MANAGEMENT CONTROL SYSTEMS

Dr Sharad L. Joshi Professor Vishwakarma Institute of Management Pune

Syllabus Topics
1. 2. 3.

4. 5. 6.

7. 8.

Characteristics of MCS Responsibility Centers Budgetary Control- Engineered, Discretionary, Committed Costs Capital Expenditure Control Transfer Pricing Balanced Scorecard, financial and nonfinancial measures MCS in a service organization Audit Financial, Internal, Cost, Management

Concept, Characteristics
1. 2.

3.

4.

5.

Management Control is the process by which managers influence other members of the organization to implement the organizations strategies. Through the process of Management Control, managers assure that resources are obtained and used, effectively and efficiently, in the accomplishment of organizations objectives. Control hierarchy is : Strategic Planning, Management Control, Operational Control and Task Control. Achieving Goal Congruence between organizational goals and individual goals is the objective of Management Control. Management Control is a repetitive activity largely based on financial and non-financial measures of performance

Example of Management Control

Decision to penetrate market in Southern India is Marketing Strategy. Ensuring that this gets reflected in Sales Budget for states in South India, breaking it down by Zonal and Regional Offices, and to oversee implementation of the budget through the sales organization is Management Control. Ensuring booking of orders, delivery of goods, billing the customers and recovering money in one of the cities in South India is Operational Control. Arranging transport for supply of material against a particular order and ensuring that the material is delivered as per promise is Task Control.

Goal Congruence

Goal Congruence means that actions that people take according to their perceived self interest are also in the interest of the organization. In evaluating management control practices, two most important questions are (a) What actions do these practices motivate people to take in their self-interest? (b) Are these actions also in the interest of the organization? According to agency theory, managers are said to be agents of the owners. Goal Congruence expects that the agents safeguard and act in the interest of the owners.
Goal Congruence is dependent on factors such as organizations work ethic, culture and management style. A control system needs to accept and consciously promote the objective of goal congruence.

Management Control Process

1. 2.

3.

4.

Strategic Planning Budgeting System to incorporate strategy and to assign responsibilities Performance Measurement and performance reporting Managerial Compensation (or Reward and recognition system to) assist adherence to budget

Strategy implementation framework

Organization Structure Design of Roles, Reporting Relationships and division of responsibilities appropriate for execution of the strategy Human Resource Management Policies and practices for Selection, Training, Performance Evaluation, Promotion and Termination of employees so as to develop knowledge, skills and attitude required to execute organizations strategy Culture The set of common beliefs, attitudes and norms that explicitly/implicitly guide actions of members of the organization Management Controls Translating organizations strategy into targets applicable for individual managers and ensuring adherence to the targets based on specific financial and nonfinancial measures.

Implementation Mechanisms of Strategy

Management Controls

Strategy

Organizati on Structure

Human Resource Management

Performance

Culture

Case for Strategy Implementation Public Sector Banks will have to leave Comfort Zone.
A comparison of PSU banks with private sector banks indicated that the PSU banks have a much lower Fee Income as compared to the private sector banks. (Fee income includes income from advisory services, syndication of loans, providing letters of credit and guarantees, and sale of other banking products). Yes Bank, which is just 8 year old, earned fee income of Rs 767 cr. for 2011-12, which is higher than 18 other public sector banks. PSU banks have been reluctant to do this mainly because of their inherent constraints. Traditionally these banks have been trained to focus on Interest Income on loans; however loans given without adequate due diligence are coming back to haunt them as bad loans. Not many PSU banks have developed expertise in the field of advisory services despite having a huge network of branches.

Case continued Public Sector Banks will have to leave Comfort Zone.
Ms Shikha Sharma CEO and MD of Axis Bank mentioned that her bank has developed a strong fee income infrastructure based on skillset of experienced employees, pursuit of product innovation, value added services, diverse distribution channels, and above all, commitment to a customer-centric approach. Fee income of Axis Bank for 2012 is Rs 4341 Cr. out of a total Rs 27436 Cr. (15.8%). Bank of Baroda which is a PSU bank has a ratio of Fee Income to Total Income of 3.7% (out of a total Rs 33589 Cr.). The bank has taken a policy decision of increasing this ratio to 10 % over a 5year period; broken down into specific year-wise targets. Comment on Strategy Implementation measures which may be needed, and especially on the Management Control Systems.

Strategic Directions for Increasing Fee Income

Identifying Services/ Products to be focused Appointing a GM Services as overall in charge Marketing Strategy / Marketing Communication Training at various levels Determining and Monitoring progressive Targets Performance Measurement/ Reward (Group Bonus?) Management Information System Sharing, Benchmarking (Meetings)

Griesinger Paradigm
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2.

Cybernetics Science of communication and control, also the way systems regulate themselves, replicate, evolve and learn. Credited to Norbert Weiner, a Mathematician. Cybernetics is essentially about systems in selfcontrol. They have goals, can measure performance, compare performance with goals, compute variance, report variance, determine causes of variance, take corrective action, and repeat the cycle until goals are met.

The Cybernetic Paradigm of the Control Process

Applying Griesingers paradigm to a real life case

ET headline - FM asks bankers to pressurize builders to speed up projects and cut prices of apartments. The builders are said to be sitting on a large inventory of unsold apartments, in which huge capital is blocked. Banks are being asked by FM to put pressure on builders, since they have funded both the builder and the home loan borrower. For example, State Banks exposure to Realty sector is 144000 Cr, ICICI Banks 81000 Cr.
Review Griesingers diagram. Assign Roles stated in the diagram to agencies in the situation stated above.

Applying Griesingers Paradigm - Solution

Information given in the case, especially FM putting pressure on the banks, passes thru Sensor and results in Formulation of Goals. The bankers entrusted with persuading the builders are the decision makers. The information analysis and communication system existing in the bank is Sensor. Based on inputs provided, the decision maker(s) perceive and formulate their Factual Premises. These are compared with goals thru a comparator which can be a committee. The decision maker(s) decide about actions needed to meet the goals. The effector is an individual or a group which puts into effect what has been decided, making behavioral choice from an available repertoire. The environment changes; to be assessed by the sensors, for the next cycle of System even the goals may be altered.

Controllers Responsibilities
1.

2. 3.

4. 5.

