Sales order processing and internal controls.
Muzorewa, Susan ; Rao, Arundhati
CASE DESCRIPTION
In this case the students will be presented with a change in
marketing strategy that will result in high growth in sales. The
students are required to analyze the financial information and assist in
the designing and developing an effective system to support the
company's internal control objectives. The student is required to
make an assessment of the inherent risks and exposures associated with
the operations of the organization and design adequate internal
controls. The case intentionally avoids any lengthy discussion of the
marketing strategies. This case is written primarily for accounting
majors in an undergraduate business program. It is suited for students
who have already been exposed to the introductory accounting, finance
and management courses. It can be taught in an introductory Accounting
Information Systems course or an upper level accounting class after at
least a brief discussion of accounting information systems. The case
could also be taught at the graduate level to business students who need
to understand and support the accountants in designing and enforcing
internal control issues. The case can be assigned as an individual
project or as a group project. The case can be tailored to meet the time
constrains of any class schedule.
CASE SYNOPSIS
BodyBrace Inc, located in Richmond, Virginia manufactures and sells
customized compressive sportswear that reduces injury, enhances physical
performance and athletic longevity in the human body. Unfortunately the
company has not realized the growth it had anticipated 10 years ago at
inception. Based on the recommendations of a marketing consultant, Mr.
Davis the founder and CEO of the company has decided to expand from
customized to mass production of the sportswear. A proposed change in
the marketing strategy is expected to result in rapid growth in sales.
However, this will require a large infusion of cash from a creditor. The
company is looking for funding from a bank to finance the expansion.
Every bank approached thus far wants assurance that a well designed
accounting system will be in place soon. BodyBrace now needs to
establish an effective Accounting System to enable it to keep track of
its activities as well as establish a sound internal control system to
ensure the integrity and reliability of its financial statements and
other data. The case encourages students to apply the internal control
guidelines laid down in Statement of Auditing Standards (SAS) No. 78 and
use data flow diagrams (DFDs) to explain the sales order process.
INTRODUCTION
BodyBrace Inc., was formed in February 1997 with a mission to
design, manufacture and sell a range of customized compression
sportswear under the brand name 'BodyBraces'. Mr. Davis, CEO
and President, owns 85% of the shares and Mr. Williams, an attorney,
owns the rest. The business office is currently located in Mr.
Davis's home. He is the only salesperson for the company and is
responsible for all company operations; there are no other employees.
BodyBrace does not own any manufacturing facilities as it outsources all
its manufacturing. Mr. Davis forwards the orders he receives to the
manufacturing facility and products are shipped by the manufacturer
directly to the customer. The products were invented to cushion
sensitive joint ligaments, to help minimize possible sports related
injuries and to enable quick recovery from such injuries. The invention
was the work of Mr. Davis a physics major. He is so proud of his product
that he is quick to tell you about the Ergonomic Study conducted by the
Central State University Human Performance Laboratory. The findings of
the study were published in a sports journal a couple years later. An
additional finding of the study was that wearing BodyBraces also
enhanced overall performance of the athlete.
At the launch of the 'BodyBraces', Mr. Davis believed
that the product would appeal to every athlete and thus tap into the $50
billion sports apparel market. The initial business plan projected
annual sales of $5 million by the third year of operations. 10 years
later those projected annual sales have not been realized. In fact in
the 2005 fiscal year, total sales were under $250,000. See Tables 1 and
2. In a meeting with the newly hired marketing consultant, Mr. Davis was
told "While you have a unique and innovative product, my analysis
as a seasoned brand manager is that you have narrowly defined your
target market. BodyBraces is a totally different concept in sports
muscle-injury management and have many attributes that anyone involved
in any sporting activity or even just a fitness program should be aware
of. My strategy therefore would be to build product awareness in the
market through mass production and mass distribution of the
product." BodyBrace now needs external financing and proposes to
finance this expansion by establishing a line of credit with a local
bank. Mr. Davis is surprised that all the banks indicate that his
ability to obtain financing is contingent upon proof of the
establishment of a business model with effective internal controls. It
is from this perspective that BodyBrace Inc. now seeks the services of
an accountant to set up an adequate system with internal controls for
his business.
