What is 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. Features of management control system  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.

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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.


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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.

What is the concept of free cash flow as applied to organization? Explain the 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: 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 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 $100million of

What is Balance Scorecard? What is the process of implementation and difficulties in implementation?

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." 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 implantation 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.


 They show that management is serious about the importance of these 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 . Also.  Measures overload. identifying the cause effect relationships among the different measures is easier said than done. it is important that the individual measures be linked with each other in a cause effect manner Integrated Measures into the management system The balanced scorecard must be integrated with the organization formal and informal structure. It is imperative that the organization focuses on a few critical measures at this point. 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. These changes do 5 . The mechanism available takes additional resource and requires a changed in the company culture.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 . could limit the usefulness of the balanced scorecard approach:  Poor correlation between nonfinancial measures and result.  No mechanism for improvement. its culture. This will be a problem with any system that is trying to develop proxy measures for future performance.  They maintain alignment of measure to ever changing strategies. otherwise management will be overloaded with measures.  Fixation on financial result. Poor Correlation between Nonfinancial measures and result Simply put there is no guarantee that future profitably will allow targets achievement in any nonfinancial area. 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. Review Measures and result Frequently Once the balance scorecard is up and running it must be consistently reviewed by senior management. Difficulties in implementing Balanced Scorecard The following problems unless suitably dealt with. While the balanced Scorecard gives some means for balancing measures. No mechanism for improvement.this pressure often overwhelms the long term uncertain payback of the nonfinancial measures. Shareholder are vocal and the board of directors often applies pressure on the stakeholders behalf . 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. and its human resources practice.Define Measures of Strategy The next step is to develop measures in support of the articulate strategy. 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. 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.

The key difference between costs and Allocated costs is that the latter will be charged based upon an estimate. since these costs are not affected by either the volume of sales or the volume of production. these should not be a part of controllable cost.34 168. Thus as it is charged based upon an estimate the budgeted figure is the same as the actual figure and hence no variances.62 Variance 0.50 (Unfavourable) --------------- Direct Labour Indirect Labour Total Controllable Costs Department Fixed Costs Allocated Costs Questions: a. They don't vary with the change in short run managerial decisions and output. missing those targets and readjusting the targets to reflect what was actually achieved.82 53. Why no variance is shown in two items? Is this correct approach in performance reporting? b. rather than actual cash values. 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 50.47 38.21 (Favourable) 8. where the same resource is also used by other activities. These are different to the Incurred costs because these costs are not exclusively related to any individual project. It too few then the manager is ignoring measures that are critical to creating success. and making a fair and reasonable charge to all projects using the resource does this.10 (Unfavourable) 8. . And some costs are controllable i. Allocated costs are a share of the costs of a resource used by a project. Girish Engineering (MCS-2004) Numerical Responsibility budgeting was introduced in a medium sized organization Girish Engineering. they can be managed and changed with the managerial decisions and output. If it too many then the manager may risk losing focus and trying to do too many things at once. the cost of the resource still needs to be recovered.e. improvements are unlikely to consistently happen no matter how good the stretch goal sound. Without a method for making improvement. Monthly report (in part) for an expense centre in factory is: [All figures in Rs. So.13 66. 6 . Should overhead expenses mentioned above be included in Controllable Costs? Why? Why not? Solution (a): Variances between actual and budgeted departmental fixed costs are obtained simply by subtraction. Solution (b): Overhead Expenses mentioned above should not be included in controllable costs because some costs are uncontrollable like fixed costs. Inertia often works against the company employees are accustomed to a self limited cycle of setting targets. Lacs] Actual 100.not happen overnight nor do they respond automatically to a new stretch targets. However. As the above overhead expenses would have certain portion of fixed expenses this is hard to control. That‘s why no variance is shown for departmental fixed costs.

Hence cost management of Division X is better than Division Y.) 28% 100 Lacs 25 lacs 7 Lacs Division Y (Rs. 7 . (MCS-2008) Numerical Particulars ROI Sales Investment EBIT Division X (Rs.) 26% 500 lacs 100 Lacs 26 lacs Analyze and comment upon performances of both the divisions Solution: Division X ROI Profit = = = = = = = = = (Profit / investment)* 100 (28/100)*25lacs 7lacs (Profit/sales)*100 (7/100)*100 7lacs (Sales/investment)*100 (100/25)*100 4 times Profit margin Turnover of investments Division Y ROI Profit = = = = = = = = = (Profit / investment)* 100 (26/100)*100lacs 26lacs (Profit/sales)*100 (26/500)*100 5. Turnover of investment of division Y is better than Division X. 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.ABC ltd.2lacs (Sales/investment)*100 (500/100)*100 5 times Profit margin Turnover of investments Profit margin of X is better than profit margin of division Y.

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. In setting up such systems. 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. Measuring Profitability There are two types of profitability measurements used in evaluating a profit center. the company has implemented its strategy. A newly developed machine that reduces costs so substantially that it will pay for itself in a year is an example. 4. and controlling the profit center's day-to-day activities and as a device for providing the proper motivation for its manager. senior management selects measures that best represent the company's strategy. An important point is that these techniques are used in only about half the situations in which. 3. while the economic report is prepared only on those occasions when economic decisions must be made. or safety. For example. coordinating. or (b) The internal rate of return implicit in the relationship between inflows and outflows. These measures can be seen as current and future critical success factors. 2. This measure is used for planning. the "payback period" criterion is used frequently. Techniques for analyzing capital investment proposals attempt to find either (a) The net present value of the project. 8 . with economic information being derived from these performance reports as well as from other sources. There is no feasible alternative to adoption. which focuses on how well the profit center is doing as an economic entity. 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 rationale for the proposal is something other than increased profitability. Many projects do not fit into a mechanical ranking scheme. The necessary information for both purposes usually cannot be obtained from a single set of data. the excess of the present value of the estimated cash inflows over the amount of investment required. Systems that attempt to rank non-quantifiable projects in order of profitability won't work. there is a measure of management performance. they are applicable. just as there are in evaluating an organization as a whole. which focuses on how well the manager is doing. Environmental laws may require investment in a new program. 6. In these situations. but many proposed investments win approval on the grounds that they improve employee morale. The present value approach assumes that the "objective function" is to increase profits. there is the measure of economic performance. considerations relating to management performance measurement have first priority in systems design-that is. conceptually. Capital Investment Measurement Most proposals require significant new capital. the management performance report for a branch store may show that the store's manager is doing an excellent job under the circumstances. The strategy's success depends on its soundness. the company's image. if they are improved. Because the management report is used frequently. Second. First.The goal of performance measurement systems is to implement strategy. the system should be designed to measure management performance routinely. A performance measurement system is simply a mechanism that improves the likelihood the organisation will implement its strategy successfully. The proposal may be so obviously attractive that a calculation of its net present value is unnecessary. as an example. The management control system should provide an orderly way of deciding on proposals that cannot be analyzed by quantitative techniques. that is. 5. There are at least four reasons for not using present value techniques in analyzing all proposals. 1. The messages conveyed by these two measures may be quite different from each other.

2) Direct Profit: This measure shows the amount that the profit center contributes to the general overhead and profit of the corporation. 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. companies measure performance of domestic profit centers at the bottom line. 5) Net Income: Here. in evaluating the performance of manager. the profit will be after the deduction of all expenses that are influenced by profit center manager. coordinating and controlling the day-to-day activities of the profit center. 9 . just as there are for the organization as a whole. 3) Controllable Profit: Headquarters expenses are divided into two categories: controllable and noncontrollable. so there is no advantage in incorporating income taxes 2) many decisions that have impact on income taxes are made at headquarters. There is. all corporate overhead is allocated to profit centers. There are two types of profitability measurements in a profit center. A focus on the contribution margin tends to direct attention away from this responsibility. The message given by these two measures may be quite different. which is the difference between the revenues and expenses. It incorporates all expenses incurred in or directly traced to the profit center. If corporate overheads are allocated to profit centers. should be allocated. first. and it is believed that profit center manager should not be judged by the consequences of these decisions. regardless of whether these items are entirely controllable by the profit center manager. However. and therefore he should focus on maximizing the spread between revenue and expenses.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? When financial performance in a responsibility center is measured in terms of profit. any of five different measures of profitability can be used. Types of Profitability measures: In order to evaluate the economic performance of a profit center. in which the focus is on how well the profit center is doing as an economic entity. one must use net income after allocating all costs. But the problem with this is that some fixed costs are controllable and all fixed costs are partially controllable. if these costs are included in the management system. in which the focus is on how well the manager is doing. budgeted costs. the responsibility center is called a profit center. The basis of allocation reflects the relative amount of expense that is incurred for each profit center. not actual costs. A weakness of this measure is that it does not recognize the motivational benefit of charging headquarters costs. Then the performance report will show an identical amount in the ―budget‖ and ―actual‖ columns for such overheads. Second. This measure is used for planning. a measure of management performance. there is a measure of economic performance. There are two arguments 1) Income after tax is constant percentage of the pretax income. the amount of net income after income tax. The controllable expenses are controlled by business unit manager. 4) Income before Taxes: In this measure. 1) Contribution Margin: The logic behind using contribution margin as a measure is that fixed expenses are not controllable by the manager. Consequently.

thus there is less need for a sophisticated management control system . use in setting selling price and for other management purposes . What are interactive controls? 1.the problem of measuring the value of human assets is intractable. 2.nevertheless difficult problem arise in deciding how time should be charged to clients . In part. a related goal is to increase their size. Their financial goal is to provide adequate compensation to the professionals. 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 . this reflects the natural tendency to associate success with large size. Goals A dominant goal of a manufacturing company is to earn a satisfactory profit.if the normal work week is 40 hrs should a job be charged for 1/40 th 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 . 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. 3.this reluctant seems to 10 . specifically a satisfactory return on assets employed. however their time and this complicate the track of measuring performance . which 'doesn't appear on its balance sheet.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 . In part. 5. Some profession notably scientist engineer.Explain special characteristics of professional organizations which impact Management Control. Marketing In a manufacturing company there is a dividing line between marketing activities and production activities only senior management is concerned with both . Research and development organization use in setting selling price and for other management purposes .such a clean separation does not exist in most Professional organisation. and professional are reluctant to keep track of how they spend their time and this complicate the track of measuring performance .separation of fixed and variable cost and analyses of variance were built on the foundation are example of organization whose product are professional service. Return on assets employed.and a way relating compensation to 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 .senior management in such organisations can personally observe what is going on and personally motivate employee . A professional organization has relatively few tangible assets. it reflects economies of scale in using the efforts of a central personnel staff and units responsible for keeping the organization up-to-date. Output and input measurement The output of a profession organisation cannot be measured in physical terms.with profit centres and formal performance reports nevertheless even a small organisations need a budget a regular comparison of performance against budget . Large public accounting firms need to have enough local offices to enable them to audit clients who have facilities located throughout the world. 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. therefore.and otherwise keeping up to date? 4. Small Size With a few exception such as some law firm and accounting firms .going to meeting .standard cost system .standard cost system.professional organisations are relatively small and operate at a single location . its principal asset is the skill of its professional staff. In many organizations. Professionals Professional organization is labour intensive and the labour is of a special type. is essentially meaningless in such organizations. seperstion of fixed and variable cost and analyses of variance were built on the foundation.

until fairly recently these marketing contribution were rewarded subjectively –that is they were taken into account in promotion and compensation decisions . These marketing activities are conducted by professional usually by professional. Senior executive take such information seriously. Such financial measures are relatively unimportant in assessing a professional's contribution to the firm's.if the normal work.some organisation now give explicit credit. it cannot wait until one learns whether a new building is well designed. usually by professional who spend much of their time in production work that is working for clients. or by subordinates. How do we evaluate the Performance Appraisal? As noted earlier in regard to teachers. The budget can be used as the basis for measuring cost performance. objective measures of performance are sometimes unavailable: The recommendations of an investment analyst can be compared with actual market behavior of the securities. a new control system actually works well. Appraisal of the large percentage of professionals who are within the extremes is much more difficult. internal audit procedures are used to control quality. 3. subject to appropriate qualifications. to these numerical ratings. For these. 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. in part. peers. and clients. if the person who hold sold the project can be identified. subordinates. and its appraisal must be largely subjective. Nevertheless difficult problem arise in deciding how time should be charged to clients . The proposed design of a building may be reviewed by architects who are not actively involved in the project. are sometimes part of a formal control system. self. professional organizations increasingly use formal systems to collect performance appraisals as a basis for personnel decisions and for discussion with the professional. In a matrix organization. 11 . individuals may be asked to make a self-appraisal. In some organizations. Budgeting and control of discretionary expenses are as important in a professional firm as in a manufacturing company. 2. the report of an audit is reviewed by a partner other than the one who is responsible for it. and in most circumstances the assessment of performance is finally a matter of human judgment by superiors. Some systems require numerical ratings of specified attributes of performance and provide for a weighted average of these ratings. perhaps as a percentage of the project revenue. although such expressions may not always be readily forthcoming. Furthermore. Managers at all levels of the org focus attention on the information produced by the system. and the doctors' skill can be measured by the success ratio of operations. For some professions. the appraisal must be made currently. Expressions of satisfaction or dissatisfaction from clients are also an important basis for judging performance. 1. Compensation may be tied. The professional's major contribution is related to quantity and above all quality of work. of course. Moreover the profession al who is responsible for obtaining the engagement may not personally involved in carrying it out . at the extremes the performance of professionals is easy to judge. These measures are. profitability. " Appraisals by a professional's peers. A subset of the management control information that has a bearing on the strategic uncertainties facing the buss becomes the focal point. the accuracy of a surgeon's diagnosis can be verified by an examination of the tissue that was removed.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. however. In some professions. In such situation it is difficult to assign appropriate credit to the person responsible for selling a new customer. both the project leader and the head of the functional unit that is the professional's organizational "home" judge performance. 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. or a bond indenture has a flaw. Judgments made by superiors are the most common. In many accounting firms. and the work of the whole firm is "peer reviewed" by another firm. if the person revenue. and the actual time taken can be compared with the planned time.

namely. could be a result of selling price variance. in that case depending upon the above analysis. One more factor could have been the overall industry volume. quality standards and promotional efforts. Better credit management to recover receivables. the net working capital is more than budgeted which indicates capital block in higher inventory. we need to understand the key causal factors that affect profit. Results from variance computation are actionable if changes in actual results are analyzed against each of this expectation. A cause of concern is that despite lower sales. Variable expenses are directly proportional to volumes and hence as is evident are less than budgeted. 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. Sales promotional expenses also show a negative variance which could be a cause of lower sales volumes. this factor is beyond the managements control and largely dependent on the state of economy. revenues and cost structure. In order to analyze the variances. From the given data. Given the estimates are correct. sales volume could be improved by better marketing. mixed variance and/or volume variance. However. we see that there is a certain amount of variance between the budgeted operating profit and actual operating profit. one needs to ensure that estimates the as realistic as possible. product mix could be improved by selling more of higher contribution products. 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. that is a negative Rs 60 lakhs. (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. Revenue variances. will ensure improve cash flow situation since less capital will be tied up in working capital. selling prices and cost structure.Kiran Company (MCS-2004) Numerical Budget versus Actual comparison for div Z of Kiran company is as follows: 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 Actual 740 436 120 28 156 412 148 Actual better (worse) than budget (60) 44 0 12 4 12 (12) (a) Carry out and overall performance analysis to decide areas needing investigation. The profit budget has embedded in it certain expectations about the state of total industry. the management needs to take corrective action areas needing improvement. company‘s market share. 12 . Better sales will ensure a higher inventory turnover.

with EVA all business units have the same profit objective for comparable investments. a relatively low rate May be used for inventories while a higher rate may be used for different types of fixed assets. First. ROI data is available for competitors that can be used as a basis for comparison. based on results. First.4 Div B Budgete d 9% 44 Actual 9% 50. The performance of different units may be compared directly to each other. There are three compelling reasons to use EVA over ROI. Nevertheless. has adopted Economic Value Added (EVA) technique for the appraisal of performance of its three divisions A. while computing EVA relevant data are given below :Particulars Div A Budgete d Profit Current Assets Fixed Assets 360 400 1600 Actual 320 360 1600 Div B Budgete d 220 800 1600 Actual 240 760 1800 Div C Budgeted 200 1200 2000 Actual 200 1400 2200 Total Budgete d 780 2400 5200 Actual 760 2520 5600 Solution: Particulars Div A Budgete d ROA EVA 18% 208 Actual 16% 170. There are three apparent benefits of an ROA measure. decision that increase a centre‘s ROI may decrease its overall profits. For example. provides different incentives for investment across business units. There are two general types : engineered expense center and discretionary expense center. but for which outputs are not measured in monetary terms. Finally. no matter what its size or what business it practices. Second.B and C. it is a common denominator that may be applied to any organizational units responsible for profitability. (MCS-2008) Numerical Shandilya Ltd. Company charges 6% for current assets and 8 % for Fixed Assets. 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 13 .4 Div C Budgeted 6% -32 Actua l 6% -60 Total Budgete d 10% 220 Actual 9% 160. Describe differences in budgeting perspective of engineered and discretionary expense centre Expense centers: Expenses center are responsibility centers for which input or expenses are measured in monetary terms. it is a comprehensive measure in that anything that effects the financial statements is reflected in this ratio.8 b) Comment upon both methods. Third advantage of EVA is that different interest rates may be used for different types of assets. the EVA approach has some inherent advantages over ROA. For example. The ROI approach. and meaningful in absolute sense.Shandilya Ltd. ROA is easy to calculate. Also. Secondly. easy to understand. on the other hand. 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.

It in no way measures the value of the output. Discretionary expense center: The output of discretionary expenses center cannot be measured in monetary terms. We emphasize that engineered expense centers have other important tasks not measured by cast alone. The term discretionary does not mean that management judgments are capricious or haphazard. 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. the difference between the two represents the efficiency of the organization unit being measured. Management has decided on certain policies that should go vern the operation of the company. 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. Their inputs can be measured in monetary terms.incurred can be estimated with a reasonable degree of reliability. The effectiveness of these aspects of performance should be controlled. the term engineered costs center refers to responsibility center i n which engineered cost predominate but it does not imply that valid engineering estimates can be made for each and every cost item. distribution. 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. trucking and similar units in the marketing organization also may be engin eered expense center and so many certain responsibility center within administrative and support department. 2. Thus. 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. When this cost is compared to actual costs. 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. if actual expense do not exceed the budget amount. Even in highly automated production department the amount of indirect labour and of various services used can vary with management discretion. Costs incurred in factory for direct labour direct material component supplies and utilities are examples. Engineered expense centers: Engineered expense center have the following characteristics: 1.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 perfo rmance . They incl ude administration and support units research and development organization and most marketing activities. Their output can be measured in physical terms. 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. There are few if any responsibility center in which all cost items are engineered. 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. Warehousing. 14 . 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. the manager has ‗lived within the budget ‗ however . 3.

