended to similar products to determine whether an item was mistaken for another part that looks the same. 3. Check the identiﬁcation. Checking the part number that the counter marked down against the part number in the database for that location sometimes reveals a problem. This is because the part number on the physical part is missing, it is mislabeled, or the code is smudged enough to alter its meaning. 4. Check the ownership. A company may have expensive parts in stock that are actually there on consignment and should not be valued. If these items were counted, there will be no corresponding record in the inventory database. The controller can then ignore the count, because the company does not own the item. 5. Check receiving records. If everyone thinks a part count is too low, the answer may simply be that it was never received. Purchasing records may show that a part was due for receipt, but the supplier never sent it. If so, the controller can go back through earlier listings of the inventory to see when a part was listed as having been received, and then compare the ﬁrst date on which it appeared in the inventory database to the receiving records in that time period to see if there was a corresponding receipt. 6. Review job cost records. It is very common for a part to be missing because it was used on product work but never logged out. For this problem, the ﬁrst place for the controller to look is the job cost records for any jobs that were open during the period when a part was recorded as missing. If the job cost records indicate an unusually high proﬁt, it is likely that a part was not charged to it. 7. Accept the variance. When all else fails, the controller must conclude that there was either an earlier counting problem that created an initial inaccuracy in the inventory database or that a part is missing due to theft or damage. At this point, there is nothing left to do but record the variance. However, the controller should keep track of the part numbers on a continuing basis for which there are a number of unexplained variances, to see if a pattern emerges that explains the problem. The process a controller goes through to reconcile inventory variances is designed to reduce the reconciliation process to the absolute minimum amount of work while still ensuring an accurate

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inventory valuation. The ﬁrst few steps either accept inventory counts or call for a quick review, which resolves the bulk of the variance analysis work. Then, subsequent steps narrow down the range of problems, so that by the time a controller is reduced to checking on the purchasing and job cost documents for a missing part, there are very few parts for which this much work must be done. Thus, this system results in accurate inventories while spending the smallest amount of time on inventory variance reconciliations.

60.8 OBSOLETE INVENTORY A side beneﬁt of setting up an inventory tracking system is that it can usually track the amount of inventory used, and sometimes even the last date when it was used. When combined with a visual inspection of the newly categorized and properly stored inventory, this almost always allows a controller to quickly determine the extent of a company’s obsolete inventory. The trouble is that the amount of obsolete parts and products is usually far higher than anyone realizes. What the controller can do to alleviate the situation is discussed in this section. The controller is in the uncomfortable position of advocating taking a reserve against inventory to ensure that the company is conservatively accounting for it. The trouble is that this old inventory may be a very large proportion of the total inventory balance. Approximately 80% of the items in an inventory are used so rarely that there is no need to keep them in stock. However, if a controller were to advocate taking a reserve for 80% of the items in inventory, there might be some protest from other members of management, who may have their pay tied to reported proﬁts, or to stock options that will drop in value if the write-off results in a large drop in proﬁts. Thus, the controller must balance the need for accurate reporting against the wishes of senior management. The answer to this quandary is to develop a systematic means for eliminating the obsolete inventory over a speciﬁc time period. When a controller is confronted with a large amount of obsolete inventory, the odds of gaining management approval of a complete write-off is extremely small. However, by quantifying the amount that must be written off, and then presenting a case to management that spreads this write-off over a moderate period of time, it is much easier to gain acceptance. Also, it is easier to gain approval for a gradual write-off just once, rather than every month, because senior management will be tempted to adjust reported earnings by altering the monthly write-off. It is easier to slowly reduce the recorded value of obsolete inventory than to do so at one time. When trying to persuade top management to authorize an inventory write-off, it is common to be confronted with the argument that the inventory has been there for years and has never bothered anyone, so why get rid of it now? The controller can use several reasons to justify the decision. One is that this inventory takes up a large amount of space, and the company can achieve a reduction in space by reducing the number of parts, thereby allowing it to use the space for other purposes. Another reason is that it takes a large warehouse staff to count and move inventory. By reducing the amount of inventory, a company can reduce the amount of warehouse staff, which is a real cost reduction. The same logic applies to the insurance that covers the inventory—less inventory results in a lower insurance expense. Also, it is likely that some of the inventory is not totally obsolete. On the contrary, there may be a supplier who is willing to take back the inventory for a moderate restocking fee; this gives the company cash or credit for more purchases. Any of these reasons are useful for persuading management to authorize a write-off. One of the main problems with obsolescence is ethics. Anyone who relies on the information in a company’s ﬁnancial statements assumes that the reported inventory values are accurate, and makes decisions, such as lending more money or investing extra funds, based on that information. If a controller gains approval for a gradual write-off of inventory, this gives accurate information only to the extent that the inventory has so far been written off. If the controller knows that there is a large amount of obsolete inventory for which a loss has not yet been recognized, irrespective of the extent to which it has already been written off, the controller is not accurately reporting ﬁnancial information. This situation brings the controller back to the uncomfortable situation of having to write off everything at once. However, there is a solution. It is important to determine who receives ﬁnancial statements and when they receive them. If outside parties receive the ﬁnancial

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statements only once a quarter or year, which is common, the controller can spread out the inventory write-off over the monthly reporting periods leading up to the next external report. This allows a modest spreading of the expense over a small time period, while still reporting the full expense to outside parties at the next scheduled release of information to them. Thus, a controller can still spread obsolescence write-offs over a short time period while still fulﬁlling the ethical responsibility of reporting complete and accurate information. A controller may still face a problem with top management, in that it absolutely forbids a complete write-off prior to the next ﬁnancial report to outside parties, such as investors and lenders. The controller now has very few options. One is to reevaluate the inventory and determine the extent to which he or she is willing to stretch the rules regarding what constitutes an obsolete part, perhaps from having been in stock for one year to eighteen months. This will probably lead to a signiﬁcant reduction in the size of the obsolescence write-off. It is strictly a judgment call by the controller as to what is a reasonable obsolescence period. A more impartial approach is to bring in consultants who can review the inventory and make a fair determination of how much of it is scrap; if this number is lower than the amount the controller had previously calculated for obsolescence, it is possible that top management will accept the amount of this write-off. If the controller still cannot budge top management on making a sufﬁcient write-off, it is time to seriously evaluate why the controller wants to remain with the company. If upper management is clearly willing to misstate ﬁnancial results, it is a good bet that the controller will be pressed at other times to bend other accounting rules too, which inevitably leads to public exposure of the company’s problems, and a ruined reputation for the controller. In short, if the controller cannot convince management to agree to at least a minimum obsolescence write-off, the controller should leave the company before the next ﬁnancial statements are issued outside of the company. Obsolete inventory tends to be a larger part of most inventories than the management team is willing to believe, and so the amount of the write-off frequently results in an acrimonious debate. There are many reasons a controller can use to persuade management to accept a complete write-off, which usually results in a write-off that is spread over some reporting periods. However, this write-off must be completed by the time the next ﬁnancial statement is due for publication outside the company, or else the controller should strongly consider leaving the company if the unreported obsolescence amount would have a major negative impact on reported assets or proﬁts.

60.9 HOW TO AVOID THE INVENTORY TRACKING PROBLEM After reading the previous sections of this chapter, it is apparent that there is a great deal of work associated with tracking inventory. This involves work by the controller in pressing for the implementation of a perpetual inventory system, as well as continual auditing to ensure that it is accurate, plus an even greater amount of work by the warehouse staff to initially set up the system and then take cycle counts to spot and correct any accuracy problems. This is quite a burden on everyone, but it is necessary as long as a company has a signiﬁcant inventory investment. However, if the investment were greatly reduced, there would be far less need to take such elaborate steps to ensure accuracy. This section describes the steps to follow if the controller wants to avoid any sort of inventory counting. There are two primary improvement areas if a company wants to reduce its inventory investment. One is a series of actions to reduce the amount of inventory currently in stock, and the other is to choke off the ﬂow of incoming items. Most companies concentrate their attention on reducing what is already in stock, not realizing that what they are removing from inventory (usually at the cost of restocking fees or obsolescence write-offs) is just as rapidly being replaced by new parts coming into the warehouse. Consequently, it is better to begin work on choking off the incoming ﬂow of inventory, which takes a long time to complete, before beginning work on clearing out what is currently in stock. These steps are presented in that order: 1. Choke off the ﬂow of incoming inventory. The following steps will reduce the inﬂow of parts to the warehouse to a trickle by allowing a company to purchase only what it requires for immediate production needs:

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(a) Eliminate volume purchases. The purchasing staff is accustomed to reducing its workload by purchasing parts in bulk, thereby reducing the amount of purchase orders it must issue. Though this saves time for the purchasing staff, it entails more work by the warehouse staff to store the extra materials, as well as a larger investment in working capital to fund it. The controller can push for a change in the buying philosophy, so that purchasing agents issue blanket purchase orders for large amounts of stock, but accept only incremental deliveries for immediate production needs. This greatly reduces the inﬂow of inventory. (b) Create accurate bills of materials. The purchasing staff must frequently make guesses about what to order for production. When they are wrong, the items purchased go into inventory, sometimes for a very long time. By giving the purchasing staff better information about what to buy, it is possible to reduce or eliminate the number of items that are incorrectly purchased. The best format for this information is a bill of materials, which lists the quantity and part number for every item in a product. This bill must be extremely accurate in order to reduce the inﬂow of parts to the warehouse, however. If the wrong parts are listed on a bill, the purchasing staff will buy those parts, which will end up in the warehouse. (c) Create an accurate production schedule. The purchasing staff must know when to buy parts, as well as how many to purchase. An accurate production schedule that lists the exact quantities and numbers of products to be built is the information the purchasing staff needs to do this. (d) Install a material requirements planning (MRP) system. Even with bills of material and a purchasing schedule, the purchasing staff needs some way to combine the information into a schedule that tells it when to buy parts and how many to buy. An MRP system does this by using the bill of materials, the production schedule, and the inventory database to calculate the parts needed for production. It even tells the purchasing staff where to buy the parts, and the necessary lead times for purchasing them. By using this system, a company avoids all unnecessary purchases and retains parts in the warehouse for only the briefest of time periods. This is the capstone of the systems needed to avoid sending large quantities of inventory into the warehouse. 2. Eliminate existing inventory. The following steps will signiﬁcantly reduce the size of any inventory, and in some cases will lead to the elimination of the warehouse area: (a) Throw out inventory. A large number of parts in any inventory are useless. They are old, they are no longer used in the company’s products, or they have been superseded by new parts. Many of them are too inexpensive to be worth the effort of returning to suppliers, so it is best to take a write-off and remove them from stock. This is frequently a large number of parts with a minimum inventory valuation, because it is more worthwhile to return the more expensive parts to suppliers. (b) Return inventory. A small number of parts are so expensive that they are worth the effort of attempting to return them to suppliers. This can be a protracted process involving a number of phone calls, so this step applies only to the most expensive parts. Also, there is almost always a restocking fee of at least 15%, so a company should not expect full payment for the inventory. In addition, many suppliers will issue credits for returned inventory, but not cash payments. Nonetheless, this is an effective way to eliminate many of the most expensive items from the warehouse. (c) Use up inventory. A difﬁcult way to reduce the quantity of inventory is to use it up. This is not easy, because many of the inventory items may be parts that are no longer used and require special interference by management to force the production staff to add them to new products. This may also require extra design work by the engineering staff. Because of all this extra effort, it is generally best to focus on the typically small number of parts in stock that are actually usable. In short, this method tends to

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eliminate only a small fraction of the inventory in exchange for a large amount of staff effort. (d) Move inventory to shop ﬂoor. An excellent option being used by many companies with just-in-time manufacturing systems is to pull inventory out of the warehouse and position it near the production areas. Once the inventory is moved out of the warehouse, the controller usually charges it off to expense and no longer includes it in the inventory tracking system. This charge-off tends to be a small amount, because mostly ﬁttings and fasteners, and other similar inexpensive items, are moved to the shop ﬂoor. This is a small dollar amount, but it usually involves a very large percentage of the parts in the warehouse, and so it has a major favorable impact on the number of items to be cycle counted and audited. Moving the parts also avoids the effort and associated paperwork needed to constantly move parts in and out of the warehouse, which also means that there are fewer chances to damage parts by moving them. This also makes it easier for the production staff, which no longer has to requisition parts from the warehouse. There are a number of steps a controller can recommend that will greatly reduce the size of a company’s inventory investment. If the investment shrinks enough, the controller may ﬁnd that it is no longer necessary to keep such tight control over the remaining inventory, which greatly reduces the efforts required of the accounting and warehousing staffs.

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CHAPTER*

61

TAX RECORDS AND PROCEDURES 61.1

INTRODUCTION 1105

61.2

TAX ORGANIZATION 1106

61.3

CENTRALIZED TAX DEPARTMENT 1107

61.4

FUNCTIONS OF THE TAX MANAGER 1108

61.5

TAX COMMUNICATIONS 1109

61.6

TAX RECORDS IN GENERAL 1109

61.12 PROPER CLASSIFICATION OF ACCOUNTS 1114

61.7

TAX CALENDAR 1110

61.13 OTHER TAXES 1114

61.8

TAX INFORMATION RECORDS 1110

61.9

TAX WORKING PAPERS AND FILES 1111

61.14 INCOME TAXES AND BUSINESS PLANNING 1115

61.10 INTERNAL REVENUE CODE AND RECORD REQUIREMENTS 1111 61.11 DIFFERENCES BETWEEN INCOME TAX ACCOUNTING AND BOOK ACCOUNTING 1113 (a) Alternative Minimum Tax 1113 (b) Treatment of These Differences in the Records 1113

61.15 SPECIAL TAX REPORTS 1115

61.1 INTRODUCTION The reporting requirements of all governmental agencies has and will continue to increase signiﬁcantly and become more complicated and complex. This is particularly true as the reporting requirements relate to federal, state, and local taxes. Federal budgetary pressures have increased demands for more thorough and efﬁcient collection of revenues. These pressures have also caused the federal government to mandate more responsibilities to the states. Federal, state, and local pressures have led to increased demand for information from taxpayers. This translates to seemingly endless rules and regulations from numerous taxing authorities that taxpayers must comply with. Additionally, the United States probably has the most extensive audit procedures and enforcement capability of any country in the world. State and local taxing authorities are following the federal government’s lead and enhancing their enforcement capabilities. It is mandatory that businesses develop and maintain adequate records to meet the requirements of these widely diverse patterns of federal, state, and local tax requirements. If the records and reporting system are not properly planned, a company could be subject to considerable ﬁnancial exposure. Emphasis must be placed on the proper recording of ﬁnancial transactions, accuracy in preparing data for tax reports, and timely reporting to concerned taxing authorities.

* The author of this chapter is Marty Gold, Senior Manager, Ernst & Young LLP, Denver, Colorado.

1105

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Ch. 61 Tax Records and Procedures

Many companies ﬁnd it necessary to refer some or all federal, state, and local tax matters to tax consultants (both certiﬁed public accountants [CPAs] and attorneys). With the complexities of the various tax laws, this is the best approach. This does not, however, relieve the controller of overall responsibility for the tax products. No matter how well tax consultants know the company’s business, the controller has a more intimate knowledge of the company. Additionally, the application of the tax laws must be considered in many of the day-to-day operating decisions. The controller has a primary function the determination of the periodic and annual earnings, and the federal, state, and local tax laws are an important factor in such a determination. The controller has a fundamental responsibility to be fully informed on tax matters. A controller has not properly carried out his or her duties if every possible step to minimize overall tax liability has not been taken. It is his or her responsibility to see that the federal tax problems are handled competently. In summary, the controller should have a working knowledge of the more important tax computations. The controller and key accounting staff should also have a basic understanding of the tax laws and should be sufﬁciently aware of tax implications to inquire into, and secure an answer to, the probable tax results of any given transaction. Finally, the controller should be able to arrive at intelligent conclusions regarding the management policies that will result in the most beneﬁcial tax results.

61.2 TAX ORGANIZATION The responsibility for the tax activities should be placed with a ﬁnancial executive who understands the relationship of the accounting function to the tax compliance and planning function. Because the tax function affects cash ﬂows and accounting determinations, it is generally considered to be a controller’s function. The increasing importance of taxes as a cost of doing business and the signiﬁcant number of taxing authorities to be considered make it imperative that the administration of tax matters be regarded as a separate and distinct function in the organization. The plan of organization in most companies gives formal recognition to the tax function. In some companies with complex tax challenges and worldwide business interests, the tax function is headed by a vice president of taxes. In other companies, a separate department is established, headed by a manager responsible for all facets of taxes. Depending on the complexity and challenging nature of the tax issues, the tax department may be organized according to the types of taxes: • Federal income taxes • State income taxes • Sales and use taxes • Property taxes • Payroll taxes In other cases, companies use a functional breakdown such as: • Tax compliance • Tax planning and research • Tax counsel A prime consideration in organizing and stafﬁng a tax department is the degree of centralization concerning the administration of tax matters. This is particularly important when a company has several plants, branches, operating units, and international operations. A generic organizational chart of a home ofﬁce tax department is illustrated In Exhibit 61.1.

