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 organizations 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: MANAGMN! "#N!$#% &'&!M is an overall process of the enterprise (hich aims to
fit together the separate plans for various segments as to assure that each harmonizes (ith the others and that
the aggregate effect of all of them on the (hole enterprise is satisfactory.
Monetary Standard: MANAGMN! "#N!$#% &'&!M is built around a financial structure and all
the resources and outputs are e)pressed in terms of money. !he results of each responsibility centre in
respect to production and resources are e)pressed in terms of a common denominator of money.
Definite pattern: It follo(s a definite pattern and time table. !he (hole operational activity is regular and
rhythmic. It is a continuous process even if the plans are changed in the light of e)perience or technology.
Coordinated System: It is a fully coordinated and integrated system.
Emphasis: Management control re*uires emphasis both on the search for planning as (ell as control. +oth
should go hand in hand to achieve the best results.
Function of every manager: Manager at every level as to focus to(ards future operational and accounting
data, ta-ing into consideration past performance, present trends and anticipated economic and technological
changes. !he nature, scope and level of control (ill be governed by the level of manager e)ercising it.
Existence of goals and plans: MANAGMN! "#N!$#% &'&!M is not possible (ithout
predetermined goals and plans. !hese t(o provide a lin- bet(een such future anticipations and actual
performance.
Forward looking: MANAGMN! "#N!$#% &'&!M is on the basis of evaluation of past performance
that the future plans or guidelines can be laid do(n. Management "ontrol 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. .eciding, planning and regulating the activities of people associated in the common tas- of
attaining the objectives of the organization is a the primary aim of MANAGMN! "#N!$#% &'&!M.
eople oriented: It is the managers, engineers and operators (hich implement the ideas and objectives of
the management. !he coordination of the main division of an organization helps in smoother operations and
less friction (hich results in the achievement of the predetermined objectives.
Scope of control
MANAGMN! "#N!$#% &'&!M is an important process in (hich accounting information is used to
accomplish the organizations objectives. !herefore the scope of control is very (ide (hich covers a very (ide
range of management activities.
olicies control: &uccess if a business depends on formulation of sound policies and their proper
implementation.
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Control over organi!ation: 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 (hen the need arises.
Control over personnel: Anything that the business accomplishes is the result of the action of those people
(ho (or- in the organization. It is the people, and not the figures, that get things done.
Control over costs: !he cost accountant is responsible to control cost sets, cost standards, labour material
and over heads. /e ma-es comparisons of actual cost data (ith standard cost. "ost control is a delicate tas-
and is supplemented by budgetary control systems.
Control over techni"ues: It involves the use of best methods and techni*ues so as to eliminate all (astages
in time, energy and material. !he tas- is accomplished by periodic analysis and chec-ing of activities of
each department (ith a vie( to avoid an eliminate all non0essential motions, functions and methods.
Control over capital Expenditure: "apital budget is prepared for the (hole concern. very project is
evaluated in terms if the advantage it accrues to the firm. 1or this purpose capital budgeting, project
analysis, study of cost of capital etc are carried out.
#verall 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.
2e define net cash flo( as net income plus non cash adjustment (hich typically means net income plus
depreciation though that cash flo(s cannot be maintained over time unless depreciated fi)ed assets are replaced.
&o management is not completely free to use its cash flo(s ho(ever it chooses. !herefore (e define the term
free cash flo(s.
Free cash flow is the cash flo( actually available for distribution to investor after the company has made all the
investment in fi)ed assets and (or-ing capital necessary to sustain ongoing operation. 2hen (e studied income
statement in accounting the emphasis (as probably on the firms net income, (hich is accounting profit.
/o(ever the value of companys operation is determined by the stream of cash flo(s that the operations (ill
generate no( and in the future. !o be more specific, the value of operation depends on all the future e)pected
free cash flo(s, defined as after0 ta) operating profit minus the amount of ne( investment in (or-ing capital and
fi)ed assets necessary to sustain the business. !herefore the (ay for managers to ma-e their companies more
valuable is to increase their free cash flo(.
Uses of FCF:
. 3ay interest to debt holders, -eeping in mind that the net cost to the company is the after ta) interest
e)pense.
!. $epay debt holders, that is, pay off some of debt.
". 3ay dividends to shareholders.
#. $epurchase stoc- from shareholders.
$. +uy mar-etable securities or other non operating assets.
In practice, most companies combine these five uses in such a (ay that the net total is e*ual to 1"1. 1or
e)ample, a company might pay interest and dividends, issue ne( debts, also sell some of its mar-etable
securities. &ome of these activities are cash outflo(s 4paying interest and dividends5 and some are cash inflo(s
4issuing debt and selling mar-etable securities5, but the net cash flo( from these five activities is e*ual to free
cash flo(s.
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Computation of free cash flows:
Eg:
&uppose the company had a 6778 N#3A! of 98:7.;million and depreciation is only the non cash charge (hich is
9877million then its operating cash flo( in 6778 (ould be N#3A! plus any non cash adjustment on the
statement of cash flo(s.
#perating cash flo( <N#3A! =depreciation 4non cash adjustment5
< 98:.7; = 9877
< 96:7.;
"ompany has 98,>??million operating assets, at the end of 6777, but 98,@77 at the end of 6778.it made a net
investment in operating assets of
Net investment in operating assets < 98@, 77 0 98,>?? < 9;>?million
If net fi)ed assets rose from 9@:7million to 98777million ho(ever company reported 9877million of
depreciation. &o its gross investment in fi)ed assets (ould be
Gross investment < net investment = depreciation
< 98;7 = 9877 < 96;7million
"ompany free cash flo(s in 6778 (as

1"1 < operating cash flo( A gross investment in operating assets
< 96:7.; 0 9>>?
< 0 98:>.:million
An algebraically e*uivalent e*uation is
1"1 < N#3A! 0 Net investment in operating assets
< 98:7.;0 9;>?
< 0 98:>.:million
ven though company had a positive N#3A!, its very high investment in operating assets resulted in a
negative free cash flo(. +ecause free cash flo( is (hat is available for distribution to investor, not only (as
there nothing for investors, but investor actually had to provide additional money to -eep the business ongoing.
A negative current 1"1 not necessarily bad provided it is due to the high gro(th or to support the gro(th. !here
is nothing (rong (ith profitable gro(thB even it causes negative free cash flo( in the short term
What is %alance Scorecard? What is the process of implementation and difficulties in implementation?
!he %alanced Scorecard 4+&"5 is a performance management tool (hich began as a concept for
measuring (hether the smaller0scale operational activities of a company are aligned (ith its larger0scale
objectives in terms of vision and strategy.
+y focusing not only on financial outcomes but also on the operational, mar-eting and developmental
inputs to these, the +alanced &corecard helps provide a more comprehensive vie( of a business, (hich in turn
helps organizations act in their best long0term interests.
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#rganizations (ere encouraged to measureCin addition to financial outputsC(hat influenced such
financial outputs. 1or e)ample, process performance, mar-et share D penetration, long term learning and s-ills
development, and so on.
!he underlying rationale is that organizations cannot directly influence financial outcomes, as these are
ElagE measures, and that the use of financial measures alone to inform the strategic control of the firm is un(ise.
#rganizations should instead also measure those areas (here direct management intervention is possible. In so
doing, the early versions of the +alanced &corecard helped organizations achieve a degree of EbalanceE in
selection of performance measures. In practice, early &corecards achieved this balance by encouraging managers
to select measures from three additional categories or perspectives: E"ustomer,E EInternal +usiness 3rocessesE
and E%earning and Gro(th.E
!he balance scorecard suggests that (e vie( the organization from four perspectives, and to develop
metrics, collect data and analyze it relative to each of these perspectives:
&he learning and growth perspecti'e : F!o achieve our vision, ho( (ill (e sustain our ability to
change and improveGH
&he (usiness process perspecti'e : F!o satisfy our shareholders and customers (hat business
processes must (e e)cel atGH
&he customer perspecti'e : F!o achieve our vision, ho( should (e appear to our customerGH
&he financial perspecti'e : F!o succeed financially, ho( should (e appear to our shareholdersGH
)mplementing a
%alanced
Scorecard
2e can summarize the implantation of a balanced scorecard in four general stepsB
1. .efine strategy.
2. .efine measure of strategy.
3. Integrate measures into the management system.
4. $evie( measures and result fre*uently.
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ach of these steps is iterative, re*uiring the participation of senior e)ecutive and employees throughout the
organization
*efine Strategy
!he balance scorecard builds a lin- bet(een 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 e)plicit and (hat that targets
have been developed.
*efine +easures of Strategy
!he ne)t step is to develop measures in support of the articulate strategy. It is imperative that the organization
focuses on a fe( critical measures at this pointB other(ise management (ill be overloaded (ith measures. Also, it
is important that the individual measures be lin-ed (ith each other in a cause effect manner
)ntegrated +easures into the management system
!he balanced scorecard must be integrated (ith the organization formal and informal structure, its culture, and its
human resources practice. 2hile the balanced &corecard gives some means for balancing measures, 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.
,e'iew +easures and result Fre-uently
#nce the balance scorecard is up and running it must be consistently revie(ed by senior management. !he
organization should be loo-ing for the follo(ing
/o( do the outcome measures say the organization is doingG
/o( do the driver measures say the organization is doingG
/o( has the organizations strategy changed since the last revie(G
/o( has the scorecard measures changedG
!he most important aspects of these revie(s are as follo(sB
!hey tell management (hether the strategy is being implemented correctly and ho(
successfully the strategy is (or-ing.
!hey sho( that management is serious about the importance of these measures.
!hey maintain alignment of measure to ever changing strategies.
*ifficulties in implementing %alanced Scorecard
!he follo(ing problems unless suitably dealt (ith, could limit the usefulness of the balanced scorecard approach:
3oor correlation bet(een nonfinancial measures and result.
1i)ation on financial result. No mechanism for improvement.
No mechanism for improvement.
Measures overload.
.oor Correlation (etween /onfinancial measures and result
&imply put there is no guarantee that future profitably (ill allo( targets achievement in any nonfinancial area.
!his is probably the biggest problem (ith the balanced scorecard because there is an inherent assumption that
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future profitability does follo( from achieving the scorecard measures, identifying the cause effect relationships
among the different measures is easier said than done.
!his (ill be a problem (ith any system that is trying to develop pro)y measures for future performance. 2hile
this does not mean that the balanced &corecard should be abandoned it is imp that comp adopting such a system
understand that the lin-s bet(een nonfinancial measures and financial performance are still poorly understood.
Fixation on Financial ,esults
As previously discussed not only are most senior managers (ell trained and very adept (ith financial measures
but they also most -eenly feel pressure regarding the financial performance of their comp. &hareholder are vocal
and the board of directors often applies pressure on the sta-eholders behalf .this pressure often over(helms the
long term uncertain paybac- of the nonfinancial measures.
/on mechanism for )mpro'ement
#ne of the most overloo-ed pitfalls of the balanced scorecard is that a company cannot achieve &tretch goals if
the "ompany has no mechanism for improvement .Infortunately achieving many of these goals re*uire complete
shifts in the (ay that business is done yet the company often does not have mechanism to ma-e those shifts . !he
mechanism available ta-es additional resource and re*uires a changed in the company culture. !hese changes do
not happen overnight nor do they respond automatically to a ne( stretch targets. Inertia often (or-s against the
company employees are accustomed to a self limited cycle of setting targets, missing those targets and readjusting
the targets to reflect (hat (as actually achieved. 2ithout a method for ma-ing improvement, improvements are
unli-ely to consistently happen no matter ho( good the stretch goal sound.
+easurement o'erload
/o( many critical measures can one manager trac- at one time (ithout losingG Infortunately there is no right
ans(er to this *uestion e)cept it is more than 8 and less than ?7. It too fe( then the manager is ignoring measures
that are critical to creating success. If it too many then the manager may ris- losing focus and trying to do too
many things at once.
0irish Engineering 1+CS2!33#4 /umerical
,esponsi(ility (udgeting was introduced in a medium sized organization 0irish Engineering.
Monthly report 4in part5 for an e)pense centre in factory is:
56ll figures in ,s. 7acs8
6ctual 9ariance
.irect %abour 877.8; 7.68 41avourable5
Indirect %abour JJ.;> @.87 4Infavourable5
!otal "ontrollable "osts 8J@.>: @.?7 4Infavourable5
.epartment 1i)ed "osts ;@.@6 00000000
Allocated "osts ?;.J6 00000000
Kuestions:
a. 2hy no variance is sho(n in t(o itemsG Is this correct approach in performance reportingG
b. &hould overhead e)penses mentioned above be included in "ontrollable "ostsG 2hyG 2hy notG
Solution 1a4:
Lariances bet(een actual and budgeted departmental fi)ed costs are obtained simply by subtraction, since these
costs are not affected by either the volume of sales or the volume of production. !hats (hy no variance is sho(n
for departmental fi)ed costs.
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Allocated costs are a share of the costs of a resource used by a project, (here the same resource is also used by
other activities. !hese are different to the Incurred costs because these costs are not e)clusively related to any
individual project. /o(ever, the cost of the resource still needs to be recovered, and ma-ing a fair and
reasonable charge to all projects using the resource does this.
!he -ey difference bet(een costs and Allocated costs is that the latter (ill be charged based upon an estimate,
rather than actual cash values. !hus as it is charged based upon an estimate the budgeted figure is the same as the
actual figure and hence no variances.
Solution 1(4:
#verhead )penses mentioned above should not be included in controllable costs because some costs are
uncontrollable li-e fi)ed costs. . !hey donMt vary (ith the change in short run managerial decisions and output.
And some costs are controllable i.e. they can be managed and changed (ith the managerial decisions and output.
As the above overhead e)penses (ould have certain portion of fi)ed e)penses this is hard to control. &o, these
should not be a part of controllable cost.
6%C ltd. 1+CS2!33:4 /umerical
.articulars *i'ision ; 1,s.4 *i'ision < 1,s.4
$#I 6@N 6JN
&ales 877 %acs ?77 lacs
Investment 6? lacs 877 %acs
+I! : %acs 6J lacs
6nalyze and comment upon performances of (oth the di'isions
Solution:
*i'ision ;
$#I < 43rofit D investment5O 877
3rofit < 46@D8775O6?lacs
< :lacs
3rofit margin < 43rofitDsales5O877
< 4:D8775O877
< :lacs
!urnover of investments < 4&alesDinvestment5O877
< 4877D6?5O877
< > times
*i'ision <
$#I < 43rofit D investment5O 877
3rofit < 46JD8775O877lacs
< 6Jlacs
3rofit margin < 43rofitDsales5O877
< 46JD?775O877
< ?.6lacs
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!urnover of investments < 4&alesDinvestment5O877
< 4?77D8775O877
< ? times
3rofit margin of P is better than profit margin of division '. !urnover of investment of division ' is better than
.ivision P.
$ence cost management of Division % is &etter than Division '(
+CS designers apparently disagree whether single measure to e'aluate the profit performance and
capital in'estment performance is prefera(le or SE.6,6&E measures for each are prefera(le =
C>++E/&
!here should be different measures used for evaluating profit performance and capital investment performance
as needed.
!he goal of performance measurement systems is to implement strategy. In setting up such systems, senior
management selects measures that best represent the companyMs strategy. !hese measures can be seen as current
and future critical success factorsB if they are improved, the company has implemented its strategy. !he strategyMs
success depends on its soundness. A performance measurement system is simply a mechanism that improves the
li-elihood the organisation (ill implement its strategy successfully.
+easuring .rofita(ility
!here are t(o types of profitability measurements used in evaluating a profit center, just as there are in
evaluating an organization as a (hole. 1irst, there is a measure of management performance, (hich focuses on
ho( (ell the manager is doing. !his measure is used for planning, coordinating, and controlling the profit
centerMs day0to0day activities and as a device for providing the proper motivation for its manager. &econd, there
is the measure of economic performance, (hich focuses on ho( (ell the profit center is doing as an economic
entity. !he messages conveyed by these t(o measures may be *uite different from each other. 1or e)ample, the
management performance report for a branch store may sho( that the storeMs manager is doing an e)cellent job
under the circumstances, (hile 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.
!he necessary information for both purposes usually cannot be obtained from a single set of data. +ecause the
management report is used fre*uently, (hile the economic report is prepared only on those occasions (hen
economic decisions must be made, considerations relating to management performance measurement have first
priority in systems design0that is, the system should be designed to measure management performance routinely,
(ith economic information being derived from these performance reports as (ell as from other sources.
Capital )n'estment +easurement
Most proposals re*uire significant ne( capital. !echni*ues for analyzing capital investment proposals attempt to
find either
4a5 !he net present value of the project, that is, the e)cess of the present value of the estimated cash inflo(s over
the amount of investment re*uired, or
4b5 !he internal rate of return implicit in the relationship bet(een inflo(s and outflo(s. An important point is
that these techni*ues are used in only about half the situations in (hich, conceptually, they are applicable.
!here are at least four reasons for not using present value techni*ues in analyzing all proposals.
1. !he proposal may be so obviously attractive that a calculation of its net present value is unnecessary. A
ne(ly developed machine that reduces costs so substantially that it (ill pay for itself in a year is an
e)ample.
2. !he estimates involved in the proposal are so uncertain that ma-ing present value calculations is
believed to be not (orth the effort0one canMt dra( a reliable conclusion from unreliable data. !his situation is
common (hen the results are heavily dependent on estimates of sales volume of ne( products for (hich no
good mar-et data e)ist. In these situations, the Epaybac- periodE criterion is used fre*uently.
;.
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4. !he rationale for the proposal is something other than increased profitability. !he present value
approach assumes that the Eobjective functionE is to increase profits, but many proposed investments (in
approval on the grounds that they improve employee morale, the companyMs image, or safety.
?.
6. !here is no feasible alternative to adoption. nvironmental la(s may re*uire investment in a ne(
program, as an e)ample.
!he management control system should provide an orderly (ay of deciding on proposals that cannot be
analyzed by *uantitative techni*ues. &ystems that attempt to ran- non0*uantifiable projects in order of
profitability (onMt (or-. Many projects do not fit into a mechanical ran-ing scheme.
What are the different methods to measure profits of a profit center in organizations? Which different
messages each type of measure is li?ely to con'ey to managers?
2hen financial performance in a responsibility center is measured in terms of profit, (hich is the difference
bet(een the revenues and e)penses, the responsibility center is called a profit center.
3rofit 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.
!here are t(o types of profitability measurements in a profit center, just as there are for the organization as a
(hole. !here is, first, a measure of management performance@ in (hich the focus is on ho( (ell the manager
is doing. !his measure is used for planning, coordinating and controlling the day0to0day activities of the profit
center. &econd, there is a measure of economic performance, in (hich the focus is on ho( (ell the profit center
is doing as an economic entity. !he message given by these t(o measures may be *uite different.
&ypes of .rofita(ility measures:
In order to evaluate the economic performance of a profit center, one must use net income after allocating all
costs. /o(ever, in evaluating the performance of manager, any of five different measures of profitability can be
used.