Designing and Operating Information and Control Systems Budgets, standards, procedures to implement the system Reporting, analyzing and consulting Internal Audit and Accounting Control Procedures, Protection of assets Economic Appraisals, Cost benefit analyses Developing personnel for Control Organization, Training managers in related matters

Formal Control Process - I

Infrastructure Organization Structure, Strategy, Operations, Patterns of Autonomy, Measurement Methods, Responsibility Centers, Transfer Pricing Management Style and Culture Principal Values, Norms and Beliefs (See slide of Reliance Industries, as an example) Principal Processes Strategic Planning, Capital Budgeting, Operating Planning, Cost Accounting, Budgeting, Reporting System, Variance Analysis

Formal Control Process - II

Rewards and Penalties Individual and Firm level, Short Term and Long Term, Promotion Policy Coordination and Integration Standing Committee, Meetings, Communication Systems, Conferences

Example of Reliance Industries Values and Beliefs

Accent on high technology areas. Faith in Investors Ethics starts from Board Room Ethics does not prevent from taking business risks Growth with dignity Stock market ultimate barometer Thrive on challenge Keep running to stay at the same place Consumers final referees

Informal Control Process

Infrastructure Personal Contacts, Networks, Emergent Roles Management Style and Culture Principal Values, Norms and Beliefs Control Process Personal Supervision, Meetings Rewards and Penalties Informal Rewards and Promotions Co-ordination and Integration Trust Based, Personal Contact

Management Control Systems - Summary

Management Control Systems is the process of implementing organizations strategy. In order to translate strategy into performance, management control systems need to be supported by appropriate Organization Structure, Human Resource Management, and corporate Culture i.e. a structure of norms and values and beliefs. The control process consists of FIVE components : Control Infrastructure, Management Style and Culture, Specific Processes, Rewards and Penalties and Mechanism for Coordination and Integration.

Responsibility Centers- I

All organizations are made up of smaller organizational units divisions, departments within divisions, sections within departments. If any of these units and sub-units is headed by a supervisor responsible for its performance, the said unit or subunit is called a Responsibility Center. The main purpose of MCS, that of implementing the Organizational Strategy is put into effect through the responsibility centers. If each of the responsibility centers meets its objectives, the objectives of the organization will have been met. An important function of Management Control Systems therefore is to control the performance of Responsibility Centers.

Responsibility Centers- II

A generic view of functioning of a responsibility center can be presented as follows.

Inputs
(Resources Used, Measured as Cost)

Work

Outputs
(Goods, Services, Effects)

Responsibility Centers- III

Responsibility Centers differ from each other in terms of

Measurability of Inputs and Outputs Measurability of Efficiency and Effectiveness of Output, in relation to Inputs. (Efficiency is ratio of Outputs to Inputs. Effectiveness is closeness of the output to objectives of the Responsibility Center).

Depending on the above, Responsibility Centers are divided in Four Types.

Types of Responsibility Centers

Type 1. Revenue Center 2. Expense Center 3. Profit Center 4. Investment Center Nature of Measurement of Inputs and Outputs
Output measured in monetary terms; no formal attempt is made to relate output to input Input measured in Monetary Terms, no attempt is made to measure output in monetary terms Both measured in monetary terms, the difference treated as profit(loss) Both measured in monetary terms, the difference treated as profit(loss). Measurement is by relating it to Capital Employed

Example Marketing Function (Bata Shoe Shop) Manufacturing Function (Foundry Section) Internal Business Unit (Larger) Internal Business Unit

Evaluation of a Revenue Center

Budgeted Revenue Vs Actual Revenue (For Individual Products/Product Categories) Comparison with previous period(s) Comparison with other comparable sales outlets Analysis of Quantity, Rate and Mix Variance

Revenue Center - Problem on Variance Analysis

The figures for a BP Petrol Pump for April 2012 and April 2011 are as follows. April 2012 April 2011 Ltrs Value, Rs Ltrs Value, Rs Petrol 467896 34137692 406789 27165369 Speed 67986 5069036 65532 4498772 Diesel 267854 11335581 278487 10707825 Total 803736 50542310 750808 42371966 Comment on relative performance of the two years.

Formulae for Computing Variances

Rate Variance Difference in Rates X Current years Volume Mix Variance - (Current Year Volume Current Year Volume at Previous years Mix %) X Prev. Year Rate Volume Variance - (Current Year Volume at Previous years Mix % - Prev. Year Volume) X Prev. Year Rate Gross Variance Total of Rate, Mix and Volume Variances, also Difference between Value between two years

Calculating Mix Variance

Apr-12

Apr-11

Ltr

Rs/ Ltr Value,Rs

Mix % Ltr

Rs/ Ltr Value,Rs

Mix % Rate Var

Mix Var Vol Var

Gross V

467896 72.96

34137692 58.22

406789 66.78 27165369 54.18

2891597 2165710 1915015 6972323

67986 74.56

5069036

8.46

65532 68.65

4498772 8.73

401797 -148673

317140

570264

267854 42.32

11335581 33.33

278487 38.45 10707825 37.09

1036595 -1163684

754845

627756

803736

50542310 100.00

750808

42371966

100

4329990

853354 2987000 8170343

Analysis of Variance
Type Amount, Rs % Rate Variance 43,29,990 53.00 Mix Variance 8,53,354 10.44 Volume Variance 29,87,000 36.56 Gross Variance 81,70,344

Expense Centers

Expense Centers are responsibility centers in the case of which input is measured in monetary terms but output (goods, services, effects) cannot be or is not attempted to be, measured in monetary terms. Examples of expense centers are manufacturing departments in a factory, administrative and support departments such as accounting and maintenance, training, transport, research and development etc. Controlling Expense Centers essentially means ensuring Efficiency and Effectiveness in their operations for which both monetary and nonmonetary measures are used.

Expense Centers Control linked to behavior of 3 types of costs

Engineered Costs are those in the case of which right or proper amount of costs can be calculated with a fair degree of reliability. (e.g. material costs, piece rate labor) Committed Costs are those which arise as a result of Commitment made by the decision maker. The costs remain constant during the period of the commitment (e.g. Office Rent, interest on term loan) Discretionary Costs (also known as Managed Costs) arise as a result of discretion or judgment exercised by the decision maker. The right or proper amount cannot be stated with exactness. A range may be stated, it is often, however, too broad to be of any practical use. Percentage change in costs to achieve desired percentage change in results can also not be stated. (Example: Advertisement Costs)

Engineered and Discretionary Expense Centers

Engineered Expense centers are those where Engineered Costs are a dominant form of costs incurred those in the case of which right or proper amount of costs can be calculated with a fair degree of reliability. Discretionary Expense Centers are those where a majority of costs incurred are of Discretionary type where the right or proper amount to be spent cannot be stated with exactness. In the case of either of these, other types of costs may also exist and need to be controlled using techniques/ practices suitable for them.

Controlling Engineered Costs

The steps in cost control are as follows. Measure output in physical terms Work back expected Input cost on the basis of a set methodology (formula, algorithm) Compare Actual Costs with expected Costs Measure Variation Analyze variation Take corrective action

Variance Analysis Problem for Material Costs

As per Standards set by Asmita Builders, 1 litre of Cement Paint, at a standard rate of Rs 58 per litre, can be used to paint 50 square feet. Actual cost incurred at a site for painting 10000 sq.ft. came to Rs 11400 for 190 litres of paint used. Compute Rate Variance and Usage Variance. Formulae : Rate Variance Difference in Rates X Actual Usage Usage Variance Difference in Usage X Std. Rate Net Variance Standard Cost - Actual Cost

Solution to the Problem

Standard usage for 10000 sq ft is 200 litres at Rs 58/ Ltr. Total Std Cost Rs 11,600. Actaul Usage 190 litres at Rs 60/Ltr, Rs 11400 Rate Variance: (58 - 60) X 190 - Rs 380 (U) Usage Variance: (200 190) X 58 Rs 580(F) Net Variance: Rs 11600 Rs 11400, Rs 200; also equal to (Rate Var. + Usage Var).