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61.3 Centralized Tax Department

E XHIBIT 61.1

O RGANIZATION C HART

FOR A

1107

T AX D EPARTMENT

61.3 CENTRALIZED TAX DEPARTMENT For a tax department to be effective, it must relate to all geographic locations and departments of the business, including subsidiaries, divisions, branches, plants, and local ofﬁces. It also must be privy to key transactions of the company before they occur. A top policy decision must be made about the degree of centralization of the corporate tax function. Normally, a centralized tax organization will exercise control over all tax policies and procedures within the company. In addition, it will manage the home ofﬁce tax organization and in some cases, direct the day-to-day activities of the decentralized tax people. However, in any event, functional control over the ﬁeld tax organization should be vested in the corporate tax manager or executive. There are some advantages to having local personnel handle certain tax functions because of the relationships with the local taxing authorities as in the case of property taxes. The corporate tax manager should make periodic reviews in these instances. The preparation of tax returns can be centralized or decentralized, depending on the circumstances and economics. If the data are in the local ofﬁce, it may be advantageous to have the return prepared locally, with appropriate review by the tax manager’s staff. Local preparation may have the advantage of greater familiarization with the applicable operations. With the availability of remote data processing capabilities, there may be advantages to centralized preparation. The records to be maintained and the format of the tax information work papers should be prescribed by the corporate tax department. Some companies, for example, have the payroll department of each entity prepare payroll tax returns, since the detail information is readily available from the payroll records. In this case, it would be prudent for the tax manager to review, sign, and ﬁle the returns. Some of the advantages in centralization of the tax responsibilities include: • More economical • Permits a higher degree of specialization • More efﬁcient use of tax resources—library, services, and the like • Promotes uniformity • More ﬂexibility in handling a workload

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Ch. 61 Tax Records and Procedures

In some circumstances, a centralized tax organization may be at a disadvantage because of lack of sufﬁcient contact with local taxing authorities or the local operating entities. This can be overcome by proper planning and making the effort to achieve the proper relationships with the local taxing authorities and the local operating personnel. As in many other areas, good communication is a key ingredient in making the relationships work well. In developing a tax organization, it is possible to decentralize some phases of the tax function, particularly when the various types of taxes and related records are considered. However, in these instances, guidance, instructions, and review must come from the central tax department. Unique and complex challenges associated with international tax operations are discussed in Chapter 16.

61.4 FUNCTIONS OF THE TAX MANAGER The functions of the tax manager will vary with the organization. However, the following is an indication of the extent of responsibilities assigned to the tax department in a generic large company: • Develop, recommend, and implement approved plans for an effective tax management program applicable to all elements of the corporation. Insure that the company complies with all applicable laws, rules, and regulations related to all applicable taxes. • Select personnel, assign duties, and establish appropriate control over tax department activities. • Plan for the administration of local or branch ofﬁce tax functions. • Maintain organized and adequate tax records, prepare forms and working papers, and establish an adequate ﬁling system. • Prepare a complete tax manual establishing procedures and responsibilities. • Evaluate the effect of tax laws, regulations, rulings, and court cases on the company’s tax liabilities and potential business activities. • Develop policies and procedures to minimize the company’s overall tax liability. • Determine that the company has ﬁled all tax returns, reports, and declarations required by law. • Review and recommend action concerning all tax adjustments proposed by the various taxing authorities or by the company’s independent public accountants and represent the company, or cause the company to be represented, in all negotiations affecting the company’s tax liabilities. • Initiate action, as directed, to obtain IRS approval, when required, with respect to changes in accounting methods, and procedures and matters pertaining to retirement or savings plans. • Prepare and prosecute in cooperation with tax accounts and/or attorneys as appropriate, or cause to be prepared and prosecuted, formal protests, claims, petitions, or court actions with respect to disputed tax matters involving the company, coordinating all such activities with other concerned functions, such as legal and accounting. • Initiate action when required, to obtain Internal Revenue Service (IRS) rulings regarding the company’s tax liability. • Analyze the tax implications of proposed acquisitions to determine present or potential problems and examine tax carry back or carry over possibilities. • Provide information concerning federal, state, local, and foreign tax matters, based on the advice of counsel, where necessary. • Analyze the tax effect of legal documents affecting the company and render advice regarding appropriate action to minimize the company’s tax liabilities with respect thereto.

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1109

• Review the annual and strategic plans to develop the tax liabilities for each period and incorporate the results into the approved plan. • Prepare, analyze, and review book accounting for income taxes.

61.5 TAX COMMUNICATIONS It is imperative that the tax department communicate with all units of the organization. To be effective, the tax department should be involved in management decisions on business acquisitions, pension plans and fringe beneﬁt programs, ﬁnancing agreements, establishment of foreign entities, including their location and form, contract terms related to taxes, divestitures of business units or products, location of facilities (state, city, or county), various kinds of business arrangements such as joint ventures or consulting agreements, and any other activity that could possibly have a federal, foreign, state, or local tax impact. Tax planning includes making all levels of management aware of the signiﬁcance of tax considerations in the decision-making process. An effective tax manager will create the opportunity to present sound and creative tax ideas to members of the management team on a regular basis. The tax manager must have an intimate knowledge of the company and its products, services, and general business operations. To achieve this, he must be in touch with all concerned and develop a network of communications sensitive to situations having potential tax implications. Success is when the tax department is consulted before, during, and after the fact on transactions involving tax matters. Another area for tax planning is involvement in the company’s short- and long-term planning process. The legitimate deferral of taxes is a signiﬁcant source of funds for many companies, and this fact should be recognized in the development of the company’s business plans, a consistent “effective tax rate” also helps in the comparison of year-to-year earnings. Much of the communication and coordination is with the accounting department, because tax returns are based on or reconciled to the accounting records.

61.6 TAX RECORDS IN GENERAL The tax laws are so complex, so great in number, and of such variation that it is not practical to keep in mind all the provisions of the laws and all the facts of the business which have a direct bearing on taxability. Consequently, the company must have the necessary records if the desirable tax planning is to be consummated, if management is to have a clear view of the tax situation, or if any degree of administrative control is to be successful. The penalties for oversight or incompetence may be severe. The nature of the records will be governed by the relative complexity of the tax issues. Broadly speaking, however, certain records are needed for administrative control purposes, to support the tax returns, and to meet the speciﬁc requirements of the law. Tax records may be grouped into four major classiﬁcations: 1. 2. 3. 4.

Tax calendar Information records Working paper ﬁles Supporting ledgers

Although these will be reviewed brieﬂy, it should be understood that in the ﬁnal analysis, their suitability and timeliness depend on an alert staff. Records cannot be suggested that will meet all needs for all times. Flexibility must be provided in the organization. Thus, if sales are made in a new state and require the collection of a sales tax, the tax staff must take the initiative to get the necessary sales analysis by states or the necessary accounts established. There is no substitute for such initiative, and it should be recognized and rewarded to foster its presence in the organization.

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Ch. 61 Tax Records and Procedures

61.7 TAX CALENDAR An administrative tool needed in most companies is a tax calendar. It is a schedule that serves as a reminder to those responsible regarding the due dates of ﬁling tax returns, preparation of various reports, payment of tax bills, hearing dates, audit dates, assessment dates, and any key tax event. The tax calendar may take several forms; however, the most common is illustrated in Exhibit 61.2. When computerized, the value of such a schedule is enhanced because automatic reminders can be programmed into the system so that all levels of the staff are made aware of upcoming deadlines. Daily status reports are also available to help management plan and prioritize the work.

Jan Feb Mar Apr May Jun

Jul Aug Sep Oct Nov Dec

Federal (Consolidated) Estimated Payments for Calendar Year 20 Tax Return for YE 12/31/ Mail Tax Packages to Subs and Divisions for YE 12/31/ Preliminary Analysis of Liability Account for Financial Statements Discuss Retirement, 5500 etc. Package To Be Completed Final Analysis of Liability Account for YE 12/31/ 1Form 599-1099 2Federal Use Tax—Highway Vehicles 2Federal Use Tax— Commercial Aircraft Federal Excise Quarterly Return Federal Excise Monthly Prepayment (2nd) Federal Excise Monthly Prepayment (1st) *May 1Tax

15

15 15*

15*

15 15

15

Final

15 31 28 X 28 31 31 31

30

31

31

31

28

31

30

31

30

31

31

30

31

30

31

15

15

15

15

15

15

15

15

15

15

15

15

Extend—Not extension of time to pay total tax liability only extension of time to ﬁle ﬁnal return.

organization will ﬁle federal, New York, Massachusetts, Washington DC, and North Dakota

2Whenever

applicable during tax year

E XHIBIT 61.2

T AX C ALENDAR

Such records may be perpetual records with revisions made as needed, or the calendar can be prepared in December of each year for the following year. Regardless of the form, the important point is the need to provide a systematic and dependable means of bringing the subject or tax event to the proper attention of those responsible in a timely manner. The advantages are clear—avoid penalties, interest, and embarrassment for ﬁling late returns and late payments.

61.8 TAX INFORMATION RECORDS Another basic type of record may be called a “tax information record” and represents a summary of the tax law and related matters as they affect the business. Such a record is used as a reference when preparing the tax return. The information may be stored in a computer or ﬁled on cards, on

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61.10 Internal Revenue Code and Record Requirements

1111

loose-leaf sheets, or even as part of the tax manual. Information to be available concerning each tax are: • Name of tax • Description of tax • Basis • Tax rates • Exemptions from tax • Time of ﬁling return • Return form number and name • Approximate time required for preparation • To whom return is sent and when • Source of data for return preparation • Why company is subject • The tax accounting • Procedure, including any special instructions • Penalties for nonpayment A page from a tax information record is shown in Exhibit 61.3. Where such data are part of a tax manual, it may be helpful to include other information, such as exhibits of the forms, perhaps a simple form of a tax calendar, general comments, and the procedure for handling. If the manual is sufﬁciently large, a table of contents is desirable. Since tax law is changing constantly, it is imperative that these information records be updated on a regular and frequent basis.

61.9 TAX WORKING PAPERS AND FILES The two types of records just discussed are of a reference nature. The remaining records may be considered as the working ﬁles and contain the ﬁgures and facts incident to the year-to-year returns. These operating ﬁles are of an inﬁnite variety and are comparable to the permanent ﬁles and working paper ﬁles in connection with an audit. The central theme is a complete and orderly record of how the amount of tax was determined each year, the payment dates, and so on. These ﬁles may include information such as: • Record of payments • Record of assessments • Reconciliations of tax data to the records • Copies of the return • Refund record, including basis • Correspondence on the tax • Research supporting the tax position or positions taken Such ﬁles must be prepared on the basis of the judgment of the tax manager based on the needs of the company.

61.10 INTERNAL REVENUE CODE AND RECORD REQUIREMENTS Under any tax law, the challenge is to set up records that will provide the necessary data with the minimum cost and effort. In considering recordkeeping requirements under federal tax laws, the principal source of data is the Internal Revenue Code (IRC) and corresponding regulations. The law is very general in regard to records, and Congress has speciﬁcally granted to the Commissioner of the Internal Revenue Service (IRS) the power to prescribe records that are

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T AX I NFORMATION R ECORD

1. Insure compliance with “DISC” regulations 2. Revise scheduling for asset depreciation range and guideline depreciation 3. Consider tax law changes to be enacted for the next year

Comments

E XHIBIT 61.3

Federal ﬁle #3, drawer 2

All except foreign legal entities, insurance co, etc. All domestic legal entities—consolidated IRS Fresno, California 1120, plus any other applicable forms 19 3/15/ Extensions through 9/15/ 35% $5,000,000 Information requested in package: Detailed income statement and balance sheet and a comprehensive analysis of differences between book income and taxable income. Calculation of alternative minimum taxable income (AMTI). Books and records of various proﬁt centers Number 260 Chief ﬁnancial ofﬁcers at various proﬁt centers 1. Company outside counsel 2. Company independent auditors 3. Company tax consultants

Federal Income Tax

File index

Source of data Account charged Contacts (Company) (External)

Rate or basis of tax Approximate amount of tax Information required

Locations covered Who must ﬁle Where ﬁled (address) Form number Period(s) covered Due Dates

Income

Ch. 61 Tax Records and Procedures

Information Needed Description and type

1112

2. California does not allow “DISC” deferral

1. Insure appropriateness of certain companies included in combined report regarding the “completed contract method of accounting for tax purposes”

California ﬁle #1, drawer #1

Books and records of various proﬁt centers Number 256 Same as federal Same as federal

California Franchise Tax Privilege of doing business Tax based on income All locations—domestic and foreign All legal entities, domestic and foreign—combined reporting Franchise Tax Board Sacramento, California 100, plus any other applicable forms 19 3/15/ Extensions through 9/15/ 9.3% $300,000 Information requested in package: 1. Apportionment data by state regarding property, payroll, and sales 2. Comprehensive analysis between federal and state taxable income

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61.11 Differences between Income Tax Accounting and Book Accounting

1113

necessary to determine the liability of the tax or will properly reﬂect the taxable income of the business. There are, however, various speciﬁc record keeping requirements, especially where foreign owned companies are involved. Care should be taken to insure that these record keeping requirements are met.

61.11 DIFFERENCES BETWEEN INCOME TAX ACCOUNTING AND BOOK ACCOUNTING The principal source of information required for federal income tax returns is, of course, the regular accounting records of the company. Although tax accounting and book accounting are more or less similar in many respects, there are three important respects in which these two differ: 1. Income and expenses speciﬁcally excluded for tax purposes. Examples include the tax-exempt income from government bonds, contributions in excess of the allowable maximum, and 50 percent of meals and entertainment expenses. 2. Differences resulting from the recognition of time when losses or income may be recognized. The reserve positions and related charge-offs are included in this group. 3. Differences in cost bases. This general category would include differences in depreciation rates and bases, treatment of maintenance and repair costs, and inventory valuation. A vital schedule for the controller’s review is the reconciliation of net income contained in the federal income tax return. This schedule reveals the major differing points between tax and book accounting. (a) ALTERNATIVE MINIMUM TAX. The Tax Reform Act of 1986 (TRA) had as one of its objectives the elimination of situations in which Congress perceived that companies were reporting healthy earnings and paying little tax on them. Certain deductions were eliminated; for example, the investment tax credit was repealed. But also the alternative minimum tax (AMT) was signiﬁcantly strengthened. It is a parallel system of taxation that has a broader income base than the regular tax system. It must be calculated in addition to the “regular” tax. If the AMT is larger, it is the tax to be paid; if the regular tax is larger, then that must be paid instead. As with the rest of TRA, AMT is a complex specialized area. (See Chapter 16 for a more detailed explanation.) Controllers should be aware of: • The alternative minimum tax must be calculated each time a regular federal income tax calculation is made. • Adjustments have to be made in calculating AMT, the biggest of which is changes to less accelerated methods of depreciation than are allowed for regular tax purposes. • Further adjustments are necessary in bringing income more in line with a company’s adjusted current earnings (ACE). The effect of all this is that while before the TRA, the controller had to reconcile between book and tax net income. Now there is a third and fourth net income called AMTI (alternative minimum taxable income) and ACE (adjusted current earnings), that must also be developed and reconciled to the other two. These calculations are very important to monitor, since they can have a direct effect on how much tax a company pays. (b) TREATMENT OF THESE DIFFERENCES IN THE RECORDS. The controller and tax manager are faced with the problem of how these differences should be treated in the records. It is necessary to maintain a running record of these differences and to reconcile book and tax ﬁgures if a company is to secure the maximum tax beneﬁts. The maintenance of such records is essential to insure that the company will not overlook a tax deduction to which it could properly be entitled to

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Ch. 61 Tax Records and Procedures

in a subsequent year. However, it does not follow that a completely independent set of books need be maintained for tax purposes. Some useful generalizations can be made, based on the three groups of differences listed in the preceding section. The ﬁrst group of items presents no signiﬁcant problem of carry over from year to year. Based on speciﬁc provisions of the IRC, they are excluded from income or expense. They appear on the reconciliation, and usually ends the matter, unless any excess of a limitation can be carried forward. Where such items are numerous, it may be found helpful to establish separate accounts, or groups of accounts, for such income or expenses. A good example of this is a separate for the tax limited meals and entertainment deduction. The second group represents those items taken into the accounts earlier or later than is required or permitted under the statute or regulations. Thus, although a provision for a contract loss may be set up on the records of a company, for tax purposes, only actual costs may constitute allowable deductions. An analysis of the accounts that would probably be prepared for the independent auditors anyway, will provide much of the necessary temporary difference data for tax purposes. Supplementary worksheets generally are sufﬁcient for this group, and separate ledgers will usually not be necessary. The major challenges arise when different cost bases are used. In any business, an analysis is necessary to determine whether a separate series of supplementary accounts need be maintained. Where substantially different depreciation bases and rates are used, separate ledgers may be required. It is becoming more common for companies to maintain the depreciation records in a computerized database downloaded from the company’s ﬁxed-asset ledger. Due to its complexity and varying methods of calculation, it is important to maintain detailed and accurate depreciation and ﬁxed asset records. The burden of proof about the correctness of the depreciation charges is clearly on the taxpayer. Although no particular form of record is required, it is essential that permanent records be maintained to reconcile the book and tax depreciation amounts from year to year.

