The Internal Audit

INTERNAL AUDIT
WHAT THE CHAPTER COVERS

• Identifying and evaluating firm’s strengths and weaknesses

• In various functional areas (management, marketing, finance
and accounting, production and operations, R&D, MIS).

• Resource based view (RBV) of the firm

• Accounting Ratios

• Value chain analysis

• Internal Factor Evaluation Matrix

 WHAT IS INTERNAL AUDIT
IN THE CONTEXT OF STRATEGIC MANAGEMENT

• Gathering and assimilating information about

• Firm’s management
• Marketing
• Finance/accounting
• Production/operations
• Research and development (R&D)
• Management information systems operations

• Provides more opportunity for participants

• To understand how their jobs, departments, and divisions fit
into the whole organization
 COMPETITIVE ADVANTAGE: THE DEBATE
External focus
I/O Approach
• Industrial Organization (I/O)
• Industry in which firm operates
influences firm performance
• Industry forces dictate firm
performance (Porter Five
forces)
• Focus efforts to compete in
attractive industries and
avoiding weak or faltering
industries
Internal focus
RBV Approach
• Resource Based View (RBV)
• Internal resources are more
important in sustaining
competitive advantage
• Firm performance is dictated by
a firm’s resources – physical,
human and organizational
• Unique internal resources
enable a firm to exploit
opportunities and neutralize
threats; creating sustainable
competitive advantage
 INTERNAL AUDIT
• All organizations have specific strengths and weaknesses

• Internal analysis pinpoints strengths and weaknesses of the

organization.

Strengths Weaknesses

Of the enterprise are assets Of the enterprise are liabilities

that boost profitability that lead to lower profitability

Forms the basis for developing

competitive advantage
PROCESS OF GAINING COMPETITIVE ADVANTAGE
 Capabilities
Ability of a firm to perform activity in a reliable manner

Distinctive competencies
A firms strengths that cannot be matched or imitated easily

Competitive Advantage
A firms attributes that enables it to outperform competition

Building a competitive advantage involves taking advantage

of distinctive competencies
RESOURCE BASED VIEW (RBV)

Physical resources

Human resources

Organizational resources
RESOURCE BASED VIEW (RBV)

Physical resources
All plant and equipment, location, technology, raw materials, machines

Human resources
Employees, training, experience, intelligence, knowledge, skills, abilities

Organizational resources
Firm structure, planning processes, information systems, patents, trademarks,
copyrights, databases, and so on
THE VRIO FRAMEWORK

V R I O
VALUE RARITY IMITABILITY ORGANIZATION

The FOUR components are typically

approached in the style of a decision tree
VALUE
• QUESTION:
• Do you offer a resource that adds value for customers?

• RESPONSE:
• No:
• You are at a competitive disadvantage and need to reassess
your resources and capabilities to uncover value.
• Yes:
• If value is established, move on in your VRIO analysis to rarity.
RARITY
• QUESTION:
• Do you control scarce resources or capabilities?

• RESPONSE:
• No:
• You have value but lack rarity, putting your company in a position
of competitive parity. Your resources are valuable but common,
which makes competing in the marketplace more challenging (but
not impossible). It’s recommended to go back one step and
reassess.
• Yes:
• With value and rarity identified, your next hurdle is imitability.
IMITIABILITY
• QUESTION:
• Is it expensive to duplicate your organization’s resource or
capability?

• RESPONSE:
• No:
• If your resource has value and rarity, but is affordable or easy to
copy, you have a temporary competitive advantage. It will
require considerable effort to stay ahead of competitors and
differentiate your services—go back one step and reassess.
• Yes:
• You offer something that’s valuable, rare, and hard to
imitate—now the focus is on your organization.
ORGANIZATION
• QUESTION:
• Does your company have organized management systems,
processes, structures, and culture to capitalize on resources and
capabilities?