Controlling Committed Costs

Committed costs can be controlled only at the stage of making the commitment (e.g. Office Rent or Interest on Term Loan) Suitable policies and procedures need to be designed so as to ensure control at the stage of commitment. These will include assigning responsibility of controlling Committed Costs (or a part thereof) to respective Responsibility Centres. A majority of Committed Costs arise from Capital Expenditure decisions; which is an important domain under Management Control.

Problem on segregating committed costs

Based on Power Expenses for 6 months (Rs lakhs), segregate committed and engineered costs. Prodn Value Power Bill Jan 327 56.75 Feb 363 58.80 Mar 410 63.10 Apr 352 57.60 May 261 52.44 Jun 314 54.60
(Using equation of the straight line, y= a + bx with Power Bill as y values and Production as x values, solution obtained thru LINEST function in EXCEL is a = Rs 32.57821 lakhs and b = Rs 0.072852 lakhs. Committed Costs are thus Rs 32.58 lakhs, approx.)

Controlling Discretionary Costs Principles and Best Practices

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Competent Managers Healthy Atmosphere Policies, Procedures, Guidelines, Rules Periodic Review of the above Using Engineered Cost Method where possible Use of the budget to promote discipline, use it selectively as ceiling, floor, guide. Use of non financial measures Benchmarking

Notes on Controlling Discretionary Costs - I

1. Competent Managers by virtue of their

knowledge and skills, keep the costs under control and get value for expenses incurred. They are also expected to make adequate use of expertise available within and outside the organization - lawyers, auditors, advertising and market research agencies etc.

Notes on Controlling Discretionary Costs - II

2. Healthy atmosphere stands for professional, task-oriented approach to work. The employees in such an organization display efficient, goal oriented behaviour which ensures teamwork and efficiency as a result of which discretionary expenses are kept under control.

Notes on Controlling Discretionary Costs - III

3.
Policies, procedures, guidelines and rules is a way of ensuring adherence to standard practices across the organization. There can be a company policy about acquiring branch office on lease or as outright purchase. Purchase Procedure will ensure that no payment is made to a supplier unless goods have been received. Banks may have guidelines about assessing credit-worthiness of a auto-loan borrower. SEBI has a set of rules for IPOs by limited companies. All these ensure uniformity, control, and compliance with objectives.

Standard Operating Procedure (SOP) for Purchase of goods

Purchase procedure begins with indents prepared by user departments. Indents are consolidated by Purchase Department so that a bulk order can be placed for similar goods. Purchase Dept. invites quotations for the goods in question. Number of quotations invited depend on expected value of the purchase (minimum 3). Value above a specified amount calls for an open tender thru a newspaper advertisement. Departmental heads have an authority to decide the source of supply up to a stated amount; beyond which the source is decided by the purchase committee. Beyond a certain amount, top 3 (or 5) suppliers may be called for negotiation before the purchase committee.
How will you deal with routine purchase of items of raw material? What changes will be required for e-buying? How to measure performance of suppliers?

Notes on Controlling Discretionary Costs - IV

4. Policies, procedures, guidelines and rules will
need to be reviewed from time to time so as to keep them up to date. For example, Daily Allowance for outstation travel should keep pace with current price levels. Rules for use of new technologies will be required to be framed. Outdated policies, procedures, guidelines and rules may be detrimental to meeting organizations objectives.

Notes on Controlling Discretionary Costs - V

5.
Engineered Cost components exist as a part of Discretionary Costs. Information Technology Department is a Discretionary Expense Center, of which data entry is an engineered cost, compensated on per entry basis; so is invoice printing as a part of marketing departments work. These components can be controlled on the basis of measuring output, working back the expected input costs and comparing them with the actual. Development of metrics for many other tasks is also attempted to control productivity and the cost.

Notes on Controlling Discretionary Costs - VI

6.
Though not as rigid as in the case of other types of costs, use of budget is common in discretionary costs to develop planning and controlling skills among managers, (e.g. for expenses such as advertising and travel). Budgets can be used as ceiling not more than the stated amount, floor not less than the stated amount in the case of developmental expenses and guide around the stated amount. Budgets are detailed for functions, sub-heads and geographical units (e.g. branches) so as to ensure higher degree of financial discipline.

Notes on Controlling Discretionary Costs - VII

7.
Non-financial measures to control discretionary costs are used to measure effectiveness, along with efficiency. Producing monthly Balance Sheet before 7th of the following month can thus be a target for accounting department. Preparing a report on age analysis of outstanding and ensuring that these are in line with the norms is a way to control Credit Control Department. Banks can similarly set norms for NPA (Non performing assets). Some of these are expressed as KPIs, considered as important as financial results.

Notes on Controlling Discretionary Costs - VIII

8.
Benchmarking is a simple yet effective method of improving performance and indirectly controlling costs. A bank can compare performance of branches in the same category with respect to their income from other services and identify best practices for the benefit of all. Benchmarking can be formalized by having an agreement with an organization considered superior in the specific segment which may share their practices with their benchmarking partner at a cost. Combination of all methods (1 to 8) is needed in order to control discretionary costs.

Cost Control of Handling Service Requests and Complaints at a Mobile Phone Company Service Center
Competent Managers, Healthy Atmosphere Policies, Procedures, Guidelines, Rules based on above (one of these could be training to staff, specifying qualifications for complaint handlers) Yearly review to identify changes required in policies, procedures, guidelines and rules Budgets, in terms of people and equipment, minimum allocation for new technologies, software, facilities Engineering Cost Method for routine complaints (Targets per day) Use of non-financial measures (Zero Complaint Week for a particular type of complaint) Benchmarking thru comparison between branches Use of Mystery Shoppers, performance audit

1. 2.

3.

4.

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6.

7. 8.

Controlling Travel Expenses

A software product company spends Rs 30 crores every year on marketing, which travel budget alone is approx, 50%. This includes expenses for travel and stay. What approach you will suggest for controlling Travel Costs? (Use approach similar to that used for controlling costs of Mobile Phone Companys service center. Give more attention to Budgeting Travel Costs by Dept., Destination, Mode of travel etc)

Profit (or Financial Performance) Centers as Responsibility Centers

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Both input and output is measured in monetary terms. The difference, profit(or surplus), is said to measure efficiency as well as effectiveness. Profit also serves as resource allocator. Considered Tool of Decentralization and of Goal Congruence Two types : Natural (e.g. Independent product or a branch) and Constructive (formed deliberately, such as Computer Department and Law Department) Profit (often called profit contribution) is measured as Profit Centers Revenue minus direct costs (before tax). Sum total of profits of all divisions may not necessarily equal firms profit; some of the prices of profit centers are merely for measurement of their respective contribution. The system presupposes a certain degree of professional maturity and systems support

Transfer Price

Since at least a part of the business transacted by the profit centers is with other intra-company profit centers, the prices charged and paid by them to each other (transfer prices) become important. Unless based on sound rules the Transfer Prices can emerge as a major source of dispute between the centers; thus negating purpose of achieving goal congruence. Unlike Inter-company profit centers, intra company profit centers do not have complete freedom to set prices. 3 possibilities (1)Profit Centers do not have the freedom to buy from outside; they must buy internally at negotiated prices. (2) Profit Centers have a long term arrangement to buy or sell intra-company (3) Buy or Sell decisions can be taken on a short term basis. (Case of large open market)

Transfer Prices 3 alternatives

1. 2.

