Internal Control and Leaking Profits
October 2004
Lost money is lost profit. Finding leaks takes
diligence, but is worth the effort when employees, vendors, and customers know
you're perpetually on the lookout for disappearing funds, no matter how small.
by Matthew
Leitch
Internal controls against fraud and big accounting problems are important,
but there's another side to internal control that can raise revenues, cut costs,
and boost profits month after month. I first came across this in the telecommunication
industry, where it has given rise to the euphemistic buzz phrase, "revenue assurance."
Several years ago, the telecom industry began to realize that, typically, 2-5 percent of revenue was not
even billed due to a combination of system problems and mistakes. Sometimes
the loss was over 10 percent of revenues. This money is lost profit. You can
imagine the reaction. Initial disbelief turned to acceptance as people realized
the many ways in which occasional errors combined and accumulated to big money.
Very soon telecoms, their consultants, and software vendors were talking
about revenue "leakage," specialist teams were formed, conferences were arranged,
and software tools began to appear. Today almost every telecom has some kind
of revenue assurance function and many have done impressive work that more than
repays the investment. More recently, telecoms have been finding similar problems
on the cost side, where they have been paying too much for services received.
Are Telecoms Special?
There are some reasons for thinking that this profit leakage is particularly
great in telecoms. The industry is fast moving, the technology complex, and
the data volumes staggering. But telecoms are not unique—far from it.
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How many times have you noticed that a hotel or restaurant has missed
something from your bill? Not often? It doesn't have to be to hit their
profits badly. When you look at the conditions under which people work and
the need to get the bill assembled before the customer leaves, it's obvious
that significant leakage will occur unless there is a reliable, comprehensive
computer system to capture all billable items and produce the bill.
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Trac Ops, a company that specializes in tackling overpayment problems,
estimates that the overall rate of overpayment across all industries is
usually between 0.05 and 0.1 percent of total payments. Of this, roughly
60 percent of overpayments are due to difficulties complying with complex
purchasing contracts. This affects retailers particularly. (Not surprisingly,
telecoms suffer from complex contracts on the billing side, especially when
they negotiate contracts with customers for which they have inadequate computer
support.)
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Insurance and reinsurance companies can lose money from errors and can
recover money by analysis and recovery projects. For example, they may identify
previously missed or unbilled reinsurance loss recoverables and third-party
deductibles.
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E-business sites have many of the same characteristics as telecoms, so
we can expect similar problems, despite computerization. Early audit work
on nonfinancial metrics to be published by Internet companies showed that
virtually all had to be adjusted for various types of error.
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Delivering products to customers at home is another problematic area.
A large firm I once worked for decided to mark the new millennium by sending
a bottle of champagne to every employee in the United Kingdom. Somehow,
between the company that managed it and the company that did the delivery,
nearly 13 percent of the champagne was never delivered. That's a truckload.
How To Cut Profit Leakage
Most of what I know about defeating leakage I learned in telecoms, but looking
at cases in other industries, the commonalities are striking. The first barrier
is a chicken and egg problem. Searching for leaks is hard work and usually involves
extracting data from computer systems and analyzing it. However, searches may
well find nothing worthwhile. How do you justify an investigation when you have
no evidence of leakage, and how do you get evidence of leakage without an investigation?
Looking in the Right Haystacks
Leakage is not evenly spread, so carve up billing or purchasing into smaller
areas with their own characteristics. Consider the risk factors that apply to
the processing in each area, such as complex contracts, poor computer support,
a history of management neglect, people telling you there are problems, and
high data volumes.
Quantify your view based on the evidence so far, but don't just pick a percentage
leakage rate. Consider the probability distribution of leakage rates. For example,
what do you think the probability is that the loss is greater than 1 percent?
How about greater than 0.1 percent? How about greater than 0.01 percent? It's
easier to do this if you have some figures from other work as a starting point
but don't give up if you haven't. Multiply the leakage rates with the value
of the bills involved and you have an idea of how much money is involved.
Sometimes it's obvious where you should look first, and the justification
is clear. However, you may find that no area has a clear cut justification for
a full project. Each area has a chance of containing big leakage, but it is
more likely that it doesn't and that a full project would be a waste of money.
