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Management Control Systems

Question-Answers

Of

Year 2001 Question Paper

Submitted by:

Taranjeet Bhardwaj 03

Shweta Kadam 22

Submitted to:

Prof. Ganachari

Q1 What is RI (EVA) analysis carried out? Explain advantages & disadvantages.

Ans: Residual income can be defined as the net income of the division, less the imputed
capital charge on the assets used by the division. The capital charge is the minimum acceptable
rate of return and is calculated by applying this required (or target) rate of return to the divisions
investment base.

Theoretically, the rate of return should be the divisions cost of capital; in most cases, however, it
is a cut off rate based on the firms objectives and strategies and will be somewhat lighter than
the divisional cost of capital. Economic Value Added (EVA) is a measure of financial
performance based on the concept that all capital has a cost and that earning more than the cost
of capital creates value for shareholders. It is after-tax net operating profit (NOPAT) minus a
capital charge. It is true economic profit consisting of all costs including the cost of capital. If a
companys return on capital exceeds its cost of capital it is creating true value for the
shareholder.

Steps for EVA analysis:

EVA = (r-c) x Capital

EVA = (r x Capital) (c x Capital)

EVA = (NOPAT- c x Capital

EVA = operating profits a capital charge

where: r = rate of return, and

c = cost of capital, or the weighted average cost of capital.

Example, Divisional Profit is Rs. 100,000, Investment Rs. 400,000 and further assuming capital
charge of 15%, the RI will be Rs.40, 000 calculated as follows:

RI = 100,000 (15% * 400,000)

= 100,000 60000

= Rs. 40,000

Residual income from the additional investment of Rs. 200,000 will be


RI = 40,000 (15% * 200,000)

= Rs. 10,000

Therefore, after making an additional investment, the total residual income of the division will be
Rs. 50,000, that is,

RI = 100,000 + 40,000 15% *(400,000 + 200,000)

= 140,000 90,000

= Rs. 50,000

Additional investment increases residual income, appropriately improving the measure of


performance.

RI has the following advantages:

1. It avoids suboptimal decisions as investments are not rejected merely because they lower
the divisional managers ROI
2. It maximizes the growth of the company and increases shareholders wealth by accepting
opportunities which earn a rate of return in excess of the cost of capital.
3. The cost of capital charge on divisional investments ensures that divisional managers are
aware of the opportunity cost of funds.
4. Charging each division with the companys cost of capital ensures that decisions taken by
different divisions are compatible with the interests of the organization as a whole.
5. Managements attention is focused more towards its primary responsibility, which is
increasing investors wealth and secondly, distortion caused by using historical cost
accounting data are reduced or eliminated so that managers can spend their time finding
ways to increase EVA. This increased awareness of the efficient use of capital will
eventually produce additional shareholder value.
6. Managers can do a better job of asset management and EVA can be used to hold
management accountable for all economic outlays whether they appear in the income
statement, on the balance sheet or in the footnotes to the financial statements. This is
possible because EVA creates one financial statement that includes all the costs of being
in business, while making managers aware of every dollar they spend.
7. Another benefit of using EVA is that it creates a common language for making decisions,
especially long-term decisions. Examples are: resolving budgeting issues and evaluating
the performance of organizational units and managers. EVA quantification of results in
financial terms also helps to energize other management programs such as TQM, quick
response and customer development by demanding and getting continuous financial
improvement. Mangers and employees adopt a long-term focus and begin to think more
like owners as they start to feel responsible for and take part in the economic value of the
firm.
8. One effective way to align employees interest with that of investors is to tie their
compensation to output from the EVA metric. People are paid for sustainable
improvements in EVA. The behavior within a company is changed through the
understanding of what drives EVA and economic returns.

