Neil Smith and Paul Scarbrough

SmithOBrien

At a time of unprecedented cynicism about corporate ethics, a company's explicit commitment to corporate responsibility is central to its success, and is increasingly seen by employees and investors as a proxy for general managerial competence. Yet, rigorous examination of how things get done, even in the best of firms, reveals large gaps between what a company tells its stakeholders and how it operates. Thus, corporate leaders, more than ever before, want assurance that the company is actually doing what it reports to the public.

Corporate responsibility auditing, a recognized management discipline first applied at APT Associates in the 1970s and later refined by The Body Shop and other companies in the mid-1990s to evaluate their environmental and social impacts, can help corporations assess how well they do what they say they do, and proactively convert rhetoric into reality.

The premise of corporate responsibility auditing is the recognition by executives that the information provided to shareholders, as well as other stakeholders, on a corporation's performance needs to be truthful and reliable. Inherent in the auditing process is the provision of crucial knowledge that will sustain the public's trust and sharpen managements's collective focus on key nonfinancial value drives (e.g., employee retention, innovation, customer satisfaction, and reduced pollution) and the events that can affect them both positively and negatively. These elements -determinants of future financial results - are easy enough to describe but not always easy to practice.

At a minimum, corporate responsibility auditing can provide a complete picture of how well a company performs against its values, industry or global standards, peers, and the expectations of essential stakeholders. Many companies use the results to put in place, both internally and in partnership with major suppliers, credible and measurable process improvements that responsibly drive efficiencies, reduce risk, seize new business opportunities, and strengthen relationships with stakeholders. For many companies, corporate responsibility auditing also provides a verifiable and credible process for reporting to stakeholders on their social and environmental impacts and the effects on profitability.

Advancements in corporate responsibility auditing have also led to its use in risk management, by identifying certain risks, with damage potential, that typically lie unidentified and unmanaged until they are brought to the attention of senior officials by activist groups or the media. Risks, such as employee discrimination, high turnover, lost productivity, and suppliers' labor and environmental practices - which can quickly erode a company's integrity and shareholder value - are rarely on the business agenda of executives, and when they surface, catch company officials unaware.

Corporate responsibility auditing can also identify how capital has been allocated across departments and business units of the company and the level and types of risks to which the capital is exposed. An experienced audit team will advise on whether risks in one part of the company may exacerbate or ameliorate those in another and, in consultation with employees and managers, recommend process improvements, which the audit will undoubtedly yield, where risks are too high. This information can provide management with a clearer understanding of acceptable tolerance levels for key value drivers, and reliable data with which to respond proactively to shifts in the work environment, key markets, and in society.

6.3.3.1 Getting Started

Laying the Groundwork. The typical corporate responsibility auditing process (Table 6.13) has a dozen or so steps to ensure it is thorough and conducted efficiently. At the start, the CEO's evident commitment and involvement are a must. Setting the right tone for what can be learned from a rigorous review, she or he can ensure support from their direct reports on the audit's business value, essential in order for the audit team to freely drill down deep and wide into the organization's practices.

After adopting an auditing framework, companies often form a steering committee of employees and managers to guide and manage the audit process. Some committees also include representatives of key external stakeholder groups. While hiring an independent CSR auditing services firm to conduct the audit, the steering committee's responsibilities include:

TABLE 6.13. Steps in Conducting a Corporate Responsibility Audit

1. Gain CEO commitment, and the support of direct reports.

2. Appoint a steering committee to guide auditing process.

3. Select a qualified, external CSR auditing services firm.

4. Diagnose the readiness of the corporate culture and leadership to adopt more progressive and responsible practices.

5. Evaluate efficacy of governance structure (BOD and senior management) and operating practices, such as environmental practices and energy conservation; quality management systems and supply chain management; human resources and labor relations; human rights; community involvement; and stakeholder engagement/collaboration.

6. Complete internal interviews or focus groups and collect internal operational data, available benchmarking data (e.g., performance information on comparable noncompeting companies, industry, and international standards).

7. Interview external stakeholders.

8. Identify fundamental or underlying reasons why operating performance and corporate/ operating goals are not aligned.

9. Compare internal performance data with the performance of peer companies and the expectations of stakeholders.

10. Audit team presents preliminary findings and recommendations to steering committee and CEO for feedback.

11. Audit team completes financial analyses of top three to five recommendations.

12. Steering committee prepares Final audit Report and presents to senior management team and Board of Directors.

• Defining the audit scope, including the key performance indicators against which current practices are assessed;

• Setting desired outcomes and learning;

• Identifying employees to be interviewed, internal documents to be reviewed, and external research of best practices and the websites of watchdog groups;

• Establishing realistic timelines, and internal reporting procedures.

It is critical that key senior officials actively participate on the steering committee and perhaps in the audit process itself. This will help ensure their buy-in of the process and motivate them to implement the resulting recommendations. Involving external stakeholders assures an increased level of objectivity in the process and can begin to build mutually beneficial relationships where they did not exist.

The audit team must include content experts, who have extensive industry experience in the business disciplines being audited, as well as organizational development specialists. The most useful audits rely on interviews and focus groups to ensure depth of information on the company's practices, and perceptions. Participants typically include employees and managers, influential suppliers, customers, regulators, and activist groups. These types of discussions, generally, unveil telling information that survey tools cannot.

6.3.3.2 The Auditing Process. A corporate responsibility audit needs to be systemic in approach and cross-functional in scope. In addition to assessing the readiness of the company's culture and leadership to adopt and sustain more progressive practices, the audit typically focuses on one or more of six key business functions: environmental practices and energy conservation; quality systems (including supply chain management); human resources and labor relations; human rights; governance; and community involvement. Opportunities to collaborate with stakeholders are sought throughout these areas.