There is ample evidence that not all this upward creep in cost is necessary. For the latter. another new base is established. By con trast costs in engineering expense center are expected to vary with short run changes in volume. 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. 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. however management principal task is to decide on the magnitud e of the job that should be done. management decides whether the proposed operating budget represent the cost of performing task efficiently for the coming period. This tendency is expressed in Parkinson‘s second law: overhead costs tend to increase period. First because managers of these centers typically want to provide more service they tend to request ad ditional resources in the budgeting process and if they make a sufficiently strong case these request will be granted. That analysis provides a new base. 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. such as the marketing departments‘ ability to generate sales. 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. 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 15 . Such an analysis is often called a zero base review. Time does not permit the more thorough analysis described in the next section. There are two drawbacks to incremental budgeting. 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. In formulating the budget for a discretionary expense center.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. 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. Management is not so much concerned with the magnitude of the task because this is largely determined by the actions of other responsibility centers.(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.

subordinates typically infer what the new CEO really wants based on how he or she interacts during the management control process. Other managers are "people oriented". they look at a few numbers. the style of the business unit manage r affects the unit's management control process. They visit various locations and spend time talking with both supervisors and staff to get a sense of how well things are going. formal education. The style of the chief executive officer affects the management control process in the entire organization. marketing. others emphasize a broader set of rewards. conducts performance review meetings. Implications for Management Control The various dimensions of management style significantly influence the operation of the control systems. others are short-term oriented. Some are analytical. Similarly. Some are long-term oriented. and they spend much time analyzing this information and deriving tentative conclusions from it. Management style is influenced by the manager's background and personality. Managers differ on how much importance they attach to formal budgets and reports as well as informal conversations and other personal contacts. but they usually arrive at their conclusions by talking with people. Personality characteristics include such variables as the manager's willingness to take risks and his or her tolerance for ambiguity. 16 . and so on – which in turn affects how the control system actually operates. Personal versus Impersonal Controls Presence of personal versus impersonal controls in organizations is an aspect of managerial style. Style affects the management control process – how the CEO prefers to use the information. or finance. The management control function in an organization is influenced by the style of senior management. such as manufacturing. Some are risk takers. others are risk averse. others use trial and error. Even if the same reports with the same set of data go with the same frequency to the CEO. Differences in Management Styles Managers manage differently. they want a large flow of quantitative information. when CEOs change. and experience in a given function. Explain some factors which may influence top management style and the implication of the top management style on management control. others are results oriented. technology. and the style of functional department managers affects the management control process in their functional areas. Some are process oriented. others prefer conversations and informal contacts.personnel and personnel related costs are by far the largest expense item in most discr etionary expense center the annual budget for these center tend to be a constant percentage of budgeted sales volume. two CEOs with different styles would use these reports ve ry differently to manage the business units. even if the formal structure does not change under a new CEO. judging the relevance and importance of what they learn partly on their appraisal of the other person. Some rely heavily on report s and certain formal documents. In fact. Background includes things like age. Some emphasize monetary rewards. Some managers are "numbers oriented".

rather. 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 frequency of these reports. The solution in this case might be to change the manager. 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 . Second a periodic charge is made for the buying unit. however. the organization will experience performance problems. If the manager recognizes this incongruity and adapts his or her style accordingly. and the actual control reflects the style of the manager's superior. the problem d isappears. the degree of tightness or looseness often is not revealed by the content of the forms or aspects of the formal control documents. The style of the CEO has a profound impact on management control. The two step pricing method correct this problem by transferring variable cost on a per unit basis. and even their preference for graphs rather than tables of numbers. 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. The manager of a routine production responsibility center can be controlled relatively tightly or loosely.this is the same amount as the amount it would pay unit x if the 17 . Thus. 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. One or both of these components should include a profit margin. The transfer price is not primarily an accounting tool. Designers of management control systems need to identify these preferences and accommodate them. or procedures.Managers' attitudes toward formal reports affect the amount of detail they want. it is a behavioral tool that motivates manager to make the right decisions. If a new senior manager with a different style takes over. If. Tight versus Loose Controls A manager's style affects the degree of tight versus loose control in any situation. rules. 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. 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. the manager is unwilling or unable to change. and whether they want numerical reports supplemented with written comments. a charge is made for each unit sold that is equal to the standard variable cost of production. It is a factor of how these formal devices are used.

1. After the product is sold. First. Which is costly. 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. 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. 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. It would be appropriate under some circumstance to divide the investment into variable and fixed component. this system create an illusion feeling that business units are making money while in fact the overall company might be losing 18 .transfer price is less than 5000 units say 4000unoits. The d ifference is their transfer prices were for not using a portion of unit X capacity that it has reserved. The difference is changed to a headq uarter account and eliminated when the business unit statement are consolidated. Also. time consuming and work against basic reason for decentralization namely autonomy of the business units mangers. The return on investment that unit X earns on competitive product is calculated and multiplied by the investment assigned to the product. the business units share the contribution earned which is selling price minus the variable manufacturing and marketing costs. In general. senior management must be aware of this situation in approved budget for the business units and in subsequent evaluation of performance against these budget. Second. 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. There are several practical problems in implementing such profit sharing system. and the buying unit is charged the total standard costs. however the sum of the business unit profit is greater than overall company profits. Profit sharing If the two step pricing system just described is not feasible. there can be arguments over the way contribution is divided betwee n the two profit centers. a profit sharing system might be used to ensure congruence of business unit interest with company interest. 2. a profit allowance based on a return on investment on variable assets would be added to the standard variable cost for each unit sold.unit y would pay $50000 under the two step methods compared with the $44000 it would pay if the transfer price were $11 per unit. 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. this method accomplished the purpose of making the marketing unit‘s interest congruent with the companies. This system operates somewhat as follows. The fixed cost calculation in the two step pricing method is based on the ca pacity 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. 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. Then. The product is transferred to the marketing unit at standard variable cost. In the example we calculated the profit allowance as a fixed monthly amount.

Control problems: The control of R & D centers. A complete product of an R&D group may require several year of effort. 1. 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. new products. Results are difficult to measure quantitatively. Nevertheless. Thus in a discretionary expense center financial control is primary exercised at the planning stage before the amount are incurred. whereas a mediocre effort may.after taking account of the debits to headquarter. If these two types of 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 approved 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. 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. Under the two sets of price s method these conflicts are smoothed over thereby not alerting senior management to these problems. Sometime. The main purpose of a discretionary expen se budget on the other hand is to allow the manager to control Cost for particular in the planning. 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. which are also discretionary expense center is difficult for the following at least a semi tangible output reasons. 19 . 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. Even if an output can be identified a reliable estimate of its value often cannot be made. A brilliant effort may come up against an insuperable obstacle. Even if the value of the output can be calculated. or new processes. As contrasted with administrative activities. consequently input as stated in an annual budget may be unrelated to outputs. the relationship of these outputs to inputs is difficult to measure and appraise. This is in contrast with the report in an engineered expense center which helps higher management to evaluate the manger efficiency. Costs are controlled primarily by deciding what task should be undertaken and what level of effort is appropriate for each. R& D usually has at least a semi tangible output in patent. by luck result in a bonanza. it is usually not possible for man agement to evaluate the efficiency of the R&D effort because of its technical nature.

and the organ ization must be built up slowly over a long time period. For product testing projects. and short term fluctuation in the work force are in efficient. on the other hand.2. they are allocated. Basic research has two characteristics: first. the time and financial requirement can be estimated. 3. there is an understanding that scientists and engineers can devote part of their time to explorations in whatever direction they find most interestin g. therefore to reduce R&D costs in years when profits are low and increase them in year when profits are high. 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. For central services that the business unit can decide whether or not to use. A research project may take year s to reach fruition. no specific allowance is made for basic research as such. If these costs are charged at all. it is unplanned management at most can specify the general area that is to be explor ed second there is often a very long time lag before basic research result in successful new product introductions. This characteristic of services makes it difficult for pricing. Explain problems faced in pricing corporate services provided to business units organized as Profit Centers Services are intangible in nature. the business unit manager cannot control the efficiency with which these activities are performed but can control the amount of the service received. 20 . In some companies. and the allocations do not include a profit component. In others. and administration). central accounting. We need to consider two types of transfers:   For central services that the receiving unit must accept but can at least partia lly control the amount used. The allocations are not transfer prices.. Research and development can seldom be controlled effectively on an annual basis. even though this is more expensive than the company can afford. In these situations. Charging business units for services furnished by corporate staff units becomes challenging work due to intangibility of services. the other extreme is product testing. The research managers typically want to build the best research organization that money can buy. R&D should be looked at as a long term investment not as an activity that varies with short run corporate profitability. we exclude the cost of central service staff units over which business units have no control (e. While pricing corporate services. There are three schools of thought about such services.g. The goal congruence problem in R&D center is similar to that in administrative centers. subject only to informal agreement with their supervisor. The principal cost is for the work force obtaining highly skilled scientific talented is often difficult. basic research in included as a lump sum in the research program and budget. Financial control system has little value in managing basic research activities. At one extreme is basic research. Business units may be required to use company staffs for services such as information technology and research and development. public relations. not as accurately as production activities. The R&D continuum: Activities conducted by R&D organization lie along a continuum. It is not reasonable.

Full cost represents the company's long run costs. After losing $29 million online the previous year. The low pric e is analogous to the introductory price that companies sometimes use for new products. Commodore's vice president of customer satisfaction. Business units may procure the service from outside. and this is the amount that should be paid. internal consulting groups. Proponents argue that if the business units do not believe the services are worth at least this amount. In this situation. These service centers are independent. Under these conditions. If it pays less than this. 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.000 calls for service each day. develop their own capability. James Reeder.One school holds that a business unit should pa y the standard variable cost of the discretionary services. Commodore arranged for FedEx to handle the entire telephone customer service operation from FedEx's hub in Memphis. the price would be full cost plus a return on investment. they might not elect to use certain services that senior management believes worthwhile from the company's viewpoint. If the internal services are not competitive with outside providers. if not. 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.com to manage its online sales. the full cost. "At that time we didn't have the greatest reputation for customer service and satisfaction. costs charged by a computer service bureau). handling more than 300. But this was FedEx's specialty.g. said. Commodore Business Machines outsourced one of its central service activities -customer service-to Federal Express. Also. such as a new project analysis program. something is wrong with either the quality or the efficiency of the service unit.com while being able to focus on the growth of its bricks and mortar business. 21 . Borders Group turned to rival Amazon. A third school advocates a price that is equivalent to the market price. it will be motivated to use more of the service than is economically justified. This possibility is most likely when senior management introduces a new service. business unit managers control both the amou nt and the efficiency of the central services. or choose not to use the service at all. The market price would be used if available (e. or to standard full cost plus a profit margin. For example. and maintenance work. Optional Use of Services In some cases. the business units would incur the investment if they provided their own service. On the other hand. Borders get to maintain an Internet sales channel and gains the operational effectiveness provided by Amazon. This type of arrangement is most often found for such activities as information technology. these central groups are profit centers.. the scope of their activity will be contracted or their services may be outsourced completely. management may decide that business units can choose whether to use central service units. Their transfer prices should be based on the same considerations as those governing other transfer prices. if business unit managers are required to pay more than the variable c ost. they must stand on their own feet.

200 4. Fixed overheads of Rs.000 Actual (Rs.) 3. Material Cost of Rs. there is negligible difference in transfer price.00. 22 . A was 19.000 24.000 4.600 Units Direct and Variable Labour Cost Material Cost Fixed Overheads Total Cost Transfer Price Profit Investment ROI = Profit/Investment 60 20 100 120 20 20 12.17. Also the sales have decreased by 400 units.000 20. a) As Financial controller of Div.000 20% 57 119.92. Therefore we can say that additional investment has not achieved any positive results.40.00.000 units of a components which goes into the final product made by Div. A would require for this additional activity. actual off take of Div.00. Div. During the year.49. The transfer price for this internal transaction was set at Rs. compare Actual Vs Budgetred Performance b) Its implications for Management Control? Solution: a) Particulars Budgeted (Rs.) 4.(Numerical) MCS – 2004 Division B of Shayana company contracted to buy from Div.00. B from Div. A.86 11.200 4.000 19.00.00. A. 20. B.00.000 For 20. 120 per unit by mutual agreement.000 22.600 units.4 lacs) and Rs. A was able to reduce material consumption by 5% but its budgeted investment overshot by 10%.200 23.60.20 lacs that Div. Per Unit) 20 Budgeted (Total in Rs. (lumpsum Rs. 20. This comprises of (per unit) Direct and Variable labour cost of Rs.000 Units For 19.000 20% Despite of increase in investment by 10%.000 20. Per Unit) 20 Actual (Total in Rs.000 4.

000 Units * Rs.000 = Rs. A that it will increase selling price per unit to Rs.MCS – 2007 Two Divisions A and B of Satyam Enterprises operate as Profit centers. Div. 950 = Rs. 1.100. 80 per unit. What would be the effect on the company (assuming Div.00.00.000 Total outlay if transferred inside = 10.00. 95.000 Units * Rs.000 b) Option B ( if the market price is reduced by Rs. B still has excess capacity) if A buys from the market c) If excess capacity of Div.00. 920 = Rs. A decided to purchase the components from open market available at Rs. 14. will company as a whole benefit if div A buys from the market. a) Assuming that no alternate use exists for excess capacity in Div. 9.000 Total relevant cost becomes Rs.000 nos.000 and overall benefit for the company would be Rs. B is not happy and justified its decision to increase price due to inflation and added that overall company profitability will reduce and the decision will lead to excess capacity in Div.000 Since total outlay if transferred inside is lesser than total purchase cost if bought from outside.000 If Div A purchase from outside.e. 95. 3. b) If the market price reduces by Rs. should Div A purchase from outside) Total Purchase Cost = 10.00. 950 = Rs. should Div.) 95. Therefore.1.00.000 Option B Amount which has recently informed Div.000 Total opportunity cost if transferred inside = Rs. 92. Rs.000 Units * Rs.00.00.5 lacs. 5.000 23 . Solution a) Option A ( Div A buys from outside) Total Purchase Cost = 10. 1000 = Rs.000 Since total purchase cost is lesser than the total outlay if transferred inside.00. 14. 1000 per unit. Particulars Total Purchase Cost Total outlay if transferred inside Total opportunity cost if transferred inside Total relevant cost Net advantage/disadvantage to company as a whole if it buys from inside Option A Amount 1.50.000 and overall benefit for the company would be Rs.50.00. 1. B.00. 950 and Rs.00.000 1.00.00. B. relevant cost is the lesser one i. A purchase from outside? Justify your answers with figures. 80 per unit and A buys from the market) Total Purchase Cost = 10.) 95.000 14. 950 = Rs.5 lacs. Units * Rs. overall benefit for the company would be Rs.) 95.000 (9.000 (3.100.000) Option C Amount 1. 1.e. Div. of required components from Div. 95.50.000 5.000 (Rs. 1.000 (Rs.00.00. 92.00. whose variable and fixed costs per unit are respectively Rs. Naturally.000 Units * Rs.00.000 Total outlay if transferred inside = 10.00.00. Div A should purchase from outside. B.000 92.00.000 Units * Rs.000 c) Option C ( if excess capacity of Div B could be used for alternative sales at yearly cost savings of Rs 14. Division A normally purchases annually 10.000 (Rs.000. B could be used for alternative sales at yearly cost savings of Rs.000 Total outlay if transferred inside = 10. 1.50. relevant cost is the lesser one i.

Increasing the profits by expanding present operations or developing new product line. introducing productivity imporevement measures. These variables have tremendous analytical value. replacement of old equipments Advantages of ROI a) ROI relates return to the level of investment and not sales as the rate of return is more realistic.Explain the concept of ROI. etc. c) ROI is an effective tool for inter-firm comparison. Tax is excluded from the numerator because the marginal of the SBU is not responsible for or in control of the tax paid. One should also ignore windfalls and income from investments not related to the operations of the division. 24 . expansion. etc. ROI is calculated with the help of the following formula: 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. increasing market share. ROI can be improved by a) b) c) d) e) f) Increasing the profit margin on sales. The profit should include only the profits arising out of the normal activities of the division. Assets not currently put to divisional use should be excluded from the investment base. Increasing the capital turnover Increasing both profit margin and capital turnover. b) ROI can be decomposed into other variables as shown. Capital employed can be ascertained from the balance sheet by including fixed and current assets. deferred revenue expenses. Diversifying. Unusual items of receipts and expenses should be excluded from the profit figure. What are its advantages? Return on investment (ROI) is the ratio of profit before tax to the gross investment. Reducing cost as that adds to the total earnings of the firm. The company should also exclude intangible assets like goodwill. One also needs to exclude their relative earnings if any. preliminary expenses.

essentially. 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. For example. and they control fixed assets by separate devices. This acts both to motivate business unit management properly and also to measure the real cost of resources committed to these items. and. In particular. then. Explain this phenomenon with as illustration. management wants to know when capital investment decisions have been made incorrectly. If these decisions are wrong. regardless of profitability. Nevertheless. When a group of units with varying degrees of marketing responsibility are ranked. some assets may be undervalued when they are capitalized. the cost accounting system usually will not identify the savings attributable to each product. Moreover. Investment decisions. serious consequences can occur-quickly. it is largely a sunk cost and should not influence future decisions. it does not solve the problem of accounting for fixed assets discussed above unless annuity depreciation is also used. EVA does not solve all the problems of measuring profitability in an investment center. Although the purchase cost of fixed assets is ordinarily capitalized. if inventories are too low. a business unit can increase its EVA by taking actions contrary to the interests of the company. some companies. a substantial amount of investment in start-up costs. receivables. 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. If net book value is used. are controlled at the point where these decisions are made. namely. 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. therefore. Controllable assets are. unnecessary capital is tied up. and so forth may be written off as expenses. 17 include a capital charge for the items as an element of cost in the business unit income statement. EVA will be temporarily depressed by new investments because of the high net book value in the early years. and office furniture and equipment. and the risk of obsolescence is increased. These companies make an interest charge for controllable assets only. To focus attention on these important controllable items. as shown in Exhibit 7-3. All business units. if inventories are too high. EVA does not do justice to the evaluation of investment center. not appear in the investment base. whereas. new product development. EVA does solve the problem created by differing profit potentials. For example. Consequently. some companies have decided to exclude fixed assets from the investment base. 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. Furthermore. in fact. and this is rarely done in practice. receivables and inventory. the capital investment analysis procedure is of primary importance in investment control. such as Quaker Oats. EVA will increase simply due to the passage of time. In view of all these problems. In these units the investment amount may be limited to inventories. Once the investment has been made. If gross book value is used. 25 . if a new machine produces a variety of products. will be motivated to increase investments if the rate of return from a potential investment exceeds the required rate prescribed by the measurement system. dealer organization. the unit with the relatively larger marketing operations will tend to have the highest EVA. This situation applies especially in marketing units. Business unit management can make dayto-day decisions that affect the level of these assets. This is far from being completely satisfactory because actual savings or revenues from a fixed asset acquisition may not be identifiable.Many experts regard EVA as a concept superior to ROI and yet in certain cases. production interruptions or lost customer business can result from the stockouts. and others when they are expensed. materialized.