61.12 PROPER CLASSIFICATION OF ACCOUNTS When designing the accounting records and account structure or chart of accounts, the controller should be aware of and consider the accounting data required for the preparation of tax returns. If provision is made in the establishment of the accounting records, it can facilitate the tax work and protect the interests of the company from a tax viewpoint. It is desirable to include in the account structure the capability for detailed analysis of various accounts. For example, repairs and maintenance should be structured so that it can be readily demonstrated that additions to a plant have not been expensed. Also, where practical, a segregation of nontaxable income and non allowable deductions should be made in the accounts. Such an account structure will save valuable time and increase the efﬁciency in preparing an accurate tax return.

61.13 OTHER TAXES In addition to the federal income tax, there are many other taxes that the business enterprise is subject to, such as: • State income taxes • Excise taxes • Sales taxes • Personal property taxes • Payroll taxes • Gross receipt taxes • Gasoline taxes

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• State franchise taxes • Real property taxes • Use taxes • Stamp taxes • City taxes • Foreign income taxes • Value-added taxes

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1115

The tax manager must be alert in developing procedures to accumulate the required date in an economical, efﬁcient, and timely manner. He or she must also be current on all changes in statutes and regulations. Provision must be made in the procedures so that applicable refunds are obtained and excessive overpayments not be made.

61.14 INCOME TAXES AND BUSINESS PLANNING Management must consider the tax consequences in its business planningfor the future. The tax manager should be involved in the detailed planning process so that business arrangements or contracts include the proper provisions to maximize the tax savings. This may be in the form of reduced taxes or deferred tax payments that can enhance considerably the cash ﬂow for the company. Another area of planning consideration is the payment of foreign taxes; these taxes can generate a credit against the federal income tax liability. This area, however, is very complex and care should be taken in foreign tax credit planning.

61.15 SPECIAL TAX REPORTS The controller or tax manager has a responsibility to see that the signiﬁcant tax burden placed on the company is communicated to all concerned. Generally speaking, most key people in the company are not always aware of the signiﬁcant amounts paid out in the various forms of taxes assessed to the company. In some companies, the tax manager prepares an annual report for management detailing the amounts of all of the taxes paid during the year. It is also sometimes prudent to include in this report how much taxes have been saved through the use of planning ideas. These types of reports can be a useful communication tool to let others in the company know the true extent of the tax burden and what’s being done about it. In summary, the controller should continually evaluate the tax planning and tax compliance to ensure that the company minimizes the overall tax burden through adequate knowledge of regulations, trends, decisions, and their application to the challenges facing the business.

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CHAPTER

62

RISK MANAGEMENT 62.1

INTRODUCTION 1117

62.2

RISK MANAGEMENT POLICIES 1117

62.6

TYPES OF INSURANCE COMPANIES 1122

62.3

RISK MANAGEMENT PROCEDURES 1118

62.7

CLAIMS ADMINISTRATION 1123

62.4

TRENDS IN INSURANCE COVERAGE 1121

62.8

INSURANCE FILES 1124

62.5

MANAGER OF RISK MANAGEMENT 1121

62.9

ANNUAL RISK MANAGEMENT REPORT 1125

62.1 INTRODUCTION Some well-managed companies have fallen because they did not pay attention to risk. For example, it is difﬁcult to recover from a ﬁre that destroys a data center or production facility, as well as a theft of all securities and cash. Though rare, these occurrences can be so catastrophic that it is not possible to recover. An otherwise healthy organization is destroyed, throwing many people out of work and eliminating the equity stake of the owners. On a lesser scale and much more common are the lawsuits that nearly every company must face from time to time. These may relate to employee injuries, customer or supplier claims regarding contracts, or perhaps sexual harassment or some form of discrimination. These lawsuits do not normally end a company’s existence, but they can cripple it if awards are excessive or the company is not in a solid ﬁnancial position to begin with. This chapter covers the risk management policies and procedures that keep a company from being seriously injured by these and other types of risk-related problems. In addition, it notes the role of the risk manager in mitigating a company’s risk by modifying internal systems as well as by purchasing insurance. The types of insurance that a company can buy are also discussed in this chapter, as well as how to select a agent or underwriter to help service a company’s needs. The chapter concludes with a discussion of how to administer insurance claims, and how to write a risk management report that clearly identiﬁes a company’s risks and how they are being met. This chapter gives the reader an overview of the risk management function.

62.2 RISK MANAGEMENT POLICIES A company must determine the amount of risk that it is willing to undertake. When the board of directors attempts to quantify this, it frequently ﬁnds that it is uncomfortable with the level of risk the company currently has and mandates more action to reduce that risk. The policy can include a number of risk management issues, such as the ﬁnancial limits for risk assumption or retention, self-insurance parameters, the ﬁnancial condition of insurance providers, and captive insurance 1117

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Ch. 62 Risk Management

1. ABC Company will obtain insurance only from companies with an A. M. Best rating of at least A+, or A++, a Standard & Poor’s rating of AAA, AA+, or a Moody’s rating of Aaa, Aa1, Aa2, or Aa3. 2. All self-insurance plans will be covered by an umbrella policy that covers all losses exceeding $50,000. 3. No insurance may be obtained from captive insurance companies. 4. The company must always have current insurance for the following categories, and in the stated amounts: Director’s and ofﬁcer’s insurance, $5 million General liability insurance, $10 million Commercial property insurance, matching the replacement cost of all structures and inventory Business interruption insurance, sufﬁcient for four months of operations E XHIBIT 62.1

A C OMPREHENSIVE P OLICY

FOR

R ISK M ANAGEMENT

companies. The policy does not have to cover some risks that are already required by law, such as workers’ compensation insurance. An example of a comprehensive insurance policy is noted in Exhibit 62.1. There are several key points to consider in the risk management policy in Exhibit 62.1. One issue is that a company may be tempted to purchase very cheap insurance, which frequently comes from an insurance provider that is in poor ﬁnancial condition. If a company has a claim on such insurance, it may ﬁnd that the provider is not in a position to pay the claim. Consequently, the ﬁrst policy item deﬁnes the minimum ﬁnancial rating that an insurance provider must attain before the company will purchase insurance from it. Another issue is that a company wants to put a cap on all risks, so that it cannot be blindsided by a large loss that is not covered by insurance. The second policy point, which requires a cap on self-insured risks, covers this problem. Finally, the board may feel more comfortable deﬁning the precise amount of insurance coverage needed in speciﬁc areas. Though the policy shows a few speciﬁc insurance amounts, it is usually better to deﬁne a formula for calculating the appropriate amount of insurance, such as commercial property insurance, that will cover the replacement cost of structures and inventory. This keeps the amount deﬁned on the policy from becoming outdated due to changing business conditions. These are some of the most important insurance issues that a risk management policy should cover.

62.3 RISK MANAGEMENT PROCEDURES Once the risk management policy has been deﬁned, it is necessary to determine a number of underlying procedures. These guide the actions of the risk manager in ensuring that the company has taken sufﬁcient steps to ensure that risks are kept at a minimum. The procedures follow a logical sequence of exploring the extent of risk issues, ﬁnding ways to mitigate those risks internally, and then using insurance to cover any risks that cannot otherwise be reduced. In more detail, the procedures are: 1. Locate risk areas. Determine all hazards to which the company is subject by performing a complete review of all properties and operations. This should include a review of not only the physical plant but also of contractual obligations, leasehold requirements, and government regulations. The review can be completed with insurable hazard checklists that are provided by most insurance companies, with the aid of a consultant, or by reviewing historical loss data provided by the company’s current insurance ﬁrm. However, the person conducting this review must guard against the FUD Principle (fear, uncertainty, and doubt) that is cheerfully practiced by all insurance companies. They tend to hone in on every conceivable risk and amplify the chance of its occurrence, so that a company will purchase lots of

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1119

unnecessary insurance. The best way to avoid this problem is to employ an extremely experienced risk manager who knows which potential risks can be safely ignored. The following areas, at a minimum, should be reviewed: (a) Buildings and equipment. The risk manager should list the type of construction, location, and hazards to which each item is exposed. Each structure and major piece of equipment should be listed separately. The current condition of each item should be determined and the replacement cost evaluated. (b) Business interruption. The risk manager should determine the amount of lost proﬁts and continuing expenses resulting from a business shutdown as the result of a speciﬁc hazard. (c) Liabilities to other parties. The risk manager should determine the risk of loss or damage to other parties by reason of company products, services, operations, or the acts of employees. This analysis should include a review of all contracts, sales orders, purchase orders, leases, and applicable laws to determine what commitments have been undertaken and what exposures exist. (d) Other assets. The risk manager should review cash, inventory, and accounts receivable to determine the possible exposure to losses by ﬁre, ﬂood, theft, or other hazards. 2. Determine the risk reduction method. Match each risk area with a method for dealing with it. The possible options for each risk area include avoidance, reduction of the hazard, retaining the hazard (i.e., self-insurance), or transferring the risk to an insurance company. Note that only the last option in this list includes the purchase of insurance, for there are many procedures that a company can implement to reduce a risk without resorting to insurance. The selection of the best option is based on a cost–beneﬁt analysis that offsets the cost of each hazard against the cost of avoiding it, factoring in the probability of the hazard’s occurrence. The general categories of risk reduction are: (a) Duplicate. A company can retain multiple copies of records to guard against the destruction of critical information. In addition, key systems such as local area networks, telephone systems, and voice mail storage can be replicated at off-site locations to avoid a shutdown caused by damage to the primary site. For example, airlines maintain elaborate backup systems for their seat reservation databases. (b) Prevent. A company can institute programs to reduce the likelihood and severity of losses. For example, some companies invite the Occupational Safety and Health Administration (OSHA) to inspect their premises and report on unsafe conditions; the companies then correct the issues to reduce their risk of loss. If a company requires employees to wear hardhats in construction areas, then a falling brick may still cause an accident, but the hardhat will reduce the incident’s severity. Examples of prevention techniques include improving lighting, installing protective devices on machinery, and enforcing safety rules. (c) Segregate. A company can split up key assets such as inventory and distribute it to multiple locations (e.g., warehouses). For example, the military maintains alternate command centers in case of war. 3. Implement internal changes to reduce risks. Once the types of risk avoidance have been determined, it is time to implement them. This usually involves new procedures or installations, such as ﬁre suppression systems in the computer processing facility, or altered cash tracking procedures that will discourage an employee from stealing money. Changes to procedures can be a lengthy process, for it includes working with the staff of each functional area to create a new procedure that is acceptable to all users, as well as following up with periodic audits to ensure that the procedures are still being followed. 4. Select an agent. Every company will require some insurance, unless it takes the hazardous approach of self-insuring virtually every risk. It is necessary to select a agent who can assist the company in procuring the best possible insurance. The right agent can be of great help

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in this process, not just in picking the cheapest insurance, but also in selecting the correct types of coverage, determining the ﬁnancial strength of insurers, postloss service, and in its general knowledge of the company’s business and of the types of risk that are most likely to occur in that environment. Unfortunately, many companies look for new agents every few years on the principle that a long-term agent will eventually raise prices and gouge the company. In reality, a long-term relationship should be encouraged, since the agent will gain a greater knowledge of the company’s risks as problems occur and claims are received, giving it a valuable insight into company operations that a new agent does not have. When selecting an agent, pick one with some longevity in the industry, since 98 percent of agents do not stay in the business for more than three years. Also, verify that the agent will not steer the company into the insurance offerings of a single insurance company; this can be most easily tested by inquiring into the number of insurance companies whose offerings the agent represents—the more the better. Also, contact other clients of the agent to see if the agent commits sufﬁcient time to annual policy reviews to ensure that ongoing client needs are properly matched to their insurance portfolios. 5. Determine the types of insurance to be purchased. Once the agent has been selected, the risk manager can show the preliminary results of the insurance review to the agent, and they can then mutually determine the types of insurance that are needed to supplement the actions already taken internally to mitigate risk. The types of insurance generally include one or more of: (a) Boiler and machinery. Covers damage to the boilers and machinery, as well as payments for injuries caused by the equipment. Providers of this insurance also review the company’s equipment and issue a report recommending safety improvements. (b) Business interruption. Allows a company to pay for its continuing expenses and in some cases will pay for all or part of its anticipated proﬁts. (c) Commercial property. The minimum “basic form” of this insurance covers losses from ﬁres, explosions, windstorms, hail, vandalism, and other perils. The “broad form,” which is an expanded version, covers everything in the basic form plus damage from falling objects, the weight of snow, water damage, and some causes of building collapse. Optional coverage includes an inﬂation escalator clause, replacement of destroyed structures at the actual replacement cost, and coverage of ﬁnished goods at their selling price (instead of at their cost). (d) Comprehensive auto liability. This coverage is usually mandatory and requires a minimum level of coverage for bodily injury and property damage. (e) Comprehensive crime. Covers property theft, robbery, safe and premises burglary, and employee dishonesty; in the case of employee dishonesty, the company purchases a ﬁdelity bond, which can cover either a named person, a speciﬁc position, or all employees. Some policies will also cover ransom payments. (f) Directors and ofﬁcers. Provides liability coverage to corporate managers for actions taken while acting as an ofﬁcer or director of the corporation. (g) General liability. Covers claims involving accidents on company premises, as well as by its products, services, agents, or contractors. An umbrella policy usually applies to liability insurance and provides extra coverage after the primary coverage is exhausted. An umbrella policy has few exclusions. (h) Group life, health, and disability. There are several types of life insurance; splitdollar life insurance covers an employee and its cost is split between the company and the employee, key person insurance covers the ﬁnancial loss to the company in case an employee dies, and a cross-purchase plan allows the co-owners of a business to buy out the share of an owner who dies. Health insurance typically covers the areas of hospital, medical, surgical, and dental expenses. Disability insurance provides income to an individual who cannot work due to an injury or illness. The

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1121

disability insurance category is subdivided into short-term disability (payments made while recovering one’s health following an injury or illness) and long-term disability (continuing payments with no anticipation of a return to work). (i) Inland marine. Covers company property that is being transported. Examples of covered items include trade show displays and ﬁnished goods being shipped. (j) Ocean marine and air cargo. Covers the transporting vehicle (including loss of income due to loss of the vehicle), liability claims against the vehicle’s owner or operator, and the cargo. (k) Workers’ compensation. Provides medical and disability coverage to workers who are injured while performing duties related to their jobs. The insurance is mandatory, the employer pays all costs, and no legal recourse is permitted against the employer. There are wide variations in each state’s coverage of workers’ compensation, including levels of compensation, types of occupations that are not covered, and the allowability of negligence lawsuits. These steps allow a risk manager to determine the types and potential severity of a company’s risks, as well as how to reduce those risks, either through internal changes or by purchasing various types of insurance coverage.

62.4 TRENDS IN INSURANCE COVERAGE The additional requirements of the 2002 Sarbanes-Oxley bill, as well as the ﬂood of incorrect ﬁnancial reporting issues that preceded it, have resulted in a startling jump in the cost of Directors and Ofﬁcers (D&O) insurance. In one case, a publicly-held software development company paid 149 times more for D&O insurance than the price quoted to a privately held software development company of approximately the same revenue size. Insurance companies are also restricting the amount of coverage their D&O policies provide. Further, they typically require larger deductibles by companies, and are also less willing to provide large amounts of coverage, forcing companies to obtain coverage under multiple policies. Finally, many policies cover only claims made during the year when the policy is in effect, rather than claims made later that pertain to accounting issues that arose during the term of the policy. The price of additional coverage for this “trailing” period has now increased substantially. In short, D&O coverage is now the most expensive component of most public companies’ insurance coverage. Larger companies have the option to concentrate all their insurance with a single carrier.By doing so, they can save money by combining deductibles that would normally have been separately incurred if many policies from different carriers were in use. For example, if a company decided that its cash reserves could safely withstand a loss of $10 million and it had maintained four insurance policies with different insurance companies, it would have to pay a higher premium in order to have deductibles of only $2.5 million on each of the policies. By doing so, simultaneous losses on all four policies could not total more than $10 million. However, if all these policies were to be combined with one carrier, the deductible on the total package could be raised to $10 million, thereby saving the company money on the increased deductible. In addition, the insurer does not have to set aside so much money in its reserves, since the reserves for multiple policies can be combined; with proper negotiation, some of this savings can be passed back to the company.

