Internal Audit + External Audit

Chap 6,7
 Internal audit
• All firms have strengths and weaknesses. Objectives and strategies are established
with the intention of capitalizing on internal strengths and overcoming weaknesses.
• Strategies are designed in part to convert a firm’s
Weaknesses  Strengths  Distinctive competencies  competitive advantage
• representative managers and employees from throughout the firm need to be
involved in determining a firm’s strengths and weaknesses. Performing an internal
audit requires gathering, assimilating, and evaluating information about the firm’s
management, marketing, finance and accounting, production and operations, R&D,
and MIS operations.
• Strategic management is a highly interactive process that requires managers from
different departments and divisions of the firm to understand the nature and effect
of their decisions in other functional business areas of the firm. For example, a
declining return on investment or profit margin ratio could be the result of
ineffective marketing, poor management policies, R&D errors, or a weak MIS.
 Resource Based View
• The basic premise of the RBV is that the mix, type, amount, and nature
of a firm’s internal resources should be considered first and foremost in
devising strategies that can lead to sustainable competitive advantage
because it is these that helps firm exploit opportunities and neutralize
threats.
• Internal resources can be grouped into three categories:
– Physical resources - that include plant and equipment, location, technology,
raw materials, machines
– Human resources – that include employees, training, experience,
intelligence, knowledge, skills, abilities.
– Organizational resources include firm structure, planning processes,
information systems, patents, trademarks, copyrights, databases.
• It is advantageous for a firm to pursue a strategy that is not currently
being implemented by any competing firm through the use of valuable
– (a) rare, (b) hard to imitate, or (c) not easily substitutable – resources.
 Organizational Culture
• The strategic-management process takes place largely
within a particular organization’s culture.
• Organizational culture can be 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.”
• Cultural products include values, beliefs, rituals,
ceremonies, stories, legends, language, symbols, heroes,
etc.
 Management
• The functions of management consist of five basic activities: planning,
organizing, motivating, staffing, and controlling.
• Planning consists of managerial activities related to preparing for the future,
such as forecasting, establishing objectives, devising strategies, developing
policies, and setting goals.
• Organizing includes those managerial activities that result in a structure of
task and authority relationships. Specific areas include job analysis,
organizational structuring, coordination.
• Motivating involves efforts directed toward shaping human behavior. Specific
topics include leadership, communication,, behavior modification, delegation
of authority, job enrichment, needs fulfillment, & organizational change.
• Staffing activities are centered on personnel or human resource
management. Included are wage and salary administration, hiring, firing,
training & management development, and union relations.
• Controlling refers to managerial activities directed toward ensuring that
actual results are consistent with planned results. Key areas of concern are
quality control, financial control & inventory control.
 Marketing
Marketing can be described as the process of defining, anticipating,
creating, and fulfilling customers’ needs. It includes:
• Customer analysis—the examination and evaluation of consumer
needs, desires, and wants— involves administering customer surveys,
evaluating market positioning strategies, developing customer profiles,
and determining optimal market segmentation strategies. Buyers,
distributors, salespeople, managers, suppliers, and creditors can all
participate in gathering this information.
• Selling includes many marketing activities, such as advertising, sales
promotion, publicity, personal selling, sales force management,
customer relations, and dealer relations.
• Product and service planning includes activities such as test
marketing, brand positioning, packaging, determining product
features/style, deleting old products and providing for customer
service.
 Marketing (cont.)
• Pricing decisions can be affected by consumers, governments,
suppliers, distributors, and competitors.
• Distribution includes distribution channels, distribution coverage,
retail site locations, sales territories, inventory levels &
transportation carriers.
• Marketing research is the systematic gathering, recording, and
analyzing of data about problems relating to the marketing of
goods and services. Competitive Intelligence and consumer
analytics are emerging trends.
• The seventh function of marketing is cost/benefit analysis, which
involves assessing the costs, benefits, and risks associated with
marketing decisions.
 Finance and Accounting
• Financial condition is often considered the single best measure of a firm’s
competitive position and overall attractiveness to investors. Analysis includes
firm’s liquidity, leverage, working capital, profitability, asset utilization, cash
flow, and equity.
• The functions of finance/accounting comprise three decisions: investment
decision, the financing decision, the dividend decision.
• The investment decision, also called capital budgeting, is the allocation and
reallocation of capital and resources to projects, products, assets, and
divisions of an organization.
• The financing decision examines various methods by which the firm can raise
capital – for example, by issuing stock, increasing debt, selling assets, or a
combination of these.
• Dividend decisions concern issues such as the percentage of earnings paid to
stockholders over time
 Ratio Analysis & Breakeven
Computing financial ratios is like taking a picture of the financial position of the
company at a point in time. They are computed from an organization’s income
statement and balance sheet and are compared (i) over time and (ii) to industry
averages.
