Building a successful company requires more than just bringing together good people and products. What is equally important are good procedures and operating philosophies–many of which, if never instituted or else used sporadically, can drain dollars out of your company in ways you never expected.

I know this from personal experience.

Paul Bumblauskas
Paul Bumblauskas

In the early 1990s, while I was chief financial officer of a business, I authorized a $100,000 open account to a company that was served by one of our 21 branches. Eventually that company went bankrupt. When it ceased operations, I found we were still actively shipping to the company, and the open accounts receivable was $135,000–most of it current.

How did the account get to $135,000 when the credit limit was set at $100,000? The bookkeeper said her manager authorized this and she felt pressured to keep from telling higher-ups.

I then met with the sales associate who managed the account. Concerned that we were doing so much business with the company just before it collapsed, I asked if he had any indication there had been a problem with the customer.

"Of course," he said. "The trades had been walking off the job for weeks." So why didn't the sales rep say anything? He replied that credit was not his job and thus he had no obligation to bring this to our attention. Furthermore, since he was paid on a "shipped" and not a "cash received" basis, he would have lost income if he had told us.

In contrast, I had a much happier experience when I was named regional vice president of sales for the same company. I empowered our sales associates to be the first line of defense on credit extension and collection. During my initial year and with record sales, we reversed almost $200,000 of bad debt and rarely had collection issues. Just as notable, strategic credit extension and collection plans were developed for large, risky, or historically problematic accounts, significantly reducing the odds of future problems.

Companies typically have complex and fragile sets of philosophies, strategies, procedures, customs, and expertise, the combination of which support, protect, and create profitability and value for the organization. This operational structure is supported by practices and control mechanisms that collectively are called the internal control system. But because of the building industry's crash, as companies have cut back resources, they've removed those internal controls, sometimes without understanding the impact of what they've done.

Strangely, when an internal control system is working, there are few losses to record and, since most risks have been addressed, any cost of upholding the system appears to be too much cost. But it's at that moment, when controls go away and other processes are left unmonitored, that disasters can occur.

Internal controls can play an important role in preventing and detecting fraud. They help protect the organization's resources, both physical (machinery and property) and intangible (reputation or intellectual property, such as trademarks). Internal control procedures can reduce variations in the way things are done, leading to more predictable outcomes. And they can help the organization accomplish specific goals or objectives.

Evolution, Not Revolution

Given all those possibilities, implementing internal controls can seem like trying to nail Jello to a wall, and justifying the extra work can seem just as foolhardy. One of the most important and truest criticisms of internal control is that the cost often exceeds the perceived or real benefit. This is particularly relevant for smaller companies or companies with decentralized operations. Many view internal control as an all-or-nothing venture. When cost-effective solutions cannot be easily identified, internal controls often are left unaddressed.

But creating internal controls needn't be expensive, and they don't have to be implemented all at once. The development of an excellent internal control system is an evolution, not a revolution.

Where do you begin? First, create an honest, ethical environment for your employees, as we know that losses are less for this type of organization. If owners and managers observe policies and procedures, others tend to follow. Employees tend to emulate good–or bad–behavior.

Next, empower everyone in the organization to be responsible for identifying internal control weaknesses and then develop a communication system so that these weaknesses can be evaluated in a consistent and confidential way. In many cases, we find that employees knew there were issues, but they did not understand their responsibility to the organization.

As for that cost/benefit question, I suggest you create an internal control advisory committee (ICAC) to manage the process. This five-member committee would be charged with identifying internal control weaknesses and risks and making recommendations to enhance the internal control environment.

For those companies with a history of significant loss, the ICAC should be armed with an initial annual budget equal to about one-third of the historical annual average loss. In other words, whatever the ICAC expects to invest, be it time or other resources, must deliver triple that value in benefits.