Assignment Course Code: MS - 43 Course Title: Management Control Systems

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ASSIGNMENT
Course Code : MS - 43
Course Title : Management Control Systems
1. Explain in detail the various elements of control systems.
The four basic elements in a control system
(1) The characteristic or condition to be controlled
(2) The sensor,
(3) The comparator, and
(4) The activator — occurs in the same sequence and maintain a consistent relationship to each other in
every system
The first element is the characteristic or condition of the operating system which is to be measured. We
select a specific characteristic because a correlation exists between it and how the system is performing. The
characteristic may be the output of the system during any stage of processing or it may be a condition that
has resulted from the output of the system. For example, it may be the heat energy produced by the furnace
or the temperature in the room which has changed because of the heat generated by the furnace. In an
elementary school system, the hours a teacher works or the gain in knowledge demonstrated by the students
on a national examination are examples of characteristics that may be selected for measurement, or control.
The second element of control, the sensor, is a means for measuring the characteristic or condition. The
control subsystem must be designed to include a sensory device or method of measurement. In a home
heating system this device would be the thermostat, and in a quality-control system this measurement might
be performed by a visual inspection of the product.
The third element of control, the comparator, determines the need for correction by comparing what is
occurring with what has been planned. Some deviation from plan is usual and expected, but when variations
are beyond those considered acceptable, corrective action is required. It is often possible to identify trends in
performance and to take action before an unacceptable variation from the norm occurs. This sort of
preventative action indicates that good control is being achieved.
The fourth element of control, the activator, is the corrective action taken to return the system to expected
output. The actual person, device, or method used to direct corrective inputs into the operating system may
take a variety of forms. It may be a hydraulic controller positioned by a solenoid or electric motor in
response to an electronic error signal, an employee directed to rework the parts that failed to pass quality
inspection, or a school principal who decides to buy additional books to provide for an increased number of
students. As long as a plan is performed within allowable limits, corrective action is not necessary; this
seldom occurs in practice, however.
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Information is the medium of control, because the flow of sensory data and later the flow of corrective
information allow a characteristic or condition of the system to be controlled. To illustrate how information
flow facilitates control, let us review the elements of control in the context of information.
2. Discuss the application of BCG Model and General Electric Planning Model for formulating
business unit strategies.
The Boston Consulting Group (BCG) Matrix.
The Boston Consulting Group Matrix (Ansoff, 1987; Ansoff and McDonnell, 1990), introduced by the Boston
Consulting Group offers a useful method for comparison of a firm’s strategic business units (business). This
matrix chooses volume growth in demand as the single measure of the future business units prospects (vertical
dimension) and the firm’s market share in relation to the share of the leading competitor (horizontal dimension).
The BCG matrix is useful for two purposes:
1) Decisions on the desirable market share positions, and
2) The assigning of the strategic funds among the business.
Applications of the BCG matrix showed it to be useful tool for making strategic position decisions about
business and for near-term strategic resource allocations. However, the BCG matrix is applicable under very
special conditions.
The future prospects in the entire firm’s business should be measurable by a single growth rate index. This is
true in business which, for the foreseeable future, can be expected to remain in the same life cycle growth stage,
and/or when the expected level of turbulence is low, which is another way of saying that the growth is not likely
to be perturbed by unexpected events. But when the business is expected to move into another growth stage in
the expected future, and/or high level turbulence is forecasted, the single growth rate measure of prospects
becomes inaccurate and perilous. What is even more dangerous is the implied assumption that high volume
growth will necessarily lead to high profitability. In today’s environment business which are technologically
turbulent, or in which competition is cut-throat, may experience profitless growth.
The future competitive dynamics within the business should be such that relative market share is the only
determinant of its competitive strength. This means that the technological conditions are stable, the rate of
growth of demand surpasses that of the supply and the competition is not intense. But when these conditions do
not hold other factors apart from the market share typically acquire dominant importance to continued
competitive success. Another way of naming the BCG matrix is the Advantage Matrix (Davies, 2003). This
matrix is used extensively in business practice. The matrix is an attempt to classify business groups in relation
to market growth and relative firm market shares. These classifications are then used in order to present
strategic options based on creating competitive advantages for analysis. Product sets can be identified –usually
referred to as stars, cash, cows, dogs and question marks.
GE Planning model
A method of evaluating businesses along two dimensions:

