Internal Controls Assessment and Electronic Data Interchange: Gresko Toys Factory

(Prepared by Robertos Karahannas, Lehigh University)

Mr. and Mrs. Gresko started Gresko Toys in the early 1960s. Initially, the company was small and few toys were produced. The talent and skills of Mr. Gresko were by far the major assets of the company. Toys were mainly made of wood and had few or no electronic parts; they were mainly manually operated and included toy cars, several kinds of dolls, and toy guns. Gresko Toys became part of the Pennsylvania tradition. Kids loved them and parents had no choice but to buy them.

Gresko Toys quickly expanded, and by 1969 it reported a sales volume of $400,000,

$50,000 of which was profit. Such profits caught the attention of other businesspeople, who began entering the market. The innovative spirit of some competitors through the introduction of fancy, battery-operated toys stole some of Gresko’s market share. As the competition became more intense, the Greskos saw their market share declining even further.

Children liked battery-operated toys.

Mr. Gresko saw this as both a threat and a challenge. He would not give up, however.

He knew that he needed better machinery to make competitive toys. With a loan from the local bank and his savings, he sought and bought what he needed. After a period of training and test marketing, Gresko Toys was again in the market and boosting sales. However, the company was generating orders that the factory could not handle. The workforce rose from a low of 50 to a high of 350 people.

Most of the workforce was on the factory floor. More equipment was purchased and the company has been expanding ever since.

Today, the company sells $20 million of toys per year. The president of the company is Mrs. Gresko. Mr. Gresko felt that he should be on the factory floor managing production.

Under him are the purchasing agent, supervising a buyer; the warehouse manager, managing two inventory clerks; a chief engineer;

and a supervisor who is in charge of the factory workers. The controller of the company is Randi, the Greskos’ elder daughter. An accounting clerk, a cashier, and a personnel manager work for her. Finally, Bob, the Greskos’

only son, is the sales manager. A credit manager and two salespeople work for him.

Company Information At present, the company’s profit margin is 9 percent, only 2 percent below the industry average. According to Mr. Gresko, $850,000 in sales was lost last year because of insufficient inventory of parts. Because of the seasonal nature of the market and the short popularity span of most toys, Gresko customers require fast delivery; if the parts are not available, it takes at least two weeks to get the paperwork ready, order the parts, and have the suppliers deliver them. Some customers cannot wait that long; others order the toys and subsequently cancel the order if it takes too long to complete. Often orders are accepted on the assumption that the parts are readily available in the warehouse; when they are not, orders are delayed for weeks. A missing part not only delays an order, but the whole assembly line.

To alleviate the problem, many parts are rushed in, which raises the cost of the toys tremendously. The fine quality of the products allows for slight price increases to make up for part of the extra cost, but customers have already complained about such price fluctuations.

The Greskos are on good terms with their suppliers. After all, the market is so competitive that a reliable supplier is crucial to a firm’s survival. Most of their major suppliers are located in Pennsylvania, where the Greskos have about 35 percent of the market share. However, those suppliers deal with the Greskos’ competitors as well. There are about a dozen suppliers with whom the Greskos deal; eight of them supply about 95 percent of all inventory parts.

Even though good supplier relations are crucial to Gresko Toys, suppliers have often complained about the Greskos’ promptness in paying. The Greskos demand on-time delivery;

the payment of the supplier invoice, however, is usually not timely. Mr. Gresko said that he does not have the time to run from the factory to the accounting department to make sure payments are on time. Late payments, however, also mean a loss of the 2 percent discount the suppliers offer for early payment.

Besides resulting in lost sales, insufficient inventory of parts also delays the whole assembly line. Workers spend much time switching jobs. A just-in-time inventory system would, according to Mr. Gresko, be more appropriate for the factory. If the parts were available in the warehouse, the machines could be set up on an assembly-line fashion and operated on scheduled runs. But the fact that the necessary parts are frequently missing, forcing production to switch to another job, is a major obstacle to a just-in-time inventory system.

The Purchasing Cycle Gresko Toys is very involved in purchasing the parts used in the production of toys. The company uses a periodic inventory system.

When sales orders are received, Bob Gresko sends a copy to the production floor. This copy is used to trigger production as well as to indicate the potential need of parts not available in inventory. The inventory clerks search for parts; when parts are out of stock, the inventory clerks issue two copies of a purchase requisition. Mr. Gresko approves this requisition before a purchase order is issued.

One copy is sent to the purchasing manager and the other to the accounting department.

The buyer checks the suppliers’ prices for the needed parts. Based on cost as well as past experience with a particular supplier, two suppliers are recommended. The purchasing manager subsequently decides on the supplier, and four copies of a purchase order are issued. The first copy is sent to the supplier, the purchasing manager files the second copy, the third is sent to the warehouse, and the fourth is sent to the accounting department. All purchase order copies are filed by supplier number.

