MANAGEMENT CONTROL SYSTEMS

PRESENTATION BY

GROUP NO 2
Yasir Chowdhary Nilesh Dhangar Vinay Gupta 06 - 07 - 08

Abdul Qadir Shaikh - 09

Q1. What is transfer pricing and its objectives? When market based transfer prices are most appropriate?
Definition: Transfer Pricing

A transfer price is the internal price charged by a selling department, division, or subsidiary of a company for a raw material, component, or finished good or service which is supplied to a buying department, division, or subsidiary of the same company. Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges made between related companies for goods, services, or use of property including intangible property. The concept of transfer pricing is fundamentally aimed at stimulating external market conditions within the organization so that the managers of individual business units are motivated to perform well.

Objectives of Transfer Pricing:

It should provide each business unit with the relevant information it needs to determine the optimum trade-off between company cost and revenues. It should bring goal congruent decisions i.e., the system should be designed so that decisions that improve business unit profits will also improve company profits.

It should help to measure the economic performance of the individual business units.
The system should be simple to understand and easy to administer.

Thus, from the objectives, it is understood that the Transfer price is mainly transferring of goods and services from one unit to another where much importance is not given to accounting basis alone but also to all other effects.

Methods of Transfer Pricing

Market-based Transfer Pricing

When the outside market for the good is well-defined, competitive, and stable, firms often use the market price as an upper bound for the transfer price. When the outside market is neither competitive nor stable, internal decision making may be distorted by dependence on market-based transfer prices.

Negotiated Transfer Pricing

The firm does not specify rules for the determination of transfer prices. Divisional managers are encouraged to negotiate a mutually agreeable transfer price.

Cost-based Transfer Pricing

In the absence of an established market price many companies base the transfer price on the production cost of the supplying division.

When are market based transfer prices are more appropriate ?

Microeconomic theory shows that when divisional managers attempt to maximize divisional profits, a market-based transfer price supports their incentives with owners incentives of maximizing overall corporate profits. Market based transfer price is appropriate, if the selling profit center can sell all of its product to either insider or outsider and if the buying center can obtain all of its requirement from either outsider or insider.

The market price represent the opportunity cost to the seller of selling the product inside. This is because if the product were not sold inside ,it would be sold outside . From company point of view , the relevant cost of the product is the market price because that is the amount of cash that has been forgone by selling inside

Other situations when market based transfer prices are more appropriate :Competent people:Manager should be interested in long-run as well as the short-run performance of their responsibility center. Good Atmosphere:Manager must regard profitability, as measure in their income statement , as an important goal and a significant consideration in the judgment of their performance.

Freedom to source:Alternative source should exist, and manager should be permitted to choose the alternative that is in their own best interests. The buying manger should be free to buy from outside, and selling manager should be free to sell outside. In this circumstance, the transfer price policy simply gives the manager of each profit center the right to deal with either insider or outsider. The market thus establishes the transfer price.
Full information:Manager must know about available alternatives and relevant cost and revenues of each.

Negotiation:There should smoothly working mechanism for negotiating contract between business units.

Q2. What do you understand by investment centre? Explain 2 different methods by which the performance of this centers are measured. Also discuss their advantages and disadvantages

Investment centre

It is a classification used for business units within an enterprise. The essential element of an investment center is that it is treated as a unit which is measured against its use of capital. The basic principle of investment centre is Profitable the case then invest else disinvest.

The two different methods by which the performance of investment centers are measured are : ROI (Return on Investment) EVA (Economic Value Added)

ROI (Return on Investment)

Return on Investment is a ratio. The numerator is

income, as reported on the income denominator is assets employed.

statement. The

The denominator is taken as the corporation`s equity in the business unit. This amount is equal to the sum of noncurrent liabilities plus shareholder`s equity from the balance sheet. It is mathematically equivalent to total assets less current liabilities, and to noncurrent assets plus working capital.

EVA /Residual Income

EVA is a trademark of Company.

Stern Stewart &

Economic Value Added is an amount rather than a ratio. It is found by subtracting a capital charge from the net operating profit. This capital charge is found by multiplying the amount of assets employed by a certain rate/cost of capital .

