Identifying Problems in Operations
Tennessee Blue Sky

Identifying Problems in Operations

Being able to quickly identify problems in your business operations is critical to success. Implementing a simple problem identification system will help you to continue to operate your business profitably.

The owner of a growing construction company is running to and from multiple job sites each day trying to stay ahead of the game. It is springtime and business is booming. In fact, he has little time, let alone interest, to balance his company's bank statements, so he hires a person to open the mail each day, take care of accounts payable, balance bank statements and perform other accounting-related tasks such as billing and recording accounts receivable.

The owner of a restaurant is concerned because her food cost is skyrocketing. Business is slower than usual and her financial statements tell her that she is losing money each month. The owner has no idea why and begins to wonder if she should stay in business.

The president of a hospital has noticed a decrease in net income for the month; something that will have to be explained to the board of directors. A cursory investigation of the income statement reveals salary expenses (somewhere in operations) are 300 percent higher than budget.

As a business owner, you may have encountered situations similar to these. How do you identify problems before they force you to make quick decisions that may not be good for your business?

A few suggestions follow which will help you to identify problems before they become so big that they jeopardize your company's ability to operate profitably.

Avoid problems by establishing a reasonable set of internal controls.

An effective control environment sets the tone throughout the organization that rules exist and that deviations from the rules are discovered and dealt with promptly. Does this mean that a small business with only two employees must invest heavily in an expensive system to keep everyone honest? No. Internal controls can be as simple as having two people, instead of only one person, involved with daily accounting activities.

The owner of the construction company as referred to in the first case could be losing money internally. An effective set of internal controls in this case would go a long way in safeguarding financial assets such as cash and accounts receivable. Internal controls which could be incorporated into this scenario may include a requirement that certain duties be performed by different people each day such as opening the mail each day, preparing daily deposits of checks received and posting customer payments to accounts receivable. This is known as segregation of duties, and your certified public accountant (CPA) will be able to provide guidance to you during an audit of your financial statements or an operational audit of your business.

Fraud is a problem in business operations. It has been estimated that businesses lose $20 billion annually due to fraud committed internally. Any steps that you take to create an awareness within operations that internal controls exist to detect such activity will yield rich dividends. Another effective control to incorporate into your operational environment is to require employees to take vacations. This would require cross training of duties so that one person could not easily conceal a fraudulent activity over an extended period of time.

Get involved with daily operations and proactively manage your business.

Whether you own a firm with fewer than 10 employees or a manufacturing company with hundreds of employees, it pays to get out into operations to see what's going on. You may find that employees are willing to talk to you if they see you often enough. You may even notice inefficient processes occurring in operations.

As in the second case presented above, the manager of an upscale restaurant could not understand why her food cost was so high compared to the industry average. It was not until she decided to stay in the restaurant until closing late one night when she discovered the culprit. It had become common practice for employees to take home several take-out boxes of food from the salad bar, generally a high-cost item for any restaurant.

A bartender had also made it common practice to give away drinks to good customers in exchange for better-than-average tips. It was no wonder the restaurant was losing money. The manager took steps to incorporate inventory controls which held employees accountable for differences at the end of the day.

For instance, bartenders started taking inventory of all items in the bar before and after a shift. At the end of a shift, the difference between ending and beginning inventory could be proved by the detailed sales transactions report from the point-of-service system. This simple control procedure created an environment of "enforced honesty" whereas before the control was implemented, the bartender figured that nothing would be missed. Because the manager decided to get involved with the day-to-day activities of her business, and not leave the "management" to the closers at night, she was able to significantly reduce her food cost and operate the restaurant profitably again.

Another effective method of identifying problems in operations is to implement an employee suggestion box. Consider providing a monetary award to employees who identify solutions to operational problems. One company offered to share up to 25 percent of the cost savings to such solutions to problems and the suggestions poured in from all over operations.

Produce an annual and monthly budget and review it monthly for variances.

Create an atmosphere of involvement during budget preparation time. As the business owner, ask your managers to submit budgets for each aspect of operations under their control. Expect your managers to create the budget and hold them accountable for adherence to the monthly budget. Compare actual monthly expenses to budgeted monthly expenses and ask for explanations if material variances occur, also known as operational problems.

One company issued financial statements on the fifth business day of each month. On the sixth day, the finance department prepared budget variance reports which were submitted to every manager. Each manager was then required to explain every significant variance (10 percent over or under, budget) for the month within one week. This practice of holding managers accountable produced an atmosphere whereby all managers knew what was going on in their departments at any given time. Seldom was a question asked of an operational manager when he or she did not know why costs were higher or lower than the formal, agreed-upon spending plan, also known as the budget.

This process of absolute accountability was referred to as the "nowhere to hide" principle and it successfully identified timely operational problems. For example, telephone expenses for one month were more than double the budgeted amount. When the manager reviewed his variance report for the month (a comparison of monthly expenses to budgeted expenses), he discovered that a service was billed twice by the telephone company, and paid twice by the company. This discovery resulted in a review of the accounts payable process which, in turn, prevented that error from occurring again in the future.

What would have happened if expense comparisons were not being reviewed each month? This error could have resulted in a permanent loss to the organization.


Implementing cost effective internal controls prevent problems before they actually occur. Consider hiring a CPA to conduct an operational audit of your company. An operational audit is a planned search for ways of improving efficiency and effectiveness and can include an evaluation of existing internal controls. Get involved with all aspects of your company's operations. Be proactive and regularly talk to employees at all levels of your organization's structure. Finally, develop a budget and plan your spending throughout the year. When you notice differences between actual monthly expenses and the projected spending plan, ask questions of the managers responsible for developing the budget for their respective departments. If you discover problems, congratulations. You have just used a problem identification system to avoid future problems as well as improve processes within your operations.

Last Updated 11/2/2011

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