3.

Market Based Using Market price as a base Cost Based Cost Plus Profit Full Cost+ Profit for high Capacity Utilization Variable Cost+ Profit for low Capacity Utilization Use of standard rather than actual Costs is desired in either case Negotiated Price

Special Pricing Alternatives

1. Two step Pricing Transfer Price is made up of 2 components, a fixed monthly charge plus per unit charge, usually on variable cost basis (like domestic electricity bills) 2. Dual Pricing Transferring and Transferee departments have different prices for the purpose of computing profit 3. Profit Sharing : Downstream profit is shared between upstream responsibility centers

Hostel Pricing Case

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An Engineering college has a Hostel. The Hostel and Engineering College are both Financial Performance (Profit) Centers. The Cost Per student according to Hostel Management comes to Rs 22,500 per student. The students find the rate on the higher side. Comparable accommodation in the area is available at Rs 15,000. The management desires to offer the rooms at Rs 15,000, provided the college subsidizes the difference. The college questions the cost, arguing, hostel makes no effort to control costs since these can be passed either to the students or to the college. What should be the transfer price policy which will ensure efficiency and motivation to perform at the Hostel level? How to ensure that the College and the Management are also motivated?

Possible plan of action

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2. 3.

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6.

Subsidy required to protect the interest of the Institution so that hostel facility is offered to students and that rooms do not remain vacant. Consider Market Price to decide subsidy Compute hostels per students cost as Standard Cost Plus Profit, not actual cost Hostels performance with respect to admissions should be evaluated on actual vs. budget. Subsidy should be charged to a Control Account; which may be distributed to colleges (on the basis of their admission quota in hostel, number of students in college or total fees). Charging subsidy direct to college is dysfunctional; they may not send students to hostel, preferring alternatives.

Transfer Price Problem

Div A and Div C are 2 intra-company profit centers. Div A suplies units to Div C. Division Cs Annual Purchase 1000 Units Div As (Supplying Dept) Price Rs 150 Market Price Rs 135 As Variable Cost P.U. Rs 120 As Fixed Cost P.U. Rs 20

Will the company benefit if purchased from market?

No. Rs 135 Rs 120 Rs 15 Rs 15000

Purchase Cost per Unit Variable Cost saved P.U. Loss per unit Total for 1000 units

If A can use the facilities elsewhere to earn Rs 18000 will the company benefit?

Yes.

Loss in Contrbn thru buying Rs 15000 Earning thru use of facilities Rs 18000 Net Benefit Rs 3000

If market price drops from 135 to 115 should we buy from outside?

Yes. Rs 115 Rs 120 Rs 5 Rs 5000

Outside purchase price As variable cost Saving per Unit Total for 1000 units

Problem 2.

Dept A (Supplying dept) Variable Cost Rs 84 p.u., Fixed Cost Rs 6 p.u., Selling Price Rs 92 p.u. Dept B (Receiving Dept) Extra Variable Cost Rs 80 p.u., Fixed Cost Rs 10 p.u., Final Selling Price Rs 176 p.u. B has offer from an outside supplier at Rs 90 p.u. Should B buy from A or from outside? What Transfer Price should be allowed to A?

Investment Centers
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Investment Centers are basically profit centers where profit center managers also have the freedom to control their Investments i.e. fixed as well as current assets deployed by them. Instead of absolute profit, profit related to Investment (ROI) is therefore used as a tool of measurement. ROI also serves as a resource allocator. Investment Centers are even a better tool of Decentralization and of Goal Congruence. Along with Profit, assets deployed by the resp. center also need to defined. Allocating all assets in Balance Sheet is often a difficult exercise in the case of intra company investment centers. The system presupposes a high degree of professionalization and systems support. Asea Brown Boveri, a MNC, has 1000 investment centers and 5000 profit centers.

Measures of performance for Investment Centers - ROI, ROA, EVA, MVA

1. Return on Investment PBIT/ Total Assets* ROI measures efficiency in use of funds from an insiders (controllers) point of view. 2. Return on Assets PAT/ Total Assets* ROA measures efficiency in use of funds from a shareholders point of view. 3. Economic Value Added = [PAT + (1-t) x Interest] [Cost of Capital (of Equity and Debt)] 4. Market Value Added = Market Value of (Equity + Marketable Debt) their Book Value. *Total Assets = Non Current Assets + Net Current Assets Net Current Assets = Current Assets Current Liabilities

Measures of performance for Investment Centers - ROI, ROA for Asian Paints Ltd, 2011-12

1. Return on Investment PBIT/ Total Assets

PBIT Rs 1394 Cr, *Av. Total Assets - Rs 2435 Cr ROI - 1394/2435, 57.25%

2. Return on Assets PAT/ Total Assets

PAT Rs 958 Cr, *Av. Total Assets - Rs 2435 Cr ROA - 958/2435, 39.34 % *Av Total Assets = Rs 1802 Cr (Non-Current) + Rs 633 Cr (Current Assets Current Liabilities)

Measures of performance for Investment Centers - EVA for Asian Paints Ltd, 2011-12
3. EVA = Net Operating Profit After Tax - Cost of Capital
Net Operating Profit after Tax [PAT+(1-t) Interest] PAT Rs 958 Cr, Interest- Rs 31 Cr, Tax Rate (t): 32.45%, PAT+ (1-t) Interest = 958+ (1-.3245) x 31 = 978.94 Cr Cost of Capital Equity 2232 Cr (92%), Debt 203 Cr (8%), Total 2435 Cr Cost of Equity 13 %, Cost of Debt 14% x (1- .3245) , 9.46% Weighted Av. Cost of Capital = 13 x .92 + 9.46 x .08 = 12.72% Cost of Capital = 2435 x 12.72% = 309.73 Cr Economic Value Added NOPAT Cost of Capital = 978.94 Cr 309.73 Cr = 669.21 Cr

Measures of performance for Investment Centers - MVA for Asian Paints Ltd, 2011-12

4.

MVA = Market Value of the firm (of Equity and Debt) Book Value (Equity+ Debt) Market Value of Asian Paints, Rs 17600 Cr Book Value of Equity + Debt, Rs 2435 Cr Market Value added (MVA), Rs 15165 Cr

Du Pont Analysis Return on Total Assets (ROA)

Net Profit ------------------------Average Total Assets Return on Assets Net Profit = ------------Net Sales Net Profit Margin Net Sales x -------------------------Average Total Assets Total Assets Turnover Ratio

Note: Av Total Assets = [Fixed Assets + (Current Assets Current Liabilities)]. Du Pont takes Net Profit as Profit after taxes, not PBIT.