1) Contri&ution Margin: !he logic behind using contribution margin as a measure is that fi)ed e)penses
are not controllable by the manager, and therefore he should focus on ma)imizing the spread bet(een
revenue and e)penses. +ut the problem (ith this is that some fi)ed costs are controllable and all fi)ed costs
are partially controllable. A focus on the contribution margin tends to direct attention a(ay from this
responsibility.
2) Direct rofit: !his measure sho(s the amount that the profit center contributes to the general overhead
and profit of the corporation. It incorporates all e)penses incurred in or directly traced to the profit center,
regardless of (hether these items are entirely controllable by the profit center manager. A (ea-ness of this
measure is that it does not recognize the motivational benefit of charging head*uarters costs.
3) Controlla&le rofit: /ead*uarters e)penses are divided into t(o categories: controllable and non0
controllable. !he controllable e)penses are controlled by business unit manager. "onse*uently, if these costs
are included in the management system, the profit (ill be after the deduction of all e)penses that are
influenced by profit center manager.
4) )ncome &efore Taxes: In this measure, all corporate overhead is allocated to profit centers. !he basis of
allocation reflects the relative amount of e)pense that is incurred for each profit center. If corporate
overheads are allocated to profit centers, budgeted costs, not actual costs, should be allocated. !hen the
performance report (ill sho( an identical amount in the FbudgetH and FactualH columns for such overheads.
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5) *et )ncome: /ere, companies measure performance of domestic profit centers at the bottom line, the
amount of net income after income ta). !here are t(o arguments 85 Income after ta) is constant percentage
of the preta) income, so there is no advantage in incorporating income ta)es 65 many decisions that have
impact on income ta)es are made at head*uarters, and it is believed that profit center manager should not be
judged by the conse*uences of these decisions.
Explain special characteristics of professional organizations which impact +anagement Control. What
are interacti'e controls?
. 0oals
A dominant goal of a manufacturing company is to earn a satisfactory profit, specifically a satisfactory return on
assets employed. A professional organization has relatively fe( tangible assetsB its principal asset is the s-ill of
its professional staff, (hich MdoesnMt appear on its balance sheet. $eturn on assets employed, therefore, is
essentially meaningless in such organizations. !heir financial goal is to provide ade*uate compensation to the
professionals.
In many organizations, a related goal is to increase their size. In part, this reflects the natural tendency to
associate success (ith large size. In part, it reflects economies of scale in using the efforts of a central personnel
staff and units responsible for -eeping the organization up0to0date. %arge public accounting firms need to have
enough local offices to enable them to audit clients (ho have facilities located throughout the (orld.
!. .rofessionals
3rofessional organization is labour intensive and the labour is of a special type. $esearch and development
organization use in setting selling price and for other management purposes .standard cost system ,separation of
fi)ed and variable cost and analyses of variance (ere built on the foundation are e)ample of organization (hose
product are professional service. 3rofessional tends to give in ade*uate (eight to the financial implication of their
decision they (ant to do the best job they can regardless of its cost.
+ecause profession are the organization most important resource some authors have advocated that the value of
these profession should be counted as assets the system that does this is called human resource accounting .in the
8Q:7s many boo-s and articles (ere (ritten on this subject but fe( comp actually such a system and (e do not
-no( of any that one current .the problem of measuring the value of human assets is intractable.
". >utput and input measurement
!he output of a profession organisation cannot be measured in physical terms, use in setting selling price and for
other management purposes .standard cost system, seperstion of fi)ed and variable cost and analyses of variance
(ere built on the foundation. 2e 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 e*uivalent to measuring the amt or *uality earned is one
measures of output in some professional organization but these monetary amts at most relate to the *uantity of
service rendered not to their *uality.
&ome profession notably scientist engineer, and professional are reluctant to -eep trac- of ho( they spend their
time and this complicate the trac- of measuring performance .this reluctant seems to have its root in tradition
usually it can be overcome if senior management is (illing to put appropriate emphasis on the necessity for
accurate time reporting .nevertheless difficult problem arise in deciding ho( time should be charged to clients .if
the normal (or- (ee- is >7 hrs should a job be charged for 8D>7
th
of a (ee- compensation for each other spent on
itG If so ho( should (or- done on evening and (ee-end be counted ho( to account for time spent reading
literature ,going to meeting ,and other(ise -eeping up to dateG
#. Small Size
10
2ith a fe( e)ception such as some la( firm and accounting firms ,professional organisations are relatively small
and operate at a single location .senior management in such organisations can personally observe (hat is going on
and personally motivate employee .thus there is less need for a sophisticated management control system ,(ith
profit centres and formal performance reports nevertheless even a small organisations need a budget a regular
comparison of performance against budget ,and a (ay relating compensation to performance.
$. +ar?eting
In a manufacturing company there is a dividing line bet(een mar-eting activities and production activities only
senior management is concerned (ith both .such a clean separation does not e)ist in most 3rofessional
organisation, ho(ever their time and this complicate the trac- of measuring performance .this reluctant seems to
have its root in tradition usually it can be overcome if senior management is (illing to put appropriate emphasis
on the necessity for accurate time reporting. Nevertheless difficult problem arise in deciding ho( time should be
charged to clients .if the normal (or-. !hese mar-eting activities are conducted by professional usually by
professional, usually by professional (ho spend much of their time in production (or- that is (or-ing for clients.
In such situation it is difficult to assign appropriate credit to the person responsible for selling a ne( customerB in
a consulting firm for e)ample a ne( engagement may result from a conversation bet(een a member of the firm
or from the reputation of one of the firm professional as an outgro(th of speeches or articles. Moreover the
profession al (ho is responsible for obtaining the engagement may not personally involved in carrying it out
.until fairly recently these mar-eting contribution (ere re(arded subjectively Athat is they (ere ta-en into
account in promotion and compensation decisions .some organisation no( give e)plicit credit, perhaps as a
percentage of the project revenue, if the person revenue, if the person (ho hold sold the project can be identified.
What is )nteracti'e 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 thin-ing about ne( strategies.
1. A subset of the management control information that has a bearing on the strategic uncertainties
facing the buss becomes the focal point.
2. &enior e)ecutive ta-e such information seriously.
3. Managers at all levels of the org focus attention on the information produced by the system.
Aow do we e'aluate the .erformance 6ppraisal?
As noted earlier in regard to teachers, at the e)tremes the performance of professionals is easy to judge.
Appraisal of the large percentage of professionals (ho are (ithin the e)tremes is much more difficult. 1or some
professions, objective measures of performance are sometimes unavailable: !he recommendations of an
investment analyst can be compared (ith actual mar-et behavior of the securitiesB the accuracy of a surgeonMs
diagnosis can be verified by an e)amination of the tissue that (as removedB and the doctorsM s-ill can be
measured by the success ratio of operations. !hese measures are, of course, subject to appropriate *ualifications,
and in most circumstances the assessment of performance is finally a matter of human judgment by superiors,
peers, self, subordinates, and clients. Rudgments made by superiors are the most common. 1or these, professional
organizations increasingly use formal systems to collect performance appraisals as a basis for personnel
decisions and for discussion (ith the professional. &ome systems re*uire numerical ratings of specified attributes
of performance and provide for a (eighted average of these ratings. "ompensation may be tied, in part, to these
numerical ratings. In a matri) organization, both the project leader and the head of the functional unit that is the
professionalMs organizational EhomeE judge performance. E
Appraisals by a professionalMs peers, or by subordinates, are sometimes part of a formal control system. In some
organizations, individuals may be as-ed to ma-e a self0appraisal. )pressions of satisfaction or dissatisfaction
from clients are also an important basis for judging performance, although such e)pressions may not al(ays be
readily forthcoming.
11
!he budget can be used as the basis for measuring cost performance, and the actual time ta-en can be compared
(ith the planned time. +udgeting and control of discretionary e)penses are as important in a professional firm
as in a manufacturing company.
&uch financial measures are relatively unimportant in assessing a professionalMs contribution to the firmMs,
profitability, ho(ever. !he professionalMs major contribution is related to *uantity and above all *uality of (or-,
and its appraisal must be largely subjective. 1urthermore, the appraisal must be made currentlyB it cannot (ait
until one learns (hether a ne( building is (ell designed, a ne( control system actually (or-s (ell, or a bond
indenture has a fla(.
In some professions, internal audit procedures are used to control *uality. In many accounting firms, the report of
an audit is revie(ed by a partner other than the one (ho is responsible for it, and the (or- of the (hole firm is
Epeer revie(edE by another firm. !he proposed design of a building may be revie(ed by architects (ho are not
actively involved in the project.
Biran Company 1+CS2!33#4 /umerical
+udget versus Actual comparison for div S of Tiran company is as follo(s:
+udget Actual Actual better 4(orse5
than budget
&ales and other income @77 :>7 4J75
Lariable e)penses >@7 >;J >>
1i)ed e)penses 867 867 7
&ales promotional e)penses >7 6@ 86
>perating profit C3 $C #
Net (or-ing capital >77 >86 86
1i)ed assets 8J7 8>@ 4865
(a) Carry out and o'erall performance analysis to decide areas needing in'estigation.
1rom the given data, (e see that there is a certain amount of variance bet(een the budgeted operating profit and
actual operating profit. In order to analyze the variances, (e need to understand the -ey causal factors that affect
profit, namely, revenues and cost structure. !he profit budget has embedded in it certain e)pectations about the
state of total industry, companys mar-et share, selling prices and cost structure. $esults from variance
computation are actionable if changes in actual results are analyzed against each of this e)pectation.
,e'enue 'ariances@ that is a negative $s J7 la-hs, could be a result of selling price variance, mi)ed variance
andDor volume variance. A combination of above three factors must have been unfavorable that is either the
volume of sales must have been belo( the budgeted volumes 4 this must be particularly true since actual variable
e)penses are less than budgeted5 andDor the selling price must have been belo( e)pectation andDor the proportion
of products sold (ith a higher contribution must have been less than budgeted.
#ne more factor could have been the overall industry volume. /o(ever, this factor is beyond the managements
control and largely dependent on the state of economy.
9aria(le expenses are directly proportional to volumes and hence as is evident are less than budgeted.
12
&ales promotional e)penses also sho( a negative variance (hich could be a cause of lo(er sales volumes.
A cause of concern is that despite lo(er sales, the net (or-ing capital is more than budgeted (hich indicates
capital bloc- in higher inventory.
Another issue is that the fi)ed assets are lo(er than the budget by $s 86 la-hs (hich may indicate slo(er
capacity e)pansion then e)pected or distressed sale of assets to tide over cash flo(.
(b) What are the remedial measures if any would you suggest (ased on analysis?
!he budgeted estimates may be too optimistic and far from reality, one needs to ensure that estimates the as
realistic as possible. Given the estimates are correct, in that case depending upon the above analysis, the
management needs to ta-e corrective action areas needing improvement, sales volume could be improved by
better mar-eting, *uality standards and promotional efforts, product mi) could be improved by selling more of
higher contribution products. +etter sales (ill ensure a higher inventory turnover. +etter credit management to
recover receivables, (ill ensure improve cash flo( situation since less capital (ill be tied up in (or-ing capital.
13
Shandilya 7td. 1+CS2!33:4 /umerical
&handilya %td. has adopted conomic Lalue Added 4LA5 techni*ue for the appraisal of performance of its three
divisions A,+ and ". "ompany charges JN for current assets and @ N for 1i)ed Assets, (hile computing LA
relevant data are given belo( :0
.articulars *i' 6 *i' % *i' C &otal
%udgete
d
6ctual %udgete
d
6ctual %udgeted 6ctual %udgete
d
6ctual
3rofit ;J7 ;67 667 6>7 677 677 :@7 :J7
"urrent Assets >77 ;J7 @77 :J7 8677 8>77 6>77 6?67
1i)ed Assets 8J77 8J77 8J77 8@77 6777 6677 ?677 ?J77
&olution:
.articulars *i' 6 *i' % *i' C &otal
%udgete
d
6ctual %udgete
d
6ctual %udgeted 6ctua
l
%udgete
d
6ctual
$#A 8@N 8JN QN QN JN JN 87N QN
LA 67@ 8:7.> >> ?7.> 0;6 0J7 667 8J7.@
(4 Comment upon (oth methods@ (ased on results.
!here are three apparent benefits of an $#A measure. 1irst, it is a comprehensive measure in that anything that
effects the financial statements is reflected in this ratio. &econdly, $#A is easy to calculate, easy to understand,
and meaningful in absolute sense. 1inally, it is a common denominator that may be applied to any organizational
units responsible for profitability, no matter (hat its size or (hat business it practices. !he performance of
different units may be compared directly to each other. Also, $#I data is available for competitors that can be
used as a basis for comparison. Nevertheless, the LA approach has some inherent advantages over $#A.
!here are three compelling reasons to use LA over $#I. First, (ith LA all business units have the same profit
objective for comparable investments. !he $#I approach, on the other hand, provides different incentives for
investment across business units. 1or e)ample, a business unit that is currently achieving ;7N $#A (ould be
most reluctant to e)pand unless it is able to earn a $#I of ;7N or more on additional assets. &econd, decision
that increase a centres $#I may decrease its overall profits. !hird advantage of LA is that different interest
rates may be used for different types of assets. 1or e)ample, a relatively lo( rate May be used for inventories
(hile a higher rate may be used for different types of fi)ed assets.
*escri(e differences in (udgeting perspecti'e of engineered and discretionary expense
centre
14
Expense centers:
)penses center are responsibility centers for (hich input or e)penses are measured in monetary
terms, but for (hich outputs are not measured in monetary terms. !here are t(o general types :
engineered e)pense center and discretionary e)pense center. !hey correspond to t(o types of costs :
ngineered costs are elements of cost for (hich the right or proper amount of costs that should be
incurred can be estimated (ith a reasonable degree of reliability. "osts incurred in factory for direct
labour direct material component supplies and utilities are e)amples.

