THE INTERNAL AUDIT

Overview:
 This chapter focuses on identifying and evaluating a firm’s strength and weaknesses in the functional areas of
business, including management, marketing, finance, accounting, production/operations, research and
development (R&D), and management information systems (MIS).

The Nature of an Internal Audit

 All organizations have strengths and weaknesses in the functional areas of business. No enterprise is equally
strong or weak in all areas.
 Internal strengths and weaknesses, coupled with external opportunities and threats and clear vision and
mission statements, provide the basis for establishing objectives and strategies.
**exemplary company showcased**
**a comprehensive strategic-management model**

Key Internal Forces

 Strategic planning must include a detailed assessment of how the firm is doing in all internal areas. A
complete internal assessment is vital to help a firm formulate, implement, and evaluate strategies to enable
it to gain and sustain competitive advantages.
 For different types of organizations, such as hospitals, universities, and government agencies, the functional
business areas differ.
**the process of gaining competitive advantage in a firm**
 Strengths that cannot be easily matched or imitated by competitors are called distinctive competencies.
 Strategies are designed in part to improve on a firm’s weaknesses, turning them into strengths—and maybe
even into distinctive competencies.

The Process of Performing an Internal Audit

 Representative managers and employees from throughout the firm need to be involved in determining a
firm’s strengths and weaknesses.
 The process of performing an internal audit provides more opportunity for participants to understand how
their jobs, departments, and divisions fit into the whole organization. Thus, performing an internal audit is an
excellent vehicle or forum for improving the process of communication in an organization.
 Strategic planning is most successful when managers and employees from all functional areas work together
to provide ideas and information.
 Knowledge of these relationships is critical for effectively establishing objectives and strategies.

The Resource-Based View

 The resource-based view (RBV) approach to competitive advantage contends that internal resources are
more important for a firm than external factors in achieving and sustaining competitive advantage.
 Proponents of the RBV theory contend that organizational performance will primarily be determined by
internal resources that can be grouped into three all-encompassing categories:
1. Physical resources – all plant and equipment, location, technology, raw materials, and machines;
2. Human resources – all employees, training, experience, intelligence, knowledge, skills, and abilities; and
3. Organizational resources – firm structure, planning processes, information systems, patents, trademarks,
copyrights, databases, and so on.
 A firm’s resources can be:
1. Tangible – labor, capital, land; resources that can more easily be bought and sold.
2. Intangible – culture, reputation, intellectual property; often more important for gaining and sustaining
competitive advantage.
 The theory asserts that it is advantageous for a firm to pursue a strategy that is not currently being
implemented by any competing firm.
 Empirical indicators – resources that enable a firm to implement strategies that improve its efficiency and
effectiveness and lead to a sustainable competitive advantage. These are:
1. Rare
2. Hard to imitate
3. Not easily substitutable

Integrating Strategy and Culture

 Organizational culture is “a pattern of behavior that has been developed by an organization as it learns to
cope with its problem of external adaptation and internal integration, and that has worked well enough to be
considered valid and to be taught to new members as the correct way to perceive, think, and feel.”
 Organizational culture captures the subtle, elusive, and largely unconscious forces that shape a workplace.
 Cultural products include values, beliefs, rituals, myths, sagas, language, symbols, and folktales. These
products or dimensions are levers that strategists can use to influence and direct strategy formulation,
implementation, and evaluation activities.
 An organization’s culture compares to an individual’s personality in the sense that no two organizations have
the same culture and no two individuals have the same personality.
 Culture is an aspect of an organization that can no longer be taken for granted in performing an internal
strategic-management audit, because culture and strategy must work together.
 Organizational culture significantly affects business decisions and must therefore be evaluated during an
internal strategic-management audit.
 The challenge of strategic management today is to bring about the changes in organizational culture and
individual mind-sets that are needed to support the formulation, implementation, and evaluation of
strategies.
 Management
 The functions of management consist of five basic activities: planning, organizing, motivating, staffing, and
controlling. These activities must be examined in strategic planning because an organization should
continually capitalize on its strengths and improve on its weaknesses in these five areas.