Performance measures for Investment Centre

ROI

EVA

It is the profitability ratio which relates the profits to the investment. Investment in turn represents the assets based utility by the unit to earn the profit.

It emphasizes the net present value concept in performance evaluation over accounting standards. It looks more to long tern then short term decisions.

Advantages of Using ROI

1) ROI is a comprehensive measure in that anything that affects financial statements is reflected in the ratio. 2) ROI is simple to calculate, easy to understand, and meaningful in an absolute sense. 3) The performance of different units can be compared directly with one another.

4) ROI data of the competitors are available to which can be used as a basis for comparison.

DISADVANTAGES OF USING ROI

It discourages managers from investing in projects that would decrease the divisional ROI but would increase the profitability of the company as a whole. Generally, projects with an ROI less than a division`s current ROI would be rejected. It can encourage myopic behaviour, in that managers may focus on the short run at the expense of the long run. A manager who is evaluated based on return on investment(ROI) may reject investment opportunities that are profitable for the whole company but that would have a negative impact on the manager's performance evaluation.

Advantages of Using EVA

1) EVA gives all business units the same profit objective for comparable investments. 2) Decisions that increase a centers ROI may decrease its overall profits. 3) Different interest rates may be used for different types of assets. 4) EVA has a stronger positive correlation with changes in a company`s market value.

DISADVANTAGES OF USING EVA

EVA is an absolute measure and hence is incapable of being used for the purposes of inter-firm and inter-divisional comparisons.

EVA could be misleading as a wealth metric because it reflects momentary swings in the capital markets rather than inherent company performance. Economic value added also cannot valuate return on expenses such as research and development. Moreover, despite being an income statement operating expense, research and development actually has the potential to yield future earnings not measured by EVA.

Q.3. What do you understand by non-profit organization? How do these organizations price their products? What criteria are used to measure their performance?

A Non-profit 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 organisation from earning a profit; it prohibits only the distribution of profits.

Non profit organization (NPO) refers to an organization that uses surplus revenues to achieve its goals rather than to distribute them as profit or dividends. A non-profit company is like any other Company. There is only one important difference. It is not supposed to make profits. In other words, it does not exist for commercial gain. While Non-profit organizations are permitted to generate surplus revenues they must be retained by the organization for its self-preservation, expansion, or plans.

Characteristics of Not-for-profit organizations (NPOs)

The objective of such organizations is not to make profit but to provide service to its members . The main source of income is admissions fees, subscriptions, donations, grant-in-aid, etc. They also prepare their accounts following the same accounting principles and systems that are followed by business for profit organizations that are run with an objective to earn profits.

PRODUCT PRICING BY NON-PROFIT ORGANISATIONS

The Non-profit organization is desired to price services at their full cost. A full cost price is the sum of direct cost, indirect cost, and, perhaps, a small allowance for increasing the

organization`s equity. This principle applies to services that are

directly related to the organization`s objectives. Pricing for peripheral activities should be market-based. Thus a NP hospital should price its health care services at full cost, but prices in its gift shop should be market based.

Measurement of NPO Performance

The best indicators of the performance of a NPO are generally not measurable in rupee (currency) terms, though rupee is the language of financial reporting. It, thus, follows that it is more difficult to measure performance in a Not-For-Profit Organization than in a for-profit organization. Performance appraisal is achieved by peer reviews. Indeed the research shows that most NPOs are attempting results measurement of some type, but all are struggling with developing quantitative measures to track their works impact on their mission.

Short Note:
Approach to marketing by professional service organisation.

Balance scorecard
Interactive control

Internal control

APPROACH TO MARKETING BY PROFESSIONAL SERVICE ORGANISATION

Advertising is generally a very useful tool for helping an organization differentiate and sell its offerings for professional service organizations, though, it has limitations. Professional services usually lack many attributes that a buyer can confidently and competently evaluate beforeor even aftermaking a purchase decision. Clients, patients, referral sources, and even competitors could interpret advertising by a firm as suggesting that it lacks competence. (If the firm is so good, it shouldnt need to advertise.)