Engineered expense centers:

ngineered e)pense center have the follo(ing characteristics:
1.
!heir inputs can be measured in monetary terms.
2.
!heir output can be measured in physical terms.
3.
!he optimal dollar amount of input re*uired to produce one unit of output can be established
ngineered e)pense center usually are found in manufacturing operations. 2arehousing, distribution,
truc-ing and similar units in the mar-eting organization also may be engineered e)pense center and so
many certain responsibility center (ithin administrative and support department. )amples 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. &uch units perform repetitive tas- for (hich standard cost
can be developed
In an engineered e)pense center the output multiplied by the standard cost or each unit produced
represents (hat the finished product should have cost. 2hen this cost is compared to actual costs, the
difference bet(een the t(o represents the efficiency of the organization unit being measured.
2e emphasize that engineered e)pense centers have other important tas-s not measured by cast alone.
!he effectiveness of these aspects of performance should be controlled. 1or e)ample e)penses center
supervisor are responsible for the *uality of good and for the volume of production in addition to their
responsibility for cost efficiency. !herefore the type and amount of production is prescribed and
specific *uality standards are set so that manufacturing costs are not minimized at the e)pense of
*uality. Moreover manager of engineered e)pense 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 ho( (ell they carry out these responsibilities.
15
!here are fe( if any responsibility center in (hich all cost items are engineered. ven in highly
automated production department the amount of indirect labour and of various services used can vary
(ith management discretion.
!hus, the term engineered costs center refers to responsibility center in (hich engineered cost
predominate but it does not imply that valid engineering estimates can be made for each and every cost
item.

*iscretionary expense center:

!he output of discretionary e)penses center cannot be measured in monetary terms. !hey include
administration and support units research and development organization and most mar-eting activities.
!he term discretionary does not mean that management judgments are capricious or haphazard.
Management has decided on certain policies that should govern the operation of the company. #ne
company may have a small head*uarter staff another company of similar size and in the same industry
may have a staff that is 87 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 (ay judging (hich decision (as
actually better manager are hired and paid to ma-e such decision after such a drastic change the level
of discretionary e)penses generally has a similar pattern from one year to the ne)t.
!he difference bet(een budgeted and actual e)pense is not a measure of efficiency in a discretionary
e)pense centre it is simply the difference bet(een the budgeted input and the actual input. It in no (ay
measures the value of the output, if actual e)pense do not e)ceed the budget amount, the manager has
Ulived (ithin the budget U ho(ever ,because by definition the budget does not purport to measure the
optimum amount of spending (e cannot say that living (ithin the budget is efficient performance .
*ifferences in (udgeting perspecti'e of engineered and discretionary expense centre

%udget preparation
!he decision that management ma-e about a discretionary e)pense budget are different from the
decisions that it ma-es about the budget for an engineered e)pense center. 1or the latter, management
decides (hether the proposed operating budget represent the cost of performing tas- efficiently for the
coming period. Management is not so much concerned (ith the magnitude of the tas- because this is
largely determined by the actions of other responsibility centers, such as the mar-eting departments
16
ability to generate sales. In formulating the budget for a discretionary e)pense center, ho(ever
management principal tas- is to decide on the magnitude of the job that should be done.

)ncremental (udgeting
/ere the current level e)penses in a discretionary e)pense center is ta-en as a starting points this
amount is adjusted for inflation for anticipated changes in the (or-load of continuing tas-s for special
tas-s and if the data are readily available for the cost of comparable (or- in similar units.
!here are t(o dra(bac-s to incremental budgeting. 1irst because managers of these centers typically
(ant to provide more service they tend to re*uest additional resources in the budgeting process and if
they ma-e a sufficiently strong case these re*uest (ill be granted. !his tendency is e)pressed in
3ar-insons second la(: overhead costs tend to increase period. !here is ample evidence that not all
this up(ard creep in cost is necessary.
!his problem is especially compounded by the fact that the current level of e)penditure in the
discretionary e)penses center is ta-en for granted and is not re0e)amined during the budget preparation
process. &econd (hen a company faces a crises or (hen a ne( management ta-es over overhead costs
are sometimes drastically reduced (ithout any adverse conse*uences.
.espite this limitation most budgeting in discretionary e)pense centers is incremental. !ime does not
permit the more thorough analysis described in the ne)t section.

Dero (ased re'iew

An alternative approach is to ma-e a thorough analysis of each discretionary e)pense center on a
schedule that (ill cover all of them over a period of five year or so. !hat analysis provides a ne( base.
!here is a li-elihood that e)penses (ill creep up gradually over the ne)t five years and this is tolerated
at the end of five years, another ne( base is established. &uch an analysis is often called a zero base
revie(.
In contrast (ith incremental budgeting (hich ta-es the current level of spending as the starting point
this more intensive revie( attempts to build up de no( the resources that actually are needed by the
activity. +asic *uestion are raisedB485 should use customerG465 (hat should the *uality level be Gare (e
doing too much4;5should the function be performed in this (ay 4>5 ho( much should it costG
17

Cost 'aria(ility
In discretionary e)pense center costs tend to vary (ith volume from one year to the ne)t but they tend
not to vary (ith short run fluctuation in volume (ithin a given year. +y contrast costs in engineering
e)pense center are e)pected to vary (ith short run changes in volume. 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 B 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
personnel and personnel related costs are by far the largest e)pense item in most discretionary e)pense
center the annual budget for these center tend to be a constant percentage of budgeted sales volume.
Explain some factors which may influence top management style and the implication of the
top management style on management control.
!he management control function in an organization is influenced by the style of senior management.
!he style of the chief e)ecutive officer affects the management control process in the entire
organization. &imilarly, the style of the business unit manager affects the unitMs management control
process, and the style of functional department managers affects the management control process in
their functional areas.

*ifferences in +anagement Styles

Managers manage differently. &ome rely heavily on reports and certain formal documentsB others
prefer conversations and informal contacts. &ome are analyticalB others use trial and error. &ome are
ris- ta-ersB others are ris- averse. &ome are process orientedB others are results oriented. &ome are
long0term orientedB others are short0term oriented. &ome emphasize monetary re(ardsB others
emphasize a broader set of re(ards.
Management style is influenced by the managerMs bac-ground and personality. +ac-ground includes
things li-e age, formal education, and e)perience in a given function, such as manufacturing,
technology, mar-eting, or finance. 3ersonality characteristics include such variables as the managerMs
(illingness to ta-e ris-s and his or her tolerance for ambiguity.
18

)mplications for +anagement Control

!he various dimensions of management style significantly influence the operation of the control
systems. ven if the same reports (ith the same set of data go (ith the same fre*uency to the "#,
t(o "#s (ith different styles (ould use these reports very differently to manage the business units.
&tyle affects the management control process A ho( the "# prefers to use the information, conducts
performance revie( meetings, and so on A (hich in turn affects ho( the control system actually
operates, even if the formal structure does not change under a ne( "#. In fact, (hen "#s change,
subordinates typically infer (hat the ne( "# really (ants based on ho( he or she interacts during
the management control process.