The following are the disadvantages of RI:

1. Like ROI, it is difficult to have satisfactory definitions of Divisional Profit and


Divisional Investment.
2. It may be difficult to calculate an accurate cost of capital. Also, decision has to be taken
whether to use the companys cost of capital or a specific divisional cost of capital. The
former enhances divisional goal congruency and latter reflects each divisions level of
risk.
3. Identifying controllable and uncontrollable factors at the divisional level may be difficult.
4. centers are a store, a sales organization and a consulting organization whose profitability
can be measure
5. It is difficult to draw comparisons between enterprises and business units with different
sizes.
6. Some researchers also find little relationship between EVA and shareholder returns .
7. Although it is suggested that EVA is relatively simple to apply, it may become
cumbersome, especially in small enterprises, if it is taken into account that the total
number of adjustments may be in the region of 160.
8. A possible way to increase EVA is to increase the use of debt in the capital structure, but
this approach could be questioned, especially for enterprises operating in a high-risk
environment.

Q2. Explain concept of Balance Scorecard.

Ans: The Balanced Scorecard (BSC) is a performance management tool which began as a
concept for measuring whether the smaller-scale operational activities of a company are aligned
with its larger-scale objectives in terms of vision and strategy. By focusing not only on financial
outcomes but also on the operational, marketing and developmental inputs to these, the Balanced
Scorecard helps provide a more comprehensive view of a business, which in turn helps
organizations act in their best long-term interests.

Organizations were encouraged to measure, in addition to financial outputs, those factors which
influenced the financial outputs. For example, process performance, market share / penetration,
long term learning and skills development, and so on. The underlying rationale is that
organizations cannot directly influence financial outcomes, as these are "lag" measures, and that
the use of financial measures alone to inform the strategic control of the firm is unwise.
Organizations should instead also measure those areas where direct management intervention is
possible. In so doing, the early versions of the Balanced Scorecard helped organizations achieve
a degree of "balance" in selection of performance measures. In practice, early Scorecards
achieved this balance by encouraging managers to select measures from three additional
categories or perspectives: "Customer," "Internal Business Processes" and "Learning and
Growth."

Use-Implementing Balanced Scorecards typically includes four processes:

1. Translating the vision into operational goals;


2. Communicating the vision and link it to individual performance;
3. Business planning;index Setting

4. Feedback and learning, and adjusting the strategy accordingly.

The Balanced Scorecard is a framework, or what can be best characterized as a strategic


management system that claims to incorporate all quantitative and abstract measures of true
importance to the enterprise. According to Kaplan and Norton, The Balanced Scorecard
provides managers with the instrumentation they need to navigate to future competitive success.

Many books and articles referring to Balanced Scorecards confuse the design process elements
and the Balanced Scorecard itself. In particular, it is common for people to refer to a strategic
linkage model or strategy map as being a Balanced Scorecard. Although it helps focus
managers' attention on strategic issues and the management of the implementation of strategy, it
is important to remember that the Balanced Scorecard itself has no role in the formation of
strategy. In fact, Balanced Scorecards can comfortably co-exist with strategic planning systems
and other tools.

Q3 How balanced scorecard is implemented?

Ans. The grouping of performance measures in general categories (perspectives) is seen to aid in
the gathering and selection of the appropriate performance measures for the enterprise.

Process of Balance Score Card

The first part of the process is creating a model for the scorecard. First, review and clarify
strategies; this often requires some facilitated arguments and discussions, so that broad
disagreements can be dealt with. Many organizations do not adequately resolve their strategic
differences, so people work separately towards different visions. For example, one automaker's
strategies for selling cars were split by group: the CEO believed in forming alliances with exotic
makers, the sales executive leaned on rebates, and the product group, with limited budgets,
souped up existing economy cars. The result was an ineffectual, expensive hodgepodge. When
one leader with a clear vision worked with others to develop strategies, they were able to
transform the culture and organizational structure to produce vehicles that eventually saved the
company.

