Вы находитесь на странице: 1из 127

Q.1) Explain briefly features of an IDEAL management control system?

Management control is a process of assuming that resources are obtained and used
effectively and efficiently in the accomplishment of the organization’s objectives. It
is a fundamental necessity for the success of a business and hence from time to time
the current performance of the various operations is compared to a predetermined
standard or ideal performance and in case of variance remedial measures are
adopted to confirm operations to set plan or policy.

Some of the features of MANAGEMENT CONTROL SYSTEM are as follows:

 Total System: MANAGEMENT CONTROL SYSTEM is an overall process of


the enterprise which aims to fit together the separate plans for various segments
as to assure that each harmonizes with the others and that the aggregate effect of
all of them on the whole enterprise is satisfactory.

 Monetary Standard: MANAGEMENT CONTROL SYSTEM is built around a


financial structure and all the resources and outputs are expressed in terms of
money. The results of each responsibility centre in respect to production and
resources are expressed in terms of a common denominator of money.

 Definite pattern: It follows a definite pattern and time table. The whole
operational activity is regular and rhythmic. It is a continuous process even if the
plans are changed in the light of experience or technology.

 Coordinated System: It is a fully coordinated and integrated system.

 Emphasis: Management control requires emphasis both on the search for


planning as well as control. Both should go hand in hand to achieve the best
results.

 Function of every manager: Manager at every level as to focus towards future


operational and accounting data, taking into consideration past performance,
present trends and anticipated economic and technological changes. The nature,
scope and level of control will be governed by the level of manager exercising it.
 Existence of goals and plans: MANAGEMENT CONTROL SYSTEM is not
possible without predetermined goals and plans. These two provide a link
between such future anticipations and actual performance.

 Forward looking: MANAGEMENT CONTROL SYSTEM is on the basis of


evaluation of past performance that the future plans or guidelines can be laid
down. Management Control involves managing the overall activity of the
enterprise for the future. It prevents deviations in operational goals.

 Continuous process: It is a continuous process over the human and material


resources. It demands vigilance at every step. Deciding, planning and regulating
the activities of people associated in the common task of attaining the objectives
of the organization is a the primary aim of MANAGEMENT CONTROL
SYSTEM.

 People oriented: It is the managers, engineers and operators which implement


the ideas and objectives of the management. The coordination of the main
division of an organization helps in smoother operations and less friction which
results in the achievement of the predetermined objectives.

2
Scope of control

MANAGEMENT CONTROL SYSTEM is an important process in which


accounting information is used to accomplish the organizations objectives.
Therefore the scope of control is very wide which covers a very wide range of
management activities.

 Policies control: Success if a business depends on formulation of sound policies


and their proper implementation.

 Control over organization: It involves designing and organizing the various


departments for the smooth running of the business. It attempts to remove the
causes of such friction and rationalizes the organizational structure as and when
the need arises.

 Control over personnel: Anything that the business accomplishes is the result
of the action of those people who work in the organization. It is the people, and
not the figures, that get things done.

 Control over costs: The cost accountant is responsible to control cost sets, cost
standards, labour material and over heads. He makes comparisons of actual cost
data with standard cost. Cost control is a delicate task and is supplemented by
budgetary control systems.

 Control over techniques: It involves the use of best methods and techniques so
as to eliminate all wastages in time, energy and material. The task is
accomplished by periodic analysis and checking of activities of each department
with a view to avoid an eliminate all non-essential motions, functions and
methods.

 Control over capital Expenditure: Capital budget is prepared for the whole
concern. Every project is evaluated in terms if the advantage it accrues to the
firm. For this purpose capital budgeting, project analysis, study of cost of capital
etc are carried out.

 Overall control: A master plan is prepared for overall control and all the
departments of the concern are involved in this procedure.

3
Q.2 What is the concept of free cash flow as applied to organization. Explain
process of computation?

We define net cash flow as net income plus non cash adjustment which typically
means net income plus depreciation though that cash flows cannot be maintained
over time unless depreciated fixed assets are replaced. So management is not
completely free to use its cash flows however it chooses. Therefore we define the
term free cash flows.

Free cash flow is the cash flow actually available for distribution to investor after
the company has made all the investment in fixed assets and working capital
necessary to sustain ongoing operation. When we studied income statement in
accounting the emphasis was probably on the firm’s net income, which is
accounting profit. However the value of company’s operation is determined by the
stream of cash flows that the operations will generate now and in the future. To be
more specific, the value of operation depends on all the future expected free cash
flows, defined as after- tax operating profit minus the amount of new investment in
working capital and fixed assets necessary to sustain the business. Therefore the
way for managers to make their companies more valuable is to increase their free
cash flow.

Uses of FCF:
1. Pay interest to debt holders, keeping in mind that the net cost to the company is
the after tax interest expense.
2. Repay debt holders, that is, pay off some of debt.
3. Pay dividends to shareholders.
4. Repurchase stock from shareholders.
5. Buy marketable securities or other non operating assets.

In practice, most companies combine these five uses in such a way that the net total
is equal to FCF. For example, a company might pay interest and dividends, issue
new debts, also sell some of its marketable securities. Some of these activities are
cash outflows (paying interest and dividends) and some are cash inflows (issuing
debt and selling marketable securities), but the net cash flow from these five
activities is equal to free cash flows.

Computation of free cash flows:


Eg:

4
Suppose the company had a 2001 NOPAT of $170.3million and depreciation is only
the non cash charge which is $100million then its operating cash flow in 2001
would be NOPAT plus any non cash adjustment on the statement of cash flows.

Operating cash flow =NOPAT +depreciation (non cash adjustment)


= $17.03 + $100
= $270.3

Company has $1,455million operating assets, at the end of 2000, but $1,800 at the
end of 2001.it made a net investment in operating assets of

Net investment in operating assets = $18, 00 - $1,455 = $345million

If net fixed assets rose from $870million to $1000million however company


reported $100million of depreciation. So its gross investment in fixed assets
would be

Gross investment = net investment + depreciation


= $130 + $100 = $230million

Company free cash flows in 2001 was

FCF = operating cash flow – gross investment in operating assets


= $270.3 - $445
= - $174.7million

An algebraically equivalent equation is

FCF = NOPAT - Net investment in operating assets


= $170.3- $345
= - $174.7million

Even though company had a positive NOPAT, its very high investment in operating
assets resulted in a negative free cash flow. Because free cash flow is what is
available for distribution to investor, not only was there nothing for investors, but
investor actually had to provide additional money to keep the business ongoing. A
negative current FCF not necessarily bad provided it is due to the high growth or to
support the growth. There is nothing wrong with profitable growth; even it causes
negative free cash flow in the short term

Q.3) What is Balance Scorecard? What is the process of implementation and


explain the difficulties in implementation?

5
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—what


influenced such 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."

6
The balance scorecard suggests that we view the organization from four
perspectives, and to develop metrics, collect data and analyze it relative to each of
these perspectives:
• The learning and growth perspective : “To achieve our vision, how will we
sustain our ability to change and improve?”

• The business process perspective : “To satisfy our shareholders and


customers what business processes must we excel at?”

• The customer perspective : “To achieve our vision, how should we appear
to our customer?”

• The financial perspective : “To succeed financially, how should we appear


to our shareholders?”

Implementing a Balanced Scorecard

We can summarize the implementation of a balanced scorecard in four general


steps;
1. Define strategy.
2. Define measure of strategy.
3. Integrate measures into the management system.
4. Review measures and result frequently.

Each of these steps is iterative, requiring the participation of senior executive and
employees throughout the organization

 Define Strategy
The balance scorecard builds a link between strategy and operational action. As a
result it is necessary to begin the process of defining a balanced scorecard by
defining the organization goals are explicit and what that targets have been
developed.

 Define Measures of Strategy


The next step is to develop measures in support of the articulate strategy. It is
imperative that the organization focuses on a few critical measures at this point;
otherwise management will be overloaded with measures. Also, it is important that
the individual measures be linked with each other in a cause effect manner

 Integrated Measures into the management system

7
The balanced scorecard must be integrated with the organization formal and informal
structure, its culture, and its human resources practice. While the balanced Scorecard
gives some means for balancing measures, the measures can still become unbalanced
by others system in the organization such as compensation policies that compensate
the manager strictly based on financial performance.

 Review Measures and result Frequently


Once the balance scorecard is up and running it must be consistently reviewed by
senior management. The organization should be looking for the following

 How do the outcome measures say the organization is doing?


 How do the driver measures say the organization is doing?
 How has the organization’s strategy changed since the last review?
 How has the scorecard measures changed?

The most important aspects of these reviews are as follows;

 They tell management whether the strategy is being implemented


correctly and how successfully the strategy is working.
 They show that management is serious about the importance of these
measures.
 They maintain alignment of measure to ever changing strategies.

 Difficulties in implementing Balanced Scorecard

The following problems unless suitably dealt with, could limit the usefulness of the
balanced scorecard approach:
• Poor correlation between nonfinancial measures and result.
• Fixation on financial result. No mechanism for improvement.
• No mechanism for improvement.
• Measures overload.

 Poor Correlation between Nonfinancial measures and result


Simply put there is no guarantee that future profitably will allow targets achievement
in any nonfinancial area. This is probably the biggest problem with the balanced
scorecard because there is an inherent assumption that future profitability does
follow from achieving the scorecard measures, identifying the cause effect
relationships among the different measures is easier said than done.

8
This will be a problem with any system that is trying to develop proxy measures for
future performance. While this does not mean that the balanced Scorecard should be
abandoned it is imp that comp adopting such a system understand that the links
between nonfinancial measures and financial performance are still poorly
understood.

 Fixation on Financial Results


As previously discussed not only are most senior managers well trained and very
adept with financial measures but they also most keenly feel pressure regarding the
financial performance of their comp. Shareholder are vocal and the board of
directors often applies pressure on the stakeholders behalf .this pressure often
overwhelms the long term uncertain payback of the nonfinancial measures.

 Non mechanism for Improvement


One of the most overlooked pitfalls of the balanced scorecard is that a company
cannot achieve Stretch goals if the Company has no mechanism for improvement
.Unfortunately achieving many of these goals require complete shifts in the way that
business is done yet the company often does not have mechanism to make those
shifts . The mechanism available takes additional resource and requires a change in
the company culture. These changes do not happen overnight nor do they respond
automatically to a new stretch targets. Inertia often works against the company
employees are accustomed to a self limited cycle of setting targets, missing those
targets and readjusting the targets to reflect what was actually achieved. Without a
method for making improvement, improvements are unlikely to consistently happen
no matter how good the stretch goal sounds.

 Measurement overload
How many critical measures can one manager track at one time without losing?
Unfortunately there is no right answer to this question except it is more than 1 and
less than 50. It too few then the manager is ignoring measures that are critical to
creating success. If it too many then the manager may risk losing focus and trying to
do too many things at once.

Q.5ABC ltd. (MCS-2008) Numerical

Particulars Division X (Rs.) Division Y (Rs.)


ROI 28% 26%
Sales 100 Lacs 500 lacs
Investment 25 lacs 100 Lacs
EBIT 7 Lacs 26 lacs

9
Analyze and comment upon performances of both the divisions
Solution:

Division X
ROI = (Profit / investment)* 100
Profit = (28/100)*25lacs
= 7lacs

Profit margin = (Profit/sales)*100


= (7/100)*100
= 7lacs

Turnover of investments = (Sales/investment)*100


= (100/25)*100
= 4 times

Division Y
ROI = (Profit / investment)* 100
Profit = (26/100)*100lacs
= 26lacs

Profit margin = (Profit/sales)*100


= (26/500)*100
= 5.2lacs

Turnover of investments = (Sales/investment)*100


= (500/100)*100
= 5 times

Profit margin of X is better than profit margin of division Y. Turnover of


investment of division Y is better than Division X.

Hence cost management of Division X is better than Division Y.

SET. 2

Q1. MCS designers apparently disagree whether single measure to evaluate the
profit performance and capital investment performance is preferable or
SEPARATE measures for each are preferable – COMMENT ?

10
ANS. There should be different measures used for evaluating profit performance
and capital investment performance as needed.

The goal of performance measurement systems is to implement strategy. In setting


up such systems, senior management selects measures that best represent the
company's strategy. These measures can be seen as current and future critical
success factors; if they are improved, the company has implemented its strategy.
The strategy's success depends on its soundness. A performance measurement
system is simply a mechanism that improves the likelihood the organisation will
implement its strategy successfully.

 Measuring Profitability

There are two types of profitability measurements used in evaluating a profit center,
just as there are in evaluating an organization as a whole. First, there is a measure of
management performance, which focuses on how well the manager is doing. This
measure is used for planning, coordinating, and controlling the profit center's day-
to-day activities and as a device for providing the proper motivation for its manager.
Second, there is the measure of economic performance, which focuses on how well
the profit center is doing as an economic entity. The messages conveyed by these
two measures may be quite different from each other. For example, the management
performance report for a branch store may show that the store's manager is doing an
excellent job under the circumstances, while the economic performance report may
indicate that because of economic and competitive conditions in its area the store is
a losing proposition and should be closed.

The necessary information for both purposes usually cannot be obtained from a
single set of data. Because the management report is used frequently, while the
economic report is prepared only on those occasions when economic decisions must
be made, considerations relating to management performance measurement have
first priority in systems design-that is, the system should be designed to measure

11
management performance routinely, with economic information being derived from
these performance reports as well as from other sources.

 Capital Investment Measurement

Most proposals require significant new capital. Techniques for analyzing capital
investment proposals attempt to find either (a) The net present value of the project,
that is, the excess of the present value of the estimated cash inflows over the amount
of investment required, or

(b) The internal rate of return implicit in the relationship between inflows and
outflows. An important point is that these techniques are used in only about half the
situations in which, conceptually, they are applicable.

There are at least four reasons for not using present value techniques in
analyzing all proposals.

1) The proposal may be so obviously attractive that a calculation of its net


present value is unnecessary. A newly developed machine that reduces costs
so substantially that it will pay for itself in a year is an example.
2) The estimates involved in the proposal are so uncertain that making present
value calculations is believed to be not worth the effort-one can't draw a
reliable conclusion from unreliable data. This situation is common when the
results are heavily dependent on estimates of sales volume of new products
for which no good market data exist. In these situations, the "payback period"
criterion is used frequently.
3) The rationale for the proposal is something other than increased profitability.
The present value approach assumes that the "objective function" is to
increase profits, but many proposed investments win approval on the grounds
that they improve employee morale, the company's image, or safety.

4) There is no feasible alternative to adoption. Environmental laws may require


investment in a new program,as an example. The management control system
12
should provide an orderly way of deciding on proposals that cannot be
analyzed by quantitative techniques. Systems that attempt to rank non-
quantifiable projects in order of profitability won't work. Many projects do
not fit into a mechanical ranking scheme.

Q.No. 2. What are the different methods to measure profits of a profit center in

organizations? Which different messages each type of measure is likely to

convey to managers?

Ans: When financial performance in a responsibility center is measured in terms of


profit, which is the difference between the revenues and expenses, the responsibility
center is called a profit center. Profit as a measure of performance is especially
useful since it enables senior management to use one comprehensive measure
instead of several measures that often point to different directions.

There are two types of profitability measurements in a profit center, just as there are
for the organization as a whole. There is, first, a measure of management
performance, in which the focus is on how well the manager is doing. This
measure is used for planning, coordinating and controlling the day-to-day activities
of the profit center. Second, there is a measure of economic performance, in which
the focus is on how well the profit center is doing as an economic entity. The
message given by these two measures may be quite different.

 Types of Profitability measures:

In order to evaluate the economic performance of a profit center, one must use net
income after allocating all costs. However, in evaluating the performance of
manager, any of five different measures of profitability can be used.

1) Contribution Margin: The logic behind using contribution margin as a


measure is that fixed expenses are not controllable by the manager, and
therefore he should focus on maximizing the spread between revenue and
13
expenses. But the problem with this is that some fixed costs are controllable
and all fixed costs are partially controllable. A focus on the contribution
margin tends to direct attention away from this responsibility.

2) Direct Profit: This measure shows the amount that the profit center
contributes to the general overhead and profit of the corporation. It
incorporates all expenses incurred in or directly traced to the profit center,
regardless of whether these items are entirely controllable by the profit center
manager. A weakness of this measure is that it does not recognize the
motivational benefit of charging headquarters costs.

3) Controllable Profit: Headquarters expenses are divided into two categories:


controllable and non-controllable. The controllable expenses are controlled
by business unit manager. Consequently, if these costs are included in the
management system, the profit will be after the deduction of all expenses that
are influenced by profit center manager.
4) Income before Taxes: In this measure, all corporate overhead is allocated to
profit centers. The basis of allocation reflects the relative amount of expense
that is incurred for each profit center. If corporate overheads are allocated to
profit centers, budgeted costs, not actual costs, should be allocated. Then the
performance report will show an identical amount in the “budget” and
“actual” columns for such overheads.
5) Net Income: Here, companies measure performance of domestic profit
centers at the bottom line, the amount of net income after income tax. There
are two arguments 1) Income after tax is constant percentage of the pretax
income, so there is no advantage in incorporating income taxes 2) many
decisions that have impact on income taxes are made at headquarters, and it is
believed that profit center manager should not be judged by the consequences
of these decisions.
14
Q3: Explain special characteristics of professional organizations which impact

Management Control. What are interactive controls?

Special Characteristic of a Professional Organization:

1. Goals

A goal of a manufacturing company is to earn a satisfactory profit specially a


satisfaction profit, specially a satisfactory return on assets its principle assets is the
skill of its professional staff which doesn’t appear on its balance sheet .return on
assets employed therefore is essential meaningless in such organization .their
financial goal is to provide adequate compensation to the professional.

2. Professionals

Professional organization is labour intensive and the labour is of a special type.


Research and development organization use in setting selling price and for other
management purposes .standard cost system ,separation of fixed and variable cost
and analyses of variance were built on the foundation are example of organization
whose product are professional service. Professional tends to give in adequate weight
to the financial implication of their decision they want to do the best job they can
regardless of its cost.

Because profession are the organization most important resource some authors have
advocated that the value of these profession should be counted as assets the system
that does this is called human resource accounting .in the 1970’s many books and
articles were written on this subject but few comp actually such a system and we do
not know of any that one current .the problem of measuring the value of human
assets is intractable.

3. Output and input measurement

The output of a profession organisation cannot be measured in physical terms, use in


setting selling price and for other management purposes .standard cost system,

15
seperstion of fixed and variable cost and analyses of variance were built on the
foundation. We can measures the number of patient a physician treats n a day and
even classify these visit by type of complaint but this is by no means equivalent to
measuring the amt or quality earned is one measures of output in some professional
organization but these monetary amts at most relate to the quantity of service
rendered not to their quality.

Some profession notably scientist engineer, and professional are reluctant to keep
track of how they spend their time and this complicate the track of measuring
performance .this reluctant seems to have its root in tradition usually it can be
overcome if senior management is willing to put appropriate emphasis on the
necessity for accurate time reporting .nevertheless difficult problem arise in deciding
how time should be charged to clients .if the normal work week is 40 hrs should a
job be charged for 1/40th of a week compensation for each other spent on it? If so
how should work done on evening and weekend be counted how to account for time
spent reading literature ,going to meeting ,and otherwise keeping up to date?

4. Small Size

With a few exception such as some law firm and accounting firms ,professional
organisations are relatively small and operate at a single location .senior
management in such organisations can personally observe what is going on and
personally motivate employee .thus there is less need for a sophisticated
management control system ,with profit centres and formal performance reports
nevertheless even a small organisations need a budget a regular comparison of
performance against budget ,and a way relating compensation to performance.

5. Marketing

In a manufacturing company there is a dividing line between marketing activities and


production activities only senior management is concerned with both .such a clean
separation does not exist in most Professional organisation, however their time and
this complicate the track of measuring performance .this reluctant seems to have its
root in tradition usually it can be overcome if senior management is willing to put
16
appropriate emphasis on the necessity for accurate time reporting. Nevertheless
difficult problem arise in deciding how time should be charged to clients .if the
normal work. These marketing activities are conducted by professional usually by
professional, usually by professional who spend much of their time in production
work that is working for clients.

In such situation it is difficult to assign appropriate credit to the person responsible


for selling a new customer; in a consulting firm for example a new engagement may
result from a conversation between a member of the firm or from the reputation of
one of the firm professional as an outgrowth of speeches or articles. Moreover the
profession al who is responsible for obtaining the engagement may not personally
involved in carrying it out .until fairly recently these marketing contribution were
rewarded subjectively –that is they were taken into account in promotion and
compensation decisions .some organisation now give explicit credit, perhaps as a
percentage of the project revenue, if the person revenue, if the person who hold sold
the project can be identified.

 What is Interactive Control?

Interactive control alerts management of strategic uncertainties either trouble or


opportunities that become the basis for manager to adapt to a rapidly changing
environments by thinking about new strategies.

1. A subset of the management control information that has a bearing on the


strategic uncertainties facing the buss becomes the focal point.

2. Senior executive take such information seriously.

3. Managers at all levels of the org focus attention on the information


produced by the system.

Q5: Shandilya Ltd. (MCS-2008) Numerical

17
Shandilya Ltd. has adopted Economic Value Added (EVA) technique for the
appraisal of performance of its three divisions A,B and C. Company charges 6% for
current assets and 8 % for Fixed Assets, while computing EVA relevant data are
given below :-

Particulars Div A Div B Div C Total


Budgeted Actual Budgeted Actual Budgeted Actual Budgeted Act
Profit 360 320 220 240 200 200 780 760
Current 400 360 800 760 1200 1400 2400 252
Assets
Fixed Assets 1600 1600 1600 1800 2000 2200 5200 560

Solution:
Particulars Div A Div B Div C Total
Budgeted Actual Budgeted Actual Budgeted Actual Budgeted Act
ROA 18% 16% 9% 9% 6% 6% 10% 9%
EVA 208 170.4 44 50.4 -32 -60 220 160

b) Comment upon both methods, based on results.

There are three apparent benefits of an ROA measure. First, it is a comprehensive


measure in that anything that effects the financial statements is reflected in this
ratio. Secondly, ROA is easy to calculate, easy to understand, and meaningful in
absolute sense. Finally, it is a common denominator that may be applied to any
organizational units responsible for profitability, no matter what its size or what
business it practices. The performance of different units may be compared directly
to each other. Also, ROI data is available for competitors that can be used as a basis
for comparison. Nevertheless, the EVA approach has some inherent advantages
over ROA.

18
There are three compelling reasons to use EVA over ROI. First, with EVA all
business units have the same profit objective for comparable investments. The ROI
approach, on the other hand, provides different incentives for investment across
business units. For example, a business unit that is currently achieving 30% ROA
would be most reluctant to expand unless it is able to earn a ROI of 30% or more on
additional assets. Second, decision that increase a centre’s ROI may decrease its
overall profits. Third advantage of EVA is that different interest rates may be used
for different types of assets. For example, a relatively low rate May be used for
inventories while a higher rate may be used for different types of fixed assets.

SET .3

MANAGEMENT CONTROL SYSTEM

 Q.1) Describe differences in budgeting perspective of engineered and


discretionary expense centre

1.Expense centers:
Expenses center are responsibility centers for which input or expenses are
measured in monetary terms, but for which outputs are not measured in
monetary terms. There are two general types: engineered expense center and
discretionary expense center. They correspond to two types of costs..
Engineered costs are elements of cost for which the right or proper amount of
costs that should be incurred can be estimated with a reasonable degree of
reliability. Costs incurred in factory for direct labour direct material
component supplies and utilities are examples.