CURRENT MARKET AND ACCOUNTING SYSTEM
Initially BodyBrace's target market was only the professional
sports teams. The first BodyBraces were sold in April 1997 to the
Washington Redskins. Since then the company has produced prototypes for
various professional football teams. Currently 22 of the 32 NFL teams
use the BodyBraces for soft tissue muscle injuries. Mr. Davis developed
a special relationship with a professional football team after its
defensive back severely injured his groin. Mr. Davis contacted the
training coach and offered the BodyBrace to enable the player to recoup
quickly and play in the NFL Championship game. Mr. Davis is proud to let
everyone who will listen know that "Eight days later, the player
played in that championship game. In fact, he states that he could not
have played without his BodyBrace." Based on this success the
professional team has made the BodyBrace a standard part of their injury
reduction regiment since 2002 and continue to use it today. Numerous
other Sports Performance and Athletic Training Programs have started
using the BodyBraces as standard equipment in their muscle treatment
regiments. BodyBrace Inc has also won contracts with the government and
Mr. Davis is very proud to have provided his BodyBraces to the US Armed
Forces and the US Olympic teams.
The company has used various methods to reach new customers. In
most cases Mr. Davis used the direct selling approach; he reached out
directly to the team trainers and coaches to create awareness of his
product. He has also used mass mailing to various organizations and club
members. Mr. Davis has appeared on Real Sports TV with Brian Gumbel as
well as on the Brooklyn Public Sports Television in New York. He has
been on the local Richmond radio and television shows. He had articles
about his company published in the Baltimore Business Journal.
Unfortunately none of this celebrity patronage has brought him the
desired results.
An examination of the current accounting system reveals that
BodyBrace's current accounting system will not be able to handle a
rapid growth in sales. "Is this all, Mr. Davis?" Ms. May an
accountant asked, "You mean all the information about the sales and
the expenses of running your business is contained in this spiral
notebook?" "Yes, Ms. May that's where I keep all the
information," Mr. Davis replied. "When I need a statement
prepared or my taxes done, I take this book to my niece who puts the
numbers together and gives me the information to take to the bank or
whoever needs the information. Sometimes she asks for a bank statement
or a credit card statement to get some more information. She prepares
the income taxes from that information. She said all I need to do is to
try to remember the date as well as to make sure I write everything down
as soon as it occurs so I don't forget anything. Believe me I am
very good at keeping all the receipts and invoices and if I lose any I
can always get the information from my credit card company. I have a
very simple way of keeping track of all my activities I tell you. My
niece recommended that I do it that way. She also recommended that I get
a software package, which I did, but I haven't gotten around to
using it yet. Since we are expanding I might have to, is that what you
are talking about?"
NEW MARKETING STRATEGY AND PROPOSED ACCOUNTING SYSTEM
Failure to achieve the desired sales volume has compelled the
company to change its marketing strategy. Recently Mr. Davis retained a
marketing consultant to develop and implement a more effective and
focused marketing strategy. In addition to custom made products, the new
strategy calls for mass production of the BodyBraces and to sell to a
larger market segment. The target market includes physically active
people of all ages. The company will pursue an aggressive advertising
campaign using several media channels to create product awareness.
BodyBrace will display its products at various schools, colleges, and
sporting events. Brochures will be placed in hospitals, gyms, health
spas, doctor's offices, and other medical facilities. The
projection is to sell at least 50,000 items in the first year (2007). A
competitive pricing strategy will be adopted to allow the company to
focus on building product awareness. The strategy is to build revenue
while creating product awareness through aggressively selling the lower
priced items. Sales are projected to double for the year 2008 and will
grow at a reduced rate after that. The projected sales are given in
Table 3. The company will continue to outsource manufacturing of the
product but will now need to keep sufficient inventory on hand to
facilitate timely shipment of the products to customers. A new office
and warehouse will be rented in Richmond, Virginia. It is estimated that
a total of 10 to 12 employees would be required to run to the business.
All the employees will earn a base salary. Initially some employees may
be temporary. Sales orders will be received as follows:
1. By sales associates from the customers over the phone or the fax
(credit card only).
2. Through the Internet (credit card only). The web site will be
checked for orders periodically throughout the day, printed and
processed by the sales associates.
The order will be fulfilled, i.e., picked, packed and shipped by
the employees in the warehouse.
Financial projections indicate that BodyBrace needs to secure a
$500,000 line of credit from the bank. This would enable the company to
stock up on inventory as well as buy some fixed assets such as furniture
and equipment that it needs to start operating at this scale. These
funds would also cover the company's operating expenses for a
period of six months. See Tables 4 and 5 for the five years projected
financial statements.
To keep up with rapid growth in sale the company now needs to
establish a better system to keep track of all its transactions.