62.5 MANAGER OF RISK MANAGEMENT In most large companies, the risk management function is assigned to a manager, who reports to the chief ﬁnancial ofﬁcer, treasurer, or controller. This executive is charged with the responsibility of implementing procedures consistent with the corporate risk management policy (as noted earlier in Exhibit 62.1). This person works closely with other functional areas, such as engineering, safety and health, personnel and industrial relations, production, plant security, legal, and accounting. It

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Ch. 62 Risk Management

is important that this person have a thorough knowledge of the company’s operations, products, and services, as well as risk history, so that he or she can evaluate risks and exposure properly. Within these constraints, the job description of a typical risk manager is: • Ascertain and appraise all corporate risks. • Estimate the probability of loss due to these risks. • Ensure compliance with state, federal, and local requirements regarding insurance. • Select the optimum method for protecting against losses, such as changes to internal procedures or by acquiring insurance. • Work with insurance agents, agents, consultants, and insurance company representatives. • Supervise a loss prevention program, including planning to minimize losses from anticipated crises. • Maintain appropriate records for all aspects of insurance administration. • Continually evaluate and keep abreast of all changes in company operations. • Stay current on new techniques being developed in the risk management ﬁeld. • Conduct a periodic audit of the risk management program to ensure that all risks have been identiﬁed and covered.

62.6 TYPES OF INSURANCE COMPANIES There are several types of insurance companies. Each one may serve a company’s insurance needs very well, but there are signiﬁcant differences between them that a company should be aware of before purchasing an insurance contract. The types of insurance companies include: • Captive insurance companies. This is a stock insurance company that is formed to underwrite the risks of its parent company or in some cases a sponsoring group or association. • Lloyds of London. This is an underwriter operating under the special authority of the English Parliament. It may write insurance coverage of a nature that other companies will not underwrite, usually because of high risks or special needs not covered by a standard insurance form. It also provides the usual types of insurance coverage. • Mutuals. This is a company in which each policyholder is an owner, and earnings are distributed as dividends. If a net loss results, policyholders may be subject to extra assessments. In most cases, however, nonassessable polices are issued. • Reciprocal organizations. This is an association of insured companies that is independently operated by a manager. Advance deposits are made, against which are charged the proportionate costs of operations. • Stock companies. This is an insurance company that behaves like a normal corporation— earnings not retained in the business are distributed to shareholders as dividends and not to policyholders. Another way to categorize insurance companies is by the type of service offered. For example, a monoline company provides only one type of insurance coverage. A multiple line company provides more than one type of insurance. A ﬁnancial services company provides not only insurance but also ﬁnancial services to customers. A company can also use self-insurance when it deliberately plans to cover losses from its own resources rather than through those of an insurer. It can be appropriate in any of the following cases: • When the administrative loss of using an insurer exceeds the amount of the loss • When a company has sufﬁcient excess resources available to cover even the largest claim • When excessive premium payments are the only alternative • When insurance is not available at any price

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62.7 Claims Administration

1123

A form of partial self-insurance is to use large deductibles on insurance policies, so that a company pays for all but the very largest claims. Finally, a company can create a captive insurer that provides insurance to the parent company. Captive insurers can provide coverage that is tailored to the parent organization, and can provide less dependence on the vagaries of the commercial insurance market. A variation on the captive insurer concept is a fronting program, in which a parent company buys insurance from an independent insurance company, which then reinsures the exposure with a captive of the parent company. This technique is used to avoid licensing the captive insurer in every state where the parent company does business, though the captive insurer must still be authorized to accept reinsurance. Fronting also allows the parent company to obtain local service from the independent insurance company while shifting the exposure to the captive company. In whatever form the self-insurance may take, the risk manager should work with the controller to determine the amount of loss reserves to set aside to pay for claims as they arise. In some states, a company can become a self-insurer for workers’ compensation. To do this, a company must qualify under state law as a self-insurer, purchase umbrella coverage for catastrophic claims, post a surety bond, and create a claims administration department to handle claims. The advantages of doing this are lower costs (by eliminating the insurer’s proﬁt) and better cash ﬂow (because there are no up-front insurance payments). The disadvantages of doing this are extra administration costs as well as the cost of qualifying the company in each state in which the company operates. These are some of the variations a company must consider when obtaining insurance, either through a third party, a controlled subsidiary, or by providing its own coverage.

62.7 CLAIMS ADMINISTRATION Some insurance companies take an extremely long time to respond to claims, and may reject them if they are not reported in a speciﬁc format. To avoid these problems, thereby receiving the full amount of claims as quickly as possible, the risk manager must implement a strict claims administration process. This section describes that process. The risk manager should assemble a summary of information to review whenever a claim is ﬁled. By having this information in one place, the risk manager avoids missing any steps that might interfere with the prompt settlement of a claim. The summary should include: • Instructions for itemizing damaged items. Be sure to compile a complete list of all damaged items, including their inventory values, estimates, appraisals, and replacement costs. This assists the claims adjusters in determining the price they will pay to compensate for any claims. • Claims representatives. There should be a list of the names, addresses, and phone numbers of the claims adjusters who handle each line of insurance. This usually requires a fair amount of updating, since there may be a number of changes to this information every year, especially if a company uses a large number of insurance companies for its various lines of insurance. • Key internal personnel. Company policy may require that the risk manager notify internal personnel if claims have been ﬁled or payments received on those claims. For example, the controller may want to know if payment for a large claim has been received, so that an entry can be made in the accounting records. • Underlying problems. The risk manager should have a standard group of follow-up steps to review whenever a claim occurs, so that there is a clear understanding of why a claim occurred, as well as how the underlying problem that caused the claim can be avoided in the future. Without these instructions, it is possible that a company will repeat the problem over and over again, resulting in many claims and a vastly increased insurance premium. • Instructions for safeguarding damaged items. If material has been damaged, it is the responsibility of the company to ensure that it is not damaged further, which would result in a larger claim. For example, a company must protect the materials in a warehouse from further damage as soon as it discovers that the roof has leaked and destroyed some items. If it does not

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Ch. 62 Risk Management

take this action, the insurer can rightly claim that it will only pay for the damage that occurred up to the point when the company could have taken corrective action. The above information is necessary for the ﬁling of every insurance claim. In addition, there are two steps related to claims administration that the risk manager should attend to on an ongoing basis: 1. Accounting techniques. The risk manager should work with the controller to develop a standard set of accounting entries that are used for insurance claims as well as summarizing the cost of risk management. These relate to accumulating cost information for each claim, so that the risk manager can easily summarize the appropriate information related to each claim and use it to ﬁle for reimbursement. This information should include the costs of claims preparation, security and property protection, cleanup, repair costs, property identiﬁcation, and storage costs. 2. Audit program. No matter how good the procedures may be for the claims administration process, it is common for the claims administration staff to forget or sidestep some procedures. This is especially common when there is frequent employee turnover in this area, with poor training of the replacement staff. To identify procedural problems, it is useful to conduct a periodic review of the claims administration process. To ensure consistency in this audit, there should be a standard audit program that forms the minimum set of audit instructions (to be expanded upon as needed) for use in conducting each audit. It can be cost effective to have some claims administered by outside service companies, quite often the insurance carrier itself. Usually high-volume, low-cost-per-unit items such as medical claims are in this category. When outside services are used, the controller must establish with the provider the controls to be followed and the reports to be prepared. Periodic audits of the outside claims processing operation should be made by the company to ensure that claims are being handled in a controlled and effective manner.

62.8 INSURANCE FILES Insurance record-keeping is vital to ascertain that adequate insurance coverage has been obtained and is being administered properly. The primary risks that this recordkeeping avoids are inadvertently dropping insurance through lack of renewal and having inadequate insurance given a company’s actual claims record. The layout of insurance records described in this section helps a company to avoid these problems. There are several main categories of insurance records. The ﬁrst section identiﬁes each policy. The next section is a tickler ﬁle, which lists key due dates for each policy. This is useful for ensuring that all policy payments are made on time, so that they do not lapse. The next section is the activity ﬁle, which describes the claim history and open claims for each policy. Finally, there is the value ﬁle, which itemizes the insurable values covered by each policy. The activity and value ﬁles are needed to determine the size of claims or the value being covered, so the risk manager can see if each policy provides a sufﬁcient amount of coverage. When properly maintained, these ﬁles give the risk manager a basis for sound management of his or her function. The contents of each type of ﬁle is: • Identiﬁcation ﬁle. Lists key information on each policy: Abstract of coverage, showing exclusions Agent Effective dates Insurer Policy number Rates, premiums, and refunds Type of insurance coverage

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62.9 Annual Risk Management Report

1125

• Tickler ﬁle. Lists key dates for each policy: Inspection dates Policy expiration date Premium payment dates Reporting dates

• Activity ﬁle. Describes the claim history and open claims for each policy: Historical comparison of premiums to losses History ﬁle on closed claims Reserves established Status of each claim Support and documentation of each claim

• Value ﬁle. Itemizes the insurable values covered by each policy: Detail of actual cash value of each item covered by a policy Detail of replacement cost of each item covered by a policy Summary of insurable values listed on each policy

62.9 ANNUAL RISK MANAGEMENT REPORT A qualiﬁed risk manager should issue a risk management report to the board of directors every year. This document reviews all perceived risks to which a company is subject, and then describes the steps taken to mitigate those risks. It is of great value to the board, because it needs to know the extent of potential risks and how they can impact company operations. Unfortunately, not many controllers or chief ﬁnancial ofﬁcers (CFOs) are aware of what should go into the annual risk management report. This presents a problem if the board asks either of these managers, to whom the risk manager usually reports, about the contents of the report. To avoid this problem, the contents of a typical risk management report are described in this section, including an example based on an organization that provides training in rock climbing. The risk management report contains four sections. The ﬁrst one is an overview that describes the contents of the report, the timing of when it is issued, and to whom it is delivered. The second section itemizes all risks that the risk manager perceives to be signiﬁcant. If every possible risk were to be listed, the document might be too voluminous for easy reading. These risks should be grouped with subheadings, rather than appearing as an enormous list that is difﬁcult for the reader to digest. The third section notes the ways to cover those risks, excluding insurance (that is the fourth section). These are operational changes such as altered procedures or processes, or additional training. Finally, the fourth section notes the insurance that has been purchased to provide additional coverage to those risk areas that cannot be adequately covered by internal changes. These four sections give the board an adequate knowledge of a company’s efforts in the risk management area. The example in Exhibit 62.2 presents an extract from the risk management report of an organization that provides rock climbing and related classes. The example skips the overview section and proceeds straight to the enumeration of risks, how they are covered, and what types of insurance are also needed. This is a good example of the format that a controller or CFO should look for in a risk management report.

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Ch. 62 Risk Management

S ECTION II: R EVIEW

OF

R ISKS

• Risks related to education: 1. Risk of school equipment failing 2. Risk of accidents due to improper instruction S ECTION III: W AYS

TO

C OVER R ISKS

• Risk of school equipment failing. School equipment is reviewed and replaced by the school governing committees on a regular basis. Instructors are also authorized to immediately remove equipment from use if they spot unusual damage that may result in equipment failure. • Risk of accidents due to improper instruction. School instructors must ﬁrst serve as assistant instructors under the supervision of a more experienced instructor, who evaluates their skills and recommends advancement to full instructor status. The typical instructor has previously completed all prerequisite courses, and has considerable outdoor experience. All instructors must have taken a mountain-oriented ﬁrst aid class within the last year. S ECTION IV: S UPPLEMENTAL I NSURANCE C OVERAGE • Risk of school equipment failing. The general liability policy covers this risk for the ﬁrst $500,000 of payments to a claimant. The umbrella policy covers this risk for an additional $5 million after the coverage provided by the general liability policy is exhausted. • Risk of accidents due to improper instruction. Same insurance coverage as for the risk of school equipment failing. E XHIBIT 62.2

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E XAMPLE

OF A

R ISK M ANAGEMENT R EPORT

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APPENDIX*

A

INTEREST TABLES

There are ﬁve tables in this appendix that relate to the most common calculations used for interest rate analyses. Each one uses a standard format that lists the interest rate, from 1% to 13%, across the top, and the number of years, from 1 to 30, down the left side. The underlying calculation for each one is noted below, as well as a brief example describing how to use each one.

SIMPLE INTEREST TABLE This table is used to ﬁnd the total interest expense on an investment or debt that is to be completed in some future period, without factoring in the impact of any compounding of interest. The calculation is: ( Interest rate number of years that interest accrues ) For example, to determine the total amount of an investment of $50,000 at the end of seven years, using an interest rate of 9%, go to the simple interest table. Then move down to the row that contains interest rate factors for seven years, and move across to ﬁnd the cell for the 9% interest rate, which contains a factor of 1.63. Then multiply this by $50,000 to arrive at $81,500.

COMPOUND INTEREST (FUTURE AMOUNT OF 1 AT COMPOUND INTEREST DUE IN N PERIODS) This table is used to ﬁnd the total interest expense on an investment or debt that is to be completed in some future period, including the impact of any compounding of interest. The calculation is: ( 1 Interest rate )

number of years

For example, to determine the total amount of an investment of $50,000 at the end of eleven years, using an interest rate of 8%, go to the compound interest table for future amounts, move down to the row that contains interest rate factors for eleven years, and move across to ﬁnd the cell for an 8% interest rate, which contains a factor of 2.3316. Then multiply this by $50,000 to arrive at $116,580.

* Reprinted with permission from Appendix C of Stephen M. Bragg, Accounting Reference Desktop (Hoboken, New Jersey, John Wiley & Sons: 2002)

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Appendix A Interest Tables

COMPOUND INTEREST (PRESENT VALUE OF 1 DUE IN N PERIODS) This table is used to determine the discounted current value of an investment that will be payable in a ﬁxed amount at some point in the future. The calculation is: 1 -------------------------------------------------------------------------number of years ( 1 Interest rate ) For example, to determine the discounted current value of a payment of $50,000 that will occur in 11 years, assuming a compounded rate of investment in the interim of 7%, go to the compound interest table for the present value of money due in future periods. Move down to the row that contains discounting factors for 11 years, and move across to ﬁnd the cell for a 7% interest rate, which contains a factor of .3166. Then multiply this by $50,000 to arrive at $15,830.

PRESENT VALUE OF ORDINARY ANNUITY OF 1 PER PERIOD This table is used to ﬁnd the present value of a ﬁxed number of payments in the future. The calculation is: 1 1 -------------------------------------------------------------------------number of years ( 1 Interest rate ) -------------------------------------------------------------------------------------Interest rate For example, to determine the present value of a series of annual payments of $2,500 for the next 22 years at a discount rate of 13%, go to the table for the present value of an ordinary annuity of 1 per period. Move down to the row that contains discounting factors for 22 years, and move across to ﬁnd the cell for a 13% interest rate, which contains a discount factor of 7.1695. Then multiply this by $2,500 to arrive at a present value of $17,923.75.

FUTURE AMOUNT OF ORDINARY ANNUITY OF 1 PER PERIOD This table is used to determine the future value of a series of ﬁxed payments. The calculation is: number of years

1 ( 1 Interest rate ) ------------------------------------------------------------------------------------Interest rate For example, to determine the future value of a series of ten $5,000 annual payments at an interest rate of 5%, go to the table for the future amount of an ordinary annuity. Move down to the row that contains compounding factors for ten years, and move across to ﬁnd the cell for a 5% interest rate, which contains a discount factor of 12.5779. Then multiply this by $5,000 to arrive at a future value of $62,889.50.

