[SOLVED] In November 2020, a consultant was employed

In November 2020, a consultant was employed to review and document the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), to ensure that these were effectively meeting the needs of the business and to provide a basis for staff training.
ITS-UK is the British subsidiary of Integrated Technology Services International (ITSI), a technology company, based in the north-east USA, which has a history of developing and providing technology solutions to major international corporations and the US Government. It has focused on science and technology as a core strength with significant Research and Development (R&D) expenditure. It is also noted for its extensive employee share ownership scheme, to encourage staff business awareness.
The UK operations are based on two main activities:
1. Consultancy services to a range of businesses.
2. Computing and telecommunications outsourcing support to companies, particularly the oil and gas industry, but increasingly to other industries and to the public sector.
The latter activity has been in response to the business opportunities created by a variety of industries that have preferred to focus on their ‘core competencies’ and outsource some of their internal support functions to external providers, particularly in information technology and accounting. The Government has also reinforced the trend by the compulsory tendering of many of its internal services in competition with outside providers.
At the same time, outsourcing of information technology (IT) services has developed in the USA, where the parent company has progressed. Project management has been a particular strength within the corporate body, developed over its 30-year history. This expertise has also been used to advantage by its UK subsidiary, with the readily available facilities of US-based staff, when dealing with multinational corporations.
Organizational Structure
ITS-UK is structured into three groups of activities:
• Consultancy business as a small separate unit
• Outsourcing Services on a matrix organizational basis
• Staff services, such as finance, commercial and human resource and administration.
Consultancy
This is the oldest established business unit of ITS-UK. It is relatively independent with a separate client base from that of the outsourcing business, though there is some commonality as its consultancy is essentially for systems applications and integration. It shares the staff services with the rest of the company, with an occasional requirement for the services of the other groups, such as the infrastructure department, on an advisory basis.
Outsourcing Services
As with many modern service providers, the functions are divided into those that deal directly with the client, known as the front office, with the back office delivery managers in charge of departments that provide the actual support staff, as follows:
• Marketing department is a small group, which has the responsibility to find new business. Staff will read initial customer requirement reviews and contract negotiations, along with appropriate resources from other departments.
• Client account managers head small departments who are in direct ongoing communication with the customer, once the contract is approved and work is ready to commence. They are to ensure that the contractual requirements are properly followed to meet customer expectations. This, in practice, is largely to meet the following criteria:
a) That proper resources are provided from the main groups of applications, infrastructure and e-mail, to meet contract specifications, e.g. the right number of the appropriately qualified systems engineers, as defined in the contract.
b) That excess resources are not allocated to the project, due to support staff lack of contract understanding.
The departments are structured on the basis of client requirements. An oil and gas group was originally developed to support one particularly large client, from which many of the staff were transferred to ITS-UK to carry on the work that they had previously provided. This original group was later divided into two, to reflect the two-division structure of the oil industry, the upstream exploration and production and the downstream marketing and refining. The Operations South group covers all other industries and local government departments.
• Applications department provides the technical resources to develop and support clients’ IT applications systems.
• Infrastructure department provides the technical resources to implement and support all computer hardware, telecommunications and networking requirements. It also includes a front-line help-desk support which is the first point of call for any customer call, such as computer, telephone or application system problems.
• E-mail is a specialist group that provides electronic mail services to customers.
Planning is a critical function for each of the applications, infrastructure and e-mail delivery managers, both with the marketing managers for early warnings as to staff requirements and with client management for ongoing needs. This latter feature has been difficult to achieve due to regular contract change requests by the major clients. The overall organization is of a matrix nature, where the service delivery managers (SDM’s) provide some 750 people to a broad range of contracts. Some staff may be permanently assigned to a major client, whilst others could be working on several different contracts in a single week.