2.Engineered expense centers:


Engineered expense center have the following characteristics:
1. Their inputs can be measured in monetary terms.
2. Their output can be measured in physical terms.
3. The optimal dollar amount of input required to produce one unit of
output can be established

19
Engineered expense center usually are found in manufacturing operations.
Warehousing, distribution, trucking and similar units in the marketing
organization also may be engineered expense center and so many certain
responsibility center within administrative and support department. Examples
are accounts receivable account payable and payroll section in the controller
department personnel record and cafeteria in the human resource department
shareholder record in the corporate secretary department and the company
motor pool. Such units perform repetitive task for which standard cost can be
developed

In an engineered expense center the output multiplied by the standard cost or


each unit produced represents what the finished product should have cost.
When this cost is compared to actual costs, the difference between the two
represents the efficiency of the organization unit being measured.

We emphasize that engineered expense centers have other important tasks not
measured by cast alone. The effectiveness of these aspects of performance
should be controlled. For example expenses center supervisor are responsible
for the quality of good and for the volume of production in addition to their
responsibility for cost efficiency. Therefore the type and amount of production
is prescribed and specific quality standards are set so that manufacturing costs
are not minimized at the expense of quality. Moreover manager of engineered
expense center may be responsible for activities such a training that are not
related to current production judgment about their performance should include
an appraisal of how well they carry out these responsibilities.

There are few if any responsibility center in which all cost items are
engineered. Even in highly automated production department the amount of
indirect labour and of various services used can vary with management
discretion.

Thus, the term engineered costs center refers to responsibility center in which
engineered cost predominate but it does not imply that valid engineering
estimates can be made for each and every cost item.

3.Discretionary expense center:

20
The output of discretionary expenses center cannot be measured in monetary
terms. They include administration and support units research and
development organization and most marketing activities.

The term discretionary does not mean that management judgments are
capricious or haphazard. Management has decided on certain policies that
should govern the operation of the company. One company may have a small
headquarter staff another company of similar size and in the same industry
may have a staff that is 10 time as large the management of both companies
may be concerned that they made the correct decision on staff size but there is
no objective way judging which decision was actually better manager are hired
and paid to make such decision after such a drastic change the level of
discretionary expenses generally has a similar pattern from one year to the
next.

The difference between budgeted and actual expense is not a measure of


efficiency in a discretionary expense centre it is simply the difference between
the budgeted input and the actual input. It in no way measures the value of the
output, if actual expense do not exceed the budget amount, the manager has
‘lived within the budget ‘ however ,because by definition the budget does not
purport to measure the optimum amount of spending we cannot say that living
within the budget is efficient performance .

4. Differences in budgeting perspective of engineered and discretionary


expense centre

 Budget preparation
The decision that management make about a discretionary expense budget are
different from the decisions that it makes about the budget for an engineered
expense center. For the latter, management decides whether the proposed
operating budget represent the cost of performing task efficiently for the
coming period. Management is not so much concerned with the magnitude of
the task because this is largely determined by the actions of other
responsibility centers, such as the marketing departments’ ability to generate
sales. In formulating the budget for a discretionary expense center, however
management principal task is to decide on the magnitude of the job that should
be done.

21
 Incremental budgeting:
Here the current level expenses in a discretionary expense center is taken as a
starting points this amount is adjusted for inflation for anticipated changes in
the workload of continuing tasks for special tasks and if the data are readily
available for the cost of comparable work in similar units.
There are two drawbacks to incremental budgeting. First because managers of
these centers typically want to provide more service they tend to request
additional resources in the budgeting process and if they make a sufficiently
strong case these request will be granted. This tendency is expressed in
Parkinson’s second law: overhead costs tend to increase period. There is
ample evidence that not all this upward creep in cost is necessary.

This problem is especially compounded by the fact that the current level of
expenditure in the discretionary expenses center is taken for granted and is not
re-examined during the budget preparation process. Second when a company
faces a crises or when a new management takes over overhead costs are
sometimes drastically reduced without any adverse consequences.

Despite this limitation most budgeting in discretionary expense centers is


incremental. Time does not permit the more thorough analysis described in the
next section.

22
 Zero based review:
An alternative approach is to make a thorough analysis of each discretionary
expense center on a schedule that will cover all of them over a period of five
year or so. That analysis provides a new base. There is a likelihood that
expenses will creep up gradually over the next five years and this is tolerated
at the end of five years, another new base is established. Such an analysis is
often called a zero base review.

In contrast with incremental budgeting which takes the current level of


spending as the starting point this more intensive review attempts to build up
de now the resources that actually are needed by the activity. Basic question
are raised;(1) should use customer?(2) what should the quality level be ?are
we doing too much(3)should the function be performed in this way (4) how
much should it cost?

 Cost variability:
In discretionary expense center costs tend to vary with volume from one year
to the next but they tend not to vary with short run fluctuation in volume
within a given year. By contrast costs in engineering expense center are
expected to vary with short run changes in volume. In part this reflect the fact
that volume changes do have an impact throughout the company even though
their actual impact cannot be measures the ; in part this reflect the fact that
volume changes do have an impact throughout the company even though their
actual impact cannot be measured in part this result from a management
personnel and personnel related costs are by far the largest expense item in
most discretionary expense center the annual budget for these center tend to be
a constant percentage of budgeted sales volume.

 Q.2) Explain some factors which may influence top management style
and the implication of the top management style on management
control.

The management control function in an organization is influenced by the style


of senior management. The style of the chief executive officer affects the
management control process in the entire organization. Similarly, the style of
the business unit manager affects the unit's management control process, and

23
the style of functional department managers affects the management control
process in their functional areas.

 Differences in Management Styles


Managers manage differently. Some rely heavily on reports and certain formal
documents; others prefer conversations and informal contacts. Some are
analytical; others use trial and error. Some are risk takers; others are risk
averse. Some are process oriented; others are results oriented. Some are long-
term oriented; others are short-term oriented. Some emphasize monetary
rewards; others emphasize a broader set of rewards.

Management style is influenced by the manager's background and personality.


Background includes things like age, formal education, and experience in a
given function, such as manufacturing, technology, marketing, or finance.
Personality characteristics include such variables as the manager's willingness
to take risks and his or her tolerance for ambiguity.

 Implications for Management Control


The various dimensions of management style significantly influence the
operation of the control systems. Even if the same reports with the same set of
data go with the same frequency to the CEO, two CEOs with different styles
would use these reports very differently to manage the business units.

Style affects the management control process – how the CEO prefers to use
the information, conducts performance review meetings, and so on – which in
turn affects how the control system actually operates, even if the formal
structure does not change under a new CEO. In fact, when CEOs change,
subordinates typically infer what the new CEO really wants based on how he
or she interacts during the management control process.

24
 Personal versus Impersonal Controls
Presence of personal versus impersonal controls in organizations is an aspect
of managerial style. Managers differ on how much importance they attach to
formal budgets and reports as well as informal conversations and other
personal contacts. Some managers are "numbers oriented"; they want a large
flow of quantitative information, and they spend much time analyzing this
information and deriving tentative conclusions from it. Other managers are
"people oriented"; they look at a few numbers, but they usually arrive at their
conclusions by talking with people, judging the relevance and importance of
what they learn partly on their appraisal of the other person. They visit various
locations and spend time talking with both supervisors and staff to get a sense
of how well things are going.

Managers' attitudes toward formal reports affect the amount of detail they
want, the frequency of these reports, and even their preference for graphs
rather than tables of numbers, and whether they want numerical reports
supplemented with written comments. Designers of management control
systems need to identify these preferences and accommodate them.

 Tight versus Loose Controls


A manager's style affects the degree of tight versus loose control in any
situation. The manager of a routine production responsibility center can be
controlled relatively tightly or loosely, and the actual control reflects the style
of the manager's superior. Thus, the degree of tightness or looseness often is
not revealed by the content of the forms or aspects of the formal control
documents, rules, or procedures. It is a factor of how these formal devices are
used. The degree of looseness tends to increase at successively higher levels in
the organization hierarchy: higher-level managers typically tend to pay less
attention to details and more to overall results.

The style of the CEO has a profound impact on management control. If a new
senior manager with a different style takes over, the system tends to change
correspondingly. It might happen that the manager's style is not a good fit with
the organization's management control requirements. If the manager
recognizes this incongruity and adapts his or her style accordingly, the
problem disappears. If, however, the manager is unwilling or unable to

25
change, the organization will experience performance problems. The solution
in this case might be to change the manager.

Q.3) Explain advantages and disadvantages of two step transfer pricing


and profit sharing methods

 Transfer pricing: If two or more profit center is jointly


responsible for product development manufacturing and marketing
each should share in the revenue that is generated when the
product is finally sold. The transfer price is not primarily an
accounting tool; rather, it is a behavioral tool that motivates
manager to make the right decisions. In particular the transfer
price should be designed so that it accomplishes the following
objective: It should provide each segment with the relevant
information required to determine the optimum tradeoff between
company cost and revenues It should induce goal congruent
decisions that is the system should be so designed that decision
improve business unit to earn more profit It should help measure
the economic performance of the individual profit center

 Two step pricing: First, a charge is made for


each unit sold that is equal to the standard variable cost of
production. Second a periodic charge is made for the buying unit.
One or both of these components should include a profit margin.
The two step pricing method correct this problem by transferring
variable cost on a per unit basis, and transferring fixed cost and
profit on a lump sum basis under this method the transfer price for
product A would be 5$ for each unit that unit Y purchases plus
$20000 per month for fixed cost. Plus $10000 per month for
profit: if transfer of product A in a certain month are at the
expected amount 5000 units then under the two step method unit y
will pay the variable cost of $25000 plus $30000 for the fixed cost
and profit a total of $55000 .this is the same amount as the amount
it would pay unit x if the transfer price is less than 5000 units say
4000unoits.unit y would pay $50000 under the two step methods

26
compared with the $44000 it would pay if the transfer price were
$11 per unit. The difference is their transfer prices were for not
using a portion of unit X capacity that it has reserved. Note that
under two step method the company variable cost for product A is
identifiable to unit Y variable cost for the product, and unit Y will
make the correct short term marketing decisions. Unit Y also has
information on upstream fixed costs and profit related to product
A and it can use these data for long term decision. The fixed cost
calculation in the two step pricing method is based on the capacity
that is reserved for the production of product A that is sold to unit
Y the investment represented by this capacity is allocated to
product A. The return on investment that unit X earns on
competitive product is calculated and multiplied by the investment
assigned to the product. In the example we calculated the profit
allowance as a fixed monthly amount. It would be appropriate
under some circumstance to divide the investment into variable
and fixed component. Then, a profit allowance based on a return
on investment on variable assets would be added to the standard
variable cost for each unit sold.

27
 Profit sharing: If the two step pricing system just described is not
feasible, a profit sharing system might be used to ensure congruence of
business unit interest with company interest. This system operates
somewhat as follows.

1. The product is transferred to the marketing unit at standard variable cost.


2. After the product is sold, the business units share the contribution earned
which is selling price minus the variable manufacturing and marketing
costs.

This method of pricing may be appropriate if the demand for the manufactured
product is not steady enough to warrant the permanent assignment of facilities
as in the two step method. In general, this method accomplished the purpose of
making the marketing unit’s interest congruent with the companies. There are
several practical problems in implementing such profit sharing system. First,
there can be arguments over the way contribution is divided between the two
profit centers. Which is costly, time consuming and work against basic reason
for decentralization namely autonomy of the business units mangers. Second,
arbitrarily divided up the profit between units does not give valid information
on the profitability of each segment of the organization.

Third since the contribution is not allocated until after the sale has been made
the manufacturing units contribution depends upon the marketing unit’s ability
to sell and on the actual selling price. Manufacturing units may perceive this
situation to be unfair

 Two set of price: in this method, the manufacturing unit’s revenue is


credited at the outside sales price, and the buying unit is charged the
total standard costs. The difference is changed to a headquarter account
and eliminated when the business unit statement are consolidated, this
transfer pricing method is sometimes used when there are frequent
conflict between the buying and selling units that cannot be resolved by
one of the other method both the buying and selling

 There are several disadvantages to the system of having two set of


transaction prices, however the sum of the business unit profit is

28
greater than overall company profits, senior management must be aware
of this situation in approved budget for the business units and in
subsequent evaluation of performance against these budget. Also, this
system create an illusion feeling that business units are making money
while in fact the overall company might be losing after taking account of
the debits to headquarter. Further this system might motivate business
unit to concentrate more on internal transfers at the expense of outside
sales

 The fact that the conflict between the business units would be
lessened under this system could be viewed as a weakness. Sometime,
it is better for the headquarter to be aware of the conflict arising out of
transfer prices because such conflict may signal problem in either the
organizational structure or In other management systems. Under the two
sets of prices method these conflicts are smoothed over thereby not
alerting senior management to these problems.

Q.4) Discuss special challenges faced in controlling R & D activities and


possible management initiatives

 Type of financial control: The financial control exercised in a


discretionary expense center is quite different from that in engineered
center the latter attempts to minimize operating cost by setting a
standard and reporting actual costs against this standards. The main
purpose of a discretionary expense budget on the other hand is to allow
the manager to control Cost for particular in the planning. Costs are
controlled primarily by deciding what task should be undertaken and
what level of effort is appropriate for each. Thus in a discretionary
expense center financial control is primary exercised at the planning
stage before the amount are incurred.

 Measurement of performance: The primary job of the manager of a


discretionary expense center is to accomplish the desired output
spending an amount that is on budget is satisfactory. This is in contrast
with the report in an engineered expense center which helps higher
management to evaluate the manger efficiency. If these two types of

29
responsibility center are carefully distinguished management may treat
the performance report for the discretionary expense center as if it were
an indication of efficiency Control over spending can be exercised by
requiring that the manger approval be obtain before the budget is over
sometimes a certain percentage of overrun is permitted without
additional approval if the budget really set forth the best estimate of
actual cost there is 50 percent probability that it will overrun and this is
the reason that some latitude is often permitted.

 Control problems: The control of R & D centers, which are also


discretionary expense center is difficult for the following at least a semi
tangible output reasons.

1. Results are difficult to measure quantitatively. As contrasted with


administrative activities, R&D usually has at least a semi tangible output in
patent, new products, or new processes. Nevertheless, the relationship of
these outputs to inputs is difficult to measure and appraise. A complete
product of an R&D group may require several year of effort; consequently
input as stated in an annual budget may be unrelated to outputs. Even if an
output can be identified a reliable estimate of its value often cannot be
made. Even if the value of the output can be calculated, it is usually not
possible for management to evaluate the efficiency of the R&D effort
because of its technical nature. A brilliant effort may come up against an
insuperable obstacle, whereas a mediocre effort may, by luck result in a
bonanza.

2. The goal congruence problem in R&D center is similar to that in


administrative centers. The research managers typically want to build the
best research organization that money can buy, even though this is more
expensive than the company can afford. A further problem is that research
people often may not have sufficient knowledge of the business to
determine the optimum direction of the research efforts.

30
3. Research and development can seldom be controlled effectively on an
annual basis. A research project may take year s to reach fruition, and the
organization must be built up slowly over a long time period. The principal
cost is for the work force obtaining highly skilled scientific talented is
often difficult, and short term fluctuation in the work force are in efficient.
It is not reasonable, therefore to reduce R&D costs in years when profits
are low and increase them in year when profits are high. R&D should be
looked at as a long term investment not as an activity that varies with short
run corporate profitability.

 The R&D continuum: Activities conducted by R&D organization lie


along a continuum. At one extreme is basic research; the other extreme
is product testing. Basic research has two characteristics: first, it is
unplanned management at most can specify the general area that is to
be explored second there is often a very long time lag before basic
research result in successful new product introductions. Financial
control system has little value in managing basic research activities. In
some companies, basic research in included as a lump sum in the
research program and budget. In others, no specific allowance is made
for basic research as such; there is an understanding that scientists and
engineers can devote part of their time to explorations in whatever
direction they find most interesting, subject only to informal
agreement with their supervisor. For product testing projects, on the
other hand, the time and financial requirement can be estimated, not as
accurately as production activities.

Q.5) Explain problems faced in pricing corporate services provided to


business units organized as Profit Centers
Services are intangible in nature. This characteristic of services makes it
difficult for pricing. Charging business units for services furnished by
corporate staff units becomes challenging work due to intangibility of
services. While pricing corporate services, we exclude the cost of central
service staff units over which business units have no control (e.g., central
accounting, public relations, and administration). If these costs are charged at
all, they are allocated, and the allocations do not include a profit component.
The allocations are not transfer prices.

31
 We need to consider two types of transfers:

O For central services that the receiving unit must accept but can at
least partially control the amount used.
O For central services that the business unit can decide whether or
not to use.

Business units may be required to use company staffs for services such as
information technology and research and development. In these situations, the
business unit manager cannot control the efficiency with which these activities
are performed but can control the amount of the service received. There are
three schools of thought about such services.

One school holds that a business unit should pay the standard variable cost of
the discretionary services. If it pays less than this, it will be motivated to use
more of the service than is economically justified. On the other hand, if
business unit managers are required to pay more than the variable cost, they
might not elect to use certain services that senior management believes
worthwhile from the company's viewpoint. This possibility is most likely
when senior management introduces a new service, such as a new project
analysis program. The low price is analogous to the introductory price that
companies sometimes use for new products.

A second school of thought advocates a price equal to the standard variable


cost plus a fair share of the standard fixed costs-that is, the full cost.
Proponents argue that if the business units do not believe the services are
worth at least this amount, something is wrong with either the quality or the
efficiency of the service unit. Full cost represents the company's long run
costs, and this is the amount that should be paid.

A third school advocates a price that is equivalent to the market price, or to


standard full cost plus a profit margin. The market price would be used if
available (e.g., costs charged by a computer service bureau); if not, the price
would be full cost plus a return on investment. The rationale for this position
is that the capital employed by service units should earn a return just as the
capital employed by manufacturing units does. Also, the business units would
incur the investment if they provided their own service.

32
 Optional Use of Services
In some cases, management may decide that business units can choose whether
to use central service units. Business units may procure the service from
outside, develop their own capability, or choose not to use the service at all.
This type of arrangement is most often found for such activities as information
technology, internal consulting groups, and maintenance work. These service
centers are independent; they must stand on their own feet. If the internal
services are not competitive with outside providers, the scope of their activity
will be contracted or their services may be outsourced completely.

For example, Commodore Business Machines outsourced one of its central


service activities-customer service-to Federal Express. James Reeder,
Commodore's vice president of customer satisfaction, said, "At that time we
didn't have the greatest reputation for customer service and satisfaction. But
this was FedEx's specialty, handling more than 300,000 calls for service each
day. Commodore arranged for FedEx to handle the entire telephone customer
service operation from FedEx's hub in Memphis.

After losing $29 million online the previous year, Borders Group turned to
rival Amazon.com to manage its online sales. Borders get to maintain an
Internet sales channel and gains the operational effectiveness provided by
Amazon.com while being able to focus on the growth of its bricks and mortar
business.

In this situation, business unit managers control both the amount and the
efficiency of the central services. Under these conditions, these central groups
are profit centers. Their transfer prices should be based on the same
considerations as those governing other transfer prices.

(Numerical) MCS – 2004

Division B of Shayana company contracted to buy from Div. A, 20,000


units of a component for the final product made by Div. B. The transfer
price for this internal transaction was set at Rs. 120 per unit by mutual
agreement. This comprises of (per unit) Direct and Variable labour cost of

33
Rs. 20; Material Cost of Rs.60; Fixed overheads of Rs.20 (lumpsum Rs.4
lacs) and Rs.20 lacs that Div. A would require for this additional activity.
During the year, actual off take of Div. B was 19,600 units. Div. A was
able to reduce material consumption by 5% but its budgeted investment
overshot by 10%.
a) As Financial controller of Div. A, compare Actual Vs Budgeted
Performance
b) Its implications for Management Control?

Solution:
a)
Particulars Budgeted Budgeted Actual Actual
(Rs. PerFor 20,000
(Total in (Rs. Per For(Total
19,600in
Units Units
Direct and Unit)
20 Rs.)
4,00,000 Unit)
20 Rs.)
3,92,000
Variable Labour
Cost
Material Cost 60 12,00,000 57 11,17,200
Fixed Overheads 20 4,00,000 4,00,000
Total Cost 100 20,00,000 19,09,200
Transfer Price 120 24,00,000 119.86 23,49,200
Profit 20 4,00,000 4,40,000
Investment 20 20,00,000 22,00,000
ROI = 20% 20%
Profit/Investment

Despite of increase in investment by 10%, there is negligible difference in


transfer price. Also the sales have decreased by 400 units. Therefore we can
say that additional investment has not achieved any positive results.

SET-4

Q.1) A)Explain the concept of ROI. What are its advantages?

Return on investment (ROI) is the ratio of profit before tax to the gross investment.

ROI is calculated with the help of the following formula:

34
ROI = (Pre-Tax Profit/Sales) X (Sales/Net Assets) or (Pre-Tax Profits/Net Assets)

The numerator is profit before tax as reported in the P&L account. The profit should
include only the profits arising out of the normal activities of the division. Unusual
items of receipts and expenses should be excluded from the profit figure. One
should also ignore windfalls and income from investments not related to the
operations of the division. Tax is excluded from the numerator because the marginal
of the SBU is not responsible for or in control of the tax paid.

Capital employed can be ascertained from the balance sheet by including fixed and
current assets. Assets not currently put to divisional use should be excluded from
the investment base. One also needs to exclude their relative earnings if any. The
company should also exclude intangible assets like goodwill, deferred revenue
expenses, preliminary expenses, etc.

ROI can be improved by:

o Increasing the profit margin on sales.

o Increasing the capital turnover

o Increasing both profit margin and capital turnover.

o Reducing cost as that adds to the total earnings of the firm.

o Increasing the profits by expanding present operations or developing new


product line, increasing market share, etc.

o Diversifying, introducing productivity improvement measures, expansion,


replacement of old equipments

Advantages of ROI

o ROI relates return to the level of investment and not sales as the rate of return
is more realistic.

o ROI can be decomposed into other variables as shown. These variables have
tremendous analytical value.

o ROI is an effective tool for inter-firm comparison.

Question 1 (b):

35
Many experts regard EVA as a concept superior to ROI and yet in certain cases,
EVA does not do justice to the evaluation of investment center. Explain this
phenomenon with as illustration.

EVA does not solve all the problems of measuring profitability in an investment
center. In particular, it does not solve the problem of accounting for fixed assets
discussed above unless annuity depreciation is also used, and this is rarely done in
practice. If gross book value is used, a business unit can increase its EVA by taking
actions contrary to the interests of the company, as shown in Exhibit 7-3. If net
book value is used, EVA will increase simply due to the passage of time.
Furthermore, EVA will be temporarily depressed by new investments because of the
high net book value in the early years. EVA does solve the problem created by
differing profit potentials. All business units, regardless of profitability, will be
motivated to increase investments if the rate of return from a potential investment
exceeds the required rate prescribed by the measurement system.