.ersonal 'ersus )mpersonal Controls

3resence of personal versus impersonal controls in organizations is an aspect of managerial style.
Managers differ on ho( much importance they attach to formal budgets and reports as (ell as informal
conversations and other personal contacts. &ome managers are Enumbers orientedEB they (ant a large
flo( of *uantitative information, and they spend much time analyzing this information and deriving
tentative conclusions from it. #ther managers are Epeople orientedEB they loo- at a fe( numbers, but
they usually arrive at their conclusions by tal-ing (ith people, judging the relevance and importance
of (hat they learn partly on their appraisal of the other person.
!hey visit various locations and spend time tal-ing (ith both supervisors and staff to get a sense of
ho( (ell things are going.
ManagersM attitudes to(ard formal reports affect the amount of detail they (ant, the fre*uency of these
reports, and even their preference for graphs rather than tables of numbers, and (hether they (ant
numerical reports supplemented (ith (ritten comments. .esigners of management control systems
need to identify these preferences and accommodate them.

&ight 'ersus 7oose Controls

A managerMs style affects the degree of tight versus loose control in any situation. !he manager of a
routine production responsibility center can be controlled relatively tightly or loosely, and the actual
control reflects the style of the managerMs superior. !hus, the degree of tightness or looseness often is
19
not revealed by the content of the forms or aspects of the formal control documents, rules, or
procedures. It is a factor of ho( these formal devices are used.
!he degree of looseness tends to increase at successively higher levels in the organization hierarchy:
higher0level managers typically tend to pay less attention to details and more to overall results.
!he style of the "# has a profound impact on management control. If a ne( senior manager (ith a
different style ta-es over, the system tends to change correspondingly. It might happen that the
managerMs style is not a good fit (ith the organizationMs management control re*uirements. If the
manager recognizes this incongruity and adapts his or her style accordingly, the problem disappears.
If, ho(ever, the manager is un(illing or unable to change, the organization (ill e)perience
performance problems. !he solution in this case might be to change the manager.
Explain ad'antages and disad'antages of two step transfer pricing and profit sharing methods

&ransfer pricing
If t(o or more profit center is jointly responsible for product development manufacturing and
mar-eting each should share in the revenue that is generated (hen the product is finally sold. !he
transfer price is not primarily an accounting toolB rather, it is a behavioral tool that motivates manager
to ma-e the right decisions. In particular the transfer price should be designed so that it accomplishes
the follo(ing objective:
It should provide each segment (ith the relevant information re*uired to determine the optimum
tradeoff bet(een 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

&wo step pricing

20
1irst, a charge is made for each unit sold that is e*ual to the standard variable cost of production.
&econd a periodic charge is made for the buying unit. #ne or both of these components should include
a profit margin.
!he t(o step pricing method correct this problem by transferring variable cost on a per unit basis, and
transferring fi)ed cost and profit on a lump sum basis under this method the transfer price for product
A (ould be ?9 for each unit that unit ' purchases plus 967777 per month for fi)ed cost. 3lus 987777
per month for profit: if transfer of product A in a certain month are at the e)pected amount ?777 units
then under the t(o step method unit y (ill pay the variable cost of 96?777 plus 9;7777 for the fi)ed
cost and profit a total of 9??777 .this is the same amount as the amount it (ould pay unit ) if the
transfer price is less than ?777 units say >777unoits.unit y (ould pay 9?7777 under the t(o step
methods compared (ith the 9>>777 it (ould pay if the transfer price (ere 988 per unit. !he difference
is their transfer prices (ere for not using a portion of unit P capacity that it has reserved.
Note that under t(o step method the company variable cost for product A is identifiable to unit '
variable cost for the product, and unit ' (ill ma-e the correct short term mar-eting decisions. Init '
also has information on upstream fi)ed costs and profit related to product A and it can use these data
for long term decision.
!he fi)ed cost calculation in the t(o step pricing method is based on the capacity that is reserved for
the production of product A that is sold to unit ' the investment represented by this capacity is
allocated to product A. !he return on investment that unit P earns on competitive product is calculated
and multiplied by the investment assigned to the product.
In the e)ample (e calculated the profit allo(ance as a fi)ed monthly amount. It (ould be appropriate
under some circumstance to divide the investment into variable and fi)ed component. !hen, a profit
allo(ance based on a return on investment on variable assets (ould be added to the standard variable
cost for each unit sold.

.rofit sharing
If the t(o step pricing system just described is not feasible, a profit sharing system might be used to
ensure congruence of business unit interest (ith company interest. !his system operates some(hat as
follo(s.
1.
!he product is transferred to the mar-eting unit at standard variable cost.
2.
After the product is sold, the business units share the contribution earned (hich is selling
price minus the variable manufacturing and mar-eting costs.
21
!his method of pricing may be appropriate if the demand for the manufactured product is not steady
enough to (arrant the permanent assignment of facilities as in the t(o step method. In general, this
method accomplished the purpose of ma-ing the mar-eting units interest congruent (ith the
companies. !here are several practical problems in implementing such profit sharing system. 1irst,
there can be arguments over the (ay contribution is divided bet(een the t(o profit centers. 2hich is
costly, time consuming and (or- against basic reason for decentralization namely autonomy of the
business units mangers. &econd, arbitrarily divided up the profit bet(een units does not give valid
information on the profitability of each segment of the organization.
!hird since the contribution is not allocated until after the sale has been made the manufacturing units
contribution depends upon the mar-eting units ability to sell and on the actual selling price.
Manufacturing units may perceive this situation to be unfair

&wo set of price

In this method, the manufacturing units revenue is credited at the outside sales price, and the buying
unit is charged the total standard costs. !he difference is changed to a head*uarter account and
eliminated (hen the business unit statement are consolidated, this transfer pricing method is
sometimes used (hen there are fre*uent conflict bet(een the buying and selling units that cannot be
resolved by one of the other method both the buying and selling

&here are se'eral disad'antages to the system of ha'ing

two set of transaction prices@ howe'er the sum of the business unit profit is greater than overall
company profits, senior management must be a(are of this situation in approved budget for the
business units and in subse*uent evaluation of performance against these budget. Also, this system
create an illusion feeling that business units are ma-ing money (hile in fact the overall company
might be losing after ta-ing account of the debits to head*uarter. 1urther this system might
motivate business unit to concentrate more on internal transfers at the e)pense of outside sales

&he fact that the conflict (etween the (usiness units

would (e lessened under this system could (e 'iewed as a wea?ness. &ometime, it is better for
the head*uarter to be a(are of the conflict arising out of transfer prices because such conflict may
signal problem in either the organizational structure or In other management systems. Inder the
22
t(o sets of prices method these conflicts are smoothed over thereby not alerting senior
management to these problems.
*iscuss special challenges faced in controlling , E * acti'ities and possi(le management
initiati'es

&ype of financial control:

!he financial control e)ercised in a discretionary e)pense center is *uite different from that in
engineered center the latter attempts to minimize operating cost by setting a standard and reporting
actual costs against this standards. !he main purpose of a discretionary e)pense budget on the other
hand is to allo( the manager to control "ost for particular in the planning. "osts are controlled
primarily by deciding (hat tas- should be underta-en and (hat level of effort is appropriate for each.
!hus in a discretionary e)pense center financial control is primary e)ercised at the planning stage
before the amount are incurred.

+easurement of performance:
!he primary job of the manager of a discretionary e)pense center is to accomplish the desired output
spending an amount that is on budget is satisfactory. !his is in contrast (ith the report in an
engineered e)pense center (hich helps higher management to evaluate the manger efficiency. If these
t(o types of responsibility center are carefully distinguished management may treat the performance
report for the discretionary e)pense center as if it (ere an indication of efficiency "ontrol over
spending can be e)ercised by re*uiring that the manger approved be obtain before the budget is over
sometimes a certain percentage of overrun is permitted (ithout additional approval if the budget really
set forth the best estimate of actual cost there is ?7 percent probability that it (ill overrun and this is
the reason that some latitude is often permitted.

Control pro(lems:
!he control of $ V . centers, (hich are also discretionary e)pense center is difficult for the follo(ing
at least a semi tangible output reasons.
23
1.
$esults are difficult to measure *uantitatively. As contrasted (ith administrative activities, $V.
usually has at least a semi tangible output in patent, ne( products, or ne( processes. Nevertheless,
the relationship of these outputs to inputs is difficult to measure and appraise. A complete product
of an $V. group may re*uire several year of effortB conse*uently input as stated in an annual
budget may be unrelated to outputs.
ven if an output can be identified a reliable estimate of its value often cannot be made. ven if
the value of the output can be calculated, it is usually not possible for management to evaluate the
efficiency of the $V. effort because of its technical nature. A brilliant effort may come up against
an insuperable obstacle, (hereas a mediocre effort may, by luc- result in a bonanza.
2.
!he goal congruence problem in $V. center is similar to that in administrative centers. !he
research managers typically (ant to build the best research organization that money can buy, even
though this is more e)pensive than the company can afford. A further problem is that research
people often may not have sufficient -no(ledge of the business to determine the optimum
direction of the research efforts.
3.
$esearch and development can seldom be controlled effectively on an annual basis. A research
project may ta-e year s to reach fruition, and the organization must be built up slo(ly over a long
time period. !he principal cost is for the (or- force obtaining highly s-illed scientific talented is
often difficult, and short term fluctuation in the (or- force are in efficient. It is not reasonable,
therefore to reduce $V. costs in years (hen profits are lo( and increase them in year (hen
profits are high. $V. should be loo-ed at as a long term investment not as an activity that varies
(ith short run corporate profitability.

&he ,E* continuum:

Activities conducted by $V. organization lie along a continuum. At one e)treme is basic researchB the
other e)treme is product testing. +asic research has t(o characteristics: first, it is unplanned
management at most can specify the general area that is to be e)plored second there is often a very
long time lag before basic research result in successful ne( product introductions.
1inancial control system has little value in managing basic research activities. In some companies,
basic research in included as a lump sum in the research program and budget. In others, no specific
allo(ance is made for basic research as suchB there is an understanding that scientists and engineers
24
can devote part of their time to e)plorations in (hatever direction they find most interesting, subject
only to informal agreement (ith their supervisor.
1or product testing projects, on the other hand, the time and financial re*uirement can be estimated,
not as accurately as production activities.
Explain pro(lems faced in pricing corporate ser'ices pro'ided to (usiness units organized as
.rofit Centers
&ervices are intangible in nature. !his characteristic of services ma-es it difficult for pricing. "harging
business units for services furnished by corporate staff units becomes challenging (or- due to
intangibility of services. 2hile pricing corporate services, (e e)clude the cost of central service staff
units over (hich business units have no control 4e.g., central accounting, public relations, and
administration5. If these costs are charged at all, they are allocated, and the allocations do not include
a profit component. !he allocations are not transfer prices.
We need to consider two types of transfers:

1or central services that the receiving unit must accept but can at least partially control the
amount used.

1or central services that the business unit can decide (hether or not to use.
+usiness units may be re*uired to use company staffs for services such as information technology and
research and development. In these situations, the business unit manager cannot control the efficiency
(ith (hich these activities are performed but can control the amount of the service received. !here are
three schools of thought about such services.
#ne school holds that a business unit should pay the standard variable cost of the discretionary
services. If it pays less than this, it (ill be motivated to use more of the service than is economically
justified. #n the other hand, if business unit managers are re*uired to pay more than the variable cost,
they might not elect to use certain services that senior management believes (orth(hile from the
companyMs vie(point. !his possibility is most li-ely (hen senior management introduces a ne(
service, such as a ne( project analysis program. !he lo( price is analogous to the introductory price
that companies sometimes use for ne( products.
25
A second school of thought advocates a price e*ual to the standard variable cost plus a fair share of the
standard fi)ed costs0that is, the full cost. 3roponents argue that if the business units do not believe the
services are (orth at least this amount, something is (rong (ith either the *uality or the efficiency of
the service unit. 1ull cost represents the companyMs long run costs, and this is the amount that should
be paid.
A third school advocates a price that is e*uivalent to the mar-et price, or to standard full cost plus a
profit margin. !he mar-et price (ould be used if available 4e.g., costs charged by a computer service
bureau5B if not, the price (ould be full cost plus a return on investment. !he 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. Also, the business units (ould incur the investment if they provided their
o(n service.

