Document Sample
toy_city Powered By Docstoc
					                                                                 Operations Management

                                                      Toys City, Inc.*

Goodman & Goodman, a CPA firm, has audited Toys City, Inc., for the last three years.
Toys City, Inc., is a regional retailer of children's toys and games. Each of the three
previous audits resulted in unqualified opinions. Toys City's year end is December 31,
and Goodman & Goodman has agreed to provide the audit report on March 1, 1998, ten
days before the annual board of directors meeting. Bert, the manager from Goodman &
Goodman in charge of the Toys City engagement, recalls that last year there was a 25
percent budget overrun. He attributes one-third of the overrun to unforeseen
circumstances and the remaining two-thirds to poor planning. He estimates that poor
planning resulted in approximately 130 hours and $3,400 in audit fees that were not billed
to Toys City. In an effort to avoid another costly overrun, Bert wisely decided to devote
more time to audit planning. By talking to various people, Bert learns that a project
management technique known as Critical Path Method (CPM) could assist an auditor in
sequencing all audit detail work (including work requested from client personnel),
efficiently allocating personnel resources, highlighting potential audit bottlenecks,
estimating completion time, determining the probability of meeting a completion
deadline, and providing a framework for relevant feedback and control as the audit
progresses. Thus, he decides to spend an additional 17 hours planning this year's audit,
including computer setup and analysis time, using CPM.

Audit planning

During the slow month of August 1997, Bert and Craig, the senior-in-charge of the Toys
City engagement, analyzed the audit plan for Toys City.

       Basically the audit work could be divided into three phases: prior to year end, year
end, and after year end. Exhibit 1 illustrates the work structure for Toys City's audit. Prior
to year end the work is relatively simple and does not require much coordination. The
work for the year end and after the year end, on the other hand, is mostly field work and
requires much tighter control and coordination. This is the part of the audit that Bert feels
the CPM method could help.

        After a careful study, 22 audit areas are identified and budgeted hours for various
levels of auditors are estimated (Exhibit 2). Billing rates for each auditor are indicated in
parentheses below the various professional levels. Combining these rates with the
   By Dinah W. Cheng and Mike Moses, Operations Management Area, Stern School of Business. This case is for the use of
students in a core course in Operations Management and is intended to have no actual relationship to any real person or organization.

budgeted hours leads to budgeted costs for the audit areas. The duration hours refer to the
net time it takes to complete an audit area. Duration hours are less than total budgeted
hours where audit areas permit simultaneous auditing by two or more audit personnel.
Thus, to some extent, duration hours are variable depending upon the number of audit
personnel available for an engagement and their assignment to various audit areas.

         Each audit area is then analyzed as a separate work package in which detailed
audit activities are specified in chronological order. For instance, the liabilities work
package is composed of 10 tasks. First it takes 2 hours to obtain a schedule of liabilities.
Then confirmations must be mailed out and processed, which take 12 hours and 39 hours
respectively. After the confirmations are processed, the debit balances must be
investigated, which takes 5 hours. While the confirmations are being mailed out, another
staff auditor could first vouch selected liabilities and then test accruals and amortization,
which takes 64 hours and 4 hours respectively. Also, after the schedule of liabilities had
been obtained, a third staff auditor can spend 4 hours testing the pension plan. Once the
pension plan, accruals, and amortization have been tested, the interest expense to debt can
then be reconciled. This takes 8 hours. This is then followed by 5 hours of verification of
the debt restriction compliance. Once the debit balances are investigated and debt
restriction compliance verified, subsequent payments can then be reviewed, which takes
10 hours. Exhibit 3 summarizes the tasks for the liabilities work package and their

       The engagement network could be depicted at various levels. A relatively detailed
schedule is used in assembling time estimates and controlling audit progress while a
summary version is useful for an overview. The summary version depicts each work
package (such as the liabilities work package) as a simple engagement activity with
duration equal to the project completion for that work package.

       Once the timing and duration of the various work packages have been worked out
in detail, they are linked together in chronological order. The relationship among the
various twenty two work packages is summarized in Exhibit 4. Using this information, a
network diagram is drawn and all critical activities are identified. The minimum time to
perform the entire engagement can also calculated.

        One benefit that has come out of this audit planning is the cost reduction resulting
from more efficient allocation of the audit staffs. For example, last year's inventory
pricing required 192 hours of staff time, 30 hours of senior time, 8 hours of manager
time, and 6 hours of partner time. Multiplying hours by the billing rates of the four
professional levels shows that this personnel scheduling plan resulted in a total cost of
$5,360. This year, Bert estimated the relative efficiency per dollar of cost for each
professional level in each work package. For the inventory pricing area, it was found that
it is more efficient to substitute 4 hours of manager time and 3 hours of senior time for 38
hours of staff time. The manager's and senior's general competence and familiarity with
Toys City's inventory enabled them to apply overall tests of reasonableness to a major
segment of inventory in lieu of staff performance of more time-consuming detail price

vouching. Total cost for the inventory pricing work thereby was reduced to $4,850,
resulting in saving $510.