Moreover, some assets may be undervalued when they are capitalized, and others
when they are expensed. Although the purchase cost of fixed assets is ordinarily
capitalized, a substantial amount of investment in start-up costs, new product
development, dealer organization, and so forth may be written off as expenses, and,
therefore, not appear in the investment base. This situation applies especially in
marketing units. In these units the investment amount may be limited to inventories,
receivables, and office furniture and equipment. When a group of units with varying
degrees of marketing responsibility are ranked, the unit with the relatively larger
marketing operations will tend to have the highest EVA.

In view of all these problems, some companies have decided to exclude fixed assets
from the investment base. These companies make an interest charge for controllable
assets only, and they control fixed assets by separate devices. Controllable assets
are, essentially, receivables and inventory. Business unit management can make
day-to-day decisions that affect the level of these assets. If these decisions are
wrong, serious consequences can occur-quickly. For example, if inventories are too
high, unnecessary capital is tied up, and the risk of obsolescence is increased;
whereas, if inventories are too low, production interruptions or lost customer
business can result from the stockouts. To focus attention on these important
controllable items, some companies, such as Quaker Oats, 17 include a capital
charge for the items as an element of cost in the business unit income statement.
This acts both to motivate business unit management properly and also to measure
the real cost of resources committed to these items.

36
Investments in fixed assets are controlled by the capital budgeting process before
the fact and by post completion audits to determine whether the anticipated cash
flows, in fact, materialized. This is far from being completely satisfactory because
actual savings or revenues from a fixed asset acquisition may not be identifiable.
For example, if a new machine produces a variety of products, the cost accounting
system usually will not identify the savings attributable to each product.

The argument for evaluating profits and capital investments separately is that this
often is consistent with what senior management wants the business unit manager to
accomplish; namely, to obtain the maximum long-run cash flow from the capital
investments the business unit manager controls and to add capital investments only
when they will provide a net return in excess of the company's cost of funding that
investment. Investment decisions, then, are controlled at the point where these
decisions are made. Consequently, the capital investment analysis procedure is of
primary importance in investment control. Once the investment has been made, it is
largely a sunk cost and should not influence future decisions. Nevertheless,
management wants to know when capital investment decisions have been made
incorrectly, not only because some action may be appropriate with respect to the
person responsible for the mistakes but also because safeguards to prevent a
recurrence may be appropriate.

Q.2 What are the different methods to evaluate the performance of an investment
centre? Discuss the merits and demerits of each? Which method would you
recommend?

The following techniques are useful in evaluating the performance of an investment


centre:

1. Return on investment (ROI):

The rate of return on investment is determined by dividing net profit or income by


the capital employed or investment made to achieve that profit.

ROI = Profit / Invested capital * 100

ROI consists of two components viz.

Profit margin

Investment turnover

ROI = Net profit / Investment

= (Net profit / Sales) * (Sales / Investment in assets)


37
It will be seen from the above formula that ROI can be improved by increasing one
or both of its components viz. the profit margin and the investment turnover in any
of the following ways:

Increasing the profit margin

Increasing the investment turnover

Increasing both profit margin and investment turnover

Capital employed is taken to be the total of shareholders funds, loans etc

The profit figure used is in calculating ROI is usually taken from the profit and loss
account, profit arising out of the normal activities of the company should only be
taken.

Capital employed for the company as a whole can be arrived at as follows:

Share capital of the company xxx

Reserves and surplus xxx

Loans (secured/unsecured) xxx

------

xxx

Less: a. Investment outside the business xxx

b. Preliminary expenses xxx

c. Debit balance of P & L A/c xxx xxx

-------

xxxx

Merits:

Return on investment analysis provides a strong incentive for optimum utilization of


the assets of the company. This encourages managers to obtain assets that will
provide a satisfactory return on investment and to dispose off assets that are not
providing an acceptable return. In selecting amongst alternative long-term

38
investment proposals, ROI provides a suitable measure for assessment of
profitability of each proposal.

Demerits:

ROI analysis is not very suitable for short-term projects and performances. In the
initial stages a new investment may yield a small ROI which may mislead the
management. Most likely the rate would improve in course of time when the initial
difficulties are overcome.

The book value of assets decline due to depreciation, the investment base will
continuously decrease in value, causing the rate of return to increase.

2. Residual income:

Residual income can be defined as the operating profit (or income) of the company
less the imputed interest on the assets used by the company. In other words, interest
on the capital invested in the company is treated as a cost and any surplus is the
residual income. Residual income is profit minus notional interest charge on capital
employed.

Residual income is affected by the size of the organization and therefore will not
provide a basis for evaluation of organizational performance. This is probably the
main reason why the management continues to make use of ROI which is relative
measure.

Not all projects start off with positive or sufficiently large positive profits in the
early years of a project to produce a positive increment to residual income.

It has been argued that a more suitable measure of performance for investment
centres, which could encourage managers to be more willing to undertake
marginally profitable projects, is residual income.

We recommend RI as a method of evaluating performance of an investment centre.


Because when RI is adopted for evaluation purposes, emphasis is placed on
marginal profit amount above the cost of capital rather than on the rate itself.

Q.3 What are the objectives of Transfer Pricing?

Transfer price if designed appropriately has the following objectives:

It should provide each segment with the relevant information required to determine
the optimum trade-off between company costs and revenues.It should induce goal
congruent decisions-i.e. the system should be so designed that decisions that

39
improve business unit profits will also improve company profits. It should help
measure the economic performance of the individual profit centers. The system
should be simple to understand and easy to administer.

 What is ideal transfer price in the situations of Limited Market Shortage of


Capacity in the industry

The ideal transfer price in the situations of Limited Market

By limited market it means that the markets for buying and selling profit centers
may be limited.

Even in case of limited market the transfer price that is ideal or satisfies the
requirement of a profit center system is the competitive price. In case if a company
is not buying or selling its product in an outside market there are some ways to find
the competitive price. They are as follows:

If published market prices are available, they can be used to establish transfer
prices. However, these should be prices actually paid in the market-place and the
conditions that exist in the outside market should be consistent with those existing
within the company.

For example, market prices that are applicable to relatively small purchases are not
valid in this case.

Market prices are set by bids. This generally can be done only if the low bidder has
a reasonable chance of obtaining the business. One company accomplishes this by
buying about one-half of a particular group of products outside the company and
one-half inside the company. The company then puts all of the products out to bid,
but selects one-half to stay inside. The company obtains valid bids, because low
bidders can expect to get some of the business. By contrast, if a company requests
bids solely to obtain a competitive price and does not award the contracts to the low
bidder, it will soon find that either no one bids or that the bids are of questionable
value.

If the production profit center sells similar products in outside markets, it is often
possible to replicate a competitive price on the basis of the outside price. If the
buying profit center purchases similar products from the outside market, it may be
possible to replicate competitive prices for its proprietary products. This can be
done by calculating the cost of the difference in design and other conditions of sale
between the competitive products and the proprietary products.

Shortage of Capacity in the industry


40
In this case, the output of the buying profit center is constrained and again company
profits may not be optimum. Some companies allow either buying profit center to
appeal a sourcing decision to a central person or committee. In this scenario a
buying profit center could appeal a selling profit center’s decision to sell outside.

The person/group would then make a sourcing decision on the basis of the
company’s best interests. In every case the transfer price would be the competitive
price. In other words, the profit center is appealing only the sourcing decision.

Even if there are constraints on sourcing, the market price is the best transfer price.
If the market price can be approximated, it is ideal transfer price.

 When do you use Cost Based Transfer Pricing?

We use cost-based transfer pricing if there is no way of approximating valid


competitive price. Transfer prices may be set up on the basis of cost plus a profit,
even though such transfer prices may be complex to calculate and the results less
satisfactory than a market-based price.

Two aspects need to be considered for cost-based transfer pricing:

The cost basis: The usual basis is the standard cost. Actual costs should not be used
because production inefficiencies will then be passed on to the buying profit center.
If the standard costs are used, there is a need to provide an incentive to set tight
standards and to improve standards.

The profit markup: In calculating the profit markup, there also are two decisions:

 What is the profit markup to be based?

The simplest and most widely used base is percentage of costs. If this base is used,
however, no account is taken of capital required. A conceptually better base is a
percentage of investment. But there may be a major practical problem in calculating
the investment applicable to a given product. If the historical cost of the fixed assets
is used, new facilities designed to reduce prices could actually increase costs
because old assets are undervalued

 What is the level of profit allowed?

The second problem with the profit allowance is the amount of the profit. The
conceptual solution is to base the profit allowance on the investment required to
meet the volume needed by the buying profit centers. The investment would be

41
calculated at a “standard” level, with fixed assets and inventories at current
replacement costs. This solution is complicated and, therefore, rarely used in
practice.

Q.4 (a) “Transfer Pricing is not an accounting tool” comment with an illustration

If a group has subsidiaries that operate in different countries with different tax rates,
manipulating the transfer prices between the subsidiaries can scale down the overall
tax bill of the group. For example the tax rate in Country A is 20% and is 50% in
Country B. In the larger interest of the group, it would be advisable to show lower
profits in Country B and higher profits in Country A. For this, the group can adjust
the transfer price in such a way that the profits in Country A increase and that in
Country B get reduced. For this the group should fix a very high transfer price if the
Division in Country A provides goods to the Division in Country B. This will
maximize the profits in Country A and minimize the profits in Country B. The
reverse will be true if the Division in Country A acquires goods from the Division
in Country B.

There is also a temptation to set up marketing subsidiaries in countries with low tax
rates and transfer products to them at a relatively low transfer price.

Transfer price is viewed as a major international tax issue. While companies indulge
in all types of activities to lower their tax liability, the tax authorities monitor
transfer prices closely in an attempt to collect the full amount of tax due. For this
they enter into agreements whereby tax is paid on specific transactions in one
country only. But if companies set unrealistic transfer price to minimize their tax
liabilities and the same is spotted by the tax authority, then the company is forced to
pay tax in both countries leading to double taxation.

There have been instances where companies have fixed unrealistic transfer prices.
The first case relates to Hoffman La Roche that imported two drugs Librium and
Valium into UK at prices of 437 pounds and 979 pounds per kilo respectively.
While the tax authorities in UK accepted the price, the Monopolies Commission did
not accept the company's argument, since the same drugs were available from an
Italian firm for 9 pounds and 28 pounds per kilo.

The company's lawyers argued the case before the Commission on two grounds viz.

1. The price was not set on cost but on what the market would bear and

2. The company had incurred an R&D cost that was included in the price.

42
These arguments did not go well with the Commission and the company was fined
1.85 million pounds for the manipulative practices adopted while fixing the transfer
price.

The second case is of Nissan. The company had falsely inflated freight charges by
40-60% to reduce the profits. The manipulation helped the company to hide tax to
the tune of 237 million dollars. The next year Nissan was made to pay 106 million
dollars in unpaid tax in the USA because the authorities felt that part of their US
marketing profits were being transferred to Japan, as transfer prices on import of
cars and trucks were too high. Interestingly the Japanese tax authorities took a
different view and returned the double tax.

With a view to avoid such cases from recurring, Organisation for Economic
Cooperation and Development issued some guidelines in 1995. These guidelines
aim at encouraging world trade. They evolved what came to be known as the arm's
length price. The principle states that the transfer price would be arrived at on the
basis as if the two . companies are independent and unrelated. The price is
determined through:

Comparable Price Method where the price is fixed on the basis of prices of similar
products or an approximation to one.Gross Margin Method where a gross margin is
established and applied to the seller's manufacturing cost.

In spite of all these efforts, it has to be admitted that setting a fair transfer price is
not easy. So the onus of proving the price has been put on the taxpayer who is
required to produce supporting documents. If the taxpayer fails to do this he is
required to pay heavy penalty. For example, in USA, failure to provide
documentary evidence results in a 40% penalty on the arm's length price. In UK the
penalty is to the tune of 100% of any tax adjustment. Other countries are also in the
process of evolving tight norms for the same. Countries across the globe also allow
the taxpayer to enter into an Advance Pricing Agreement whereby dispute can be
avoided and so also the costly penalty of double taxation and penalty.

Q.4.( b) Market Price is ideal transfer price even in limited markets. Comments

By limited market it means that the markets for buying and selling profit centers
may be limited.

Even in case of limited market the transfer price that is ideal or satisfies the
requirement of a profit center system is the competitive price. In case if a company
is not buying or selling its product in an outside market there are some ways to find
the competitive price. They are as follows:

43
1. If published market prices are available, they can be used to establish transfer
prices. However, these should be prices actually paid in the market-place and the
conditions that exist in the outside market should be consistent with those existing
within the company. For example, market prices that are applicable to relatively
small purchases are not valid in this case.

2.Market prices are set by bids. This generally can be done only if the low bidder
has a reasonable chance of obtaining the business. One company accomplishes this
by buying about one-half of a particular group of products outside the company and
one-half inside the company.

The company then puts all of the products out to bid, but selects one-half to stay
inside. The company obtains valid bids, because low bidders can expect to get some
of the business. By contrast, if a company requests bids solely to obtain a
competitive price and does not award the contracts to the low bidder, it will soon
find that either no one bids or that the bids are of questionable value.

3.If the production profit center sells similar products in outside markets, it is often
possible to replicate a competitive price on the basis of the outside price.

4.If the buying profit center purchases similar products from the outside market, it
may be possible to replicate competitive prices for its proprietary products. This can
be done by calculating the cost of the difference in design and other conditions of
sale between the competitive products and the proprietary products.So we see from
the above arguments that market price is ideal transfer price even in limited markets

SET .5

Q.1) Describe and illustrate significance of human behavior patterns in

management control system.

Ans. Management control systems influence human behavior. Good management


control systems influence behavior in a goal congruent manner; that is, they ensure
that individual actions taken to achieve personal goals also help to achieve the
organization's goals. The concept of goal congruence, describing how it is affected
both by informal actions and by formal systems.
Senior management wants the organization to attain the organization's goals. But the
individual members of the organization have their own personal goals, and they are

44
not necessarily consistent with those of the organization. The central purpose of a
management control system, then, is to ensure a high level of what is called "goal
congruence." In a goal congruent process, the actions people are led to take in
accordance with their perceived self interest are also in the best interest of the
organization.
The significance of human behavior patterns in management control system can be

explained with the help of Informal Factors that influence Goal Congruence. In

the informal forces both internal and external factors play a key role.

External Factors

External factors are norms of desirable behavior that exist in the society of which
the organization is a part. These norms include a set of attitudes, often collectively
referred to as the work ethic, which is manifested in employees' loyalty to the
organization, their diligence, their spirit, and their pride in doing a good job (rather
than just putting in time). Some of these attitudes are local that is, specific to the
city or region in which the organization does its work. In encouraging companies to
locate in their city or state, chambers of commerce and other promotional
organizations often claim that their locality has a loyal, diligent workforce. Other
attitudes and norms are industry-specific. Still others are national; some countries,
such as Japan and Singapore, have a reputation for excellent work ethics.

Internal Factors
 Culture
The most important internal factor is the organization's own culture-the common
beliefs, shared values, norms of behavior and assumptions that are implicitly and
explicitly manifested throughout the organization. Cultural norms are extremely
important since they explain why two organizations with identical formal
management control systems, may vary in terms of actual control. A company's
45
culture usually exists unchanged for many years. Certain practices become rituals,
carried on almost automatically because "this is the way things are done here."
Others are taboo ("we just don't do that here"), although no one may remember why.
Organizational culture is also influenced strongly by the personality and policies of
the CEO, and by those of lower-level managers with respect to the areas they
control. If the organization is unionized, the rules and norms accepted by the union
also have a major influence on the organization's culture. Attempts to change
practices almost always meet with resistance, and the larger and more mature the
organization, the greater the resistance is.
 Management Style
The internal factor that probably has the strongest impact on management control is
management style. Usually, subordinates' attitudes reflect what they perceive their
superiors' attitudes to be, and their superiors' attitudes ultimately stem from the
CEO.
Managers come in all shapes and sizes. Some are charismatic and outgoing; others
are less ebullient. Some spend much time looking and talking to people
(management by walking around); others rely more heavily on written reports.

46
The Informal Organization
The lines on an organization chart depict the formal relationships-that is, the official
authority and responsibilities-of each manager. The chart may show, for example,
that the production manager of Division A reports to the general manager of
Division A. But in the course of fulfilling his or her responsibilities, the production
manager of Division A actually communicates with many other people in the
organization, as well as with other managers, support units, the headquarters staff,
and people who are simply friends and acquaintances. In extreme situations, the
production manager, with all these other communication sources available, may not
pay adequate attention to messages received from the general manager; this is
especially likely to occur when the production manager is evaluated on production
efficiency rather than on overall performance. The realities of the management
control process cannot be understood without recognizing the importance of the
relationships that constitute the informal organization.

 Perception and Communication


In working toward the goals of the organization, operating managers must know
what these goals are and what actions they are supposed to take in order to achieve
them. They receive this information through various channels, both formal (e.g.,
budgets and other official documents) and informal (e.g., conversations). Despite
this range of channels, it is not always clear what senior management wants done.
An organization is a complicated entity, and the actions that should be taken by
anyone part to further the common goals cannot be stated with absolute clarity even
in the best of circumstances.
Moreover, the messages received from different sources may conflict with one
another, or be subject to differing interpretations. For example, the budget
mechanism may convey the impression that managers are supposed to aim for the
highest profits possible in a given year, whereas senior management does not
actually want them to skimp on maintenance or employee training since such
actions, although increasing current profits, might reduce future profitability. The

47
informal factors discussed above have a major influence on the effectiveness of an
organization’s management control. The other major influence is the formal
systems. These systems can be classified into two types: (1) the management
control system itself and (2) rules, which are described in this section.
The Formal Control System
Rules

We use the word rules as shorthand for all types of formal instructions and controls,
including: standing instructions, job descriptions, standard operating procedures,
manuals, and ethical guidelines. Rules range from the most trivial (e.g., paper clips
will be issued only on the basis of a signed requisition) to the most important):e.g.,
capital expenditures of over $5 million must be approved by the board' of directors).
Some rules are guides; that is, organization members are permitted, and indeed
expected, to depart from them, either under specified circumstances or when their
own best judgment indicates that a departure would be in the best interests of the
organization.
Some rules are positive requirements that certain actions be taken (e.g., fire drills at
prescribed intervals). Others are prohibitions against unethical, illegal, or other
undesirable actions. Finally, there are rules that should never be broken under any
circumstances: a rule prohibiting the payment of bribes, for example, or a rule that
airline pilots must never take off without permission from the air traffic controller.
Some specific types of rules are listed below:

 Physical Controls
Security guards, locked storerooms, vaults, computer passwords, television
surveillance, and other physical controls may be part of the control structure.

 Manuals
Much judgment is involved in deciding which rules should be written into a
manual, which should be considered to be guidelines rather than fiats, how much
48
discretion should be allowed, and a host of other considerations. Manuals in
bureaucratic organizations are more detailed than are those in other
organizations; large organizations have more manuals and rules than small ones;
centralized organizations have more than decentralized ones; and organizations
with geographically dispersed units performing similar functions (such as fast-
food restaurant chains) have more than do single-site organizations
 System Safeguards
Various safeguards are built into the information processing system to ensure
that the information flowing through the system is accurate, and to prevent (or at
least minimize) fraud of every sort. These include: cross-checking totals with
details, requiring signatures and other evidence that a transaction has been
authorized, separating duties, counting cash and other portable assets frequently,
and a number of other procedures described in texts on auditing.

 Task Control Systems


Task control is the process of assuring that specific tasks are carried out
efficiently and effectively. Many of these tasks are controlled by rules. If a task
is automated, the automated system itself provides the control.

Q.2) Write short notes on

a. Concept of profit centre in non-profit organization

b. Management control in matrix structures

c. Implications of differentiated strategies on controls.

Ans. a) Concept of profit centre in NPO


By law NPO are allowed to make profit but are restrained from distributing it to
owners and management This way they are non profit making organizations (from
the owner's point of view). Such organizations include religious, charitable and

49
educational trusts. Prime goal of management control systems in such organization
is enhancing the service spread first and if possible then cost control rather and than
operating efficiency. On the financial front, they enjoy many concessions from the
government such as taxes, subsidies, grants etc so also they attract special control
from these assisting institutes.
Characteristics:

1. Absent of profit performance measure leads to problems in assessing the


efficiency of the organization. If the organization shows large net income it may
be because that NPO may not be providing the services to the extent possible/
expected. If the organization shows net losses it may show the NPO facing risk of
bankruptcy. Hence non availability of clear-cut performance yardstick makes the
problem of control worst.

2. NPO's have contributed capital Plant: NPOs do not have shareholder as its
stakeholder. The capital contribution to the business comes by way of contributions
to assets such as building and equipments. Second kind of contribution could be in
the form of monetary assistance, which entitles the organization to reap the interest
on it keeping the principal amount intact.

3. Operating Assets represents the resources used for running day to day
activities. And the contributed assets are not allowed to mix up with the operating
assets.
4. Fund accounting: NPO need to keep two types of financial statements one set
for contributed capital and another for operating capital. The nature of the
contributed capital is beyond control of the management and therefore management
concentrates on controlling the operating assets/investments.

5. Governance: Usually NPO are managed by trusts, who exercise less control on
operational matters. Hence performance control is less demanding from owners'
point of view and difficult from the point of view of management.

50
These characteristics pose difficulty in pricing of the product/services - what could
be appropriate price? Usually it is set at total/full cost. The more stress expected on
allocation of scare resources. Though not stricter control, but a sense of control can
be built among the managers by way of using budgets for various activities and
expenses. Non profit basis makes performance evaluation quite impossible. But one
can make the things easier by concentrating on adherence to costs budgets, and
enhancing the service base.

b) Management control in matrix structures


Matrix organizational structure assigns multiple responsibilities to the functional
heads. Evaluation of performance of such organizational entities is very difficult.
Though they offer economies of using scarce functional staff, it poses problems of
casting the individual responsibility. This form of organization is very complex,
from the point of view of management control system.

At the end we must not forget that the management control system is for the
organization and not the organization exists for management control system. One
has to mold and remold the management control system to suit the given
organization structure
A citation by Anthony is worth noting in this regard.

Usually in an advertisement agency, account supervisors are shifted from one


account to another on periodic basis, this practice allows the agency to look at the
account from the perspectives of different executives. However taking in to
consideration the time lag of result realization in such services is quite large. And
this may pose problem of performance assessment of a particular executive. This
does not mean a control system designer should insist on abandoning the rotation
system of the executives.
Matrix structure offers advantages such as faster decision making process,
efficiency and effectiveness but simultaneously it may pose problems such as added
complexity in control function, assignment of responsibility and authority etc.

51
c) Implications of differentiated strategies on controls
Different corporate strategies imply the following differences in the context in
which control systems need to be designed: As firms become more diversified,
corporate-level managers may not have significant knowledge of, or experience in,
the activities of the company's various business units. If so, corporate-level
managers for highly diversified firms cannot expect to control the different
businesses on the basis of intimate knowledge of their activities, and performance
evaluation tends to be carried out at arm's length. Single-industry and related
diversified firms possess corporatewide core competencies (on which the strategies
of most of the business units are based. Communication channels and transfer of
competencies across business units, therefore, are critical in such firms. In contrast,
there are low levels of interdependence among the business units of unrelated
diversified firms. This implies that as firms become more diversified, it may be
desirable to change the balance in control systems from an emphasis on fostering
cooperation to an emphasis on encouraging entrepreneurial spirit.