>ptional Use of Ser'ices

In some cases, management may decide that business units can choose (hether to use central service
units. +usiness units may procure the service from outside, develop their o(n capability, or choose not
to use the service at all. !his type of arrangement is most often found for such activities as information
technology, internal consulting groups, and maintenance (or-. !hese service centers are independentB
they must stand on their o(n feet. If the internal services are not competitive (ith outside providers,
the scope of their activity (ill be contracted or their services may be outsourced completely.
1or e)ample, "ommodore +usiness Machines outsourced one of its central service activities0customer
service0to 1ederal )press. Rames $eeder, "ommodoreMs vice president of customer satisfaction, said,
EAt that time (e didnMt have the greatest reputation for customer service and satisfaction. +ut this (as
1ed)Ms specialty, handling more than ;77,777 calls for service each day. "ommodore arranged for
1ed) to handle the entire telephone customer service operation from 1ed)Ms hub in Memphis.
After losing 96Q million online the previous year, +orders Group turned to rival Amazon.com to
manage its online sales. +orders get to maintain an Internet sales channel and gains the operational
effectiveness provided by Amazon.com (hile being able to focus on the gro(th of its bric-s and
mortar business.
In this situation, business unit managers control both the amount and the efficiency of the central
services. Inder these conditions, these central groups are profit centers. !heir transfer prices should
be based on the same considerations as those governing other transfer prices.
26
1/umerical4 +CS = !33#
*i'ision % of Shayana company contracted to (uy from *i'. 6@ !3@333 units of a components
which goes into the final product made (y *i'. %. &he transfer price for this internal transaction
was set at ,s. !3 per unit (y mutual agreement. &his comprises of 1per unit4 *irect and 9aria(le
la(our cost of ,s. !3F +aterial Cost of ,s.C3F Fixed o'erheads of ,s.!3 1lumpsum ,s.# lacs4 and
,s.!3 lacs that *i'. 6 would re-uire for this additional acti'ity. *uring the year@ actual off ta?e
of *i'. % from *i'. 6 was G@C33 units. *i'. 6 was a(le to reduce material consumption (y $H
(ut its (udgeted in'estment o'ershot (y 3H.
a)
6s Financial controller of *i'. 6@ compare 6ctual 9s %udgetred .erformance
b)
)ts implications for +anagement Control?
Solution:
a4
.articulars
For 20,000 Units
For 19,600
Units
%udgeted 1,s.
%udgeted
1&otal in ,s.4
6ctual
1,s. .er Unit4
6ctual 1&otal in ,s.4
*irect and
9aria(le 7a(our
Cost
67 >,77,777 67 ;,Q6,777
+aterial Cost J7 86,77,777 ?: 88,8:,677
Fixed >'erheads 67 >,77,777 >,77,777
&otal Cost 877 67,77,777 8Q,7Q,677
&ransfer .rice 867 6>,77,777 88Q.@J 6;,>Q,677
.rofit 67 >,77,777 >,>7,777
27
)n'estment 67 67,77,777 66,77,777
,>) I
.rofitJ)n'estment
67N 67N
.espite of increase in investment by 87N, there is negligible difference in transfer price. Also the
sales have decreased by >77 units. !herefore (e can say that additional investment has not achieved
any positive results.
28
+CS = !33K
&wo *i'isions 6 and % of Satyam Enterprises operate as .rofit centers. *i'ision 6 normally
purchases annually 3@333 nos. of re-uired components from *i'. %F which has recently informed
*i'. 6 that it will increase selling price per unit to ,s.@33. *i'. 6 decided to purchase the
components from open mar?et a'aila(le at ,s. 333 per unit. /aturally@ *i'. % is not happy and
Lustified its decision to increase price due to inflation and added that o'erall company
profita(ility will reduce and the decision will lead to excess capacity in *i'. %@ whose 'aria(le
and fixed costs per unit are respecti'ely ,s. G$3 and ,s. @33.
a)
6ssuming that no alternate use exists for excess capacity in *i'. %@ will company as a
whole (enefit if di' 6 (uys from the mar?et.
b)
)f the mar?et price reduces (y ,s. :3 per unit. What would (e the effect on the company
1assuming *i'. % still has excess capacity4 if 6 (uys from the mar?et
c)
)f excess capacity of *i'. % could (e used for alternati'e sales at yearly cost sa'ings of ,s.
#.$ lacs@ should *i'. 6 purchase from outside?
Mustify your answers with figures.
Solution
a)
>ption 6 1 *i' 6 (uys from outside4
!otal 3urchase "ost < 87,777 Inits O $s. 8777 < $s. 8,77,77,777
!otal outlay if transferred inside < 87,777 Inits O $s. Q?7 < $s. Q?,77,777
&ince total outlay if transferred inside is lesser than total purchase cost if bought from outside,
relevant cost is the lesser one i.e. $s. Q?,77,777 and overall benefit for the company (ould be $s.
?,77,777
b)
>ption % 1 if the mar?et price is reduced (y ,s. :3 per unit and 6 (uys from the mar?et4
!otal 3urchase "ost < 87,777 Inits O $s. Q67 < $s. Q6,77,777
!otal outlay if transferred inside < 87,777 Inits O $s. Q?7 < $s. Q?,77,777
&ince total purchase cost is lesser than the total outlay if transferred inside, relevant cost is the
lesser one i.e. Q6,77,777 and overall benefit for the company (ould be $s. ;,77,777
c)
>ption C 1 if excess capacity of *i' % could (e used for alternati'e sales at yearly cost
sa'ings of ,s #.$ lacs@ should *i' 6 purchase from outside4
!otal 3urchase "ost < 87,777 Inits O $s. 8,777 < $s. 8,77,77,777
!otal outlay if transferred inside < 87,777 Inits O $s. Q?7 < $s. Q?,77,777
!otal opportunity cost if transferred inside < $s. 8>,?7,777
!otal relevant cost becomes $s. 8,77,77,777
29
If .iv A purchase from outside, overall benefit for the company (ould be $s. Q,?7,777.
!herefore, .iv A should purchase from outside.
.articulars >ption 6
6mount
>ption %
6mount
>ption C
6mount
&otal .urchase Cost 8,77,77,777 Q6,77,777 8,77,77,777
&otal outlay if transferred inside Q?,77,777 Q?,77,777 Q?,77,777
&otal opportunity cost if transferred inside 0 0 8>,?7,777
&otal rele'ant cost Q?,77,777 Q6,77,777 8,77,77,777
/et ad'antageJdisad'antage to company as a whole if
it (uys from inside
$@33@333 1"@33@3334 1G@$3@3334
Explain the concept of ,>). What are its ad'antages?
$eturn on investment 4$#I5 is the ratio of profit before ta) to the gross investment.
$#I is calculated (ith the help of the follo(ing formula:
$#I < (Pre-Tax Profit/Sales) P (Sales/Net Assets) or (Pre-Tax Profits/Net Assets)
!he numerator is profit before ta) as reported in the 3V% account. !he profit should include only the profits
arising out of the normal activities of the division. Inusual items of receipts and e)penses should be e)cluded
from the profit figure. #ne should also ignore (indfalls and income from investments not related to the
operations of the division. !a) is e)cluded from the numerator because the marginal of the &+I is not
responsible for or in control of the ta) paid.
"apital employed can be ascertained from the balance sheet by including fi)ed and current assets. Assets not
currently put to divisional use should be e)cluded from the investment base. #ne also needs to e)clude their
relative earnings if any. !he company should also e)clude intangible assets li-e good(ill, deferred revenue
e)penses, preliminary e)penses, etc.
,>) can (e impro'ed (y
a) Increasing the profit margin on sales.
b) Increasing the capital turnover
c) Increasing both profit margin and capital turnover.
d) $educing cost as that adds to the total earnings of the firm.
e) Increasing the profits by e)panding present operations or developing ne( product line, increasing
mar-et share, etc.
30
f) .iversifying, introducing productivity imporevement measures, e)pansion, replacement of old
e*uipments
6d'antages of ,>)
a) $#I relates return to the level of investment and not sales as the rate of return is more realistic.
b) $#I can be decomposed into other variables as sho(n. !hese variables have tremendous analytical
value.
c) $#I is an effective tool for inter0firm comparison.
31
+any experts regard E96 as a concept superior to ,>) and yet in certain cases@ E96 does not do Lustice
to the e'aluation of in'estment center. Explain this phenomenon with as illustration.
LA does not solve all the problems of measuring profitability in an investment center. In particular, it does not
solve the problem of accounting for fi)ed assets discussed above unless annuity depreciation is also used, and
this is rarely done in practice. If gross boo- value is used, a business unit can increase its LA by ta-ing actions
contrary to the interests of the company, as sho(n in )hibit :0;. If net boo- value is used, LA (ill increase
simply due to the passage of time. 1urthermore, LA (ill be temporarily depressed by ne( investments because
of the high net boo- value in the early years. LA does solve the problem created by differing profit potentials.
All business units, regardless of profitability, (ill be motivated to increase investments if the rate of return from
a potential investment e)ceeds the re*uired rate prescribed by the measurement system.
Moreover, some assets may be undervalued (hen they are capitalized, and others (hen they are e)pensed.
Although the purchase cost of fi)ed assets is ordinarily capitalized, a substantial amount of investment in start0up
costs, ne( product development, dealer organization, and so forth may be (ritten off as e)penses, and, therefore,
not appear in the investment base. !his situation applies especially in mar-eting units. In these units the
investment amount may be limited to inventories, receivables, and office furniture and e*uipment. 2hen a group
of units (ith varying degrees of mar-eting responsibility are ran-ed, the unit (ith the relatively larger mar-eting
operations (ill tend to have the highest LA.
In vie( of all these problems, some companies have decided to e)clude fi)ed assets from the investment base.
!hese companies ma-e an interest charge for controllable assets only, and they control fi)ed assets by separate
devices. "ontrollable assets are, essentially, receivables and inventory. +usiness unit management can ma-e day0
to0day decisions that affect the level of these assets. If these decisions are (rong, serious conse*uences can
occur0*uic-ly. 1or e)ample, if inventories are too high, unnecessary capital is tied up, and the ris- of
obsolescence is increasedB (hereas, if inventories are too lo(, production interruptions or lost customer business
can result from the stoc-outs. !o focus attention on these important controllable items, some companies, such as
Kua-er #ats, 8: include a capital charge for the items as an element of cost in the business unit income
statement. !his acts both to motivate business unit management properly and also to measure the real cost of
resources committed to these items.
Investments in fi)ed assets are controlled by the capital budgeting process before the fact and by post completion
audits to determine (hether the anticipated cash flo(s, in fact, materialized. !his is far from being completely
satisfactory because actual savings or revenues from a fi)ed asset ac*uisition may not be identifiable. 1or
e)ample, if a ne( machine produces a variety of products, the cost accounting system usually (ill not identify
the savings attributable to each product.
!he argument for evaluating profits and capital investments separately is that this often is consistent (ith (hat
senior management (ants the business unit manager to accomplishB namely, to obtain the ma)imum long0run
cash flo( from the capital investments the business unit manager controls and to add capital investments only
(hen they (ill provide a net return in e)cess of the companyMs cost of funding that investment. Investment
decisions, then, are controlled at the point (here these decisions are made. "onse*uently, the capital investment
analysis procedure is of primary importance in investment control. #nce the investment has been made, it is
largely a sun- cost and should not influence future decisions. Nevertheless, management (ants to -no( (hen
capital investment decisions have been made incorrectly, not only because some action may be appropriate (ith
respect to the person responsible for the mista-es but also because safeguards to prevent a recurrence may be
appropriate.
32
)llustration
What are the different methods to e'aluate the performance of an in'estment centre? *iscuss the merits
and demerits of each? Which method would you recommend?
!he follo(ing techni*ues are useful in evaluating the performance of an investment centre:
,eturn on in'estment 1,>)4
!he rate of return on investment is determined by dividing net profit or income by the capital employed or
investment made to achieve that profit.
33
$#I < 3rofit D Invested capital O 877
$#I consists of t(o components viz.
a. 3rofit margin
b. Investment turnover
$#I < Net profit D Investment
< 4Net profit D &ales5 O 4&ales D Investment in assets5
It (ill be seen from the above formula that $#I can be improved by increasing one or both of its components
viz. the profit margin and the investment turnover in any of the follo(ing (ays:
Increasing the profit margin
Increasing the investment turnover
Increasing both profit margin and investment
turnover
"apital employed is ta-en to be the total of shareholders funds, loans etc
!he profit figure used is in calculating $#I is usually ta-en from the profit and loss account, profit arising out of
the normal activities of the company should only be ta-en.
"apital employed for the company as a (hole can be arrived at as follo(s:
&hare capital of the company )))
$eserves and surplus )))
%oans 4securedDunsecured5 )))
000000
)))
%ess: a. Investment outside the business )))
b. 3reliminary e)penses )))
c. .ebit balance of 3 V % ADc ))) )))
0000000
))))
Merits:
34
$eturn on investment analysis provides a strong incentive for optimum utilization of the assets of the
company. !his encourages managers to obtain assets that (ill provide a satisfactory return on investment and
to dispose off assets that are not providing an acceptable return. In selecting amongst alternative long0term
investment proposals, $#I provides a suitable measure for assessment of profitability of each proposal.
.emerits:
$#I analysis is not very suitable for short0term projects and performances. In the initial stages a ne(
investment may yield a small $#I (hich may mislead the management. Most li-ely the rate (ould improve in
course of time (hen the initial difficulties are overcome.
!he boo- value of assets decline due to depreciation, the investment base (ill continuously decrease in
value, causing the rate of return to increase.

,esidual income
$esidual income can be defined as the operating profit 4or income5 of the company less the imputed interest on
the assets used by the company. In other (ords, interest on the capital invested in the company is treated as a
cost and any surplus is the residual income. $esidual income is profit minus notional interest charge on capital
employed.
$esidual income is affected by the size of the organization and therefore (ill not provide a basis for evaluation
of organizational performance. !his is probably the main reason (hy the management continues to ma-e use of
$#I (hich is relative measure.
Not all projects start off (ith positive or sufficiently large positive profits in the early years of a project to
produce a positive increment to residual income.
It has been argued that a more suitable measure of performance for investment centres, (hich could encourage
managers to be more (illing to underta-e marginally profitable projects, is residual income.
2e recommend $I as a method of evaluating performance of an investment centre. +ecause (hen $I is adopted
for evaluation purposes, emphasis is placed on marginal profit amount above the cost of capital rather than on
the rate itself.
What are the o(Lecti'es of &ransfer .ricing?
!ransfer price if designed appropriately has the follo(ing objectives:
35

It should provide each segment (ith the relevant information re*uired to determine the optimum trade0
off bet(een company costs and revenues.