Norm Norm for PBIT should be 18%. With 1:1 Debt-Equity Ratio, 14 % rate of Interest and 32% Tax Rate, PAT should be 7.5% of Total Assets. The norm will change with Debt/ Equity Ratio. For a company with no Debt, the Norm will be approx. 12%.

Du Pont Analysis for Asian Paints Ltd, 2011-12 Return on Assets

Net Profit / Av. Total Assets
Net Profit (PAT) Rs 958 Cr, Av.Total Assets-Rs 2435 Cr ROA - 958/2435, 39.34 %

Net Profit/ Net Sales (Profit Margin)

Net Profit (PAT) Rs 958 Cr, Total Sales Rs 8105 Cr NP to Sales 958/ 8105 11.82%

Net Sales/ Av. Total Assets (Asset Turnover or Rotation)

Net Sales Rs 8105 Cr, Av Total Assets Rs 2435 Cr Rotation 8105/2435 , 3.329 Times Crosscheck 11.82 x 3.329 = 39.34% ( 958 = 958 x 8105
2435 8105 2435 )

Du Pont Analysis, Extended, Return on Equity (ROE)

Net Profit = ----------- = Equity Net Profit ----------Net Sales X Net Sales ---------x Av. Tot. Assets ----------------Equity

Av. Total Assets

Return on Net Profit Assets Financial Equity Margin Turnover Leverage 958/ 2232 = 958/8105 x 8105/2435 x 2435/2232 42.92% = 11.82% x 3.329 x 1.09 Equity holders get 42.92%, while overall ROI is 39.34%.

UoP December 2011 Problem

A division of XYZ Ltd has assets of Rs 30 lakhs, invested Capital Rs 22 Lakhs and Income of Rs 8 lakhs ignoring taxes.
1. What is Divisions ROI? 2. If weighted average Cost of Capital is 18%, what is EVA? 3. If management uses ROI as a performance measure, what effects on management behaviour do you expect? 4. If management uses EVA as a performance measure, what effects on management behaviour do you expect?

UoP December 2011 - Solution to the Problem - I

1. ROI = Profit Ignoring Tax / Av. Total Assets = Rs 8 Lakhs / Rs 30 Lakhs = 26.67% Approx. 2. EVA = = = = Profit Ignoring Tax Cost of Capital X Capital Rs 8 Lakhs - 18% X Rs 22 Lakhs Rs 8 Lakhs - Rs 3.96 lakhs Rs 4.04 Lakhs

Uop December 2011 -Solution to the problem (Continued)

3. To use ROI as a performance measure, the management will have to specify ROI norms. While overall ROI may be higher than the norm, some of the projects may not have covered Cost of Capital and may thus destroy value. These projects need to be reworked or discontinued; this does not happen under ROI method. Pursuit of higher ROI may result in rejecting projects which may have yielded positive EVA; thus opportunities lost. 4. With EVA as a performance measure, projects yielding positive EVA will be selected. This is good enough since Cost of Capital will always be covered. Problems stated above with respect to ROI will be overcome. Using variable Cost of Capital depending on asset class (e.g. Working Capital), managers can be guided to choose projects that add value for shareholders and thus achieve goal congruence .

Capital Expenditure Control

1.

2. 3.

4.

Important because large amounts are involved. Wrong choice can be disastrous. Delays may mean lost opportunities/ cost overruns. Pre, During and Post Expenditure Control needed Sound judgment, effective monitoring mechanism important Financing Capital Expenditure projects also a part of the system. Raising funds for new projects, allocation of funds for on-going projects, financing overruns are all important.
Risk Management may be practiced to control uncertainties (Study Impact & Probability. Use Escalation, Extra Work Clause, Insurance, Hedging)

5.

Format of Capital Expenditure Budget

Budget 2011-12 Rs. Lakhs
Budget Provision B/F Budget Provision Current Yr

Total

Budgeted Expenditure Curr. Year

Budgeted Expenditure C/F

Head Office Factory

36.00

34.00 147.00

34.00 183.00

34.00 97.00

86.00

Western Region Eastern Region

24.00

17.00 -

17.00 24.00

15.00 24.00

2.00 -

60.00

198.00

258.00

170.00

88.00

Capital Expenditure Pre Expenditure Control

Generating viable, superior project ideas is an important step to maintain/ improve ROI. Evaluation and approval based on financial and nonfinancial measures. Screening and ranking criteria need to be decided (Payback, IRR, Present Value) Five Categories Repair and Replacement, Improvement, Cost Reduction, Capacity Enhancement, New Products. Capital Expenditure Budget to be allotted to each. Screening/ Ranking not relevant for the first two.

Capital Expenditure During Project Expenditure Control

Crucial for effective control of expenditure Techniques of project management (such as PERT/ CPM) may be used for reporting and monitoring. An illustration for effective project control and reporting follows.

SrN 1 2 3 4 5 6 7 8

Task Status Completed Completed Completed Not Started Started Not Started Completed Not Started Total

BCWS 50 50 90 70 100 90 60 510

BCWP 50 50 90 0 80 0 60 330

ACWP 50 40 140 0 90 0 50 370

Schedule Variance 0 0 -100% -20% -100% -35.29%

Cost Variance 0 +20% -55.5% -12.5% +16.6% -12.12%

Key: BC Budgeted Cost WS Work Scheduled WP Work Performed AC- Actual Cost

Schedule Variance (BCWP BCWS)/BCWS. Cost Var.- (BCWP ACWP)/BCWP Expected Cost at Completion (say) Rs 5.50 lakhs * (370/330) = 6,16,667 Expected Overrun Rs 6,16,667 Rs 5,50,000 = Rs 66,667

Capital Expenditure Post Expenditure Control

Comparison of Actual Payback, IRR, PV with Planned to be carried out regularly Guidelines to be provided for future planning based on the comparison Delay/ Cost Over-run may require revision of Capital Expenditure projects

Capital Budgeting Problem UoP May 2012

The expected cash flow of a project is as follows. Year Cash Flow 0 - 1,00,000 1 20,000 2 30,000 3 40,000 4 50,000 5 30,000
The cost of capital is 12 percent. Calculate the following: (a) Net Present Value (b) Internal Rate of Return (c) Payback Period

Computation of Present Value at 12% Discounting Rate

Year
Compounding Cash flow Factor
(1.12 raised to year)

Discounting Factor

Present Value

(1 / Compounding (Cash flow X discounting factor) factor)

0 1 2 3 4 5

-100000 20000 30000 40000 50000 30000

1 1.12 1.2544 1.404928 1.573519 1.762342

1 0.892857 0.797194 0.711780 0.635518 0.567427 Net Present Value

-100000.00 17857.14 23915.82 28471.21 31775.90 17022.81

Total

170000

19042.88

Computing Internal Rate of Return by trial and error method

Year Cash Flow PV at 12% PV at 16% PV at 18% PV at 19%

0 1 2 3 4 5

-100000 20000 30000 40000 50000 30000

-100000 17857.14 23915.82 28471.21 31775.9 17022.81

-100000 17241.38 22294.89 25626.31 27614.55 14283.39

-100000 16949.15 21545.53 24345.23 25789.44 13113.28

-100000 16806.72 21184.94 23736.63 24933.44 12571.48

NPV 19042.88 7060.52 1742.64 -766.78 Note : IRR is the rate at which NPV is zero. IRR in this case is thus between 18% and 19%, > 18 % and < 19%. Ratio of 766.78 to (1742.64 + 766.78 ) is .31. IRR, by interpolation, is thus (19% - .31) = 18.69%.