 Strategic planning: given the low level of interdependencies, conglomerates


tend to use vertical strategic planning systems-that is, business units prepare
strategic plans & submit to senior management to review & approve. The
horizontal dimension might be incorporated into the strategic planning process in
a number of different ways. First, a group executive might be given the
responsibility to develop a strategic plan for the group as a whole that explicitly
identifies synergies across individual business units within the group. Second,
strategic plans of individual business units could have an interdependence
section, in which the general manager of the business unit identifies the focal
linkages with other business units and how those linkages will be exploited.
Third, the corporate office could require joint strategic plans for interdependent
business units. Finally, strategic plans of individual business units could be
circulated to managers of similar business units to critique and review. These
methods are not mutually exclusive. In fact, several of them could be pursued
52
fruit. fully at the same time.
 Budgeting: The chief executives of single-industry firms may be able to control
the operations of subordinates through informal and personally oriented
mechanisms, such as frequent personal interactions. This lessens the need to rely
as heavily on the budgeting system as the tool of control. On the other hand, in a
conglomerate it is nearly impossible for the chief executive to rely on informal
interpersonal interactions as a control tool; much of the communication and con-
trol has to be achieved through the formal budgeting stem. This implies the
following budgeting system characteristics in a conglomerate. Business unit
managers have somewhat greater influence in developing their budgets since
they, not the corporate office, possess most of the information about their respec-
tive product/market environments. Greater emphasis is often placed on meeting
the budget since the chief executive has no other informal controls available.
 Transfer Pricing: Transfers of goods and services between business units are
more frequent in single-industry and related diversified firms than in
conglomerates. The usual transfer pricing policy in a conglomerate is to give
sourcing flexibility to business units and use arm's-length market prices.
However, in a single-industry or a related diversified firm, synergies may be
important, and business units may not be given the freedom to make sourcing
decisions.
 Incentive Compensation: The incentive compensation policy tends to differ
across corporate strategies in the following ways-
 Use of formulas: Conglomerates, in general, are more likely to use formulas to
determine business unit managers' bonuses; that is, they may base a larger
portion of the bonus on quantitative, financial measures, such as X percent bonus
on actual economic value added (EVA) in excess of budgeted EVA. These
formula-based bonus plans are employed because senior management typically
is not familiar with what goes on in a variety of disparate businesses. Senior
managers of single-industry and related diversified firms tend to base a larger
fraction of the business unit managers’ bonus on subjective factors. In many
53
related diversified firms, greater degrees of interrelationships imply that one
unit's performance can be affected by the decisions and actions of other units.
Therefore, for companies with highly interdependent business units, formula-
based plans that are tied strictly to financial performance criteria could be
counterproductive.
 Profitability measures: In the case of unrelated diversified firms, the incentive
bonus of the 'business unit managers tend to be determined primarily by the
profitabi1ity of that unit, rather than the profitability of the firm~ Its purpose is
to motivate managers to act as though the business unit were their own company.
In contrast, single-industry and related diversified firms tend to base the
incentive bonus of a business unit manager on both the performance of that unit
and the performance of a larger organizational unit (such as the product group to
which the business unit belongs or perhaps even .the overall corporation). When
business units are interdependent, the more the incentive bonus of general
managers emphasizes the separate performance of each unit, the greater the
possibility of interunit conflict. On the other hand, basing the bonus of general
managers more on the overall corporate performance is likely to encourage
greater interunit cooperation, thereby increasing managers' motivation to exploit
interdependencies rather than their individual results.
 Business Unit Strategy: Diversified corporations segment themselves into
business units and typically assign different strategies to the individual business
units. Many chief executive officers of multi business organizations do not adopt
a standardized, uniform approach to controlling their business units; instead, they
tailor the approach to each business unit's strategy.The strategy of a business unit
depends on two interrelated aspects: (1) Its mission ("What are its overall
objectives?") and (2) its competitive advantage. ("How should the business unit
compete in its industry to accomplish its mission?"). Typically business units
choose from four missions: build, hold, harvest, and divest. The business unit has
two generic ways to compete and develop a sustainable competitive advantage:
low cost and differentiation.
54
 Mission The mission for existing business units could be either build, hold, or
harvest. These missions constitute a continuum, with "pure build" at one end and
"pure harvest" at the other end. To implement the strategy effectively, there
should be congruence between the mission chosen and the types of controls
used. The mission of the business unit influences the uncertainties that general
managers face and the short-term versus long-term trade-offs they make.
Management control systems can be systematically varied to help motivate the
man ager to cope effectively with uncertainty and make appropriate short-
term versus long term trade-offs. Thus, different missions often require
systematically different management control systems.
 Mission and Uncertainty "Build" units tend to face greater environmental
uncertainty than "harvest" units for several reasons: Build strategies typically are
undertaken in the growth stage of the product life cycle, whereas harvest
strategies typically are undertaken in the mature decline stage of the product life
cycle. Such factors as manufacturing process; product technology; market
demand; relations with suppliers, buyers, and distribution channels; number of
competitors; and competitive structure change more rapidly and are more
unpredictable in the growth stage than in the mature/decline stage. An objective
of a build business unit is to increase market share. Because the total market
share of all firms in an industry is 100 percent, the .battle for market share is a
zero-sum game; thus, a build strategy puts a business unit in greater conflict with
its competitors than does a harvest strategy. Competitors' actions are likely to be
unpredictable, and this contributes to the uncertainty that build business units
face. On both the input side and the output side, build managers tend to
experience greater dependencies on external individuals and organizations than
do harvest managers. For instance, a build mission signifies additional capital
investment (greater dependence on capital markets), expansion of capacity
(greater dependence on the technological environment), increase in market share
(greater dependence on customers and competitors), increase in production
volume (greater dependence on raw material suppliers and labor markets), and so
55
on. The greater the external dependencies a business unit faces, the greater the
uncertainty it confronts.Build business units are often in new and evolving
industries; thus, build managers are likely to have less experience in their
industries. This also contributes to the greater uncertainty that managers of build
units face in dealing with external constituencies.
 Mission and Time Span The choice of build versus harvest strategies has
implications for short-term versus long-term profit trade-offs. The share-building
strategy includes (a) price 'cutting, (b) major R&D expenditures (to introduce
new products), and (c) major market development expenditures. These actions
are aimed at establishing market leadership, but they depress short-term profits.
Thus, many decisions that a build unit manager makes, today may not result in
profits until some future period. A harvest strategy, on the other hand,
concentrates on maximizing short-term profits.
 Strategic Planning When the environment is uncertain, the strategic planning
process is especially important management needs to think about how to cope
with the uncertainties, and this usually requll1 longer-range view of planning
than is possible in the annual budget. If the environment is stable, there may be
no strategic planning process at all or only a broad-brush strategic plan. Thus,
the strategic planning process is more critical and more important for build, as
compared with harvest, business units. Nevertheless, some strategic planning of
the harvest business units may be necessary because the company's overall
strategic plan must encompass all of its businesses to effectively balance cash
flows. In screening capital investments and allocating resources, the system may
be more quantitative and financial for harvest units. A harvest business unit
operates in a mature industry and does not offer tremendous new investment
possibilities. Hence, the required earnings rate for such a business unit may be
relatively high to motivate the manager to search for project with truly
exceptional returns. Because harvest units tend to experience stable
environments with predictable products, technologies, competitors, and
customers), discounted cash flow PCF) analysis often can be used more
56
confidently. The required information used to evaluate investments from harvest
units is primarily financial. A build unit, however, is positioned on the growth
stage of the product life cycle. Since the corporate office wants to take advantage
of the opportunities in a growing market, senior management may set a relatively
low discount rate, thereby motivating build managers to forward more
investment ideas to corporate office. Given the product/market uncertainties,
financial analysis of some projects from build units may be unreliable. For such
projects, nonfinancial data are more important.
 Budgeting The calculational aspects of variance analysis comparing actual
results with the budget identify variances as either favorable or unfavorable.
However, a favorable variance does not necessarily imply favorable
performance, nor does an unfavorable variance imply unfavorable performance.
The link between a favorable or unfavorable variance, on the one hand, and
favorable or unfavorable performance, on the other hand, depends on the
strategic context of the business unit under evaluation.
 Incentive Compensation Syste In designing an incentive compensation package
for business unit managers, the following questions need to be resolved:
1. 1. What should the size of incentive bonus payments be relative to the general
manager's base salary? Should the incentive bonus payments have upper
limits?
2. What measures of performance (e.g., profit, EVA, sales volume, market
share, product
development) should be used when deciding the general manager's incentive
bonus awards? If multiple performance measures are employed, how should
they be weighted?
3. How much reliance should be placed on subjective judgments in deciding on
the bonus amount?
4. How frequently (semiannual, annual, biennial, etc.) should incentive awards
be made?

57
With respect to the first question, many firms use the principle that the riskier the
strategy, the greater the proportion of the general manager's compensation in bonus
compared to salary (the "risk/return" principle). They maintain that because
managers in charge of more uncertain task situations should be willing.to take
greater risks, they should have a higher percentage of their remuneration in the form
of an incentive bonus. Thus, "build" managers are more likely than "harvest"
managers to rely on bonuses.
As to the second question, when rewards are tied to certain performance criteria,
behaviour ls influenced by the desire to optimize performance with respect to those
criteria. Some performance criteria (cost control, operating profits, and cash flow
from operations) focus more on short-term results, whereas other performance
criteria (market share, new product development, market development, and people
development) focus on long-term profitability. Thus,
linking incentive bonus to short-term criteria tends to promote a short-term focus on
the part of the general manager and, similarly, linking incentive bonus to long-term
criteria is likely to promote long-term focus. Considering the relative differences in
time horizons of build and harvest managers, it may not be appropriate to use a
single, uniform financial criterion, such as operating profits, to evaluate the
performance of every business unit. A better idea would be louse multiple
performance criteria, with differential weights for each criterion depending on the
business unit's mission.

The third question asks how much subjective judgment should affect bonus
amounts. At one extreme, a manager's bonus might be a strict formula-based plan,
with the bonus tied to performance on quantifiable criteria (e.g., X percent bonus on
actual profits in excess of budgeted profits). At the other extreme, a manager's
incentive bonus amounts might be based solely on the superior's subjective
judgment or discretion. Alternatively, incentive bonus amounts might also be based
on a combination of formula-based and subjective approaches. Performance on
most long-term criteria (market development, new-product development, and people

58
development) is harder to measure objectively than is performance along most
short-run criteria (operating profits, cash flow from operations, and return on
investment).As already noted, build managers- in contrast with harvest managers,
should concentrate more on the long run, so they typically are evaluated more
subjectively than are harvest managers.

As to the final question, the frequency of bonus awards does influence the time
horizon of managers. More frequent bonus awards encourage managers to
concentrate on short-term performance since they have the effect of motivating
managers to focus on those facets of the business they can affect in the short run.
 Competitive Advantage A business unit can choose to compete.
Either as a differentiated player or as a low-cost player, Choosing a
differentiation 'approach, rather than a low-cost approach, increases
uncertainty of a business unit's task environment for three reasons.

1. Product innovation is more critical for differentiation business units than for
low cost business units. This is partly because a low-cost business unit, with
primary emphasis on cost reduction, typically prefers to keep its product
offerings stable over time; a differentiation business unit, with its primary
focus on uniqueness & exclusivity, is likely to engage in greater product
innovation.

2. A low cost business unit typically tend to have narrow product lines to
minimize the inventory carry costs as well as to benefit from scale
economies. Differentiation business units on the other hand tend to have a
broader set of products to create uniqueness.

3. Low cost business units typically produce no-frill commodity products&


these products succeed primarily because they have lower prices than
competing products. However product differentiation business units succeed
59
if customers perceive that the products have advantages over competing
products. Since the customer perception is difficult to learn about, & since
customer loyalty is subject to change resulting from actions of competitors or
other reasons, the demand for differentiated products is typically more
difficult to predict than the demand for commodities.

Q.3) Which management control practices, if followed, in performance

measurement of investment centres are likely to induce goal congruence, in

respect of following assets

d. (i) Idle (ii) Intangible (iii) Leased

e. (i) Cash (ii) Receivables (iii) Inventories

Ans. In some business units, the focus is on profit as measured by the difference
between revenues and expenses. In other business units, profit is compared with the
assets employed in earning it. We refer to the latter group of responsibility centers
as investment centers.

Measuring Assets Employed

In deciding what investment base to use to evaluate investment center managers,


headquarters asks two questions: First, what practices will induce business unit
managers to use their assets most efficiently and to acquire the proper amount and
kind of new assets? Presumably, when their profits are related to assets employed,
business unit managers will try to improve their performance as measured in this
way. \Senior management wants the actions that they take toward this end to be in
the best interest of the whole corporation. Second, what practices best measure the
performance of the unit as an economic entity?

60
 Cash

Most companies control cash centrally because central control permits use of a
smaller cash balance than would be the case if each business unit held the cash
balances it needed to weather the unevenness of its cash inflows and outflows.
Business unit cash balances may well be only the "float" between daily receipts and
daily disbursements. Consequently, the actual cash balances at the business unit
level tend to be much smaller than would be required if the business unit were an
independent company. Many companies therefore use a formula to calculate the
cash to be included in the investment base. For example, General Motors was
reported to use 4.5 percent of annual sales; Du Pont was reported to use two months'
costs of sales minus depreciation.
One reason to include cash at a higher amount than the balance carried by a
business unit is that the higher amount is necessary to allow comparisons to outside
companies. If only the actual cash were shown: by internal units would appear
abnormally high and might mislead senior management.
Some companies omit cash from the investment base. These companies reason that
the amount of cash approximates the current liabilities; if this is so, the sum of
accounts receivable and inventories will approximate the working capital.

 Receivables
Business unit managers can influence the level of receivables, not only indirectly
by their ability to generate sales, and directly, by establishing credit terms by
approving individual credit accounts and credit limits, and by the collecting
overdue amount. In the interest of simplicity, receivable included at the actual
end-.of-period balances, although the average of intraperiod balances is
conceptually a better measure of the am should be related to profits.
Whether to include accounts receivable at selling prices or at cost of goods sold
is debatable. One could argue that the business unit's real investment in accounts
receivable is only the cost of goods sold and that a satisfactory return on this

61
investment is probably enough. On the other hand, it is possible to argue that the
business unit could reinvest the money collected from accounts receivable, and,
therefore, accounts receivable should be included at selling prices. The usual
practice is to take the simpler alternative-that is, receivables at the book amount,
which is the selling price less an allowance for bad debts.
If the business unit does not control credits and collections, receivables may be
calculated on a formula basis. This formula should be consistent with the normal
payment period-for example, 30 days' sales where payment is made 30 days after
the shipment of goods.

 Inventories
Inventories ordinarily are treated in a manner similar to receivables –that is they
are often recorded at end-of-period amounts even though intraperiod averages
would be preferable conceptually. If the company uses LIFO (last in first out) for
financial accounting purposes, a different valuation method usually is used for
business unit profit reporting because LIFO inventory balances tend to be
unrealistically low in periods of inflation. In these circumstances, inventories
should be valued at standard or average costs, and these same costs should be used
to measure cost of sales on the business unit income statement
If work-in-process inventory is financed by advance payments or by progress
payments from the customer, as is typically the case with goods that require a long
manufacturing period, these payments either are subtracted from the gross inventory
amounts or reported as liabilities.

For e.g. with manufacturing periods a year or greater, Boeing received


progress payments for its airplanes and recorded them as liabilities.

Some companies subtract accounts payable from inventory on the grounds that
accounts payable represent financing of part of the inventory by vendors, at zero
cost to the business unit. The corporate capital required for inventories is only the
difference between the gross inventory amount and accounts payable. If the
business unit can influence the payment period allowed by vendors, then including
62
accounts payable in the calculation encourages the manager to seek the most
favorable terms. In times of high interest rates or credit stringency, managers might
be encouraged to consider forgoing the cash discount to have, in effect, additional
financing provided by vendors. On the other hand, delaying payments unduly to
reduce net current assets may not be in the company's best interest since this may
hurt its credit rating.
 Leased Assets
Suppose the business unit whose financial statements are shown in Exhibit 1 (see
page 21) sold its fixed assets for their book value of $300,000, returned the proceeds
of the sale to corporate headquarters, and then leased back the assets at a rental rate
of $60,000 per year. As Exhibit 2 (see page 21) shows, the business unit's income
before taxes would decrease because the new rental expense would be higher than
the depreciation charge that was eliminated. Nevertheless, economic valued added
would increase because the higher cost would be more than offset by the decrease in
the capital charge. Because of this, business unit managers are induced to lease,
rather than own, assets whenever the interest charge that is built into the rental cost
is less than the capital charge that is applied to the business unit's investment base.
(Here, as elsewhere, this generalization oversimplifies because, in the real world,
the impact of income taxes must also be taken into account.)
Many leases are financing arrangements-that is, they provide an alternative way of
getting to use assets that otherwise would be acquired by funds obtained from debt
and equity financing. Financial leases (i.e., long-term leases equivalent to the
present value of the stream of lease charges) are similar to debt and are so reported
on the balance sheet. Financing decisions usually are made by corporate
headquarters. For these reasons, restrictions usually are placed on the business unit
manager's freedom to lease assets.
 Idle Assets
If a business unit has idle asset that can be used by other units, the business unit
may be permitted to exclude them from the investment base if it classifies them as
available. The purpose of this permission is to encourage business unit managers to
63
release underutilized assets to units that may have better use for them. However, if
the fixed assets cannot be used by other units, permitting the business unit manager
to remove them from the investment base could result in dysfunctional actions For
example; it could encourage the business unit manager to idle partially utilized
assets that are not earning a return equal to the business unit's profit objective. If
there is no alternative use for the equipment, any contribution from this equipment
will improve company profits.
 Intangible Assets
Some companies tend to be R&D intensive (e.g., pharmaceutical firms such as
Novartis spend huge amounts on developing new products); others tend to be
marketing intensive (e.g., consumer products firms such as Unilever spend huge
amounts on advertising). There are advantages to capitalizing intangible assets such
as R&D and marketing and then amortizing them over a selected life. This method
should change how the business unit manager views these expenditures. By
accounting for these assets as long-term investments, the business unit manager will
gain less short-term benefit from reducing out lays on such item, For instance, if
R&D expenditures are expensed immediately, each dollar of R&D cut would be a
dollar more in pretax profits. On the other hand, if R&D costs are capitalized, each
dollar cut will reduce the assets employed by a dollar; the capital charge is thus
reduced only by one dollar times the cost of capital, which has a much smaller
positive impact on economic valued added.

SET.6

Q.1) What do you understand by Goal Congruence? What are the informal
factors that influence goal congruence?

Ans: This term is used when the same goals are shared by top managers and their
subordinates. This is one of the many criteria used to judge the performance of an
accounting system. The system can achieve its goal more effectively and perform
better when organizational goals can be well aligned with the personal and group
64
goals of subordinates and superiors. The goals of the company should be the same
as the goals of the individual business segments. Corporate goals can be
communicated by budgets, organization charts, and job descriptions.

 Goal Congruence- Meaning Individuals work in different hierarchies


and handle different responsibilities & may have different goals. But they must
come together as far as Company’s Goal is concerned (there action must speak Co’s
language.)

Goal Congruence

Example 1– The HR manager has devised a HR training program to enhance the


skills of its sales personnel, with an objective to enhance their productivity But if
company is in strategic need of attaining a certain sales volume in a given quarter, it
can not do so on account of non availability of personnel.

Example 2– The marketing department has planned an impressive advertising


campaign, which promises good returns, But say due to cash crunch Company’s
current financial position may not let to lose the strings

Example 3 – Production Manager may get a good applause for reducing cycle time;
But at what cost? Building up the high inventory i.e. higher investment in current
assets. While doing so he just overlooked the financial interest of the company. •
After completing the given activity in more efficient manner the concerned manager
scores the point/s on his score card. • Whether his actions are leading to scoring of
points on the organization’s score card too? if it is so then only one can say the
organization is marching towards a common goal.

Every individual working in an organization has got his own motive to do the work.
Individuals act in their own interest, based on their own motivations. And it is
always not necessarily consistent with the Co’s goal. In a goal congruence process,
the actions the people are led to take in accordance with their perceived self interest

65
are also in the best interest of the organization i.e. Goal congruence ensures that the
action of manager taken in their best interest is also in the best interest of the
organization.

Informal factors that influence goal congruence:

Informal Factors –

External factors – set of attitudes of the society, work ethics of the society

Internal factors – (Factors within the organization)

• Culture-Common beliefs, shared values, norms of behavior & assumptions

• Implicitly accepted and explicitly built into.

• Mgt. Style – Informal/Formal

• The Communication Channels

• Perception and Communication – e.g. Budget (meaning) strict profit.

 Organizations with Business Divisions (Profit Centre) format have


observed that Divisional Controllers experience divided loyalty in carrying out
their functions, causing a possible dysfunction. How could such a situation be
resolved? Define role of controller which suits your suggestion.

To the extent the decision are decentralized top management may lose some control.
Relying on control reports is not as effective as personal knowledge of an operation.
With profit center, top management must change its approach to control. Instead of
personal direction senior management must rely to a considerable extent on
management control reports.

Competent units that were once cooperating as functional units may now compete
with one another dis advantageously. An increase in one manager’s profit may
66
decrease those of another. This decrease in cooperation may manifest itself in a
manager unwillingness to refer sales lead to another business unit, even though that
unit is better qualified to follow up on the lead in production decision that have
undesirable cost consequence on other units or in the hoarding of personnel or
equipment that from the overall company standpoint would be better off used in
another units.

There may be too much emphasis on short run profitability at the expense of long
run profitability. In the desire to report high current profits, the profit center
manager may skip on R&D, training, maintenance. This tendency is especially
prevalent when the turnover of profit center managers is relatively high. In these
circumstances, manager may have good reason to believe that their action may not
affect profitability until after they have moved to other job.

There is no complete satisfactory system for ensuring that each profit center by
optimizing its own profit , will optimize company profits.

If headquarter management is more capable or has better information then the


average profit center manager the quality of some of the decision may be reduced.

Divisionalization may cause additional cost because it may require additional


management staff personnel and recordkeeping and may lead to redundant at each
profit center.

Business units as profit centers:

Business units are usually set up at profit centers. Business unit managers tend to
control product development, manufacturing, and marketing resources. They are in
a position to influence revenue and cost and as such can be held accountable for the
bottom line. However as pointed out in the next section a business unit manager
authority may be constrained such constrained should be incorporated in designing
and operating profit center.

Constraint on business unit authority

67
To realize fully the advantage of the profit center concept the business unit manger
would have to be as autonomous as the president of the independent company. As a
practical matter however such autonomy is not feasible. If a company were divided
into completely independent units the organization would be giving up the
advantage of size and synergism. Also senior management authority that a board of
director gives to the chief executive. Consequently business unit structure represents
trade off between business unit autonomy and corporate constraint. The
effectiveness of a business units organization is largely dependent on how well
these trade off are made.

The performance of a profit center is appraised by comparing actual results for one
or more orf these measures with budgeting amounts. In addition, data on
competitors and the industry provide a good cross check on the appropriate of the
budget. Data for individual companies are available from the securities and
exchange commission for about key business ratios; standard & poor computer
services, Inc; Robert Morris associates annual statement studies; and annual survey
published in fortune, business week, and Forbes. Trade associations publish data for
the companies in their industries.