• RESPONSE:
• No:
• Without the internal organization and support, it will be difficult to
fully realize the potential of your valuable, rare, and
costly-to-imitate resources. Your company will have a unused
competitive advantage and will need to reassess how to attain
the needed organization.
• Yes:
• Your company has achieved the ultimate goal of sustained
competitive advantage when it has successfully identified all four
components of the VRIO framework.
IMPLICATION OF VRIO ANALYSIS
IMPLICATION OF VRIO ANALYSIS
VRIO FRAMEWORK TEMPLATE
Resources Physical / Human / Organizational

VALUE

RARITY

IMITABILIT
Y

ORGANIZATI
ON
VRIO framework example
• Value:

• Uses human capital management data to hire and retain

innovative, productive employees

• These employees consistently create some of the most

popular consumer products and services in the world
VRIO framework example
• Rarity:

• No other companies are using data-based employee

management so extensively.
VRIO framework example
• Imitability:

• Data-based human capital management is both costly and

difficult to imitate, at least for the near future. Companies
have to build the software and invest in training their HR
staff on the new technology and strategy.
VRIO framework example
• Organization:

• Google is organized to capture value from this capability

• Its IT department has the skills to collect and maintain the

data

• While HR and team leaders are trained on how to use

the data to hire, promote, manage, and improve
performance of employees.
VRIO framework example
• VRIO framework allowed Google to take a completely different approach to
human capital management and make decisions using massive amounts of
objective data

• Example:
• Google’s People Operations team set out to identify which characteristics
make a great manager

• The data includes surveys, performance evaluations, and great-manager

nominations

• Google also conducts double-blind interviews with the company's highest-

and lowest-rated managers

• By determining what qualifies as a great manager, Google strengthens its

internal team and the foundation of its sustained competitive advantage.
Integrating strategy and culture
 INTEGRATING STRATEGY AND
CULTURE
• Organizational culture
• Internal phenomenon that permeates all departments and divisions
of an organization.

• Defined as “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.”

• Captures the subtle, elusive, and largely unconscious forces that shape
a workplace. remarkably resistant to change, culture can represent a
major strength or weakness for the firm.
• It can be an underlying reason for strengths or weaknesses in any of
the major business functions
CULTURAL PRODUCTS DEFINED
 INTEGRATING STRATEGY AND
CULTURE

• Culture can inhibit strategic management:

• Miss changes in external environment because they are blinded by

strongly held beliefs

• When a culture has been effective in the past, natural tendency to

stick with it in future, even during times of major strategic change
VALUE CHAIN ANALYSIS
FIRM’S MANAGEMENT
FIRM’S MANAGEMENT
MANAGEMENT AUDIT CHECKLIST OF QUESTIONS

1. Does the firm use strategic-management concepts?

2. Are company objectives and goals measurable and well
communicated?
3. Do managers at all hierarchical levels plan effectively?
4. Do managers delegate authority well?
5. Is the organization’s structure appropriate?
6. Are job descriptions and job specifications clear?
7. Is employee morale high?
8. Are employee turnover and absenteeism low?
9. Are organizational reward and control mechanisms effective?
MARKETING
• Marketing
• the process of defining, anticipating, creating, and fulfilling
customers’ needs and wants for products and services
FUNCTIONS OF MARKETING
MARKETING
• Customer analysis

• 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

• Essential in developing an effective mission statement

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

• Important when a company is pursuing product development

or diversification
PRICING
• Five major stakeholders affect pricing decisions:

• Consumers, governments, suppliers, distributors, and

competitors

• Sometimes an organization will pursue a forward integration

strategy primarily to gain better control over prices charged to
consumers
DISTRIBUTION
• Includes:

• Warehousing, distribution channels, distribution coverage,

retail site locations, sales territories, inventory levels and
location, transportation carriers, wholesaling, and retailing

• Especially important when a firm is striving to implement a market

development or forward integration strategy
MARKETING RESEARCH
• Systematic gathering, recording, and analyzing of data about
problems relating to the marketing of goods and services

• Can uncover critical strengths and weaknesses

COST/BENEFIT ANALYSIS
Three steps are required to perform a cost/benefit analysis:

• Compute the total costs associated with a decision

• Estimate the total benefits from the decision

• Compare the total costs with the total benefits

COST/BENEFIT ANALYSIS
• Net present value (NPV) NPV
Difference between the
present value of cash
• Present value of benefits (PVB) inflows and the present
value of cash outflows over
a period of time.
• Present value of costs (PVC)

• Benefit cost ratio (Bcr) = PVB / PVc

• Net benefit = PVB – PVc

• nPV/k (where k is the level of funds available)