Computing Payback Period

Year 0 1 2 3 4 5 Cash Flow -100000 20000 30000 40000 50000 30000 Cash Flow, Cumulative 20000 50000 90000 140000 170000

Note : Cumulative Cash inflow exceeds Cash Outflow of Rs 100000 between year 3 and 4. Shortfall at the end of year 3 is Rs 10000, while cash inflow for year 4 is Rs 50000. .2 Year (10000/50000) is sufficient to cover the shortfall. Payback period is thus 3.2 years.

Budgetary Control

Purpose of the Budget is to translate Strategic Plan in timebound activities, to be accomplished by respective responsibility centers. Budget is said to be one year slice of the Strategic Plan. (e.g. Current year sale as a part of a long term new market penetration strategy, State level budgets). It is also the most common form of Management Control. Adhering to budget automatically ensures goal congruence. Budget may contain both monetary and non-monetary targets. All four types of responsibility centers viz. Revenue Centers, Expense Centers, Profit Centers and Investment Centers come under the purview of Budget. Budget represents two way commitment on the part of the management and the responsibility center managers.

Uses of the Budget

Fine Tuning of the Strategic Plan, operationalizing it in realistic terms. Coordination between interdependent departments while setting targets which affect each other (e.g. Production and Sales) Assigning responsibility for action(s) Creating a basis for performance evaluation Promoting planning skills and self discipline across organizational units (Budgets are said to be like school bells and Monday mornings).

Budget Preparation Process

Setting up a Budget Department to administer the Budget. An important task is to provide necessary information, formats and technical assistance Forming Budget Committee at Senior Level for review and approval, resolving problems Issuance of guidelines related to overall assumptions, growth objectives, corporate policies Steering Budgets through a bottom up and top down process with a time bound plan Negotiation, review, approval, circulation

Behavioral aspect of the Budget

Budget needs to be participatory so as to ensure acceptance and implementation Ideal budget is said to be challenging but attainable, most companies prefer achievable budgets with incentive for exceeding the budget Senior Management Involvement is a must Budget Department should have a reputation for impartiality and fairness. It also has to ensure that budgets do not contain buffer. Budgets mature over time. Persisting with budgetary control over a long period is necessary.

Zero Base Budgeting (ZBB)

Zero Base Budgeting was formulated by Peter Phyrr in 1970. It is not a new technique but an approach to formulation of the budget. In a typical budget, current years budget is formed with a few (usually) upward changes in the previous years figures. ZBB argues that each years figures should start with Zero, and then built objectively based on properly justified needs for current year. ZBB works with a Decision Unit which is a responsibility center. Each decision unit will need to justify each of the tasks undertaken, known as decision packages, separately, based on cost benefit analysis. Consequences of not funding the decision package need also be stated. A decision package can be stated as one among stated options. It can also start with a minimum to be expanded as per justified need. Overall budget is made up of accepted decision packages (i.e. tasks). ZBB has a potential to cut down vast unnecessary expenditure.

Budgetary Control with respect to Engineered, Discretionary and Committed Costs

Budgetary Control for Engineered Costsl is usually through Flexible Budgeting. Since cost per unit is known, additional budgetary provision can be made based on output. (e.g. Painting cost per sq. ft.). Variance analysis should be used to analyze deviation from the budget. The budget for discretionary cost should be prepared in detail and itemized so as to develop clarity and financial discipline among managers (e.g. Dept. wise/ Destination-wise/ mode-wise Travelling Expenses). It may be stated as Floor, Ceiling or a guide to promote desired behaviour. Committed Cost budget needs to be approved by a high level committee, since committed costs can be best controlled at the stage of commitment (e.g. Interest on Long Term Loan)

Performance Measurement Financial Measures

Since purpose of MCS is to implement strategy, measuring performance of responsible managers (with respect to implementation) is an essential part of the system. This is done with the help of Financial and Non-financial Measures. Financial Measures of performance are those discussed in the context of Revenue and Expense Centers, Profit Centers and Investment Centers. These include Budgets, Analysis of Variance, Transfer Pricing, Profit Computations, Return on Investment, Du Pont Analysis, EVA, MVA etc. Organizations also use a variety of ratios based on Financial Statements; these are evaluated in comparison with specified norms (e.g. 2:1 Norm used for Current Ratio).

Performance Measurement Non financial Measures

Responsibility centers also have non financial objectives such as Market Share and Talent Acquisition, which are equally important for attainment of goal congruence. Key Success Factors (KSF) and Key Performance Indicators (KPI) are often stated in measurable, yet non-financial terms (e.g. Restricting attrition rate to maximum 2.5% for a BPO firm). An example of KSFs for a tour and travel company follows. Evolving meaningful non-financial measures is an important feature of a Management Control System. Balanced Score Card is a widely accepted system to balance financial and non financial perspective on performance. Similar methodologies, such as Malcom Baldrige criteria are also used.

Key Success Factors (KSFs) for a tour and travel operator

Latest Information (about travel, stay and food) Adequate occupancy ratio Cash Flow Speedy redressal of customer complaints Trained Manpower The control system for the company will revolve around creating measures for each one of these and use them as tools of control.

Balanced Score Card

BSC was developed by Robert Kaplan and David Norton over 1990 to 1996. The technique has been adopted by several organizations not merely for performance measurement but as a strategic management system; it is thus used to (a) clarify vision and strategy
(b) Communicate and link strategic objectives and measures (c) Plan, Set Targets and align strategic initiatives (d) Enhance strategic feedback and learning

Four perspectives of Balanced Score Card are as follows.

1. 2. 3. 4. Financial Perspective Customer Perspective Internal Business Perspective Learning and Growth Perspective

Implementing BSC in practice

Balanced Score Card works by requiring an organization to spell out precise strategic initiatives in each of the four perspectives of the BSC. Further, measures for every strategic initiative are defined so that responsible managers have clarity about actions to be taken and about measurement of performance. Examples for the four aspects and two case studies on BSC implementation follow.

Financial Perspective
1. 2. 3. 4.

Return on Capital Cash Flow Profitability Consistency of performance

Customer Perspective
1. 2. 3. 4.

