Digital Systems - A Case Study
Note: This article may seem mundane, but trust me, it has everything to do with what is going on now. If I can't tell you this way, I would have to use jargon and buzzwords, leaving a lot not communicated. Please hang in there until the end. It will make sense then. Humanity Awakens was a macro view of what is happening. This is a micro view.
The Business Model
When I was thirty-four, I thought I had outgrown Pensacola, Florida and was ready for the big time. I started looking in a few of the national newspapers. I responded to an ad in a Dallas newspaper, flew there for an interview, and you guessed it, got the job and was sent to Pensacola. A software company listed on the N.Y. Stock Exchange had just acquired a software company in Pensacola. I had just performed the audit of that company for the buyer, but did not know who the buyer was until that meeting. We were both surprised.
The company in Pensacola was Digital Systems, Inc. It was a three year old company started by two partners (fraternity brothers), a recent accounting major and a marketing major. They had purchased a recently written software code that ran an accounting package geared for CPA firms to perform client accounting. They coupled their new software with a $80,000 midi mainframe Digital brand computer, and sold the package, complete with training, for about $100,00. There was no other product out there to compete with us. We later geared it to construction companies as well.
The company grew so fast that it needed more capital to continue. The profit margins were out of this world, so the Big company acquired us. The two thirty year old partners each became millionaires. One left to sit under a tree for a year to figure out what he wanted to do with his life (the accountant). The other stayed on as the president. He was to be paid a salary and a flat percentage of sales. The holding company made a living by leasing its software to banks to operate with. Another major company illegally interfered with their business, which slowed their growth for a few years. Their rival finally settled the suit and paid $X Million in damages to our new holding company - we were their first expansion with that money. It was very exciting for both of us.
I was hired as the General Accounting Manager. This was our business model. We stole salesmen from IBM, set them up with a van and a $100,000 computer system in the back and placed or sent them in/to major cities around the country. Other salesmen lived in Pensacola, and flew out every Monday and returned on Friday. They left their vans parked at airports. The salesmen would set up at CPA meetings and make sales. The sales were phenomenal. I once asked Dan, one of our Regional Sales Managers, how the salesmen made such numbers of sales. As a whole, accountants are quiet and difficult to approach - very conservative. Dan just laughed and said. "It's easy Jim, we hire assistants for the salesmen. We take a size 2 girl and push her into a size zero jumpsuit. The accountants can't stay away."
Dan was a people-people if ever there was one. He made my overwhelming job fun. One day I saw him at the other end of the hall. He immediately went to a crouch as though he was going to quick-draw on me, then shot me the bird. After that, whenever we first saw each other in the mornings, that is what we would do. Sometimes, when I would have my head down hard at it, he would tap on the open door and stick his finger in.
When I performed the pre-sale audit, we knew that there were inventory problems. All company's get into some trouble as a result of fast growth. Management is usually slow to delegate authority, implement normal business controls, hire experienced people, relook at their business and make further changes. Typically, management just sees money flowing and growth, not realizing that it can kill you. During fast growth or change, the time is right for theft, embezzlement and fraud as well as sloppy mistakes. The theft pickings are easy.
Four days after being on the job, the Corporate Controller sent from Dallas was fired by the Pensacola President, for attempting to implement controls. I was stunned; he was a really nice guy who took it all in stride. He told me, "The first marine on the beach was always a dead marine." A report was due out in a week on the true valuation of the supposedly million dollar inventory, about which we had no idea what it was or where it was. I asked the controller as he was walking out what I was supposed to do. I will never forget it. He put his brief case down, stood on one leg, flapped his arms like a bird and said, "Wing It." then walked out laughing.
A month later I was costing out the inventory. This was about one year before the first spreadsheet program hit the market, Visi-calc. I took an eighteen inch wide, thirteen column spreadsheet and pasted it to another one. As I located inventory, I logged it in and then came back to cost it all out. I would spend forever adding up the columns and rows. make a change, then come back and have to re-add it. This went on day and night to the point that I was about to drop from exhaustion.
