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Manufacturing
Forensic Investigation of an Unexpected Loss

Background

The business manufactured components for the perfume industry, in particular the aluminium nozzles used in perfume bottles to spray perfume. Customers included the leading global beauty brands. It was a £13m turnover subsidiary of a small plc.

The manufacturing operation was old fashioned and labour intensive. Nothing had really changed in years. It was a ‘steady away’ subsidiary that wasn’t particularly exciting but it recorded steady profits every year. Because of this ‘unexciting’ image, the company had suffered a lack of investment and the parent company did not really pay it much attention.

Then, totally unexpectedly, in Month 11 of one particular year, the business recorded a significant loss. This confused both the local management team and the parent company’s divisional management team. Nobody understood the reason for this loss and, it being Month 11, there was no time to react to the loss before year end. Consequently, the business caused embarrassment at PLC level.

The Brief

After the initial discussion between Group and the local management team, it was mutually agreed that the local Finance Director would leave the business with immediate effect.

I was recruited as an Interim Finance director without any handover period. My brief was as follows:

To dive deeply into the figures and explain why a sudden loss had been reported in P11
To comment upon the reliability of the month end process at the subsidiary
To prepare a corrective action plan for any areas of weakness or concern
To help to bed in the Financial Controller who was recruited to replace the departed Finance Director

Assignment

Having reviewed the published Management Accounts for each month for the previous three years and having discussed month end processes with the Assistant Accountant, it became clear that the ‘sudden’ significant loss was neither a sudden nor a one-off hit.

The accounts had been reported inaccurately for a long period. Provisions and Prepayments had been used for a long time to smooth out the reported bottom line.

This revelation to the PLC led to the Divisional Finance Director responsible for the business to leave the Group at short notice.

The next step was to try and unravel the impact of the provisions and prepayments each month to get to the underlying performance of the business. This exercise showed that the business was fundamentally lossmaking.

The next step was to identify why the business was lossmaking when it had a large order book and a sister company that represented 60% of it’s turnover. The answer was due to a number of factors each of which was a surprise to the Group, namely:

The cost of aluminium had been very volatile for a sustained period. The business was not updating it’s standard costs regularly enough. This resulted in tenders being won based upon material costs that were understated
The business did not have a manufacturing performance reporting system that was reconciled to the Management Accounts. Hence the margin declared in the Management Accounts could be manipulated by provisions without it being noted and questioned by third parties
In particular, the business did not report the actual cost of production compared to the theoretical (standard) cost of production. By not doing this, it did not identify that ther were huge variances in material and labour cost against standard
Labour cost was running well above standard due to the lack of investment in the site’s plant and machinery. This led to regular machine breakdowns which proved to be a double whammy (a) high maintenance costs were incurred and (b) labour efficiency was terrible because direct labour heads were stood around not producing
The implication of this was that the sister company that represented 60% of the company’s turnover was receiving a transfer price that was too low. They, in turn, were tendering for contracts and winning them based upon artificially low costs. This was another form of lost profit to the Group

Conclusion

These findings were presented to the local Management Team and a selection of Main Board directors. It was a tense afternoon but the findings, the implications of the findings and the potential corrective action plan for each step were discussed in an awful lot of detail.

The audience seemed comforted by the fact that the root causes of the reported loss had been identified and explained. They were extremely uncomfortable and upset that the local team and the divisional management team had not been close enough to the action to identify that the Management Accounts couldn’t possibly have been accurate.

One main Board Director commented that the presentation had been the clearest and most effective presentation of financial information to non-financial colleagues that he had ever witnessed.

After formal sign off of the proposed action plan, a communications programme was commenced within the manufacturing business. Every department was given a message that the business had been under-performing – the reasons why – and the proposed route to get back onto an even keel. The corrective action plan then commenced and, once the new Financial Controller had been properly inducted, the assignment came to an end.

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What our clients say

Jeremy Fletcher Interim CFO, Bespak Europe

“ Les quickly provided detailed, logical and very understandable analyses and presentations of his findings.

Les demonstrated a strong drive and enthusiasm to achieve the task he had been set. He was absolutely open and honest with key stakeholders and he was not afraid to say what he saw.”

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