For many professional service organizations, the most logical way to approach advertising will be closer to networking other than general advertising.
Marketing by professional service organizations takes the form of personal contacts, speeches, articles and so on.

These marketing activities are usually conducted by the professionals who spend much of their time in production work that is working for clients.

BLANACED SCORECARD

The Balanced Scorecard was developed in the early 1990s by

Professor Robert S. Kaplan of Harvard Business School and Dr. Norton who is a founder and director of the Palladium Group. it's a

management system that enables your organization to set, track,

and achieve its key business strategies and objectives. After the business strategies are developed, they are deployed and tracked through the Four strategic perspectives.

1) customer, 2) financial,

3) internal business process and

4) learning and growth.

Customer Perspective: Measures your customers' satisfaction and their performance requirements for your organization and what it delivers, whether it's products or services.
Financial Perspective: Tracks your financial requirements and performance. Internal Business Perspective: Measures your critical-tocustomer process requirements and measures. Knowledge, Education, and Growth Perspective: Focuses on how you educate your employees, how you gain and capture your knowledge, and how you use it to maintain a competitive edge within your markets.

These four Perspectives have to be measured, analyzed, and improved together continuously in order for your business to thrive. If you ignore any one of these four legs, it'll be like sitting on a four-legged stool with a broken leg. You'll eventually lose your balance and fall flat on your face. And lying flat on your face is no way to run a business!

We not only have to measure these critical four Perspectives, but also set strategies, goals, objectives, and tactics to make them happen. And while We're at it, we have to make sure that our strategies and tactics are congruent. They have to work together and create a single thread, tying together in ways that make sense. This isn't an optional exercise; it's essential. The future of the business depends on it.

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. A subset of the management control information that has a bearing on the strategic uncertainties facing the buss becomes the focal point. Senior executive take such information seriously. Managers at all levels of the organisation focus attention on the information produced by the system.

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.

Internal control is the process designed to ensure reliable financial reporting, effective and efficient operations, and compliance with applicable laws and regulations. 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.

case study

Q.2.How should the transfer pricing system operate for each department?(market price, full retail. Full cost , variable cost) The transfer pricing system should be operated at market price system because the department could cut off the non value added costs for other department and still refer to the market situation The aim should be to maximize profits for each of the departments but not at the cost of other department

Q.3 If it were found that the trade in could be wholesaled for only $ 3000 which manager should take the loss?

If the used car is sold at auction for $3,000 after the trade-in value was set at $4,800, the company should note a loss of $1,800. However, if the new car salesman only gives $3,500 of value to the new customer based on the Blue Book value, then the loss reflected on the income statement and balance sheet should only be $500. The wholesale guidebook value for used cars is $3500 Hence the trade in is lower than the guidebook This makes the Used car sales department manager (Amy Robins) responsible for the loss

Q.4 North Country incurred a year-to-date loss of about $59,000, before allocation of fixed costs, on the wholesaling of used cars, which is theoretically supposed to be a break-even operation. Where do you think the problem lies?

New car owners were giving customers looking to trade-in existing cars above market valuations on their used cars. If new owners were providing credit for $4,800 for a used car that is worth $3,500, the used car group would have a difficult time making a profit. While there would be times (like the example above) where they could sell the car for $5,200 and still make a profit despite the inflated prices, most of the time they will have difficulty selling the used car above its Blue Book value of $3,500. Therefore, the used car division may be operating at a loss because the cost they are using for the used cars is too high.

Q.5 Should profit centres be evaluated on gross profit or full cost profit? Profit center should be evaluted at full cost because: Full cost not only includes COGS but will also account for the traceable fixed cost related to that profit center This method could encourage the manager responsible to control the cost precisely

Q. 6. What advice do you have for the owners?

All NCAI managers should come together to decide the fair transfer pricing.

By doing that, the decision making will be accepted by all the managers and thereby decrease any competition between them. Each department should be evaluated by full cost pricing system to control costs in a better way
Proper incentives should be given to each manager based not only on the department performance but all the overall company performance.

Thank you