It should induce goal congruent decisions0i.e. the system should be so designed that decisions that
improve business unit profits (ill also improve company profits.

It should help measure the economic performance of the individual profit centers.

!he system should be simple to understand and easy to administer.

What is ideal transfer price in the situations of

a.
7imited +ar?et
b.
Shortage of Capacity in the industry
!he ideal transfer price in the situations of :
a.
7imited +ar?et
+y limited mar-et it means that the mar-ets for buying and selling profit centers may be limited.
ven in case of limited mar-et the transfer price that is ideal or satisfies the re*uirement of a profit center
system is the competitive price. In case if a company is not buying or selling its product in an outside mar-et
there are some (ays to find the competitive price. !hey are as follo(s:
1.
If published market prices are available, they can be used to establish transfer prices. /o(ever,
these should be prices actually paid in the mar-et0place and the conditions that e)ist in the outside mar-et
should be consistent (ith those e)isting (ithin the company.
1or e)ample, mar-et prices that are applicable to relatively small purchases are not valid in this case.
2.
Mar-et prices are set by bids. !his generally can be done only if the lo( bidder has a
reasonable chance of obtaining the business. #ne company accomplishes this
-
by buying about one0half of a particular group of products outside the company
-
and one0half inside the company.
!he company then puts all of the products out to bid, but selects one0half to stay inside. !he company
obtains valid bids, because lo( bidders can e)pect to get some of the business. +y contrast, if a company
re*uests bids solely to obtain a competitive price and does not a(ard the contracts to the lo( bidder, it
(ill soon find that either no one bids or that the bids are of *uestionable value.
36
3.
If the production profit center sells similar products in outside mar-ets, it is often possible to
replicate a competitive price on the basis of the outside price.
4.
If the buying profit center purchases similar products from the outside mar-et, it may be
possible to replicate competitive prices for its proprietary products. !his can be done by calculating the
cost of the difference in design and other conditions of sale bet(een the competitive products and the
proprietary products.
b.
Shortage of Capacity in the industry
In this case, the output of the buying profit center is constrained and again company profits may not be
optimum. &ome companies allo( either buying profit center to appeal a sourcing decision to a central person or
committee. In this scenario a buying profit center could appeal a selling profit centers decision to sell outside.
!he personDgroup (ould then ma-e a sourcing decision on the basis of the companys best interests. In every
case the transfer price (ould be the competitive price. In other (ords, the profit center is appealing only the
sourcing decision.
ven if there are constraints on sourcing, the market price is the best transfer price. If the mar-et price can be
appro)imated, it is ideal transfer price.

When do you use Cost %ased &ransfer .ricing?

2e use cost-based transfer pricin if there is no (ay of appro)imating valid competitive price.
!ransfer prices may be set up on the basis of cost plus a profit, even though such transfer prices may be comple)
to calculate and the results less satisfactory than a mar-et0based price.
!(o aspects need to be considered for cost0based transfer pricing:
1.
&he cost (asis: !he usual basis is the standard cost. Actual costs should not be used because production
inefficiencies (ill then be passed on to the buying profit center. If the standard costs are used, there is a need
to provide an incentive to set tight standards and to improve standards.
2.
&he profit mar?up: In calculating the profit mar-up, there also are t(o decisions:
+hat is the profit markup to &e &ased,
!he simplest and most (idely used base is percentage of costs. If this base is used, ho(ever, no account is
ta-en of capital re*uired. A conceptually better base is a percentae of investment! +ut there may be a major
practical problem in calculating the investment applicable to a given product. If the historical cost of the fi)ed
assets is used, ne( facilities designed to reduce prices could actually increase costs because old assets are
undervalued.
37
+hat is the level of profit allowed,
!he second problem (ith the profit allo(ance is the amount of the profit. !he conceptual solution is to base
the profit allo(ance on the investment re*uired to meet the volume needed by the buying profit centers. !he
investment (ould be calculated at a FstandardH level, (ith fi)ed assets and inventories at current replacement
costs. !his solution is complicated and, therefore, rarely used in practice.
38
N&ransfer .ricing is not an accounting toolO comment with an illustration
If a group has subsidiaries that operate in different countries (ith different ta) rates, manipulating the transfer
prices bet(een the subsidiaries can scale do(n the overall ta) bill of the group. 1or e)ample the ta) rate in
"ountry A is 67N and is ?7N in "ountry +. In the larger interest of the group, it (ould be advisable to sho(
lo(er profits in "ountry + and higher profits in "ountry A. 1or this, the group can adjust the transfer price in
such a (ay that the profits in "ountry A increase and that in "ountry + get reduced. 1or this the group should fi)
a very high transfer price if the .ivision in "ountry A provides goods to the .ivision in "ountry +. !his (ill
ma)imize the profits in "ountry A and minimize the profits in "ountry +. !he reverse (ill be true if the .ivision
in "ountry A ac*uires goods from the .ivision in "ountry +.
!here is also a temptation to set up mar-eting subsidiaries in countries (ith lo( ta) rates and transfer products to
them at a relatively lo( transfer price.
!ransfer price is vie(ed as a major international ta) issue. 2hile companies indulge in all types of activities to
lo(er their ta) liability, the ta) authorities monitor transfer prices closely in an attempt to collect the full amount
of ta) due. 1or this they enter into agreements (hereby ta) is paid on specific transactions in one country only.
+ut if companies set unrealistic transfer price to minimize their ta) liabilities and the same is spotted by the ta)
authority, then the company is forced to pay ta) in both countries leading to double ta)ation.
!here have been instances (here companies have fi)ed unrealistic transfer prices. !he first case relates to
/offman %a $oche that imported t(o drugs %ibrium and Lalium into IT at prices of >;: pounds and Q:Q
pounds per -ilo respectively. 2hile the ta) authorities in IT accepted the price, the Monopolies "ommission did
not accept the companyMs argument, since the same drugs (ere available from an Italian firm for Q pounds and 6@
pounds per -ilo.
!he companyMs la(yers argued the case before the "ommission on t(o grounds viz.
8. !he price (as not set on cost but on (hat the mar-et (ould bear and
6. !he company had incurred an $V. cost that (as included in the price.
!hese arguments did not go (ell (ith the "ommission and the company (as fined 8.@? million pounds
for the manipulative practices adopted (hile fi)ing the transfer price.
!he second case is of Nissan. !he company had falsely inflated freight charges by >70J7N to reduce the profits.
!he manipulation helped the company to hide ta) to the tune of 6;: million dollars. !he ne)t year Nissan (as
39
made to pay 87J million dollars in unpaid ta) in the I&A because the authorities felt that part of their I&
mar-eting profits (ere being transferred to Rapan, as transfer prices on import of cars and truc-s (ere too high.
Interestingly the Rapanese ta) authorities too- a different vie( and returned the double ta).
2ith a vie( to avoid such cases from recurring, #rganisation for conomic "ooperation and .evelopment
issued some guidelines in 8QQ?. !hese guidelines aim at encouraging (orld trade. !hey evolved (hat came to be
-no(n as the armMs length price. !he principle states that the transfer price (ould be arrived at on the basis as if
the t(o . companies are independent and unrelated. !he price is determined through:

"omparable 3rice Method (here the price is fi)ed on the basis of prices of similar products or an
appro)imation to one.