Planning
 Planning is the process by which a person (1) determines whether to attempt a task, (2) works out the most
effective way of reaching desired objectives, and (3) prepares to over come unexpected difficulties with
adequate resources.
 It helps a firm achieve maximum effect from a given effort. It also enables a firm to take into account relevant
factors and focus on the critical ones.
 It allows an organization to identify and take advantage of external opportunities as well as minimize the
impact of external threats.
 An organization can develop synergy through planning. Synergy exists when everyone pulls together as a
team that knows what it wants to achieve.
 Planning allows a firm to adapt to changing markets and thus shape its destiny.

Organizing
 The purpose of organizing is to achieve coordinated effort by defining task and authority relationships.
Organizing means determining who does what and who reports to whom.
 The organizing function of management can be viewed as consisting of three sequential activities:
1. Breaking down tasks (work specialization) into jobs requires the development of job descriptions and job
specifications.
2. Combining jobs to form departments (departmentalization) results in an organizational structure, span
of control, and a chain of command.
3. Delegating authority is an important organizing activity, as evidenced in the old saying, “You can tell how
good a manager is by observing how his or her department functions when he or she isn’t there.”

Motivating
 Motivating is the process of influencing people to accomplish specific objectives, it explains why some people
work hard and others do not.
 The motivating function of management includes at least four major components:
1. Leadership – when managers and employees of a firm strive to achieve high levels of productivity, this
indicates that the firm’s strategists are good leaders.
2. Group dynamics – democratic behavior on the part of leaders results in more positive attitudes toward
change and higher productivity than does autocratic behavior.
3. Communication – good two-way communication is vital for gaining support for departmental and
divisional objectives and policies.
4. Organizational change

Staffing
 The management function of staffing, or human resource (HR) management, includes activities such as
recruiting, interviewing, selecting, training, developing, evaluating, promoting, transferring, and dismissing
employees, as well as managing union relations.
 The complexity and importance of HR activities have increased to such a degree that all but the smallest
organizations generally have a full-time human resource manager.
 The HR department coordinates staffing decisions in the firm so that an organization as a whole meets legal
requirements. This department also provides needed consistency in administering company rules, wages,
policies, and employee benefits as well as collective bargaining with unions.
Controlling
 The controlling function of management includes all of those activities undertaken to ensure that actual
operations conform to planned operations.
 All managers in an organization have controlling responsibilities.
 Controlling consists of four basic steps:
1. Establishing performance standards
2. Measuring individual and organizational performance
3. Comparing actual performance to planned performance standards
4. Taking corrective actions
 Measuring individual performance is often conducted ineffectively or not at all in organizations. An
organization should examine various methods, such as the graphic rating scale and then develop or select a
performance-appraisal approach that best suits the firm’s needs.

Marketing
 Marketing can be described as the process of defining, anticipating, creating, and fulfilling customers’ needs
and wants for products and services.

Customer Analysis
 Customer analysis—the examination and evaluation of consumer needs, desires, and wants—involves
administering customer surveys, analyzing consumer information, evaluating market positioning strategies,
developing customer profiles, and determining optimal market segmentation strategies.

Selling Products and Services

 Successful strategy implementation generally rests on the ability of an organization to sell some product or
service.
 Selling includes many marketing activities, such as advertising, sales promotion, publicity, personal selling,
sales force management, customer relations, and dealer relations.
 Personal selling is most important for industrial goods companies, whereas advertising is most important for
consumer goods companies.

Product and Service Planning

 Product and service planning includes activities such as test marketing; product and brand positioning;
devising warranties; packaging; determining product options, features, style, and quality; deleting old
products; and providing for customer service. Product and service planning is particularly important when a
company is pursuing product development or diversification.
 One of the most effective product and service planning techniques is test marketing. Test markets allow an
organization to test alternative marketing plans and to forecast future sales of new products.

Pricing
 Five major stakeholders affect pricing decisions: consumers, governments, suppliers, distributors, and
competitors.
 Intense price competition, coupled with Internet price-comparative shopping, has reduced profit margins to
bare minimum levels for most companies.
 In contrast to popular opinion, online sales are more expensive for companies than brick-and-mortar sales,
after factoring in the cost of shipping, handling, and the higher rates of returns.