The actual audit began on January 4, 1998, as planned. Soon after the audit began, Bert
received a request from John, one of the staff auditors who would be auditing the
receivables. John was getting married and would like to take a week (40 audit hours) off
for his honeymoon from January 16 to January 20. There was no other auditor available
in the firm to replace him. To ensure that the audit would complete on schedule and on
budget, John was advised to delay his honeymoon plan until the entire project was
completed. After failing to convince Bert that his plan would not affect the progress of
the project, John reluctantly postponed his honeymoon and the audit engagement
proceeded without any interruption.

       After the Toys City audit had progressed 106 duration hours, a need for
acceleration arose when Bert was informed by the Toys City controller that merger
negotiations had been initiated with a toy manufacturer. The controller urgently requested
delivery of the audit report 1½ weeks (60 hours) earlier than originally agreed. Bert
assured the Toys City controller that he would attempt to comply with the acceleration

       Since it was an extremely busy period for Goodman & Goodman, no idle auditing
personnel were available in the firm for assignment to the Toys City engagement. Thus
work package durations (not budgeted hours) could be reduced only by application of
personnel at overtime rates, increased use of more experienced professionals (i.e., seniors,
managers, and partners), and similar cost-inflating alternatives. Since Bert's CPM
knowledge is still rather elementary and it is important to be able to reduce the project
completion time by 60 hours at the lowest cost, Bert decided to hire Gary Fay, an external
consultant, to advise him on how to proceed. After talking to Bert and various people in
personnel, Gary quickly came up with the estimated acceleration times and costs for
various activities tabulated in Exhibit 5. Based on these costs, the schedule for the
remaining auditing procedures was revised. Bert was happy with revised schedule as the
additional cost was reasonable. The Toys City engagement was finally completed two
days earlier than scheduled.

        After the delivery of the audit report, Bert evaluated the auditing procedures. He
realized that the completion time of several work packages in fact could fluctuate
depending on the individual staff performing the audit as well as the actual amount of
work load. This year they were lucky that the work load turned out to be much less (so
that they actually completed early). For future planning, he felt that he needs more
assurance about the completion time so that undesirable outcomes could be prevented.

     Again he sought help from Gary Fay. Gary suggested that a procedure similar to
CPM called PERT could be applied. First, from the large amounts of prior history on

comparable audit activities, and by talking to auditors who are familiar with the condition
of Toys City's books, the effectiveness of internal control, and the likely problem areas of
the engagement, optimistic and pessimistic time estimates were obtained for the work
packages whose completion time may fluctuate. The information is summarized in
Exhibit 6. Based on this information and results from previous calculations, the
probability that the entire engagement would complete within a certain time could then be


1. Taking into consideration tasks that can be performed simultaneously, prepare a
   detailed CPM network for the liabilities work package. What is the earliest finish time
   for the package? What is the critical path?

2.    Present a summary network for the entire audit plan with all the work prior to year
     end and each of the work packages presented as a single activity. Determine how long
     the entire audit will take.

3.    If you were Bert, would you have accommodated John's vacation request? Why?
     What is the maximum time you would be comfortable giving John off if his only
     responsibility was the auditing of the receivables?

4. After examining the data in Exhibit 5, Bert notices that the normal time and normal
   cost are different from the ones shown in Exhibit 2. He suspects that there are some
   errors in the calculation. What do you think?

5. Recommend an accelerating plan that would reduce the auditing engagement by 60
   hours at minimum additional costs. What is the additional cost? Is a 79-hour
   reduction feasible, and if so, at what cost? Would a corporate limit on per-hour
   reduction cost of $150 an hour ever become a problem if further reductions were
   required? Why?

6. Based on the information given in Exhibit 6, determine the probability that the entire
   audit would be completed within 311 duration hours. Is it likely that the engagement
   would be completed before the deadline? Is it likely that an activity that was not on
   the initial critical path would now be on the critical path? Which activity does this
   happen to? What percent of the time, and why?