Business Controls Overview
Expansion in Outsourcing had been rapid, with an emphasis on drive and initiative, to some neglect of a detailed controls framework. The main financial performance measure is the net margin. This is set by corporate headquarters as 6%, which effectively is the prime objective of ITS-UK. Contacts with clients tend to be agreed on a gross margin basis, but which obviously must be carefully set, usually at least 20%. This has been deemed to be the minimum required contribution to cover overheads and profit, although questions were being raised as to the appropriateness of this level, as the net margin of 6% is becoming increasingly difficult to achieve, with some of the following points raised as contributory factors:
1. Following the early, large, long-term contracts, which were relatively simple to administer, overhead costs have risen disproportionately due to:
• many small contracts, which administratively are often as expensive as much larger ones; overall lower net margins are therefore a natural outcome of the decreasing size of average contracts;
• lack of standardization of contract terms leading to complex administrative and financial controls, e.g. billing;
• arrangements have to be individually monitored, as computer systems have been unable to fully accommodate all the variations.
The 20% gross margin target is therefore contributing increasingly more to overheads than to profit.
2. A further reason for lowering profitability is believed to be that the drive for market share, which had taken precedence over gross margin, has resulted in ‘loss-leaders’ which were not living up to expectations. One particularly large contract, started with a 15% gross margin, in the expectancy of leading to other more lucrative work, but has not yet proved to have done so.
3. The mechanism of charging the IT person’s time to the contract, through a timesheet, is not being properly controlled. Staff may work on a number of small contracts in a week, possibly for the same client, which is not always obvious to the person concerned. Time is, therefore, often incorrectly charged, which results in a waste of administrative effort to correct, along with client dissatisfaction. A particularly difficult situation is where a variety of different types of contracts may be in force with a single client company. A systems engineer may work on a fixed price contract on one day so that time charged to the contract will be for internal ITS-UK purposes only, i.e. it will not affect the charge to the client. Then on the following day, he may be supporting a reimbursable (time and materials) contract, when time charged is reimbursed by the client. If these times get mixed up, the consequences can be significant. A lack of contract understanding, therefore, may be leading to costs that should be chargeable to the contract and paid by the client, but are not being identified as such. These costs will therefore remain as a charge against ITS-UK’s profits.
4. The increasing complexity of the matrix organization may be leading to wastage. Ideally, resources should be provided to meet clients’ needs as and when needed. In practice, this flexibility can only be met if there are readily available staff resources at any time, which would inevitably lead to reserve people. However, such standby staff have a price, who generate no income, if not used.
A response to the above problems has been to improve financial planning and budgetary controls. Before looking at these two control mechanisms, the nature of the various contractual arrangements must be understood.
Contractual Relationships
ITS-UK receives its income through the provision of technology services, which are governed by various contractual relationships with the client. This commercial relationship will tend to depend upon the balancing of risk and reward. The reward to the contractor will be influenced by the amount of perceived risk, that is, the higher the risk that the contractor is expected to meet, then the higher the reward the contractor will expect to receive. In practice, where risk is deemed to be high both for its frequency and impact, the customer normally bears this risk, supporting a standard cost reimbursable (or ‘time and materials’) type of contract. For low risk projects, the contractor is more likely to bear the risk with a fixed cost type of contract preferred. An example of the former may be an innovative oil construction computer control system in a frontier zone, whilst ongoing systems support may typify the latter.
A third major category has emerged in recent years, where various concepts of sharing risk and reward have been created, to be known as incentive or target cost contracts, frequently as part of long-term ‘alliancing’ relationships. All three types of contracts are found within ITS-UK, with the target cost tending to dominate the larger contracts, and therefore, comprise a significant element of the sales revenue.
Contract Costs
Each client, covering several contracts, or sometimes a single major contract, is treated as a profit centre, to include all costs that are specific to the contract, plus indirect cost allocations, and their revenues. It is crucial to the profitability of all target and time and materials contracts to be clear as to what is recoverable in the contract, i.e. that which will be paid by the client. The contract should list all categories of support staff and probably their rates, along with all services and equipment. For example, if 50% of an accountant is recoverable per a large contract, but 75% of an accountant’s time is actually used to support the contract, 50% will be charged to the client and the other 25% will have to be absorbed by ITS-UK, as a general overhead cost, directly charged against ITS-UK’s own profits. These recoverable costs are often known as ‘direct cost’, which is not as normal per cost accounting terminology, where an accountant’s time, partially allocated to a contract, would be regarded as an indirect cost.