• Liquidity ratios measure a firm’s ability to meet maturing short-term
obligations.
• Leverage ratios measure the extent to which a firm has been financed by debt.
• Activity ratios measure how effectively a firm is using its resources.
• Profitability ratios measure management’s overall effectiveness as shown by
the returns generated on sales and investment.
• Growth ratios measure the firm’s ability to maintain its economic position in
the growth of the economy and industry.
• 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). BE Quantity = TFC
divided by (price – VC).
Some important ratios
 Production and Operations
The production/operations function of a business consists of all those activities that
transform inputs into goods and services. It deals with inputs, transformations and outputs.
Its basic functions /decision areas are:
• Process: These decisions include choice of technology, facility layout, process flow
analysis, facility location, and transportation analysis and distances from raw materials to
production sites to customers.
• Capacity: These decisions include forecasting, facilities planning, scheduling and queuing
analysis and capacity utilization (the extent to which a manufacturing plant’s output
reaches its potential output)
• Inventory: These decisions involve managing the level of raw materials, work-in-process,
and finished goods, especially considering what to order, when to order, how much to
order, and materials handling.
• Workforce: These decisions involve managing the skilled, unskilled, and managerial
employees by caring for job design, work measurement, work standards, and motivation
techniques.
• Quality: These decisions are aimed at ensuring that high-quality goods and services are
produced by caring for quality control, sampling, testing, quality assurance, and cost
control.
 RND and MIS
• 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 competition.
• R&D in organizations can take two basic forms: (1) internal R&D, in which an
organization operates its own R&D department, or (2) contract R&D, in which a firm
hires independent researchers / agencies to develop specific products.
• Four approaches to determining R&D budget allocations commonly used are: (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, or
(4) deciding how many successful new products are needed and working backward to
estimate the required R&D investment.
• An effective management information system collects, stores, synthesizes, and
presents information in such a manner that it answers important operating and
strategic questions.
• An MIS receives raw material from both the external and internal environment of an
organization and transforms it into outputs such as written reports, tables, graphs,
checks, purchase orders, invoices, inventory records, payroll accounts, etc.
 Value Chain Analysis
• 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 initial step in implementing this procedure is to divide a firm’s operations into specific
activities or business processes. Then the analyst attaches a cost to each discrete activity. The
costs could be in terms of both time and money. Finally, the analyst converts the cost data
into information by looking for competitive cost strengths / weaknesses that may yield
competitive advantage / disadvantage.
• A core competence is a Value Chain Activity that a firm performs especially well.
• Benchmarking entails measuring costs of value chain activities across an industry to
determine “best practices” among competing firms for the purpose of duplicating or
improving on those best practices. Typical sources of benchmarking information include trade
publications, suppliers, distributors, customers, creditors, shareholders, lobbyists, and willing
rival firms.
• Internal Factor Evaluation (IFE) Matrix. This strategy-formulation tool summarizes and
evaluates the major strengths and weaknesses in each of the functional areas of a business by
assigning them weights according to importance to firm and rates according to organization’s
ability. 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
An actual IFE Matrix
 The External Audit
• The purpose of an external audit is to develop a finite list
of opportunities that could benefit a firm and threats that
should be avoided.
• External forces can be divided into five broad categories:
(1) economic forces (2) social, cultural, demographic, and
natural environment forces (3) political, governmental,
and legal forces (4) tech- nological forces and (5)
competitive forces (PESTLE + Task Environment)
• Make sure the factors selected are specific and actionable,
i.e. meaningful in terms of strategic implications.
 The process of performing external audit
1. A company first must gather competitive intelligence and information
about environmental factors from magazines, trade journals, and
newspapers, and the internet. Suppliers, distributors, salespersons,
customers, and competitors represent other sources of vital information.
2. This information is submitted periodically to a committee of managers
charged with performing the external audit.
3. Once information is gathered, it is assimilated and evaluated. A series of
meetings of managers is conducted to collectively identify the most
important opportunities and threats facing the firm. These key external
factors should be listed on flip charts or a chalk- board. These are then
ranked for importance.
4. A final list of the most important key external factors should be
communicated and distributed widely in the organization.
 The Industrial Organization (I/O)View
• The I/O advocates that external (industry) factors – such as,
economies of scale, barriers to market entry, product differentiation,
the economy, and level of competitiveness - are more important than
internal factors (resources, capabilities, structure, and operations) in a
firm for achieving competitive advantage.
• Competitive advantage is determined by competitive positioning
within an industry, striving to compete in attractive industries,
avoiding weak industries, and gaining full understanding of key
external factor relationships within that attractive industry.
• However, it is not a question of whether external or internal factors
are more important in gaining and maintaining competitive advantage.