The next step is agreeing on what capabilities are needed within the company to actually pursue
the strategy. At the automaker, they needed to innovate without access to capital. They created a
new design process that included as many people as possible, from suppliers to factory workers
and mechanics, so that everyone shared the same strategic goals, and worked together to pursue
them. Lead time was cut in half, costs were slashed, and the products gained immediate critical
acclaim; sales went up as costs went down. As if to show that this was not simply an issue of
new technology, the same automaker changed their leadership style and methods, abandoning
their principles of involvement - and suffered higher costs and lower sales.

The Four perspectives of Balance Score Card

The scorecard measures an organizations performance from four key perspectives:

The grouping of performance measures in general categories (perspectives) is seen to aid in the
gathering and selection of the appropriate performance measures for the enterprise. Four general
perspectives have been proposed by the Balanced Scorecard:

1) Financial Perspective:

The financial perspective examines if the companys implementation and execution of its
strategy are contributing to the bottom-line improvement of the company. It represents the long-
term strategic objectives of the organization and thus it incorporates the tangible outcomes of the
strategy in traditional financial terms.

2) Customer Perspective

The customer perspective defines the value proposition that the organization will apply to satisfy
customers and thus generate more sales to the most desired customer groups. The measures that
are selected for the customer perspective should measure both the value that is delivered to the
customer which may involve time, quality, performance and service and cost and the outcomes
that come as a result of this value proposition. The value proposition can be centered on one of
the three: operational excellence, customer intimacy or product leadership, while maintaining
threshold levels at the other two.

3) Internal process perspective

The internal process perspective is concerned with the processes that create and deliver the
customer value proposition. It focuses on all the activities and key processes required in order for
the company to excel at providing the value expected by the customers both productively and
efficiently. These can include both short-term and long-term objectives as well as incorporating
innovative process development in order to stimulate improveme

4) Innovation and learning Perspective

The innovation and learning perspective is the foundation of any strategy and focuses on the
intangible assets of an organization, mainly on the internal skills and capabilities that are
required to support the value-creating internal processes. The Innovation & Learning Perspective
is concerned with the jobs (human capital), the systems (information capital), and the climate
(organization capital) of the enterprise. These three factors relate to what Kaplan and Norton
claim is the infrastructure that is needed in order to enable ambitious objectives in the other three
perspectives to be achieved.

Q4 What is profit centre?

When the manager is held responsible for both cost (inputs) and revenues (output) and thus, for
profit of a responsibility centre, it is called a Profit Centre. In a Profit Centre, both inputs and
outputs are measured in terms of money. The difference between revenues and costs represents
profit where the former exceeds the latter and loss when it is vice versa. The term revenue with
reference to responsibility accounting is used in a different sense altogether. According to
generally accepted principles of accounting, revenues are recognised only when sales are made
to external customers. For evaluating the performance of a profit centre, the revenue represents a
monetary measure of output emanating from a profit centre during a given period, irrespective of
whether the revenue is realised or not. The underlying principle is that a department has output
representing goods and services which are capable of monetary measurement.

The relevant profit to facilitate the evaluation of performance measurement of a profit centre is
the pre-tax profit of a responsibility centre. The profit of all the departments so calculated will
not necessarily be equivalent to the profit of the entire organisation. The variance will arise
because costs which are not attributable to any single department, are excluded from the
computation of the department's profits and the same are adjusted while determining the profits
of the whole organization. Hence, it is the divisional profit which is required for the purpose of
managerial control. As the profit provides more effective appraisal of the manager's performance,
the manager of the profit centre is highly motivated in his decision-making relating to inputs and
outputs so that profits can be maximized. In consonance with the above objective, by creating
more profit centres in an organisation, decentralisation of activities can be easily effected. The
profit centre approach cannot be uniformly applied to all responsibility centres. The following
are the criteria to be considered for making a responsibility centre into a profit centre. A profit
centre must maintain additional record keeping to measure inputs and outputs in monetary terms.