Distribution
  Distribution includes warehousing, distribution channels, distribution coverage, retail site locations, sales
territories, inventory levels and location, transportation carriers, wholesaling, and retailing.
 Most producers today do not sell their goods directly to consumers. Various marketing entities act as
intermediaries; they bear a variety of names such as wholesalers, retailers, brokers, facilitators, agents,
vendors—or simply distributors.
 Organizations should consider the costs and benefits of various wholesaling and retailing options. Once a
marketing channel is chosen, an organization usually must adhere to it for an extended period of time.

Marketing Research
 Marketing research is the systematic gathering, recording, and analyzing of data about problems relating to
the marketing of goods and services.
 Marketing researchers employ numerous scales, instruments, procedures, concepts, and techniques to
gather information; their research can uncover critical strengths and weaknesses.

Cost/Benefit Analysis
 The seventh function of marketing is cost/benefit analysis, which involves assessing the costs, benefits, and
risks associated with marketing decisions.
 Three steps are required to perform a cost/benefit analysis:
1. compute the total costs associated with a decision
2. estimate the total benefits from the decision
3. compare the total costs with the total benefits.
 Sometimes the variables included in a cost/benefit analysis cannot be quantified or even measured, but
usually reasonable estimates can be made to allow the analysis to be performed.
 One key factor to be considered is risk.
 Cost/benefit analysis should also be performed when a company is evaluating alternative ways to be socially
responsible.
 Government agencies across the world rely on a basic set of key cost/benefit indicators, including the
following:
1. Net present value (NPV)
2. Present value of benefits (PVB)
3. Present value of costs (PVC)
4. Benefit cost ratio (BCR) = PVB/PVC
5. Net benefit = PVB – PVC
6. NPV/k (where k is the level of funds available)
 Finance and Accounting
 Financial condition is often considered the single-best measure of a firm’s competitive position and overall
attractiveness to investors.
 Financial factors often alter existing strategies and change implementation plans.

Finance/Accounting Functions
 According to James Van Horne, the functions of finance/accounting comprise three decisions:
1. investment decision – also called capital budgeting, is the allocation and reallocation of capital and
resources to projects, products, assets, and divisions of an organization.
2. financing decision – determines the best capital structure for the firm and includes examining various
methods by which the firm can raise capital. Two key financial ratios that indicate whether a firm’s
financing decisions have been effective are the debt-to-equity ratio and the debt-to-total-assets ratio.
3. dividend decision – concern issues such as the percentage of earnings paid to stockholders, the stability
of dividends paid over time, and the repurchase or issuance of stock. Three financial ratios that are
helpful in evaluating a firm’s dividend decisions are the earnings-per-share ratio, the dividends-per-share
ratio, and the price-earnings ratio.
 Financial ratio analysis is the most widely used method for determining an organization’s strengths and
weaknesses in the investment, financing, and dividend areas.
 Financial ratios are equally applicable in for-profit and nonprofit organizations.

Financial Ratios
 Financial ratios are computed from an organization’s income statement and balance sheet.
 Trend analysis is a useful technique that incorporates both the time and industry average dimensions of
financial ratios. Note that the dotted lines reveal projected ratios.
**insert figure 4-3**
 Financial ratio analysis should be conducted on three separate fronts:
1. How has each ratio changed over time? – this information provides a means of evaluating historical
trends.
2. How does each ratio compare to industry norms? – a firm’s inventory turnover ratio may appear
impressive at first glance but may pale when compared to industry standards or norms.
3. How does each ratio compare with key competitors? – if a firm’s profitability ratio is trending up over
time and compares favorably to the industry average, but it is trending down relative to its lead ing
competitor, there may be reason for concern.
 Financial ratio analysis is not without some limitations. For example, financial ratios are based on accounting
data, and firms differ in their treatment of such items as depreciation, inventory valuation, R&D
expenditures, pension plan costs, mergers, and taxes. Also, seasonal factors can influence comparative ratios.
 Another limitation of financial ratios in terms of including them as key internal factors in the upcoming IFE
Matrix is that financial ratios are not very “actionable” in terms of revealing potential strategies needed.
**a summary of key financial ratios**