Gross Margin Method (here a gross margin is established and applied to the sellerMs manufacturing
cost.
In spite of all these efforts, it has to be admitted that setting a fair transfer price is not easy. &o the onus
of proving the price has been put on the ta)payer (ho is re*uired to produce supporting documents. If the
ta)payer fails to do this he is re*uired to pay heavy penalty. 1or e)ample, in I&A, failure to provide
documentary evidence results in a >7N penalty on the armMs length price. In IT the penalty is to the tune of
877N of any ta) adjustment. #ther countries are also in the process of evolving tight norms for the same.
"ountries across the globe also allo( the ta)payer to enter into an Advance 3ricing Agreement (hereby dispute
can be avoided and so also the costly penalty of double ta)ation and penalty.
+ar?et .rice is ideal transfer price e'en in limited mar?ets. Comments
+y limited mar-et it means that the mar-ets for buying and selling profit centers may be limited.
ven in case of limited mar-et the transfer price that is ideal or satisfies the re*uirement of a profit center
system is the competitive price. In case if a company is not buying or selling its product in an outside mar-et
there are some (ays to find the competitive price. !hey are as follo(s:
8. If published market prices are available, they can be used to establish transfer prices. /o(ever, these should
be prices actually paid in the mar-et0place and the conditions that e)ist in the outside mar-et should be
consistent (ith those e)isting (ithin the company. 1or e)ample, mar-et prices that are applicable to relatively
small purchases are not valid in this case.
40
6. Mar-et prices are set by bids. !his generally can be done only if the lo( bidder has a reasonable chance of
obtaining the business. #ne company accomplishes this by buying about one0half of a particular group of
products outside the company and one0half inside the company.
!he company then puts all of the products out to bid, but selects one0half to stay inside. !he company obtains
valid bids, because lo( bidders can e)pect to get some of the business. +y contrast, if a company re*uests bids
solely to obtain a competitive price and does not a(ard the contracts to the lo( bidder, it (ill soon find that
either no one bids or that the bids are of *uestionable value.
;. If the production profit center sells similar products in outside mar-ets, it is often possible to replicate a
competitive price on the basis of the outside price.
>.If the buying profit center purchases similar products from the outside mar-et, it may be possible to replicate
competitive prices for its proprietary products. !his can be done by calculating the cost of the difference in
design and other conditions of sale bet(een the competitive products and the proprietary products.&o (e see
from the above arguments that mar-et price is ideal transfer price even in limited mar-ets
.ivision of Aparna "ompany manufactures 3roduct A, (hich is sold to another division as a component of
its product +B (hich then is sold to third division to be used as part of its 3roduct " 4sold to outside mar-et5.
Intra company transactions rule: standard cost plus a 87 percent return on fi)ed assets and inventory, to be
paid by the buying division.
&tandard "ost per Init 3roduct A 3roduct + 3roduct "
O3urchase of outside material 4$s.5 >7 J7 67
.irect. %abour 4$s.5 67 67 >7
Lariable overhead 4$s.5 67
67 >7
O1i)ed overhead per unit. 4$s.5 J7
J7 67
Average Inventory 4$s.5 8> lacs
; lacs J lacs
Net 1i)ed Assets 4$s.5 J lacs
Q lacs ;.6 lacs
&tandard 3roduction 4Inits5 6 lacs
6 lacs 6 lacs
4a5 .etermine from above data, transfer prices for 3roducts A, + and &tandard "ost of 3roduct ".
4b5 3roduct " could become uncompetitive since upstream margins are added. "omment.
Ans(er
4a5: &tandard "ost of 3roduct A
#utside material 4>7 O 6 lac units5 @7,77,777
.irect %abour 467 O 6 lac units5 >7,77,777
Lariable #./. 467 O 6 lac units5 >7,77,777
8,J7,77,777
41
= 87N on 41A = Inventory5
i.e. 87N on 67 lacs 6,77,777
@C!@33@333
!ransfer 3rice for 3roduct A < 8,J6,77,777 < :
6,77,777
&tandard "ost of 3roduct +
#utside material 4J7 O 6 lac units5 8,67,77,777
.irect %abour 467 O 6 lac units5 >7,77,777
Lariable #./. 467 O 6 lac units5 >7,77,777
6,77,77,777
= 87N on 41A = Inventory5
i.e. 87N on 86 lacs 8,67,777
!@3@!3@333
!ransfer 3rice for 3roduct A < 6,78,67,777 < 33.C
6,77,777
&tandard "ost of 3roduct "
#utside material 467 O 6 lac units5 >7,77,777
.irect %abour 4>7 O 6 lac units5 @7,77,777
Lariable #./. 4>7 O 6 lac units5 @7,77,777
1i)ed #./. 467 O 6 lac units5 67,77,777
!@!3@33@333
4b5 2hile arriving at the cost of 3roduct ", margins of 3roduct A, (hich become an input to 3roduct +, and
3roduct +, (hich in turn become an input to 3roduct ", are added. &o (hen it is sold to outside mar-et, it
suffers a disadvantage from its competitors as far as pricing is concerned, as its price (ill normally be high
compared to products of similar category. &o it might become uncompetitive.
+ut in the long run, customers (ill distinguish bet(een a good product and a bad product and the one (ith
the best *uality (ill survive. &o if the *uality of product " is better than its competitors than only it can survive
in this competitive mar-et.
Another strategy for the company is to cut the margins added by 3roducts A and +, and then come out (ith
3roduct " (ith a lo(er price tag on it. !his may do (ell to the product by ma-ing higher revenues and
capturing the mar-et share.
*escri(e and illustrate significance of human (eha'ior patterns in management control system.
Management control systems influence human behavior. "ood management control systems influence
behavior in a goal congruent mannerB that is, they ensure that individual actions ta-en to achieve personal goals
also help to achieve the organizationMs goals. !he concept of goal congruence, describing ho( it is affected both
by informal actions and by formal systems.
&enior management (ants the organization to attain the organizationMs goals. +ut the individual members of the
42
organization have their o(n personal goals, and they are not necessarily consistent (ith those of the
organization. !he central purpose of a management control system, then, is to ensure a high level of (hat is
called Egoal congruence.E #n a oal conruent process$ the actions people are led to take in accordance %ith
their perceived self interest are also in the best interest of the orani&ation!
!he significance of human behavior patterns in management control system can be e)plained (ith the help of
)nformal Factors that influence 0oal Congruence. In the informal forces both internal and e)ternal factors
play a -ey role.
External Factors
)ternal factors are norms of desirable behavior that e)ist in the society of (hich the organization is a part.
!hese norms include a set of attitudes, often collectively referred to as the %ork ethic$ (hich is manifested in
employeesM loyalty to the organization, their diligence, their spirit, and their pride in doing a good job 4rather than
just putting in time5. &ome of these attitudes are local that is, specific to the city or region in (hich the
organization does its (or-. In encouraging companies to locate in their city or state, chambers of commerce and
other promotional organizations often claim that their locality has a loyal, diligent (or-force. #ther attitudes and
norms are industry0specific. &till others are nationalB some countries, such as Rapan and &ingapore, have a
reputation for e)cellent (or- ethics.
)nternal Factors
Culture
!he most important internal factor is the organizationMs o(n culture0the common beliefs, shared values, norms of
behavior and assumptions that are implicitly and e)plicitly manifested throughout the organization. "ultural
norms are e)tremely important since they e)plain (hy t(o organizations (ith identical formal management
control systems, may vary in terms of actual control. A companyMs culture usually e)ists unchanged for many
years. "ertain practices become rituals, carried on almost automatically because Ethis is the (ay things are done
here.E #thers are taboo 4E(e just donMt do that hereE5, although no one may remember (hy. #rganizational
culture is also influenced strongly by the personality and policies of the "#, and by those of lo(er0level
managers (ith respect to the areas they control. If the organization is unionized, the rules and norms accepted by
the union also have a major influence on the organizationMs culture. Attempts to change practices almost al(ays
meet (ith resistance, and the larger and more mature the organization, the greater the resistance is.
Management Style
!he internal factor that probably has the strongest impact on management control is management style. Isually,
subordinatesM attitudes reflect (hat they perceive their superiorsM attitudes to be, and their superiorsM attitudes
ultimately stem from the "#.
Managers come in all shapes and sizes. &ome are charismatic and outgoingB others are less ebullient. &ome spend
much time loo-ing and tal-ing to people 4management by (al-ing around5B others rely more heavily on (ritten
reports.
The )nformal #rgani!ation
!he lines on an organization chart depict the formal relationships0that is, the official authority and
responsibilities0of each manager. !he chart may sho(, for e)ample, that the production manager of .ivision A
reports to the general manager of .ivision A. +ut in the course of fulfilling his or her responsibilities, the
production manager of .ivision A actually communicates (ith many other people in the organization, as (ell as
(ith other managers, support units, the head*uarters staff, and people (ho are simply friends and ac*uaintances.
In e)treme situations, the production manager, (ith all these other communication sources available, may not
pay ade*uate attention to messages received from the general managerB this is especially li-ely to occur (hen the
production manager is evaluated on production efficiency rather than on overall performance. !he realities of the
management control process cannot be understood (ithout recognizing the importance of the relationships that
43
constitute the informal organization.
erception and Communication
In (or-ing to(ard the goals of the organization, operating managers must -no( (hat these goals are and (hat
actions they are supposed to ta-e in order to achieve them. !hey receive this information through various
channels, both formal 4e.g., budgets and other official documents5 and informal 4e.g., conversations5. .espite
this range of channels, it is not al(ays clear (hat senior management (ants done. An organization is a
complicated entity, and the actions that should be ta-en by anyone part to further the common goals cannot be
stated (ith absolute clarity even in the best of circumstances.
Moreover, the messages received from different sources may conflict (ith one another, or be subject to differing
interpretations. 1or e)ample, the budget mechanism may convey the impression that managers are supposed to
aim for the highest profits possible in a given year, (hereas senior management does not actually (ant them to
s-imp on maintenance or employee training since such actions, although increasing current profits, might reduce
future profitability.
!he informal factors discussed above have a major influence on the effectiveness of an organizations
management control. !he other major influence is the formal systems. !hese systems can be classified into t(o
types: 485 the management control system itself and 465 rules, (hich are described in this section.
&he Formal Control System
,ules
2e use the (ord rules as shorthand for all types of formal instructions and controls, including: standing
instructions, job descriptions, standard operating procedures, manuals, and ethical guidelines. $ules range from
the most trivial 4e.g., paper clips (ill be issued only on the basis of a signed re*uisition5 to the most
important5:e.g., capital e)penditures of over 9? million must be approved by the boardM of directors5.
&ome rules are guidesB that is, organization members are permitted, and indeed e)pected, to depart from them,
either under specified circumstances or (hen their o(n best judgment indicates that a departure (ould be in the
best interests of the organization.
&ome rules are positive re*uirements that certain actions be ta-en 4e.g., fire drills at prescribed intervals5. #thers
are prohibitions against unethical, illegal, or other undesirable actions. 1inally, there are rules that should never
be bro-en under any circumstances: a rule prohibiting the payment of bribes, for e)ample, or a rule that airline
pilots must never ta-e off (ithout permission from the air traffic controller.
&ome specific types of rules are listed belo(:
hysical Controls
&ecurity guards, loc-ed storerooms, vaults, computer pass(ords, television surveillance, and other physical
controls may be part of the control structure.
Manuals
Much judgment is involved in deciding (hich rules should be (ritten into a manual, (hich should be considered
to be guidelines rather than fiats, ho( much discretion should be allo(ed, and a host of other considerations.
Manuals in bureaucratic organizations are more detailed than are those in other organizationsB large organizations
have more manuals and rules than small onesB centralized organizations have more than decentralized onesB and
organizations (ith geographically dispersed units performing similar functions 4such as fast0food restaurant
chains5 have more than do single0site organizations
System Safeguards
Larious safeguards are built into the information processing system to ensure that the information flo(ing
through the system is accurate, and to prevent 4or at least minimize5 fraud of every sort. !hese include: cross0
chec-ing totals (ith details, re*uiring signatures and other evidence that a transaction has been authorized,
separating duties, counting cash and other portable assets fre*uently, and a number of other procedures described
44
in te)ts on auditing.
Task Control Systems
!as- control is the process of assuring that specific tas-s are carried out efficiently and effectively. Many of these
tas-s are controlled by rules. If a tas- is automated, the automated system itself provides the control.
Concept of profit centre in /.>
+y la( N3# are allo(ed to ma-e profit but are restrained from distributing it to o(ners and
management !his (ay they are non profit ma-ing organizations 4from the o(nerMs point of vie(5. &uch
organizations include religious, charitable and educational trusts. 3rime 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. #n the financial front, they enjoy many concessions from the government such as ta)es, subsidies,
grants etc so also they attract special control from these assisting institutes.
Characteristics:
8. Absent of profit performance measure leads to problems in assessing the efficiency of the organization. If the
organization sho(s large net income it may be because that N3# may not be providing the services to the
e)tent possibleD e)pected. If the organization sho(s net losses it may sho( the N3# facing ris- of ban-ruptcy.
/ence non availability of clear0cut performance yardstic- ma-es the problem of control (orst.
6. N3#Ms have contributed capital 3lant: N3#s do not have shareholder as its sta-eholder. !he capital
contribution to the business comes by (ay of contributions to assets such as building and e*uipments. &econd
-ind of contribution could be in the form of monetary assistance, (hich entitles the organization to reap the
interest on it -eeping the principal amount intact.
;. #perating Assets represents the resources used for running day to day activities. And the contributed assets
are not allo(ed to mi) up (ith the operating assets.
>. 1und accounting: N3# need to -eep t(o types of financial statements one set for contributed capital and
another for operating capital. !he nature of the contributed capital is beyond control of the management and
therefore management concentrates on controlling the operating assetsDinvestments.
?. Governance: Isually N3# are managed by trusts, (ho e)ercise less control on operational matters. /ence
performance control is less demanding from o(nersM point of vie( and difficult from the point of vie( of
management.
!hese characteristics pose difficulty in pricing of the productDservices 0 (hat could be appropriate priceG Isually
it is set at totalDfull cost. !he more stress e)pected on allocation of scare resources. !hough not stricter control,
but a sense of control can be built among the managers by (ay of using budgets for various activities and
e)penses. Non profit basis ma-es performance evaluation *uite impossible. +ut one can ma-e the things easier
by concentrating on adherence to costs budgets, and enhancing the service base.
+anagement control in matrix structures
45
Matri) organizational structure assigns multiple responsibilities to the functional heads. valuation of
performance of such organizational entities is very difficult. !hough they offer economies of using scares
functional staff, it poses problems of casting the individual responsibility. !his form of organization is very
comple), from the point of vie( of management control system.
At the end (e must not forget that the management control system is for the organization and not the
organization e)ists for management control system. #ne has to mold and remold the management control system
to suit the given organization structure
A citation by Anthony is (orth noting in this regard.
Isually in an advertisement agency, account supervisors are shifted from one
account to another on periodic basis, this practice allo(s the agency to loo- at the account from the perspectives
of different e)ecutives. /o(ever ta-ing in to consideration the time lag of result realization in such services is
*uite large. And this may pose problem of performance assessment of a particular e)ecutive. !his does not mean
a control system designer should insist on abandoning the rotation system of the e)ecutives.
Matri) structure offers advantages such as faster decision ma-ing process, efficiency and effectiveness but
simultaneously it may pose problems such as added comple)ity in control function, assignment of responsibility
and authority etc.
)mplications of differentiated strategies on controls
.ifferent corporate strategies imply the follo(ing differences in the conte)t in (hich control systems need to be
designed:
As firms become more diversified, corporate0level managers may not have significant -no(ledge of, or
e)perience in, the activities of the companyMs various business units. If so, corporate0level managers for highly
diversified firms cannot e)pect to control the different businesses on the basis of intimate -no(ledge of their
activities, and performance evaluation tends to be carried out at armMs length.
&ingle0industry and related diversified firms possess corporate(ide core competencies 4on (hich the strategies
of most of the business units are based. "ommunication channels and transfer of competencies across business
units, therefore, are critical in such firms. In contrast, there are lo( levels of interdependence among the business
units of unrelated diversified firms. !his implies that as firms become more diversified, 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 planning:
Given the lo( level of interdependencies, conglomerates tend to use vertical strategic planning systems0that is,
business units prepare strategic plans V submit to senior management to revie( V approve. !he horizontal
dimension might be incorporated into the strategic planning process in a number of different (ays. 1irst, a group