Revenues: choosing the appropriate revenue recognition method is important.


Should revenue be recognized at the time as order is received, at the time an order is
shipped, or at the time cash is received?

In addition to that decision, issues related to common revenues may need to be


considered. There are some situations in which two or more profit centers
participate in the sales effort that results in a sale; ideally, each should be given
appropriate credit for its part in this transaction. Many companies have not given
much attention to the solution of these common revenue problems. They take the
position that the identification of price responsibility for revenue generation is too
complicated to be practical and that sale personnel must recognize they are working
not only for their own profit center but also for the overall good of the company.
They for example, may credit the business unit that takes an order for a product

68
handled by the another unit with the equivalent of a brokerage commission or a
finder fee. In the case of a bank the branch performing a service may be given
explicit credit for that service even though the customer account is maintained in
another branch.

Role of controller

• It should publish procedure and forms for the preparation of the


budget.

• It should provide assistance to budgetees in the preparation of their


budget.

• It should administer the process of making budget revision during the


year.

• It should coordinate the work of budget departments in lower echelons

• It should analyze reported performance against budget, interprets the


result, and prepares summary report for senior management.

 Part of a multinational group, Sundaram Shoe Company(SSC), established


its own facilities in India over 75 years ago and enjoyed an excellent record-
high market share for its diverse range of shoes, growth and profits. SC
markets its products through company owned shops and its own personnel.
Organization structure is functional. Since 2001, profitability, market share
are slipping. Pressure from cheap Chinese shoes and also premium shoes
like Nike has made the company think< of organizational restructuring and
introducing Comensurate Control System to regain its position. Although
SSC outsources, 30% of products, it is seen as a production oriented
company. SSC wants to adopt measures to reduce costs, strengthen
marketing and be in a position to produce and meet unexpected and
unusual customer demands. How should the company reorganize to achieve
Goal Congruence. Define Performance Metric?

69
In a goal congruent process, the actions people are led to take in accordance with
their perceived self-interest are also in the best interest of the organization. A firm’s
strategy has a major influence on its structure. The type of structure in turn
influences the design of the organization’s management control systems. Sundaram
Shoe Company’s (SSC) organization structure is functional which involves the
notion of a manager who brings specialized knowledge to bear on decisions related
to a specific function, vis-à-vis a general purpose manager who lacks the specialized
knowledge. A skilled marketing and production manager would be able to make
better decisions in their respective fields. He would also be able to supervise
workers in the same function better than the generalist would. Thus an important
advantage of the functional structure is efficiency. A major disadvantage of this
structure is that there is no unambiguous way of determining the effectiveness of the
separate functional managers because each function contributes jointly to the
organization’s final output. Therefore, there is no way of determining how much of
the profit was earned respectively by the several production departments.

Sundaram Shoe Company which was a market leader for a period of over 75 years
has been losing market share, which has impacted its profitability. Also it needs to
be seen that the company outsources about 30% of its products. The company aims
to strengthen marketing, reduce costs and wants to be in a position to customize
products as per the demands of the customer. Thus, Sundaram needs to re-organize
its organization structure which is functional to a Business Unit form of
organization. The benefits of the re-organization would be that the business unit or
the division would be responsible for all the functions involved in producing and
marketing a specified product line. The business managers act almost as if their
units are separate companies. They are responsible for planning and co-coordinating
the work of the separate functions. Their performance is measured by the
profitability of the business unit. This is a valid criterion because profit reflects the
activities of both marketing and production.

70
Though business unit managers exercise broad authority over their units,
headquarters reserves certain key prerogatives. Headquarters are responsible for
obtaining funds for the company as a whole and allocating it to the business unit, as
well as approving budgets and judging the performance of business unit managers,
setting their compensation.

A major advantage of the Business unit structure of organization is that because it is


close to the market for its products than the headquarters, its manager may make
sounder production and marketing decisions than headquarters might and the unit as
a whole reacts to new threats or opportunities quickly. This re-organization would
help in achieving goal congruence in the organization.

Performance Metrics are high-level measures what you are doing; that is, they
assess your overall performance in the areas you are measuring. They are external in
nature and are most closely tied to outputs, customer requirements, and business
needs for the process.

The performance measurement system should cover the following areas at a


minimum:

CUSTOMERS

1. Performance against customer requirements

2. Customer Satisfaction

PERFORMANCE OF INTERNAL WORK PROCESSES

1. Cycle times

2. Product and service quality

3. Cost performance (could be productivity measures, inventory, etc.)

SUPPLIERS

1. Performance of suppliers against your requirements

FINANCIAL

71
1. Profitability (could be at the company, product line, or individual level)

2. Market share growth and other standard financial measures

EMPLOYEE

1. Associate satisfaction

SET .7

Q: 1) (A) Describe the factors which impact service organization

Ans: Factors which impact service organization:


 Absence of Inventory Buffer:
Goods can be held as inventory, which is a buffer that dampens the impact on
production activity of fluctuations in sales volume. Services cannot be stored. The
airplane seat, hotel room, hospital operating room, or the hours of lawyers,
physicians, scientists, and other professionals that are not used today are gone
forever. Thus, although a manufacturing company can earn revenue in the future
from products that are on hand today, a service company cannot do so. It must try to
minimize its unused capacity.

Moreover, the costs of many service organizations are essentially fixed in the short
run. In the short run, a hotel cannot reduce its costs substantially by closing off
some of its rooms. Accounting firms, law firms, and other professional
organizations are reluctant to layoff professional personnel in times of low sales
volume because of the effect on morale and the costs of rehiring and training.

 Difficulty in Controlling Quality:


A manufacturing company can inspect its products before they are shipped to the
consumer, and their quality can be measured visually or with instruments
(tolerances, purity, weight, color, and so on). A service company cannot judge
product quality until the moment the service is rendered, and then the judgments are
often subjective. Restaurant management can examine the food in the kitchen, but

72
customer satisfaction depends to a considerable extent on the way it is served. The
quality of education is so difficult to measure that few educational organizations
have a formal quality control system.

 Labor Intensive:
Manufacturing companies add equipment and automate production lines, thereby
replacing labor and reducing costs. Most service companies are labor intensive and
cannot do this. Hospitals do add expensive equipment, but mostly to provide better
treatment, and this increases costs. A law firm expands by adding partners and new
support personnel.

 Multi-Unit Organizations:
Some service organizations operate many units in various locations; each unit
relatively small. These organizations are fast-food restaurant chains, auto rental
companies, gasoline service stations, and many others. Some of the units are owned;
others operate under a franchise. The similarity of the separate units provides a
common basis for analyzing budgets and evaluating performance not available to
the manufacturing company. The information for each unit can be compared with
system wide or regional averages, and high performers and low performers can be
identified. However because units differ in the mix of services they provide, in the
resources that they use, and in other ways, care must be taken in making such
comparisons.

Q:1) (B) Explain special characteristics of professional organization which


would have a bearing on their control system.

Ans: Special Characteristics of Professional Organization:


 Goals:
A dominant goal of a manufacturing company is to earn a satisfactory profit,
specifically a satisfactory return on assets employed. A professional organization
73
has relatively few tangible assets; its principal asset is the skill of its professional
staff, which doesn't appear on its balance sheet. Return on assets employed,
therefore, is essentially meaningless in such organizations. Their financial goal is to
provide adequate compensation to the professionals.

In many organizations, a related goal is to increase their size. In part, this reflects
the natural tendency to associate success with large size. In part, it reflects
economies of scale in using the efforts of a central personnel staff and units
responsible for keeping the organization up to- date. Large public accounting firms
need to have enough local offices to enable them to audit clients who have facilities
located throughout the world.
 Professionals:
Professional organizations are labor intensive, and the labor is of a special type.
Many professionals prefer to work independently, rather than as part of a team.
Professionals who are also managers tend to work only part time on management
activities; senior partners in an accounting firm participate actively in audit
engagements; senior partners in law firms have clients. Education for most
professions does not include education in management, but quite naturally stresses
the skills of the profession, rather than management; for this and other reasons,
professionals tend to look down on managers. Professionals tend to give inadequate
weight to the financial implications of their decisions; they want to do the best job
they can, re- I regardless of its cost. This attitude affects the attitude of support
staffs and nonprofessionals in the organization; it leads to inadequate cost control.
 Output and Input Measurement:
The output of a professional organization cannot be measured in physical terms,
such as units, tons, or gallons. We can measure the number of hours a lawyer spends
on a case, but this is a measure of input, not output. Output is the effectiveness of
the lawyer's work, and this is not measured by the number of pages in a brief or the
number of hours in the courtroom. We can measure the number of patients a
physician treats in a day, and even classify these visits by type of complaint; but this
74
is by no means equivalent to measuring the amount or quality of service the
physician has provided. At most, what is measured is the physician's efficiency in
treating patients, which is of some use in identifying slackers and hard workers.
Revenues earned is one measure of output in some professional organizations, but
these monetary amounts, at most, relate to the quantity of services rendered, not to
their quality (although poor quality is reflected in reduced revenues in the long run).
Furthermore, the work done by many professionals is non repetitive. No two
consulting jobs or research and development projects are quite the same. This
makes it difficult to plan the time required for a task, to set reasonable standards for
task performance, and to judge how satisfactory the performance was. Some tasks
are essentially repetitive: the drafting of simple wills, deeds, sales contracts, and
similar documents; the taking of a physical inventory by an auditor; and certain
medical and surgical procedures. The development of standards for such tasks may
be worthwhile, although in using these standards, unusual circumstances that affect
a specific job must be taken into account.
 Small Size:
With a few exceptions, such as some law firms and accounting firms, professional
organizations are relatively small and operate at a single location. Senior
management in such organizations can personally observe what is going on and
personally motivate employees. Thus, there is less need for a sophisticated
management control system, with profit centers and formal performance reports.
Nevertheless, even a small organization needs a budget, a regular comparison of
performance against budget, and a way of relating compensation to performance.
 Marketing:
In a manufacturing company there is a clear dividing line between marketing
activities and production activities; only senior management is concerned with both.
Such a clean separation does not exist in most professional organizations. In some,
such as law, medicine, and accounting, the profession's ethical code limits the
amount and character of overt marketing efforts by professionals (although these
restrictions have been relaxed in recent years). Marketing is an essential activity in
75
almost all organizations, however. If it can't be conducted openly, it takes the form
of personal contacts, speeches, articles, conversations on the golf course, and so on.
These marketing activities are conducted by professionals, usually by professionals
who spend much of their time in production work-that is, working for clients.
In this situation, it is difficult to assign appropriate credit to the person responsible
for "selling" a new customer. In a consulting firm, for example, a new engagement
may result from a conversation between a member of the firm and an acquaintance
in a company, or from the reputation of one of the firm's professionals as an
outgrowth of speeches or articles. Moreover, the professional who is responsible for
obtaining the engagement may not be personally involved in carrying it out. Until
fairly recently, these marketing contributions were rewarded subjectively- that is,
they were taken into account in promotion and compensation decisions. Some
organizations now give explicit credit, perhaps as a percentage of the project's
revenue, if the person who "sold" the project can be identified.

Q:2) Every SBU is a profit center but every profit center is not a SBU? What
are the conditions that should be fulfill for an organization unit to be converted
into a profit center? What are the different ways to measure the performance
of profit center? Discuss their relevant merits and demerits.

Ans: Conditions for an organization to be converted into a profit centre: Many


management decisions involve proposals to increase expenses with the expectation
of an even greater increase in sales revenue. Such decisions are said to involve
expense/revenue trade-offs. Additional advertising expense is an example. Before it
is safe to delegate such a trade-off decision to a lower-level manager, two
conditions should exist.
• The manager should have access to the relevant information needed for making
such a decision.
• There should be some way to measure the effectiveness of the trade-offs the
manager has made.

76
A major step in creating profit centers is to determine the lowest point in an
organization where these two conditions prevail. All responsibility centers fit into a
continuum ranging from those that clearly should be profit centers to those that
clearly should not. Management must decide whether the advantages of giving
profit responsibility offset the disadvantages, which are discussed below. As with
all management control system design choices, there is no clear line of demarcation.
 Ways to Measure Performance:
There are two types of profitability measurements used in evaluating a profit center,
just as there are in evaluating an organization as a whole. First, there is the measure
of management performance, which focuses on how well the manager is doing. This
measure is used for planning, coordinating, and controlling the profit center's day-
to-day activities and as a device for providing the proper motivation for its manager.
Second, there is the measure of economic performance, which focuses on how well
the profit center is doing as an economic entity. The messages conveyed by these
two measures may be quite different from each other. For example, the management
performance report for a branch store may show that the store's manager is doing an
excellent job under the circumstances, while the economic performance report may
indicate that because of economic and competitive conditions in its area the store is
a losing proposition and should be closed. .

The necessary information for both purposes usually cannot be obtained from a
single set of data. Because the management report is used frequently, while the
economic report is prepared only on those occasions when economic decisions must
be made, considerations relating to management performance measurement have
first priority in systems design-that is, the system should be designed to measure
management performance routinely, with economic information being derived from
these performance reports as well as from other sources.
 Types of Profitability Measures
A profit center's economic performance is always measured by net income (i.e., the
income remaining after all costs, including a fair share of the corporate overhead,
77
have been allocated to the profit center). The performance of the profit center
manager, however, may be evaluated by five different measures of profitability: (1)
contribution margin, (2) direct profit, (3) controllable profit, (4) income before
income taxes, or (5) net income
(1) Contribution Margin:
Contribution margin reflects the spread between revenue and variable expenses. The
principal argument in favor of using it to measure the performance of profit center
managers is that since fixed expenses are beyond their control, managers should
focus their attention on maximizing contribution. The problem with this argument is
that its premises are inaccurate; in fact, almost all fixed expenses are at least
partially controllable by the manager, and some are entirely controllable. Many
expense items are discretionary; that is, they can be changed at the discretion of the
profit center manager. Presumably, senior management wants the profit center to
keep these discretionary expenses in line with amounts agreed on in the budget
formulation process. A focus on the contribution margin tends to direct attention
away from this responsibility. Further, even if an expense, such as administrative
salaries, cannot be changed in the short run, the profit center manager is still
responsible for controlling employees' efficiency and productivity.
(2) Direct Profit:
This measure reflects a profit center's contribution to the general overhead and
profit of the corporation. It incorporates all expenses either incurred by or directly
traceable to the profit center, regardless of whether or not these items are within the
profit center manager's control. Expenses incurred at headquarters, however, are not
included in this calculation. A weakness of the direct profit measure is that it does
not recognize the motivational benefit of charging headquarters costs.
(3) Controllable Profit:
Headquarters expenses can be divided into two categories: controllable and non
controllable. The former category includes expenses that are controllable, at least to
a degree, by the business unit manager-information technology services, for
example. If these costs are included in the measurement system, profit will be what
78
remains after the deduction of all expenses that may be influenced by the profit
center manager. A major disadvantage of this measure is that because it excludes
non controllable headquarters expenses it cannot be directly compared with either
published data or trade association data reporting the profits of other companies in
the industry.
(4) Income before Taxes:
In this measure, all corporate overhead is allocated to profit centers based on the
relative amount of expense each profit center incurs. There are two arguments
against such allocations. First, since the costs incurred by corporate staff
departments such as finance, accounting, and human resource management are not
controllable by profit center managers, these managers should not be held
accountable for them. Second, it may be difficult to allocate corporate staff services
in a manner that would properly reflect the amount of costs incurred by each profit
center.

There are, however, three arguments in favor of incorporating a portion of corporate


overhead into the profit centers' performance reports. First, corporate service units
have a tendency to increase their power base and to enhance their own excellence
without regard to their effect on the company as a whole. Allocating corporate
overhead costs to profit centers increases the likelihood that profit center manager§
will question these costs, thus serving to keep head office spending in check. (Some
companies have actually been known to sell their corporate jets because of
complaints from profit center managers about the cost of these expensive items.)
Second, the performance of each profit center will become more realistic and more
readily comparable to the performance of competitors who pay for similar services.
Finally, when managers know that their respective centers will not show a profit
unless all-costs, including the allocated share of corporate overhead, are recovered,
they are motivated to make optimum long-term marketing decisions as to pricing,
product mix, and so forth, that will ultimately benefit (and even ensure the viability
of) the company as a whole.
79
If profit centers are to be charged for a portion of corporate overhead, this item
should be calculated on the basis of budgeted, rather than actual, costs, in which
case the "budget" and "actual" columns in the profit center's performance report will
show identical amounts for this particular item. This ensures that profit center
managers will not complain about either the arbitrariness of the allocation or their
lack of control over these costs, since their performance reports will show no
variance in the overhead allocation. Instead, such variances would appear in the
reports of the responsibility center that actually incurred these costs. .
(5) Net Income:
Here, companies measure the performance of domestic profit centers according to
the bottom line, the amount of net income after income tax. There are two principal
arguments against using this measure: (1) after tax income is often a constant
percentage of the pretax income, in which case there would be no advantage in
incorporating income taxes, and (2) since many of the decisions that affect income
taxes are made at headquarters, it is not appropriate to judge profit center managers
on the consequences of these decisions. There are situations, however, in which the
effective income tax rate does vary among profit centers. For example, foreign
subsidiaries or business units with foreign operations may have different effective
income tax rates. In other cases, profit centers may influence income taxes through
their installment credit policies, their decisions on acquiring or disposing of
equipment, and their use of other generally accepted accounting procedures to
distinguish gross income from taxable income. In these situations, it may be
desirable to allocate income tax expenses
to profit centers not only to measure their economic profitability but also to
motivate managers to minimize tax liability.
Merits:
• The quality of decisions may improve because they are being made by
managers closest to the point of decision.

80
• The speed of operating decisions may be increased since they do not have to
be referred to corporate headquarters. . Headquarters management, relieved of
day-to-day decision making, can concentrate on broader issues.
• Managers, subject to fewer corporate restraints, are freer to use their
imagination and initiative.Because profit centers are similar to independent
companies, they provide an excellent training ground for general
management. Their managers gain experience in managing all functional
areas, and upper management gains the opportunity to evaluate their potential
for higher-level jobs.
• Profit consciousness is enhanced since managers who are responsible' for
profits will constantly seek ways to increase them. (A manager responsible
for marketing activities, for example, will tend to authorize promotion
expenditures that increase sales, whereas a manager responsible for profits
will be motivated to make promotion expenditures that increase profits.).
• Profit centers provide top management with ready-made information on the
profitability of the company's individual components. . Because their output
is so readily measured, profit centers are particularly responsive to pressures
to improve their competitive performance.
Demerits:
• Decentralized decision making will force top management to rely more
on management control reports than on personal knowledge of an
operation, entailing some loss of control.
• If headquarters management is more capable or better informed than the
average profit center manager, the quality of decisions made at the unit
level may be reduced.
• Friction may increase because of arguments over the appropriate transfer
price, the assignment of common costs, and the credit for revenues that
were formerly generated jointly by two or more business units working
together.

81
• Organization units that once cooperated as functional units may now be
in competition with one another. An increase in profits for one manager
may mean a decrease for another. In such situations, a manager may fail
to refer sales leads to another business unit better qualified to pursue
them; may hoard personnel or equipment that, from the overall company
standpoint, would be better off used in another unit; or may make
production decisions that have undesirable cost consequences for other
units.
• Divisionalization may impose additional costs because of the additional
management, staff personnel, and record keeping required, and may lead
to task redundancies at each profit center.

Q:3) what are different types of Strategic Missions at SBU level? How do these
missions affect Strategic Planning process and Budgeting at SBU Level?

Different Types of Strategic Missions:


Business Unit Mission:
In a diversified firm one of the important tasks of senior management is resource
deployment, that is, make decisions regarding the use of the cash generated from
some business units to finance growth in other business units. Several planning
models have been developed to help corporate level managers of diversified firms to
effectively allocate resources. These models suggest that a firm has business units in
several categories, identified by their mission; the appropriate strategies for each
category differ. Together, the several units make up a portfolio, the components of
which differ as to their risk/reward characteristics just as the components of an
investment portfolio differ. Both the corporate 'office and the business unit general
manager are involved in identifying the missions of individual business units. Of the
many planning models, two of the most widely used are Boston Consulting Group's
two-by-two growth-share matrix and General Electric Company/McKinsey &
Company's three-by-three industry attractiveness-business strength matrix. While
these models differ in the methodologies they use to develop the most appropriate

82
missions for the various business units, they have the same set of missions from
which to choose: build, hold, harvest, and divest.
 Build: This mission implies an objective of increased market share, even at
the expense of short-term earnings and cash flow (e.g., Merck's bio-technology,
Black and Decker's handheld electric tools).

 Hold: This strategic mission is geared to the protection of the business


unit's market share and competitive position (e.g.: IBM's mainframe
computers).

 Harvest: This mission has the objective of maximizing short-term


earnings and cash flow, even at the expense of market share (e.g.,
American Brands' tobacco products, General Electric's and Sylvania's
light bulbs)

 Divest: This mission indicates a decision to withdraw from the


business either through a process of slow liquidation or outright sale.
While the planning models can aid in the formulation of missions, they
are not cook books. A business unit's position on a planning grid
should not be the sole basis for deciding its mission.

 Business Unit Competitive Advantage: Every business unit should


develop a competitive advantage in order to accomplish its mission.
Three interrelated questions have to be considered in developing the
business unit's competitive= advantage. First, what is the structure of
the industry in which the business unit operates? Second, how should
the business unit exploit the industry's structure? Third, what will be
the basis of the business unit's competitive advantage?

83
 Industry Analysis: Research has highlighted the important role
industry conditions play in the performance of individual firms. Studies
have shown that average industry profitability is, by far, the most
significant predictor of firm performance. According to Porter, the
structure of an industry should be analyzed in terms of the collective
strength of five competitive forces.
1. The intensity of rivalry among existing competitors. Factors affecting direct
rivalry are industry growth, product differentiability, number and diversity of
competitors, level of fixed costs, intermittent overcapacity, and exit barriers.
2. The bargaining power of customers. Factors affecting buyer power are number of
buyers, buyer's switching costs, buyer's ability to integrate backward, impact of the
business unit's product on buyer's total costs, impact of the business unit's product
on buyer's product quality/ performance, and significance of the business unit's
volume to buyers.
3. The bargaining power of suppliers. Factors affecting supplier power are number
of suppliers, supplier's ability to integrate forward, presence of substitute inputs, and
importance of the business unit's volume to suppliers.
4. Threat from substitutes. Factors affecting substitute threat are relative
price/performance of substitutes, buyer's switching costs, and buyer's propensity to
substitute.
5. The threat of new entry. Factors affecting entry barriers are capital requirements,
access to distribution channels, economies of scale, product differentiation,
technological complexity of product or process, expected retaliation from existing
firms, and government policy.

 We make three observations with regard to the industry analysis:


1. The more powerful the five forces are, the less profitable an industry is likely to
be. In industries where average profitability is high (such as soft drinks and
pharmaceuticals), the five forces are weak (e.g., in the soft drink industry, entry
barriers are high). In industries where the average profitability is low (such as steel
84
and coal), the five forces are strong (e.g., in the steel industry, threat from
substitutes is high).

2. Depending on the relative strength of the five forces, the key strategic issues
facing the business unit will differ from one industry to another.