When a responsibility centre renders only services to other departments at the instance of the
management, e.g., internal audit.it cannot be made a profit centre. A profit centre will gain more
meaning and significance only when the divisional managers of responsibility centres have
empowered adequately in their decision making relating to quality and quantity of outputs and
also their relation to costs. If the output of a division is fairly homogeneous (e.g., cement), a
profit centre will not prove to be more beneficial than a cost centre. Again, due to intense
competition prevailing among different profit centres, there will be continuous friction among
the centres arresting the growth and expansion of the whole organisation. A profit centre will
generate too much of interest in the short-run profit to the detriment of long-term results.

Q5 Explain types of expense centre along with there sketches


Ans: Expense Centre:

A centre or a unit of an organisation for whom a standard amount of cost to be incurred is


predetermined and its performance its performance is evaluated by making a comparison
between standard and actual costs is known as an expense centre. Any difference between
standard and actual cost should be segregated further under two heads viz., controllable and un-
controllable for an objective evaluation of expense centre performance.

There are two types of expense centre


Engineered expense centre
Discretionary expense centre

Engineered expense centre

Engineered expense centre are those where inputs or cost can be measured in advance with
reasonable opportunity. They are usually formed in manufacturing operations where standard
cost is used i.e. warehouse, distribution, trucking, etc. Engineered expenses are those expenses
which are arrived at with reasonable reliability
E.g. Material cost, labor cost.

Engineered expense centre

Performance Measure for the RC is std.cost: -


Std Cost of doing actual activity = Std. cost of unit activity * Quantum of Actual activity
One can establish relationship between I & O , hence performance measurement is
relatively easy
Discretionary Expenses Center

It includes administration and support units like financial, accounting , legal, Public Relation,
HRD, R&D, advertising & Marketing. Discretionary expenses are those expenses which can not
be established with perfect accuracy ensuring that managers adhere to the budgeted level of
expenditures while successfully accomplishing the tasks of their center. They are those expenses
which incurred as per organization policies derived from strategic planning & its goal and
objectives.

-e.g. R&D, Advt. Dept, a Movie Project

Discretionary Expenses Center

Difficult to estimate Input (hence called MANAGED costs)


Output can not be measured in monetary terms.
Difficult to establish optimal relationship between I and O
Performance Measure for the RC is Budgeted Input and Actual Input.

Q6 Identify some Internal controls


Ans:
Internal controls
Internal control is a process-effected by a an entitys board of directors, management, and other
personnel-designed to provide reasonable assurance regarding the achievement of objectives in
the following categories:

Effectiveness & efficiency of operations


Reliability of financial reporting
Compliance with applicable laws & regulations

Internal controls can be detective, corrective, or preventive by nature.

1. Detective controls:
They are designed to detect errors or irregularities that may have occurred.
2. Corrective controls
They are designed to correct errors or irregularities that have been detected.
3. Preventive controls
They are designed to keep errors or irregularities from occurring in the first place.

Q7. Transfer pricing is an accounting tool, comment.

Transfer Pricing

When divisions transfer products or render services to each other, a transfer pricing is used to
charge for the products or services

Benefits of Transfer Pricing

1. Divisions can be evaluated as profit or investment centers.

2. Divisions are forced to control costs and operate competitively.

3. If divisions are permitted to buy component parts wherever they can find the best price
(either internally or externally), transfer pricing will allow a company to maximize its profits.