(1) Industry attractiveness and
(2) Competitive position; in general, the more attractive the industry and the more competitive the position,
the more an organization should invest in a business
GE model because the BCG matrix is relatively narrow and overly simplistic, General Electric (GE) developed
the GE model, a more sophisticated approach to managing diversified business units. The Business Screen is a
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portfolio management technique that can also be represented in the form of a matrix. Rather than focusing
solely on market growth and market share, however, the GE model considers industry attractiveness and
competitive position. These two factors are divided into three categories, to make the nine-cell matrix these
cells, in turn, classify business units as winners, losers, question marks, average businesses, or profit producers.
As, both market growth and market share appear in a broad list of factors that determine the overall
attractiveness of an industry and the overall quality of a firms competitive position. Other determinants of
industry attractiveness (in addition to market growth) include market size, capital requirements, and competitive
intensity. In general, the greater the market growth, the larger the market, the smaller the capital requirements,
and the less the competitive intensity, the more attractive and industry will be. Other determinants of an
organizations competitive position in an industry (besides market share) include technological know-how,
product quality, service network, price competitiveness, and operating costs. In general, businesses with large
market share, technological know-how, high product quality, a quality service network, competitive prices, and
low operating costs are in a favorable competitive position.
Think of the GE model as a way of applying SWOT analysis to the implementation and management of a
diversification strategy. The determinants of industry attractiveness are similar to the environmental
opportunities and threats
3. Explain the concept of profit centres and discuss about the performance management of profit
centres.
Profit center is a section of a company treated as a separate business. Thus profits or losses for a profit
center are calculated separately
A profit center manager is held accountable for both revenues, and costs (expenses), and therefore, profits.
What this means in terms of managerial responsibilities is that the manager has to drive the sales revenue
generating activities which leads to cash inflows and at the same time control the cost (cash outflows)
causing activities. This makes the profit center management more challenging than cost centre management.
Profit center management is equivalent to running an independent business because a profit center business
unit or department is treated as a distinct entity enabling revenues and expenses to be determined and its
profitability to be measured.
Business organizations may be organized in terms of profit centers where the profit center's revenues and
expenses are held separate from the main company's in order to determine their profitability. Usually
different profit centers are separated for accounting purposes so that the management can follow how much
profit each center makes and compare their relative efficiency and profit. Examples of typical profit centers
are a store, a sales organization and a consulting organization whose profitability can be measured.
Performance management in profit centers:
In the business world, a profit center is an area of a company that adds directly to its bottom line profit. Like
with all areas of life following the 80/20 rule, also known as Pereto’s Law, most of a company’s profits are
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likely to come from only a handful of operations, products, or divisions. Microsoft has thousands of
products, but the major profit centers are the Windows operating system and the Microsoft Office software.
Each profit center provided the stream of funds for the company to use when it expanded into other fields
such as video games with the X-Box as well as fund large share repurchases and cash dividends.
A manager or executive in charge of a profit center is likely to face a much more difficult job than someone
overseeing a division that is not classified as a profit center. The reason is simple. A profit center manager is
going to have to both increase sales by generating additional revenue and decreasing costs (as a percentage
of revenue), much like an entrepreneur would have to do in his or her own independent business.
A cost center manager, on the other hand, only has to worry about staying within budget. (A cost center is a
department that is important to the overall success of a company but its contribution to revenues and profits
can be only incrementally measured. A cost center is an area that typically runs red ink in upfront losses but
will result in a much richer company if managed correctly; think the research division of a major
pharmaceutical corporation that spends billions developing new drug treatments without selling a single pill
for years. Clearly, if the pipeline were to dry up and the cost center shut down, the company would soon
find itself a shadow of its former self. Yet, it is a cost center and not a profit center that is likely to find itself
at the top of a list when it comes to recessionary layoffs.)
Many businesses are tempted to treat all divisions as cost centers instead of profit centers. This can be a
horrible mistake because if managers are rewarded simply on cutting costs, they will not make sufficient
reinvestment in a business to grow profitably for the future. Hence, you eventually end up with outdated
equipment, facilities, and staff and your customers are likely to go elsewhere because their needs aren’t
being met. A profit center approach, on the other hand, blends the need for current cash with the desire to
grow earnings in the future, making a manager accountable for the long-term health of a business.