3. Understanding the nature of each force helps the firm to formulate effective
strategies. Supplier selection (a strategic issue) is aided by the analysis of the
relative power of several supplier groups; the business unit should link with the
supplier group for which it has the best competitive advantage. Similarly, analyzing
the relative bargaining power of several buyer groups will facilitate selection of
target customer segments.
 Generic Competitive Advantage:
The five-force analysis is the starting point for developing a competitive advantage
since it helps to identify the opportunities and threats in the external environment.
With this understanding, Porter claims that the business unit has two generic ways
of responding to the opportunities in the external environment and developing a
sustainable competitive advantage: low cost and differentiation.
 Low Cost: Cost leadership can be achieved through such approaches
as economies of scale in production; experience curve effects, tight
cost control, and cost minimization (in such areas as research and
development, service, sales force, or advertising). Some firms
following this strategy include Charles Schwab in discount brokerage,
Wal-Mart in discount retailing, Texas Instruments in consumer
electronics, Emerson Electric in electric motors, Hyundai in
automobiles, Dell in computers, Black and Decker in machine tools,
Nucor in steel, Lincoln Electric in arc welding equipment, and BIC in
pens.
 Differentiation:

85
The primary focus of this strategy is to differentiate the product offering of the
business unit, creating something that is perceived by customers as being unique.
Approaches to product differentiation include brand loyalty (Coca-Cola and Pepsi
Cola in soft drinks), superior customer service (Nordstrom in retailing), dealer
network (Caterpillar Tractors in construction equipment), product design and
product features (Hewlett-Packard in electronics), and technology (Cisco in
communications infrastructure). Other examples of firms following a differentiation
strategy include BMW in automobiles; Stouffer's in frozen foods, Neiman-Marcus
in retailing, Mont Blanc in pens, and Rolex in wristwatches.
 Value Chain Analysis:
Business units can develop competitive advantage based on low cost,
differentiation, or both. The most attractive competitive position is to achieve cost-
cum-differentiation.
SET 8

1. What is a responsibility centre? List and explain different types of

Responsibility Centers with sketches.

Responsibility centers:

A responsibility center is an organization unit that is headed by a manager who is


responsible for its activities. In a sense, a company is a collection of responsibility
centers. Each of which is represented by box on the on the organization are
responsibility centers for section work shifts or other small organization units. At a
higher level are departments or business units that consist of several of these smaller
units plus staff and management people these larger units are also responsibility
center. And from the stand point of senior management and the board of directors,
the whole company is responsibility center although the term is usually used to refer
to unit within the company.

86
Nature of responsibility centers

A responsibility center exist one or more purpose are its objectives. The company as
a whole has goals, and senior management has decided on a set of strategies to
accomplish these goals. The objectives of responsibility centers are to help
implement these strategies. Because the organization is the sum of its responsibility
centers, if the strategies are sound and if each responsibility center, if the strategies
are sound and if each responsibility center meets its objectives the whole
organization should achieve its goals. A responsibility center uses inputs, and a
variety of services. Its work with these resources and it usually require working
capital, equipment, and other asset to do this work. As a result of this work the
responsibility center produces output which is classified either as goods if they are
tangible or as services if they are intangible. Every responsibility center has output
that is it does something. In a production plant, the outputs are goods. In staff units,
such as human resources, transportation, engineering, accounting, and
administration, the output s are services. For many responsibility centers, especially
staff units, outputs are difficult to measure; nevertheless, they exist. The products
produced by a responsibility center or to the outside marketplace. In the first case,
the product are inputs to the other responsibility center in the latter case, they are
output s of the whole organization.

Types of Responsibility Centers

Cost Center

Cost centers are divisions that add to the cost of the organization, but only indirectly
add to the profit of the company. Typical examples include Research and
Development, Marketing and Customer service. Companies may choose to classify
business units as cost centers, profit centers, or investment centers. There are some
significant advantages to classifying simple, straightforward divisions as cost
centers, since cost is easy to measure. However, cost centers create incentives for
managers to underfund their units in order to benefit themselves, and this
underfunding may result in adverse consequences for the company as a whole
(reduced sales because of bad customer service experiences, for example). Because
the cost centre has a negative impact on profit (at least on the surface) it is a likely
target for rollbacks and layoffs when budgets are cut. Operational decisions in a
87
contact centre, for example, are typically driven by cost considerations. Financial
investments in new equipment, technology and staff are often difficult to justify to
management because indirect profitability is hard to translate to bottom-line figures.
Business metrics are sometimes employed to quantify the benefits of a cost centre
and relate costs and benefits to those of the organization as a whole. In a contact
centre, for example, metrics such as average handle time, service level and cost per
call are used in conjunction with other calculations to justify current or improved
funding.

Profit Center

A responsibility centre is called a profit centre when the manager is held responsible
for both costs (inputs) and revenues (outputs) and thus for profit. Despite the name,
a profit centre can exist in nonprofits organizations (though it might not be referred
to as such) when a responsibility centre receives revenues for its services. A profit
centre is a big segment of activity for which both revenues and costs are
accumulated: A centre, whose performance is measured in terms of both - the
expense it incurs and revenue it earns, is termed as a profit centre. The output of a
responsibility centre may either be meant for internal consumption or for outside
customers. In the latter case, the revenue is realized when the sales are made. That
is, when the output is meant for outsiders, then the revenue will be measured from
the price charged from customers. If the output is meant for other responsibility
centre, then management takes a decision whether to treat the centre as profit centre
or not. In fact, any responsibility centre can be turned into a profit centre by
determining a selling price for its outputs. For instance, in case of a process
industry, the output of one process may be transferred to another process at a profit
by taking into account the market price. Such transfers will give some profit to that
responsibility centre. Although such transfers do not increase the Company’s assets,
they help in management control process.

88
Investment Centre

An investment centre goes a step further than a profit centre does. Its success is
measured not only by its income but also by relating that income to its invested
capital, as in a ratio of income to the value of the capital employed. In practice, the
term investment centre is not widely used. Instead, the term profit centre is used
indiscriminately to describe centers that are always assigned responsibility for
revenues and expenses, but may or may not be assigned responsibility for the capital
investment. It is defined as a responsibility centre in which inputs are measured in
terms of cost / expenses and outputs are measured in terms of revenues and in which
assets employed are also measured. A responsibility centre is called an investment
centre, when its manager is responsible for costs and revenues as well as for the
investment in assets used by his centre. He is responsible for maintaining a
satisfactory return on investment i.e. asset employed in his responsibility centre.
The investment centre manager has control over revenues, expenses and the
amounts invested in the centre’s assets. The manager of an investment centre is
required to earn a satisfactory return. Thus, return on investment (ROI) is used as
the performance evaluation criterion in an investment centre. He also formulates the
credit policy, which has a direct influence on debt collection, and the inventory
policy, which determines the investment in inventory. The Vice President
(Investments) of a mutual funds company may be in charge of an Investment
Centre. In the Investment Centre, the manager in charge is held responsible for the
proper utilization of assets. He is expected to earn a satisfactory return on the assets
employed in his responsibility centre. Measurement of assets employed poses many
problems. It becomes difficult to determine the amount of assets employed in a
particular responsibility centre. Some of the assets are in the physical possession of
the responsibility centre while for some assets it may depend upon other
responsibility centers or the Head Office of the company. This is particularly true of
cash or heavy plant and equipment. Whether such assets should be included in the
figure of assets employed of the responsibility centre and if included, at how much
value, is a difficult question. On account of these difficulties, investment centers are
generally used only for relatively large units, which have independent divisions,
both manufacturing and marketing, for their individual products.

2. Explain the process of evaluation of Responsibility Center from one stage to


another with the help of illustration-cum-experiences of the corporate.
89
Process of evaluation of Responsibility Center.

1. The organization is divided into various responsibility centers. Each


responsibility centre is put under the charge of a responsibility manager.

2. The targets or budgets of each responsibility centre are set in consultation


with the manager of responsibility centre, so that he may be able to give full
information about his department. The manager of responsibility centre
should know as what is expected of him - each centre should have a clear set
of goals. The responsibility and authority of each centre should be well
defined.

3. Managers are charged with the items and responsibility, over which they can
exercise a significant degree of direct control.

4. Goals defined for each area of responsibility should be attainable with


efficient and effective performance.

5. The actual performance is communicated to the managers concerned. If it


falls short of the standards, the variances are conveyed to the top
management. The names of persons responsible for the variances are also
conveyed so that responsibility may be fixed.

The purpose of all these steps is to assign responsibility to different individuals so


that their performance is improved and costs are controlled. The personal factor in
Responsibility Accounting is most important. The management may prepare the
best plan or the budget and put up before its staff, but its success depends upon the
initiative and the will of the workers to execute it

Example of Responsibility Center

The Sarva Shiksha Abhiyan emphasizes quality improvement in elementary


education for which it deems necessary that resource groups and responsibility
centers from national to sub-district levels are identified. These groups would
oversee the policy, planning, implementation and monitoring of all quality related
interventions. Their major role would be to advise and assist at various levels in
curriculum development, pedagogical improvement, teacher education/training and
activities related to classroom transaction. In order to facilitate a decentralized mode
of education, these groups would need to be constituted at various operational
levels, namely - national, state, district and sub district. The following could be
involved in the groups:

90
National level - NCERT, NIEPA, Universities, NGOs, experts and eminent
educationists.

State level - SCERT, SIEMAT, Universities, IASEs/CTEs, NGOs, experts and


eminent educationists.

District level - DIETs, representatives from DPEP District Resource Group, higher
educational institutions, innovative teachers from the districts, NGOs.

Sub-district - BRC/BEO, representatives from CRCs, innovative teachers.

3. Briefly define Discretionary Expense Center, Engineered Expense Center,


Profit Centre and Investment Centre? How is budget prepared in
Discretionary Expenses Centre?
Engineered expense centers:

Engineered expense center have the following characteristics:

- Their inputs can be measured in monetary terms.

- Their output can be measured in physical terms.

- The optimal dollar amount of input required to produce one unit of output can be
established.

Engineered expense center usually are found in manufacturing operations.


Warehousing, distribution, trucking and similar units in the marketing organization
also may be engineered expense center and so many certain responsibility center
within administrative and support department. Examples are accounts receivable
account payable and payroll section in the controller department personnel record
and cafeteria in the human resource department shareholder record in the corporate
secretary department and the company motor pool. Such units perform repetitive
task for which standard cost can be developed. In an engineered expense center the
output multiplied by the standard cost of each unit produced represents what the
finished product should have cost. When this cost is compared to actual costs, the
difference between the two represents the efficiency of the organization unit being
measured. We emphasize that engineered expense centers have other important
tasks not measured by cast alone. The effectiveness of this aspect of performance
should be controlled. For example expenses center supervisor are responsible for the
quality of good and for the volume of production in addition to their responsibility
for cost efficiency. Therefore the type and amount of production is prescribed and
specific quality standards are set so that manufacturing costs are not minimized at

91
the expense of quality. Moreover manager of engineered expense center may be
responsible for activities such a training that are not related to current production
judgment about their performance should include an appraisal of how well they
carry out these responsibilities. There are few if any responsibility center in which
all cost items are engineered. Even in highly automated production department the
amount of indirect labor and of various services used can vary with management
discretion. Thus, the term engineered costs center refers to responsibility center in
which engineered cost predominate but in does not imply that valid engineering
estimates can be made for each and every cost item.

Discretionary expense center:

The output of discretionary expenses center cannot be measured in monitory terms.


They include administration and support units research and development
organization and most marketing activities. The term discretionary does not mean
that management judgment is capricious or haphazard. Management has decided on
certain policies that should govern the operation of the company. Whether to match
exceed or spend less than the marketing effort of its competitor; the level of service
that the company provides to the customer. The appropriate amount of spending for
R & D, financial planning public relation and many other activities. One company
may have a small headquarter staff another company of similar size and in the same
industry may have a staff that is 10 times as large. the management of both
companies may be concerned that they made the correct decision on staff size but
there is no objective way judging which decision was actually better manager are
hired and paid to make such decision. After such a drastic change the level of
discretionary expenses generally has a similar pattern from one year to the next. The
difference between budgeted and actual expense is not a measure of efficiency in a
discretionary expense center it is simply the difference between the budgeted input
and the actual input. It in no way measures the value of the output. if actual expense
do not exceed the budget amount, the manager has ‘lived within the budget ‘
however ,because by definition the budget does not purport to measure the optimum
amount of spending we cannot say that living within the budgeted is efficient
performance.

Profit Center

A responsibility centre is called a profit centre when the manager is held responsible
for both costs (inputs) and revenues (outputs) and thus for profit. Despite the name,
a profit centre can exist in nonprofits organizations (though it might not be referred
to as such) when a responsibility centre receives revenues for its services. A profit
centre is a big segment of activity for which both revenues and costs are

92
accumulated: A centre, whose performance is measured in terms of both - the
expense it incurs and revenue it earns, is termed as a profit centre. The output of a
responsibility centre may either be meant for internal consumption or for outside
customers. In the latter case, the revenue is realized when the sales are made. That
is, when the output is meant for outsiders, then the revenue will be measured from
the price charged from customers. If the output is meant for other responsibility
centre, then management takes a decision whether to treat the centre as profit centre
or not. In fact, any responsibility centre can be turned into a profit centre by
determining a selling price for its outputs. For instance, in case of a process
industry, the output of one process may be transferred to another process at a profit
by taking into account the market price. Such transfers will give some profit to that
responsibility centre. Although such transfers do not increase the Company’s assets,
they help in management control process.

Investment Centre

An investment centre goes a step further than a profit centre does. Its success is
measured not only by its income but also by relating that income to its invested
capital, as in a ratio of income to the value of the capital employed. In practice, the
term investment centre is not widely used. Instead, the term profit centre is used
indiscriminately to describe centers that are always assigned responsibility for
revenues and expenses, but may or may not be assigned responsibility for the capital
investment. It is defined as a responsibility centre in which inputs are measured in
terms of cost / expenses and outputs are measured in terms of revenues and in which
assets employed are also measured. A responsibility centre is called an investment
centre, when its manager is responsible for costs and revenues as well as for the
investment in assets used by his centre. He is responsible for maintaining a
satisfactory return on investment i.e. asset employed in his responsibility centre.
The investment centre manager has control over revenues, expenses and the
amounts invested in the centre’s assets. The manager of an investment centre is
required to earn a satisfactory return. Thus, return on investment (ROI) is used as
the performance evaluation criterion in an investment centre. He also formulates the
credit policy, which has a direct influence on debt collection, and the inventory
policy, which determines the investment in inventory. The Vice President
(Investments) of a mutual funds company may be in charge of an Investment
Centre. In the Investment Centre, the manager in charge is held responsible for the
proper utilization of assets. He is expected to earn a satisfactory return on the assets
employed in his responsibility centre.

Budget Preparation.

The decision that management make about a discretionary expense budget are
different from the decisions that it makes about the budget for an engineered
expense center. For the latter management decides whether the proposed operating

93
budget represent the cost of performing task efficiently for the coming period.
management is not so much concerned with the magnitude of the task because this
is largely determined by the actions of other responsibility centers, such as the
marketing departments ability to generate sales. In formulating the budget for a
discretionary expense center, however management principal task is to decide on
the magnitude of the job that should be done. These tasks can be divided generally
into two types continuing and special. Continuing task are those that continue from
year to year for example financial statement preparation by the controller’s office.
Special tasks are one shot project for example developing and installing a profit
budgeting system in a newly acquired division. The technique management by
objective is often used in preparing the budget for a discretionary expense center.
Management by objective is a formal process in which a budget purposes to
accomplish specific tasks and state a mean for measuring whether these tasks have
been accomplished. There are two different approach to planning for the
discretionary expense center increment budgeting and zero based review.

SET .9

Q1. Describe inherent difficulties creation of profit centres may cause and
advantages possible?
Under which situation creation of profit centre is not advisable.

Under which situation creation of profit centre is not advisable


Decentralized decision making will force top management to rely more on
management control reports than on personal knowledge of an operation, entailing
some loss of control. If headquarters management is mere capable or better
informed than the average profit center manager, the quality of decisions made at
the unit level way be reduced. Friction may increase because of arguments over the
appropriate transfer price, the assignment of common costs, and the credit for
revenues that were formerly generated jointly by two or more business units
working together.

Organization units that once cooperated as functional units may now be in


competition with one another. An increase in profits for one manager may mean a
decrease for another. In such situation a manager may fail to refer sales leads to
another business unit better qualified to pursue them; may hoard personnel or
equipment that, from the overall company’s, standpoint, would be better off used in
another unit; or may make production decisions that have undesirable cost
consequences for other units.

Divisionalization may impose additional costs because of the additional


management, staff personnel, and record keeping required, and may lead to task
redundancies at each profit center.Competent general managers may not exist in a
94
functional organization because there may not have been sufficient opportunities for
them to develop general management competence.
There may be too much emphasis on short-run profitability at the expense of long-
run profitability. In the desire to report high current profits, the profit center
manager may skimp on R&D, training programs, or maintenance. This tendency is
especially prevalent when the turnover of profit center managers is relatively high.
In these circumstances, managers may have good reason to believe that their actions
may not affect profitability until after they have moved to other jobs. There is no
completely satisfactory system for ensuring that optimizing the profits of each
individual profit center will optimize the profits of the company as a whole.

Q2.What are the challenges faced in pricing corporate services provided to


Business Units operating as “profit centers?”

Business Units as Profit Centers


Most business units are created as profit centers since managers in charge of such
units typically control product development, manufacturing, and marketing
resources. These managers are in a position to influence revenues and costs and as
such can be held accountable for the "bottom line." However, as pointed out in the
next section, a business unit manager's authority may be constrained in various
ways, which ought to be reflected in a profit center's design and operation.

Constraints on Business Unit Authority


To realize fully the benefits of the profit center concept, the business unit manager
would have to be as autonomous as the president of an independent company. As a
practical matter, however, such autonomy is not feasible. If a company were divided
into completely independent units, the organization would lose the advantages of
size and synergy. Furthermore in delegating to business unit management all the
authority that the board of directors has given to the CEO, senior management
would be abdicating its own responsibility. Consequently, business unit structures
represent trade-offs between business unit autonomy and corporate constraints. The
effectiveness of a business unit organization is largely dependent on how well these
trade-offs are made.

Constraints from Other Business Units.


One of the main problems occurs when business units must deal with one another. It
is useful to think of managing a profit center in terms of control over three types of
decisions:
(1) The product decision (what goods or services to make and sell),
(2) The marketing decision (how, where, and for how much are these goods or
services to be sold?), and
(3) The procurement or sourcing decision (how to obtain or manufacture the goods
or services). If a business unit manager controls all three activities, there is usually

95
no difficulty in assigning profit responsibility and measuring performance. In
general, the greater the degree of integration within a company,
the more difficult it becomes to assign responsibility to a single profit center for all
three activities in a given product line; that is, if the production, procurement, and
marketing decisions for a single product line are split among two or more business
units, separating the contribution of each business unit to the overall success of the
product line may be difficult.

Constraints from Corporate Management


The constraints imposed by corporate management can be grouped into three types:
(1) Those resulting from strategic considerations,
(2) Those resulting because uniformity is required, and
(3) Those resulting from the economies of centralization.

Most companies retain certain decisions, especially financial decisions, at the


corporate level, at least for domestic activities. Consequently, one of the major
constraints on business units results from corporate control over new investments.
Business units must compete with one another for a share of the available funds.
Thus, a business unit could find its expansion plans thwarted because another unit
has convinced senior management that it has a more

Attractive program. Corporate management .also imposes other constraints. Each


business unit has a "charter" that specifies the marketing and/or production activities
that it is permitted to undertake, and it must refrain from operating beyond its
charter, even though it sees profit opportunities in doing so. Also, the maintenance
of the proper corporate image may require constraints on the quality of products or
on public relations activities.

Companies impose some constraints on business units because of the necessity for
Uniformity. One-constraint is that business Units must conform to corporate
accounting and MCS This constraint is especially troublesome for units that have
been acquired from another company and that have been accustomed to using
different systems.

Q.3) Write Short Notes on


1. Zero Based Budgeting
2. Internal Control\

Zero Based Budgeting:

96
Zero-based budgeting is a technique of planning and decision-making which
reverses the working process of traditional budgeting. In traditional incremental
budgeting, departmental managers justify only increases over the previous year
budget and what has been already spent is automatically sanctioned. No reference is
made to the previous level of expenditure. By contrast, in zero-based budgeting,
every department function is reviewed comprehensively and all expenditures must
be approved, rather than only increases.[1] Zero-based budgeting requires the budget
request be justified in complete detail by each division manager starting from the
zero-base. The zero-base is indifferent to whether the total budget is increasing or
decreasing.

The term "zero-based budgeting" is sometimes used in personal finance to


describe the practice of budgeting every dollar of income received, and then
adjusting some part of the budget downward for every other part that needs to be
adjusted upward. It would be more technically correct to refer to this practice as
"active-balanced budgeting".

Advantages of Zero-Based Budgeting:

1. Efficient allocation of resources, as it is based on needs and benefits.


2. Drives managers to find cost effective ways to improve operations.
3. Detects inflated budgets.
4. Municipal planning departments are exempt from this budgeting practice.
5. Useful for service departments where the output is difficult to identify.
6. Increases staff motivation by providing greater initiative and responsibility in
decision-making.
7. Increases communication and coordination within the organization.
8. Identifies and eliminates wasteful and obsolete operations.
9. Identifies opportunities for outsourcing.
10.Forces cost centers to identify their mission and their relationship to overall
goals.

Disadvantages of Zero-Based Budgeting:

1. Difficult to define decision units and decision packages, as it is time-


consuming and exhaustive.
2. Forced to justify every detail related to expenditure. The R&D department is
threatened whereas the production department benefits.
3. Necessary to train managers. Zero-based budgeting must be clearly
understood by managers at various levels to be successfully implemented.
Difficult to administer and communicate the budgeting because more
managers are involved in the process.
4. In a large organization, the volume of forms may be so large that no one
person could read it all. Compressing the information down to a usable size
might remove critically important details.

97
5. Honesty of the managers must be reliable and uniform. Any manager that
exaggerates skews the results

Internal Control:

Internal control is defined as a process affected by an organization's structure,


work and authority flows, people and management information systems, designed
to help the organization accomplish specific goals or objectives.[1] It is a means by
which an organization's resources are directed, monitored, and measured. It plays
an important role in preventing and detecting fraud and protecting the
organization's resources, both physical (e.g., machinery and property) and
intangible (e.g., reputation or intellectual property such as trademarks). At the
organizational level, internal control objectives relate to the reliability of financial
reporting, timely feedback on the achievement of operational or strategic goals, and
compliance with laws and regulations. At the specific transaction level, internal
control refers to the actions taken to achieve a specific objective (e.g., how to
ensure the organization's payments to third parties are for valid services rendered.)
Internal control procedures reduce process variation, leading to more predictable
outcomes

Describing Internal Controls:

Internal controls may be described in terms of: a) the objective they pertain to; and
b) the nature of the control activity itself.

Objective categorization

Internal control activities are designed to provide reasonable assurance that


particular objectives are achieved, or related progress understood. The specific
target used to determine whether a control is operating effectively is called the
control objective. Control objectives fall under several detailed categories; in
financial auditing, they relate to particular financial statement assertions,[5] but
broader frameworks are helpful to also capture operational and compliance aspects:

1. Existence (Validity): Only valid or authorized transactions are processed (i.e.,


no invalid transactions)
2. Occurrence (Cutoff): Transactions occurred during the correct period or were
processed timely.
3. Completeness: All transactions are processed that should be (i.e., no
omissions)
4. Valuation: Transactions are calculated using an appropriate methodology or
are computationally accurate.
5. Rights & Obligations: Assets represent the rights of the company, and
liabilities its obligations, as of a given date.