Breakeven Analysis
 Because consumers remain price sensitive, many firms have lowered prices to compete. As a firm lowers
prices, its breakeven (BE) point in terms of units sold increases.
 The breakeven point can be defined as the quantity of units that a firm must sell for its total revenues (TR) to
equal its total costs (TC).
 Note that the before and after chart in Figure 4-4 reveals that the TR line rotates to the right with a decrease
in price, thus increasing the quantity (Q) that must be sold just to break even.
**insert figure 4-4**
  The before and after charts in Figure 4-5 show that increasing fixed costs (FC) raises a firm’s breakeven
quantity.
 Increasing a firm’s FC therefore significantly raises the quantity of goods that must be sold to break even.
 Figure 4-5 reveals that adding fixed costs may be detrimental whenever there is doubt that significantly more
units can be sold to offset those expenditures.
**insert figure 4-5**
 Figure 4-6 illustrates how far the breakeven point shifts with both a price decrease and an increase in fixed
costs. If a firm does not break even, then it will of course incur losses, and losses are not good, especially
sustained losses.
**insert figure 4-6**
 Finally, note in Figures 4-4, 4-5, and 4-6 that variable costs (VC), such as labor and materials, when increased,
have the effect of raising the breakeven point, too. When the TR line remains constant, the effect of
increasing VC is to increase TC, which increases the point at which TR = TC = BE.
 The formula for calculating the breakeven point is BE Quantity = TFC divided by (price – VC).
 There are some limitations of breakeven analysis, including the following points:
1. Breakeven analysis is only a supply side (i.e., costs only) analysis because it reveals nothing about what
sales are likely to be for the product at various prices.
2. It assumes that fixed costs are constant. Although this is true in the short run, an increase in the scale of
production will cause fixed costs to rise.
3. It assumes average variable costs are constant per unit of output, at least in the range of likely quantities
of sales.
 Production/Operations
 The production/operations function of a business consists of all those activities that transform inputs into
goods and services.
 The extent to which a manufacturing plant’s output reaches its potential out put is called capacity utilization,
a key strategic variable. The higher the capacity utilization, the better; otherwise, equipment may sit idle.
 Production/operations activities often represent the largest part of an organization’s human and capital
assets. Strengths and weaknesses in the five functions of production can mean the success or failure of an
enterprise.
**insert table 6-6**
 Increasingly in production settings, a new breed of robots called collaborative machines, are working
alongside people.
**insert table 6-7**

Research and Development

 The fifth major area of internal operations that should be examined for specific strengths and weaknesses as
input into formulating strategies is research and development (R&D).
 Firms pursuing a product-development strategy especially need to have a strong R&D orientation.
 Organizations invest in R&D because they believe that such an investment will lead to a superior product or
service and will give them competitive advantages.
 Effective management of the R&D function requires a strategic and operational partnership between R&D
and the other vital business functions.

Internal and External Research and Development

 Four approaches to determining research and development budget allocations commonly are used:
1. financing as many project proposals as possible
2. using a percentage-of-sales method
3. budgeting about the same amount that competitors spend for R&D
4. deciding how many successful new products are needed and working backward to estimate the required
R&D investment.
 Most firms have no choice but to continually develop new and improved products because of changing
consumer needs and tastes, new technologies, shortened product life cycles, and increased domestic and
foreign competition.

Management Information Systems

 Information ties all business functions together and provides the basis for all managerial decisions.
 A purpose of a management information system is to improve the performance of an enterprise by
improving the quality of managerial decisions.
 Two types of data it gathers:
1. Internal – marketing, finance, production, and personnel matters.
2. External – social, cultural, demographic, environmental, economic, political, governmental, legal,
technological, and competitive factors.
 A management information system (MIS) receives raw material from both the external and internal
evaluation of an organization.