A closely related concept to a profit center is an investment center. Whereas a profit center measures simply
the overall contribution of a division’s profitability to the parent corporation, an investment center measures
all uses of capital against a theoretical required rate of return. Although the investment center approach is
extremely useful in evaluating the overall profitability of a company as measured by return on capital
deployed, it can be manipulated by managers who know how accounting rules work. By simply modifying
depreciation rates, for instance, they could increase the estimated return on invested capital. They could also
change the so-called hurdle rate to a more easily attainable figure (the hurdle rate is a return a profit center
or other division must earn in order to be considered a good investment for the company; in other words, it
is a minimum acceptable rate of return).
The legendary management consultant and thinker Peter Drucker originally created the term profit center in
the 1940’s. He subsequently asserted that the term profit center is a misnomer that leads managers to focus
on the wrong overall priorities, insisting instead that everything is a cost center. By focusing only on the
absolute profit of a division, factors such as return on capital, opportunity cost, efficient use of resources,
and relative returns are ignored to the detriment of the stockholder or owner.
4. What is transfer pricing? Explain the various methods used for transfer pricing.
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Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges made between
related parties for goods, services, or use of property (including intangible property). Transfer prices among
components of an enterprise may be used to reflect allocation of resources among such components, or for
other purposes. OECD Transfer Pricing Guidelines state, “Transfer prices are significant for both taxpayers
and tax administrations because they determine in large part the income and expenses, and therefore taxable
profits, of associated enterprises in different tax jurisdictions.”
Many governments have adopted transfer pricing rules that apply in determining or adjusting income taxes
of domestic and multinational taxpayers. The OECD has adopted guidelines followed, in whole or in part,
by many of its member countries in adopting rules. United States and Canadian rules are similar in many
respects to OECD guidelines, with certain points of material difference. A few countries follow rules that
are materially different overall.
The rules of nearly all countries permit related parties to set prices in any manner, but permit the tax
authorities to adjust those prices where the prices charged are outside an arm's length range. Rules are
generally provided for determining what constitutes such arm's length prices, and how any analysis should
proceed. Prices actually charged are compared to prices or measures of profitability for unrelated
transactions and parties. The rules generally require that market level, functions, risks, and terms of sale of
unrelated party transactions or activities be reasonably comparable to such items with respect to the related
party transactions or profitability being tested.
Most systems allow use of multiple methods, where appropriate and supported by reliable data, to test
related party prices. Among the commonly used methods are comparable uncontrolled prices, cost plus,
resale price or markup, and profitability based methods. Many systems differentiate methods of testing
goods from those for services or use of property due to inherent differences in business aspects of such
broad types of transactions. Some systems provide mechanisms for sharing or allocation of costs of
acquiring assets (including intangible assets) among related parties in a manner designed to reduce tax
controversy.
Most tax treaties and many tax systems provide mechanisms for resolving disputes among taxpayers and
governments in a manner designed to reduce the potential for double taxation. Many systems also permit
advance agreement between taxpayers and one or more governments regarding mechanisms for setting
related party prices.
Many systems impose penalties where the tax authority has adjusted related party prices. Some tax systems
provide that taxpayers may avoid such penalties by preparing documentation in advance regarding prices
charged between the taxpayer and related parties. Some systems require that such documentation be
prepared in advance in all cases
Methods for transfer pricing:
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Testing of prices
Tax authorities generally examine prices actually charged between related parties to determine whether
adjustments are appropriate. Such examination is by comparison (testing) of such prices to comparable
prices charged among unrelated parties. Such testing may occur only on examination of tax returns by the
tax authority, or taxpayers may be required to conduct such testing themselves in advance or filing tax
returns. Such testing requires a determination of how the testing must be conducted, referred to as a transfer
pricing method
Best method rule
Some systems give preference to a specific method of testing prices. OECD and U.S. systems, however,
provide that the method used to test the appropriateness of related party prices should be that method that
produces the most reliable measure of arm's length results. This is often known as a "best method" rule.
Under this approach, the system may require that more than one testing method be considered. Factors to be
considered include comparability of tested and independent items, reliability of available data and
assumptions under the method, and validation of the results of the method by other methods.
Comparable uncontrolled price (CUP)
Most systems consider a third party price for identical goods, services, or property under identical
conditions, called a comparable uncontrolled price (CUP), to be the most reliable indicator of an arm's