26 . ROI = Profit / Invested capital * 100 ROI consists of two components viz.Illustration 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: 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.

a. 27 . Most likely the rate would improve in course of time when the initial difficulties are overcome. 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. Debit balance of P & L A/c xxx xxx xxx xxx ------xxxx Merits: Return on investment analysis provides a strong incentive for optimum utilization of the assets of the company. the investment base will continuously decrease in value. Demerits: ROI analysis is not very suitable for short-term projects and performances. Profit margin Investment turnover ROI = Net profit / Investment = (Net profit / Sales) * (Sales / Investment in assets) It will be seen from the above formula that ROI can be improved by increasing one or both of its components viz. In selecting amongst alternative long-term investment proposals. Preliminary expenses c. ROI provides a suitable measure for assessment of profitability of each proposal. In the initial stages a new investment may yield a small ROI which may mislead the management. The book value of assets decline due to depreciation. Investment outside the business b. 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 Reserves and surplus Loans (secured/unsecured) xxx xxx xxx -----xxx Less: a. 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. b. loans etc The profit figure used is in calculating ROI is usually taken from the profit and loss account. causing the rate of return to increase.

Because when RI is adopted for evaluation purposes.  It should induce goal congruent decisions-i. is residual income. Limited Market Shortage of Capacity in the industry The ideal transfer price in the situations of : 28 . 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. which could encourage managers to be more willing to undertake marginally profitable projects. We recommend RI as a method of evaluating performance of an investment centre. Residual income is affected by the size of the organization and therefore will not provide a basis for evaluation of organizational performance. 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. interest on the capital invested in the company is treated as a cost and any surplus is the residual income.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.   It should help measure the economic performance of the individual profit centers. It has been argued that a more suitable measure of performance for investment centres. What is ideal transfer price in the situations of a. The system should be simple to understand and easy to administer. b. This is probably the main reason why the management continues to make use of ROI which is relative measure.e. In other words. the system should be so designed that decisions that improve business unit profits will also improve company profits. emphasis is placed on marginal profit amount above the cost of capital rather than on the rate itself. Residual income is profit minus notional interest charge on capital employed.

the profit center is appealing only the sourcing decision. The company obtains valid bids. it may be possible to replicate competitive prices for its proprietary products. it will soon find that either no one bids or that the bids are of questionable value. Shortage of Capacity in the industry In this case. it is often possible to replicate a competitive price on the basis of the outside price. 4. In every case the transfer price would be the competitive price.a. the output of the buying profit center is constrained and again company profits may not be optimum. 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. If published market prices are available. 3. but selects one-half to stay inside. if a company requests bids solely to obtain a competitive price and does not award the contracts to the low bidder. However. they can be used to establish transfer prices. 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. Some companies allow either buying profit center to appeal a sourcing decision to a central person or committee. 29 . Market prices are set by bids. This generally can be done only if the low bidder has a reasonable chance of obtaining the business. The person/group would then make a sourcing decision on the basis of the company‘s best interests. 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. For example. because low bidders can expect to get some of 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. By contrast. b. In this scenario a buying profit center could appeal a selling profit center‘s decision to sell outside. If the buying profit center purchases similar products from the outside market. 2. market prices that are applicable to relatively small purchases are not valid in this case. If the production profit center sells similar products in outside markets. Limited Market By limited market it means that the markets for buying and selling profit centers may be limited. The company then puts all of the products out to bid. 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. In other words. They are as follows: 1.

The conceptual solution is to base the profit allowance on the investment required to meet the volume needed by the buying profit centers. the market price is the best transfer price. therefore. The investment would be calculated at a ―standard‖ level. If the standard costs are used. This solution is complicated and. even though such transfer prices may be complex to calculate and the results less satisfactory than a market-based price. 30 . 2. with fixed assets and inventories at current replacement costs.Even if there are constraints on sourcing. The profit markup: In calculating the profit markup. there is a need to provide an incentive to set tight standards and to improve standards. If the historical cost of the fixed assets is used. Actual costs should not be used because production inefficiencies will then be passed on to the buying profit center. If the market price can be approximated. When do you use Cost Based Transfer Pricing? We use cost-based transfer pricing if there is no way of approximating valid competitive price. If this base is used. however. Transfer prices may be set up on the basis of cost plus a profit. What is the level of profit allowed? The second problem with the profit allowance is the amount of the profit. rarely used in practice. there also are two decisions: What is the profit markup to be based? The simplest and most widely used base is percentage of costs. it is ideal transfer price. new facilities designed to reduce prices could actually increase costs because old assets are undervalued. The cost basis: The usual basis is the standard cost. Two aspects need to be considered for cost-based transfer pricing: 1. But there may be a major practical problem in calculating the investment applicable to a given product. no account is taken of capital required. A conceptually better base is a percentage of investment.

“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. There have been instances where companies have fixed unrealistic transfer prices. 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 31 . But if companies set unrealistic transfer price to minimize their tax liabilities and the same is spotted by the tax authority. In the larger interest of the group. The manipulation helped the company to hide tax to the tune of 237 million dollars. 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. 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. While companies indulge in all types of activities to lower their tax liability. While the tax authorities in UK accepted the price. it would be advisable to show lower profits in Country B and higher profits in Country A. then the company is forced to pay tax in both countries leading to double taxation. For this they enter into agreements whereby tax is paid on specific transactions in one country only. The reverse will be true if the Division in Country A acquires goods from the Division in Country B. The company had falsely inflated freight charges by 40-60% to reduce the profits. The company's lawyers argued the case before the Commission on two grounds viz. 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. For example the tax rate in Country A is 20% and is 50% in Country B. Transfer price is viewed as a major international tax issue. These arguments did not go well with the Commission and the company was fined 1. The second case is of Nissan. The company had incurred an R&D cost that was included in the price. For this. 1. since the same drugs were available from an Italian firm for 9 pounds and 28 pounds per kilo. 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. This will maximize the profits in Country A and minimize the profits in Country B. The price was not set on cost but on what the market would bear and 2. the tax authorities monitor transfer prices closely in an attempt to collect the full amount of tax due. the Monopolies Commission did not accept the company's argument.85 million pounds for the manipulative practices adopted while fixing the transfer price.

In spite of all these efforts.marketing profits were being transferred to Japan. These guidelines aim at encouraging world trade. Organisation for Economic Cooperation and Development issued some guidelines in 1995. They evolved what came to be known as the arm's length price. it has to be admitted that setting a fair transfer price is not easy. If the taxpayer fails to do this he is required to pay heavy penalty. 2. They are as follows: 1. in USA. For example. 32 . With a view to avoid such cases from recurring. 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. Market prices are set by bids. For example.  Gross Margin Method where a gross margin is established and applied to the seller's manufacturing cost. Other countries are also in the process of evolving tight norms for the same. One company accomplishes this by buying about one-half of a particular group of products outside the company and one-half inside the company. Comments By limited market it means that the markets for buying and selling profit centers may be limited. they can be used to establish transfer prices. 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. If published market prices are available. failure to provide documentary evidence results in a 40% penalty on the arm's length price. Interestingly the Japanese tax authorities took a different view and returned the double tax. market prices that are applicable to relatively small purchases are not valid in this case. 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. In UK the penalty is to the tune of 100% of any tax adjustment. This generally can be done only if the low bidder has a reasonable chance of obtaining the business. The principle states that the transfer price would be arrived at on the basis as if the two . 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. companies are independent and unrelated. However. as transfer prices on import of cars and trucks were too high. 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. Market Price is ideal transfer price even in limited markets. So the onus of proving the price has been put on the taxpayer who is required to produce supporting documents.

which is sold to another division as a component of its product B.000 + 10% on (FA + Inventory) i. it may be possible to replicate competitive prices for its proprietary products.000 = 81 2.) (Units) Product A 40 20 20 60 14 lacs 6 lacs 2 lacs Product B 60 20 20 60 3 lacs 9 lacs 2 lacs Product C 20 40 40 20 6 lacs 3. If the production profit center sells similar products in outside markets.00. it is often possible to replicate a competitive price on the basis of the outside price.000 1. it will soon find that either no one bids or that the bids are of questionable value.) (Rs.000 1. if a company requests bids solely to obtain a competitive price and does not award the contracts to the low bidder. which then is sold to third division to be used as part of its Product C (sold to outside market). The company obtains valid bids. By contrast.e.) (Rs.H. Intra company transactions rule: standard cost plus a 10 percent return on fixed assets and inventory.000 40. (20 * 2 lac units) 80.00. Average Inventory Net Fixed Assets Standard Production (a) (b) (Rs. Comment.00.) (Rs.The company then puts all of the products out to bid. Answer (a): Standard Cost of Product A Outside material (40 * 2 lac units) Direct Labour (20 * 2 lac units) Variable O. 4.So we see from the above arguments that market price is ideal transfer price even in limited markets Division of Aparna Company manufactures Product A. transfer prices for Products A. 3.) (Rs.00.If the buying profit center purchases similar products from the outside market.00.000 Transfer Price for Product A = 1. B and Standard Cost of Product C. because low bidders can expect to get some of the business. Standard Cost per Unit *Purchase of outside material Direct. but selects one-half to stay inside.000 40.2 lacs 2 lacs Determine from above data. 10% on 20 lacs 2.00.00. Product C could become uncompetitive since upstream margins are added.000 33 .60.) (Rs. 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. Labour Variable overhead *Fixed overhead per unit. to be paid by the buying division.62.00.62.

000 2." In a goal congruent process.01. (20 * 2 lac units) 1.000 20.H. Management control systems influence human behavior.00.000 80.000 Standard Cost of Product C Outside material (20 * 2 lac units) Direct Labour (40 * 2 lac units) Variable O. and they are not necessarily consistent with those of the organization.e. and then come out with Product C with a lower price tag on it.00.00. But the individual members of the organization have their own personal goals.000 (b) While arriving at the cost of Product C.20.6 2. So it might become uncompetitive. then.00. Good management control systems influence behavior in a goal congruent manner. as its price will normally be high compared to products of similar category.000 + 10% on (FA + Inventory) i. The concept of goal congruence.Standard Cost of Product B Outside material (60 * 2 lac units) Direct Labour (20 * 2 lac units) Variable O. The significance of human behavior patterns in management control system can be explained with the help of Informal Factors that influence Goal Congruence.000 2. This may do well to the product by making higher revenues and capturing the market share. the actions people are led to take in accordance with their perceived self interest are also in the best interest of the organization. Another strategy for the company is to cut the margins added by Products A and B. margins of Product A.000 = 100. and Product B.20. which in turn become an input to Product C.H. that is.20.000 Transfer Price for Product A = 2.000 2. (20 * 2 lac units) 40.20.00. The central purpose of a management control system. customers will distinguish between a good product and a bad product and the one with the best quality will survive.01. they ensure that individual actions taken to achieve personal goals also help to achieve the organization's goals.00.000 40.00.H.00. which become an input to Product B.000 80. (40 * 2 lac units) Fixed O.000 40. are added. is to ensure a high level of what is called "goal congruence.20. In the informal forces both internal and external factors play a key role. 10% on 12 lacs 1. But in the long run. So if the quality of product C is better than its competitors than only it can survive in this competitive market.00. it suffers a disadvantage from its competitors as far as pricing is concerned. Describe and illustrate significance of human behavior patterns in management control system. Senior management wants the organization to attain the organization's goals. So when it is sold to outside market.00. 34 .00. describing how it is affected both by informal actions and by formal systems.

Managers come in all shapes and sizes.. others are less ebullient.g. 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. whereas senior management does not actually want them to skimp on maintenance or employee training since such actions. the headquarters staff. Moreover. But in the course of fulfilling his or her responsibilities. Still others are national. with all these other communication sources available. and their superiors' attitudes ultimately stem from the CEO. specific to the city or region in which the organization does its work. Some of these attitudes are local that is. Perception and Communication In working toward the goals of the organization. the rules and norms accepted by the union also have a major influence on the organization's culture. although no one may remember why. An organization is a complicated entity. diligent workforce. the production manager of Division A actually communicates with many other people in the organization. might reduce 35 .. and their pride in doing a good job (rather than just putting in time). Management Style The internal factor that probably has the strongest impact on management control is management style. subordinates' attitudes reflect what they perceive their superiors' attitudes to be. the official authority and responsibilities-of each manager. Usually. A company's culture usually exists unchanged for many years. others rely more heavily on written reports. support units. conversations). or be subject to differing interpretations." Others are taboo ("we just don't do that here"). such as Japan and Singapore. In extreme situations. their spirit. For example. and people who are simply friends and acquaintances. The realities of the management control process cannot be understood without recognizing the importance of the relationships that constitute the informal organization. If the organization is unionized. that the production manager of Division A reports to the general manager of Division A. carried on almost automatically because "this is the way things are done here. These norms include a set of attitudes. budgets and other official documents) and informal (e. which is manifested in employees' loyalty to the organization. may vary in terms of actual control. Organizational culture is also influenced strongly by the personality and policies of the CEO. as well as with other managers. often collectively referred to as the work ethic. chambers of commerce and other promotional organizations often claim that their locality has a loyal. Some spend much time looking and talking to people (management by walking around). for example. although increasing current profits. both formal (e. Certain practices become rituals.g. have a reputation for excellent work ethics. the greater the resistance is. Other attitudes and norms are industry-specific. shared values. In encouraging companies to locate in their city or state. the messages received from different sources may conflict with one another. The chart may show. Internal Factors Culture The most important internal factor is the organization's own culture-the common beliefs. Cultural norms are extremely important since they explain why two organizations with identical formal management control systems. some countries. Some are charismatic and outgoing. it is not always clear what senior management wants done. and by those of lower-level managers with respect to the areas they control. Attempts to change practices almost always meet with resistance.External Factors External factors are norms of desirable behavior that exist in the society of which the organization is a part. norms of behavior and assumptions that are implicitly and explicitly manifested throughout the organization. their diligence. operating managers must know what these goals are and what actions they are supposed to take in order to achieve them. the production manager. the budget mechanism may convey the impression that managers are supposed to aim for the highest profits possible in a given year. 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. and the larger and more mature the organization. Despite this range of channels. The Informal Organization The lines on an organization chart depict the formal relationships-that is. They receive this information through various channels.

capital expenditures of over $5 million must be approved by the board' of directors). job descriptions. how much discretion should be allowed. that is..g. organization members are permitted. and to prevent (or at least minimize) fraud of every sort. which should be considered to be guidelines rather than fiats.future profitability. computer passwords. The informal factors discussed above have a major influence on the effectiveness of an organization‘s management control. or other undesirable actions. and a number of other procedures described in texts on auditing. Rules range from the most trivial (e. standard operating procedures. Some rules are guides. These include: crosschecking totals with details. Many of these tasks are controlled by rules.g. Manuals in bureaucratic organizations are more detailed than are those in other organizations. there are rules that should never be broken under any circumstances: a rule prohibiting the payment of bribes.. 36 . Finally. and ethical guidelines. large organizations have more manuals and rules than small ones. illegal. Others are prohibitions against unethical. centralized organizations have more than decentralized ones.g. separating duties. The Formal Control System Rules We use the word rules as shorthand for all types of formal instructions and controls. to depart from them. requiring signatures and other evidence that a transaction has been authorized. for example. counting cash and other portable assets frequently.. manuals. 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. These systems can be classified into two types: (1) the management control system itself and (2) rules. Manuals Much judgment is involved in deciding which rules should be written into a manual. paper clips will be issued only on the basis of a signed requisition) to the most important):e. fire drills at prescribed intervals). locked storerooms. 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. either under specified circumstances or when their own best judgment indicates that a departure would be in the best interests of the organization. the automated system itself provides the control. and a host of other considerations. television surveillance. vaults. including: standing instructions. Task Control Systems Task control is the process of assuring that specific tasks are carried out efficiently and effectively. and indeed expected. which are described in this section. Some rules are positive requirements that certain actions be taken (e. If a task is automated. and other physical controls may be part of the control structure. The other major influence is the formal systems.

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. Absent of profit performance measure leads to problems in assessing the efficiency of the organization. The more stress expected on allocation of scare resources. On the financial front. which entitles the organization to reap the interest on it keeping the principal amount intact. Management control in matrix structures Matrix organizational structure assigns multiple responsibilities to the functional heads. subsidies. 4.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). This form of organization is very complex. grants etc so also they attract special control from these assisting institutes. from the point of view of management control system. This does not mean 37 . and enhancing the service base. Operating Assets represents the resources used for running day to day activities. who exercise less control on operational matters. 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. And the contributed assets are not allowed to mix up with the operating assets.what could be appropriate price? Usually it is set at total/full cost. Hence performance control is less demanding from owners' point of view and difficult from the point of view of management. 2. If the organization shows net losses it may show the NPO facing risk of bankruptcy. But one can make the things easier by concentrating on adherence to costs budgets. 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. If the organization shows large net income it may be because that NPO may not be providing the services to the extent possible/ expected. The capital contribution to the business comes by way of contributions to assets such as building and equipments. 3. account supervisors are shifted from one account to another on periodic basis. it poses problems of casting the individual responsibility. Non profit basis makes performance evaluation quite impossible. Evaluation of performance of such organizational entities is very difficult. this practice allows the agency to look at the account from the perspectives of different executives. Though they offer economies of using scares functional staff. These characteristics pose difficulty in pricing of the product/services . 5. Second kind of contribution could be in the form of monetary assistance. The nature of the contributed capital is beyond control of the management and therefore management concentrates on controlling the operating assets/investments. NPO's have contributed capital Plant: NPOs do not have shareholder as its stakeholder. Hence non availability of clear-cut performance yardstick makes the problem of control worst. Governance: Usually NPO are managed by trusts. Such organizations include religious. 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. they enjoy many concessions from the government such as taxes. but a sense of control can be built among the managers by way of using budgets for various activities and expenses. Usually in an advertisement agency. Though not stricter control. Fund accounting: NPO need to keep two types of financial statements one set for contributed capital and another for operating capital. Characteristics: 1. charitable and educational trusts.

therefore. Budgeting The chief executives of single-industry firms may be able to control the operations of subordinates through informal and personally oriented mechanisms. corporate-level managers for highly diversified firms cannot expect to control the different businesses on the basis of intimate knowledge of their activities. strategic plans of individual business units could have an interdependence section. First. 38 . not the corporate office. Matrix structure offers advantages such as faster decision making process. 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. much of the communication and control has to be achieved through the formal budgeting stem. several of them could be pursued fruitfully at the same time. This implies the following budgeting system characteristics in a conglomerate. assignment of responsibility and authority etc. business units prepare strategic plans & submit to senior management to review & approve. corporate-level managers may not have significant knowledge of. Second. such as frequent personal interactions. These methods are not mutually exclusive. in which the general manager of the business unit identifies the focal linkages with other business units and how those linkages will be exploited. This implies that as firms become more diversified. efficiency and effectiveness but simultaneously it may pose problems such as added complexity in control function. or experience in. possess most of the information about their respective product/market environments. Single-industry and related diversified firms possess corporatewide core competencies (on which the strategies of most of the business units are based. the corporate office could require joint strategic plans for interdependent business units. 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 plans of individual business units could be circulated to managers of similar business units to critique and review. are critical in such firms. In contrast. Communication channels and transfer of competencies across business units. If so. Finally. in a conglomerate it is nearly impossible for the chief executive to rely on informal interpersonal interactions as a control tool. the activities of the company's various business units. The horizontal dimension might be incorporated into the strategic planning process in a number of different ways. Greater emphasis is often placed on meeting the budget since the chief executive has no other informal controls available. 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. conglomerates tend to use vertical strategic planning systems-that is. In fact. Strategic planning: Given the low level of interdependencies. and performance evaluation tends to be carried out at arm's length. Business unit managers have somewhat greater influence in developing their budgets since they.a control system designer should insist on abandoning the rotation system of the executives. Third. On the other hand. there are low levels of interdependence among the business units of unrelated diversified firms. This lessens the need to rely as heavily on the budgeting system as the tool of control.