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1%

1.01 1.02 1.03 1.04 1.05 1.06 1.07 1.08 1.09 1.10 1.11 1.12 1.13 1.14 1.15 1.16 1.17 1.18 1.19 1.20 1.21 1.22 1.23 1.24 1.25 1.26 1.27 1.28 1.29 1.30

Number of Years

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

2% 1.02 1.04 1.06 1.08 1.10 1.12 1.14 1.16 1.18 1.20 1.22 1.24 1.26 1.28 1.30 1.32 1.34 1.36 1.38 1.40 1.42 1.44 1.46 1.48 1.50 1.52 1.54 1.56 1.58 1.60

3% 1.03 1.06 1.09 1.12 1.15 1.18 1.21 1.24 1.27 1.30 1.33 1.36 1.39 1.42 1.45 1.48 1.51 1.54 1.57 1.60 1.63 1.66 1.69 1.72 1.75 1.78 1.81 1.84 1.87 1.90

4% 1.04 1.08 1.12 1.16 1.20 1.24 1.28 1.32 1.36 1.40 1.44 1.48 1.52 1.56 1.60 1.64 1.68 1.72 1.76 1.80 1.84 1.88 1.92 1.96 2.00 2.04 2.08 2.12 2.16 2.20

5% 1.05 1.10 1.15 1.20 1.25 1.30 1.35 1.40 1.45 1.50 1.55 1.60 1.65 1.70 1.75 1.80 1.85 1.90 1.95 2.00 2.05 2.10 2.15 2.20 2.25 2.30 2.35 2.40 2.45 2.50

1.06 1.12 1.18 1.24 1.30 1.36 1.42 1.48 1.54 1.60 1.66 1.72 1.78 1.84 1.90 1.96 2.02 2.08 2.14 2.20 2.26 2.32 2.38 2.44 2.50 2.56 2.62 2.68 2.74 2.80

6%

Interest Rate

1.07 1.14 1.21 1.28 1.35 1.42 1.49 1.56 1.63 1.70 1.77 1.84 1.91 1.98 2.05 2.12 2.19 2.26 2.33 2.40 2.47 2.54 2.61 2.68 2.75 2.82 2.89 2.96 3.03 3.10

7%

S IMPLE I NTEREST T ABLE

8% 1.08 1.16 1.24 1.32 1.40 1.48 1.56 1.64 1.72 1.80 1.88 1.96 2.04 2.12 2.20 2.28 2.36 2.44 2.52 2.60 2.68 2.76 2.84 2.92 3.00 3.08 3.16 3.24 3.32 3.40

9% 1.09 1.18 1.27 1.36 1.45 1.54 1.63 1.72 1.81 1.90 1.99 2.08 2.17 2.26 2.35 2.44 2.53 2.62 2.71 2.80 2.89 2.98 3.07 3.16 3.25 3.34 3.43 3.52 3.61 3.70

1.10 1.20 1.30 1.40 1.50 1.60 1.70 1.80 1.90 2.00 2.10 2.20 2.30 2.40 2.50 2.60 2.70 2.80 2.90 3.00 3.10 3.20 3.30 3.40 3.50 3.60 3.70 3.80 3.90 4.00

10% 1.11 1.22 1.33 1.44 1.55 1.66 1.77 1.88 1.99 2.10 2.21 2.32 2.43 2.54 2.65 2.76 2.87 2.98 3.09 3.20 3.31 3.42 3.53 3.64 3.75 3.86 3.97 4.08 4.19 4.30

11%

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1.13 1.26 1.39 1.52 1.65 1.78 1.91 2.04 2.17 2.30 2.43 2.56 2.69 2.82 2.95 3.08 3.21 3.34 3.47 3.60 3.73 3.86 3.99 4.12 4.25 4.38 4.51 4.64 4.77 4.90

13%

Simple Interest Table

1.12 1.24 1.36 1.48 1.60 1.72 1.84 1.96 2.08 2.20 2.32 2.44 2.56 2.68 2.80 2.92 3.04 3.16 3.28 3.40 3.52 3.64 3.76 3.88 4.00 4.12 4.24 4.36 4.48 4.60

12%

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1%

1.0100 1.0201 1.0303 1.0406 1.0510 1.0615 1.0721 1.0829 1.0937 1.1046 1.1157 1.1268 1.1381 1.1495 1.1610 1.1726 1.1843 1.1961 1.2081 1.2202 1.2324 1.2447 1.2572 1.2697 1.2824 1.2953 1.3082 1.3213 1.3345 1.3478

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

1.0200 1.0404 1.0612 1.0824 1.1041 1.1262 1.1487 1.1717 1.1951 1.2190 1.2434 1.2682 1.2936 1.3195 1.3459 1.3728 1.4002 1.4282 1.4568 1.4859 1.5157 1.5460 1.5769 1.6084 1.6406 1.6734 1.7069 1.7410 1.7758 1.8114

2%

Compound Interest Table

Number of Years

1130

1.0300 1.0609 1.0927 1.1255 1.1593 1.1941 1.2299 1.2668 1.3048 1.3439 1.3842 1.4258 1.4685 1.5126 1.5580 1.6047 1.6528 1.7024 1.7535 1.8061 1.8603 1.9161 1.9736 2.0328 2.0938 2.1566 2.2213 2.2879 2.3566 2.4273

3% 1.0400 1.0816 1.1249 1.1699 1.2167 1.2653 1.3159 1.3686 1.4233 1.4802 1.5395 1.6010 1.6651 1.7317 1.8009 1.8730 1.9479 2.0258 2.1068 2.1911 2.2788 2.3699 2.4647 2.5633 2.6658 2.7725 2.8834 2.9987 3.1187 3.2434

4% 1.0500 1.1025 1.1576 1.2155 1.2763 1.3401 1.4071 1.4775 1.5513 1.6289 1.7103 1.7959 1.8856 1.9799 2.0789 2.1829 2.2920 2.4066 2.5270 2.6533 2.7860 2.9253 3.0715 3.2251 3.3864 3.5557 3.7335 3.9201 4.1161 4.3219

5%

F UTURE A MOUNT

1.0600 1.1236 1.1910 1.2625 1.3382 1.4185 1.5036 1.5938 1.6895 1.7908 1.8983 2.0122 2.1329 2.2609 2.3966 2.5404 2.6928 2.8543 3.0256 3.2071 3.3996 3.6035 3.8197 4.0489 4.2919 4.5494 4.8223 5.1117 5.4184 5.7435

6% 1.0700 1.1449 1.2250 1.3108 1.4026 1.5007 1.6058 1.7182 1.8385 1.9672 2.1049 2.2522 2.4098 2.5785 2.7590 2.9522 3.1588 3.3799 3.6165 3.8697 4.1406 4.4304 4.7405 5.0724 5.4274 5.8074 6.2139 6.6488 7.1143 7.6123

7%

Interest Rate

1.0800 1.1664 1.2597 1.3605 1.4693 1.5869 1.7138 1.8509 1.9990 2.1589 2.3316 2.5182 2.7196 2.9372 3.1722 3.4259 3.7000 3.9960 4.3157 4.6610 5.0338 5.4365 5.8715 6.3412 6.8485 7.3964 7.9881 8.6271 9.3173 10.0627

8%

C OMPOUND I NTEREST T ABLE 1 AT C OMPOUND I NTEREST D UE

OF

IN

1.0900 1.1881 1.2950 1.4116 1.5386 1.6771 1.8280 1.9926 2.1719 2.3674 2.5804 2.8127 3.0658 3.3417 3.6425 3.9703 4.3276 4.7171 5.1417 5.6044 6.1088 6.6586 7.2579 7.9111 8.6231 9.3992 10.2451 11.1671 12.1722 13.2677

9%

N P ERIODS

1.1000 1.2100 1.3310 1.4641 1.6105 1.7716 1.9487 2.1436 2.3579 2.5937 2.8531 3.1384 3.4523 3.7975 4.1772 4.5950 5.0545 5.5599 6.1159 6.7275 7.4002 8.1403 8.9543 9.8497 10.8347 11.9182 13.1100 14.4210 15.8631 17.4494

10% 1.1100 1.2321 1.3676 1.5181 1.6851 1.8704 2.0762 2.3045 2.5580 2.8394 3.1518 3.4985 3.8833 4.3104 4.7846 5.3109 5.8951 6.5436 7.2633 8.0623 8.9492 9.9336 11.0263 12.2392 13.5855 15.0799 16.7386 18.5799 20.6237 22.8923

11%

1.1200 1.2544 1.4049 1.5735 1.7623 1.9738 2.2107 2.4760 2.7731 3.1058 3.4785 3.8960 4.3635 4.8871 5.4736 6.1304 6.8660 7.6900 8.6128 9.6463 10.8038 12.1003 13.5523 15.1786 17.0001 19.0401 21.3249 23.8839 26.7499 29.9599

12%

1.1300 1.2769 1.4429 1.6305 1.8424 2.0820 2.3526 2.6584 3.0040 3.3946 3.8359 4.3345 4.8980 5.5348 6.2543 7.0673 7.9861 9.0243 10.1974 11.5231 13.0211 14.7138 16.6266 18.7881 21.2305 23.9905 27.1093 30.6335 34.6158 39.1159

13%

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1%

0.9901 0.9803 0.9706 0.9610 0.9515 0.9420 0.9327 0.9235 0.9143 0.9053 0.8963 0.8874 0.8787 0.8700 0.8613 0.8528 0.8444 0.8360 0.8277 0.8195 0.8114 0.8034 0.7954 0.7876 0.7798 0.7720 0.7644 0.7568 0.7493 0.7419

Number of Years

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

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2% 0.9804 0.9612 0.9423 0.9238 0.9057 0.8880 0.8706 0.8535 0.8368 0.8203 0.8043 0.7885 0.7730 0.7579 0.7430 0.7284 0.7142 0.7002 0.6864 0.6730 0.6598 0.6468 0.6342 0.6217 0.6095 0.5976 0.5859 0.5744 0.5631 0.5521

3% 0.9709 0.9426 0.9151 0.8885 0.8626 0.8375 0.8131 0.7894 0.7664 0.7441 0.7224 0.7014 0.6810 0.6611 0.6419 0.6232 0.6050 0.5874 0.5703 0.5537 0.5375 0.5219 0.5067 0.4919 0.4776 0.4637 0.4502 0.4371 0.4243 0.4120

4% 0.9615 0.9246 0.8890 0.8548 0.8219 0.7903 0.7599 0.7307 0.7026 0.6756 0.6496 0.6246 0.6006 0.5775 0.5553 0.5339 0.5134 0.4936 0.4746 0.4564 0.4388 0.4220 0.4057 0.3901 0.3751 0.3607 0.3468 0.3335 0.3207 0.3083

5% 0.9524 0.9070 0.8638 0.8227 0.7835 0.7462 0.7107 0.6768 0.6446 0.6139 0.5847 0.5568 0.5303 0.5051 0.4810 0.4581 0.4363 0.4155 0.3957 0.3769 0.3589 0.3418 0.3256 0.3101 0.2953 0.2812 0.2678 0.2551 0.2429 0.2314

0.9434 0.8900 0.8396 0.7921 0.7473 0.7050 0.6651 0.6274 0.5919 0.5584 0.5268 0.4970 0.4688 0.4423 0.4173 0.3936 0.3714 0.3503 0.3305 0.3118 0.2942 0.2775 0.2618 0.2470 0.2330 0.2198 0.2074 0.1956 0.1846 0.1741

6% 0.9346 0.8734 0.8163 0.7629 0.7130 0.6663 0.6227 0.5820 0.5439 0.5083 0.4751 0.4440 0.4150 0.3878 0.3624 0.3387 0.3166 0.2959 0.2765 0.2584 0.2415 0.2257 0.2109 0.1971 0.1842 0.1722 0.1609 0.1504 0.1406 0.1314

7%

Interest Rate 8% 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835 0.5403 0.5002 0.4632 0.4289 0.3971 0.3677 0.3405 0.3152 0.2919 0.2703 0.2502 0.2317 0.2145 0.1987 0.1839 0.1703 0.1577 0.1460 0.1352 0.1252 0.1159 0.1073 0.0994

C OMPOUND I NTEREST T ABLE P RESENT V ALUE OF 1 D UE IN N P ERIODS

9% 0.9174 0.8417 0.7722 0.7084 0.6499 0.5963 0.5470 0.5019 0.4604 0.4224 0.3875 0.3555 0.3262 0.2992 0.2745 0.2519 0.2311 0.2120 0.1945 0.1784 0.1637 0.1502 0.1378 0.1264 0.1160 0.1064 0.0976 0.0895 0.0822 0.0754

10% 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645 0.5132 0.4665 0.4241 0.3855 0.3505 0.3186 0.2897 0.2633 0.2394 0.2176 0.1978 0.1799 0.1635 0.1486 0.1351 0.1228 0.1117 0.1015 0.0923 0.0839 0.0763 0.0693 0.0630 0.0573

11%

12% 0.8929 0.7972 0.7118 0.6355 0.5674 0.5066 0.4523 0.4039 0.3606 0.3220 0.2875 0.2567 0.2292 0.2046 0.1827 0.1631 0.1456 0.1300 0.1161 0.1037 0.0926 0.0826 0.0738 0.0659 0.0588 0.0525 0.0469 0.0419 0.0374 0.0334

13%

1131

0.8850 0.7831 0.6931 0.6133 0.5428 0.4803 0.4251 0.3762 0.3329 0.2946 0.2607 0.2307 0.2042 0.1807 0.1599 0.1415 0.1252 0.1108 0.0981 0.0868 0.0768 0.0680 0.0601 0.0532 0.0471 0.0417 0.0369 0.0326 0.0289 0.0256

Compound Interest Table

0.9009 0.8116 0.7312 0.6587 0.5935 0.5346 0.4817 0.4339 0.3909 0.3522 0.3173 0.2858 0.2575 0.2320 0.2090 0.1883 0.1696 0.1528 0.1377 0.1240 0.1117 0.1007 0.0907 0.0817 0.0736 0.0663 0.0597 0.0538 0.0485 0.0437

Appndx_controllership.fm Page 1131 Wednesday, December 10, 2003 11:14 AM

Black process 45.0° 133.0 LPI

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

1%

0.9901 1.9704 2.9410 3.9020 4.8534 5.7955 6.7282 7.6517 8.5660 9.4713 10.3676 11.2551 12.1337 13.0037 13.8651 14.7179 15.5623 16.3983 17.2260 18.0456 18.8570 19.6604 20.4558 21.2434 22.0232 22.7952 23.5596 24.3164 25.0658 25.8077

2% 0.9804 1.9416 2.8839 3.8077 4.7135 5.6014 6.4720 7.3255 8.1622 8.9826 9.7868 10.5753 11.3484 12.1062 12.8493 13.5777 14.2919 14.9920 15.6785 16.3514 17.0112 17.6580 18.2922 18.9139 19.5235 20.1210 20.7069 21.2813 21.8444 22.3965

3% 0.9709 1.9135 2.8286 3.7171 4.5797 5.4172 6.2303 7.0197 7.7861 8.5302 9.2526 9.9540 10.6350 11.2961 11.9379 12.5611 13.1661 13.7535 14.3238 14.8775 15.4150 15.9369 16.4436 16.9355 17.4131 17.8768 18.3270 18.7641 19.1885 19.6004

0.9615 1.8861 2.7751 3.6299 4.4518 5.2421 6.0021 6.7327 7.4353 8.1109 8.7605 9.3851 9.9856 10.5631 11.1184 11.6523 12.1657 12.6593 13.1339 13.5903 14.0292 14.4511 14.8568 15.2470 15.6221 15.9828 16.3296 16.6631 16.9837 17.2920

4% 0.9524 1.8594 2.7232 3.5460 4.3295 5.0757 5.7864 6.4632 7.1078 7.7217 8.3064 8.8633 9.3936 9.8986 10.3797 10.8378 11.2741 11.6896 12.0853 12.4622 12.8212 13.1630 13.4886 13.7986 14.0939 14.3752 14.6430 14.8981 15.1411 15.3725

5%

P RESENT V ALUE

Present Value of Ordinary Annuity of 1 per Period

Number of Years

1132

OF

0.9434 1.8334 2.6730 3.4651 4.2124 4.9173 5.5824 6.2098 6.8017 7.3601 7.8869 8.3838 8.8527 9.2950 9.7122 10.1059 10.4773 10.8276 11.1581 11.4699 11.7641 12.0416 12.3034 12.5504 12.7834 13.0032 13.2105 13.4062 13.5907 13.7648

6%

Interest Rate

OF

0.9346 1.8080 2.6243 3.3872 4.1002 4.7665 5.3893 5.9713 6.5152 7.0236 7.4987 7.9427 8.3577 8.7455 9.1079 9.4466 9.7632 10.0591 10.3356 10.5940 10.8355 11.0612 11.2722 11.4693 11.6536 11.8258 11.9867 12.1371 12.2777 12.4090

7%

O RDINARY A NNUITY

1 PER

0.9259 1.7833 2.5771 3.3121 3.9927 4.6229 5.2064 5.7466 6.2469 6.7101 7.1390 7.5361 7.9038 8.2442 8.5595 8.8514 9.1216 9.3719 9.6036 9.8181 10.0168 10.2007 10.3711 10.5288 10.6748 10.8100 10.9352 11.0511 11.1584 11.2578

8%

P ERIOD

9% 0.9174 1.7591 2.5313 3.2397 3.8897 4.4859 5.0330 5.5348 5.9952 6.4177 6.8052 7.1607 7.4869 7.7862 8.0607 8.3126 8.5436 8.7556 8.9501 9.1285 9.2922 9.4424 9.5802 9.7066 9.8226 9.9290 10.0266 10.1161 10.1983 10.2737

10% 0.9091 1.7355 2.4869 3.1699 3.7908 4.3553 4.8684 5.3349 5.7590 6.1446 6.4951 6.8137 7.1034 7.3667 7.6061 7.8237 8.0216 8.2014 8.3649 8.5136 8.6487 8.7715 8.8832 8.9847 9.0770 9.1609 9.2372 9.3066 9.3696 9.4269

11% 0.9009 1.7125 2.4437 3.1024 3.6959 4.2305 4.7122 5.1461 5.5370 5.8892 6.2065 6.4924 6.7499 6.9819 7.1909 7.3792 7.5488 7.7016 7.8393 7.9633 8.0751 8.1757 8.2664 8.3481 8.4217 8.4881 8.5478 8.6016 8.6501 8.6938

12% 0.8929 1.6901 2.4018 3.0373 3.6048 4.1114 4.5638 4.9676 5.3282 5.6502 5.9377 6.1944 6.4235 6.6282 6.8109 6.9740 7.1196 7.2497 7.3658 7.4694 7.5620 7.6446 7.7184 7.7843 7.8431 7.8957 7.9426 7.9844 8.0218 8.0552

13% 0.8850 1.6681 2.3612 2.9745 3.5172 3.9975 4.4226 4.7988 5.1317 5.4262 5.6869 5.9176 6.1218 6.3025 6.4624 6.6039 6.7291 6.8399 6.9380 7.0248 7.1016 7.1695 7.2297 7.2829 7.3300 7.3717 7.4086 7.4412 7.4701 7.4957

