Background : The top management of the engineering company has been extremely happy with the performance of the outsourced internal audit team for the Stores activity (details given in the article in earlier issue of the Journal). The management wants the internal auditors to now assess the procurement activity in terms of process improvements with optimal controls, compliance with laid down systems and procedures and cost rationalisation. The engineering company, whose turnover is 350 crores, is into manufacturing and giving services for cooling appliances like air-conditioners — window, split, cascade etc., refrigerators, water coolers.
The auditee has three units, the largest factory located at Thane with other two units at Vapi and Hyderabad. The pro-curement function is centralised at Thane factory with one person each at Vapi and Hyderabad who act as co-ordinators. Total purchases including raw materials, bought-out items, packing materials and consum-ables aggregate to 190 crores.
The management feels that there is scope of improving the procurement activity procedures leading to cost rationalisation.
The management aim also includes ac-curacy in financial reporting, compliance with applicable laws and regulations. The management objectives are also part of the three pillars of the ‘Integrated Framework — Internal Controls’ by COSO (Committee of Sponsoring Organisations of the Tread-way Commission), USA.
Based on the above background, the partner-in-charge of the internal audit firm had a meeting with his audit manager to chalk out the audit programme. As a first step a flowchart of the ‘procurement activity’ was prepared.
Based on the inputs gathered during the flowcharting process and the flowchart, a detailed checklist was prepared for meeting the audit programme objectives. The check-list identified the objectives for this area — Refer Exhibit 1.
Exhibit 1 :
1. Have purchasing authority limits been established, and what mechanisms prevent such limits being exceeded ?
2. Are adequate purchasing procedures in place and what processes ensure that they are maintained up-to-date ?
3. How can management be assured that purchase orders are issued only from authorised sources ?
4. What mechanisms prevent the processing of purchase orders without established policy conditions ?
5. Are all purchase orders formally justified and suitably authorised, and how is this evidenced ?
6. Are purchase orders adequately sup-ported with sufficient details, descriptions, specifications, prices, delivery location and freight terms in order to ensure that the precise requirements of the business are met ?
7. What processes prevent the despatch of inaccurate, incomplete or ambiguous purchase orders ?
8. What processes prevent the raising and despatch of duplicate purchase orders ?
9. What mechanisms ensure that optimal quantities of goods are ordered to support the operational requirements of the business ?
10. What mechanisms ensure that all sub-sequent purchase order amendments are valid, authorised and correctly applied ?
11. What mechanisms are in place to prevent over-ordering of items ?
12. How are potential vendors selected and what prevents the use of poor quality vendors ?
13. How can management be certain that the purchasing function fully researches the optimum sources for their require-ments ?
14. Are vendors adequately and inde-pendently assessed for ‘approved’ status, and what prevents staff/vendor misuse of the process ?
15. Are accurate and up-to-date records of approved/suitable vendors maintained, and what mechanisms prevent either unauthorised or invalid access or amendment of such records ?
16. Is the performance of vendors monitored against all requirements and expectations so that unsuitable, unreliable or poor quality suppliers can be promptly identified and ap-propriate action taken ? Further, whether there is a suitable vendor rating mechanism and vendors are intimated of their ratings every six months/year ?
17. Would management be alerted if there was either undue preference being given to a specific vendor, an unreason-able demand being placed on any one vendor or the potential for an unethical relationship being established between a vendor and purchasing management ?
18. Is there adequate liaison between the purchasing function and all other affected activities (i.e. production, sales, stock control, etc.) and how are problems and conflicts avoided ?
19. Does the purchasing function maintain an adequate awareness of market conditions, prices, etc. in order to ensure the placement of orders at the optimum price ?
20. How can management be sure that all available discounts are suitably exploited ?
21. Where applicable, are all relevant purchase versus leasing options adequately appraised to ensure that the most advantageous purchase terms are utilised ?
22. How can management be certain that all the required quality and standards for supplied goods are achieved ?
23. Would the supply of sub-standard, inadequate or poor quality goods be detected ?
24. Are all rejected and returned goods correctly identified and a suitable credit claimed and accounted for ?
25. How can management be certain that all the goods ordered and invoiced have in fact been received on time ?
26. Are the processes of ordering, account-ing and receiving goods adequately segregated to prevent staff malpractice ?
27. Where goods are obtained from over-seas suppliers, how can management be certain that all the relevant import and foreign exchange regulations have been identified and correctly addressed ?
28. Are management provided with ac-curate, timely and relevant information on purchasing activities to support their decision-making, etc. ?
Considering that this audit involved large volume of transactions — the software being used in procurement being an ERP, the traditional method of manual vouching would take a lot of time for the audit. It was therefore decided to use a data analysis software — IDEA to carry out a 100% check on all transactions depending on the objectives (using IDEA, the audit for the procurement activity would take only four to five days for the Mumbai — Thane factory). Additionally, back up steps taken in the analysis would also be available in the software.