                             Exhibit 1 Work structure of the Toys City engagement

                                                        Perform Audit

                    Prior to year end                      Year end                        After year end

Preliminary   Review of                      Preparation
discussions    internal                        of audit
with client    control                         program

                                                            Cash              Inventory
                                                            count            observation

                                                                 General        Audit of       Audit of
                                                                procedures       cash        receivables

                                                     Exhibit 2 Audit plan

                                                      Time budget (in hours)
Audit areas                       Staff   Senior      Manager       Partner       Total budgeted     Budgeted    Duration
                                  ($20)   ($30)         ($40)        ($50)            hours            cost       hours
Discussions with Toys City                      1             2                                 3         110            2
Review of internal control                      8             2                                10         320            8
Compliance tests                                5                                               5         150            5
Year-end procedures                  20         3              1                               24         530           13
    Field work:
Observation of inventory            16         12              8              2                 38      1,100          25
General audit procedures             7                                        8                 15        540          11
Audit of cash                       31          7                             3                 41        980          19
Audit of receivables                10          8              2                                20        520          10
Inventory pricing                  154         33             12              6                205      4,850         145
Audit of other current assets       27          4                                               31        660          11
Audit of liabilities               102         28             15              8                153      3,880          93
Audit of fixed assets               29          9                             4                 42       1050          22
Audit of sales                      10          5              1                                16        390           6
Audit of COGS                       42          7              4              2                 55      1,310          25
Audit of other revenues and
expenses                             17          7             1                                25        590           10
Audit of capital stock and R/E
                                                                              1                  1         50            1
Lawyer’s letter                                                1                                 1         40            1
Management’s letter                                            1                                 1         40            1
Subsequent review                    12          8             6              4                 30        920           18
Preparation of financial
statements                                     12              3                                15         480         15
Preparation of tax returns                                    12                                12         480         12
Partner/manager review                                         4             4                   8         360          6
Total hours                        477        165             95            42                 779    $ 20,390        479

                                     Exhibit 3 Activities in the liabilities work package

                      Activity      Description                             Duration (hours)
                             1.     Obtain schedule of liabilities                      2
                             2.     Mail confirmations                                 12
                             3.     Process confirmations                              39
                             4.     Investigate debit balances                          5
                             5.     Test pension plan                                   4
                             6.     Vouch selected liabilities                         64
                             7.     Test accruals and amortization                      4
                             8.     Reconcile interest expense to debit                 8
                             9.     Verify debt restriction compliance                  5
                           10.      Review subsequent payments                         10

 Exhibit 4 Predecessors and successors relationship of the various work packages

Activity     Description                              Immediate predecessors
        1.   Discussions with Toys City                                         —
        2.   Review internal control                                             1
        3.   Compliance tests                                                    2
        4.   Year end procedures                                                 3
        5.   Observation of inventory                                            4
        6.   General audit procedures                                            5
        7.   Audit of cash                                                       5
        8.   Audit of receivables                                                7
        9.   Inventory pricing                                                   5
       10.   Audit of other current assets                                       6
       11.   Audit of liabilities                                                9
       12.   Audit of fixed assets                                              10
       13.   Audit of sales                                                      8
       14.   Audit of COGS                                                       9
       15.   Audit of other revenues and expenses                           13, 14
       16.   Audit of capital stock and R/E                                     15
       17.   Lawyer’s letter                                                    11
       18.   Management’s letter                                            12, 16
       19.   Subsequent review                                              12, 16
       20.   Preparation of financial statements                        17, 18, 19
       21.   Preparation of tax returns                                 17, 18, 19
       22.   Partner/manager review                                         20, 21

                  Exhibit 5 Time-cost trade-off of Toys City engagement

                                                     Normal                  Acceleration*
    Activity     Description                         Time   Cost             Time Cost
            9.   Inventory pricing                     92   $3,055            56    $4521

          10.    Audit of other current assets          11         660        11      660
          11.    Audit of liabilities                   93        3,880       53     4,720
          12.    Audit of fixed assets                  22        1,050       22     1,050
          13.    Audit of sales                          6         390         6      390
          14.    Audit of COGS                          25        1,310       25     1,310
          15.    Audit of other revenues and            10         590         5      790
          16.    Audit of capital stock and R/E          1        50           1       50
          17.    Lawyer’s letter                         1        40           1       40
          18.    Management’s letter                     1        40           1       40
          19.    Subsequent review                      18        920          3     1,670
          20.    Preparation of financial               15        480         10     1080
          21.    Preparation of tax returns             12        480         2       980
          22.    Partner/manager review                  6        360         6       360

*Acceleration time is the minimum time the activity can be completed. Acceleration cost is the
 total cost for the maximum reduction assuming that the cost is incurred in a linear fashion.

   Exhibit 6 Alternate Completion Times for Some Activities in Toy City Engagement

   Activity      Description                         Optimistic     Most       Pessimistic
          5.     Observation of inventory                20            25          40
          9.     Inventory pricing                      138           145          152
         10.     Audit of other current assets            9            11          12
         11.     Audit of liabilities                    90            93          95
         15.     Audit of other revenues and              8            10          12
         21.     Preparation of Tax Returns              10          12             25
         22.     Partner/manager review                   5           6             10