A corporate responsibility audit can provide a system for managing change. Thus the audit team should start by assessing the corporate culture and leadership to determine early whether or not the organization has the capacity to change and how best to address obstacles (e.g., people and systems) before assessing the efficacy of the operating practices.

When risks or operating deficiencies are later uncovered, the audit team must think about the underlying causes and associated costs and how best to reduce or eliminate them. Replacing one toxic with another "alternative" one is not enough. Rethinking the process to remove the need for all toxic inputs in the target, and is frequently achieved. Additionally, the team will want to consider the costs and effects of its findings and recommendations across different operating areas.

The most efficient approach to conducting a corporate responsibility audit is to assess some practices company-wide, such as governance, human resources, energy conservation, and community relations. Other business functions, including environmental, health and safety (along with quality systems and production practices), human rights, and supplier relations, should be assessed at a business unit or even plant level, where the audit team, along with these employees, can consider various scenarios for improving performance and reducing costs that may also be replicable later in other facilities. Additionally, in order to accurately analyze the financial effects of making any substantial improvements, the audit team will need to review the raw direct and overhead costs of current practices. These costs are usually readily available at lower-level operating units.

In analyzing the business case for its recommendations, audit teams employ a number of accounting techniques. Because the effects of most corporate responsibility issues cross departmental and divisional lines and because activities drive costs, it is necessary to understand how certain activities and practices impact financially and strategically the entire organization.

For these reasons, Activity-Based Costing (ABC), the most accurate method of cost analysis, is particularly helpful in identifying all of the individual costs of an operating practice or an event, such as a chemical spill. In analyzing a spill, for example, the audit team can attach a dollar value to waste of materials and labor, system changes, unused capacity, and the spill's myriad overhead costs, as well as corporate legal, PR, and other administrative support costs, all of which need to be carefully understood in considering process improvements.

For the most part, few of these costs will appear in traditional cost estimates. Although ABC has proved, in most cases, too complex and time-consuming to fully replace most traditional (financial) accounting systems, it can be very successfully used for special studies to break down activities and estimate their associated costs, provoke change, and make decisions. Even in the most sophisticated companies, the full costs of events, such as chemical spills, discrimination lawsuits, product liability lawsuits, or other litigation and regulatory risks, are very poorly understood. A cross-functional analysis of the problem, including its costs, is normally not done, except by a corporate responsibility audit, in most companies.

Real Options is another valuation method used by audit teams for nonfinancial value drivers, by estimating how the sustainability of the driver will affect the company's financial performance. Based on the fact that variability has an important effect on economic value, particularly in trying to protect value drivers from worst-case scenarios, Real Options infuses a more global and market-focused thought process to quantifying how improvements in the company's social and environmental performance will affect the bottom line. The approach draws upon the knowledge and a consensus of opinions from key experts inside the company (e.g., HR, EHS, or community affairs managers) to forecast the probability of certain events, such as a product breakthrough, or the probable positive and negative financial effects of current or improved practices, including the risk of litigation and available reserve capacity for emergencies. A natural consequence of this type of data review and interviewing is that the internal experts also become more careful and dedicated to the quality of their input.

Although Real Options uses a sophisticated mathematical model to make the numerical calculations, the analysis, an extension of classic financial options theory, is based on the data and opinions provided by the managers themselves instead of having been parachuted in by a consultant-provided ABS study. This method captures the expert judgment of managers and allows it to become a source of competitive advantage over time.

6.3.3.3 Presenting the Audit Results. Once the audit has been completed, the audit team then presents a Preliminary Report to the entire steering committee and the CEO for feedback on its findings and recommendations. The team will want to especially highlight low hanging fruit - areas in which simple, more responsible practices would quickly improve the bottom line and begin to demonstrate the business case for adopting more complicated changes later.

These changes can be as simple as adopting practices to reduce paper use, or as complex as suggesting that the HR module of an ERP application be purchased to track diversity issues more cheaply.

The Final Audit Report includes the team's detailed cost-benefit analyses of the three to five most value-added recommendations. The steering committee then presents the audit results to the entire senior management team and the Board of Directors.

It is important to recognize that managers are traditionally reluctant to undertake a rigorous examination of their operating practices for fear that any negative findings will be seen only as an indication of failure. Additionally, good social and environmental performance is often perceived as too costly. Yet, example after example demonstrate that operating responsibly saves money and, in some cases, even creates profitable new opportunities. According to companies that have completed corporate responsibility audits and implemented the recommended improvements, the payback has ranged from six to twenty times the cost of the audit over six months to three years. For example, Dupont, which has been conducting similar reviews for years, reports having saved more than a half billion dollars.

6.3.3.4 Conclusion. For many leading companies, operating responsibly is implicit in their core business strategy, and corporate responsibility auditing is routinely used in maximizing values drivers and in reporting honestly to stakeholders on the company's entire performance.

Others, however, remain unconvinced, and still see operating responsibly as an external extraction of money and management's time.

Experience in corporate responsibility auditing suggests that it can be part of a company's core business model, or an expensive and useless external exercise. When built into the fabric of the business as part of creating shareholder value, it reveals value opportunities not observable otherwise. When tacked on to the fringes of business operations, corporate responsibility auditing functions in a similar fashion to business fads; it becomes an expensive and pointless tactic. So, just like everything else a business does, there is a big, big difference between doing it and doing it well.

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