Effective integration and understanding of both kinds of factors is the
key to securing and keeping a competitive advantage.
 Competitive forces
• By definition, competitors are firms that offer similar products and services in the
same market. Market commonality can be defined as the number and
significance of markets that a firm competes in with rivals. Resource similarity is
the extent to which the type and amount of a firm’s internal resources are
comparable to a rival.
• An important part of an external audit is identifying rival firms and determining
their strengths, weaknesses, capabilities, opportunities, threats, objectives, and
strategies.
• How are they likely to respond to PESTLE factors?
• How vulnerable are we/they to their/our strategies?
• How are our products positioned in relation to them?
• To what extent are new firms entering and old firms leaving this industry?
• What is the nature of supplier and distributor relationships in this industry?
• To what extent could substitute products or services be a threat to competitors in
this industry?
 Competitive Intelligence
• Is a systematic and ethical process for gathering and analyzing information about the
competition’s activities and general business trends to further a business’s own goals.
Competitive information is equally applicable for strategy formulation,
implementation, and evaluation decisions.
• The three basic objectives of a CI program are (1) to provide a general understanding
of an industry and its competitors, (2) to assess the impact strategic actions would
have on competitors, and (3) to identify potential moves that a competitor might
make.
• Some ethical ways of gathering competitive intelligence:
– Ask salespersons
–  Reverse engineer rival firms’ products
– Use surveys and interviews of customers, suppliers, and distributors
– Conduct on-site visits to rival firm operations
–  Search online databases
– Systematically monitor relevant trade publications, magazines, and newspapers
•  All the information one could wish for can be collected without resorting to unethical
tactics.
Michael Porter’s 5 forces Model
 Conditions That Cause High Rivalry Among Competing Firms

1. High number of competing firms

3. Similar capability of firms competing
4. Falling demand for the industry’s products
5. Falling product prices in the industry
6. When consumers can switch brands easily
7. When barriers to leaving the market are high
8. When barriers to entering the market are low
9. When fixed costs are high among firms competing
10. When the product is perishable
11. When rivals have excess capacity
12. When rivals sell similar products/services
 Potential entry of new competitors
& development of substitute products
• Barriers to entry can include the need to gain economies of scale quickly,
the lack of experience in new technology, strong customer loyalty, large
capital requirements, lack of adequate distribution channels, government
regulatory policies e.g. tariffs, lack of access to raw materials, possession
of patents, and potential saturation of the market.
• When the threat of new firms entering the market is strong, incumbent
firms fortify their positions and take actions to deter new entrants by
lowering prices, extending warranties, adding features, or offering
financing specials.
• The presence of substitute products puts a ceiling on the price that can
be charged before consumers will switch to the substitute product. Price
ceilings equate to profit ceilings and more intense competition among
rivals.
Bargaining power of suppliers & consumers
• The bargaining power of suppliers affects the intensity of competition in an
industry, especially when there are few suppliers or when the cost of
switching raw materials is especially high. It is in the best interests of both
suppliers and producers to assist each other with reasonable prices,
improved quality, just-in-time deliveries, and provision of other useful
services, thus enhancing long-term profitability for all concerned.
• Firms may pursue a backward integration strategy to gain control or
ownership of suppliers or use outside suppliers of component parts.
• Bargaining power of consumers is high when they are large in number or
buy in volume, when products being purchased are
standard/undifferentiated, when they are informed about sellers’ products,
prices, and costs or if sellers are struggling in the face of falling consumer
demand.
 Forecasts and assumptions
• Forecasts are educated assumptions about future trends and events. A
sense of the future permeates all action and underlies every decision a
person makes. The question, therefore, is not whether we should forecast
but rather how we can best forecast to enable us to move beyond our
ordinarily unarticulated assumptions about the future.
• Most organizations forecast (project) their own revenues and profits,
market share or customer loyalty in local areas.
• Forecasting tools can be broadly categorized into two groups: quantitative
techniques and qualitative techniques.
• Assumptions are present estimates of future events, over which the
manager has little control. Without reasonable assumptions, the strategy-
formulation process could not proceed effectively. Firms that have the best
information generally make the most accurate assumptions.
 EFE and CPM
• An external factor evaluation (EFE) matrix allows strategists to
summarize and evaluate external environmental factors influencing
a firm and their importance and rating between 1 and 4 to indicate
how effectively the firm’s current strategies respond to the factor.
The highest possible total weighted score for an organization is 4.0
and the lowest possible total weighted score is 1.0.
• The Competitive Profile Matrix (CPM) identifies a firm’s major
competitors and its particular strengths and weaknesses in relation
to a sample firm’s strategic position. The weights and total
weighted scores in both a CPM and an EFE have the same meaning.
However, critical suc- cess factors in a CPM include both internal
and external issues
EFE Matrix