Don't give up. Think of the areas you are analyzing as a portfolio of opportunities
to make money, and approach each one in stages, each designed to give you more
information. Begin by asking more questions about risk factors and existing
evidence of leakage. Have a look at customer complaints. Examine correcting
journals to see what is coming up. Talk to people who do the work, and ask them
what they think. If the chance of finding worthwhile leakage is still reasonable,
try extracting and analyzing a sample of data, perhaps just some of the easier
items to analyze. If the evidence still looks promising, move on to a more comprehensive
analysis.
If at any stage for a given area the evidence doesn't justify the next incremental
step, then stop. Incremental investigation will flush out opportunities that
would be uneconomic if you just rushed to a full project. One of the best ways
to get evidence about leakage is to improve internal controls, which is part
of integrating recovery with other control/system/process improvement work.
Integrating with Other Improvement Projects
The weaknesses that leads to leakage tends to go along with others that result
in customer dissatisfaction, wasted time, accounting concerns, and so on. That
means a lot of people are interested in the same areas but for different reasons.
Try to set up an integrated project that has multiple objectives (i.e., customer
satisfaction, reduced leakage, recovery, controls assurance, lower cost of operation)
and brings together the skills and tools of people with different interests.
Clearly it makes sense to improve things so that leakage doesn't happen again,
so process/system/control improvements tend to follow recovery projects. However,
it also helps recovery efforts to begin improving controls before the recovery
project starts. Why? Most controls are checks on data or processing, so when
you add new ones, you have more opportunities to record information about errors
and likely leakage. Besides, if an improvement is obviously needed, why wait
for the recovery project?
The Hard Parts
Once you are looking in the right places, doing analysis (usually by computer)
to find suspected errors turns out to be the easy bit. The hard parts are (1)
investigating suspected errors to find out if they really are errors, and (2)
getting money from other parties.
No matter how clear cut the errors seem to be when you look at what the computer
has extracted, you should expect the majority of these "errors" to be false
alarms on further investigation. Later, when you have checked the errors and
got down to a smaller number of cases you are fairly sure are real errors, you
will present your case to a customer or supplier and find that a significant
proportion of items never result in recovered money, even when you are in the
right. Customers leave you rather than pay the money they owe. (Don't worry
about lost business; they were only with you because they were getting free
service.) Suppliers waste time hoping you will give up. Expect the huge sums
initially under suspicion to be whittled down to a much smaller amount actually
recovered.
Organized Evidence
A key part of success is having a well organized and documented approach
to investigating suspected items. You need to know what your investigation has
established and what is still unknown. At some point, you will have to approach
customers or suppliers and ask for money, so it is worth being clear about how
you could still be wrong.
Don't write a detailed procedure imagining it will apply to all items because
in practice the items will be too varied. Do make every effort to break down
the items into sub-groups, prioritize them, and look for ways to use computer
power to speed up the investigation of each sub-group.
Incremental Steps
Recovery projects tend to be a bit messy because the data is, and so it is
difficult to judge how much work is still needed and what the financial results
will be. The work involves learning a lot as you go along. It makes sense to
take some suspect items through to cash recovery as soon as possible, and keep
doing that with sets of successively less valuable, more complex items. Do not
try to get all items through each stage before moving on to the next stage of
processing.
Software Tools
Software tools are important, but not just for extraction and reconciliation
of data. An ideal tool would help with monitoring the evidence and estimates
for multiple potential areas, extracting and comparing data, managing data as
you investigate and seek recovery, and reporting on progress and results.
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Don't act as if you know exactly what will be recovered. Be intelligent
about uncertainty concerning the amount of leakage and prospects for
recovery.
Prefer an integrated project that achieves improvements and recoveries.
Proceed incrementally, reviewing evidence and prospects frequently,
and taking items through to cash as early as possible to maximize learning.
Use computer tools fully. Make sure people with IT skills work closely
with others.
Be realistic about recovery prospects. Most suspected errors turn
out to be false alarms and many of the rest are never paid.
Do not give up. Your systems and processes probably aren't as good
as you think they are, and there is good money to be made from improvements
and recoveries.
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