MARKETING AUDIT CHECKLIST OF QUESTIONS
• Are markets segmented effectively?
• Is the organization positioned well among competitors?
• Has the firm’s market share been increasing?
• Are present channels of distribution reliable and cost effective?
• Does the firm have an effective sales organization?
• Does the firm conduct market research?
• Are product quality and customer service good?
• Are the firm’s products and services priced appropriately?
• Does the firm have an effective promotion, advertising, and publicity
strategy?
• Are marketing, planning, and budgeting effective?
• Do the firm’s marketing managers have adequate experience and
training?
• Is the firm’s Internet presence excellent as compared to rivals?
FINANCE / ACCOUNTING FUNCTION
Allocation and reallocation of capital and resources; to
Investment
projects, products, assets, and divisions of an
Decision
organization

Determines the best capital structure for the firm and

Financing
includes examining various methods by which the firm
Decision
can raise capital

Issues such as percentage of earnings paid to

stockholders, stability of dividends paid over time,
Dividend
repurchase or issuance of stock; determine amount of
Decision
funds that are retained in a firm compared to amount
paid out to stockholders
https://www.moneycontrol.com/financials/hindustanunilever/balance-sheetVI/HU#HU
 FINANCIAL RATIOS
• Liquidity ratios:
• Firm’s ability to meet maturing short-term obligations
• Leverage ratios
• Extent to which a firm has been financed by debt.
• Activity ratios:
• How effectively a firm is using its resources
• Profitability ratios
• Management’s overall effectiveness as shown by the returns
generated on sales and investment.
• Growth ratios
• Firm’s ability to maintain its economic position in the growth of the
economy and industry
FINANCE/ACCOUNTING FUNCTIONS

• How has each ratio changed over time?

• How does each ratio compare to industry norms?

• How does each ratio compare with key competitors?

FINANCE/ACCOUNTING AUDIT
CHECKLIST
• Where is the firm financially strong and weak as indicated by
financial ratio analyses?
• Can the firm raise needed short-term capital?
• Can the firm raise needed long-term capital through debt and/or
equity?
• Does the firm have sufficient working capital?
• Are capital budgeting procedures effective?
• Are dividend payout policies reasonable?
• Does the firm have good relations with its investors and
stockholders?
• Are the firm’s financial managers experienced and well trained?
• Is the firm’s debt situation excellent?
PRODUCTION/OPERATIONS
• Consists of all those activities that transforms inputs into goods
and services

• Deals with inputs, transformations, and outputs that vary across

industries and markets.
FUNCTIONS WITHIN PRODUCTION/OPERATIONS
IMPLICATIONS OF VARIOUS STRATEGIES ON
PRODUCTION/OPERATIONS
PRODUCTION/OPERATIONS AUDIT CHECKLIST

• Are supplies of raw materials, parts, and subassemblies reliable

and reasonable?
• Are facilities, equipment, machinery, and offices in good
condition?
• Are inventory-control policies and procedures effective?
• Are quality-control policies and procedures effective?
• Are facilities, resources, and markets strategically located?
• Does the firm have technological competencies?
RESEARCH AND DEVELOPMENT AUDIT

• Does the firm have R&D facilities? Are they adequate?

• If outside R&D firms are used, are they cost-effective?
• Are the organization’s R&D personnel well qualified?
• Are R&D resources allocated effectively?
• Are management information and computer systems
adequate?
• Is communication between R&D and other organizational units
effective?
• Are present products technologically competitive?
MANAGEMENT INFORMATION SYSTEMS

• A management information system’s purpose is to improve the

performance of an enterprise by improving the quality of
managerial decisions

• An effective information system thus collects, codes, stores,

synthesizes, and presents information in such a manner that it
answers important operating and strategic questions
 MANAGEMENT INFORMATION SYSTEMS AUDIT
• Do all managers in the firm use the information system to make decisions?
• Is there a chief information officer or director of information systems position
in the firm?
• Are data in the information system updated regularly?
• Do managers from all functional areas of the firm contribute input to the
information system?
• Are there effective passwords for entry into the firm’s information system?
• Are strategists of the firm familiar with the information systems of rival firms?
• Is the information system user-friendly?
• Do all users of the information system understand the competitive
advantages that information can provide firms?
• Are computer training workshops provided for users of the information
system?
• Is the firm’s information system continually being improved in content- and
user-friendliness?
 VALUE CHAIN ANALYSIS - STAGES

• Step 1: Disaggregate the firm into separate activities

• Step 2: Estimate the cost that each activity contributes to total costs

• Step 3: Identify cost drivers

• Step 4: Identify linkages

• Step 5: Identify opportunities for reducing costs

PORTER’S VALUE CHAIN

• A sequential chain of the main activities that the firm undertakes.