98
6. Presentation & Disclosure (Classification): Components of financial
statements (or other reporting) are properly classified (by type or account)
and described.
7. Reasonableness-transactions or results appear reasonable relative to other
data or trends.

Activity categorization

Control activities may also be described by the type or nature of activity. These
include (but are not limited to):

• Segregation of duties - separating authorization, custody, and record keeping


roles to limit risk of fraud or error by one person.
• Authorization of transactions - review of particular transactions by an
appropriate person.
• Retention of records - maintaining documentation to substantiate transactions.
• Supervision or monitoring of operations - observation or review of ongoing
operational activity.
• Physical safeguards - usage of cameras, locks, physical barriers, etc. to
protect property.
• Analysis of results, periodic and regular operational reviews, metrics, and
other key performance indicators (KPIs).
• IT Security - usage of passwords, access logs, etc. to ensure access restricted
to authorized personnel. S

Q4 .Veena Pvt. Ltd., a small multiproduct company is taken over by a


multinational company ( e.g. Hindustan Lever.) What changes in the control
system would you expect and why?

Since Veena is a small multiproduct company it would require changes in control


system which would be related to transfer pricing a, as this company would
generally provide inputs to HUL. Thus the domestic operations generally involve
transfer of goods and services only In view of this difference many other
considerations, in addition to the criteria used in domestic operations for the
determination of transfer price, are involved. These include:

(a) Fair Price: This is an important factor one needs to consider while determining
the transfer price for foreign operations. Companies that enter into joint ventures
must ensure that the transfer price charged is fair. If such companies charge a higher
transfer price, it would reduce the profits of the joint venture and as a result reduce
the foreign partner's share of profits.

(b) Government Regulations: All countries have a regulatory framework under


which business units operate. Where government rules and regulations regarding
transfer prices are lenient, the parent company should fix a higher transfer price for

99
all transfers to countries with high income tax rates. This approach would enable the
parent company to minimize taxes in such countries.

(c) Exchange Control Restrictions: Every country has foreign exchange control
regulations.
These regulations impose a limit on the amount of foreign exchange available for
the import of certain goods. To accommodate the foreign subsidiary the parent
company may have a lower transfer price so that the subsidiary is able to import a
larger quantity of required goods.

(d) Income Tax Regulations: The rates of income tax vary from country to country.
To overcome this difference the transfer price should be so fixed that countries with
low tax rates show profits while others end up with a loss. This helps the parent
company to reduce its taxes on a global basis.

(e) Desire to accumulate funds: A company that wishes to accumulate funds in a


particular country may fix the transfer prices in such a manner that it facilitates
shifting of funds into that country.

(I) Tariffs- and Duties: No country likes high imports. In order to restrict imports
countries impose restrictions such as quantitative restrictions, high duties and tariffs
and banning import of products. The general practice is to charge import duties as a
percentage of the value of products imported, although a lower tariff may be levied
if the import value is lower. It is seen that the impact of tariffs on the profitability of
foreign operations is generally the reverse of the incidence of income taxes in
transfer pricing. As such a low transfer price would lead to low import duties on
transfer, the profit arising in that country would be high. This results in high income
taxes in that country. It is therefore advisable that companies must compute the net
effect of these factors while determining transfer prices.

In designing performance evaluation systems for acquired Veena company,HUL


could use the following guidelines

Subsidiary managers should not be held responsible for translation effects. The
simplest way to achieve this objective is to compare budgets and actual results using
the same metric and isolate inflation-related effects through variance analysis. It is
pointless for managers to worry about the appropriate metric. The MNE should
choose whatever metric is more convenient.

Transaction effects are best handled through centralized coordination of the MNE's
overall hedging needs. This is likely to be cheaper and simpler, and it prevents the
subsidiary manager from becoming a foreign exchange rate forecaster and
speculator.

100
The subsidiary manager should be held responsible for the dependence effects of
exchange rates resulting from economic exposure.

Evaluation of the subsidiary as a basis for a decision to locate operations in a


country or to relocate operations from a country should reflect the consequences of
translation. Transaction and economic exposures.

SET 10

Q.1) What are the Special Characteristics of Professional Service Organization?

Answer:

Goals
A dominant goal of a manufacturing company is to earn a satisfactory profit,
specifically a satisfactory return on assets employed. A professional organization
has relatively few tangible assets; its principal asset is the skill of its professional
staff, which 'doesn't appear on its balance sheet. Return on assets employed,
therefore, is essentially meaningless in such organizations. Their financial goal is to
provide adequate compensation to the professionals.

In many organizations, a related goal is to increase their size. In part, this reflects
the natural tendency to associate success with large size. In part, it reflects
economies of scale in using the efforts of a central personnel staff and units
responsible for keeping the organization up-to-date. Large public accounting firms
need to have enough local offices to enable them to audit clients who have facilities
located throughout the world.

Professionals
Professional organizations are labor intensive, and the labor is of a special type.
Many professionals prefer to work independently, rather than as part of a team.
Professionals who are also managers tend to work only part time on management
activities; senior partners in an accounting firm participate actively in audit
engagements; senior partners in law firms have clients. Education for most
professions does not include education in management, but quite naturally stresses
the skills of the profession, rather than management; for this and other reasons,
professionals tend to look down on managers.

Professionals tend to give inadequate weight to the financial implications of their


decisions; they want to do the best job they can, regardless of its cost. This attitude
affects the attitude of support staffs and nonprofessionals in the organization; it
leads to inadequate cost control.

Output and Input Measurement

101
The output of a professional organization cannot be measured in physical terms,
such as units, tons, or gallons. We can measure the number of hours a lawyer spends
on a case, out this is a measure of input, not output. Output is the effectiveness of
the lawyer's work, and this is not measured by the number of pages in a brief or the
number of hours in the courtroom. We can measure the number of patients a
physician Teats in a day, and even classify these visits by type of complaint; but this
is by no means equivalent to measuring the amount or quality of service the
physician has provided. At most, what is measured is tl1e physician's efficiency in
treating patients, which is of some use in identifying slackers and hard workers.
Revenues earned is one measure of output in some professional organizations, but
these monetary amounts, at most, relate to the quantity of services rendered, not to
their quality (although poor quality is reflected in reduced revenues in the long run).

Furthermore, the work done by many professionals is non repetitive. No two


consulting jobs or research and development projects are quite the same. This
makes it difficult to plan the time required for a task, to set reasonable standards for
task performance, and to judge how satisfactory the performance was. Some tasks
are essentially repetitive: the drafting of simple wills, deeds, sales contracts, and
similar documents; the taking of a physical inventory by an auditor; and certain
medical and surgical procedures. The development of standards for such tasks may
be worthwhile, although in using these standards, usual circumstances that affect a
specific job must be taken into account. Some professionals, notably scientists,
engineers, and professors, are reluctant to keep track of how they spend their time,
and this complicates the task of measuring performance. This reluctance seems to
have its roots in tradition; usually, it can be overcome if senior management is
willing to put appropriate emphasis on the necessity of accurate time reporting.
Nevertheless, difficult problems arise in deciding how time should be charged to
clients.

If the normal work week is 40 hours, should a job be charged for 1140th of a week's
compensation for each hour spent on it? If so, how should work done on evenings
and weekends be counted? (Professionals are "exempt" employees-that is, they are
not subject to government requirements of overtime payments.) How to account for
time spent reading literature, going to meetings, and otherwise keeping up-to-date?

Small Size
With a few exceptions, such as some law firms and accounting firms, professional
organizations are relatively small and operate at a single location. Senior
management in such organization can personally observe what is going on and
personally motivate employees. Thus, there is less need for a sophisticated
management control system, with profit centers and formal performance reports.
Nevertheless, even a small organization needs a budget, a regular comparison of
performance against budget, and a way of relating compensation to performance.

102
How is Marketing done in them?
In a manufacturing company there is a clear dividing line between marketing
activities and production activities; only senior management is concerned with both.
Such a clean separation does not exist in most professional organizations. In some,
such as law, medicine, and accounting, the profession's ethical code limits the
amount and character of overt marketing efforts by professionals (although these
restrictions have been relaxed in recent years). Marketing is an essential activity in
almost all organizations, however. If it can't be conducted openly, it takes the form
of personal contacts, speeches, articles, conversations on the golf course, and so on.
These marketing activities are conducted by professionals, usually by professionals
who spend much of their time in production work-that is, working for clients.
In this situation, it is difficult to assign appropriate credit to the person responsible
for "selling" a new customer. In a consulting firm, for example, a new engagement
may result from a conversation between a member of the firm and an acquaintance
in a company, or from the reputation of one of the professionals as an outgrowth of
speeches or articles.
Moreover, the professional who is responsible for obtaining the engagement may
not be personally involved in carrying it out. Until fairly recently, these marketing
contributions were rewarded subjectively-that is, they were taken into account in
promotion and compensation decisions. Some organizations now give explicit
credit, perhaps as a percentage of the project's revenue, if the person who "sold" the
project can be identified.

How do we evaluate the Performance Appraisal?


As noted earlier in regard to teachers, at the extremes the performance of
professionals is easy to judge. Appraisal of the large percentage of professionals
who are within the extremes is much more difficult. For some professions, objective
measures of performance are sometimes unavailable: The recommendations of an
investment analyst can be compared with actual market behavior of the securities;
the accuracy of a surgeon's diagnosis can be verified by an examination of the tissue
that was removed; and the doctors' skill can be measured by the success ratio of
operations. These measures are, of course, subject to appropriate qualifications, and
in most circumstances the assessment of performance is finally a matter of human
judgment by superiors, peers, self, subordinates, and clients. Judgments made by
superiors are the most common. For these, professional organizations increasingly
use formal systems to collect performance appraisals as a basis for personnel
decisions and for discussion with the professional. Some systems require numerical
ratings of specified attributes of performance and provide for a weighted average of
these ratings. Compensation may be tied, in part, to these numerical ratings. In a
matrix organization, both the project leader and the head of the functional unit that
is the professional's organizational "home" judge performance. "

Appraisals by a professional's peers, or by subordinates, are sometimes part of a


formal control system. In some organizations, individuals may be asked to make a

103
self-appraisal. Expressions of satisfaction or dissatisfaction from clients are also an
important basis for judging performance, although such expressions may not always
be readily forthcoming.

The budget can be used as the basis for measuring cost performance, and the actual
time taken can be compared with the planned time. Budgeting and control of
discretionary expenses are as important in a professional firm as in a manufacturing
company.

Such financial measures are relatively unimportant in assessing a professional's


contribution to the firm's, profitability, however. The professional's major
contribution is related to quantity and above all quality of work, and its appraisal
must be largely subjective. Furthermore, the appraisal must be made currently; it
cannot wait until one learns whether a new building is well designed, a new control
system actually works well, or a bond indenture has a flaw.

In some professions, internal audit procedures are used to control quality. In many
accounting firms, the report of an audit is reviewed by a partner other than the one
who is responsible for it, and the work of the whole firm is "peer reviewed" by
another firm. The proposed design of a building may be reviewed by architects who
are not actively involved in the project.

Q.2) What is a Non - Profit Organization? How is the performance of this


organization evaluated?

Answer:

Introduction
A nonprofit organization, as defined by law, is an organization that cannot distribute
assets or income to, or for the benefit of, its members, officers, or directors. The
organization can, of course, compensate its employees, including officers and
members, for services rendered and for goods supplied. This definition does not
prohibit an organization from earning a profit; it prohibits only the distribution of
profits. A nonprofit organization needs to earn a modest profit, on average, to
provide funds for working capital and for possible “rainy days.”

Performance evaluation of nonprofit organization


For any organization, the most important reasons to measure performance are to
improve effectiveness and to acquire information that will allow the organization to
drive its agenda forward. If the motivation for doing evaluation remains outside an
organization, the evaluation will have limited impact. To do performance
assessment effectively, an organization must commit to adopting a culture of
measurement, because acceptance must come from senior management, staff,
funders, and board members alike.

104
 Board self-evaluation
Members of the Board of Directors should regularly evaluate the quality of their
activities on a regular basis. Activities might include staffing the Board with new
members, developing the members into well-trained and resourced members,
discussing and debating topics to make wise decisions, and supervising the CEO.
Probably the biggest problem with Board self-evaluation is that it does not occur
frequently enough. As a result, Board members have no clear impression of how
they are performing as members of a governing Board. Poor Board operations,
when undetected, can adversely affect the entire organization.
 Staff and volunteer (individual) performance evaluation
Most of us are familiar with employee performance appraisals, which evaluate the
quality of an individual’s performance in their position in the organization. Ideally,
those appraisals reference the individual’s written job description and performance
goals to assess the quality of the individual’s progress toward achieving the desired
results described in those documents. Continued problems in individual
performance often are the results of poor strategic planning, program planning and
staff development. If overall planning is not done effectively, individuals can
experience continued frustration, stress and low morale, resulting in their poor
overall performance. Experienced leaders have learned that continued problems in
performance are not always the result of a poor work ethic – the recurring problems
may be the result of larger, more systemic problems in the organizations.
 Program evaluation
Program evaluations have become much more common, particularly because donors
demand them to ensure that their investments are making a difference in their
communities. Program evaluations are typically focused on the quality of the
program’s process, goals or outcomes. An ineffective program evaluation process
often is the result of poor program planning – programs should be designed so they
can be evaluated. It can also be the result of improper training about evaluation.
Sometimes, leaders do not realize that they have the responsibility to verify to the
public that the nonprofit is indeed making a positive impact in the community.
When program evaluations are not performed well, or at all, there is little feedback
to the strategic and program planning activities. When strategic and program
planning are done poorly, the entire organization is adversely effected.
 Evaluation of cross-functional processes
Cross-functional processes are those that span several systems, such as programs,
functions and projects. Common examples of major processes include information
technology systems and quality management of services. Because these cross-
functional processes span so many areas of the organization, problems in these
processes can be the result of any type of ineffective planning, development and
operating activities.
 Organizational evaluation
Ongoing evaluation of the entire organization is a major responsibility of all leaders
in the organization. Leaders sometimes do not recognize the ongoing activities of

105
management to actually include organizational evaluations – but they do. The
activities of organizational evaluation occur every day. However, those evaluations
usually are not done systematically. As a result, useful evaluation information is not
provided to the strategic and program planning processes. Consequently, both
processes can be ineffective because they do not focus on improving the quality of
operations in the workplace.

Q.3) A Well Diversified company – Pritam International Ltd. sells one of its
divisions to a group of its own company managers. Explain what significant
changes in systems and control procedures can be expected? Why?

Answer:
As, we Pritam International is a well diversified company. Sometimes, excessive
diversification and that too in unrelated lines of business causes failure in the
business operations. One of the major reason for failures of many Mergers and
Diversification is excessive diversification. As, excessive diversification is ominous
especially, in unrelated lines of business. As, there may be no advantage of
operating synergy. Neither through:

I) Sharing common resources nor


II) Sharing common core competencies
Therefore, it may be a strategic decision by the promoters and directors of the
company to sell one of its divisions. As, this may be impacting their core business.
Sometimes, your core business tends to get neglected mainily due to excesive
diversification. As, the division is being sold to its own company managers. There,
might not be major changes in management control and systems. As, most of its
managers will be the same. But, they will have more autonomy to take decisions
independently after acquisition. Now there will be less red tapism and managers can
take more risk. The managers will manage the firm in their own style. As, they are
not answerable to their superiors.

Currently, they are answerable to their stake-holders. As, the management is


completely in their hands and that too with full autonomy. The management might
have identified the flaws in the previous controls and systems of the company
because of which the company might not be so effective and efficient. As, they have
been associated with the company over aperiod of time. They have a better
understanding about the business dynamics and environment in which the firm
operates. So, they can take necessary steps to overcome the flaws and improve the
management control and systems.
So, that is why there will be some significant changes in the management control
and systems and procedures if there is further scope for improvement.

SET 11

106
Q.1)Why Balance Score Card is considered superior to other methods of
Performance Appraisal? Prepare Balance Score Card for any organization you
are familiar with.

ANSWER:

What is the Balanced Scorecard?


The rationale for the development of the Balanced Scorecard was a growing
dissatisfaction with traditional, financial measures of performance. These measures
suffer from a number of serious drawbacks in that they take a short-term, lagged
(i.e., historic) view of performance. The shift towards flexible, lean
production/service systems in many firms has strengthened the requirement for
performance measurement systems to become more broadly based, incorporating
both non-financial and external measures of performance. According to Kaplan and
Norton, the Balanced Scorecard provides a better assessment of performance as it
"enables companies to track financial results while simultaneously monitoring
progress in building the capabilities and acquiring the intangible assets they need for
future growth".

The original scorecard designed by Kaplan and Norton contained four key
groupings of performance measures. These four groupings, called ‘perspectives’ by
Kaplan and Norton, were considered sufficient to track the key drivers of both
current and future financial performance of the firm. The perspectives focused on
the achievements of the firm in four areas: namely the financial, customer, internal
business process and innovation/learning perspectives. The four perspectives can be
represented as an interlinked hierarchy. The firm’s strategy underlies the whole
scorecard, as the measures for each of the four perspectives are drawn from this
strategy.

To obtain a satisfactory overview of performance, the scorecard will require a mix


of lagging and leading (forward looking) measures. Financial measures tend to be

107
lagged and consequently, the measures chosen for the other perspectives will need
to include leading measures. In general, outcome measures tend to be lagged, for
example, current market share is the result of past decisions and consequently is a
lagging measure. Thus the challenge in designing a Balanced Scorecard is to choose
driver measures which lead changes in the outcome measures in the non-financial
perspectives and which ultimately drive the financial measures.

Once the firm’s objectives have been agreed and the appropriate outcome and driver
measures chosen for each of the perspectives, firm and managerial performance is
assessed by comparing actual attainment on each measure with the target set for that
measure.

Objective Measure Target Actual

Benefits from adopting the Balanced Scorecard


There are several benefits from implementing a Balanced Scorecard. Originally the
Balanced Scorecard was seen as a useful tool for performance measurement. In this
role, the Balanced Scorecard was seen as integrating financial/non-financial,
internal/external and leading /lagging information on firm performance in a
coherent fashion.

Later it was realised that the Balanced Scorecard could play a pivotal role in the
strategic management process. Because the Balanced Scorecard requires
management to clarify and obtain consensus on the strategic objectives of the firm,
it can assist in the communication of the chosen strategy, consequently aligning the
efforts both of individuals and of departments. In this role, there is a clear link
between the Balanced Scorecard and management by objectives (MBO). Effective
implementation of a Balanced Scorecard project will generally involve the
development of a series of hierarchical (cascaded) scorecards. Given the overall
corporate scorecard, supporting scorecards can be developed for each department
within the firm. Within each department, a scorecard can be developed for each
manager (or perhaps even for each individual member of staff) which links the
objectives on each perspective for that manager back to the objectives for each
perspective outlined in the scorecard for the department and finally, back to the
objectives listed in the firm’s overall scorecard.

108
The Balanced Scorecard could be used to assist in corporate restructuring. In recent
years, many firms have migrated away from a traditional hierarchical structure to a
flatter, team-based organisational structure. The Balanced Scorecard can support
such changes, as it can help clarify the objectives and the critical success factors for
the newly formed teams.

Apart from the communication and co-ordination roles of the Balanced Scorecard in
strategic implementation, the Balanced Scorecard can be used to link strategy to
specific critical success factors in the customer, internal business process and
growth/learning perspectives. By setting both short and long-term targets for driver
and outcome measures and by comparing actual attainment against target, feedback
is obtained on how well the strategy is being implemented and on whether the
strategy is working.

Building on the Balanced Scorecard’s use as a strategic management tool, it has


been suggested that the Balanced Scorecard can play a role in the investment
appraisal process(5). Traditional methods of investment appraisal such as
discounted cash flow do not cope well with investments which generate indirect
rather than direct financial returns. Examples of these include investments which
enhance the future ‘flexibility’ of a firm or investments in the firm’s infrastructure,
such as an enhanced management information system. The Balanced Scorecard can
assist management’s investment appraisal decisions as it provides managers with a
mechanism to incorporate the strategic aspects of the investment into the appraisal
process. This could be achieved by using a weighting system developed from a
firm’s Balanced Scorecard measures to evaluate new projects. An index score
would be calculated for each investment opportunity and projects would then be
ranked and selected based on this score.

Balance Score Card of Credit Card Company

109
Q .2)Soniya Company has two Divisions: A & B. Return on Investment for
both divisions is 20%. Details are given below:-

Particulars Div A Div B


Divisional sales 4000000 9600000
Divisional Investment 2000000 3200000
Profit 400000 640000
Analyse and comment on divisional performance of each.

ANSWER

As Profit Margin = Profit *100


Sales

Profit Margin for Division ‘A’= 4,00,000 /40,00,000 *100 = 10%

Profit Margin for Division ‘B’ = 6,40,000/ 96,00,000 *100 = 6.6%

Turnover of Investment = Sales * 100

Investment

110
Turnover of Investment for Division ‘A’ = 40,00,000/20,00,000 = 2 times

Turnover of Investment for Division ‘B’ = 96,00,000/32,00,000 = 3 times

As Return on investment for both Divisions A and B is 20%.

COMMENTS:-

Division ‘A’ – Although ‘A’ has more profit margin than Division ‘B’ that is 10%
as compared to 6.6% of ‘B’, so it has more profitability but inspite of it, division
‘A’ has lower turnover of investment that its assets management is bad than
Division ‘B’, it can be improved by increased sales or reducing investment.

Division ‘B’ – Needs to improve profit margin by increasing sales and reduce
variable cost and sales at same price or by reducing salesprice and increase the
volume of sales so that its profit would improve. As it has good assets management
shown by its turnoverof Division ‘B’ that is 3 times which is better than Division
‘A’. So it can become profitable organisation by improving Profit Margin.

Q.4)Discuss and illustrate differences and similarities between

- Strategy Formulation and Management Control

- Management Control and Task Control

ANSWER

Some Distinction between Strategy Formulation and management Control

Characteristics Strategy Formulation Management Control


a) Focus of plan On one aspect at a time On entire organisation
b) Complexities Many variables hence Less complex
complex
c) Nature of information Tailor-made for the Integrated, more internal
issue, more external and and historical, more
predictive, less accurate. accurate.
d) Structure Unstructured and Rhythmic, definite

111
irregular, each problem pattern, set procedure
being different
e) Communication of Relatively simple Relatively difficult
information
f) Purpose of estimates Show expected results Lead to desired result
g) Persons involved Staff and top Line and top
management management
h) No. of persons Small Large
involved
i) Mental activity Creative, analytical Administrative,
persuasive
j) Planning and control Planning dominant but Emphasis on both
some control planning and control
k) Time horizon Tends to be long Tends to be short
l) End result Policies and precedents Action within policies
laid
m) Appraisal of job done Extremely difficult Less difficult

112
b) Some Distinction between Management Control and Task Control

Characteristics Task Control Management control


a) Focus of plan Single task or transaction On entire organisation
b) Nature of information Tailor-made to Integrated, more internal
operation, specific, often and historical, more
non- financial, real time accurate
c) Persons involved Supervisors Line and top
management
d) Mental activity Follow directives or Administrative,
none as in case of persuasive
machines or set
objectives
e) Time horizon Day to day Tends to be short
f) Type of cost Engineered- Existence of Discretionary- Control is
objective standard more difficult due to
against which actuals can subjective consideration.
be compared makes
control easier.

