Private Fitness Llc

Case 15-1: Private Fitness LLC*

Private Fitness LLC is a springboard case that can be used as the basis of
a discussion of management's need for information. It serves the same
purpose for Part 2 of the book that the Kim Fuller case did for Part 1.
Approach
This case uses a small business as its setting so that students can
visualize the business's activities, and so questions of generally accepted
accounting principles will be essentially irrelevant. In fact, a shift the
student needs to make as he/she begins Part 2 of the book is to think of
accounting primarily in terms of its usefulness to a company's
management, rather than in terms of reporting to shareholders and other
outside parties. Because of the differing focus of Part 1 of the book,
particularly the later chapters, some students will forget that they are
dealing here with information for an apparently unsophisticated manager to
help her run a small business, and not data for a NYSE company.
This case is compelling both because students understand the business
fitness-trainingand because there is a real problem to discuss. A trusted
employee was both stealing cash and, by not recording all sales, diverting
some revenues to herself.
Discussion of this simple case helps students think about both the records
needed to run the business and the challenges managers face in making
sure the information put into the records is recorded accurately (i.e., the
challenges faced in maintaining an effective internal control system). The
case illustrates a common problem faced in many small businesseslack
of overlapping controls, or in this case, what auditors call separation of
duties.
Discussion
To run this simple privately-held business, Rosemary does not have to be
concerned with generally accepted accounting principles. She does need to

keep records that will allow the easy preparation of a tax return. But her
primary concern should be in maintaining systems records that allow her to
manage the business effectively. These include the following:
1. Scheduling system. What instructors, and other employees, should be
on duty at what hours? When should classes of particular types be
scheduled? What rooms should be used for what purposes at what hours?
When should facility cleaning and maintenance be scheduled? What is the
capacity utilization? Are more space, equipment, or instructors needed?
2. Revenue system. Revenue is dependent on the number of clients
attending classes and private workouts.
3. Payroll system. What pay is due the employees? Most of the
compensation is commission-based, paid as a percentage of revenue
associated with the instructors activities. But the manager, Kate Hoffman,
is also paid a salary.
4. Operating cost system. Bills for on-going items, like rent, heat, and light,
need to be paid on time. The expenses need to be recorded accurately and
tracked over time so that trends can be monitored.
5. Fixed asset system. The costs of the facility and equipment need to be
assigned to time periods.
Issues that might be raised:
1. How often should Rosemary prepare summary financial statements
(e.g., monthly, quarterly, annually)? Does she need an income statement,
or is a cash flow statement sufficient for her management purposes? Does
she need to prepare a balance sheet at all?
2. How should prices be set? Should they be set only by looking at
competitors prices, or should they depend on costs (e.g., cost of the space
and equipment used and required instructor expertise)? If the latter, does
Rosemary need a job costing system, or would a periodic back of the
envelope calculation be sufficient?

3. Should Rosemary pay herself a salary and commission for the classes
she ran, or should she take merely the residual profits (or cash flow) from
the business?
4. Should the equipment (e.g., exercise bicycles) be expensed when
acquired, or should the equipment costs be spread over some period of
time to provide a more meaningful time-series picture of costs? If the latter,
what equipment life should be used, and should the cost of equipment be
spread equally to time periods over that useful life?
Addressing the Specific Problems
Students must first recognize that there are two problems to be solvedthe
theft of cash and the unrecorded revenue. There are a lot of internal control
options, most of which involve options that go far beyond the accounting. I
like to divide the options into three categories, (1) action controlsthose
that limit the managers ability to perform the specific bad actions, (2)
results controlsthose that improve the pay-for-performance system, and
(3) personnel/cultural controlsthose that encourage either more
employee honesty (self-control) or encourage employees to monitor each
others behaviors (social control).
1. Action controlse.g., hire a supervisor (accomplish separation of
duties), camera with videotaping capability, locked cash box, use of
receipts and reconciliations with cash in the drawer/cash register.
2. Results controlsStudents must recognize that providing Kate a bonus
of, say, 10% of revenues or profits does little to reduce her motivation to
pocket 100% of the revenue through theft of cash or direct pocketing of
revenues. Revenue-based bonus systems could be effective motivators if
Rosemary is sure that every client is recognized on the system, but by
themselves they wont ensure that every client is recognized.
There are some more creative and better possibilities. For example, should
instructors be set up as little entrepreneurs? Let them keep all the
revenue, but charge them a fixed fee for access to the facility. If this
alternative is chosen, then Rosemary would have to develop a fee
schedule that could be based on a cost accounting.

3. Personnel/cultural controlsstricter hiring criteria (e.g., background

checks), building a strong family culture, group rewards (which encourage
mutual monitoring).
What should Rosemary do?
To answer this question, students will have to consider the benefits (control
effectiveness) and costs in this specific setting. Some alternatives, such as
a camera, might be effective in tracking usage of the facility, but it is an
expensive solution. A wide range of answers are possible here. Students
should see that there is not just one solution to this problem.
The case also raises the question as to what Rosemary should do with
Kate. Some students get emotionally involved in considering this issue, but
these discussions are probably not worth much class time.

It is not easy to become a corporate company. When entrepreneurs like

Rosemary enters the market with limited sources, the very important thing
is to create a team. The team members should be professional of their
business in accordance with the jobs that they are doing.
Rosemary is an instructor and she also hired 5 instructors to run the
classes and training sessions. It is very suitable to hire instructors for
training. And training is also a field that Rosemary has experience. Apart
from them, she hired Kate Hoffman who also has an instructor experience
and a close friend of her. Rosemary has given the marketing, facility up
keep, scheduling and record keeping responsibilities to her. Although Kate
has no experience on those specialized fields, Rosemary also has a limited
knowledge about those tasks. It is very dangerous for a manager to give
disproportionate responsibilities to the employees. If as a manager or
company owner, you are not an expert on the marketing, accounting,

human resources and other departments functions, it is a good idea to hire

professionals or receive consultancy.
To run a company, it is not only enough to know the technical
functionalities. The company should at least have a trustable accountant
and cash handler in order to control the money flow. Since Rosemary is not
an accountant it is very easy for her to lose the control about the company
records. It is very clear that Kate is telling lie to Rosemary and
unfortunately she has no records to proof Kate that she is telling lie.
It seems that Kate and other instructor are taking care of cashier when they
have time. It is also very dangerous in terms of cash security. Only 1
person should be responsible as a cash handler and all of the money flow
should be cashiers own responsibility.
Rosemary should definitely fire Kate. Although they have a friendship,
Rosemary has lots of evidence in order not to trust her any more.
Afterwards, she should define the tasks in the company such as,
Management of The Trainers & Schedules, Cashier, Accountant and Sales
& Marketing. She should be working with quality and experienced people to
manage those functions and give timely feedbacks and reports to her.
Since Rosemary prefers to spend her time with her family, she needs to
have experienced and trustworthy managers to delegate and run the
business.
Although the company is not a profitable company, the efficiency and
planning is very important. There are some classes which has only 1&2
attendees. Running those classes will not bring the company profit. There
should be a capacity planning, profit forecasting and budgeting in order to
make long and short term financial and business plans of the company.
Since this needs a very different expertise on business administration, it is
not logical to handle the issue to the instructors. She should hire
professional managers to run the business and administrative issues.
Instructors should do the necessary training, keep up and scheduling
functions.

The salaries should be fixed because the company is not a profitable

company. Paying the commission to the employees based on gross
revenues will make the fixed costs uncertain and non-manageable.