Managing Voluminous Consumer Data

 Basically, every time you get online and do anything at any website with any company or anybody, that
information is dissected to determine your patterns of behavior; resultant information is disseminated to
marketers.
 Value Chain Analysis
 According to Porter, the business of a firm can best be described as a value chain, in which total revenues
minus total costs of all activities undertaken to develop and market a product or service yields value.
 All firms in a given industry have a similar value chain.
 Value chain analysis (VCA) refers to the process whereby a firm determines the costs associated with
organizational activities from purchasing raw materials to manufacturing product(s) to marketing those
products.
 The VCA process can enable a firm to better identify its own strengths and weaknesses, especially as
compared to competitors’ value chain analyses and their own data examined over time.
 Substantial judgment may be required in performing a VCA because different items along the value chain
may impact other items positively or negatively, at times creating complex interrelationships.
 Initial steps in implementing VCA:
1. Divide a firm’s operations into specific activities or business processes.
2. Then the analyst attempts to attach a cost to each discrete activity; the costs could be in terms of both
time and money.
3. The analyst converts the cost data into information by looking for competitive cost strengths and
weaknesses that may yield competitive advantage or disadvantage.
 VCA can be critically important for a firm in monitoring whether its prices and costs are competitive.
**insert figure 4-7**
 The combined costs of all the various activities in a company’s value chain define the firm’s cost of doing
business. Firms should determine where cost advantages and disadvantages in their value chain occur
relative to the value chain of rival firms.
 Value chains differ immensely across industries and firms. However, all firms should use value chain analysis
to develop and nurture a core competence and convert this competence into a distinctive competence.
 A core competence is a VCA that a firm performs especially well. When a core competence evolves into a
major competitive advantage, then it is called a distinctive competence.
 More and more companies are using VCA to gain and sustain competitive advantage by being especially
efficient and effective along various parts of the value chain.
**insert figure 4-8**

Benchmarking
 Benchmarking is an analytical tool used to compare a firm's value chain activities against industry
competitors to identify best practices. By measuring costs and performance, firms can improve their
competitiveness by adopting or enhancing these best practices to gain advantages in areas such as cost,
service, reputation, or operation.
 A comprehensive survey on benchmarking result:
1. Mission and vision statements along with customer surveys are the most used (77% of organizations) of
20 improvement tools, followed by SWOT analysis (72%), and informal benchmarking (68%).
Performance benchmarking was used by 49% and best practice benchmarking was used by 39% of
respondents.
2. The tools that are likely to increase the most in popularity over the next 3 years are performance
benchmarking, informal benchmarking, SWOT, and best practice benchmarking. More than 60% of
organizations not currently using these tools indicated they are likely to use them in the next 3 years.
 The hardest part of benchmarking can be gaining access to other firms’ value chain analyses with associated
costs.

The Internal Factor Evaluation Matrix

 A summary step in conducting an internal strategic-management audit is to construct an Internal Factor
Evaluation (IFE) Matrix.
  This strategy-formulation tool summarizes and evaluates the major strengths and weaknesses in the
functional areas of a business, and it also provides a basis for identifying and evaluating relationships among
those areas; intuitive judgments are required in developing an IFE Matrix.
 IFE Matrix can be developed in five steps:
1. List key internal factors as identified in the internal-audit process. Use a total of 20 internal factors,
including both strengths and weaknesses. Be as specific as possible, using percentages, ratios, and
comparative numbers. Include action able factors that can provide insight regarding strategies to pursue.
Also, be as divisional as possible, because consolidated data oftentimes is not as revealing or useful in
deciding among strategies as the underlying by-segment or division data.
2. Assign a weight that ranges from 0.0 (not important) to 1.0 (all-important) to each factor. The weight
assigned to a given factor indicates the relative importance of the factor to being successful in the firm’s
industry. Regardless of whether a key factor is an internal strength or weakness, factors considered to
have the greatest effect on organizational performance should be assigned the highest weights. The sum
of all weights must equal 1.0.
3. Assign a 1 to 4 rating to each factor to indicate whether that factor represents a major weakness (rating =
1), a minor weakness (rating = 2), a minor strength (rating = 3), or a major strength (rating = 4). Note that
strengths must receive a 3 or 4 rating and weaknesses must receive a 1 or 2 rating. Ratings are thus
company-based, whereas the weights in step 2 are industry-based.
4. Multiply each factor’s weight by its rating to determine a weighted score for each variable.
5. Sum the weighted scores for each variable to determine the total weighted score for the organization.
**insert table 6-8**
 Regardless of how many factors are included in an IFE Matrix, the total weighted score can range from a low
of 1.0 to a high of 4.0, with the average score being 2.5. Total weighted scores well below 2.5 characterize
organizations that are weak internally, whereas scores significantly above 2.5 indicate a strong internal
position.