"The banks will demand audited financial statements for the amount
of credit you are seeking Mr. Davis. Without the financing, you may not
be able to realize the expansion you have envisioned." On hearing
this from the accountant, Mr. Davis's response was "Well I
guess we will go with the system that you are proposing. I have never
bothered before because I have never needed a loan from the bank. The
product was customized and the cost of the goods was so low that I have
always had the money to finance my activities. Right now all the
business owes is $16,000 for some legal work I needed done with the
patent." The accountant said "Mr. Davis, you will be pleased
with the accounting information system we will design for your company.
We will design a system that will accurately capture all the financial
and nonfinancial transactions of the business to allow efficient
day-to-day operations as well as assist you and the management in making
decisions for the company.
The system will provide monthly and annual financial statements as
well as support management by providing regular summary reports,
exception reports, and interim reports necessary for decision-making.
The system will establish adequate internal controls for your company
which most banks are interested in. All procedures will be documented
with appropriate flowcharts to facilitate with training new
employees."
She explains to Mr. Davis that Statement of Auditing Standards
(SAS) No. 78 defines internal control as a process effected by an
entity's board of directors, management, and other personnel,
designed to provide reasonable assurance regarding the achievement of
objectives in the following categories: a) reliability of financial
reporting, b) effectiveness and efficiency of operations, and c)
compliance with applicable laws and regulations. The term process is
used because internal control is viewed not as one event or
circumstance, but as a series of actions conducted through basic
management of the entity. Internal control is a dynamic process. While
Mr. Davis is excited about the new direction his company has to take, he
is a little apprehensive. After meeting the marketing consultant, Mr.
Davis's biggest worry was that for the new plans to be implemented
he will have to increase the company's debts from $16,000 to
$500,000. Now that he has met with the accountant his worries have
grown. So far he has not had to deal with any employees. He is well
aware of the fact that even the best employee needs to be trained and
supervised. He does not know what internal controls are needed to safe
guard his company's assets and has never heard of SAS No. 78 until
now.
DISCUSSION QUESTIONS
1. What financial statements, summary, exception and interim
reports are produced by an accounting system?
2. What are the four broad objectives of an internal control
system?
3. What are the five components of internal control as defined in
SAS No. 78 and briefly discuss some elements of the components as they
relate to BodyBrace' operations?
4. Identify the six control activities classifying each control
procedure within the SAS No. 78 Framework. Identify the areas where
these controls would be required for BodyBrace's operations.
5. Identify the transactions that will be performed in the sales
order processing at BodyBrace Inc. Specify the departments involved, the
documents that will provide the audit trail, support the internal
control objective as well as enable financial reporting. Identify the
risks associated with the transactions and recommend the controls that
reduce the risk.
6. Draw a context, physical and logical DFD to graphically explain
the sales order process.
Susan Muzorewa, Delaware State University
Arundhati Rao, Towson University
Table 1
BodyBrace Inc.
Income Statement (year ended December 31)
2004 2005 2006
Sales $205,000 $245,000 $294,000
Cost of Goods Sold 27,500 32,800 40,000
Gross Margin 177,500 212,200 254,000
Operating Expenses:
Salary Expense 90,000 100,000 140,000
Advertising Expense 25,000 40,000 50,000
Rent Expense 12,000 12,000 12,000
Telephone Expense 13,000 13,500 14,000
Travel & Entertainment Expense 19,600 22,000 24,300
Other Expenses 3,500 6,500 3,500
Total Expenses 163,100 194,000 243,800
Income before taxes 14,400 18,200 10,200
Income Taxes 5,040 6,370 3,570
Net Income $9,360 $11,830 $6,630
Table 2
BodyBrace Inc.