SET 12

Q.2 Suresh Ltd. (Numerical) (MCS-2007)

(a) Define profit in this case and prepare a statement for both divisions and
overall company.

Solution:

i) Profitability statement of Division A:-

113
Particulars Amount(Rs.)
Selling price p.u. 35
Variable Cost p.u. 11
Contribution p.u. 24

Contribution Expected sales Total Total Fixed Net profit


p.u. (no. of units) contribution cost (Rs.) (Rs.)
24 2000 48000 60000 (12000)
24 3000 72000 60000 12000
24 6000 144000 60000 84000

ii) Profitability statement of Division B:-

Selling Total Contribution Expected Total Total Net


p.u. variable p.u. sales (no. contribution Fixed profit
cost p.u. of units) cost (Rs.)
(Rs.)
90 42 48 2000 96000 90000 6000
80 42 38 3000 114000 90000 24000
50 42 8 6000 48000 90000 (42000)
[Note: Total Variable cost p.u. = Variable cost p.u. (Rs.7) + Transfer price of
intermediate product (Rs.35)]

iii) Profitability statement of Company as a whole:-

Expected sales Net profit of Net profit of Total Net profit


division A (Rs.) Division B (Rs.)
2000 (12000) 6000 (6000)
3000 12000 24000 36000
6000 84000 (42000) 42000

114
(b) State the selling price which maximizes profits for division B and company as
a whole. Comment on why the latter price is unlikely to be selected by
division B.

Solution:

As per the calculation in part (a), selling price p.u. of Rs.80 maximizes profit for
division B whereas selling price p.u. of Rs.50 maximizes profit for the Company
as a whole. However, if Division B opts for selling price p.u. of Rs.50 in order to
maximize Company’s profit, it would suffer a loss of Rs.42000. Therefore,
Division B would not select Selling price p.u. of Rs.50.

115
116
Q.3 Explain different organizational goals. Comment on goal of shareholder
value maximization in particular.
Goals

Although we often refer to the goals of a corporation, a corporation does not have
goals; it is an artificial being with no mind or decision-making ability of its own.
Corporate goals are determined by the chief executive officer (CEO) of the
corporation, with the advice of other members of senior management, and they are
usually ratified by the board of directors. In many corporations, the goals originally
set by the founder persist for generations. Examples are Henry Ford, Ford Motor
Company; Alfred P. Sloan, General Motors Corporation; Walt Disney, Walt Disney
Company; George Eastman, Eastman Kodak; and Sam Walton, Wal-Mart.
Economic Goals
Shareholder's value, Earning per share and Market value, all relate to maximizing
shareholder's value, which is not a desirable goal, because what is 'maximum' is
difficult to determine. Although optimizing shareholder value may be one goal, but
there are other stakeholders in the business also such as customers, employees,
creditors, community and so on. Again, shareholder value is usually equated with
the market value of the company's stock. But market value is not an accurate
measure of the worth of shareholders' investments. Besides, such value can be
obtained only when the share is traded in the stock exchange.
It is interesting to note that Henry Ford's operating philosophy was 'satisfactory
profit', not 'maximum profit'. He said, "A reasonable profit is right, but not too
much. So, it has been my policy to force the price of the car down as fast as
production would permit and give the benefit to the user and laborers, with resulting
surprisingly enormous benefit to ourselves"
Other goals such as adding new products, or product-line or new business
actually indicate normal organizational growth.

Social Goals
However, every organization has its share of responsibility towards the local
community where it is situated, and the public at large. It is very difficult to
incorporate in Management Control System such goals as taking pride in an
organization which cares for the society and renders service to the public. Of
course, any concrete structural programme indicating its operational expenses,
methods of providing service, personnel involved in rendering service and the
nature of the service in details can, however, be mentioned through an
appropriate system.

Profitability

In a business, profitability is usually the most important goal.


Return on investment can be found by simply dividing profit (i.e., revenues
minus expenses) by investment, but this method does not draw attention to the two
principal components: profit margin and investment turnover.
In the basic form of this equation, "investment" refers to the shareholders'
investment, which consists of proceeds from the issuance of stock, plus retained
earnings.
One of management's responsibilities is to arrive at the right balance between the
two main sources of financing: debt and equity. The shareholders' investment (i.e.,

117
equity) is the amount of financing that was not obtained by debt, that is, by
borrowing. For many purposes, the source of financing is not relevant;
"investment" thus means the total of debt capital and equity capital.
"Profitability" refers to profits in the long run, rather than in the current quarter or
year. Many current expenditure (e.g., amounts spent on advertising or research and
development) reduce current profits but increase profits over time.
Some CEOs stress only part of the profitability equation. Jack Welch, former
CEO of General Electric Company, explicitly focused on revenue; he stated that
General Electric should not be in any business in which its sales revenues were not
the largest or the second largest of any company in that business. This does not
imply that Welch neglected the other components
of the equation; rather, it suggests that in his mind there was a close correlation
between market share and return on investment.
Other CEOs, however, emphasize revenues for a different reason: For them,
company size is a goal. Such a priority can lead to problems. If expenses are too
high, the profit margin will not give shareholders a good return on their
investment. Even if the profit margin is satisfactory, the organization may still not
earn a good return if the investment is too large.
Some CEOs focus on profit either as a monetary amount or as a percentage of
revenue. This focus does not recognize the simple fact that if additional profits are
obtained by a greater than proportional increase in investment, each dollar of
investment has earned less.

Maximizing Shareholder Value


In the 1980s and 1990s the term shareholder value appeared frequently in the
business literature. This concept is that the appropriate goal of a for-profit
corporation is to maximize shareholder value. Although the meaning of this term
was not always clear, it probably refers to the market price of the corporation's
stock. We believe, however, that achieving satisfactory profit is a better way of
stating a corporation's goal, for two reasons.
First, "maximizing" implies that there is a way of finding the maximum amount
that a company can earn. This is not the case. In deciding between two courses of
action, management usually selects the one it believes will increase profitability the
most. But management rarely, if ever, identifies all the possible alternatives and
their respective effects on profitability. Furthermore, profit maximization requires
that marginal costs and a demand curve be calculated, and managers usually do not
know what these are. If maximization were the goal, managers would spend every
working hour (and many sleepless nights) thinking about endless alternatives for
increasing profitability; life is generally considered to be too short to warrant such
an effort.
Second, although optimizing shareholder value may be a major goal, it is by no
means the only goal for most organizations. Certainly a business that does not earn
a profit at least equal to its cost of capital is not doing its job; unless it does so, it
cannot discharge any other responsibilities. But economic performance is not the
sole responsibility of a business, nor is shareholder value. Most managers want to
behave ethically, and most feel an obligation to other stakeholders in the
organization in addition to shareholders.
Example: Henry Ford's operating philosophy was satisfactory profit, not
maximum profit. He wrote let me say right here that I do not believe that we
should make such an awful profit on our cars. A reasonable profit is right, but
not too much. So it has been my policy to force the price of the car down as fast
as production would permit, and give the benefits to the users and laborers-with
resulting surprisingly enormous benefits to ourselves.
By rejecting the maximization concept, we do not mean to question the validity of
certain obvious principles. A course of action that decreases expenses without

118
affecting another element, such as market share, is sound. So is a course of action
that increases expenses with a greater than proportional increase in revenues, such
as expanding the advertising budget. So, too, are actions that increase profit with a
less than proportional increase in shareholder investment (or, of course, with no
such increase at all), such as purchasing a cost-saving machine. These principles
assume, in all cases, that the course of action is ethical and consistent with the cor-
poration's other goals.
An organization's pursuit of profitability is affected by management's willingness to
take risks. The degree of risk-taking varies with the personalities of individual
managers. Nevertheless there is always an upper limit; some organizations
explicitly state that management's primary responsibility is to preserve the
company's assets, with profitability considered a secondary goal. The Asian
.financial crisis during 1996-1998 is traceable, in large part, to the fact that banks in
Asia's emerging markets made what appeared to be highly profitable loans without
paying adequate attention to the level of risk involved.

119
Multiple Stakeholder Approach
Organizations participate in three markets: the capital market, the product market,
and the factor market. A firm raises funds in the capital market, and the public
stockholders are therefore an important constituency. The firm sells its goods and
services in the product market, and customers form a key constituency. It competes
for resources such as human capital and raw materials in the factor market and the
prime constituencies are the company's employees and suppliers and the various
communities in which the resources and the company's operations are located.
The firm has a responsibility to all these multiple stakeholders-shareholders,
customers, employees, suppliers, and communities. Ideally, its management control
system should identify the goals for each of these groups and develop scorecards to
track performance.
Example: In 2005, the Acer Group, headquartered in Taiwan, was one of the
largest computer companies The Company subscribed to the multiple
stakeholder approach and managed its internal operations to satisfy the needs
of several constituencies. To quote Stan 'Shih,-the founder, "The customer is
number 1, the employee is number 2, the shareholder is number 3. I keep this
message consistent with all my colleagues. I even consider the company's
banks, suppliers, and others we do business with are our stakeholders; even
society is stakeholder. I do my best to run the company that way."
Lincoln Electric Company is well known for its philosophy that employee
satisfaction was more important than shareholder value. James Lincoln wrote: "The
last group to be considered is the stockholders who own stock because they think it
will be more profitable than investing more in any other way. The absentee
stockholder is not' of any value to the customer or to the worker, since he has no
knowledge of nor interest in the company other than greater dividends and advance
in the price of his stock." Donald F. Hastings, chairman and chief executive officer,
emphasized that this was still the company's philosophy in 1996.

Q.4 Explain and illustrate with one example differences between 3 forms of
internal audit- Financial, Operational & Management.

Financial Audit-
Financial Audit is a historically oriented, independent evaluation performed by
internal auditor or external auditor for the purpose of attesting to the fairness,
accuracy and reliability of the financial data, providing protection for the entity's
assets; evaluating the adequacy and accomplishment of the system (internal control)
designed,
provide for the aforementioned Fairness and Protection, Financial data, while not
being the only source of evidence, are the primary evidential source. The evaluation
is
performed on a planned basis rather than a request".

Institute of Internal Auditor:-


Financial audit takes care of the protective aspect of the business and it does not
normally carry out constructive appraisal function of the business operations. It
helps in detection and prevention of fraud. It also verifies whether documentation
and flow of activities arc in conformity with the internal control system introduced
and developed within the organization. It helps coordinating with statutory auditor
to help them in proper discharge of their function. Besides, financial audit also
ensures compliance with statutory laws especially in financial and accounting

120
matters.

Objectives of Financial Audit:

-To see that established accounting systems and procedures have been complied
with
-To see that proper records have been maintained for the fixed assets of the
Concern to look into correctness of the financial data and records along with
correctness of the accounting procedure followed.
-To see whether scrap, salvage and surplus materials have been properly accounted
for etc.
-To see that internal control system has been working properly.
-To see that any abrupt variation in sales, purchases etc.; with respect to immediate
previous year are not due to any irregularity
-To see that the credit control has been strictly followed.
-To see that all payments have been made with proper authorization and
approval. .
-To see that preparation of salary and wage pay roll has been properly done.
budgetary control system, if any scope and performance of internal audit, if any,
suggestions for improvements in performance, if any, and improved inventory
policies.
The opinion expressed by the auditors shall be based on verified data, reference to
ich shall also be made here and, if practicable, included after the company has been
forded on opportunity to comment on them.

Management Audit
It is a complex task closely related with the process of management. It is highly
result oriented. It requires inter/multi-disciplinary approach as it involves
examination, review and appraisal of various policies and actions of management on
the basis of certain norms/standards.
It undertakes comprehensive and critical review of all organizational activities
with wider perspective.
It goes beyond conventional audit and audits the efficacy of the management
itself.
Definition:
It's a comprehensive and constructive examination of an organization, the
structure of a company, institution or branch of government or of any components
thereof, such as division or department and its plans, objectives, its means of
operations and its use of human and physical facilities.
William P. Leonard
It's an investigation of a business from the higher level downwards in order to
ascertain whether sound management prevails throughout, thus facilitating the
most effective relationship with the outside world and the most efficient and
smooth running internally.
Leslie Howard
It is an audit performed with the object of examining the efficacy of the
121
institution/control systems, management procedures towards the achievement of
enterprise goals.
Churchill & Cyert
It is an objective and independent appraisal of the effectiveness of managers and
the effectiveness of the corporate structure in the achievement of company
objectives and policies. Its aim is to identify existing and potential management
weaknesses within an organization and to recommend ways to rectify these
weaknesses.
Chartered Institute of Management Accountants
London
Thus it can be seen that management audit is an examination, review and
appraisal of the various policies and actions of the management. It is a tool for
the evaluation of methods and performance in all the areas of the enterprise.
Objectives:
1. To ascertain the provision of proper control at different levels, their effectiveness
I in accomplishing management goals.
2. Ascertain objectives of the organization are properly communicated and
understood at all levels.
3. To reveal defects or irregularities in any of the elements examined and to indicate
what improvements are possible to obtain the best results of the operations of the
company.
4. To assist the management to achieve the most efficient administration of its
operations.
5. To suggest to the management the ways and means to achieve the objectives if
the management of the organization itself lacks the knowledge of efficient
management.
6. It aims to achieve the efficiency of management and assess the strength and
weaknesses of the organization structure, its management team and its corporate
culture.
7. To ascertain the provision of proper control at different levels, their effectiveness
in
accomplishing management goals.
8. Ascertain objectives of the organization are properly communicated and
understood at all levels.
9. To reveal defects or irregularities in any of the elements examined and to indicate
what improvements are possible to obtain the best results of the operations of the
company.
10. To assist the management to achieve the most efficient administration of its
operations.
11. To suggest to the management the ways and means to achieve the objectives if
the
management of the organization itself lacks the knowledge of efficient
management.
12. It aims to achieve the efficiency of management and assess the strength and
122
weaknesses of the organization structure, its management team and its corporate
culture.
13. To help the management at all levels in the effective and efficient discharge of
their duties and responsibilities.
The auditor must apprise managerial performance at all levels of the
organization. The audit starts right at the top level of the management. It studies the
managerial performance at all the levels of management. The audit has to study the
decision-making system of the organization and also the level of autonomy granted
to the managers at different levels of the organization. The authority and
responsibility given at the different levels of the management. One of the most
important things that the audit must study is that the mangers at various levels use
the authority.

Conducting Management Audit


Management audit requires an interdisciplinary approach since it involves a
review of all aspects of management functions. It has to be conducted by a team of
experts because this requires 3 varieties of skills, which one individual may not
possess.
The team may consist of management experts, accountants, and the operation
research specialists, the industry experts and even social scientists.
The auditors must have analytical mind and ability to look at a management
function form the point of view of the organization as a whole. They therefore have
to be properly trained in this aspect. They need to have through knowledge of the
management science and they should be acquainted with the salient features of
various functional areas.

Under financial audit, the entire emphasis is on macro-aspect, the individual


transactions being- scrutinized for check of the aggregates. It is concerned with
examination of transactions recorded in the books of account. It reviews the
procedure and internal checks, and scrutinizes individual transactions for the
purpose of verification, of Profit and Loss Account and Balance Sheet. Financial
audit is not concerned with ~ avoidance of profiteering motive. It indicates the
financial position and over~ performance of the business, regardless of its
performance in various segments. Financial audit is applicable to all classes of
companies and industries irrespective of size and Dan of operations.
Instead of serving the interest of the management and the Government, it serves
interest of shareholders. Financial audit is organization - oriented. It is conducted
under Sections 224 - 232 of the Companies Act 1956.

Financial Audit Management Audit


It is concerned with financial aspects of It is concerned with the review of the
business transactions of the year under past
audit Performance to ascertain whether it is in
tune with the objectives, policies and
procedures of the enterprise.

123
The auditor examines the past financial The management auditor reports on
records to report his opinion on the truth performance of the management during
and fairness of the representations made
in the financial statements. Examination a particular period and suggest ways to
of the performance of the management is remedy the deficiencies, including
beyond his scope modification of objectives, policies etc.

Past year '(Financial) transactions are No limit as to the period to be covered


Covered Enterprises such as companies,
trust and societies etc.

There is legal compulsion as regards


Financial audit is compulsory in the case management audit.
of certain enterprises such as companies,
trust and societies etc.
The auditor reports to the owner, i.e. The auditor reports to the management
shareholders in the Case of a company

Q.5 Explain briefly various stages of management control process citing salient
features of each.

Management control process involves communication of information to the


managers at various levels of hierarchy and their interactions arising out of them.
These communications aim towards attaining the organization's goals. But
individual managers have their personal goals also. For example, a young manager
with good education, experience, personality and social background joins a
company like Britannia Industries or Reliance. The company finds him fit for the
position as per job specifications, appoints him and makes him aware of what the
company expects of him. The young manager sets his goals of gaining rich
experience for his career progress besides adequate compensation packages.
Naturally, his actions will be directed towards achieving his own objectives and
goals while serving the company. Thus, his self-interest and the best interest of the
organization are apparently in conflict. But the best results can be achieved by
perfectly matching the two interests and this is called 'goal congruence'.
It is quite apparent that perfect congruence between the goals of the individual and
the organization individual's goals and the organization's goals can never happen.
Yet, the main purpose of a management control system is to assure goal congruence
between the interest of the individual and the organization as far as practicable.

Management control systems


Formal and Informal Communication
As mentioned earlier, all the communication of information may be either formal or
informal. The formal communication system involves strategic plan, budgets,
standards and reports whereas the informal communication is made through letters
and memos, verbally or even by facial expression.

124
Formal communications are all documented and addressed to the responsible
managers for their information and actions, if necessary. However, the actions
depend on the perception of the individual managers.
Informal communication, on the other hand, relates to some external factors-work
ethics, management style and culture. Added to these factors is the existence of an
informal organization within the structured formal organization.
Informality refers to the relaxation of sharp differentiation and explicit
description of behavior as indicated in the hierarchy and thereby, moving away
from superior/subordinate relationship. However, such relations depend on the
personal capabilities of the manager such as education, experience, expertise, trust
and cooperation. For example, Accounts Manager of Nasik Plant (see the
organization chart in the diagram 3.2) reports to the General Manager of the Plant.
While visiting the Corporate Office for attending a Training Course, he meets other
colleagues, parallel officers and even the Finance Director. The latter communicates
some important matter to him verbally and wants action thereon. Accounts Manager
carried out the instructions so given. As per the organization chart, he should inform
his General Manager, but it depends on his own perception of the situation, and he
mayor may not report to the General Manager.
Work Ethics, Management Style and Culture
External factors like work ethics vary from place to place. Therefore, organization
work culture depends on the general behavior of the people in the society where the
organization situates. Work culture generally differs because of the life style and the
attitude towards the work. For example, people of Mumbai lead very fast life. Time
has more value at Mumbai as compared to Kolkata, where people take things easily
and leisurely. Japanese and Korean people have reputation for their excellent work
culture.
However, the most important internal factor is the organization's culture and
climate. The culture refers to the set of common beliefs, attitudes, norms,
relationships and assumptions that are explicitly or implicitly accepted and
evidenced throughout the organization. The writer joined Union Carbide as an
Assistant just three days before Christmas Eve. On the very second day, when he
attended Christmas lunch, his table was shared by none other than the General Sales
Manager Dr. W.R. Correa. He kept us amused with various stories of his recent tour
abroad and recited Urdu 'shairies', even sharing jokes. Such a situation was
unthinkable in Jessop & Co., where sharp differences were maintained at every
level of hierarchy.
Management control systems
Climate is used to designate the quality of the internal environment that
conditions the quality of cooperation, the development of individuals, the extent of
members' dedication or commitment to organizational purpose and the efficiency
with which that purpose is translated into results. Climate is the atmosphere in
which individuals work help, judge, and reward, constrain and find out about each
other. It influences moral-the attitude of the individual towards his/her work and
environment.
Culture differs between the organizations, but cultural norms are extremely
important. They are not written like formal communication. But the existence of a
good culture can be felt from the behavior of the members of the organization. Once
the writer landed up with his family at Hyderabad in the early morning to discover
that nobody had come to receive them at the station. His visit was arranged through
non other than the Director of the company himself. His unit being new, telephone
directory did not include any number of his unit, but the parent organization's
telephone number was located. When an executive of the parent company was
contacted, he immediately sent an officer of the company with a car to pick us up to
their Guest House, entertain with coffee and then put up in a Hotel. What
125
subsequently happened is a different matter, but the attitude and treatment of that
member of organization speak volumes about their excellent culture.
In any organization, the culture remains unchanged as long as the Chief
Executive remains in position. When a new executive replaces him, there is
likelihood of some change in the culture, unless the new Chief follows the footsteps
of his predecessor and maintains it. Generally, if higher positions are filled in
through promotion of internal executives, the culture remains unchanged and the
traditions are maintained.
The other important internal factor which influences management control system
is management style-that is the attitude of the superior to his subordinates and the
latter's reaction through their perception of the attitude of their superiors. Again, the
attitude ultimately stems from the temperament of the Chief Executive, who
controls the entire organization. That is why R. W. Emerson said "an institute is the
lengthened shadow of a man".

Importance of Informal Communication


An organization indulges in informal control process when encountering non-
routine decision-making or when seeking new information to increase
understanding of some problem areas. During a very critical period in an
organization, the writer found that the Chief Executive used to call managers
informally at his residence or club to extract information in a relaxed manner rather
than in a tense situation prevailing in the factory.
Formal Control Process
Formal communication system is structured as per the 'hierarchy outlined in the
organization chart. The system has the following four components:
(a) Strategic plan and programme
(b) Budgeting
(c) Operations and measurement in responsibility centers (d) Reporting

(a) Strategic Plan and Programme


The foundation of management control process lies in the organization's goals and
its strategies for attaining these goals. A strategic plan is prepared in order to
implement the strategies, after carefully considering opportunities and threats in the
external environment as well as the strengths and weaknesses in the internal
environment. Thus, a strategic plan and programme is prepared as a guideline to
budgeting.
(b) Budgeting
The strategic plan is converted to an annual budget incorporating planned
expenditure and revenues for individual responsibility centers. Expenses and
revenues are marked for each responsibility centre period wise, say monthly,
quarterly, half yearly, and annually.
(c) Operations and Measurement
Responsibility centers operate within the framework of the budget, established
standards, standing instructions, practices and operating procedures embodied in
'rules', and 'manuals'. Thus, besides budget, the responsibility centers are also
guided by a large number of rules. They record the resources actually used and

126
revenue earned.
They also classify
the data by

programmes as well as by responsibility centers for performance measurement.


(d) Reporting
Actual performance is analyzed, measured and reported against plan, indicating
variances and highlighting areas of weaknesses. If the performance is satisfactory,
feedback information is sent to the responsibility centre concerned for praise or
reward. If the same is unsatisfactory feedback communication is sent to the
responsibility centre concerned for corrective action. If such action requires to be
included in the budget, then the latter is revised to give effect to the changed
position. If required, then the plan itself can be revised and a new basis of control
may be established.
The aforesaid formal control process has been presented in the following
diagram:

127