Value for Money Competitive Pricing Transparent, Hassle free relationship Professional after sales service

Internal Business Process Perspective

1. 2. 3. 4.

Quality service Safety, Loss Control Superior Project Management Just In Time Delivery

Innovation Perspective
1. 2. 3.

Continuous Improvement Product/ service Innovation Empowered WorkForce

Case 1: Customer Perspective

Offering great shopping experience is a strategic initiative adopted by a fashion retailer as a part of Customer Perspective. The store translated this into six actionable elements as follows.

1. Great looking store with fashion impact 2. Customer welcomed by attractive associates with a smile 3. Clear communication of special sales 4. Associates with good product knowledge 5. Personal name recognition by attending associate 6. Sincere thanks and an invitation to return soon Mystery Shopper audits would be used to evaluate performance of individual stores.

Case 2: Learning and Growth Perspective

Employee Satisfaction is an objective adopted by an organization as a part of Learning and Growth Perspective. This translated this into six actionable elements as follows. 1. Involvement with decisions 2. Recognition for doing a good job 3. Access to sufficient information to do the job well 4. Active encouragement to be creative and use initiative 5. Support from staff functions 6. Overall satisfaction with company Employees will be required to score their ratings on 1 to 5 scale. Executives have a drill-down capability to determine satisfaction by departments, location and supervisor.

MCS in Service Organizations

1. 2. 3. 4.

5. 6. 7. 8.

9.

Service Sector growing, has special features such as No inventorying, Production/Consumption simultaneous etc.) Pricing done differently e.g. Time Basis Transfer Pricing needed same rules Control Problems Inability to set standards, Team work imperative, Matrix Organization, Behavioral Characteristics of individuals differ Performance Appraisal difficult of people not at extremes Control on Managed Costs Important, same rules Budgeting necessary Activity Based Costing useful for Cost Control, Resource Allocation Risk Management Important for Fin. Services Companies

Controlling Discretionary Costs Principles and Best Practices

1. 2. 3. 4. 5.

6.

7. 8.

Competent Managers Healthy Atmosphere Policies, Procedures, Guidelines, Rules Periodic Review of the above Using Engineered Cost Method where possible Use of the budget to promote discipline, use it selectively as ceiling, floor, guide. Use of non financial measures Benchmarking

Banking Case of ICICI Bank 2011-12 (Rs Cr)

Interest Earned-Advances Interest Earned-Investments Other Income Interest Expended Operating Expenses Prov. For contingencies Net Profit

23858 9684 7503 41045 22809 7850 3921 34580 6465

(Other Income inclusive of Interest on Investments is 17187 Cr, while Profit is 6465 Cr. Without O.I., there is loss).

ICICI Bank Important Indicators

Interest Expended / Interest Earned Other Income/ Total Income Total Assets/ Libilities Total Investments Total Deposits Total Advances Investments / Total Assets Advances / Total Assets Advances / Deposits

68% 18% Rs 473647 Cr Rs 159560 Cr Rs 255500 Cr Rs 253728 Cr 34% 54% 99%

Insurance Business Case of Bajaj Allianz Insurance Co. Ltd 2011-12(Rs Cr.)
1. 2. 3. 4. 5. 6. 7. 8.

Net Earned Premium Net Incurred Claims Net Commissions Management Expenses Total Expenses (2+3+4) Underwriting results(1-5) Income from Investments Profit Before Tax

2474.7 1905.3 74.9 672.2 2652.4 -177.7 371.7 194.0

Insurance Segments of Bajaj Allianz

Fire Marine Auto (Comprehensive and Third Party) Health Credit Aviation Workmens compensation Personal Accident

KSFs for Banks, Insurance Companies

Risk Management (Avoid NPAs, Hedging w.r.t. foreign exchange/ stock market, Reinsurance) Effective use of Information Technology Volumes spread is leveraged with large scale, distribution of risk also with scale B2B Skills for bank, insurance managers Excellent systems for Internal Checks

KSFs for BPOs

Human Resource Management (Manpower Development, Training, Compensation, Motivation) Superior Technology Support (should include transaction logs) Effective Complaint Redressal (Mystery caller audits useful to ensure compliance)

Auditing

Auditing is defined as A systematic examination of the books and records of a business in order to ascertain or verify and to report upon the facts regarding financial operation and the result thereof. Auditing supports Control Systems by locating the errors of omission and commission, systems lacunae, deviations from procedures and acts of dishonesty. This results in improving reliability and accuracy of accounting records. More importantly it enforces higher degree of discipline and compliance with policies, procedures, guidelines and rules.

Principles of Auditing
1. Segregation of duties (interdependent tasks carried out by different rather than same individual). 2. Adequate physical supervision 3. Open line of information from bottom to the top 4. Defined levels of authority 5. Restricting access to organizations assets 6. Verification of records by an independent authority (external auditor) 7. Respecting independence of the external authority 8. Existence of a top level committee to oversee audit

Types of Audit
1. 2. 3. 4.

Financial Audit Cost Audit Internal Audit Management Audit

Financial Audit

Financial Audit is a historically oriented independent evaluation performed by an external auditor for the purpose of attesting the fairness, accuracy and reliability of financial data, providing protection for the entitys assets and evaluating the adequacy and accomplishments of systems designed to provide for the aforesaid fairness and protection. Financial data while not being the only source, is the primary evidential source. The evaluation is performed not on order but on a planned basis.

Objectives of Financial Audit

1. Assessing compliance with accounting procedure laid down by management. 2. Prevention of fraud, waste and detection of error. 3. Plugging loopholes in financial management policy or arising out of process of working. 4. Compliance with the Companies (Auditors Report) order, 2003. 5.Ascertaining compliance with statutory laws and rules relating to financial and accounting matters.

Internal Audit

Internal Audit is carried out using similar methodology as for external audit, with a much larger sample and with higher frequency. Internal Audit aims at covering areas of operation which are likely to be left out of external audit, because of a smaller sample. Internal Audit thus plays a role complementary to External Audit. External Audit works, by and large, at the level of Management Control. Internal Audit works at the level of Operational Control, ensuring that routine procedures are adhered to.

Objectives of Internal Audit

1. Assessing compliance with accounting procedure laid down by management. (Kitchen Order Tickets in restaurants is an example). 2. Assessing adequacy and reliability of management information and control systems 3. Appraisal, review and evaluation of the adequacy and timeliness of financial reporting. 4. Safeguarding assets, ensuring asset accounting and utilization 5. Appraising systems and procedures 6. Compliance with statutory laws and rules 7. Prevention and detection of fraud, misappropriation and embezzlement

Cost Audit

Cost Audit is an audit of efficiency; of expenditure while work is in progress and not as a post mortem examination. Propriety audit is an audit of executive actions and plans financial expenditure. Efficiency audit ensures that resources flow into the most remunerative channels. Pricing, Product Mix, Cost Control and Inventory Valuation are objectives of Cost Accounting. Cost Audit ensures that these are satisfied.

Objectives of Cost Audit

1.