length price. All systems permit testing using this method. Further, it may be possible to reliably adjust
CUPs where the goods, services, or property are identical but the sales terms or other limited items are
different. As an example, an interest adjustment could be applied where the only difference in sales
transactions is time for payment (e.g., 30 days vs. 60 days). CUPs are based on actual transactions. For
commodities, actual transactions of other parties may be reported in a reliable manner. For other items, "in-
house" comparables, i.e., transactions of one of the controlled parties with third parties, may be the only
available reliable data.
Other transactional methods
Among other methods relying on actual transactions (generally between one tested party and third parties)
and not indices, aggregates, or market surveys are:
• Cost plus (C+) method: goods or services provided to unrelated parties are consistently priced at actual
cost plus a fixed markup. Testing is by comparison of the markup percentages
• Resale price method (RPM): goods are regularly offered by a seller or purchased by a retailer to/from
unrelated parties at a standard "list" price less a fixed discount. Testing is by comparison of the discount
percentages.
• Gross margin method: similar to resale price method, recognized in a few systems.
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Profitability methods
Some methods of testing prices do not rely on actual transactions. Use of these methods may be necessary
due to the lack of reliable data for transactional methods. In some cases, non-transactional methods may be
more reliable than transactional methods because market and economic adjustments to transactions may not
be reliable. These methods may include:
• Comparable profits method (CPM): profit levels of similarly situated companies in similarly industries
may be compared to an appropriate tested party. See U.S. rules below.
• Transactional net margin method (TNMM): while called a transactional method, the testing is based on
profitability of similar businesses. See OECD guidelines below.
• Profit split method: total enterprise profits are split in a formulary manner based on econometric
analyses
CPM and TNMM have a practical advantage in ease of implementation. Both methods rely on microeconomic
analysis of data rather than specific transactions. These methods are discussed further with respect to the U.S.
and OECD systems.
Two methods are often provided for splitting profits: comparable profit split and residual profit split. The
former requires that profit split be derived from the combined operating profit of uncontrolled taxpayers
whose transactions and activities are comparable to the transactions and activities being tested. The residual
profit split method requires a two step process: first profits are allocated to routine operations, then the
residual profit is allocated based on no routine contributions of the parties. The residual allocation may be
based on external market benchmarks or estimation based on capitalized costs.
Tested party & profit level indicator
Where testing of prices occurs on other than a purely transactional basis, such as CPM or TNMM, it may be
necessary to determine which of the two related parties should be tested] Testing is to be done of that party
testing of which will produce the most reliable results. Generally, this means that the tested party is that party
with the most easily compared functions and risks. Comparing the tested party's results to those of
comparable parties may require adjustments to results of the tested party or the comparables for such items as
levels of inventory or receivables.
Testing requires determination of what indication of profitability should be used. This may be net profit on the
transaction, return on assets employed, or some other measure. Reliability is generally improved for TNMM
and CPM by using a range of results and multiple year data
5. Discuss performance management and explain the requirements for a performance management
system. ‘
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Performance management (PM) includes activities that ensure that goals are consistently being met in an
effective and efficient manner. Performance management can focus on the performance of an organization, a
department, employee, or even the processes to build a product or service, as well as many other areas.
Performance management as referenced on this page is a broad term coined by Dr. Aubrey Daniels in the late
1970s to describe a technology (i.e. science imbedded in applications methods) for managing behavior and
results, two critical elements of what is known as performance
Managing employee or system performance facilitates the effective delivery of strategic and operational
goals. There is a clear and immediate correlation between using performance management programs or
software and improved business and organizational results.
For employee performance management, using integrated software, rather than a spreadsheet based recording
system, may deliver a significant return on investment through a range of direct and indirect sales benefits,
operational efficiency benefits and by unlocking the latent potential in every employees work day (i.e. the
time they spend not actually doing their job). Requirements may include:
Direct financial gain
• Grow sales
• Reduce costs
• Stop project overruns
• Aligns the organization directly behind the CEO's goals
• Decreases the time it takes to create strategic or operational changes by communicating the changes
through a new set of goals
Motivated workforce
• Optimizes incentive plans to specific goals for over achievement, not just business as usual
• Improves employee engagement because everyone understands how they are directly contributing to the
organizations high level goals
• Create transparency in achievement of goals
• High confidence in bonus payment process
• Professional development programs are better aligned directly to achieving business level goals
Improved management control
• Flexible, responsive to management needs