hold. the greater the possibility of interunit conflict. they tailor the approach to each business unit's strategy. the more the incentive bonus of general managers emphasizes the separate performance of each unit. In contrast. However. or harvest. Incentive Compensation The incentive compensation policy tends to differ across corporate strategies in the following waysUse of formulas: Conglomerates. Many chief executive officers of multi business organizations do not adopt a standardized. These formula-based bonus plans are employed because senior management typically is not familiar with what goes on in a variety of disparate businesses. 39 . rather than the profitability of the firm~ Its purpose is to motivate managers to act as though the business unit were their own company. thereby increasing managers' motivation to exploit interdependencies rather than their individual results. The mission of the business unit influences the uncertainties that general managers face and the short-term versus long-term trade-offs they make. different missions often require systematically different management control systems. synergies may be important. in general. greater degrees of interrelationships imply that one unit's performance can be affected by the decisions and actions of other units. harvest. formula-based plans that are tied strictly to financial performance criteria could be counterproductive. The strategy of a business unit depends on two interrelated aspects: (1) Its mission ("What are its overall objectives?") and (2) its competitive advantage. for companies with highly interdependent business units. that is. Profitability measures: In the case of unrelated diversified firms. These missions constitute a continuum. such as X percent bonus on actual economic value added (EVA) in excess of budgeted EVA. they may base a larger portion of the bonus on quantitative. there should be congruence between the mission chosen and the types of controls used. The usual transfer pricing policy in a conglomerate is to give sourcing flexibility to business units and use arm's-length market prices. Mission The mission for existing business units could be either build. the incentive bonus of the 'business unit managers tend to be determined primarily by the profitabi1ity of that unit. Typically business units choose from four missions: build. In many related diversified firms. Therefore.the overall corporation). 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 . Senior managers of single-industry and related diversified firms tend to base a larger fraction of the business unit managers‘ bonus on subjective factors. instead. The business unit has two generic ways to compete and develop a sustainable competitive advantage: low cost and differentiation. in a single-industry or a related diversified firm. When business units are interdependent. Business Unit Strategy: Diversified corporations segment themselves into business units and typically assign different strategies to the individual business units. uniform approach to controlling their business units. and divest. To implement the strategy effectively. Thus.Transfer Pricing Transfers of goods and services between business units are more frequent in single-industry and related diversified firms than in conglomerates. are more likely to use formulas to determine business unit managers' bonuses. and business units may not be given the freedom to make sourcing decisions. Management control systems can be systematically varied to help motivate the manager to cope effectively with uncertainty and make appropriate short-term versus long term trade-offs. basing the bonus of general managers more on the overall corporate performance is likely to encourage greater interunit cooperation. hold. ("How should the business unit compete in its industry to accomplish its mission?"). with "pure build" at one end and "pure harvest" at the other end. financial measures. On the other hand.

This also contributes to the greater uncertainty that managers of build units face in dealing with external constituencies. increase in market share (greater dependence on customers and competitors). concentrates on maximizing short-term profits. whereas harvest strategies typically are undertaken in the mature decline stage of the product life cycle. today may not result in profits until some future period. Nevertheless. Because the total market share of all firms in an industry is 100 percent. nonfinancial data are more important. number of competitors. 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.battle for market share is a zero-sum game. product technology. If the environment is stable. Competitors' actions are likely to be unpredictable. business units. as compared with harvest. 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. On both the input side and the output side. increase in production volume (greater dependence on raw material suppliers and labor markets). thus. These actions are aimed at establishing market leadership. relations with suppliers. market demand. and so on. the system may be more quantitative and financial for harvest units. Since the corporate office wants to take advantage of the opportunities in a growing market. Because harvest units tend to experience stable environments with predictable products. build managers are likely to have less experience in their industries. the strategic planning process is especially important management needs to think about how to cope with the uncertainties. and distribution channels. Thus. thus. there may be no strategic planning process at all or only a broad-brush strategic plan. The greater the external dependencies a business unit faces. The required information used to evaluate investments from harvest units is primarily financial. Strategic Planning When the environment is uncertain. Such factors as manufacturing process. Build business units are often in new and evolving industries. the greater the uncertainty it confronts. on the other hand. Given the product/market uncertainties. expansion of capacity (greater dependence on the technological environment). thereby motivating build managers to forward more investment ideas to corporate office. buyers. the strategic planning process is more critical and more important for build. and (c) major market development expenditures. financial analysis of some projects from build units may be unreliable. a build mission signifies additional capital investment (greater dependence on capital markets). and this contributes to the uncertainty that build business units face. build managers tend to experience greater dependencies on external individuals and organizations than do harvest managers. For instance. In screening capital investments and allocating resources. (b) major R&D expenditures (to introduce new products). a build strategy puts a business unit in greater conflict with its competitors than does a harvest strategy. and customers). A harvest business unit operates in a mature industry and does not offer tremendous new investment possibilities. A harvest strategy. technologies. however. The share-building strategy includes (a) price 'cutting. the . competitors. but they depress short-term profits. Thus. . 40 . and this usually requll1 longer-range view of planning than is possible in the annual budget. and competitive structure change more rapidly and are more unpredictable in the growth stage than in the mature/decline stage. A build unit. An objective of a build business unit is to increase market share. senior management may set a relatively low discount rate. Mission and Time Span The choice of build versus harvest strategies has implications for short-term versus long-term profit trade-offs. discounted cash flow PCF) analysis often can be used more confidently. is positioned on the growth stage of the product life cycle. Hence.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. many decisions that a build unit manager makes. For such projects.

As already noted.Budgeting The calculational aspects of variance analysis comparing actual results with the budget identify variances as either favorable or unfavorable. What measures of performance (e. Thus. a favorable variance does not necessarily imply favorable performance. product development) should be used when deciding the general manager's incentive bonus awards? If multiple performance measures are employed. whereas other performance criteria (market share. "build" managers are more likely than "harvest" managers to rely on bonuses. operating profits. Either as a differentiated player or as a low-cost player. the greater the proportion of the general manager's compensation in bonus compared to salary (the "risk/return" principle).g. 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. build managers. increases uncertainty of a business unit's task environment for three reasons. how should they be weighted? 3.in contrast with harvest managers. The link between a favorable or unfavorable variance. 41 . However. How frequently (semiannual. Thus. on the one hand. nor does an unfavorable variance imply unfavorable performance. X percent bonus on actual profits in excess of budgeted profits). new product development.to take greater risks. At one extreme. Alternatively. Performance on most long-term criteria (market development. depends on the strategic context of the business unit under evaluation. with differential weights for each criterion depending on the business unit's mission. As to the fourth question. Competitive Advantage A business unit can choose to compete. sales volume. behaviour ls influenced by the desire to optimize performance with respect to those criteria. so they typically are evaluated more subjectively than are harvest managers. the following questions need to be resolved: 1.. The third question asks how much subjective judgment should affect bonus amounts. and favorable or unfavorable performance.g. new-product development. Choosing a differentiation 'approach. and people development) focus on long-term profitability. a manager's incentive bonus amounts might be based solely on the superior's subjective judgment or discretion. cash flow from operations. such as operating profits. many firms use the principle that the riskier the strategy.. They maintain that because managers in charge of more uncertain task situations should be willing. How much reliance should be placed on subjective judgments in deciding on the bonus amount? 4. the frequency of bonus awards does influence the time horizon of managers. linking incentive bonus to short-term criteria tends to promote a short-term focus on the part of the general manager and. they should have a higher percentage of their remuneration in the form of an incentive bonus. biennial. market share. As to the second question. linking incentive bonus to long-term criteria is likely to promote long-term focus. a manager's bonus might be a strict formula-based plan. 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. EVA. and people development) is harder to measure objectively than is performance along most short-run criteria (operating profits. etc.) should incentive awards be made? With respect to the first question. rather than a low-cost approach. to evaluate the performance of every business unit. profit. similarly. market development. on the other hand. Considering the relative differences in time horizons of build and harvest managers. should concentrate more on the long run. Some performance criteria (cost control. A better idea would be louse multiple performance criteria. with the bonus tied to performance on quantifiable criteria (e. annual. uniform financial criterion. it may not be appropriate to use a single. At the other extreme. incentive bonus amounts might also be based on a combination of formula-based and subjective approaches. and return on investment). Incentive Compensation System In designing an incentive compensation package for business unit managers. when rewards are tied to certain performance criteria. and cash flow from operations) focus more on short-term results.

If only the actual cash were shown: by internal units would appear abnormally high and might mislead senior management. Du Pont was reported to use two months' costs of sales minus depreciation. However product differentiation business units succeed if customers perceive that the products have advantages over competing products. with primary emphasis on cost reduction. This is partly because a low-cost business unit. 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. For example. headquarters asks two questions: First. not only indirectly by their ability to 42 . in respect of following assets: (i) Cash (ii) Receivables (iii) Inventories (iv) Idle (v) Intangible (vi) Leased In some business units. These companies reason that the amount of cash approximates the current liabilities. 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. Which management control practices. Some companies omit cash from the investment base.1. Many companies therefore use a formula to calculate the cash to be included in the investment base. Since the customer perception is difficult to learn about. & since customer loyalty is subject to change resulting from actions of competitors or other reasons. Receivables Business unit managers can influence the level of receivables. 2. profit is compared with the assets employed in earning it. 3. is likely to engage in greater product innovation. the demand for differentiated products is typically more difficult to predict than the demand for commodities. business unit managers will try to improve their performance as measured in this way. if followed. Differentiation business units on the other hand tend to have a broader set of products to create uniqueness.5 percent of annual sales. when their profits are related to assets employed. if this is so. Business unit cash balances may well be only the "float" between daily receipts and daily disbursements. Low cost business units typically produce no-frill commodity products& these products succeed primarily because they have lower prices than competing products. General Motors was reported to use 4. in performance measurement of investment centres are likely to induce goal congruence. the focus is on profit as measured by the difference between revenues and expenses. with its primary focus on uniqueness & exclusivity. \Senior management wants the actions that they take toward this end to be in the best interest of the whole corporation. 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. typically prefers to keep its product offerings stable over time. 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. Measuring Assets Employed In deciding what investment base to use to evaluate investment center managers. a differentiation business unit. Second. 3. Product innovation is more critical for differentiation business units than for low cost business units. the sum of accounts receivable and inventories will approximate the working capital. In other business units. We refer to the latter group of responsibility centers as investment centers. Consequently. what practices best measure the performance of the unit as an economic entity? 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.

the impact of income taxes must also be taken into account. these payments either are subtracted from the gross inventory amounts or reported as liabilities. at zero cost to the business unit. in effect. although the average of intraperiod balances is conceptually a better measure of the am should be related to profits. Because of this. and then leased back the assets at a rental rate of $60. delaying payments unduly to reduce net current assets may not be in the company's best interest since this may hurt its credit rating. the business unit's income before taxes would decrease because the new rental expense would be higher than the depreciation charge that was eliminated. therefore.) Many leases are financing arrangements-that is. The usual practice is to take the simpler alternative-that is. This formula should be consistent with the normal payment period-for example. receivables at the book amount. returned the proceeds of the sale to corporate headquarters. this generalization oversimplifies because.of-period balances. Inventories Inventories ordinarily are treated in a manner similar to receivables –that is they are often recorded at endof-period amounts even though intraperiod averages would be preferable conceptually. with manufacturing periods a year or greater. receivable included at the actual end-. 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. managers might be encouraged to consider forgoing the cash discount to have. which is the selling price less an allowance for bad debts. in the real world. 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 the interest of simplicity. as elsewhere. If the business unit does not control credits and collections. and by the collecting overdue amount. Boeing received progress payments for its airplanes and recorded them as liabilities. Whether to include accounts receivable at selling prices or at cost of goods sold is debatable. Some companies subtract accounts payable from inventory on the grounds that accounts payable represent financing of part of the inventory by vendors. On the other hand. For e. As Exhibit 2 (see page 21) shows. economic valued added would increase because the higher cost would be more than offset by the decrease in the capital charge. inventories should be valued at standard or average costs. In times of high interest rates or credit stringency. 30 days' sales where payment is made 30 days after the shipment of goods. 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.000 per year. rather than own.000. If the company uses LIFO (last in first out) for financial accounting purposes. then including accounts payable in the calculation encourages the manager to seek the most favorable terms. 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. The corporate capital required for inventories is only the difference between the gross inventory amount and accounts payable.g. receivables may be calculated on a formula basis. and directly. accounts receivable should be included at selling prices. Nevertheless. they provide an alternative way of getting to use assets that 43 . 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 investment is probably enough. If the business unit can influence the payment period allowed by vendors. In these circumstances. by establishing credit terms by approving individual credit accounts and credit limits. On the other hand. additional financing provided by vendors. and. it is possible to argue that the business unit could reinvest the money collected from accounts receivable. as is typically the case with goods that require a long manufacturing period. business unit managers are induced to lease. (Here.generate sales.

g. For instance. Idle Assets If a business unit has idle asset that can be used by other units. There are advantages to capitalizing intangible assets such as R&D and marketing and then amortizing them over a selected life.e. NUMERICAL – ANANYA Ltd. if R&D costs are capitalized.. consumer products firms such as Unilever spend huge amounts on advertising). This method should change how the business unit manager views these expenditures. On the other hand.otherwise would be acquired by funds obtained from debt and equity financing. By accounting for these assets as long-term investments.. permitting the business unit manager to remove them from the investment base could result in dysfunctional actions For example. the business unit may be permitted to exclude them from the investment base if it classifies them as available. For these reasons. 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. The purpose of this permission is to encourage business unit managers to release underutilized assets to units that may have better use for them. If there is no alternative use for the equipment.g. restrictions usually are placed on the business unit manager's freedom to lease assets. if the fixed assets cannot be used by other units. which has a much smaller positive impact on economic valued added. if R&D expenditures are expensed immediately. However. each dollar cut will reduce the assets employed by a dollar. 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. the capital charge is thus reduced only by one dollar times the cost of capital. the business unit manager will gain less short-term benefit from reducing out lays on such item.. others tend to be marketing intensive (e. (2004) 44 . Financial leases (i. each dollar of R&D cut would be a dollar more in pretax profits. Financing decisions usually are made by corporate headquarters. Intangible Assets Some companies tend to be R&D intensive (e. any contribution from this equipment will improve company profits. pharmaceutical firms such as Novartis spend huge amounts on developing new products).

Operating Expenses TOTAL M 400 (NIL) (200) 200 P 400 (100) (100) 200 C 400 (50) (150) 200 Therefore.Exhibit 2 We know that formula for Return on Investment is: ROI = NET PROFIT INVESTMENT Now.Depreciation Less. Investment for: M = 0 + 200 = 200 P = 200 + 1000 = 1200 C = 200 + 500 = 700 Now. ROI for: M = 200 = 100 % 200 45 . Net Profit for M. Investment = Fixed assets + Net working Capital (We assume Current Assets as the Net Working Capital as there are no Current Liabilities given in the question) Therefore. P and C: Particulars Profit before Depreciation & Operating Expenses Less.

57 % 700 Since there are no fixed assets in marketing division. the depreciation rate is 10 %. And it is always not necessarily consistent with the Co‘s goal. • After completing the given activity in more efficient manner the concerned manager scores the point/s on his score card.e.e. Individuals act in their own interest. Goal congruence ensures that the action of manager taken in their best interest is also in the best interest of the organization.P = 200 = 16. organization charts. based on their own motivations. 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 goals of subordinates and superiors. 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. • 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.67 % 1200 C = 200 = 28. Hence. But they must come together as far as Company‘s Goal is concerned (there action must speak Co‘s language. Corporate goals can be communicated by budgets. reduction in the value of an asset due to depreciation is likely to have a positive impact on ROI. So going ahead if the operating expenses for div P & C remains at the same level. but the operating expenses are much higher for these division. Informal factors that influence goal congruence: 46 . While doing so he just overlooked the financial interest of the company. Goal Congruence. and job descriptions. higher investment in current assets. What do you understand by Goal Congruence? What are the informal factors that influence goal congruence? This term is used when the same goals are shared by top managers and their subordinates. the actions the people are led to take in accordance with their perceived self interest are also in the best interest of the organization i.) Goal Congruence Example 1– The HR manager has devised a HR training program to enhance the skills of its sales personnel. In a goal congruence process. The goals of the company should be the same as the goals of the individual business segments. with an objective to enhance their productivity But if company is in strategic need of attaining a certain sales volume in a given quarter. any further increase in op exp is likely to drag the ROI down Since the asset is depreciated for10 years as per SLM method. Even the rate of increase in ROI for Div P would be higher since the asset of a higher value is depreciated than the Div C. But at what cost? Building up the high inventory i. which promises good returns. it can not do so on account of non availability of personnel.Meaning Individuals work in different hierarchies and handle different responsibilities & may have different goals. Example 2– The marketing department has planned an impressive advertising campaign. the ROI is higher.

How could such a situation be resolved? Define role of controller which suits your suggestion. There is no complete satisfactory system for ensuring that each profit center by optimizing its own profit . Business units as profit centers: Business units are usually set up at profit centers.External factors – set of attitudes of the society. training. Organizations with Business Divisions (Profit Centre) format have observed that Divisional Controllers experience divided loyalty in carrying out their functions.  Mgt. The effectiveness of a business units organization is largely dependent on how well these trade off are made. 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. 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. norms of behavior & assumptions  Implicitly accepted and explicitly built into. This decrease in cooperation may manifest itself in a manager unwillingness to refer sales lead to another business unit. Business unit managers tend to control product development.g. Constraint on business unit authority 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. Relying on control reports is not as effective as personal knowledge of an operation. maintenance. 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. An increase in one manager‘s profit may decrease those of another. manager may have good reason to believe that their action may not affect profitability until after they have moved to other job. To the extent the decision are decentralized top management may lose some control. Style – Informal/Formal  The Communication Channels  Perception and Communication – e. work ethics of the society Internal factors – (Factors within the organization)  Culture-Common beliefs. This tendency is especially prevalent when the turnover of profit center managers is relatively high. Competent units that were once cooperating as functional units may now compete with one another dis advantageously. In these circumstances. Divisionalization may cause additional cost because it may require additional management staff personnel and recordkeeping and may lead to redundant at each profit center. Instead of personal direction senior management must rely to a considerable extent on management control reports. 47 . the profit center manager may skip on R&D. They are in a position to influence revenue and cost and as such can be held accountable for the bottom line. shared values. and marketing resources. top management must change its approach to control. If a company were divided into completely independent units the organization would be giving up the advantage of size and synergism. manufacturing. With profit center. 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. will optimize company profits. causing a possible dysfunction. Budget (meaning) strict profit. As a practical matter however such autonomy is not feasible. 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.