Appndx_controllership.fm Page 1132 Wednesday, December 10, 2003 11:14 AM

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Number of Years

1%

1.0000 2.0100 3.0301 4.0604 5.1010 6.1520 7.2135 8.2857 9.3685 10.4622 11.5668 12.6825 13.8093 14.9474 16.0969 17.2579 18.4304 19.6147 20.8109 22.0190 23.2392 24.4716 25.7163 26.9735 28.2432 29.5256 30.8209 32.1291 33.4504 34.7849

2% 1.0000 2.0200 3.0604 4.1216 5.2040 6.3081 7.4343 8.5830 9.7546 10.9497 12.1687 13.4121 14.6803 15.9739 17.2934 18.6393 20.0121 21.4123 22.8406 24.2974 25.7833 27.2990 28.8450 30.4219 32.0303 33.6709 35.3443 37.0512 38.7922 40.5681

3% 1.0000 2.0300 3.0909 4.1836 5.3091 6.4684 7.6625 8.8923 10.1591 11.4639 12.8078 14.1920 15.6178 17.0863 18.5989 20.1569 21.7616 23.4144 25.1169 26.8704 28.6765 30.5368 32.4529 34.4265 36.4593 38.5530 40.7096 42.9309 45.2189 47.5754

1.0000 2.0400 3.1216 4.2465 5.4163 6.6330 7.8983 9.2142 10.5828 12.0061 13.4864 15.0258 16.6268 18.2919 20.0236 21.8245 23.6975 25.6454 27.6712 29.7781 31.9692 34.2480 36.6179 39.0826 41.6459 44.3117 47.0842 49.9676 52.9663 56.0849

4% 1.0000 2.0500 3.1525 4.3101 5.5256 6.8019 8.1420 9.5491 11.0266 12.5779 14.2068 15.9171 17.7130 19.5986 21.5786 23.6575 25.8404 28.1324 30.5390 33.0660 35.7193 38.5052 41.4305 44.5020 47.7271 51.1135 54.6691 58.4026 62.3227 66.4388

5%

F UTURE A MOUNT

6% 1.0000 2.0700 3.2149 4.4399 5.7507 7.1533 8.6540 10.2598 11.9780 13.8164 15.7836 17.8885 20.1406 22.5505 25.1290 27.8881 30.8402 33.9990 37.3790 40.9955 44.8652 49.0057 53.4361 58.1767 63.2490 68.6765 74.4838 80.6977 87.3465 94.4608

7%

Interest Rate

O RDINARY A NNUITY

1.0000 2.0600 3.1836 4.3746 5.6371 6.9753 8.3938 9.8975 11.4913 13.1808 14.9716 16.8699 18.8821 21.0151 23.2760 25.6725 28.2129 30.9057 33.7600 36.7856 39.9927 43.3923 46.9958 50.8156 54.8645 59.1564 63.7058 68.5281 73.6398 79.0582

OF

1

8%

PER

9%

Black process 45.0° 133.0 LPI

10% 1.0000 2.1000 3.3100 4.6410 6.1051 7.7156 9.4872 11.4359 13.5795 15.9374 18.5312 21.3843 24.5227 27.9750 31.7725 35.9497 40.5447 45.5992 51.1591 57.2750 64.0025 71.4027 79.5430 88.4973 98.3471 109.1818 121.0999 134.2099 148.6309 164.4940

11% 1.0000 2.1100 3.3421 4.7097 6.2278 7.9129 9.7833 11.8594 14.1640 16.7220 19.5614 22.7132 26.2116 30.0949 34.4054 39.1899 44.5008 50.3959 56.9395 64.2028 72.2651 81.2143 91.1479 102.1742 114.4133 127.9988 143.0786 159.8173 178.3972 199.0209

12% 1.0000 2.1200 3.3744 4.7793 6.3528 8.1152 10.0890 12.2997 14.7757 17.5487 20.6546 24.1331 28.0291 32.3926 37.2797 42.7533 48.8837 55.7497 63.4397 72.0524 81.6987 92.5026 104.6029 118.1552 133.3339 150.3339 169.3740 190.6989 214.5828 241.3327

13%

1133

1.0000 2.1300 3.4069 4.8498 6.4803 8.3227 10.4047 12.7573 15.4157 18.4197 21.8143 25.6502 29.9847 34.8827 40.4175 46.6717 53.7391 61.7251 70.7494 80.9468 92.4699 105.4910 120.2048 136.8315 155.6196 176.8501 200.8406 227.9499 258.5834 293.1992

Future Amount of Ordinary Annuity of 1 per Period

1.0000 2.0900 3.2781 4.5731 5.9847 7.5233 9.2004 11.0285 13.0210 15.1929 17.5603 20.1407 22.9534 26.0192 29.3609 33.0034 36.9737 41.3013 46.0185 51.1601 56.7645 62.8733 69.5319 76.7898 84.7009 93.3240 102.7231 112.9682 124.1354 136.3075

P ERIOD

1.0000 2.0800 3.2464 4.5061 5.8666 7.3359 8.9228 10.6366 12.4876 14.4866 16.6455 18.9771 21.4953 24.2149 27.1521 30.3243 33.7502 37.4502 41.4463 45.7620 50.4229 55.4568 60.8933 66.7648 73.1059 79.9544 87.3508 95.3388 103.9659 113.2832

OF

Appndx_controllership.fm Page 1133 Wednesday, December 10, 2003 11:14 AM

Appndx_controllership.fm Page 1134 Wednesday, December 10, 2003 11:14 AM

Black process 45.0° 133.0 LPI

00_dummyix.fm Page 1135 Wednesday, December 10, 2003 10:39 AM

INDEX

Acceptable use policy, 844 Access, restricted and controlled, 836 Accounting accounting principles board, 36 benchmarking key practices, 14 electronic transactions, 14 ethics in, 7 function and processes, 5 outsourcing the accounting function, 14, 1035 advantages of outsourcing, 1037–1038 contractual issues in, 1042–1044 costs of, 1044–1046 finding a supplier, 1035–1037 function-specific outsourcing, 1039–1040 management of, 1047–1051 personnel issues, 1046–1047 risks of outsourcing, 1040, 1042 practices, 35 principles and standards, 36–39, 41, 44, 53–54 role of, 5 staff career plan development, 167, 169 motivation, 171 promoting, 163–164 recruiting, 159, 161–163 supervision, 169 turnover, 164–165 turnover reduction, 165 staff activites, 5 standards, 36 systems, 57 tasks of, 3 tax accounting compared with book accounting, 1113 Accounting measures for review partnering, 972–973, 977 process centering, 969 Accounting period interim, 1023 Accounting Principles Board (APB), 36 opinions, 40 Accounting research bulletins (ARBs), 39 Accounting staff, 159 training, 169 Accounting statistical standards, 309 Accounting systems

advanced, 967, 984 computer-integrated manufacturing, 1001, 1004 data collection, 58 tools, 59 data summarization, 60 data warehousing, 984 electronic cash, 980–981 enterprise resource planning (ERP), 819 advantages of, 819 asset base and reporting requirement, 821 asset grouping for reporting purposes, 821 EAM integration, 820–821 fixed-asset module, 819 in service businesses, 492 integrated distribution management, 988, 992 internet, 973–976 ISO 9000, 976–977 just-in-time, 993, 997 manufacturing accounting and cost system, 404, 423 manufacturing resource planning, 985, 988 outputs variances, 80 paperless office, 977–980 partnering, 969, 971, 973 process centering, 967–969 product design, 997, 1001 virtual corporation, the, 982–984 world class, 985, 1004 Accounts payable best practices, 1005–1006 Accounts receivable best practices, 1006 Accumulated earnings tax, 296 Acquisitions and mergers accounting for a business combination, purchase method, 943, 945, 947 acquisition cycle, the, 917, 919 acquisition team, the, 921–922 analysis of the prospect, 922–928 corporate objectives in relation to, 916–917 criteria for, 919–920 critical success factors, 964 differing accounting policies in, 929 diversification, 963–964 divestments, 965 1135

Black process 45.0° 133.0 LPI

00_dummyix.fm Page 1136 Wednesday, December 10, 2003 10:39 AM

1136

Index

Acquisitions and mergers, continued effective integration, 964–965 financial analysis objectives, 928 financial or operating reasons for, 916 history of, 916 information sources of, 920–921 leveraged buyouts, 941–942 management mistakes, 962–963 tax considerations, 947, 949 asset acquisition, 947 financial impact of an acquisition, 949–950 financial report on an acquisition, 950, 953 section 338 transaction, 947 stock acquisition, 948 type A reorganization, 948 type B reorganization, 948 type C reorganization, 949 valuation of the acquisition, 929, 931 appraised value, 932 capitalized earnings (P/E Multiples), 931 comparing values, 938 discounted cash flow, 932, 938 multinational business valuation, 939–940 Activity-based costing (ABC), 427 best practices, 1006 capital investment, impact on, 639 controlling manufacturing expense, 427–428, 440 cost of services, 490 used in budgeting, 449 Adjusted current earnings (ACE), 1113 Almanac of Business and Financial Ratios, 921 Alternative minimum tax (AMT), 1113 American Institute of Certified Public Accountants (AICPA), 36, 38 Accounting Trends & Techniques, 747 document sources, 39 American Institute of Certified Public Accountants (AICPA) Committee on Terminology depreciation defined, 656 Analysis correlation, 342 end use, 344 evaluationg acquisiton prospects, 922, 924–926, 928 expense variances in manufacturing, 449–450 financial analysis in acquisitions and mergers, 928 margin analysis, 719 product line, 344

Black process 45.0° 133.0 LPI

ratios and trend, 110 sales, 334–335 time series, 342 valuation of an acquisition, 929 appraised value, 931 book value, 931 capitalized earnings, 931 comparing valuation methods, 938 discounted cash flow, 932, 938 market value, 931 multinational business valuation, 939 Annual plan advertising budget, 388 budgeting, 234 compared to strategic plan, 212 cost–volume–profit relationship, 256 in service businesses, 493, 497 marketing expense budget, 392 profit planning, 233, 255 Annual report SEC reporting requirements, 773 Annual report to shareholders controller review of trends, 747 FASB requirements, 744 financial statements, 746–747 highlights or summary page, 745, 747 industry specific, 745 letter to shareholders, 746 management’s discussion and analysis, 746–747 New York Stock Exchange requirements, 744 preparation of, 744 purpose of, 744 report of managements responsibilities, 746 review of operations, 746 SEC requirements, 744 supplemental information, 746 Anticipation surveys, 347 Area concentration banking, 542 best practices, 1007 Assets appraisal and appraisal records, 657 depreciation reserve, 658 fixed investment in, 624 loss or gain on, 658 fixed planning and control of, 624–625 fully depreciated, 657 Audits activities, 131 audit committee, 130 control function, 137 internal, 129

00_dummyix.fm Page 1137 Wednesday, December 10, 2003 10:39 AM

Index

inventory systems, 1094 managing the internal audit function, 130, 136–138 objectives, 132–133, 136 reporting relationships, 129 Audits, activities, internal audit, 134 Balanced scorecard reporting best practices, 1007 Bar code scanners, 59 Barron’s, 920 Becker Data Bank, the, 615 Benchmarking, 320 general and administrative expenses, 509 in the planning and control of R&D, 485 Best practices e-commerce security, 851 Best practices to improve functions of the accounting department, 1005, 1020 Bill of materials (BOM), 431 Board of Directors, 116 internal control responsiblitiy, 116 Branding, 86 Break-even, 256 analysis to evaluate a forecast, 269 calculation of, 258 profit planning, and, 256 reporting, 719 Budgeting approval of budget, 246 best practices, 1007, 1009 budgetary control measues, 451 capital assets budget, 239 capital expenditures budget, 243 cash budget, 239 length of budget period, 539 relation to other budgets, 539 communication of budgetary information, 451 control function in, 247 controllers role in, 247, 253 cost of goods sold, 243 direct labor, 241 financial statements, 238 finished goods, 591, 594 flexibility in standards, 453 for control of G&A expenses, 501 general and administrative expenses, 509 indirect labor, 451 inventory budget, 241 management approval of, 253 manufacturing expense budget, 241, 442, 449 operating expense budget, 243 operational budgets, 239

Black process 45.0° 133.0 LPI

1137

other long-term budgets, 239 other working capital budgets, 239 process for the planning and control of R&D expenses, 470, 476 production budget, 240 profit planning, 234 purchases budget, 240 raw materials, 585, 589 sales budget, 239 See also Annual plan work-in-process, 590–591 Business interruption, 1119–1120 Business management defined, 603 Business plan, 188 basic elements of, 191 factors to recognize, 188 framework for, 188 integrated planning structure, 190 plan frequency, 194 sales planning as the basis of, 338–339 Business requirements of the organization, understanding, 824 Business Week, 920 bustup acquisition, 965 Calendars fiscal year, 1021 thirteen month fixed calendar, 1023 thirteen-period year, 1023 Capital asset pricing model (CAPM), 693 Capital budget, 213, 469 budgeting process, 625–626 Capital markets changes in, 182 Cash flows analysis of, 552–553 consolidated statement of, 671 discounted, 277 discounted cash flow (DCF), 932 discounted cash flow methods of valuation, 632, 635 internal rate of return, 935 managing liabilities, 661, 670 planning and control of accelerating cash receipts, 542–543 administration of cash receipts, 542 cash forecasting, 530, 536 controller vs. the treasurer, duties of the, 530 disbursements, 546–549 estimating cash receipts, 536, 539 internal cash receipt procedures, 543

00_dummyix.fm Page 1138 Wednesday, December 10, 2003 10:39 AM

1138

Index

Cash flows, continued internal control, 547–548 internal control of cash receipts, 543 misappropriating cash, methods of, 544, 546 objectives of, 530 present value of future cash flows, 932, 935 reporting, 714 Cash method of accounting, 297 Certifications, 169 certified internal auditor, 169 certified management accountant (CMA), 169 certified production and inventory manager, 169 certified production manager, 169 certified public accountant (CPA), 169 Change management adequacy of motivation, 876–877 adequacy of sponsorship, 874, 876 business environment, 869 changes to technology and business process, 869 clarity of vision, 877–878 competing projects, 871–872 continuous improvement, 33 cost of failure, 873–874 defining the change management challenge, 870 degree of disruption, 873 degree of resistance, 878 executive management practices, 28–30 facilitating, 23, 31 factors of, 870 implementation history, 870–871 implementing CRM, 900–901 mobilizing the organization, 31–32 risks of, 874 Chart of accounts best practices, 1009 Chief Accounting Officers (CAOs) controller as, 11 See also Controller Chief Executive Officer (CEO) investor relations, 181 Chief Financial Officer (CFOs), 605 change management and, 24, 26–27 communication, 28 enlist support of CEO, 30–31 financial agenda, 25–26 financial planning, and, 215 investor relations, 181 tasks of, 24 team building, 27

Black process 45.0° 133.0 LPI

Chief Operating Officer (COO), 8 Closing activities best practices, 1009 Closing period acceleration of, 1024–1025, 1029–1030, 1032 Code of ethics, 7 communication of, 8 judgments by the controller, 9 topics for inclusion in, 8 Collection best practices, 1010 Collection of accounts receivable altered payment methods, 563 collection techniques, 562–563 control of, 559, 568 shrinking the cycle, 564 Collection of accounts receivables measurement of accounts receivable, 564 Commissions best practices, 1010 Committee on Accounting Procedure (CAP), 36 Communications investor relations, 174 staff, 165, 169 financial information, 170 general information, 170 operational information, 170 personal performance information, 170 Compact disc (CD) jukebox for document storage, 977 Company mission, 230 Company organization, 86 Competition benchmarking, 320 global, 324 Competitors, 87 Compound interest, 1127–1128 Computer integrated manufacturing (CIM), 1001 components of, 1001 effects on the accounting system, 1002 performance measurements, 1003 Confidentiality, 833 Contract pension administration outsourcing, 1044 Contract terms database best practices, 1010 Contracts cash management outsourcing, 1043 collections management outsourcing, 1043 internal audit outsourcing, 1043 outsourcing, 1042, 1044 payroll processing outsourcing, 1044

00_dummyix.fm Page 1139 Wednesday, December 10, 2003 10:39 AM

Index

tax return preparation outsourcing, 1044 transaction processing outsourcing, 1044 Control function, 119 accounting/statistical control, 309–310 accounts receivable, 118, 566, 568 benchmarking, 320 cash flows, 118 collection management, 562, 564 collection of accounts payable, 118 customer margin analysis, 561 elimination of controls, 119 employee payroll management, 118 examples of internal controls, 117 expense management, 119 fixed assets, 118 fraud, 121–122 prevention of, 122–124 general and administrative expenses, 499, 510 granting credit to customers, 559–561 inventory, 118 inventory management, 118 investments, 118 manufacturing expenses, 425 marketing expenses, 372 measurement of accounts receivable, 565–566 notes payable, 118 objectives, 116 payroll expenses, 119 performance measures, 318 preplanning manufacturing expense, 449 project risk management, 879 reporting unfavorable trends, 449 resposibility for, 116 revenues, 118 sales analysis, 336 stage-gate system, 485 standards, 311–314 Controller, 11 accounting function, 14 accounts receivable, 568 alternative minimum tax, 1113 business cycle forecasting, 349 compared with treasurer, 530 control function, 13 customer credit level, 561 customer margin analysis, 561 fixed assets, thirteen functions in control and planning of, 624–625 functions in small companies, 14 future role, 19–20 general and administrative expenses, 499 influence on decisions in manufacturing expense budget, 429, 433, 436