The methodology followed was, to :
1. flowchart the process
2. prepare a control checklist
3. pinpoint control weaknesses based on this flowcharting and control checklist
4. conduct a transaction-based audit on a few transactions and documentation
5. use IDEA software to conduct a comprehensive check on all trans-actions based on deviations observed during the manual check on a few transactions — this is with a view to identify comprehensively the extent and value of the deviations to quantify, and also to give an assurance to management that other than these transactions there were no deviations during the year
6. in addition as will be seen from a few observations — external evidence was also collected from vendors in the form of quotations/statements for corroborating the internal incon-sistencies observed
7. give recommendations to make the system robust to avoid controllable costs and enable smooth operations.
Observations arising from the internal audit :
Following the checklist and using IDEA, the audit was completed in a two weeks time at the Thane factory. Two more days were spent in collecting external evidence from vendors. Since ‘Procurement’ was a central function, visit to Vapi and Hyderabad was not required and all documentation was available at Thane. Overall, there were number of control weaknesses in procure-ment which were leading to avoidable costs being incurred.
A few major observations on systems and procedures are given below :
1. Purchase from dealers rather than manufacturers :
Materials were purchased from dealers, rather than from manufacturers. This led to an extra cost of Rs.7.8 lacs as worked out from Excise Gate Passes. The study established, in some cases dealer’s margin amounted to 25% to 30%.
(Manufacturers give Excise Gate pass which is given to customers based on dealer price and dealers negotiate some more margin to this price based on credit terms, freight and marketing costs. The procurement function should ensure that this margin is not high as the dealer enjoys incentives in the form of turnover discount, various schemes from manufacturer).
Recommendation — Prices should be negotiated with the dealers. Possibilities of sourcing materials directly from the manufactueres should be investigated.
Cost savings — Based on this input from internal audit, the cost savings were around Rs.5.6 lacs.
2. Quotations not available from all approved vendors :
o For raw material-formulation and packing material-formulation, quotations are not available from all approved vendors. In turn, no Quotation Comparison Sheets (QCS) have been prepared. Each purchase should have Quotation Comparison Sheet.
Recommendation — Quotations should be obtained from more than one supplier, and QCS should be prepared for all orders. Monopoly suppliers should be listed separately, and specific sanction of ‘pro-curement’ committee should be obtained.
(Process improvement suggestion).
3. Order finalisation by Purchase Committee :
Benchmark for Purchase Order finalisation by Purchase Committee has been established at Rs.50 lacs and above. Purchase Order analysis shows that only 17 out of 512 Purchase Orders are above Rs.50 lacs during January 2003 to May 2003.
Recommendation — There is a need for increasing number of orders being finalised by Purchase Committee. The base may be reduced in the range of Purchase Orders of Rs.10 lacs and above.
(Process improvement and cost savings suggestion — Stricter review will lead to better control for major purchases.
Action — The base was revised to Rs.10 lacs and above for all Purchase Orders. This revised base was also incorporated in the SOP — Standard Operating Procedure —effective from 1st June 2003).
4. Sale of by-product at nominal prices compared to same product being available in market at much higher rates leading to loss to the company :
By-product being sold at Re.1/- per MT, basically to one buyer, while the value of the by-product is much more in the market (The market price was known to the internal auditor as similar by-product was sold by another client).
All by-product was sold to one dealer without inviting tenders. Examination of earlier years’ records revealed that by-product had been sold at an average price of Rs.200 per MT, and the same was sold to two or three dealers in a year.
This being the case, the internal auditor, with permission from his partner, ap-proached three vendors in the market directly, including two who had supplied earlier, and obtained quotes for the by-product. Sample was drawn from the factory and supplied to these buyers. On receiving the quotes directly from vendors it was observed that the quotes were in the range of Rs.200/- to Rs.220/- per MT.
The main reason of this lapse was that by-product sale was not considered to be a purchase activity and was outside the purview of the Purchase Committee. Though transactions were huge, senior officials did not pay attention to the systems and procedures being followed in terms of quotations, vendor analysis, etc. This led to a junior Purchase Official and Stores-in-charge (who certified the disposal) conniving and ensuring that this was handed out at almost no cost to a supplier.
The matter was brought to the attention of the Materials Head, Finance Director and CEO. They blacklisted the existing vendor, investigated further and sacked one Purchase Officer and Stores-in-charge and also set up the systems and procedures recommended by the internal auditor.
Recommendation — Sale of by-product to be overseen by Procurement Committee and sale to be made on the basis of tender.
(Cost-savings and systems streamlining suggestion).
Other observations were :
1. Indents pending with procurement function for more than a month and not converted to Purchase Orders.
2. Advances given to vendors but material not supplied for over two to three months.
3. Materials received more than the Purchase Orders but still accepted in Stores and payment made for the same. Tolerance limits for excess material were not specified in the Purchase Orders. Vendors therefore started taking advantage of this and dumping excess material since they knew that this would be accepted and not returned back.
4. Freight not being negotiated properly with vendors and vendors starting to charge extra at higher rates under the guise of freight.
5. Cases observed where the bought-outs supplied by the vendor and the labour job undertaken from another vendor; also in actual effect was the same vendor in two different names and the same not communicated to Purchase Committee.
Conclusion : Based on the thorough review and sug-gestions by the internal auditors, the management strengthened the processes leading to a robust procurement process and thus considerable savings to the company.