Planning
For business planning purposes, the time horizon tends to be shorter than for most organizations. Business had been expanding rapidly, with the only real constraint being resources, where there has been a shortage of technically skilled IT people. The larger contracts tended to be for three to five years, so that a high degree of security exists for the levels of income from the major clients in the medium term. Otherwise, the annual budget cycle tends to predominate, to meet corporate objectives, with a general plan for the longer term, mainly focusing on the larger contracts plus a general business view for potential markets.
Budgeting
Until recently, the budget had been prepared on a programme basis, i.e. by client, and for the total UK operations, to support corporate planning requirements. Control, therefore, could only be applied to these levels, effectively the client as the profit centre, with the back-office groups being excluded, to any detailed extent. The overall results, which were not meeting profit expectations, led to the realization that further controls were required. From this year, the budget has also been structured by all responsibility centres, that is, to include the back offices as expense centres.
Budget Preparation
The following steps are observed:
1. The year’s programme is agreed, essentially:
• Confirm the continuation of existing contracts.
• Clarify contract renewal expectations, for contracts that will be up for renewal in the budget period.
• Agree scope of any new business.
2. All departmental managers prepare their budget costs, by person and cost detail, for each contract or new business category.
3. Results are consolidated by contract, or new business category, by budget co-ordinator.
4. Service delivery managers then review their results with each of the client managers, for agreement as to conformance with contract and to ensure that derived profit margins are as expected.
5. Once agreed, all results are consolidated, along with staff service departments, to produce a draft operational budget for Outsourcing Services, for review by the group manager to ensure that corporate objectives are met.
6. Adjustments may be made, as required (they usually are!).
Management Reporting
Quarterly reports are transmitted to the head office, for the major contracts, overall actual cost position and full year forecasts. For major international clients, a world-wide consolidation is undertaken for overall ITSI support, i.e. global support for global companies; an increasing expectation of such clients.
Internal monthly reports are reviewed by the operations manager with his client and service delivery managers. An example of a section of the report is shown below for July 2020, for one particular major client (one profit centre) with six different contracts. In practice, this is very limited in its use. The computerized accounting system (a modern integrated ‘enterprise’ reporting system) has the facility to accommodate the input of budget data, but it requires the budget to be prepared at a very detailed level for input, which is very time consuming and has not yet been adequately implemented. Comparisons are therefore made on a manual basis, e.g. by downloading the relevant actual data in the budget format. For example, if the budget identifies a training cost for applications staff on Exoil Oil & Chemicals, actual data will be extracted manually from the system for direct comparison. This type of work is partially performed, but the problem is the heavy use of resources to prepare the reports; a good example of the increasing overhead costs deemed necessary to support the overall business, but which is cutting into the overall net margin.
Questions
Following the review of the planning and control systems of Integrated Technology Services (UK) Ltd (ITS-UK), the group manager James Gunn has asked you, the consultant, into his office to discuss a number of points arising. He is accompanied by the operations manager.
Mr Gunn opened the meeting, ‘We have some concern with the net profit margin as the sole performance measure of our business. It is not necessarily the actual percentage of 6% that is giving us trouble, maybe it is a suitable figure as many of our competitors are facing even tighter margins, but it is the concept. Frankly, we are not clear as to why this is the sole measurement criteria, surely there are other ways of measuring how well our business is performing. We believe that we have a good business, and the market is there for future growth, but maybe there are other ways of looking at how well we are doing. We are not financial people, so we look to you for help. We would therefore like you to look into this and prepare a report on the merits of this net margin measure and any suitable alternatives that we can propose to our corporate managers.
The other item that we want you to review is the budget process. Here, we believe that we have a good system, but we need to get it running properly. The problem is that it is going to take more resources to do so, probably an extra accountant for some £35,000 per year, plus benefits and support costs which will come to nearly £50,000. We, therefore, need a good case to go to head office to justify this and we would like you to come up with that justification.’
Required:
1. Prepare the report on the net margin, as requested by the group manager.
2. Prepare a justification of the budgeting system, covering the principles of the budget, its features and advantages, in general, along with the specific advantages for ITS-UK, to meet the needs of local management

Question: In November 2020, a consultant was employed