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. market share are slipping. business week. 30% of products. Sundaram Shoe Company(SSC). and annual survey published in fortune. Since 2001. may credit the business unit that takes an order for a product handled by the another unit with the equivalent of a brokerage commission or a finder fee. Define Performance Metric? In a goal congruent process. there is no way of determining how much of the profit was earned respectively by the several production departments. standard & poor computer services. Part of a multinational group. it is seen as a production oriented company. the actions people are led to take in accordance with their perceived selfinterest are also in the best interest of the organization. There are some situations in which two or more profit centers participate in the sales effort that results in a sale. Inc. Data for individual companies are available from the securities and exchange commission for about key business ratios. In addition. 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. strengthen marketing and be in a position to produce and meet unexpected and unusual customer demands. 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. 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. data on competitors and the industry provide a good cross check on the appropriate of the budget. SC markets its products through company owned shops and its own personnel. ideally. interprets the result. It should coordinate the work of budget departments in lower echelons It should analyze reported performance against budget. Robert Morris associates annual statement studies. 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. Organization structure is functional. How should the company reorganize to achieve Goal Congruence. 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. established its own facilities in India over 75 years ago and enjoyed an excellent record-high market share for its diverse range of shoes. Should revenue be recognized at the time as order is received. or at the time cash is received? In addition to that decision. 48 . They for example. Therefore. at the time an order is shipped. vis-à-vis a general purpose manager who lacks the specialized knowledge. Although SSC outsources. and prepares summary report for senior management. It should administer the process of making budget revision during the year. The type of structure in turn influences the design of the organization’s management control systems.The performance of a profit center is appraised by comparing actual results for one or more orf these measures with budgeting amounts. and Forbes.        Role of controller It should publish procedure and forms for the preparation of the budget. A skilled marketing and production manager would be able to make better decisions in their respective fields. It should provide assistance to budgetees in the preparation of their budget. issues related to common revenues may need to be considered. SSC wants to adopt measures to reduce costs. profitability. Revenues Choosing the appropriate revenue recognition method is important. Trade associations publish data for the companies in their industries. A firm’s strategy has a major influence on its structure. 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. growth and profits.

Sundaram needs to re-organize its organization structure which is functional to a Business Unit form of organization. reduce costs and wants to be in a position to customize products as per the demands of the customer. 2. Also it needs to be seen that the company outsources about 30% of its products. as well as approving budgets and judging the performance of business unit managers. The company aims to strengthen marketing. 2. which has impacted its profitability. 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. Performance against customer requirements Customer Satisfaction  PERFORMANCE OF INTERNAL WORK PROCESSES 1. Profitability (could be at the company. or individual level) Market share growth and other standard financial measures  EMPLOYEE 1. customer requirements. and business needs for the process. Headquarters are responsible for obtaining funds for the company as a whole and allocating it to the business unit. 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. etc. Associate satisfaction 49 . They are external in nature and are most closely tied to outputs.) \  SUPPLIERS 1. 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. Their performance is measured by the profitability of the business unit. Thus. The business managers act almost as if their units are separate companies. inventory. Performance Metrics are high-level measures what you are doing. headquarters reserves certain key prerogatives. 2. Cycle times Product and service quality Cost performance (could be productivity measures. This is a valid criterion because profit reflects the activities of both marketing and production.Sundaram Shoe Company which was a market leader for a period of over 75 years has been losing market share. They are responsible for planning and co-coordinating the work of the separate functions. 3. product line. they assess your overall performance in the areas you are measuring. setting their compensation. This re-organization would help in achieving goal congruence in the organization. The performance measurement system should cover the following areas at a minimum:  CUSTOMERS 1. Though business unit managers exercise broad authority over their units. Performance of suppliers against your requirements  FINANCIAL 1. that is.

C.05*1600) = 100 lakhs C = 100 – (0.* Capital Employed) In this case. lakhs) and comment on divisional performance. on Fixed Assets * Total Fixed Assets) + (W. Division Profit Fixed Assets Current Assets -A B 220 400 300 800 1600 160 ---- C ________ D E 100 600 1000 110 400 800 180 200 800 Controller feels corporate finance rates on current assets and .10*600) + (0. C. D and E and the present performance. on Current Assets * Total Current Assets) A = 300 – (0.10*200) + (0.Ananaya & Company comprises of five divisions A.10*800) + (0.C.05*800) = 120 lakhs 50 .10*400) + (0.A. the controller has suggested management to switch over to economic value added (EVA) as the criterion rather than return on assets. metric is return on assets.05*800) = 30 lakhs E = 180 – (0.C.C.C. EVA = Profit – (W.25% B = 220/2000*100 = 11% C = 100/1600*100 = 6.05*160) = 212 lakhs B = 220 – (0. Compute and tabulate both return on assets and EVA on the basis of following information (Rs.17% E = 180/1000*100 = 18% Economic Value Added (EVA) = Profit – (W.A.A.05*1000) = -10 lakhs D = 110 – (0.C. Solution: Working Note: Return on Assets = Profit * 100 Total Assets A = 300/960*100 = 31.10*400) + (0.25% D = 110/1200*100 = 9.fixed assets should be 5% and 10% respectively. B. However.

which is a buffer that dampens the impact on production activity of fluctuations in sales volume. Division B is a better performer than divisions C and D in terms of R. as well as E. 2.) (Rs. The reason why division A has performed the best is that it has the best working capital management that can be reflected in the total amount invested in current assets and which is the least among the five divisions. 7. scientists. physicians.V. 3. although a manufacturing company can earn revenue in the future from products that are on hand today.A. 6. as well as E. or the hours of lawyers.A.17% 18.00% Economic Value Added (E. Its current assets are the highest and this reflects that it has huge sums of money held up either in debtors or inventory or rather it is holding a large amount of cash which is not a good sign. lakhs) 212 100 -10 30 120 5. a service company cannot do so. the costs of many service organizations are essentially fixed in the short run. It appears from the above analysis that division A has performed the best among the five divisions. 10. it can be clearly noticed that divisions C and D seem to be in trouble. and other 51 . Return on Assets (R. Division E is the second best both in terms of R. and other professionals that are not used today are gone forever. The airplane seat. In the short run. Services cannot be stored.O.O. Though division E has the same amount invested in current assets as that of division D and perhaps a lesser amount invested in fixed assets its profitability is much better and hence it has delivered a better performance. Accounting firms.Summary Division A B C D E Comments: 1. hospital operating room. Though division C has also invested a huge amount in fixed assets the advantage is offset due to the fact that it perhaps has a larger investment in current assets. law firms.A.25% 9.O. hotel room. It must try to minimize its unused capacity. A company which is into an expansion and overall growth mode primarily invests into fixed assets and this is also one of the major reasons why the performance of division A is the best amongst all. 8.) 31. a hotel cannot reduce its costs substantially by closing off some of its rooms. Factors which impact service organization Absence of Inventory Buffer: Goods can be held as inventory. Thus. The above reason holds true for the poor performance of divisions C and D as can be seen that they have a huge amount invested in current assets which does not indicate good signs about their operational efficiency.A. Also. Moreover.V.V.A. 9.00% 6. 4. Division A has performed the best when seen in terms of return on assets and economic value added.25% 11. but the major problem with this division is that it has a terrible working capital management.A.

Many professionals prefer to work independently. Return on assets employed. and this increases costs. Their financial goal is to provide adequate compensation to the professionals. In many organizations. and in other ways. and so on). Hospitals do add expensive equipment. professionals tend to look down on managers. and many others. and high performers and low performers can be identified. but this is a measure of input. each unit relatively small. weight. it reflects economies of scale in using the efforts of a central personnel staff and units responsible for keeping the organization up to. Difficulty in Controlling Quality: A manufacturing company can inspect its products before they are shipped to the consumer. A law firm expands by adding partners and new support personnel. purity. We can measure the number of patients a physician treats in a 52 . it leads to inadequate cost control. Professionals: Professional organizations are labor intensive. A professional organization has relatively few tangible assets. Professionals tend to give inadequate weight to the financial implications of their decisions. is essentially meaningless in such organizations. but customer satisfaction depends to a considerable extent on the way it is served. a related goal is to increase their size. in the resources that they use. These organizations are fast-food restaurant chains. they want to do the best job they can. The similarity of the separate units provides a common basis for analyzing budgets and evaluating performance not available to the manufacturing company. Labour Intensive: Manufacturing companies add equipment and automate production lines. Output and Input Measurement: The output of a professional organization cannot be measured in physical terms. Explain special characteristics of professional organization which would have a bearing on their control system. auto rental companies. color. Restaurant management can examine the food in the kitchen. care must be taken in making such comparisons. such as units. Multi-Unit Organizations: Some service organizations operate many units in various locations. not output. Professionals who are also managers tend to work only part time on management activities. Some of the units are owned. specifically a satisfactory return on assets employed. but mostly to provide better treatment. gasoline service stations. The information for each unit can be compared with system wide or regional averages. which doesn't appear on its balance sheet. The quality of education is so difficult to measure that few educational organizations have a formal quality control system. its principal asset is the skill of its professional staff.date. Goals: A dominant goal of a manufacturing company is to earn a satisfactory profit. re. We can measure the number of hours a lawyer spends on a case. rather than management. A service company cannot judge product quality until the moment the service is rendered. and the labor is of a special type. Most service companies are labor intensive and cannot do this. and their quality can be measured visually or with instruments (tolerances. but quite naturally stresses the skills of the profession. for this and other reasons. therefore. Education for most professions does not include education in management. This attitude affects the attitude of support staffs and nonprofessionals in the organization. and then the judgments are often subjective.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. In part. Output is the effectiveness of the lawyer's work.I regardless of its cost. or gallons. this reflects the natural tendency to associate success with large size. Large public accounting firms need to have enough local offices to enable them to audit clients who have facilities located throughout the world. rather than as part of a team. others operate under a franchise. thereby replacing labor and reducing costs. and this is not measured by the number of pages in a brief or the number of hours in the courtroom. senior partners in an accounting firm participate actively in audit engagements. senior partners in law firms have clients. However because units differ in the mix of services they provide. In part. tons.

Revenues earned is one measure of output in some professional organizations. Before it is safe to delegate such a trade-off decision to a lower-level manager. deeds. to set reasonable standards for task performance. working for clients. only senior management is concerned with both. if the person who "sold" the project can be identified. which is of some use in identifying slackers and hard workers. and certain medical and surgical procedures. Senior management in such organizations can personally observe what is going on and personally motivate employees. No two consulting jobs or research and development projects are quite the same. speeches. however. At most. Furthermore. there is less need for a sophisticated management control system. they were taken into account in promotion and compensation decisions. even a small organization needs a budget. and similar documents. These marketing activities are conducted by professionals. and even classify these visits by type of complaint. or from the reputation of one of the firm's professionals as an outgrowth of speeches or articles. This makes it difficult to plan the time required for a task. medicine. such as law. what is measured is the physician's efficiency in treating patients. with profit centers and formal performance reports.that is. perhaps as a percentage of the project's revenue. but this is by no means equivalent to measuring the amount or quality of service the physician has provided. such as some law firms and accounting firms. but these monetary amounts. 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. the work done by many professionals is non repetitive. and to judge how satisfactory the performance was. and so on.   The manager should have access to the relevant information needed for making such a decision. professional organizations are relatively small and operate at a single location.day. although in using these standards. 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. Marketing: In a manufacturing company there is a clear dividing line between marketing activities and production activities. 53 . the professional who is responsible for obtaining the engagement may not be personally involved in carrying it out. In a consulting firm. usually by professionals who spend much of their time in production work-that is. The development of standards for such tasks may be worthwhile. a new engagement may result from a conversation between a member of the firm and an acquaintance in a company. Small Size: With a few exceptions. articles. In some. these marketing contributions were rewarded subjectively. relate to the quantity of services rendered. two conditions should exist. a regular comparison of performance against budget. Such a clean separation does not exist in most professional organizations. it is difficult to assign appropriate credit to the person responsible for "selling" a new customer. conversations on the golf course. Marketing is an essential activity in almost all organizations. unusual circumstances that affect a specific job must be taken into account. There should be some way to measure the effectiveness of the trade-offs the manager has made. If it can't be conducted openly. and a way of relating compensation to performance. In this situation. Such decisions are said to involve expense/revenue trade-offs. the taking of a physical inventory by an auditor. 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). Additional advertising expense is an example. Some organizations now give explicit credit. it takes the form of personal contacts. not to their quality (although poor quality is reflected in reduced revenues in the long run). at most. Thus. Until fairly recently. sales contracts. and accounting. Some tasks are essentially repetitive: the drafting of simple wills. Moreover. for example. Nevertheless.

and some are entirely controllable. just as there are in evaluating an organization as a whole. Further. Types of Profitability Measures A profit center's economic performance is always measured by net income (i. the system should be designed to measure management performance routinely.. such as administrative salaries. . in fact. however.e. Presumably. there is no clear line of demarcation. Many expense items are discretionary. 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. A weakness of the direct profit measure is that it does not recognize the motivational benefit of charging headquarters costs. This measure is used for planning. that is. The performance of the profit center manager. A focus on the contribution margin tends to direct attention away from this responsibility. the management performance report for a branch store may show that the store's manager is doing an excellent job under the circumstances. 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. since the costs incurred by corporate 54 . Expenses incurred at headquarters. All responsibility centers fit into a continuum ranging from those that clearly should be profit centers to those that clearly should not. by the business unit manager-information technology services. Ways to Measure Performance: There are two types of profitability measurements used in evaluating a profit center. senior management wants the profit center to keep these discretionary expenses in line with amounts agreed on in the budget formulation process. Second. Management must decide whether the advantages of giving profit responsibility offset the disadvantages. The former category includes expenses that are controllable. (3) controllable profit. regardless of whether or not these items are within the profit center manager's control. which focuses on how well the profit center is doing as an economic entity. The problem with this argument is that its premises are inaccurate. The messages conveyed by these two measures may be quite different from each other. There are two arguments against such allocations. may be evaluated by five different measures of profitability: (1) contribution margin. As with all management control system design choices. almost all fixed expenses are at least partially controllable by the manager. coordinating. there is the measure of management performance. If these costs are included in the measurement system. considerations relating to management performance measurement have first priority in systems design-that is. profit will be what remains after the deduction of all expenses that may be influenced by the profit center manager. all corporate overhead is allocated to profit centers based on the relative amount of expense each profit center incurs. which are discussed below. First. the income remaining after all costs. for example. the profit center manager is still responsible for controlling employees' efficiency and productivity. or (5) net income (1) Contribution Margin: Contribution margin reflects the spread between revenue and variable expenses. Because the management report is used frequently. and controlling the profit center's day-to-day activities and as a device for providing the proper motivation for its manager. cannot be changed in the short run. (2) direct profit. with economic information being derived from these performance reports as well as from other sources. even if an expense. (2) Direct Profit: This measure reflects a profit center's contribution to the general overhead and profit of the corporation. however. (3) Controllable Profit: Headquarters expenses can be divided into two categories: controllable and non controllable. which focuses on how well the manager is doing. have been allocated to the profit center). (4) Income before Taxes: In this measure. there is the measure of economic performance. (4) income before income taxes. including a fair share of the corporate overhead. at least to a degree. they can be changed at the discretion of the profit center manager. It incorporates all expenses either incurred by or directly traceable to the profit center. For example. First. are not included in this calculation. The necessary information for both purposes usually cannot be obtained from a single set of data. 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.A major step in creating profit centers is to determine the lowest point in an organization where these two conditions prevail. while the economic report is prepared only on those occasions when economic decisions must be made. managers should focus their attention on maximizing contribution.

Second. rather than actual. There are situations. relieved of day-to-day decision making. costs. The speed of operating decisions may be increased since they do not have to be referred to corporate headquarters. Allocating corporate overhead costs to profit centers increases the likelihood that profit center manager§ will question these costs. 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.) Second. in which case there would be no advantage in incorporating income taxes (2) since many of the decisions that affect income taxes are made at headquarters. they are motivated to make optimum long-term marketing decisions as to pricing. and so forth. in which the effective income tax rate does vary among profit centers. for example. First. three arguments in favor of incorporating a portion of corporate overhead into the profit centers' performance reports. profit centers may influence income taxes through their installment credit policies. are recovered. Because profit centers are similar to independent companies. For example. foreign subsidiaries or business units with foreign operations may have different effective income tax rates. .staff departments such as finance. 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. subject to fewer corporate restraints. whereas a manager responsible for profits will be motivated to make promotion expenditures that increase profits. since their performance reports will show no variance in the overhead allocation. and upper management gains the opportunity to evaluate their potential for higher-level jobs. thus serving to keep head office spending in check. In these situations. will tend to authorize promotion expenditures that increase sales. There are. This ensures that profit center managers will not complain about either the arbitrariness of the allocation or their lack of control over these costs. however. (A manager responsible for marketing activities. Headquarters management. however. and their use of other generally accepted accounting procedures to distinguish gross income from taxable income. in which case the "budget" and "actual" columns in the profit center's performance report will show identical amounts for this particular item. that will ultimately benefit (and even ensure the viability of) the company as a whole. they provide an excellent training ground for general management. the amount of net income after income tax. (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. (5) Net Income: Here. the performance of each profit center will become more realistic and more readily comparable to the performance of competitors who pay for similar services. 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. can concentrate on broader issues. these managers should not be held accountable for them. In other cases. when managers know that their respective centers will not show a profit unless all-costs. There are two principal arguments against using this measure: (1) after tax income is often a constant percentage of the pretax income. product mix. their decisions on acquiring or disposing of equipment. accounting. such variances would appear in the reports of the responsibility center that actually incurred these costs. 55 . Finally.). are freer to use their imagination and initiative. it is not appropriate to judge profit center managers on the consequences of these decisions. Their managers gain experience in managing all functional areas. Profit consciousness is enhanced since managers who are responsible' for profits will constantly seek ways to increase them. Managers. . Instead. this item should be calculated on the basis of budgeted. companies measure the performance of domestic profit centers according to the bottom line. and human resource management are not controllable by profit center managers. including the allocated share of corporate overhead. Merits:      The quality of decisions may improve because they are being made by managers closest to the point of decision. If profit centers are to be charged for a portion of corporate overhead.