Dan had all of his salesmen in town one week to learn the new software updates. They would meet and train by day and party by night. While they were here, I met with each salesman to get a record the inventory in their possession. I discovered that some of them rented a second van, had loaded another computer in it, and left it at other airports that we knew nothing about. Dan knew how hard I was working on getting controls on the inventory. I came in late one morning after working till about 2:00 AM and was unlocking my door. I heard a bunch of salesmen in the boardroom next door with Dan. Dan hollered, "Hey Costa, come here. We've got something for you." I walked in to see fifteen men, all dressed in dark suits with long sleeved white shirts on, all grinning from ear to ear, shooting me the bird! It was indeed a humbling feeling. That moment keeps returning to me now when I think about three hundred million citizens doing the same to the government soon!
Two months later help arrived. Dallas sent two recent MBA grads as Controller and Assistant Controller. A month later they brought in a $30,000 inventory software package. I was to run the day to day accounting and hire a programmer to install and run the inventory system, and the Controllers were to end the inventory shrinkage problem we were experiencing. Now I never did analysis work; they were responsible for that. I just managed people and ran two mainframes. I was responsible for what came in and went out. I was no longer responsible for the lost prior inventory, or so I thought.
My workload increased. I was running the Digital software, that we sold, for our own in-house accounting. I was controlling the inventory system. The Controllers noted that our profit margins were falling each and every month. They were convinced that upper management was stealing the inventory. So now every month we would count and reload this huge inventory even though we had purchased this expensive perpetual inventory program. We were now running an automated system manually! Guess who was having to do that? Then, the Dallas Controller got tired of loading our General Ledger numbers into his Banking system accounting program, to consolidate our combined financial reports. So now I was expected to not only run our General ledger program, but run in tandem on their banking software system at the same time.
Our Controllers were so convinced that that inventory embezzlement was occurring and we were losing money left and right that Dallas decided that they would pay all invoices out of Dallas. So now our Accounts Payable clerk had to process all invoices, keypunch them into our A/P system so she could track them and I could get the numbers, then she had to photo-copy all of that batch and send the originals for Dallas to process. So here we were again running manual systems when we had two automated systems that weren't being used properly. The manual copies had to be utilized because it would take Dallas so long to load their version that vendors would call for a status, and the clerk knew which batch the invoice was in at Dallas. So much for high priced automation.
The Accounts Payable clerk got so burned out and frustrated that she came to me crying one day and said she was quitting. I called the off-the-wall Inventory programmer and he and I took her to lunch. Three hours later we brought her back to work drunk. I called her boyfriend to come and get her then informed her that it was against company policy to resign while inebriated. She came back to work happy the next day.
One month prior to my hiring, but after the Dallas merger, the Pensacola President was playing with his new calculator. He figured out that his big bonus each month was based on a percentage of raw sales, not on Sales Margin, or sales gross profit. So he correctly reasoned he could sell everything at a loss and still he would make more money. So he created a new division to wholesale just the computer equipment. He stole an attorney from the Digital factory in Boston, and the attorney then stole a half dozen top telephone salesmen from Digital and we were in business. Digital factory was the third largest computer manufacturer in the country and now we were their largest purchaser. If we had an inventory problem then, we really had one now.
CTE, that new division, would order a truckload of midi mainframes from the factory in Boston, load them on an eighteen wheeler to be delivered to us in Florida. However, the attorney would call the trucking line and have the truck drop off two systems at this rented warehouse and then three at another recently rented warehouse space. When the truck arrived in Florida, we had a shipping nightmare, as we were never informed of the drop shipments. It would be months before we could piece together the paperwork. In the meantime, their telephone sales force would call companies like GM or banks and sell hardware to them at greatly discounted rates. We were turning a lot of inventory!