2. 3.

4.

5.

Verification of cost accounts and to examine whether the the cost accounting plan has been adhered to. Examining adequacy of Budgetary Control System Examining prices in related party transactions and commenting on their deviation from normal prices Suggesting measures to achieve break-even point, where necessary and comment on defaults if any w.r.t. Government and Financial Institutions Commenting on scope and performance of Internal Audit.

Management Audit

Management Audit attempts to evaluate the performance of various management processes and functions. It is an audit to examine, review and appraise policies and actions of the management on the basis predetermined standards. It is an extension of the Management Control Process. With a view to achieving these objectives, Management Audit carries out a thorough examination of Panning and Control functions. It reviews Systems and Procedures in use. It also makes a detailed review of functional areas like Purchase, Manufacturing, Marketing, Logistics, Human Resource Management and Finance.

Objectives of Management Audit

1. To locate waste and deficiencies 2. To search for better and improved methods 3 To suggest better systems for control 4. To find out better and more efficient ways to execute plans 5. To help using human and physical facilities in a better manner

Illustration I - Internal Controls for operating Bank Account

Bank Accounts should be regularly reconciled Issue of cheques should be controlled, signing authority should be specified Documents supporting a Cheque should be specified and maintained, issue of duplicate cheques against same documents stopped As far as possible only crossed cheques be issued

Illustration II - Internal Controls on Accounting for Fixed Assets

Capital Expenditure should be authorized by specified persons only Plant and property registers should be maintained Fixed Assets should be physically verified at periodic intervals Sale, scrapping and write-off should be under proper authorization Depreciation rates should be properly authorized

Control System Design

Troston Company has 175 employees, paid on hourly rate, 40 Hours week. Overtime is paid at twice the rate. Employees swipe bar coded clock cards kept in a rack near the factory gate. How to ensure that only the authorized employees enter? that there are no proxies? that O.T. is authorized?
What is the crosscheck on overall number of employees every month? How to ensure that time spent in the factory is for legitimate tasks only?

Solution to Troston Case

In order to ensure that unauthorized persons do not enter, it is necessary that a supervisor who knows the employees is present near the gate. To ensure that employees do not swipe cards of friends, supervision is necessary. Introduction of biometric identification (thru thumb impression or iris scanning) will help in overcoming both these problems. However attention is still necessary to prevent entry of unauthorized individuals. Overtime should always be authorized by immediate superior and endorsed by Production Planning Dept. Before signing the payroll, the Chief Accountant should reconcile current months total employee strength = prev. months figure + Employees added during the month employees left during the month. The latter two should be reported by Personnel Dept. every month. There should be several time recording machines inside the factory to record start time and end time of jobs, which are to be punched by the workers. Total time spent on various jobs by a worker should match with total time spent computed as difference between in and out times.

UoP May 2011

A company has practice of fixing inter-departmental transfer price for its product on the basis of cost plus return on investment in the division. The budget for division A for the year is as follows. Annual Budgeted Output 6,00,000 Units Variable Cost Rs 10 per Unit Fixed Cost For Div. A Rs 10.20 lakhs Total Investment in the Division Rs 20 lakhs Expected Return on Investment 24% Calculate transfer price for Div A.

UoP 2011 Solution

Computation of Transfer Price
Amount Quantity, Units Per Unit, RS

Variable Cost, P.U. Fixed Cost Return On Investment 24% on Rs 20 lakhs Transfer Price 10,20,000 4,80,000 6,00,000 6,00,000

10.00 1.70 0.80 12.50

UoP December 2010

Division X of a large divisionalized manufacturing firm produces a part that is used as as input by Division Y to manufacture the finished product. The various per unit costs incurred by Division X are as follows. Direct Material Costs Rs 25 Other Costs incurred by Division X are: Direct Labour Cost Rs 6 Fixed Selling and Admin. Cost Rs 10,00,000 Variable Overhead Rs 4 Variable Selling Cost Per Unit Rs 2 Fixed Overheads* Rs 8 *At volume of 2,00,000 Units Rs 43 Currently DIV X is selling the part to an external customer at Rs 65 p.u. Div X has a capacity of 2 lakh units per year. However due to recession it expects to sell 1.50 lakh units. The variable selling expenses are available in case units are not transferred to Div Y. Div Y has been buying the same part from outside at Rs 60 p.u. Div Y expects to purchase 50,000 units in the coming year. Div Y offers to buy 50,000 units from Div X ar Rs 40 P.U. You are required: a) To determine the minimum transfer price that Div X would accept. b) To determine the maximum transfer price that Div Y would pay. c) Should Div X accept the proposal of Div Y? d) With Av. Investment of Div X, of Rs 100 lakhs, compute ROI assuming 50,000 units are tranferred to Div Y at Rs 48 each.

UoP December 2010 Solution

1. Minimum transfer price that Div X will accept is Rs 35 up to sale of 50,000 units since Rs 35 is its variable cost and it currently has idle capacity of 50,000 units. 2. Maximum transfer price that Y will pay is Rs 60 since this is the price at which it buys components from the market. 3. X should accept the proposal of Div Y of sale at Rs 40 p.u. since it is above its variable cost Rs 35 p.u.

UoP December 2010 Solution Continued.

Computation of ROI for Division X is as follows. Sale of 1,50,000 Units at Rs 65 Rs 97,50,000 Sale of 50,000 Units at Rs 48 Rs 24,00,000 Total Rs 111,50,000 (A) Less Variable Cost of 1.50 lakh units at Rs 37 Rs 55,50,000 Variable Cost of 50,000 units at Rs 35 Rs 17,50,000 Total Variable Cost Rs 72,50,000 (B) Contribution Rs 39,00,000 (C=A-B) Less Fixed Overhead 2 lakh units at Rs 8 p.u. Rs 16,00,000 Fixed Selling and Admn Costs Rs 10,00,000 Total Fixed Costs Rs 26,00,000 (D) Profit for Div X Rs 13,00,000 (C-D) ROI on Rs 100 lakhs 13%

UoP 2009
M/s Suparna fixes interdivisional transfer price of its product on the basis of cost plus an estimated return on Investments in its divisions. The relevant portion of the budget for Div X for the year 2009-10 is given below. Land and Building Rs 3,00,000 Plant and Machinery Rs 5,00,000 Stock Rs 2,00,000 Bills Receivable Rs 1,00,000 Debtors Rs 2,00,000 Annual Fixed Cost of the Divn. Rs 8,00,000 Variable Cost Per Unit Rs 10 Budgeted Volume of production per year (units) 5,00,000 Desired Return on Investment 27%. You are required to determine transfer price for the Division.

UoP 2009 Solution

Transfer Price for M/s Suparna for 2009-10 Amount Variable Cost, P.U. Fixed Cost Return On Investment 27% on Rs 13 lakhs (Total of all assets) Transfer Price 8,00,000 3,51,000 5,00,000 5,00,000 Quantity, Units Per Unit, RS 10.00 1.60 0.702

12.302

Thank you !