Black process 45.0° 133.0 LPI

1139

influence on R&D activities, 485 information security management, 831, 841 inventory valuation duties, 596 job description, 16 manufacturing expense budget, 426, 435, 454 outsourcing the accounting function, 1035– 1037, 1039 request for proposals, 1036 planning and control of sales, 333 planning function, 12 project communication, 887 project risk management, 879 providing timely, accurate financial information, 1021, 1034 R&D budgeting assistance, 477 relationship to CFO, 18–19 reporting function, 13 reporting function in inventory control, 573, 575 role in investment decisions, 605–606 role of, 6 budgeting, 247, 253 in investor relations, 173, 180 in strategic planning, 208, 230 sales forecasting, 331 shareholders equity, 686 supportive facilitating functions in strategic planning, 230–231 Controller division, 869 Corporate development plan, 191 Cost accounting in service businesses, 490 purpose of, 58 storing and allocating costs, 441–442 Cost estimation methods engineering method, 436 judgement method, 436 linear regression method, 439 scattergraph method, 437 Cost of goods sold, 601 Costing methodologies, 57 activity-based See also Activity-based costing (ABC) activity-based costing (ABC), 76 allocation of overhead costs, 77 process flow, 78 system development, 77 direct costing, 61, 71 situations when not recommended, 73 uses for, 72 job, 61–63 labor, 64 overhead allocation, 65

00_dummyix.fm Page 1140 Wednesday, December 10, 2003 10:39 AM

1140

Index

Costing methodologies, continued process costing, 61, 66 process development, 79, 81 project costing taxation strategy, 300 standard costing, 61, 69 factors in creating, 70 manufacturing resources planning, 71 uses for, 70–71 target, 62 target costing, 79 throughput accounting analysis model, 74 priority of orders, 74 throughput costing, 73 Cost-of-service accounting, 490 Costs, 372 employee-related manufacturing costs, 441 equipment-related manufacturing costs, 441 incentives to reduce, 450 indirect production costs, 441 inventory, 597 inventory costs, 572 materials-related manufacturing costs, 441 occupancy-related manufacturing costs, 441 records management system costs, 1079–1080 shared services impact on, 903–905 Cost-volume-profit, 263 See also break-even analysis Cost-volume-profit relationship, 473 Cryptography, 862 Customer credit granting process, 559, 561 margin analysis, 561 Customer credit best practices, 1011 Customer relationship management (CRM) business case for, 900–901 contingency plan, 902 introduction, 899 team building, 901–902 Cyclical indicators, 347 Data collection system payroll, 511 Data warehouses, 818 Debt instruments, 606 Department of Labor (DOL), 614 Development plan integrated planning structure, 190 Digital signatures best practices, 1011 Direct labor, 495

Black process 45.0° 133.0 LPI

Disclosure policy, 178–179 Divestments analysis of, 965 reasons for, 917 Dividends policy and planning, 695, 697 reinvestment programs, 704 Document imaging best practices, 1011 Dow Jones Industrials, 694 e-cash, 980–981 e-commerce, 851 Econometric models, 347 Electronic Data Gathering, Analysis, and Retrieval (EDGAR), 773 Electronic data interchange (EDI), 866 best practices, 1011 Electronic funds transfer best practices, 1012 Electronic pen data entry, 60 Electronic time clocks, 59 Employee Retirement Income Security Act of 1974 (ERISA), 610, 613–615 summary annual report, 617 Enterprise asset management (EAM), 820 Enterprise resources planning (ERP), 1087 Equipment capital expenditure proposals, 627 cost of automation, 639 depreciation, 656 idle equipment, 655–656 lease versus buy, 649 obsolescence, 657 records and recording, 653 Equity securities, 606 Ethics, 133 Executive opinion composites, 343 expense, 499 Expense reporting, automated best practices, 1012 Expenses bad debt, 559–561, 565 expense control report, 730 formulating the expense account structure, 426 manufacturing distinguishing characteristics, 426 planning and control of, 425 Financial Accounting Foundation (FAF), 36 Financial accounting standards advisory council, 36 Financial Accounting Standards Board (FASB), 36, 38, 605, 661, 744

00_dummyix.fm Page 1141 Wednesday, December 10, 2003 10:39 AM

Index

accounting pronouncement process, 36–37 alternative methods of accounting, 466 document sources, 39 interpretations, 44 SEC, 37 software development costs, 468 Statement No. 2, 468 statements of financial accounting, 53 statements of financial accounting concepts, 53 technical bulletins, 37, 56 Statement of cash flows, 539 Financial analyst information needs of, 176, 178 Financial Analysts’ Federation Corporate Information Committee Report, 747 Financial information system (FIS) automated, 779, 795 cost of system, 793 documentation of existing system, 782–783 final selection, 794 RFP distribution, 786, 788 RFP preparation, 785–786 site visit, 793 software packages, advantages of, 780 software testing, 801, 813 analysis test tools, 813 automated test tools, 812 completion of test stage, 812 cost of, 802 defect resolution, 809, 812 development team, 809 high-level test work plan, 807 importance of, 801–802 packaged systems, 802 performance test tools, 813 resource requirements, 807–808 roles and responsibilities, 808 software, 808 test execution, 806–807 test management process, 809 test stages, 804, 806 test team, 808 testing strategy, 803 user team, 809 system requirements, defining, 780, 782 testing the system, 797 issue tracking and resolution, 799 participants, 800 real versus mock testing data, 798 security testing, 799 sign off criteria, 799–800 testing duration, 797

Black process 45.0° 133.0 LPI

1141

testing scenarios, 798 volume testing, 799 vendor contract negotiation, 794 vendor demonstrations, 792 vendor evaluation criteria, 794 vendor proposal, review of, 788, 792 vendor review, reference calls, 792 Financial statements, 238 accounting treatment of research and development costs, 466 balance sheet, 752 basic, 238 compressing the closing schedule, 1026–1029 consolidated balance sheets, 671 consolidated income statement, 751 consolidated statement of cash flows, 671 consolidated statements of income and retained earnings, 671 daily financial statement, 714 fast closing schedule, 1029–1033 interim reports, 1025 reconciling accuracy against a fast closing schedule, 1033–1034 statement of cash flows, 753 statement of estimated financial condition, 245 statement of estimated income and expense, 243 statement of financial position, 751 statement of income and expense, 271 statement of shareholders equity, 754 status reports, 714 supporting documents, 239 Fiscal year selection of, 1021 Forbes, 920 Forecasting business cycle, the, 345 cash forecasting, 530–531 information sources, 344 judgmental methods, 342 mathematical statistical methods, 342 methods, 347 reporting on accuracy of cash forecast, 719 sales, 341 Foreign Corrupt Practices Act, 126, 158 Fortune, 920 Fraud dealing with a fraud situation, 125 detection, 123 prevention, 122, 543 SEC prohibition of, 762, 764 types of, 121

00_dummyix.fm Page 1142 Wednesday, December 10, 2003 10:39 AM

1142

Index

General and administrative expenses (G&A), 499 budgeting, 509–510 components of, 499–500 control over, 500, 505 reducing, 505, 509 General ledger, use as a data warehouse best practices, 1012 Generally accepted accounting principles (GAAP), 38, 596 document sources, 39 enterprise resource planning, 819 impact on capital budget, 641, 644 shareholders equity, 686 Globalization, 139 accounting requirements of, 146 changing nature of international trade, 140 communications, open, 147 data requirements, uniform, 148 exchange rates, 152–153 import/export regulations, 157 Foreign Corrupt Practices Act, 158 managing currency risk, 157 measuring foreign operations, 149 multinational business valuation, 939 political risks, 153 transfer pricing, 154–155, 157 Goals, 87 Government Accounting Standards Board (GASB), 37–38 Gross margin, 72 Gross national product (GNP), 344 Growth managing, 20–22 Hacker attack, 833 Hardware or software failure, 833 Hurdle rate See also capital budget Hurdle rates cost of capital, 637 multiple, 637 single rate, 636 value of, 636 Independent auditor, 117 Industrial Research Institute, Inc., 471 Inflation, 638 Information technology (IT), 869 support models, 815 complicated systems architecture, 817 documentation, 818 geographic challenges, 816 inadequately trained users, 815

Black process 45.0° 133.0 LPI

management reporting requirments, 818 mixed skill sets, 816 month-end close support, 816 multilevel support model, 817 staff retention, 816 Institute of management accounting (IMA), 466 Integrated distribution management (IDM), 988 componenets of, 988 effects on the accounting system, 989 performance measurements, 991 Integrity, 834 Interest rate analyses, 1127 Interest tables, 1127 Interim reports bombproofing, 1025 exception reporting, 1025 pitfalls of, 1025 selecting the number of interim reporting periods, 1022 value of, 1024 Internal audit staff, 117 Internal controls capital investments, 655, 658 in research and development, 469 management of liabilities, 674 Internal Revenue Code (IRC), 600, 610 Internal Revenue Service (IRS), 1022, 1111 International Accounting Standards Board (IASB), 38 Internet site accounting control point implementation, 974 implementation issues affecting accounting department, 974 Intrusion, 833 Inventory, 241, 1089 best practices, 1012–1013 budgeting for finished goods, 591, 594 budgeting for raw materials, 585, 589 budgeting for work-in-process, 590–591 controller reporting function in, 573, 575 costs and benefits of carrying inventory, 571, 573 inventory cutoff, 584–585 just-in-time, 668 material just-in-time manufacturing systems, 576, 580 material requirements planning systems, 575–576 obsolete inventory, 581, 583, 1100–1101 periodic count, 1090 periodic versus perpetual valuation systems, 1089

00_dummyix.fm Page 1143 Wednesday, December 10, 2003 10:39 AM

Index

perpetual inventory system auditing and measuring, 1094–1095 benefits of, 1090 physical inventory complications, 1098 physical inventory procedure, 1095–1096, 1098 system setup, 1091, 1093–1094 reconciling inventory variances, 1099–1100 reducing inventory, 583–584 reduction of during economic contraction, 346 reordering systems, 580–581 tracking problems, 1101–1103 valuation consistency in, 600 cost base, departure from, 599 cost base, selection of, 598–599 cost basis, 596 inbound transportation costs, 602 interim statements, 601 overhead and burden, 602 purchasing department expense, 601 reserves, 602 responsibility for, 596 significance of, 595–596 storage and handling costs, 601 tax considerations, 600–601 valuation base, 597 valuation and tax strategy, 297 Inventory management, 571 Inventory valuation, 71, 73 Investments accounting and disclosure requirements for employee benefit plans, 609–610 capital, 213 capital assets, 624 capital expenditures accounting control of, 648 activity-based costing, 639 board of directors appproval, 641 budgeting, 625–626 classifying and ranking proposed capital projects, 639, 641 controller, 624–625 cost of capital, 637 evaluating projects, methods of, 628, 635 foreign investments, 638 GAAP, 641 hurdle rates, 636, 638 impact of, 623–624 inflation, 638 information gathering to support proposals, 628 information supporting, 627–628

Black process 45.0° 133.0 LPI

1143

lease versus buy decisions, 649 limit of, 626–627 manufacturing environment, new, 639 mutually exclusive capital proposals, 652–653 postproject appraisals or audits, 648–649 project authorization, 645 project evaluation, 627–630, 632, 635 working capital, 649 controller’s role in, 624 controls, 557 criteria for selecting, 555 decision process, 604 financial accounting records for, 606 financial accounting standards, 604–605 financial reports on, 609 instruments for, 555 inventory, 1089 reports to management, 557 restrictions, 555 short-term funds, 555, 557 valuation of, 632, 635 Investor relations (IR), 173 activities, 173 communications, 175 evolving nature of, 174 management of, 182–183 objectives of, 174 structure for, 179–180 Investors, 175 Invoicing best practices, 1013–1014 ISO 9000, 976 Journal entries, automated recurring best practices, 1014 Just-in-time (JIT), 993 components of, 993 cost reporting, 405–406 effects on the accounting system, 994 manufacturing systems, 576, 580 performance measurements, 996 production techniques, 316 Key relationships, 215 Labor relations, 87 Liabilities benefits from debt incrrence, 669 bond ratings, 670 contingent, 671–672 corrective action, 668

00_dummyix.fm Page 1144 Wednesday, December 10, 2003 10:39 AM

1144

Index

Liabilities, continued credit agreements, illustrative provisions of, 662, 666 debt, risks of too much, 668 defined, 659–660 direct, 660–662 current, 660 long-term, 661 information on debt capacity, sources of, 669 leverage, 671 long-range financial plan, 672 managing, 672–673 objectives of liability management, 660 planning the current, 666–667 reports, 673–674 standards for debt capacity, 669–670 standards to measure and control current, 667 LIFO inventory method, 601 Lockbox collections best practices, 1014 Lockbox system, 542 Lower of cost or market defined, 600 Management equity, of shareholders, 685 internal reports, 711 rules of reporting, 711 liabilities, 659, 674 mistakes in aquisitions, 962 shareholders equity, 688 Management systems, 985 computer-integrated manufacturing, 1001 integrated distribution management, 988 just-in-time, 993 manufacturing resource planning, 985 product design, 997 Management team, 87 Manuals accounting manuals, 1053 creating procedures manuals, 1054, 1056–1057 suggested procedures, 1057–1059 distribution list creation and maintenance, 1063–1064 electronic, 1075 advanced indexing features, 1072–1073 basic form, 1069 benefits of, 1066–1067 built-in help features, 1073–1074 disadvantages of, 1068–1069 hypertext features, 1069–1071 maintenance of, 1077

Black process 45.0° 133.0 LPI

PDF documents, 1076–1077 writing for, 1074–1075 maintenance of manuals, 1059 responsibility for, 1060 specifications for, 1060 master copy creation and storage, 1062–1063 physical construction of, 1061–1062 physical distribution process, 1064–1066 retrieval of, 1066 Manufacturing, 425 allocating indirect production costs, 440, 442 batch size cost factors in cost control, 432 control of indirect labor cost, 451 cost center determination, 427 cost control through variance analysis, 439–440 cost estimation methods, 436–438 direct labor cost factors in cost control, 431 expenses, 425 control of cost elements, 427 departmentalization of expenses, 427 responsibitlity for, 426 fixed and variable cost factors in cost control, 428–429 fixed costs committed costs, 436 discretionary costs, 435 programmable costs, 435 JIT techniques and manufacturing expenses, 426, 446, 456 overhead factors in cost control, 433–435 planning and control of costs direct material costs, 408, 412 general aspects of manufacturing, 403–404 labor costs, 416, 423 manufacturing cost accounting, 404–405 manufacturing cost analysis, 406–407 manufacturing management problems, 405–406 types of cost systems, 407 standards to aid cost control, 427 time factors in cost control, 435 Manufacturing resource planning (MRP II), 985 components of, 986 effects on the accounting system, 986 performance measurements, 987 Marketing, 371 expenses, 371 planning and control of expenses, 372 advertising and sales promotion, 392, 397 analysis purpose and methods of, 374, 386

00_dummyix.fm Page 1145 Wednesday, December 10, 2003 10:39 AM

Index

application, analysis by manner of, 375, 377 basic approach, 373 contribution margin approach, 376–377 control of expenses, 397 customer, analysis by, 380, 382 planning marketing expenses, 386 size of order, analysis by, 382, 384 standards, 397, 402 territory, analysis by, 377 Marketplace, 87 Mergers and acquisitions, 297 taxation strategy, and, 297 Monopoly situations, 87 Moody’s Manuals, 921 National business publications Business Week, 471 Fortune, 471 Planning Review, 471 Natural business year, 1021 advantages of as the fiscal year, 1022 Net operating loss carryforwards, 298 See also taxation strategy New employees payroll setup, 511 New market activities, 88 Nondisclosure agreement, 836 Nonexempt employees, 511 Operating budget R&D, 472 Operations plan, 191 integrated planning structure, 190 Outsourcing accounts payable check printing, 1036 advantages of, 1037–1038 best practices, 1014–1015 cash management, 1039–1040 collections, 1036, 1039, 1041 contractual issues, 1043–1044 financial statement preparation, 1039, 1041 internal audit, 1039, 1041 payroll, 1036 payroll processing, 1039 pension plan administration, 1039 suppliers of accounting functions, 1035 tax return preparation, 1040–1041 taxation and internal auditing, 1036 transaction processing, 1036, 1040 Paper-based data entry, 60