• Displays data relationships
• Helps audit / comply with legislative requirements
• Simplifies communication of strategic goals scenario planning
• Provides well documented and communicated process documentation
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6. Explain the risk characteristics of banks and discuss the role of management control systems in
containing risk.
Risk characteristics of banks
Review/Renewal: Multi-tier Credit Approving Authority, constitution wise delegation of powers, Higher
delegated powers for better-rated customers; discriminatory time schedule for review/renewal, Hurdle rates
and Bench marks for fresh exposures and periodicity for renewal based on risk rating, etc are formulated.
Risk Rating Model: Set up comprehensive risk scoring system on a six to nine point scale. Clearly define
rating thresholds and review the ratings periodically preferably at half yearly intervals. Rating migration is
to be mapped to estimate the expected loss.
Risk based scientific pricing: Link loan pricing to expected loss. High-risk category borrowers are to be
priced high. Build historical data on default losses. Allocate capital to absorb the unexpected loss. Adopt the
RAROC framework.
Portfolio Management The need for credit portfolio management emanates from the necessity to optimize
the benefits associated with diversification and to reduce the potential adverse impact of concentration of
exposures to a particular borrower, sector or
Industry. Stipulate quantitative ceiling on aggregate exposure on specific rating categories, distribution of
borrowers in various industry, business group and conduct rapid portfolio reviews.
Loan Review Mechanism This should be done independent of credit operations. It is also referred as Credit
Audit covering review of sanction process, compliance status, review of risk rating, and pick up of warning
signals and recommendation of corrective action with the objective of improving credit quality.
Liquidity Risk: Bank Deposits generally have a much shorter contractual maturity than loans and liquidity
management needs to provide a cushion to cover anticipated deposit withdrawals.
Interest Rate Risk - Interest Rate Risk is the potential negative impact on the Net Interest Income and it
refers to the vulnerability of an institution’s financial condition to the movement in interest rates.
Forex Risk: Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse exchange
rate movement during a period in which it has an open position, either
spot or forward or both in same foreign currency.
Role of the Management control Function for risk
Depending on the size of the organization the risk management function may range from a single risk
champion, a part time risk manager, to a full scale risk management department.
• setting policy and strategy for risk management
• Primary champion of risk management at strategic and operational level
• building a risk aware culture within the organization including appropriate education
• establishing internal risk policy and structures for business units
• designing and reviewing processes for risk management
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• co-coordinating the various functional activities which advise on risk management issues within the
organization
• developing risk response processes, including contingency and business continuity programmes
• preparing reports on risk for the board and the stakeholders
• focusing the internal audit work on the significant risks, as identified by management, and auditing the risk
management processes across an organization
• providing assurance on the management of risk
• providing active support and involvement in the risk management process
• facilitating risk identification/assessment and educating line staff in risk management and internal control
• co-coordinating risk reporting to the board, audit committee, etc
In determining the most appropriate role for a particular organization, Internal Audit should ensure that the
professional requirements for independence and objectivity are not breached.
The resources required to implement the organization’s risk management policy should be clearly established at
each level of management and within each business unit. In addition to other operational functions they may
have, those involved in risk management should have their roles in coordinating risk management
policy/strategy clearly defined. The same clear definition is also required for those involved in the audit and
review of internal controls and facilitating the risk management process.
Risk management should be embedded within the organization through the strategy and budget processes. It
should be highlighted in induction and all other training and development as well as within operational
processes e.g. product/service development projects.
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Assignment Course Code: MS - 43 Course Title: Management Control Systems

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1. Explain in detail the various elements of control systems.

The four basic elements in a control system

(1) The characteristic or condition to be controlled

(2) The sensor,

(3) The comparator, and

A method of evaluating businesses along two dimensions:

Performance management in profit centers:

Methods for transfer pricing:

Best method rule

Comparable uncontrolled price (CUP)

Other transactional methods

Tested party & profit level indicator

Direct financial gain

Improved management control

• Flexible, responsive to management needs

Role of the Management control Function for risk

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