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Published by Dhaval Lagwankar

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Published by: Dhaval Lagwankar on Jun 17, 2010
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Management Control System
Q.1 How is RI (EVA) analysis carried out? Explain advantages and disadvantages.Ans.
The EVA method is based on the past performance of the corporate enterprise. Theunderlying economic principle in this method is to determine whether the firm is earning ahigher rate of return on the entire invested funds than the cost of such funds (measured interms of weighted average cost of capital, WACC). If the answer is positive, the firm’smanagement is adding to the shareholders value by earning extra for them. On the contrary, if the WACC is higher than the corporate earning rate, the firm’s operations have eroded theexisting wealth of its equity shareholders. In operational terms, the method attempts tomeasure economic value added (or destroyed) for equity shareholders, by the firm’soperations, in a given year.Since WACC takes care of the financial costs of all sources of providers of investedfunds in a corporate enterprise, it is imperative that operating profits after taxes (and not net profits after taxes) should be considered to measure EVA. The accounting profits after taxes,as reported by the income statement, need adjustments for interest costs. The profit should bethe net operating profit after taxes and the cost of funds will be the product of the total capitalsupplied (including retained earnings) and WACC 
EVA= [Net operating profits after taxes – [Total Capital * WACC]Example
; Following is the condensed income statement of a firm for the current year;Particulars Amt (in lakhs)Sales Revenue500Less: Operating costs300Less: Interest costs 12Earnings before taxes188Less: Taxes (0.40) 75.2Earnings after taxes 112.8The firm’s existing capital consists of Rs 150 lakhs Equity funds, having 15% costand of Rs 100 lakh 12% debt. Determine the economic value added during the year.
Solution(I)Determination of Net Operating Profit After TaxesParticulars Amt (in lakhs)
Sales revenue 500Less: Operating Costs300Operating profit (EBIT) 200Less: Taxes (0.40) 80
Management Control System
 Net operating profit after taxes (NOPAT) 120
(II)Determination of WACCParticulars Amt (in lakhs)
Equity (150 lakh * 15%)22.512% Debt (100 lakh * 7.2%) 7.2Total Cost29.7WACC (29.7 lakh/ 250 lakh) 11.88%Cost of debt= 12% (1 – 0.4 tax rate) = 7.2%
(III)Determination of EVA
EVA = NOPAT – (Total capital * WACC)Rs 120 lakh – (Rs 250 lakh * 11.88%)Rs 120 lakh – Rs 29.7 lakh = Rs 90.3 lakhDuring the current year, the firm has added an economic value of Rs.90.3 lakh to theexisting wealth of equity shareholders. Essentially, the EVA approach is a modifiedaccounting approach to determine profits earned after meeting all financial costs of all the providers of capital. Its major advantage is that this approach reflects the true profit positionof the firm.
RI (EVA) has the following advantages:
(i)It avoids suboptimal decisions as investments are not rejected merely because theylower the divisional manager’s ROI.(ii)It maximizes the growth of the company and increases shareholders’ wealth byaccepting opportunities which earn a rate of return in excess of the cost of capital.(iii)The cost of capital charge on divisional investments ensures that divisionalmanagers are aware of the opportunity cost of funds.(iv)Charging each division with the company’s cost of capital ensures that decisionstaken by different divisions are compatible with the interests of the organization asa whole.
RI (EVA) has the following weaknesses:
Management Control System
(i)Like ROI it is difficult to have satisfactory definitions of ‘divisional profits’ and‘divisional investment’.(ii)It may be difficult to calculate an accurate cost of capital. Also, decision has to betaken whether to use the company’s cost of capital or a specific divisional cost of capital. The former enhances divisional goal congruency and the latter reflectseach division’s level of risk.(iii)Identifying controllable and uncontrollable factors at the divisional level may bedifficult.
Q. 2 Discuss the significance of human behavioral pattern in management control?Ans.
Management control system influence human behavior same as human behavior influences management control system. Human behavior helps in performing a goodmanagement control system by goal congruent manner. Thus following are the ways in whichthe human behavior influences the management control system.
Goal congruence:
Senior management wants the organization to attain the organization’s goal. But theindividual members of the organization have their own personal goals, and they are notnecessarily consistent with those of the organization. The central purpose of a managementcontrol system, then, is to ensure a high level of what is called “goal congruence”. In a goalcongruence process, the actions people are led to take in accordance with their perceived self-interest are also in the best interest of the organization.Obviously in our imperfect world, perfect congruence between individual goals andorganizational goals does not exists – if for no other reason than that individual participantsusually want as much compensation as they get while the organization maintains that salariescan go only so high without adversely affecting profits.Thus an individual should always think on how he can improvise his organizationsgoal along with his own goal.
Work ethics:
 There are some external factors that influence the desirable behavior that exists in thesociety of which organization is a part. These norms or factors include a set of attitudes, oftencollectively known as the work ethic, which is manifested in employees’ loyalty to theorganization, 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 inwhich the organization does its work.
This is the most important internal factor – is the organization’s own culture and howis the individual of the organization are understanding and maintaining the culture. Theculture consists of – the common beliefs, shared values, norms of behavior, and assumptionsthat are implicitly accepted and explicitly manifested throughout the organization. Culturalnorms are extremely important since they explain why two organizations, with identicalformal management control systems, may vary in terms of actual control.A company’s culture usually exists unchanged for many years. Certain practices become rituals because “this is the way things are done here”. Organizational culture is alsoinfluenced strongly by the personality and policies of the CEO, and by those of lower levelmanagers with respect to the areas they control. If the organization is unionised, the rules and

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