Black process 45.0° 133.0 LPI

1145

Paperless office implementation issues affecting accounting, 978 Partnering accounting control points in, 971 accounting errors in, 971 accounting systems in, 969 electronic data interchange (EDI), 969, 972 implementation issues affecting accounting, 970 wire transfers in, 970 Payments best practices, 1015 Payroll, 511 best practices, 1015, 1018 compensation, 513 deductions, 511–512 child support, 520 unpaid taxes, 520–521 frequency of payment, 513 internal management reports, 730 steps for processing, 511 taxes employees working abroad, 518 federal income, 515, 517 Medicare, 517 remitting federal taxes, 519–520 Social Security, 517 state income, 518 termination payments, 514 unemployment insurance, 521, 523 work week, 513 Pension Benefit Guaranty Corporation, 614 Performance management performance improvement projects, 879 systems performance management, 823 components of performance, 827–828 controllership role in planning for, 824–825 importance to controller, 823 ongoing process of, 823–824 organizational flow of performance information, 828–829 six essential steps, 825, 827 Performance measurement amount of inventory investment, 991 average percentage of order lines filled on first shipment, 992 BOM accuracy, 987, 997 breakeven level, 1003 breakeven time, 1000 cell output, 997 committed delivery date compliance, 992

00_dummyix.fm Page 1146 Wednesday, December 10, 2003 10:39 AM

1146

Index

Performance measurement, continued cost of design team, 1000 cost of scrap, 996 cost of transportation per order, 991 cost of warehousing per order, 992 customer returns, 997 debt-equity ratio, 1004 defective parts per million, 997 degree of conformance to specifications, 1001 delivery performance, 996 facility efficiency, 992 floor space utilization, 997 inventory accuracy, 987, 992 inventory turnover, 1003 inventory turns, 991 investment in the design process, 1000 labor-routing accuracy, 987 manufacturing resource planning, 987 materials cost, 996 number of delivery releases with full lead time, 988 number of design projects per product team, 1001 number of design revisions after release to production, 1000 number of engineering changes in first year after introduction, 1001 number of iterations of the design cycle, 1000 number of new products per year versus number of new competitors’ products, 1000 number of schedule changes, 988 overhead rate, 1004 production backlog, 996 production plan performance, 988 proportion of back orders, 992 proportion of damaged goods, 992 proportion of drawings created on paper, 1000 proportion of maintenance staff to direct labor staff, 1004 proportion of new parts used on a new product, 1000 proportion of products completed on time, 1001 size of purchasing staff, 1004 square footage utilized, 1004 supplier delivery performance, 988, 997 total cycle time, 992, 1004 trend in sales volume, 1000 trend in unit cost, 1000 value added by cell per employee, 996 work-in-process inventory, 996

Black process 45.0° 133.0 LPI

Performance measures, 318 See also benchmarking Petty cash funds See Cash flows Planning See Business plan; Annual plan; Development plan; Operations plan; Planning process; Profit planning; Strategic plan Planning process, 195 alternative scenario development, 196 control of expenditures, 236 coordination of, 235 near-term plan development, 339 plan guidelines, 194 planning cycle illustrated, 237 profit planning, 234, 255 research and development budget, 470 sales management, 333 statistical techniques for, 272, 277, 281 timetables and scheduling, 196 twelve steps, 192 waste prevention, 236 Plants (physical facilities) capacity reports, 728 records and recording, 653, 655 Policies and procedures, 88 enforcing information system security, 843, 849 information security management, 839 physical inventory procedure, 1095–1098 records and records management, 1080–1082, 1084 risk management, 1117–1118 buildings and equipment, 1119 business interruption, 1119 insurance, 1120–1121 liabilities to other parties, 1119 locate risk areas, 1118 risk reduction method, 1119 See also Manuals Portable document format (PDF), 1076 Process centering, 967, 969 accounting control point implementation, 968 accounting errors, 968 accounting functions in, 968 accounting staff, reduction of, 968 implementation issues affecting accounting, 967 Product design process, 997 components of, 997 effects on the accounting system, 998 performance measurements, 999

00_dummyix.fm Page 1147 Wednesday, December 10, 2003 10:39 AM

Index

Product pricing, 88 Profit planning analysis in, 255 definition of, 233 elements of, 233 sales revenue, 258 Profit supportive financial statements, 238 Project communications campaign definition, 891, 895 introduction, 887–888 plans, 895, 897 principles, 889 program overview, 888 strategy, 888–889 Project management implementing CRM, 901 Project risk management See Risk Management Property taxes, 301 taxation strategy and, 301 Punch clocks, 59 Purchasing best practices, 1018 Quality Assurance Institute, 803 Quality standards ISO 9000, 976 Ratios, 85 accounts receivable, 564 and trend lines, 86 balance sheet measurements, 90, 94 accounts payable turnover, 93 current ratio, 91, 667 debt to equity, 90 depreciation to fixed assets, 93 earnings per share, 688 economic value added (EVA), 93 fixed-asset turnover, 93 growth, 94–95 growth measurements, 95 market value added (MVA), 94 quick ratio, 92, 667 repairs and maintenance expense to fixed assets, 93 retained earnings to capital, 93 return on assets, 91 return on equity related to growth in earnings per share, 687 return on shareholder equity, 91 sales to accounts receivable, 92 working capital productivity, 94 cash flow, 96–97

Black process 45.0° 133.0 LPI

1147

adequacy, 96 dividend payout ratio, 96 long-term debt repayment, 96 operating, 97 return on assets, 96 to sales, 96 current debt to inventory, 668 current debt to net worth, 668 customer service measurements, 99–100 customer turnover, 99 number of custmer complaints, 100 response time to customer complaints, 100 cycle time measurements, 110 distribution measurements, 100 average delivery time, 100 percentage of on-time deliveries, 100 percentage of products damaged in transit, 101 engineering measurements, 101, 103 bill of material (BOM) accuracy, 101 number of patent applications filed, 102 percentage of new parts used on products, 102 percentage of new products introduced in the period, 102 percentage of products reaching market before competition, 102 percentage of released designs matching target costs, 102 percentage of sales from new products, 102 time from design inception to production, 102 fixed assets to net worth, 627 human resources measurements, 103, 105 average time to fill requested positions, 103 average yearly wage per employee, 103 employee turnover rate, 104 indirect to direct personnel ratio, 104 minorities percentage, 104 percentage of employees with certifications, 104 ratio of fringe benefits to direct labor, 104 trend of headcount, 104 marginal income ratio, 262 materials management measurements, 105, 107 inventory accuracy, 105 inventory turnover, 105 number of suppliers used by commodity code, 106 obsolete inventory percentage, 106 percentage of on-time part deliveries, 106

00_dummyix.fm Page 1148 Wednesday, December 10, 2003 10:39 AM

1148

Index

Ratios, continued percentage of suppliers using electronic data interchange, 106 total number of components, 106 minimum net working capital, 667 nonfinancial performance measurements, 97, 99 average collection period, 98 percentage of accounts receivable, 98 ratio of purchase discounts to total purchases, 98 time to produce financial statements, 98 transaction error rate, 98 transactions processed per person, 99 number of days payables on hand, 668 payout ratio, 687 percent return on net sales, 474 production measurements, 106, 108 average equipment setup time, 107 percentage of acceptable products completed, 107 percentage of scrap, 107 unit of output per employee hour, 107 work-in-process (WIP) turnover, 108 profitability measurements, 88 break-even point, 89 number of times interest is earned, 89 operating margins by division, segment, product line, 89 overhead rate, 89 percentage return on net sales, 90 sales returns and allowances to gross sales, 90 sales/profits per person, 90 relationships between, 110–111 return on assets, 473 sales and marketing measurements, 108–109 backlog to sales, 109 market share, 108 number of major accounts for which the company is the preferred supplier, 109 sales trend by product line, 109 turnover of plant and equipment, 627 uses of, 85 Records management computer-based, 1086–1087 costs of, 1079–1080 policies and procedures, 1080–1082, 1084 responsibility for, 1079 tax accounting compared with book accounting, 1113 tax classification of accounts, 1114

Black process 45.0° 133.0 LPI

tax record requirements, 1084, 1086 tax records, 1109 tax calendar, 1110 tax information records, 1110–1111 working papers and files, 1111 tax requirements, 1111 treatment of record differences between tax accounting and book accounting, 1113–1114 Recruiting methods, 88 Reporting accurate, 713 best practices, 1019 cost effective reports, 713 importance of commentary, 712 information technology support, 818 internal management payroll reports, 730 internal management reports capacity reports, 728, 730 cash reports, 719 introduction, 711 margin reports, 714, 719 payroll, 730 rules of reporting, 711, 713 sales and expense reports, 730 status reports, 714 key function of SEC, 761 out-of-the-ordinary revenues and expenses, 711 risk management report, 1125 SEC reporting requirements, 764–765, 768, 775 Form 10-K, 769 Form 10-Q, 769 Form 10-SB, 768 Form 8-K, 769 Form S-1, 770 Form S-2, 770 Form S-3, 770 Form S-4, 770 Form SB-2, 768 Schedule 13E-3, 775 seven primary SEC reporting forms, 771 simple and clear, 712 special tax reports, 1115 standardized, 713 tailored to audience, 712 timely, 713 trends, 712 types of reports, 737 usefulness, 713 Reporting relationships, 129

00_dummyix.fm Page 1149 Wednesday, December 10, 2003 10:39 AM

Index

Research and development (R&D), 463 accounting treatment in financial statements, 466 categorization of R&D costs, 468 determing the total budget, 470 determining the effectiveness of the R&D effort, 481, 485 elements of R&D costs, 468 excludable expenses, 469 impact on corporate earnings, 464 information sources on R&D spending, 471 integration with other functions, 465 operating budgets, 472 organization of financial functions, 466 project risk, 475 project selection, 472 quantitative techniques for evaluation of, 473 relation to corporate objectives, 464 role of the financial executive, 469 system focus, 465 Rich Text Format (RTF), 1076 Risk analysis, 214 forgery, impersonation, falsification, 865 information security, 834 inventory valuation, 597 R&D, 475 Risk management, 1117 annual risk management report, 1125 insurance claims administration, 1123–1124 insurance companies, 1122–1123 insurance coverage, 1121 insurance files, 1124–1125 introduction, 1117 manager of risk management, 1121–1122 performance improvement projects, 879 policies, 1117–1118 procedures, 1118–1121 project risk management, 879 address key risks, 884 approach, 881 assigning risk owners, 884 evaluating relevant risks, 883 identifying relevant risks, 882 manage and track risks, 885 project risk categories, 880 revisit project plan, 885 S corporation, 301 Sales budget, 340 forecasting, 341 plan, 340 quotas, 352–354

Black process 45.0° 133.0 LPI

1149

reports, 354 Sales analysis deductions from sales, 336 Sales management function analytical statements for, 332 benchmarking, 352 budgets and quotas, 332 controller’s role in, 331 distribution problems, 331 expense budgets and standards, 332 forecasting variables, 330 in service businesses, 493 internal management reports sales and expense reports, 730 marginal cost method effect on pricing, 365 market share, 344 organization problems, 332 periodic income and expense statements, 332 planning and control problems, 332 price problems, 331 product pricing policy, 355, 358 product problems, 331 return-on-assets-employed effect on pricing, 366 sales forecasting, 341 sales method problems, 332 sales reports, 354–355 sales standards, 350, 352 total cost method effect on pricing, 363 Sales volumes customer margins, 561 Salomon Smith Barney Index, the, 615 Securities and Exchange Commission (SEC), 126, 471 creation of, 761–762 EDGAR, 773, 775 antivirus measures, 774 errors in file submission, 774 exemption from making electronic submissions, 774 EDGAR filing manual, 775 form 10-K, 471 forms, 769, 773 going private transactions, 775 Investment Advisors Act of 1940, 764 Investment Company Act of 1940, 764 Public Utility Holding Company Act of 1935, 763 Regulation FD, 768–769 Regulation S-B, 768 Regulation S-K, 767–768 Regulation S-X, 764, 767 Securities Act of 1933, 762 Securities Act of 1934, 762–763

00_dummyix.fm Page 1150 Wednesday, December 10, 2003 10:39 AM

1150

Index

Securities and Exchange Commission (SEC), cont. shareholders equity, 686 Trust Indenture Act of 1939, 763–764 Security management digital signatures, 861 cryptography, 862–863 demand for digital signature technology, 866–867 digital certificates, 864–865 forgery, impersonation, falsification, 865 legal issues, 867–868 e-commerce best practices, 851 critical security measures, 854, 859 system architecture, 851–853 information security, 831 basic security principles, 833–834 client-server systems, 840 corporate spending on, 832 defining, 832 effective security program components, 834, 840 encryption techniques, 840 interconnected customer and vendor systems, 840–841 networks and the internet, 840 risk driven security approach, 834 role of the controller, 841 threats to security, 832–833 information system security components of enforceable policy, 843 policies and procedure, 843, 845 threat of prosecution, 843 role of the controller in decision making, 831 Senior management internal control responsibility, 116 Service businesses, 487 actvity-based costing in, 490 cost accounting in, 490, 492 cost of services, 490 essential analyses in, 487–488 exceptions to manufacturing costing techniques in, 490 organization of, 488 planning system, 492 schedule of accounts structure for, 489 strategic planning in, 498 Service level agreements (SLAs), 909 Setting, 110 Shared services as strategic path to operational effectiveness, 903 business case for shared services, 905–906

Black process 45.0° 133.0 LPI

customer relations, 908 Deloitte Consulting survey, 904 highlights of, 904 structure of the survey, 904 implementation of, 906–907 operations, 908 results of survey, 904, 911 service level agreements (SLAs), 909 synergies achieved, 903 Shareholders equity controller, the, 686–687 cost of capital, 688, 690–691 cost of debt, 691–692 cost of equity, 692 dividend policy, 695, 697, 704 growth in earnings per share, 688 growth of equity as a source of capital, 687 importance of, 686 return on, 687–688 weighted cost of capital, 694–695 Shareholders, reports to annual report contents of, 744, 747, 754 preparation of, 744 purpose of, 744 controller, 743 importance of form, 757–758 management’s responsibilities, 755, 757 quarterly report, 759 security analysts and investment advisors, 759–760 standardization, 758 Signature plate best practices, 1019 Simple interest table, 1127 Standard & Poor’s 500, 694 Standard & Poor’s Index of 500 Stocks, the, 615 Standard & Poor’s Industry Surveys, 920 Standard & Poor’s Stock Reports, 921 Standards accounting/statistical, 311 as cost control, 312 electronic data interchange (EDI), 866 ISO 9000, 976–977 managerial control of business functions, 314 manufacturing, 412, 414 determing normal activity, 440 performance, 313 performance standards, 480 planning and control of manufacturing costs, 426–427, 442, 449 secure electronic transaction (SET), 867 standards of care for information, 837

00_dummyix.fm Page 1151 Wednesday, December 10, 2003 10:39 AM

1151

Index

State government payroll periods, 514 tax issues income taxes, 518 unemployment taxes, 521, 523 termination payments, 514 Statements of Financial Accounting Standards (SFASs) SFAS No. 115, 605 Statistical process control (SPC), 324 Stocks accounting treatment of stock dividends, 704 preferred, 692 records and recording, 706–707 repurchase of common shares, 706 stock splits, 704 Strategic business unit (SBU), 212 plan, 212 Strategic plan, 187, 190, 211, 213 business mission or purpose, 200 components of, 190 consolidation and testing, 216 critical success factors, 199 developing strategies, 205 environmental analysis, 198 financial content of, 216 financial exhibits in, 217, 230 improving the process, 210 in-depth review of, 196 in-service businesses, 498 integrated planning structure, 190 long-range planning, 189 objectives, 202 planning period, 208 role of the controller, 208 System focus, 465 Target costing best practices, 1019 Tax Reform Act of 1986 (TRA), 1113 Taxation strategy accelerated deductions, 295 accumulated earnings tax, 296 acquisition and merger considerations, 947, 949 available tax credits, 295 cash method of accounting, 297 income taxes and business planning, 1115 inventory valuation, 297 mergers and acquisitions, 297–298

Black process 45.0° 133.0 LPI

net operating loss carryforwards, 298–299 nexus, 299–300 nonallowable expense avoidance, 296 passive activity losses, 300 project costing, 300–301 property taxes, 301 S corporations, 301 sales and use taxes, 302 tax-exempt income, 296 transfer pricing, 301, 303, 305 unemployment taxes, 305 Taxes, 1114 Technology automated financial information system choosing, 779, 795 testing strategies, 797, 800 cash management and, 554 computer-based record keeping, 1086 electric invoice delivery, 564 enterprise resource planning (ERP), 819 inventory tracking software, 1091–1092 IT support, 815 relational database management systems, 819 systems performance management, 823, 829 See also Security management Terminal data entry, 60 Throughput accounting, 61 Time clock best practices, 1019 Time series analysis, 342 Time series models, 347 Total quality management (TQM), 324 Training, 88 Treasury regulations Section 1.471.2, 600 Trend, 85, 449 insurance coverage, 1121 monitoring and reporting R&D, 477 Type A reorganization, 948 Type B reorganization, 948 Type C reorganization, 949 Vacation accruals, automatic best practices, 1020 Valuation of an acquisition, 929, 940 Variance analysis, reduced best practices, 1020 Viruses and trojan horses, 833 Wall Street Journal, the, 920 Workers’ compensation, 1121