 VALUE CHAIN ANALYSIS – PRIMARY ACTIVITIES
• Inbound logistics: Arranging the inbound movement of materials, parts, and/or
finished inventory from suppliers to manufacturing or assembly plants,
warehouses, or retail stores

• Operations: Concerned with managing the process that converts inputs (in the
forms of raw materials, labor, and energy) into outputs (in the form of goods
and/or services).

• Outbound logistics: Is the process related to the storage and movement of the
final product and the related information flows from the end of the production line
to the end user

• Marketing and sales: Selling a product or service and processes for creating,
communicating, delivering, and exchanging offerings that have value for
customers, clients, partners, and society at large.

• Service: includes all the activities required to keep the product/service working
effectively for the buyer after it is sold and delivered.
 VALUE CHAIN ANALYSIS – SUPPORT ACTIVITIES

• Infrastructure: Activities such as accounting, legal, finance, control, public

relations, quality assurance and general (strategic) management.

• Technological development: Equipment, hardware, software, procedures and

technical knowledge brought to bear in the firm's transformation of inputs into
outputs.

• Human resources management: All activities involved in recruiting, hiring,

training, developing, compensating and (if necessary) dismissing or laying off
personnel.

• Procurement: Acquisition of goods, services or works from an outside external

source. In this field company also makes decisions of purchases.
DISAGGREGATION OF INBOUND LOGISTICS VALUE
CHAIN ACTIVITIES FOR A TYPICAL MANUFACTURING FIRM
DISAGGREGATION OF OPERATIONS VALUE CHAIN
ACTIVITIES FOR A TYPICAL MANUFACTURING FIRM
DISAGGREGATION OF OUTBOUND LOGISTICS VALUE
CHAIN ACTIVITIES FOR A TYPICAL MANUFACTURING FIRM
DISAGGREGATION OF MARKETING & SALES VALUE
CHAIN ACTIVITIES FOR A TYPICAL MANUFACTURING FIRM
DISAGGREGATION OF CUSTOMER SERVICE VALUE
CHAIN ACTIVITIES FOR A TYPICAL MANUFACTURING FIRM
DISAGGREGATION OF SUPPORT VALUE CHAIN ACTIVITIES
FOR A TYPICAL MANUFACTURING FIRM
 VALUE CHAIN ANALYSIS

• Identifies:

• Relative importance of each activity with respect to total cost

• Cost drivers for each activity and comparative efficiency with which firm
performs each activity

• How costs in one activity influence costs in another

• Which activities should be undertaken within the firm and which activities
should be outsourced
TRANSFORMING VALUE CHAIN ACTIVITIES INTO
SUSTAINED COMPETITIVE ADVANTAGE
THE INTERNAL FACTOR EVALUATION (IFE) MATRIX

• List key internal factors as identified in the internal-audit process

• Assign a weight that ranges from 0.0 (not important) to 1.0

(all-important) to each factor

• Assign a 1-to-10 rating to each factor to indicate whether that factor

represents a strength or weakness

• Multiply each factor’s weight by its rating to determine a weighted score

for each variable

• Sum the weighted scores for each variable to determine the total
weighted score for the organization
EVALUATE THE INTERNAL FACTOR MATRIX FOR A
SAMPLE MANUFACTURING FIRM GIVEN BELOW

Company Competitor1 Competitior2

Key Internal Factors Weight
Rating Rating Rating

Product Performance 0.10 8 5 1

Reputation 0.10 8 10 5

Manufactring capability 0.10 2 10 5

Technological Skills 0.05 10 1 3

Dealer Network / Distribution capability 0.05 9 4 5

New product innovation capability 0.05 9 4 5

Financial resources 0.10 5 10 3

Relative cost position 0.30 5 10 1

Customer service capability 0.15 5 7 1

TOTAL 1.00