During this time, Dallas would send the two Controllers audit tests to perform to try to smoke out the embezzlers in upper management. Dallas was convinced that the Pensacola president and the attorney were stealing. Quite often I would get called into the Controllers' office and handed a brown envelope containing a new test that had to be performed immediately. I would have to stay after work to do some of it so as not to alert management. Then on top of that, we discovered that some of our computers turned up behind the Iron Curtain, in violation of Federal law. So now the Department of Justice was sending subpoenas searching for information on who and how. I had to work on those subpoenas without any of the Pensacola management and some of the Dallas management knowing about it, as the Dallas President was suspected of being involved. And of course, this was all done at nights. I was becoming totally burned out. I felt that it couldn't possible get any worse.
Of course, I was wrong. When I worked for the bank, I was slightly involved in Letters of Credit. These are large transfers of money between banks, used when you don't want to take another's check. Also, when I worked in banking, the U.S. adopted the Uniform Commercial Code. This was a prelude to globalization; it was a standard business law practice that was being adopted by most countries. It was not publicized as so, but it was taking business practices from under common law to International Maritime law. When I saw it I fell in love with it. To me , it was like looking at a beautiful painting. It was so logical, concise and somewhat simple. I ordered a copy of the code and read it from cover to cover, like it was a steamy romance novel. Suddenly, people at Digital quit asking the disbarred attorney for legal advice and started coming to me with all of their business problems. Next to the attorney, I was the oldest employee there, at thirty-five. So I became the legal officer.
Letters of Credit
Let me give you an example of what I was getting hit with. If we were doing business for $100,000, you would give that money to your bank. That bank would then send me a Letter of Credit, stating they were holding the cash and would pay me as soon as I performed. I would then ship the goods to you, and then send the invoice and proof of receipt of the goods by you, to the bank, and the bank would then wire me the money. All of these terms would be spelled out explicitly in the Letter of Credit so you had to be careful when you wrote or accepted one.
But then CTE began selling to South America and Europe. In those countries, a Letter of Credit could sometimes be something else entirely. If you weren't careful. they might say, in a round-about way, that the bank is not holding the funds but rather is saying that the customer is a good guy and will probably put the cash up at a later date, maybe. Again, we were selling product at a hundred thousand dollars at a time. I once had the attorney throw a round wad of money to me at 6:00 PM one evening. I asked what it was and was told a buyer was in from South America and had just bought a system. He was paying in cash so he wouldn't be hassled by Customs. I had no place to lock it up, so I took it home with me in my briefcase for the night. It was the wild west folks. At other times, we would file UCC-! Financing statements on the machines until fully paid for, as this retained title to the machines in case we did not get fully paid. This was right out of my UCC Commercial Code book. I was so grateful I had read it and knew to do that to protect us on the scarier Letters of Credit. I am proud to say we never got burned when we could have.
I had now been with the company about a year and a half. The inventory system was working fine, in my opinion. I had learned to watch for drop shipments and vans at airports. All inventory in and out had been accounted for perfectly for most of that year and a half. But still we were losing two million dollars a year, and the Controllers in Pensacola and Dallas were sure management was getting it through inventory somehow. Although I was running two distinct automated accounting systems, they did not trust those numbers, so we continued on with manual accounting as well. I was growing tired and thinking about quitting. I was dead tired. I resigned twice, but was talked into staying both times.
The Controllers called me into their office one Wednesday afternoon and said I needed to clear my desk for another emergency project from Dallas. My thought was there goes my free weekend again. They gave me a brown envelope with two tickets for the Bahamas! I worked most of Thursday night to clear my desk and flew out with my wife Friday morning. All I wanted to do was sleep while she wanted to stay up all night partying. The last day out we compromised. We ended up alone on the back side of a deserted island, just the two of us and a newly discovered bottle of coconut rum. It was heaven!
A few months later it was our financial year end. We had auditors out the wazoo at inventory time. Two were from a national CPA firm, one was from Dallas corporate office and one was from a German CPA firm, representing a major stockholder in our holding company. All eyes were on the inventory system that some still believed was false somehow. I remember about nine O'clock one night we were all sitting around on desk tops theorizing between "book " and ""Physical". Suddenly, I busted out laughing. All eight of us were wearing dark three piece suits and black wing tips. Even the Dallas Treasurer, a female CPA, was wearing a dark suit and ugly black pumps. We looked stupid and I announced that.