a manager may fail to refer sales leads to another business unit better qualified to pursue them.g. or may make production decisions that have undesirable cost consequences for other units. Both the corporate 'office and the business unit general manager are involved in identifying the missions of individual business units. the quality of decisions made at the unit level may be reduced.. and the credit for revenues that were formerly generated jointly by two or more business units working together.: IBM's mainframe computers). that is. the assignment of common costs. Because their output is so readily measured. Organization units that once cooperated as functional units may now be in competition with one another. profit centers are particularly responsive to pressures to improve their competitive performance. Merck's bio-technology. Black and Decker's handheld electric tools). If headquarters management is more capable or better informed than the average profit center manager. General Electric's and Sylvania's light bulbs) Divest: 56 . While these models differ in the methodologies they use to develop the most appropriate missions for the various business units. staff personnel. even at the expense of market share (e. . Profit centers provide top management with ready-made information on the profitability of the company's individual components. from the overall company standpoint. Of the many planning models. Several planning models have been developed to help corporate level managers of diversified firms to effectively allocate resources. would be better off used in another unit. they have the same set of missions from which to choose: build. Build: This mission implies an objective of increased market share. 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. harvest.. and record keeping required.g. These models suggest that a firm has business units in several categories. hold. identified by their mission. In such situations. Harvest: This mission has the objective of maximizing short-term earnings and cash flow. make decisions regarding the use of the cash generated from some business units to finance growth in other business units. American Brands' tobacco products. the several units make up a portfolio. An increase in profits for one manager may mean a decrease for another. and divest. may hoard personnel or equipment that. the components of which differ as to their risk/reward characteristics just as the components of an investment portfolio differ. Divisionalization may impose additional costs because of the additional management. 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. and may lead to task redundancies at each profit center.  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. Friction may increase because of arguments over the appropriate transfer price.g. Together. the appropriate strategies for each category differ. even at the expense of short-term earnings and cash flow (e. Hold: This strategic mission is geared to the protection of the business unit's market share and competitive position (e.

by far. Some firms following this strategy include Charles Schwab in discount brokerage. The threat of new entry. or advertising). The intensity of rivalry among existing competitors. the less profitable an industry is likely to be. Studies have shown that average industry profitability is. and importance of the business unit's volume to suppliers. Factors affecting substitute threat are relative price/performance of substitutes. level of fixed costs.. Factors affecting buyer power are number of buyers. In industries where the average profitability is low (such as steel and coal).  Low Cost: Cost leadership can be achieved through such approaches as economies of scale in production.  We make three observations with regard to the industry analysis: 1. economies of scale. Three interrelated questions have to be considered in developing the business unit's competitive= advantage. Understanding the nature of each force helps the firm to formulate effective strategies. presence of substitute inputs. impact of the business unit's product on buyer's product quality/ performance. analyzing the relative bargaining power of several buyer groups will facilitate selection of target customer segments. buyer's switching costs. sales force. With this understanding. intermittent overcapacity. in the steel industry. they are not cook books.. A business unit's position on a planning grid should not be the sole basis for deciding its mission. Similarly. tight cost control. buyer's ability to integrate backward. the key strategic issues facing the business unit will differ from one industry to another. 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.This mission indicates a decision to withdraw from the business either through a process of slow liquidation or outright sale. access to distribution channels. and exit barriers. Business Unit Competitive Advantage: Every business unit should develop a competitive advantage in order to accomplish its mission. what is the structure of the industry in which the business unit operates? Second. Supplier selection (a strategic issue) is aided by the analysis of the relative power of several supplier groups. According to Porter. The more powerful the five forces are. in the soft drink industry. The bargaining power of customers. how should the business unit exploit the industry's structure? Third. product differentiation. entry barriers are high). While the planning models can aid in the formulation of missions. 3. 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. and government policy. technological complexity of product or process. product differentiability. the five forces are strong (e. Threat from substitutes. The bargaining power of suppliers. number and diversity of competitors. impact of the business unit's product on buyer's total costs. threat from substitutes is high). expected retaliation from existing firms. 1. 3. 2.g. Depending on the relative strength of the five forces. service. supplier's ability to integrate forward. First. 4.g. experience curve effects. the structure of an industry should be analyzed in terms of the collective strength of five competitive forces. Factors affecting entry barriers are capital requirements. and cost minimization (in such areas as research and development. 5. and buyer's propensity to substitute. In industries where average profitability is high (such as soft drinks and pharmaceuticals). Factors affecting supplier power are number of suppliers. what will be the basis of the business unit's competitive advantage? Industry Analysis: Research has highlighted the important role industry conditions play in the performance of individual firms. Wal- 57 . buyer's switching costs. Factors affecting direct rivalry are industry growth. 2. the five forces are weak (e. the most significant predictor of firm performance. and significance of the business unit's volume to buyers. the business unit should link with the supplier group for which it has the best competitive advantage.

Value Chain Analysis: Business units can develop competitive advantage based on low cost. Currently.04 Budgeted at actual volume 720 11322 361 3096 13909 21040 2103. Neiman-Marcus in retailing. [All figures are in Rs. It is experiencing crisis. Other examples of firms following a differentiation strategy include BMW in automobiles. Texas Instruments in consumer electronics. the costs incurred depend on managements judgment as to the appropriate amount under the circumstances. Controller developed a standard for each overhead expense item (relating expense to volume of activity). direct material.39 actual 582 12552 711 3114 17329 21218 2413. The most attractive competitive position is to achieve cost-cum-differentiation. therefore. and BIC in pens.  Differentiation: The primary focus of this strategy is to differentiate the product offering of the business unit. superior customer service (Nordstrom in retailing). components. (B) Can the supervisor be held responsible for all overhead expenses included? Why/why not? Solution (A) There is two general types of expense centers: engineered and discretionary.2005 given to concerned Production Supervisor for comments is tabulated. a factory‘s costs for direct labor. Management has. Emerson Electric in electric motors. Approaches to product differentiation include brand loyalty (Coca-Cola and Pepsi Cola in soft drinks). Engineered costs are those for which the ―right‖ or ―proper‖ amount can be estimated with reasonable reliability for example. scrap Allocated expenses Total per ton (Rs. Hyundai in automobiles. Tools Maintenance. This label relate to two types of cost. Dell in computers. Mont Blanc in pens. Summarized expenses for November. Black and Decker in machine tools. Stouffer's in frozen foods.Mart in discount retailing. Lincoln Electric in arc welding equipment. dealer network (Caterpillar Tractors in construction equipment). Pritam Engineering manufacturers (MCS-2005) Numerical Pritam Engineering manufacturing variety of metal product at many factories. 000] Item Management Supervision Indirect labour Idle time Materials. From historical data. Engineered expense centers 58 . decided to detailed expense control system including responsibility budgets for overhead expense items at each factory. Nucor in steel. and technology (Cisco in communications infrastructure). supplies. creating something that is perceived by customers as being unique. and Rolex in wristwatches.) Standard at nominal volume 720 12706 420 3600 14840 21040 2133. product design and product features (Hewlett-Packard in electronics). and utilities. differentiation.3 (A) Explain with justification which of the two (1) or (2) is more meaningful for expense control. In discretionary expense centers. or both. Discretionary costs (also called managed costs) are those for which not such engineered estimate is feasible.

One company may have a small headquarters staff. In a sense. we can easily estimate ―proper‖ or ―right‖ amount with responsible reliability. distribution. The senior managers of each company may each be convinced that their respective decisions on staff size are correct. The difference between the theoretical and the actual cost represents the efficiency of the expense center being measure. These engineered expense centers are usually located within departments that are discretionary expense centers. What is a responsibility centre? List and explain different types of Responsibility Centers. From the standpoint of senior management and and the board of directors. maintenance. their supervisors are responsible for the quality of the products and volume of production as well as for efficiency. public relations. Responsibility centers: 59 . accounts receivable. public relations. At the lowest level are the centers of the sections. Materials. The output of these centers cannot be measured in monetary terms. research and development operations. work shift. their performance reviews should include an appraisal of how well they carry out these responsibilities. the entire company is a responsibility center. Departments or business units comprising several of these smaller units are higher in the hierarchy. Even in highly automated production departments. responsibility centers in which all cost items are engineered. human resources). both decisions may be equally good under the circumstances. (B) A responsibility center is an organization unit that is headed by a manager who is responsible for its activities. As far as above stated over heads are concern. and the company motor pool. Thus the term engineered expense center refers to responsibility centers in which engineered costs predominate. with the differences‘ in size reflecting other underlying deference‘s in the two companies. personnel records and the cafeteria in the human resources department. output multiplied by the standard cost of each unit produced measures what the finished product should have cost. tools. while another company of similar size and in the same industry may have a staff 10 times as large. and specific quality standards are set.g. accounts payable. But it does not imply that valid engineered estimates can be made for each and every cost item. So that manufacturing costs are not minimized at the expense of quality. Discretionary expense centers Discretionary expense centers include administrative and support units (e. financial planning. We emphasize that engineered expense centers have other important tasks not measured by cost alone. Rather it reflects management‘s decisions regarding certain policies: whether to match or exceed the marketing efforts of competitors. legal. Such units perform repetitive tasks for which standard costs can be developed. There are few. There for standard (1) is more meaningful for expenses control. the type and level of production are prescribed. if any. but there is no objective way to judge which (if either) is right. shareholder records in the corporate secretary department. though the term is usually used to refer to units within the company and there for Supervisor is responsible for the uses of the Above stated Resources (over heads) like Indirect labor. each of which is represented by a box on the organization chart. and other small organization units. and a host of other activities. These responsibility centers form a hierarchy. the use of indirect labor and various services can vary with management‘s discretion. Moreover. accounting. and payroll sections in the controller department. Warehousing. a company is a collection of responsibility centers. the level of services the company should provide to its customers. Therefore. as may certain responsibility centers within administrative and support department for instance. scrape and Management supervision by proper supervising supervisor can control the listed overhead expenses. idle time. and similar units within the marketing organization may also be engineered expense centers.Engineered expense centers are usually found a manufacturing operations. In an engineered expense center. and the appropriate amounts to spend for R&D. managers of engineered expense centers may be responsible for activities such as training and employee development that are not related to current production. trucking. The term discretionary does into imply that managements judgment as to optimum cost is capricious or haphazard. and most marketing activities. industrial relations.

Its work with these resources and it usually require working capital. since cost is easy to measure. profit centers. if the strategies are sound and if each responsibility center meets its objectives the whole organization should achieve its goals. 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. they are output s of the whole organization. the product are inputs to the other responsibility center in the latter case. There are some significant advantages to classifying simple. The products produced by a responsibility center or to the outside marketplace. Marketing and Customer service. the whole company is responsibility center although the term is usually used to refer to unit within the company. are typically driven by cost considerations. accounting. especially staff units. Companies may choose to classify business units as cost centers. The objectives of responsibility centers are to help implement these strategies. Operational decisions in a contact centre. metrics such as average handle time. such as human resources. Financial investments in new equipment. and administration. 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. or investment centers. and senior management has decided on a set of strategies to accomplish these goals. transportation. they exist. cost centers create incentives for managers to underfund their units in order to benefit themselves. Because the organization is the sum of its responsibility centers. the outputs are goods. the output s are services. Each of which is represented by box on the on the organization are responsibility centers for section work shifts or other small organization units. if the strategies are sound and if each responsibility center. outputs are difficult to measure. technology and staff are often difficult to justify to management because indirect profitability is hard to translate to bottom-line figures. and a variety of services. for example. In a production plant. for example. A responsibility center uses inputs. 60 . In a contact centre. service level and cost per call are used in conjunction with other calculations to justify current or improved funding. Typical examples include Research and Development. 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. However.A responsibility center is an organization unit that is headed by a manager who is responsible for its activities. a company is a collection of responsibility centers. In a sense. In the first case. and other asset to do this work. and this underfunding may result in adverse consequences for the company as a whole (reduced sales because of bad customer service experiences. Nature of responsibility centers A responsibility center exist one or more purpose are its objectives. nevertheless. Every responsibility center has output that is it does something. 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. For many responsibility centers. The company as a whole has goals. equipment. for example). but only indirectly add to the profit of the company. straightforward divisions as cost centers. Types of Responsibility Centers a) Cost Center Cost centers are divisions that add to the cost of the organization. And from the stand point of senior management and the board of directors. In staff units. engineering.

This is particularly 61 . the term investment centre is not widely used. In fact. For instance.b) 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. whose performance is measured in terms of both . which has a direct influence on debt collection. A responsibility centre is called an investment centre. The manager of an investment centre is required to earn a satisfactory return. The investment centre manager has control over revenues. when its manager is responsible for costs and revenues as well as for the investment in assets used by his centre. He is expected to earn a satisfactory return on the assets employed in his responsibility centre. but may or may not be assigned responsibility for the capital investment. is termed as a profit centre. Its success is measured not only by its income but also by relating that income to its invested capital. the term profit centre is used indiscriminately to describe centers that are always assigned responsibility for revenues and expenses. The output of a responsibility centre may either be meant for internal consumption or for outside customers. the revenue is realized when the sales are made. A profit centre is a big segment of activity for which both revenues and costs are accumulated: A centre. Thus. any responsibility centre can be turned into a profit centre by determining a selling price for its outputs. then management takes a decision whether to treat the centre as profit centre or not. He also formulates the credit policy. they help in management control process. asset employed in his responsibility centre. 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.the expense it incurs and revenue it earns.e. In the latter case. and the inventory policy. when the output is meant for outsiders. He is responsible for maintaining a satisfactory return on investment i. In practice. Although such transfers do not increase the Company‘s assets. the manager in charge is held responsible for the proper utilization of assets. as in a ratio of income to the value of the capital employed. If the output is meant for other responsibility centre. Despite the name. Measurement of assets employed poses many problems. which determines the investment in inventory. the output of one process may be transferred to another process at a profit by taking into account the market price. expenses and the amounts invested in the centre‘s assets. c) Investment Centre An investment centre goes a step further than a profit centre does. 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. In the Investment Centre. in case of a process industry. 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. The Vice President (Investments) of a mutual funds company may be in charge of an Investment Centre. Instead. Such transfers will give some profit to that responsibility centre. then the revenue will be measured from the price charged from customers. That is. return on investment (ROI) is used as the performance evaluation criterion in an investment centre.

investment centers are generally used only for relatively large units. On account of these difficulties. at how much value. If it falls short of the standards. Managers are charged with the items and responsibility. The targets or budgets of each responsibility centre are set in consultation with the manager of responsibility centre. The manager of responsibility centre should know as what is expected of him . 5. Explain the process of evaluation of Responsibility Center from one stage to another with the help of illustration-cum-experiences of the corporate. Whether such assets should be included in the figure of assets employed of the responsibility centre and if included. so that he may be able to give full information about his department. Goals defined for each area of responsibility should be attainable with efficient and effective performance. The actual performance is communicated to the managers concerned. implementation and monitoring of all quality related interventions. The management may prepare the best plan or the budget and put up before its staff. planning. 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. for their individual products. The personal factor in Responsibility Accounting is most important. teacher education/training and activities related to classroom transaction. The responsibility and authority of each centre should be well defined. both manufacturing and marketing. pedagogical improvement.each centre should have a clear set of goals. is a difficult question. The organization is divided into various responsibility centers. These groups would oversee the policy.true of cash or heavy plant and equipment. 4. 2. which have independent divisions. over which they can exercise a significant degree of direct control. Their major role would be to advise and assist at various levels in curriculum development. 1. The purpose of all these steps is to assign responsibility to different individuals so that their performance is improved and costs are controlled. Each responsibility centre is put under the charge of a responsibility manager. In order to 62 . The names of persons responsible for the variances are also conveyed so that responsibility may be fixed. Process of evaluation of Responsibility Center. 3. the variances are conveyed to the top management.

After such a drastic change the level of discretionary expenses generally has a 63 . Such units perform repetitive task for which standard cost can be developed. higher educational institutions. experts and eminent educationists. When this cost is compared to actual costs. The following could be involved in the groups: National level . Universities. Even in highly automated production department the amount of indirect labor and of various services used can vary with management discretion. 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. financial planning public relation and many other activities. NGOs. 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.The optimal dollar amount of input required to produce one unit of output can be established. Engineered Expense Center. State level . 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. Universities. NGOs. They include administration and support units research and development organization and most marketing activities. Thus. 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. 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. innovative teachers. Engineered expense center usually are found in manufacturing operations. The term discretionary does not mean that management judgment is capricious or haphazard. There are few if any responsibility center in which all cost items are engineered. . Profit Centre and Investment Centre? How is budget prepared in Discretionary Expenses Centre? Engineered expense centers: Engineered expense center have the following characteristics: .facilitate a decentralized mode of education. NIEPA. distribution. The effectiveness of this aspect of performance should be controlled. 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.DIETs. Discretionary expense center: The output of discretionary expenses center cannot be measured in monitory terms. IASEs/CTEs. NGOs.SCERT. Briefly define Discretionary Expense Center. district and sub district. state. these groups would need to be constituted at various operational levels. Whether to match exceed or spend less than the marketing effort of its competitor.BRC/BEO. 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 appropriate amount of spending for R & D. In an engineered expense center the output multiplied by the standard cost of each unit produced represents what the finished product should have cost. the difference between the two represents the efficiency of the organization unit being measured. SIEMAT. experts and eminent educationists. Warehousing. 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. namely . We emphasize that engineered expense centers have other important tasks not measured by cast alone.national.Their inputs can be measured in monetary terms. District level . . Sub-district . innovative teachers from the districts. representatives from CRCs. representatives from DPEP District Resource Group. the level of service that the company provides to the customer.NCERT. Management has decided on certain policies that should govern the operation of the company.Their output can be measured in physical terms.

and record keeping required. If headquarters management is mere capable or better informed than the average profit center manager. the manager has ‗lived within the budget ‗ however . Organization units that once cooperated as functional units may now be in competition with one another. 64 . 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. Continuing task are those that continue from year to year for example financial statement preparation by the controller‘s office. and the credit for revenues that were formerly generated jointly by two or more business units working together.similar pattern from one year to the next. 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. This tendency is especially prevalent when the turnover of profit center managers is relatively high. the quality of decisions made at the unit level way be reduced. from the overall company‘s. In such situation a manager may fail to refer sales leads to another business unit better qualified to pursue them. In the desire to report high current profits.Competent general managers may not exist in a functional organization because there may not have been sufficient opportunities for them to develop general management competence. For the latter management decides whether the proposed operating budget represent the cost of performing task efficiently for the coming period. would be better off used in another unit. It in no way measures the value of the output. or maintenance. if actual expense do not exceed the budget amount. There are two different approach to planning for the discretionary expense center increment budgeting and zero based review. such as the marketing departments ability to generate sales. Friction may increase because of arguments over the appropriate transfer price. entailing some loss of control. may hoard personnel or equipment that. 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. standpoint. the profit center manager may skimp on R&D. or may make production decisions that have undesirable cost consequences for other units. 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. training programs. Describe inherent difficulties creation of profit centres may cause and advantages possible? Under which situation creation of profit centre is not advisable. 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. management is not so much concerned with the magnitude of the task because this is largely determined by the actions of other responsibility centers. managers may have good reason to believe that their actions may not affect profitability until after they have moved to other jobs. In formulating the budget for a discretionary expense center. the assignment of common costs. 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. The technique management by objective is often used in preparing the budget for a discretionary expense center. Divisionalization may impose additional costs because of the additional management. and may lead to task redundancies at each profit center. Special tasks are one shot project for example developing and installing a profit budgeting system in a newly acquired division. staff personnel. In these circumstances.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. An increase in profits for one manager may mean a decrease for another. Budget Preparation. There may be too much emphasis on short-run profitability at the expense of long-run profitability.