Concept :-
Transfer price is defined as the value placed on transfer of goods or services
among two or more profit centers.
For selling profit center, the transfer price is major determinant of its revenue and
hence its profits.
For buying profit center, the transfer price is major determinant of the expenses
incurred and hence its profit.
The price of inter divisional sales affects the selling divisional sales and buying
divisional cost.
Transfer price is fundamentally an attempt to simulate external market condition
within the organization.
Two divisions can be made completely independent of each other.
Objectives :
It should provide each segment with the relevant information required to
determine the optimum trade off between company cost and revenue.
It should induce goal congruent decisions. ( Decisions regarding division and
company )
It should help measure the economic performance of individual profit centers.
The system should be easy to administer.
Mechanism of Transfer Pricing :
Transfer price, means the value placed on a transfer of goods or services in
transaction.
The FUNDAMENTAL PRINCIPLE is that the transfer price should be similar to
the price that would be charged if the product were sold to out side customers or
purchased from out side supplier.
When profit center of an organization buy product from and sell to one other, two
decisions are to be carried out and reviewed periodically.
Sourcing Decision: Should the company produce the product inside the
company or purchase it from an out side vendor?
Transfer Price Decision: If produced inside, at what price should be the
product transferred to next centre?
It starts from simple to extremely complex depending upon the nature of business.
Hence transfer pricing is not actually an accounting tool but a behavioral tool to assist managers
in management control.

Q8. State the conditions under which transfer price mechanism is likely to induce Goal
Congruence.

The conditions under which transfer price mechanism is likely to induce Goal Congruence are
as follows:

Transfer price will induce goal congruence if all the conditions listed below exist.

Competent People: Managers interested in long run and short run performance
and staff involved in negotiation and arbitration of transfer price.
Good Atmosphere: They should perceive that it is a mechanism.
Market Price: It should base on well established market price, which reflects
same conditions like quantity, quality, delivery time, etc.
Freedom to Source: Buying manager should have freedom to buy from out side
and selling manager should have freedom to sell out side.
Full of Information: Managers must have all information about the alternatives
and cost.
Negotiation: Smooth mechanism for contract between business units.
The Constraints on Sourcing :
In actual all these conditions are not present the major short falls are:

Limited Market: Market for buying or selling is limited due to several reasons.
Existences of internal capacity limit the development of external sales.
If company is sole producer of a differentiated product no out side source
exists.
If company has developed significant facilities, it does not allow using out
side sources unless out side selling price approaches the companys
variable cost.
Excess or Shortage of Capacity :
If selling unit can not sell all it can produce is excess capacity. The profit
can not be optimizing if buying unit purchase from out side suppliers.
If buying unit can not obtain product it requires from out side while selling
unit is selling it out side is shortage of capacity. Out put of buying unit
constrained.

Q9. Internal Auditing means nothing but policing, comment.

Internal auditing is a profession and activity involved in helping organisations achieve their
stated objectives. It does this by utilizing a systematic methodology for analyzing business
processes, procedures and activities with the goal of highlighting organizational problems and
recommending solutions. Professionals called internal auditors are employed by organizations to
perform the internal auditing activity.

The scope of internal auditing within an organization is broad and may involve topics such as the
efficacy of operations, the reliability of financial reporting, deterring and investigating fraud,
safeguarding assets, and compliance with laws and regulations.

Internal auditing frequently involves measuring compliance with the entity's policies and
procedures. However, Internal auditors are not responsible for the execution of company
activities; they advise management and the Board of Directors (or similar oversight body)
regarding how to better execute their responsibilities. As a result of their broad scope of
involvement, internal auditors may have a variety of higher educational and professional
backgrounds.

Publicly-traded corporations typically have an internal auditing department, led by a Chief Audit
Executive ("CAE") who generally reports to the Audit Committee of the Board of Directors, with
administrative reporting to the Chief Executive Officer.

Role in internal control


Internal auditing activity is primarily directed at improving internal control. Internal control is
broadly defined as a process, effected by an entity's board of directors, management, and other
personnel, designed to provide reasonable assurance regarding the achievement of objectives in
the following internal control categories:

Effectiveness and efficiency of operations.


Reliability of financial reporting.

Compliance with laws and regulations.

Management is responsible for internal control. Managers establish policies and processes to
help the organization achieve specific objectives in each of these categories. Internal auditors
perform audits to evaluate whether the policies and processes are designed and operating
effectively and provide recommendations for improvement.

Hence we can say that internal auditing means nothing but policing.