We were two days from the final day of the audit. Here's how a bad audit works. In-House and independent folks are on great speaking terms throughout the audit. On the last day, however, you become mortal enemies. This is when you fight about the major unresolved problems at the end. Heads will roll after that day. In-house hopes that the independents will be fired by their firms when they return home, because they gave in to the competition. The independents will try to hold to their numbers and the in-house will get fired for screwing up. It's a serious day for all.
So, I had to step up to the plate and do what I had trained for all my life. I took the independents out on their last night and got them stinking drunk to slow down their performance the next morning before they flew out. Boy, the next day we slugged it out. There was one long pregnant pause when no one in the room was talking; we were all mad. Ken, the 65 year old Dallas Controller, was terribly scared for his job and was most upset. Then, this twenty-eight old senior independent auditor on site, broke the silence. "Did ya'll know that Ken's wife likes to talk while having sex?" he asked. Everyone in the room was stunned and just stared at him. Then he continued, "Yeah. She's already called him three times today!" Never in my life have I seen anyone so expertly change the mood so quickly. Even Ken was falling out of his chair laughing. The auditors flew out shortly thereafter.
The final score was Independents one, in-house four. The twenty-eight year old senior resigned after returning to Texas. He said he was burned out from being on the road so much, had gotten enough national experience, and was going to settle down in a local CPA firm. The two Pensacola Controllers got it, along with Ken and eventually the president of the holding company. Two months after the audit, I was totally burned out and had to save myself and my failing marriage.
The third time I attempted to resign I succeeded. I kicked my resignation notice under the new controller's door and walked out! I bought a sack of burgers and took my wife and kids to one of the local Civil War forts and sat on the grass on top of it. My wife thought I was freaking out because all I could talk about was how wonderful it felt to be in the sunlight. It felt so warm and beautiful. Six months later CTE was closed. Six months after that Digital Systems was closed.
What Really Happened
It took me years to figure out what happened. Sometimes, history changes on you so fast that you can't see it. It's like standing on the deck of a ship that is moving but you can't see that. Your reference is the horizon, and it tells you that you are standing still. That is what happened to us at Digital.
Let me recap what we thought we knew at the time:
A. Digital was making a ton of profit selling hundred thousand dollar computer systems to CPA firms around the country, by sending salesmen to call on them. We had zero competition.
B. The company was growing fast and needed help. Digital was purchased.
C. Management was retained and left in charge, after he had just been made a millionaire.
D. Inventory had been a problem. Automated accounting and inventory systems were installed.
E. The company lost $2 Million the following year.
F. The Controllers assumed it was from stolen inventory.
Here is what I now think happened.
A. In the beginning, Digital was profitable. Correct.
B. The company was growing fast and needed help. Correct.
C. Management. To hand someone that just became a millionaire the same company that he had growing pains with, and expect him to work day and night to cause the needed changes, is absurd.
On top of that, to put him and the attorney on bonus programs based solely on sales volume and not gross profit, is suicidal. They both sold everything for a loss and they got rich doing it.
D. Inventory System. The automated systems were running perfectly. But in spite of that, both Digital and the holding company couldn't trust the systems and required that they be run manually. Even though they were both in that software technology business, they themselves could not adopt to it. They continually tested the numbers going in and out, confirmed those numbers as accurate, but still refused to believe them. Management could not adopt to the new technology. It was the same story of the old woodcutter using the new chainsaw manually.
E. $2 Million Loss. The Controllers learned in MBA school to always suspect the biggest number. Old school taught that that number would always be either labor or inventory. They zeroed in on inventory. They just couldn't prove it.
F. Assumed Stolen Inventory. That assumption was wrong. Here is my opinion of what happened.
On January 1, year 1, Digital sold a computer for $80,000, added software to it, running the bill up to $100,000.
