MANAGEMENT CONTROL SYSTEMS

UNIVERSITY QUESTION - ANSWERS

Submitted By: Akbar Gooni (09) Amman Sonde (10) Anup Bhala (14) Apurva Deshpande (15) Asna Shaikh (17)

Submitted To: Dr. Ganachari

Rizvi Institute of Management Studies and Research

Bandra, Mumbai-50

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 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 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 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.

Q2: 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 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.

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 doesnt 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 1970s 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, 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 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. 3. Senior executive take such information seriously. Managers at all levels of the org focus attention on the information produced by

the system.

Q4: Kiran Company (MCS-2004) Numerical

Budget versus Actual comparison for div Z of Kiran company is as follows:

Budget

Actual

Actual better (worse) than budget

Sales and other income Variable expenses Fixed expenses Sales promotional expenses Operating profit Net working capital Fixed assets

800 480 120 40 160 400 160

740 436 120 28 156 412 148

(60) 44 0 12 4 12 (12)

(a)

Carry out and overall performance analysis to decide areas needing investigation.

From the given data, we see that there is a certain amount of variance between the budgeted operating profit and actual operating profit. In order to analyze the variances, we need to understand the key causal factors that affect profit, namely, revenues and cost structure. The profit budget has embedded in it certain expectations about the state of total industry, companys market share, selling prices and cost structure. Results from variance computation are actionable if changes in actual results are analyzed against each of this expectation. Revenue variances, that is a negative Rs 60 lakhs, could be a result of selling price variance, mixed variance and/or volume variance. A combination of above three factors must have been unfavorable that is either the volume of sales must have been below the budgeted volumes ( this must be particularly true since actual variable expenses are less than budgeted) and/or the selling

price must have been below expectation and/or the proportion of products sold with a higher contribution must have been less than budgeted. One more factor could have been the overall industry volume. However, this factor is beyond the managements control and largely dependent on the state of economy. Variable expenses are directly proportional to volumes and hence as is evident are less than budgeted. Sales promotional expenses also show a negative variance which could be a cause of lower sales volumes. A cause of concern is that despite lower sales, the net working capital is more than budgeted which indicates capital block in higher inventory. Another issue is that the fixed assets are lower than the budget by Rs 12 lakhs which may indicate slower capacity expansion then expected or distressed sale of assets to tide over cash flow.

(b) What are the remedial measures if any would you suggest based on analysis? The budgeted estimates may be too optimistic and far from reality, one needs to ensure that estimates the as realistic as possible. Given the estimates are correct, in that case depending upon the above analysis, the management needs to take corrective action areas needing improvement, sales volume could be improved by better marketing, quality standards and promotional efforts, product mix could be improved by selling more of higher contribution products. Better sales will ensure a higher inventory turnover. Better credit management to recover receivables, will ensure improve cash flow situation since less capital will be tied up in working capital.

Q5: Shandilya Ltd. (MCS-2008) Numerical 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 Budgete d Profit Current Assets Fixed Assets 360 400 1600 Div B Actua Budgete l 320 360 1600 d 220 800 1600 Actua l 240 760 1800 Div C Budgete d 200 1200 2000 Actua l 200 1400 2200 Total Budgete d 780 2400 5200 Actua l 760 2520 5600

Solution: Particulars Div A Budgete d ROA EVA 18% 208 Div B Actua Budgete l 16% 170.4 d 9% 44 Actua l 9% 50.4 Div C Budgete d 6% -32 Total Actua Budgete l 6% -60 d 10% 220 Actua l 9% 160.8

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. 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 centres 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.