The Nature of an Internal Audit

All organizations have strengths and weaknesses in the functional areas of business. No enter­prise is equally strong or weak in all areas. Maytag, for example, is known for excellent produc­tion and product design, whereas Procter & Gamble is known for superb marketing. Internal strengths and weaknesses, coupled with external opportunities and threats and clear vision and mission statements, provide the basis for establishing objectives and strategies. Objectives and strategies are established with the intention of capitalizing on internal strengths and overcom­ing weaknesses. the internal-audit part of the strategic-management process is illustrated in Figure 4-1 with white shading.

1. Key Internal Forces

It is impossible in a strategic-management text to review in depth all the material presented in courses such as marketing, finance, accounting, management, management information systems, and production and operations; there are many subareas within these functions, such as customer service, warranties, advertising, packaging, and pricing under marketing. However, strategic planning must include a detailed assessment of how the firm is doing in all internal areas. A complete internal assessment is vital to help a firm formulate, implement, and evaluate strategies to enable it to gain and sustain competitive advantages.

For different types of organizations, such as hospitals, universities, and government agen­cies, the functional business areas differ. In a hospital, for example, functional areas may include cardiology, hematology, nursing, maintenance, physician support, and receivables. Functional areas of a university can include athletic programs, placement services, housing, fund-raising, academic research, counseling, and intramural programs. Regardless of the type or size of firm, effective strategic planning hinges on identification and prioritization of internal strengths and weaknesses.

2. The Process of Gaining Competitive Advantage in a Firm

Strengths that cannot be easily matched or imitated by competitors are called distinctive competencies. Building competitive advantages involves taking advantage of distinctive com­petencies. Strategies are designed in part to improve on a firm’s weaknesses, turning them into strengths—and maybe even into distinctive competencies. Figure 4-2 illustrates that all firms should continually strive to improve on their weaknesses, turning them into strengths, and ulti­mately develop distinctive competencies that can provide the firm with competitive advantages over rival firms.

3. The Process of Performing an Internal Audit

The process of performing an internal audit closely parallels the process of performing an external audit. Representative managers and employees from throughout the firm need to be involved in determining a firm’s strengths and weaknesses. The internal audit requires gather­ing, assimilating, and prioritizing information about the firm’s management, marketing, finance and accounting, production and operations, R&D, and MIS operations to reveal the firm’s most important strengths and most severe weaknesses.

Compared to the external audit, the process of performing an internal audit provides more opportunity for participants to understand how their jobs, departments, and divisions fit into the whole organization. This is a great benefit because managers and employees perform better when they understand how their work affects other areas and activities of the firm. For example, when marketing and manufacturing managers jointly discuss issues related to internal strengths and weaknesses, they gain a better appreciation of the issues, problems, concerns, and needs of all the functional areas. Thus, performing an internal audit is an excellent vehicle or forum for improving the process of communication in an organization.

William King believes a task force of managers from different units of the organization, sup­ported by staff, should be charged with determining the 20 most important strengths and weak­nesses that should influence the future of the firm. According to King,

The development of conclusions on the 20 most important organizational strengths and weaknesses can be, as any experienced manager knows, a difficult task, when it involves managers representing various organizational interests and points of view. Developing a 20-page list of strengths and weaknesses could be accomplished relatively easily, but a list of the 20 most important ones involves significant analysis and negotiation. This is true because of the judgments that are required and the impact which such a list will inevitably have as it is used in the formulation, implementation, and evaluation of strategies.¹

Strategic planning is most successful when managers and employees from all functional areas work together to provide ideas and information. Financial managers, for example, may need to restrict the number of feasible options available to operations managers, or R&D managers may develop products for which marketing managers need to set higher objectives. A key to organizational success is effective coordination and understanding among managers from all functional business areas. Through involvement in performing an internal strategic- management audit, managers from different departments and divisions of the firm come to understand the nature and effect of decisions in other functional business areas in their firm. Knowledge of these relationships is critical for effectively establishing objectives and strate­gies. Financial ratio analysis, for example, exemplifies the complexity of relationships among the functional areas of business. A declining return on investment or profit margin ratio could, for example, be the result of ineffective marketing, poor management policies, R&D errors, or a weak MIS.

4. The Resource-Based View

Some researchers emphasize the importance of the internal-audit part of the strategic-management process by comparing it to the external audit. Robert Grant, for example, concluded that the inter­nal audit is more important, saying:

In a world where customer preferences are volatile, the identity of customers is chang­ing, and the technologies for serving customer requirements are continually evolving, an externally focused orientation does not provide a secure foundation for formulating long­term strategy. When the external environment is in a state of flux, the firm’s own resources and capabilities may be a much more stable basis on which to define its identity. Hence, a definition of a business in terms of what it is capable of doing may offer a more durable basis for strategy.²

The resource-based view (RBV) approach to competitive advantage contends that inter­nal resources are more important for a firm than external factors in achieving and sustaining competitive advantage. In contrast to the Industrial Organization (I/O) theory presented in the pre­vious chapter, proponents of the RBV view/theory contend that organizational performance will primarily be determined by internal resources that can be grouped into three all-encompassing categories: physical resources, human resources, and organizational resources.³ Physical resources include all plant and equipment, location, technology, raw materials, and machines; human resources include all employees, training, experience, intelligence, knowledge, skills, and abilities; and organizational resources include firm structure, planning processes, information systems, patents, trademarks, copyrights, databases, and so on. A firm’s resources can be tan­gible, such as labor, capital, land, plant, and equipment, or resources can be intangible, such as culture, knowledge, brand equity, reputation, and intellectual property. Since tangible resources can more easily be bought and sold, intangible resources are often more important for gaining and sustaining competitive advantage.

Resource-based view theory asserts that resources are actually what helps a firm exploit opportunities and neutralize threats. As indicated in the Academic Research Capsule 4-1, RBV theory may be helpful in identifying diversification targets.

The basic premise of the RBV is that the mix, type, amount, and nature of a firm’s internal resources should be considered first and foremost in devising strategies that can lead to sus­tainable competitive advantage. Managing strategically according to the RBV involves develop­ing and exploiting a firm’s unique resources and capabilities, and continually maintaining and strengthening those resources. The theory asserts that it is advantageous for a firm to pursue a strategy that is not currently being implemented by any competing firm. When other firms are unable to duplicate a particular strategy, then the focal firm has a sustainable competitive advan­tage, according to RBV theorists.

A resource can be considered valuable to the extent that it is (1) rare, (2) hard to imitate, or (3) not easily substitutable. Often called empirical indicators, these three characteristics of resources enable a firm to implement strategies that improve its efficiency and effectiveness and lead to a sustainable competitive advantage. The more a resource(s) is rare (not held by many firms in the industry), hard to imitate (hard to copy or achieve), and/or not easily substitutable (invulnerable to threat of substitution from different products), the stronger a firm’s competitive advantage will be and the longer it will last. See Exercise 4F at the end of this chapter that reveals how an organization can use RBV theory as a tool in formulating strategies to better understand competitive advantages.

Source: David Fred, David Forest (2016), Strategic Management: A Competitive Advantage Approach, Concepts and Cases, Pearson (16th Edition).