Thus. where. Corporate management .also imposes other constraints. and (3) The procurement or sourcing decision (how to obtain or manufacture the goods or services). Companies impose some constraints on business units because of the necessity for Uniformity. Constraints from Corporate Management The constraints imposed by corporate management can be grouped into three types: (1) Those resulting from strategic considerations. Furthermore in delegating to business unit management all the authority that the board of directors has given to the CEO. As a practical matter. (2) Those resulting because uniformity is required. at the corporate level. the greater the degree of integration within a company. The effectiveness of a business unit organization is largely dependent on how well these trade-offs are made. even though it sees profit opportunities in doing so. and (3) Those resulting from the economies of centralization. Most companies retain certain decisions. Consequently. which ought to be reflected in a profit center's design and operation. and for how much are these goods or services to be sold?). the maintenance of the proper corporate image may require constraints on the quality of products or on public relations activities. such autonomy is not feasible. a business unit manager's authority may be constrained in various ways. Consequently. the more difficult it becomes to assign responsibility to a single profit center for all three activities in a given product line. If a company were divided into completely independent units. 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). Each business unit has a "charter" that specifies the marketing and/or production activities that it is permitted to undertake. and marketing resources. In general. 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. business unit structures represent trade-offs between business unit autonomy and corporate constraints. a business unit could find its expansion plans thwarted because another unit has convinced senior management that it has a more Attractive program. one of the major constraints on business units results from corporate control over new investments. Constraints from Other Business Units. If a business unit manager controls all three activities. however. as pointed out in the next section. if the production. These managers are in a position to influence revenues and costs and as such can be held accountable for the "bottom line." However. 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. that is. One of the main problems occurs when business units must deal with one another. especially financial decisions. 65 . the business unit manager would have to be as autonomous as the president of an independent company. there is usually no difficulty in assigning profit responsibility and measuring performance. senior management would be abdicating its own responsibility. (2) The marketing decision (how. and it must refrain from operating beyond its charter. Constraints on Business Unit Authority To realize fully the benefits of the profit center concept. Business units must compete with one another for a share of the available funds. Also. at least for domestic activities.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. the organization would lose the advantages of size and synergy. procurement. manufacturing.

Advantages of Zero-Based Budgeting: 1. monitored. Zero-based budgeting must be clearly understood by managers at various levels to be successfully implemented. Honesty of the managers must be reliable and uniform.g. 3. Useful for service departments where the output is difficult to identify. as it is time-consuming and exhaustive. Efficient allocation of resources. Any manager that exaggerates skews the results 4. people and management information systems. The zero-base is indifferent to whether the total budget is increasing or decreasing. Identifies opportunities for outsourcing. in zero-based budgeting. and measured. 9. 5. 6. Compressing the information down to a usable size might remove critically important details. [1] Zerobased budgeting requires the budget request be justified in complete detail by each division manager starting from the zero-base. Internal Control Internal control is defined as a process affected by an organization's structure.) Internal control procedures reduce process variation. Difficult to administer and communicate the budgeting because more managers are involved in the process. rather than only increases. machinery and property) and intangible (e. 8. work and authority flows. Detects inflated budgets. 2. and compliance with laws and regulations. 10. both physical (e. It plays an important role in preventing and detecting fraud and protecting the organization's resources. Forces cost centers to identify their mission and their relationship to overall goals.. reputation or intellectual property such as trademarks).. 3. The term "zero-based budgeting" is sometimes used in personal finance to describe the practice of budgeting every dollar of income received. Drives managers to find cost effective ways to improve operations. the volume of forms may be so large that no one person could read it all. Municipal planning departments are exempt from this budgeting practice. Increases staff motivation by providing greater initiative and responsibility in decision-making. At the organizational level.[1] It is a means by which an organization's resources are directed. In a large organization. Forced to justify every detail related to expenditure. At the specific transaction level. internal control refers to the actions taken to achieve a specific objective (e.g. as it is based on needs and benefits. timely feedback on the achievement of operational or strategic goals. The R&D department is threatened whereas the production department benefits.. 7.Zero Based Budgeting Zero-based budgeting is a technique of planning and decision-making which reverses the working process of traditional budgeting. Necessary to train managers. 5. It would be more technically correct to refer to this practice as "activebalanced budgeting". Increases communication and coordination within the organization.g. 4. Identifies and eliminates wasteful and obsolete operations. how to ensure the organization's payments to third parties are for valid services rendered. internal control objectives relate to the reliability of financial reporting. In traditional incremental budgeting. Difficult to define decision units and decision packages. By contrast. departmental managers justify only increases over the previous year budget and what has been already spent is automatically sanctioned. leading to more predictable outcomes 66 . No reference is made to the previous level of expenditure. every department function is reviewed comprehensively and all expenditures must be approved. designed to help the organization accomplish specific goals or objectives. and then adjusting some part of the budget downward for every other part that needs to be adjusted upward. Disadvantages of Zero-Based Budgeting: 1. 2.

as of a given date.Describing Internal Controls: Internal controls may be described in terms of: a) the objective they pertain to. Companies that enter into joint ventures must ensure that the transfer price charged is fair. Veena Pvt. 4. physical barriers. Supervision or monitoring of operations .. to ensure access restricted to authorized personnel. Retention of records . These include: (a) Fair Price: This is an important factor one needs to consider while determining the transfer price for foreign operations. are involved. 3. in addition to the criteria used in domestic operations for the determination of transfer price. no omissions) Valuation: Transactions are calculated using an appropriate methodology or are computationally accurate.usage of cameras. Reasonableness-transactions or results appear reasonable relative to other data or trends.review of particular transactions by an appropriate person.e. etc. access logs. Completeness: All transactions are processed that should be (i. Rights & Obligations: Assets represent the rights of the company.e. 7. metrics. and liabilities its obligations. a small multiproduct company is taken over by a multinational company ( e. IT Security . Hindustan Lever. as this company would generally provide inputs to HUL. 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. to protect property. locks.. the parent company should fix a 67 . they relate to particular financial statement assertions. or related progress understood. custody. Control objectives fall under several detailed categories. no invalid transactions) Occurrence (Cutoff): Transactions occurred during the correct period or were processed timely.usage of passwords.observation or review of ongoing operational activity. These include (but are not limited to):        Segregation of duties . The specific target used to determine whether a control is operating effectively is called the control objective. 2. 6. and other key performance indicators (KPIs). Ltd. periodic and regular operational reviews. (b) Government Regulations: All countries have a regulatory framework under which business units operate.) 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.maintaining documentation to substantiate transactions. Existence (Validity): Only valid or authorized transactions are processed (i. Thus the domestic operations generally involve transfer of goods and services only In view of this difference many other considerations. in financial auditing. Physical safeguards . Analysis of results. Authorization of transactions . etc. Activity categorization Control activities may also be described by the type or nature of activity.[5] but broader frameworks are helpful to also capture operational and compliance aspects: 1.g. If such companies charge a higher transfer price. Where government rules and regulations regarding transfer prices are lenient. and record keeping roles to limit risk of fraud or error by one person. it would reduce the profits of the joint venture and as a result reduce the foreign partner's share of profits. 5. Presentation & Disclosure (Classification): Components of financial statements (or other reporting) are properly classified (by type or account) and described..separating authorization.

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. It is therefore advisable that companies must compute the net effect of these factors while determining transfer prices. This helps the parent company to reduce its taxes on a global basis. although a lower tariff may be levied if the import value is lower. 68 . These regulations impose a limit on the amount of foreign exchange available for the import of certain goods. 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. The general practice is to charge import duties as a percentage of the value of products imported. In designing performance evaluation systems for acquired Veena company.higher transfer price for all transfers to countries with high income tax rates. the profit arising in that country would be high.and Duties: No country likes high imports. It is pointless for managers to worry about the appropriate metric. high duties and tariffs and banning import of products. The subsidiary manager should be held responsible for the dependence effects of exchange rates resulting from economic exposure. 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. (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. This is likely to be cheaper and simpler. Transaction effects are best handled through centralized coordination of the MNE's overall hedging needs.HUL could use the following guidelines Subsidiary managers should not be held responsible for translation effects. Transaction and economic exposures. (f) Tariffs. In order to restrict imports countries impose restrictions such as quantitative restrictions. 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. This approach would enable the parent company to minimize taxes in such countries. (d) Income Tax Regulations: The rates of income tax vary from country to country. (c) Exchange Control Restrictions: Every country has foreign exchange control regulations. As such a low transfer price would lead to low import duties on transfer. 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. This results in high income taxes in that country. The MNE should choose whatever metric is more convenient. and it prevents the subsidiary manager from becoming a foreign exchange rate forecaster and speculator.

for services rendered and for goods supplied. If overall planning is not done effectively. those evaluations usually are not done systematically. Program evaluations are typically focused on the quality of the program‘s process. resulting in their poor overall performance. staff. program planning and staff development. and supervising the CEO. when undetected. and board members alike. Poor Board operations. Organizational evaluation Ongoing evaluation of the entire organization is a major responsibility of all leaders in the organization. there is little feedback to the strategic and program planning activities. The activities of organizational evaluation occur every day. goals or outcomes.   Program evaluation Program evaluations have become much more common. Leaders sometimes do not recognize the ongoing activities of management to actually include organizational evaluations – but they do. is an organization that cannot distribute assets or income to. developing the members into well-trained and resourced members. development and operating activities. 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. compensate its employees. or directors. This definition does not prohibit an organization from earning a profit. discussing and debating topics to make wise decisions. Consequently. Common examples of major processes include information technology systems and quality management of services. officers.   69 . Evaluation of cross-functional processes Cross-functional processes are those that span several systems. It can also be the result of improper training about evaluation. the entire organization is adversely effected. such as programs.What is a Non . If the motivation for doing evaluation remains outside an organization. to provide funds for working capital and for possible ―rainy days. Because these cross-functional processes span so many areas of the organization.Profit Organization? How is the performance of this organization evaluated? A nonprofit organization. Staff and volunteer (individual) performance evaluation Most of us are familiar with employee performance appraisals. individuals can experience continued frustration. To do performance assessment effectively. both processes can be ineffective because they do not focus on improving the quality of operations in the workplace. the evaluation will have limited impact. When program evaluations are not performed well. Continued problems in individual performance often are the results of poor strategic planning. more systemic problems in the organizations. because acceptance must come from senior management. its members. can adversely affect the entire organization. it prohibits only the distribution of profits. which evaluate the quality of an individual‘s performance in their position in the organization. functions and projects. Activities might include staffing the Board with new members. 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. An ineffective program evaluation process often is the result of poor program planning – programs should be designed so they can be evaluated. or at all. 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. 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. A nonprofit organization needs to earn a modest profit. Ideally. useful evaluation information is not provided to the strategic and program planning processes. an organization must commit to adopting a culture of measurement. When strategic and program planning are done poorly. problems in these processes can be the result of any type of ineffective planning. However. funders. The organization can. particularly because donors demand them to ensure that their investments are making a difference in their communities. Board members have no clear impression of how they are performing as members of a governing Board. on average. including officers and members.‖ Performance evaluation of nonprofit organization For any organization. or for the benefit of. As a result. Sometimes.  Board self-evaluation Members of the Board of Directors should regularly evaluate the quality of their activities on a regular basis. Probably the biggest problem with Board self-evaluation is that it does not occur frequently enough. stress and low morale. of course. As a result. as defined by law.

4 times SP. Sometimes. excessive diversification is ominous especially. As. As. it may be a strategic decision by the promoters and directors of the company to sell one of its divisions. also sells old TV exchanged (under scheme) by customer while purchasing new TV . So. there may be no advantage of operating synergy. They have a better understanding about the business dynamics and environment in which the firm operates. that is why there will be some significant changes in the management control and systems and procedures if there is further scope for improvement. There.SG Rs 114. they have been associated with the company over aperiod of time. they can take necessary steps to overcome the flaws and improve the management control and systems. the division is being sold to its own company managers. most of its managers will be the same. might not be major changes in management control and systems. A TV dealership Veena Television (VT) is organized into four profit centers. spare parts(SP) and servicing (SG) each headed by manager BTV in addition to BVTV sales. Currently. BTV pays a service commission of Rs 250 per TV sold .5 times SG and 1. in one particular instance a new TV was sold for 14150(financed by cash rs2000. So. colour TV. sells one of its divisions to a group of its own company managers. Sometimes.BTV Rs 665.A Well Diversified company – Pritam International Ltd. As. your core business tends to get neglected mainily due to excesive diversification. Compute the profitability of the transaction assuming sales commission of $250 for the trade in on a selling price of $5000    SOLUTION:       SP of New TV by CTV = $14150. they are not answerable to their superiors. the management is completely in their hands and that too with full autonomy. resulting and servicing for which she would use services of SP and SG price chargeable to BTV by SP and SG are at market rates Rs235 for parts by SP and Rs 470 for services by SG.Shivangi Manager of BTV. As. Bank loan 7350and Rs 4800. As. this may be impacting their core business. As. examined the old TV (valued at Rs 3500 by TV trade magazine) and felt that she could get Rs 5000 for that TV offer repairing cabinet. believed that she could sell the trade in at $5000 Other Cost: Rs235 for parts by SP and Rs 470 for services by SG Compute at market price At cost price Gross and net profit each 70 . Neither through: I) II) Sharing common resources nor Sharing common core competencies Therefore.exchange price for old TV agreed by CTV manager )cost of new TV was Rs 11420. But. As. 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. Shivangi of BTV Dept. they are answerable to their stake-holders. One of the major reason for failures of many Mergers and Diversification is excessive diversification. Now there will be less red tapism and managers can take more risk. we Pritam International is a well diversified company. As. Market price are arrived at after marking up cost by 3.overhead fixed per sale are CTV Rs 835. excessive diversification and that too in unrelated lines of business causes failure in the business operations. Black and White. The managers will manage the firm in their own style. they will have more autonomy to take decisions independently after acquisition. Explain what significant changes in systems and control procedures can be expected? Why? As. Original cost= $11420 ($14150= $2000 cash down payment + $4800 trade in allowance + $7350 bank loan) Guide Book Value =$3500 Ms. in unrelated lines of business.SP RS 32 .

What is the Balanced Scorecard? The rationale for the development of the Balanced Scorecard was a growing dissatisfaction with traditional. The shift towards flexible. financial measures of performance. historic) view of performance. 5000-5505= (-505) Particulars Sales Selling commission Gross profit Overhead Servicing Net profit before common exp New TV 14150 0 2730 835 0 1895 OLD TV 5000 250 -505 665 470 -1640 Service 470 0 470 114 0 591 Parts 235 0 235 32 0 123 If the trade-in is recorded @ $3500 Particulars Sales Selling commission Gross profit Overhead Servicing New TV 14150 0 2730 835 0 OLD TV 5000 250 1045 665 470 Service 470 0 470 114 0 Parts 235 0 235 32 0 Net profit before common exp 1895 -340 356 123 Why Balance Score Card is considered superior to other methods of Performance Appraisal? Prepare Balance Score Card for any organization you are familiar with. lean 71 .e.. lagged (i.When trade-in is recorded @ $4800 4800+470+235=5505. These measures suffer from a number of serious drawbacks in that they take a short-term.

The perspectives focused on the achievements of the firm in four areas: namely the financial. The four perspectives can be represented as an interlinked hierarchy. Once the firm‘s objectives have been agreed and the appropriate outcome and driver measures chosen for each of the perspectives. there is a clear link between the Balanced Scorecard and 72 . for example. were considered sufficient to track the key drivers of both current and future financial performance of the firm. Because the Balanced Scorecard requires management to clarify and obtain consensus on the strategic objectives of the firm. the scorecard will require a mix of lagging and leading (forward looking) measures. In this role. as the measures for each of the four perspectives are drawn from this strategy. outcome measures tend to be lagged. internal business process and innovation/learning perspectives. Financial measures tend to be lagged and consequently. incorporating both non-financial and external measures of performance. In this role. firm and managerial performance is assessed by comparing actual attainment on each measure with the target set for that measure. The firm‘s strategy underlies the whole scorecard. To obtain a satisfactory overview of performance. internal/external and leading /lagging information on firm performance in a coherent fashion. In general. Originally the Balanced Scorecard was seen as a useful tool for performance measurement. it can assist in the communication of the chosen strategy. Objective Measure Target Actual Benefits from adopting the Balanced Scorecard There are several benefits from implementing a Balanced Scorecard. The original scorecard designed by Kaplan and Norton contained four key groupings of performance measures. 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.production/service systems in many firms has strengthened the requirement for performance measurement systems to become more broadly based. According to Kaplan and Norton. the measures chosen for the other perspectives will need to include leading measures. customer. the Balanced Scorecard was seen as integrating financial/non-financial. current market share is the result of past decisions and consequently is a lagging measure. consequently aligning the efforts both of individuals and of departments. These four groupings. called ‗perspectives‘ by 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". Later it was realised that the Balanced Scorecard could play a pivotal role in the strategic management process.

This could be achieved by using a weighting system developed from a firm‘s Balanced Scorecard measures to evaluate new projects. back to the objectives listed in the firm‘s overall scorecard. it has been suggested that the Balanced Scorecard can play a role in the investment appraisal process. Balance Score Card of Credit Card Company 73 . many firms have migrated away from a traditional hierarchical structure to a flatter. The Balanced Scorecard could be used to assist in corporate restructuring. the Balanced Scorecard can be used to link strategy to specific critical success factors in the customer. By setting both short and long-term targets for driver and outcome measures and by comparing actual attainment against target. Within each department. supporting scorecards can be developed for each department within the firm. Building on the Balanced Scorecard‘s use as a strategic management tool. 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. Given the overall corporate scorecard. such as an enhanced management information system.management by objectives (MBO). In recent years. Effective implementation of a Balanced Scorecard project will generally involve the development of a series of hierarchical (cascaded) scorecards. 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. Examples of these include investments which enhance the future ‗flexibility‘ of a firm or investments in the firm‘s infrastructure. 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. feedback is obtained on how well the strategy is being implemented and on whether the strategy is working. The Balanced Scorecard can support such changes. Traditional methods of investment appraisal such as discounted cash flow do not cope well with investments which generate indirect rather than direct financial returns. team-based organisational structure. internal business process and growth/learning perspectives. An index score would be calculated for each investment opportunity and projects would then be ranked and selected based on this score.