On December 31, year 2, that same sale would appear differently. The hard drive in the sale above was the size of a washing machine. It cost us $15,000 alone. By the end of year 2, PCs were available that cost $3,000 for the entire system, that outperformed that $80,000 machine sold in year 1.
By year 2, we had competition to worry about when pricing the sale.
So now let's look at the Gross Selling Profit Margin for both sales.
Year 1 Year 2
Sales Revenue: $100,000 $25,000
Cost of Sales:
Hardware 40,000 3,000
Software 1,000 1,000
Salesman Commission 2,000 2,000
Travel - Salesman 2,000 2,000
- ----------------- ---------------
Total Cost of Sale $45,000 $8,000
Gross Selling Profit: $55,000 $17,000
Because of the change in technology, we lost $38,000 from each sale (55K - 17K) that used to go towards overhead and profit. Multiply that times the number of sales we made that year and it quickly adds up to the $2 Million loss. The hardware technology had changed so fast that the Controllers failed to sense it. The commissions per sale remained the same. We were now paying salesmen to fly from Florida to California to sell a toothbrush. A company cannot remain in business long doing that. So, Digital went under.
As for the Customs investigation, no wrongdoing was found on our part. We sold a system to Bob, who sold it to Mary, who sold it to Emile - not our responsibility.
The embezzlement never occurred. The holding company screwed up by offering contracts to key players and salesmen without considering the coming wave of technological change. That was why the Holding company president was fired by the Board. All three of the Controllers were terminated for not analyzing properly.
Now back to me. Six months after I left, I thought I was ready to run with the big boys again, based on my experience. But I did not have that MBA certificate. I went back to the university to visit my friend that was still the head of the Accounting department, and now the MBA program. You remember, the one that told me to take sixty hours and you will graduate. When I made the appointment with him, he said to bring my resume with me.
Let me stop here and explain one fact to you. When the partners realized they had growing problems, they headed to a known intellectual they trusted for help. That's right, to the attorney/CPA Accounting Department Head at the university. He brokered the deal between the Holding company and Digital and made a fat commission on it. He reviewed my resume then threw it back to me, saying, "Get out of here. We don't have a thing to teach you that you haven't already learned." As much as I hated to, I had to agree with him. So I moved to the Masters of Computer Science arena.
Two years later the hardware and spreadsheet software was emerging. With that technology I could have done what was taking me 70 to 80 hours a week at Digital to accomplish in only about 20 hours a week now. I know that for a fact because I sold myself as a controller or consultant to systematize similar companies in trouble and converting them to automated systems. It always only required just a few hours a day and I would get bored and go find another hell hole to convert. In 20 hours a week I could do what took a room full of clerks to accomplish before.
Micro to Macro
Let's go from Micro back to Macro; lets again look at the big picture. Let's multiply what happened at Digital to half of the companies in America at that time. Digital's business model stopped working due to rapid technological change, and so have a lot of other major companies. Many of them are still limping along, but suffering just the same. These are some of those Too Big To Fails. They have been propping themselves up with fraud. But Jim, that was thirty years ago, how can they still be alive, you might say. Hold on Sports Fans. What if the government has been purchasing their stock so that now the company and the corporations are one and the same?
As John Nesbitt predicted in his book of the mid 80s, Megatrends, the computer was now upon us and would drastically change the world we knew. It was going to displace a majority of the labor force. It would end up with machines making the machines. Our economic system would have to either change or implode. Well, it's now imploding. TPTB could not bear to make the requisite changes, because they would have lost immediate profits. So folks, that third wave is now upon us. By the way, Nesbitt said that the first major cultural wave that changed humans was when we stopped being nomadic and became agrarian. The second wave is when we became manufacturers. And now the third wave is the computer age.
With all that being said in the prior paragraph, I have to agree with Bix Weir, author of the Road To Roota website and newsletter. His theory is that some of the big people saw this coming thirty years ago and have been orchestrating the fall of our economic system to wrestle control of it from the bankers, so that society can be set free to grow anew.