Approximately a week after the initiation of the purchase, the parts are received. The warehouse manager, along with the inventory clerks, inspect and count the received parts.

The purchase order copy that the purchasing manager previously received is used as the basis of comparison. A receiving report in three parts is prepared. If prices and quantities received agree with those ordered and with the information on the packing slip the carrier receives, the parts are accepted. If any differences exist, Mr. Gresko is called in to decide whether to accept or reject the parts.

On many occasions, acceptance of parts will be delayed for days until the suppliers are informed and an agreement is reached.

One copy of the receiving report is sent to the purchasing manager and another to the accounting department. The original copy is kept at the warehouse. The accounting clerk files the receiving report along with the purchase requisition and the purchase order by supplier number. The clerk also prepares the necessary journal entry and credits the related supplier in the subsidiary ledger. When the supplier sends the invoice, the accounting clerk matches the information to the purchase requisition, purchase order, and receiving report and prepares a disbursement voucher.

This voucher is used for two purposes. It initiates the journal entry for the disbursement of cash, and the cashier uses it to issue a check.

Randi Gresko, as well as Mrs. Gresko, must sign the checks before they are sent to the suppliers.

Electronic Data Interchange In search of anything that could improve the present system at the Gresko Toys factory, Mr.
Gresko came across the EDI system. One of his suppliers had attended a conference on EDI and had supplied Mr. Gresko with the conference material. Looking at the present system, Mr. Gresko tried to find EDI applications that would benefit the company’s operations and at the same time improve its financial position.
For EDI to be implemented, certain databases will need to be established. An inventory master file with all relevant information is the key to the system. Predetermined order quantities and minimum inventory levels will need to be set for each item based on forecasts.
At the warehouse, the inventory clerks will be constantly updating this database.
When inventory levels drop below acceptable levels, an EDI purchase requisition will be issued to the purchasing department.
A supplier master file with related information on supplier performance will be accessed to identify potential suppliers.
Depending on how advanced the system is, the computer or the purchasing manager will choose the proper supplier and issue an EDI order. This means that the factory’s suppliers will also need to be using EDI.
Various ways of developing EDI links with suppliers are available. In the Gresko case, developing an independent system seems more appropriate; it is cheaper and perhaps easier to convince suppliers to join in. Software is readily available in the market and is easy to set up. Someone, however, should help set up the EDI links with the suppliers.
Once an EDI order is issued, the supplier will receive the message instantaneously. The open purchase order will be kept in a database until the receipt of the parts. Any changes to the order can be made by accessing the particular transmitted order and making the change.
Suppliers can send the parts as well as their invoices more quickly. An EDI invoice can be sent to the Gresko factory upon shipment.
On arrival of the parts, the receiving clerk will prepare a receiving report and file it in a receiving database file. This report will be used to verify prices by accessing the purchase order.
Credit terms, volume discounts, trade allowances, and other adjustments to quoted prices can be settled through EDI-transmitted messages.
If adjustments from disagreements occur, the transaction is entered into the adjusted database file. The inventory master file is also updated, and the open purchase order is closed.
In addition, the supplier-history file and the accounts payable file are updated, and an evaluated receipts settlement (ERS) is established.
An ERS is a database containing records to be used for the payment of suppliers. The EDI order is matched against the receiving and adjusted database files. This comparison creates a payment input file that contains the following three data items: (1) the scheduled payment date, within which any discount can be obtained;
(2) the latest possible payment date; and (3) the remittance record for such payments.
At the beginning of every day, the treasurer (who presently does not exist at Gresko Toys) should receive a listing of the payment input file; this listing will indicate what has to be paid and when. The treasurer will initiate an EDI payment pending the approval of Mrs.
Gresko. Upon approval and the transmission of the payment, the supplier records as well as the accounts payable records will be automatically updated. For an EFT to occur, the banks that serve Gresko and its suppliers will also need to be using EDI. If such intermediary banks are not using EDI, Gresko and its suppliers will need to rely on a manual system of cash disbursement to settle their transactions.
Conclusion Mr. Gresko has hired you to look at the present accounting system and his suggested EDI implementation plan. He wants you to identify the problem areas and look into the feasibility of setting up EDI links with the company’s suppliers.
Required:

a. Draw a document flowchart of the present accounting system at Gresko.

b. What control problems, if any, exist in the accounting system?

c. Draw a document flowchart of the accounting system of the Gresko Toys factory using EDI as Mr. Gresko suggested.

d. Do some research on your own. What EDI options, other than the one Mr. Gresko suggested, are available to the Gresko Toys factory?

e. Discuss the possible implementation of an EDI system at the Gresko Toys factory.
What areas should Mr. Gresko concentrate on, and what are the related issues associated with implementing EDI at the factory?