Balance Sheet
12/31/2004 12/31/2005 12/31/2006
Assets
Cash $ 5,000 $ 3,500 $ 6,000
Furniture & Equipment (net) 15,000 11,000 7,000
Investments 1,500 1,000 3,500
Other Long Term Assets 25,000 22,000 34,500
Total Assets $ 46,500 $ 37,500 $ 51,000
Liabilities and Equity
Current Liabilities 3,000 8,000 3,500
Other Liabilities 0 0 16,000
Common Stock 25,000 25,000 25,000
Retained Earnings 18,500 4,500 6,500
Total Liabilities and
Owner's Equity $ 46,500 $ 37,500 $ 51,000
Table 3
Projected Sales Under New Marketing Strategy
Selling Gross
Item Price Cost Profit
Shoulder Brace 269.99 35.00 234.99
Shorts 169.99 35.00 134.99
Elbow Brace 39.99 7.00 32.99
Shin Splint 39.99 7.00 32.99
Knee Brace 24.99 7.00 17.99
Ankle Brace 21.99 7.00 14.99
Item Projected Sales in Units
2007 2008 2009 2010 2011
Shoulder Brace 2,000 4,000 6,000 9,000 10,350
Shorts 2,000 4,000 6,000 9,000 10,350
Elbow Brace 12,000 24,000 36,000 54,000 62,100
Shin Splint 12,000 24,000 36,000 54,000 62,100
Knee Brace 12,000 24,000 36,000 54,000 62,100
Ankle Brace 12,000 24,000 36,000 54,000 62,100
52 000 104 000 156 000 234 000 269 100
Sales will double in 2008, increase by 50% in 2009 and 2010 and
increase by 15% in 2011.
Manufacturing cost per item is held constant as per agreement with
manufacturer.
Increase in other costs will be offset by increase in selling price.
Table 4
BodyBrace Inc.
Projected Income Statement (for the year ended December 31)
2007 2008 2009
Sales 2,500,000 5,000,000 7,500,000
Cost of Goods Sold 476,000 952,000 1,428,000
Gross Margin 2,024,000 4,048,000 6,072,000
Operating Expenses:
Salary Expense 450,000 750,000 1,125,000
Advertising Expense 200,000 400,000 500,000
Rent Expense 60,000 60,000 60,000
Insurance Expense 20,000 20,600 21,000
Telephone Expense 60,000 61,800 63,000
Travel & Entertainment Expense 100,000 140,000 140,000
Interest Expense 20,000 20,600 22,000
Other Expenses 50,000 50,000 50,000
Total Expenses 960,000 1,503,000 1,981,000
Income Before taxes 1,064,000 2,545,000 4,091,000
Income Taxes 372,400 890,750 1,431,850
Net Income 691,600 1,654,250 2,659,150
2010 2011
Sales 11,250,000 12,937,500
Cost of Goods Sold 2,142,000 2,463,300
Gross Margin 9,108,000 10,474,200
Operating Expenses:
Salary Expense 1,687,500 1,940,625
Advertising Expense 500,000 500,000
Rent Expense 60,000 60,000
Insurance Expense 22,000 23,000
Telephone Expense 65,000 67,000
Travel & Entertainment Expense 150,000 150,000
Interest Expense 24,000 24,000
Other Expenses 125,000 150,000
Total Expenses 2,633,500 2,914,625
Income Before taxes 6,474,500 7,559,575
Income Taxes 2,266,075 2,645,851
Net Income 4,208,425 4,913,724
Table 5
BodyBrace Inc.
Projected Balance Sheet
2007 2008 2009
Assets
Cash 10,000 50,000 100,000
Accounts Receivable 200,000 300,000 360,000
Inventory 60,000 100,000 100,000
Other Current Assets 10,000 10,000 10,000
Furniture (net) 20,000 30,000 28,000
Equipment (net) 75,000 75,000 250,000
Investments 50,000 60,000 75,000
Other Long Term Assets 650,000 690,000 1,000,000
Total Assets 1,075,000 1,315,000 1,923,000
Liabilities and Equity
Current Liabilities 40,000 50,000 60,000
Long-Term Notes Payable 200,000 30,000 30,000
Long Term Liabilities 115,000 40,000 20,000
Common Stock 10,000 10,000 10,000
Contributed Capital 15,000 15,000 15,000
Retained Earnings 695,000 1,170,000 1,788,000
Total Liabilities and Equity 1,075,000 1,315,000 1,923,000
2010 2011
Assets
Cash 100,000 200,000
Accounts Receivable 300,000 250,000
Inventory 80,000 75,000
Other Current Assets 15,000 20,000
Furniture (net) 23,000 350,000
Equipment (net) 240,000 350,000
Investments 310,000 645,000
Other Long Term Assets 1,600,000 2,150,000
Total Assets 2,668,000 4,040,000
Liabilities and Eauity
Current Liabilities 33,000 25,000
Long-Term Notes Payable 50,000 40,000
Long Term Liabilities 60,000 50,000
Common Stock 10,000 10,000
Contributed Capital 15,000 15,000
Retained Earnings 2,500,000 3,900,000
Total Liabilities and Equity 2,668,000 4,040,000