Return on Investment for both divisions is 20%. COMMENTS:Division „A‟ – Although ‗A‘ has more profit margin than Division ‗B‘ that is 10% as compared to 6.6% of ‗B‘. will company benefit as a whole if Div A buys from the market. Two divisions A and B of sonali enterprises operate Profit centers.000 = 2 times Turnover of Investment for Division ‗B‘ = 96.u to Rs. Div A decided to purchase the components from open market available at Rs.40.u. 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.00. are Rs.1100. Assuming that no alternate use exists for excess capacity in Div B. If the market price reduces by Rs.6% Turnover of Investment = Sales * 100 Investment Div A 4000000 2000000 400000 Div B 9600000 3200000 640000 Turnover of Investment for Division ‗A‘ = 40. 950 and Rs.00.000/ 96. So it can become profitable organisation by improving Profit Margin.00.C and Fixed cost p. Div A normally purchases annually 10000 nos. which has recently informed Div A that it will increase selling price p.00. 1100.00. division ‗A‘ has lower turnover of investment that its assets management is bad than Division ‗B‘.000 = 3 times As Return on investment for both Divisions A and B is 20%. Analyse and comment on divisional performance of each. What would be the effect on the company (assuming Div B has still excess capacity) if A buys from market. 2.000/20.000 *100 = 10% Profit Margin for Division ‗B‘ = 6.1000 p.u. of required components from Div B.00.000/32. so it has more profitability but inspite of it. whose V. Details are given below.00. Particulars Divisional sales Divisional Investment Profit SOLUTION As Profit Margin = Profit *100 Sales Profit Margin for Division ‗A‘= 4.80 p. 1.000 /40.000 *100 = 6.u Div B is not happy and justified its decision to increase price due to inflation and added that the overall company profitability will reduce and decision will lead to excess capacity in Div B. As it has good assets management shown by its turnoverof Division ‗B‘ that is 3 times which is better than Division ‗A‘.Soniya Company has two Divisions: A & B. it can be improved by increased sales or reducing investment. 74 .

20.000 Nil 10.45.80 p.) Total Purchase Cost Total Outlay Cost Net Cash Outflow To The Company As A Whole 10.50.000 The Company as a whole benefit if „A‟ buys from outside supplier at Rs.5 lakhs Division ‗A‘ action BUY OUTSIDE (Rs.50. SOLUTION 1) Division ‗A‘ action BUY OUTSIDE (Rs.000 9. 75 . (1000-80) = 920 3) If excess capacity of Div B could be use for alternative sales at yearly costs savings of Rs. Company should purchase from outside.000 (Rs.000 (Rs. 2) If the market price reduces by Rs.00. 14. should Div A purchase from outside? Justify your answers with figures.000 8.) Total Purchase Cost Total Outlay Cost Net Cash Outflow To The Company As A Whole 9.50.u Division ‗A‘ action BUY OUTSIDE (Rs.55.50.) Nil 9.) BUY INSIDE Nil 9. 14.000 Nil 9.) Total Purchase Cost Total Outlay Cost Revenue From Using These Facilities Net Cash Outflow To The Company As A Whole 10.) BUY INSIDE Therefore.3. If excess capacity of Div B could be use for alternative sales at yearly costs savings of Rs.00.000 9.000 Nil BUY INSIDE The Company as a whole will benefit if Division „A‟ buys inside from Division „B‟.50.5 lacs.000 9.50.000 (Rs.000 Nil 9.

Discuss and illustrate differences and similarities between Strategy Formulation and Management Control Characteristics a) Focus of plan b) Complexities c) Nature of information d) Structure e) Communication of information f) Purpose of estimates g) Persons involved h) No. analytical Planning dominant but some control Tends to be long Policies and precedents Extremely difficult Management Control On entire organisation Less complex Integrated.Existence of objective standard against which actuals can be compared makes control easier.financial. more accurate. definite pattern. Rhythmic. often non. more internal and historical. persuasive Tends to be short Discretionary.Control is more difficult due to subjective consideration. more internal and historical. real time Supervisors Follow directives or none as in case of machines or set objectives Day to day Engineered. each problem being different Relatively simple Show expected results Staff and top management Small Creative. Unstructured and irregular. of persons involved i) Mental activity j) Planning and control k) Time horizon l) End result m) Appraisal of job done Strategy Formulation On one aspect at a time Many variables hence complex Tailor-made for the issue. 76 . specific. set procedure Relatively difficult Lead to desired result Line and top management Large Administrative. less accurate. more accurate Line and top management Administrative. more external and predictive. Management control On entire organisation Integrated. persuasive Emphasis on both planning and control Tends to be short Action within policies laid Less difficult Management Control and Task Control Characteristics a) Focus of plan b) Nature of information c) Persons involved d) Mental activity e) Time horizon f) Type of cost Task Control Single task or transaction Tailor-made to operation.

= Rs. Rs.20 lakh. Lakh) Amount (Rs. it would suffer a loss of Rs./unit) Thus on the basis of full actual cost incurred by division X. Working notes:Variable cost for division Y: Desired RoI =10% of Rs. the offer is beneficial to the company as a whole.2 lakh per month 77 . will the manager be interested in accepting the market offer? Solution: Particulars Cost of critical component for division X Cost of other material Fixed & processing costs Total cost for division X Selling price of final product Net loss for division X Desired profit for division X Amount (Rs.60/unit. (Numerical) (MCS-2006) (1) On the basis of costing. So.(b)] 5 (Working note) 25 (5000 units * Rs.a. Solution: Particulars Cash inflow (a) Cash outlay: Variable cost for division Y Material bought by division X from outside Total cash outlay (b) Net cash inflow to Company as a whole [(a).10/unit if it accepts the market offer whereas its target profit margin is Rs.e.500/unit) 30 20 Amount (Rs.4 Cr./unit) 220 500 290 1010 1000 10 60 Amount (Rs.Girish Engineering Ltd. So. (2) Is this offer beneficial to the company as a whole? Justify with figures. p.1000/unit) Thus. i. division X would not accept the market offer.a. Lakh) 50 (5000 units * Rs. the Company as an entity would receive cash inflow of Rs.2.24 lakh p.

contribution p. In this case.u.u. (desired profit margin). division X‘s total costs would turn out to Rs.60 p.80 Contribution per month = Rs. division Y prevents shifting of any operational inefficiencies from selling division to buying division i. = 400000/5000 = Rs. for division Y would be Rs.40 p.e. Solution: Currently. So. However. Girish Engineering Ltd.u. of units) 2000 3000 6000 Total contribution 48000 72000 144000 Total Fixed (Rs. (3) If yes.4 lakh per month Fixed cost p. is made by division Y exclusively to produce the component required by division X. this method of transfer pricing is not feasible as division X would suffer loss if it accepts the market offer under this scenario.2. total contribution for division Y would be Rs.100 An annual investment of Rs2. which would unnecessarily increase the costs for division X and thereby eat up its profit margin. (Numerical) (MCS-2007) (a) Define profit in this case and prepare a statement for both divisions and overall company. cash outflow associated with this investment is not relevant for the above concerned decision regarding accept the market offer.4 Cr. divisions X & Y can negotiate a transfer price by taking into account full actual variable cost (Rs.) 60000 60000 60000 cost Net profit (Rs.5 lakh Variable cost p.u. Amount(Rs.250000 resulting in RoI of 12. is following 2 step transfer pricing method wherein the selling division charges actual variable cost along with profit mark-up & separately allocates a particular amount of fixed costs per month to the buying division. Taking into consideration only half of the fixed costs of selling division i.u. Solution: i) Profitability statement of Division A:Particulars Selling price p. for division Y = 500000/5000 = Rs.) (12000) 12000 84000 78 .e. Variable Cost p.940 (500 + 290 + 150) & would earn a profit margin of Rs. Also.100 p.5% (250000/2000000) which is more than the desired RoI of 10%. how should the company organize its transfer pricing mechanism? Illustrate. total Variable cost per month for division Y = 11 lakh – 6 lakh = Rs. in the case of division X (buying division) & division Y (selling division).4 Cr.10/unit. is assigned by division Y to division X but it does not imply that a special investment of Rs. division X. Suresh Ltd.) & half of fixed costs incurred by division Y that is assigned to division X (Rs. Thus. 24 24 24 Expected sales (no.) & add a mark-up of say Rs.6 lakh Total sales value for division Y = 220 * 5000 = Rs.u.50 (150 – 100).u.u. Therefore.u.u.) 35 11 24 Contribution p.11 lakh per month So. Contribution p.Fixed cost assigned to division X = Rs.

Eastman Kodak.35)] iii) Profitability statement of Company as a whole:Expected sales 2000 3000 6000 Net profit of division A (Rs. and Sam Walton. In many corporations. George Eastman. but there are other stakeholders in the business also such as customers. a corporation does not have goals. Economic Goals Shareholder's value.u. sales (no. not 'maximum profit'.u. it would suffer a loss of Rs. if Division B opts for selling price p. employees. Walt Disney. Explain different organizational goals. because what is 'maximum' is difficult to determine. it is an artificial being with no mind or decision-making ability of its own.) p. with the advice of other members of senior management. Besides. which is not a desirable goal. of Rs. Total Contribution Expected Total Total Fixed Net profit variable cost p. Although optimizing shareholder value may be one goal. Therefore.50 maximizes profit for the Company as a whole. community and so on.u. Goals Although we often refer to the goals of a corporation. Division B would not select Selling price p.) (Rs. Comment on why the latter price is unlikely to be selected by division B. creditors. Ford Motor Company. Solution: As per the calculation in part (a). But market value is not an accurate measure of the worth of shareholders' investments. of Rs. He said.80 maximizes profit for division B whereas selling price p.u.ii) Profitability statement of Division B:Selling p. with resulting surprisingly enormous benefit to ourselves" 79 . 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. but not too much.u. selling price p. Alfred P.u. the goals originally set by the founder persist for generations. "A reasonable profit is right. So. = Variable cost p.u.) 6000 24000 (42000) Total Net profit (6000) 36000 42000 (b) State the selling price which maximizes profits for division B and company as a whole. Wal-Mart. Examples are Henry Ford. of contribution cost (Rs. of Rs.42000. such value can be obtained only when the share is traded in the stock exchange. all relate to maximizing shareholder's value. Earning per share and Market value. (Rs. of Rs.) (12000) 12000 84000 Net profit of Division B (Rs. and they are usually ratified by the board of directors. General Motors Corporation. Again. Walt Disney Company. Sloan. Corporate goals are determined by the chief executive officer (CEO) of the corporation.50.u. shareholder value is usually equated with the market value of the company's stock. units) 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. Comment on goal of shareholder value maximization in particular.50 in order to maximize Company‘s profit. However.u.7) + Transfer price of intermediate product (Rs. It is interesting to note that Henry Ford's operating philosophy was 'satisfactory profit'.

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. and managers usually do not know what these are. for two reasons. "investment" thus means the total of debt capital and equity capital. by borrowing. "maximizing" implies that there is a way of finding the maximum amount that a company can earn. managers 80 .Other goals such as adding new products. Some CEOs stress only part of the profitability equation. identifies all the possible alternatives and their respective effects on profitability. any concrete structural programme indicating its operational expenses. Furthermore. that achieving satisfactory profit is a better way of stating a corporation's goal. be mentioned through an appropriate system. management usually selects the one it believes will increase profitability the most. and the public at large.e. This focus does not recognize the simple fact that if additional profits are obtained by a greater than proportional increase in investment. however.e. Many current expenditure (e. profitability is usually the most important goal. the source of financing is not relevant. Other CEOs. Maximizing Shareholder Value In the 1980s and 1990s the term shareholder value appeared frequently in the business literature. Such a priority can lead to problems. methods of providing service. This concept is that the appropriate goal of a for-profit corporation is to maximize shareholder value. Even if the profit margin is satisfactory.. Social Goals However. Some CEOs focus on profit either as a monetary amount or as a percentage of revenue.g. If maximization were the goal. it suggests that in his mind there was a close correlation between market share and return on investment. amounts spent on advertising or research and development) reduce current profits but increase profits over time. revenues minus expenses) by investment. This is not the case. "investment" refers to the shareholders' investment. explicitly focused on revenue. but this method does not draw attention to the two principal components: profit margin and investment turnover. But management rarely. In the basic form of this equation. For many purposes. profit maximization requires that marginal costs and a demand curve be calculated. emphasize revenues for a different reason: For them.. personnel involved in rendering service and the nature of the service in details can. it probably refers to the market price of the corporation's stock. the organization may still not earn a good return if the investment is too large. however. former CEO of General Electric Company. however. or product-line or new business actually indicate normal organizational growth. "Profitability" refers to profits in the long run. Although the meaning of this term was not always clear. If expenses are too high. plus retained earnings. that is. In deciding between two courses of action. First. the profit margin will not give shareholders a good return on their investment. each dollar of investment has earned less. 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. Return on investment can be found by simply dividing profit (i. The shareholders' investment (i. company size is a goal. Profitability In a business. which consists of proceeds from the issuance of stock. rather.. every organization has its share of responsibility towards the local community where it is situated. equity) is the amount of financing that was not obtained by debt. if ever. One of management's responsibilities is to arrive at the right balance between the two main sources of financing: debt and equity. rather than in the current quarter or year. We believe. This does not imply that Welch neglected the other components of the equation. Jack Welch.

since he has no knowledge of nor interest in the company other than greater dividends and advance in the price of his stock.financial crisis during 1996-1998 is traceable. I do my best to run the company that way. headquartered in Taiwan. suppliers. He wrote let me say right here that I do not believe that we should make such an awful profit on our cars. Certainly a business that does not earn a profit at least equal to its cost of capital is not doing its job. I even consider the company's banks. such as market share. and communities. 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. is sound. nor is shareholder value. Second. 81 . are actions that increase profit with a less than proportional increase in shareholder investment (or. with no such increase at all). The Asian . in large part. 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. and the factor market. customers. unless it does so. and give the benefits to the users and laborers-with resulting surprisingly enormous benefits to ourselves. it is by no means the only goal for most organizations. that the course of action is ethical and consistent with the corporation's other goals. although optimizing shareholder value may be a major goal. employees. Multiple Stakeholder Approach Organizations participate in three markets: the capital market. 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." Lincoln Electric Company is well known for its philosophy that employee satisfaction was more important than shareholder value. The firm has a responsibility to all these multiple stakeholders-shareholders. even society is stakeholder. in all cases. A reasonable profit is right. its management control system should identify the goals for each of these groups and develop scorecards to track performance. such as expanding the advertising budget. Example: Henry Ford's operating philosophy was satisfactory profit. So. life is generally considered to be too short to warrant such an effort. the employee is number 2. These principles assume. too. So it has been my policy to force the price of the car down as fast as production would permit. and the public stockholders are therefore an important constituency. and customers form a key constituency. Nevertheless there is always an upper limit. Hastings.-the founder. emphasized that this was still the company's philosophy in 1996. Example: In 2005. I keep this message consistent with all my colleagues. The degree of risk-taking varies with the personalities of individual managers. suppliers. but not too much. chairman and chief executive officer. The absentee stockholder is not' of any value to the customer or to the worker. the Acer Group. and others we do business with are our stakeholders. it cannot discharge any other responsibilities. such as purchasing a cost-saving machine. So is a course of action that increases expenses with a greater than proportional increase in revenues. the shareholder is number 3. A course of action that decreases expenses without affecting another element.would spend every working hour (and many sleepless nights) thinking about endless alternatives for increasing profitability. 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. we do not mean to question the validity of certain obvious principles. A firm raises funds in the capital market. "The customer is number 1. some organizations explicitly state that management's primary responsibility is to preserve the company's assets. The firm sells its goods and services in the product market. and most feel an obligation to other stakeholders in the organization in addition to shareholders. By rejecting the maximization concept. of course. the product market. Ideally." Donald F. To quote Stan 'Shih. Most managers want to behave ethically. But economic performance is not the sole responsibility of a business. with profitability considered a secondary goal. An organization's pursuit of profitability is affected by management's willingness to take risks. not maximum profit.

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 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.

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 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               To ascertain the provision of proper control at different levels, their effectiveness I in accomplishing management goals. Ascertain objectives of the organization are properly communicated and understood at all levels. 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. To assist the management to achieve the most efficient administration of its operations. 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. 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. To ascertain the provision of proper control at different levels, their effectiveness in accomplishing management goals. Ascertain objectives of the organization are properly communicated and understood at all levels. 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. To assist the management to achieve the most efficient administration of its operations. 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. 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. 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 It is concerned with financial aspects of business transactions of the year under audit The auditor examines the past financial records to report his opinion on the truth and fairness of the representations made in the financial statements. Examination of the performance of the management is beyond his scope

Management Audit It is concerned with the review of the past Performance to ascertain whether it is in tune with the objectives, policies and procedures of the enterprise. The management auditor reports on performance of the management during a particular period and suggest ways to remedy the deficiencies, including modification of objectives, policies etc.

Past year '(Financial) transactions are Covered Enterprises such as companies, trust and societies etc.

No limit as to the period to be covered

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

The auditor reports to the management


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.

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. 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.


W. after carefully considering opportunities and threats in the external environment as well as the strengths and weaknesses in the internal environment. During a very critical period in an organization. he immediately sent an officer of the company with a car to pick us up to their Guest House. practices and operating procedures embodied in 'rules'. When a new executive replaces him. Expenses and revenues are marked for each responsibility centre period wise. (b) Budgeting The strategic plan is converted to an annual budget incorporating planned expenditure and revenues for individual responsibility centers. (c) Operations and Measurement Responsibility centers operate within the framework of the budget. Formal Control Process Formal communication system is structured as per the 'hierarchy outlined in the organization chart. It influences moral-the attitude of the individual towards his/her work and environment. Thus. and 'manuals'. the responsibility 86 . say monthly. A strategic plan is prepared in order to implement the strategies. the extent of members' dedication or commitment to organizational purpose and the efficiency with which that purpose is translated into results. half yearly. and annually. the culture remains unchanged and the traditions are maintained. telephone directory did not include any number of his unit. When an executive of the parent company was contacted. but the attitude and treatment of that member of organization speak volumes about their excellent culture. 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. besides budget. judge. the attitude ultimately stems from the temperament of the Chief Executive. Climate is the atmosphere in which individuals work help. Generally. That is why R. but cultural norms are extremely important. 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. standing instructions. 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. but the parent organization's telephone number was located. Again. the culture remains unchanged as long as the Chief Executive remains in position. Emerson said "an institute is the lengthened shadow of a man". if higher positions are filled in through promotion of internal executives.Management control systems Climate is used to designate the quality of the internal environment that conditions the quality of cooperation. a strategic plan and programme is prepared as a guideline to budgeting. and reward. The system has the following four components: (a) Strategic Plan and Programme The foundation of management control process lies in the organization's goals and its strategies for attaining these goals. entertain with coffee and then put up in a Hotel. But the existence of a good culture can be felt from the behavior of the members of the organization. the development of individuals. His unit being new. established standards. constrain and find out about each other. quarterly. His visit was arranged through non other than the Director of the company himself. there is likelihood of some change in the culture. Culture differs between the organizations. unless the new Chief follows the footsteps of his predecessor and maintains it. 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. In any organization. Thus. who controls the entire organization. They are not written like formal communication. What subsequently happened is a different matter.

If the same is unsatisfactory feedback communication is sent to the responsibility centre concerned for corrective action. measured and reported against plan. indicating variances and highlighting areas of weaknesses. They record the resources actually used and revenue earned. then the latter is revised to give effect to the changed position. If such action requires to be included in the budget. They also classify the data by programmes as well as by responsibility centers for performance measurement. If required.centers are also guided by a large number of rules. The aforesaid formal control process has been presented in the following diagram: 87 . If the performance is satisfactory. feedback information is sent to the responsibility centre concerned for praise or reward. then the plan itself can be revised and a new basis of control may be established. (d) Reporting Actual performance is analyzed.

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