e)ecutive might be given the responsibility to develop a strategic plan for the group as a (hole that e)plicitly
identifies synergies across individual business units (ithin the group. &econd, strategic plans of individual
business units could have an interdependence section, in (hich the general manager of the business unit
identifies the focal lin-ages (ith other business units and ho( those lin-ages (ill be e)ploited. !hird, the
corporate office could re*uire joint strategic plans for interdependent business units. 1inally, strategic plans of
individual business units could be circulated to managers of similar business units to criti*ue and revie(.
!hese methods are not mutually e)clusive. In fact, several of them could be pursued fruitfully at the same time.
46
%udgeting
!he chief e)ecutives of single0industry firms may be able to control the operations of subordinates through
informal and personally oriented mechanisms, such as fre*uent personal interactions. !his lessens the need to
rely as heavily on the budgeting system as the tool of control.
#n the other hand, in a conglomerate it is nearly impossible for the chief e)ecutive to rely on informal
interpersonal interactions as a control toolB much of the communication and control has to be achieved through
the formal budgeting stem. !his implies the follo(ing budgeting system characteristics in a conglomerate.
+usiness unit managers have some(hat greater influence in developing their budgets since they, not the
corporate office, possess most of the information about their respective productDmar-et environments. Greater
emphasis is often placed on meeting the budget since the chief e)ecutive has no other informal controls
available.
&ransfer .ricing
!ransfers of goods and services bet(een business units are more fre*uent in single0industry and related
diversified firms than in conglomerates. !he usual transfer pricing policy in a conglomerate is to give sourcing
fle)ibility to business units and use armMs0length mar-et prices. /o(ever, in a single0industry or a related
diversified firm, synergies may be important, and business units may not be given the freedom to ma-e sourcing
decisions.
)ncenti'e Compensation
!he incentive compensation policy tends to differ across corporate strategies in the follo(ing (ays0
-se of formulas:
"onglomerates, in general, are more li-ely to use formulas to determine business unit managersM bonusesB that
is, they may base a larger portion of the bonus on *uantitative, financial measures, such as P percent bonus on
actual economic value added 4LA5 in e)cess of budgeted LA. !hese formula0based bonus plans are employed
because senior management typically is not familiar (ith (hat goes on in a variety of disparate businesses.
&enior managers of single0industry and related diversified firms tend to base a larger fraction of the business unit
managers bonus on subjective factors. In many related diversified firms, greater degrees of interrelationships
imply that one unitMs performance can be affected by the decisions and actions of other units. !herefore, for
companies (ith highly interdependent business units, formula0based plans that are tied strictly to financial
performance criteria could be counterproductive.
rofita&ility measures:
In the case of unrelated diversified firms, the incentive bonus of the Mbusiness unit managers tend to be
determined primarily by the profitabi8ity of that unit, rather than the profitability of the firmW Its purpose is to
motivate managers to act as though the business unit (ere their o(n company.
In contrast, single0industry 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 4such as the
product group to (hich the business unit belongs or perhaps even .the overall corporation5. 2hen business units
are interdependent, the more the incentive bonus of general managers emphasizes the separate performance of
each unit, the greater the possibility of interunit conflict. #n the other hand, basing the bonus of general
managers more on the overall corporate performance is li-ely to encourage greater interunit cooperation, thereby
increasing managersM motivation to e)ploit interdependencies rather than their individual results.
.usiness -nit Strategy:
.iversified corporations segment themselves into business units and typically assign different strategies to the
individual business units. Many chief e)ecutive officers of multi business organizations do not adopt a
standardized, uniform approach to controlling their business unitsB instead, they tailor the approach to each
47
business unitMs strategy.
!he strategy of a business unit depends on t(o interrelated aspects:
485 Its mission 4E2hat are its overall objectivesGE5 and 465 its competitive advantage.
4E/o( should the business unit compete in its industry to accomplish its missionGE5. !ypically
business units choose from four missions: build, hold, harvest, and divest. !he business unit has t(o generic
(ays to compete and develop a sustainable competitive advantage: lo( cost and differentiation.
Mission
!he mission for e)isting business units could be either build, hold, or harvest. !hese missions constitute a
continuum, (ith Epure buildE at one end and Epure harvestE at the other end. !o implement the strategy
effectively, there should be congruence bet(een the mission chosen and the types of controls used. !he mission
of the business unit influences the uncertainties that general managers face and the short0term versus long0term
trade0offs they ma-e.
Management control systems can be systematically varied to help motivate the manager to cope effectively (ith
uncertainty and ma-e appropriate short0term versus long term trade0offs. !hus, different missions often re*uire
systematically different management control systems.
+ission and Uncertainty
E+uildE units tend to face greater environmental uncertainty than EharvestE units for several
reasons: +uild strategies typically are underta-en in the gro(th stage of the product life cycle, (hereas harvest
strategies typically are underta-en in the mature decline stage of the product life cycle. &uch factors as
manufacturing processB product technologyB mar-et demandB relations (ith suppliers, buyers, and distribution
channelsB number of competitorsB and competitive structure change more rapidly and are more unpredictable in
the gro(th stage than in the matureDdecline stage.
An objective of a build business unit is to increase mar-et share. +ecause the total mar-et share of all firms in an
industry is 877 percent, the .battle for mar-et share is a zero0sum gameB thus, a build strategy puts a business unit
in greater conflict (ith its competitors than does a harvest strategy. "ompetitorsM actions are li-ely to be
unpredictable, and this contributes to the uncertainty that build business units face.
#n both the input side and the output side, build managers tend to e)perience greater dependencies on e)ternal
individuals and organizations than do harvest managers. 1or instance, a build mission signifies additional capital
investment 4greater dependence on capital mar-ets5, e)pansion of capacity 4greater dependence on the
technological environment5, increase in mar-et share 4greater dependence on customers and competitors5,
increase in production volume 4greater dependence on ra( material suppliers and labor mar-ets5, and so on. !he
greater the e)ternal dependencies a business unit faces, the greater the uncertainty it confronts.
.
+uild business units are often in ne( and evolving industriesB thus, build managers are li-ely to have less
e)perience in their industries. !his also contributes to the greater uncertainty that managers of build units face in
dealing (ith e)ternal constituencies.
+ission and &ime Span
!he choice of build versus harvest strategies has implications for short0term versus long0term profit trade0offs.
!he share0building strategy includes (a) price Mcutting, (b) major $V. e)penditures 4to introduce ne( products5,
and (c) major mar-et development e)penditures. !hese actions are aimed at establishing mar-et leadership, but
they depress short0term profits. !hus, many decisions that a build unit manager ma-es, today may not result in
profits until some future period. A harvest strategy, on the other hand, concentrates on ma)imizing short0term
profits.
Strategic .lanning
2hen the environment is uncertain, the strategic planning process is especially important management needs to
thin- about ho( to cope (ith the uncertainties, and this usually re*ull8 longer0range vie( of planning than is
48
possible in the annual budget. If the environment is stable, there may be no strategic planning process at all or
only a broad0brush strategic plan. !hus, the strategic planning process is more critical and more important for
build, as compared (ith harvest, business units. Nevertheless, some strategic planning of the harvest business
units may be necessary because the companyMs overall strategic plan must encompass all of its businesses to
effectively balance cash flo(s.
In screening capital investments and allocating resources, the system may be more *uantitative and financial for
harvest units. A harvest business unit operates in a mature industry and does not offer tremendous ne(
investment possibilities. /ence, the re*uired earnings rate for such a business unit may be relatively high to
motivate the manager to search for project (ith truly e)ceptional returns. +ecause harvest units tend to
e)perience stable environments (ith predictable products, technologies, competitors, and customers5, discounted
cash flo( 3"15 analysis often can be used more confidently. !he re*uired information used to evaluate
investments from harvest units is primarily financial.
A build unit, ho(ever, is positioned on the gro(th stage of the product life cycle. &ince the corporate office
(ants to ta-e advantage of the opportunities in a gro(ing mar-et, senior management may set a relatively lo(
discount rate, thereby motivating build managers to for(ard more investment ideas to corporate office. Given the
productDmar-et uncertainties, financial analysis of some projects from build units may be unreliable. 1or such
projects, nonfinancial data are more important.
%udgeting
!he calculational aspects of variance analysis comparing actual results (ith the budget identify variances as
either favorable or unfavorable. /o(ever, a favorable variance does not necessarily imply favorable
performance, nor does an unfavorable variance imply unfavorable performance. !he lin- bet(een a favorable or
unfavorable variance, on the one hand, and favorable or unfavorable performance, on the other hand, depends on
the strategic conte)t of the business unit under evaluation.
)ncenti'e Compensation System
In designing an incentive compensation pac-age for business unit managers, the follo(ing *uestions need to be
resolved:
1. 2hat should the size of incentive bonus payments be relative to the general managerMs base salaryG
&hould the incentive bonus payments have upper limitsG
2. 2hat measures of performance 4e.g., profit, LA, sales volume, mar-et share, product
development5 should be used (hen deciding the general managerMs incentive bonus a(ardsG If multiple
performance measures are employed, ho( should they be (eightedG
3. /o( much reliance should be placed on subjective judgments in deciding on the bonus amountG
4. /o( fre*uently 4semiannual, annual, biennial, etc.5 should incentive a(ards be madeG
2ith respect to the first -uestion, many firms use the principle that the ris-ier the strategy, the greater the
proportion of the general managerMs compensation in bonus compared to salary 4the Eris-DreturnE principle5. !hey
maintain that because managers in charge of more uncertain tas- situations should be (illing.to ta-e greater
ris-s, they should have a higher percentage of their remuneration in the form of an incentive bonus. !hus,
EbuildE managers are more li-ely than EharvestE managers to rely on bonuses.
As to the second -uestion, (hen re(ards are tied to certain performance criteria, behaviour ls influenced by the
desire to optimize performance (ith respect to those criteria. &ome performance criteria 4cost control, operating
profits, and cash flo( from operations5 focus more on short0term results, (hereas other performance criteria
4mar-et share, ne( product development, mar-et development, and people development5 focus on long0term
profitability. !hus,
lin-ing incentive bonus to short0term criteria tends to promote a short0term focus on the part of the general
manager and, similarly, lin-ing incentive bonus to long0term criteria is li-ely to promote long0term focus.
"onsidering the relative differences in time horizons of build and harvest managers, it may not be appropriate to
49
use a single, uniform financial criterion, such as operating profits, to evaluate the performance of every business
unit. A better idea (ould be louse multiple performance criteria, (ith differential (eights for each criterion
depending on the business unitMs mission.
!he third *uestion as-s ho( much subjective judgment should affect bonus amounts. At one e)treme, a
managerMs bonus might be a strict formula0based plan, (ith the bonus tied to performance on *uantifiable criteria
4e.g., P percent bonus on actual profits in e)cess of budgeted profits5. At the other e)treme, a managerMs
incentive bonus amounts might be based solely on the superiorMs subjective judgment or discretion. Alternatively,
incentive bonus amounts might also be based on a combination of formula0based and subjective approaches.
3erformance on most long0term criteria 4mar-et development, ne(0product development, and people
development5 is harder to measure objectively than is performance along most short0run criteria 4operating
profits, cash flo( from operations, and return on investment5.As already noted, build managers0 in contrast (ith
harvest managers, should concentrate more on the long run, so they typically are evaluated more subjectively
than are harvest managers.
As to the fourth *uestion, the fre*uency of bonus a(ards does influence the time horizon of managers. More
fre*uent bonus a(ards encourage managers to concentrate on short0term performance since they have the effect
of motivating managers to focus on those facets of the business they can affect in the short run.
Competiti'e 6d'antage
A business unit can choose to compete. ither as a differentiated player or as a lo(0cost player, "hoosing a
differentiation Mapproach, rather than a lo(0cost approach, increases uncertainty of a business unitMs tas-
environment for three reasons.
1. 3roduct innovation is more critical for differentiation business units than for lo( cost business units.
!his is partly because a lo(0cost business unit, (ith primary emphasis on cost reduction, typically
prefers to -eep its product offerings stable over timeB a differentiation business unit, (ith its primary
focus on uni*ueness V e)clusivity, is li-ely to engage in greater product innovation.
2. A lo( cost business unit typically tend to have narro( product lines to minimize the inventory carry
costs as (ell as to benefit from scale economies. .ifferentiation business units on the other hand tend to
have a broader set of products to create uni*ueness.
3. %o( cost business units typically produce no0frill commodity productsV these products succeed
primarily because they have lo(er prices than competing products. /o(ever product differentiation
business units succeed if customers perceive that the products have advantages over competing
products. &ince the customer perception is difficult to learn about, V since customer loyalty is subject to
change resulting from actions of competitors or other reasons, the demand for differentiated products is
typically more difficult to predict than the demand for commodities.
". Which management control practices@ if followed@ in performance measurement of in'estment centres
are li?ely to induce goal congruence@ in respect of following assets:
1i4 Cash 1ii4 ,ecei'a(les 1iii4 )n'entories 1i'4 )dle 1'4 )ntangi(le 1'i4 7eased
In some business units, the focus is on profit as measured by the difference bet(een revenues and e)penses. In
other business units, profit is compared (ith the assets employed in earning it. 2e refer to the latter group of
responsibility centers as investment centers.
+easuring 6ssets Employed
In deciding (hat investment base to use to evaluate investment center managers, head*uarters as-s t(o
50
*uestions: 1irst, (hat practices (ill induce business unit managers to use their assets most efficiently and to
ac*uire the proper amount and -ind of ne( assetsG 3resumably, (hen their profits are related to assets employed,
business unit managers (ill try to improve their performance as measured in this (ay. X&enior management
(ants the actions that they ta-e to(ard this end to be in the best interest of the (hole corporation. &econd, (hat
practices best measure the performance of the unit as an economic entityG
Cash
Most companies control cash centrally because central control permits use of a smaller cash balance than
(ould be the case if each business unit held the cash balances it needed to (eather the unevenness of its cash
inflo(s and outflo(s. +usiness unit cash balances may (ell be only the EfloatE bet(een daily receipts and daily
disbursements. "onse*uently, the actual cash balances at the business unit level tend to be much smaller than
(ould be re*uired if the business unit (ere an independent company. Many companies therefore use a formula
to calculate the cash to be included in the investment base. 1or e)ample, General Motors (as reported to use >.?
percent of annual salesB .u 3ont (as reported to use t(o monthsM costs of sales minus depreciation.
#ne reason to include cash at a higher amount than the balance carried by a business unit is that the higher
amount is necessary to allo( comparisons to outside companies. If only the actual cash (ere sho(n: by internal
units (ould appear abnormally high and might mislead senior management.
&ome companies omit cash from the investment base. !hese companies reason that the amount of cash
appro)imates the current liabilitiesB if this is so, the sum of accounts receivable and inventories (ill appro)imate
the (or-ing capital.
,ecei'a(les
+usiness unit managers can influence the level of receivables, not only indirectly by their ability to
generate sales, and directly, by establishing credit terms by approving individual credit accounts and credit
limits, and by the collecting overdue amount. In the interest of simplicity, receivable included at the actual
end0.of0period balances, although the average of intraperiod balances is conceptually a better measure of the
am should be related to profits.
2hether to include accounts receivable at selling prices or at cost of goods sold is debatable. #ne could
argue that the business unitMs real investment in accounts receivable is only the cost of goods sold and that a
satisfactory return on this investment is probably enough. #n the other hand, it is possible to argue that the
business unit could reinvest the money collected from accounts receivable, and, therefore, accounts
receivable should be included at selling prices. !he usual practice is to ta-e the simpler alternative0that is,
receivables at the boo- amount, (hich is the selling price less an allo(ance for bad debts.
If the business unit does not control credits and collections, receivables may be calculated on a formula
basis. !his formula should be consistent (ith the normal payment period0for e)ample, ;7 daysM sales (here
payment is made ;7 days after the shipment of goods.
)n'entories
Inventories ordinarily are treated in a manner similar to receivables Athat is they are often recorded at end0
of0period amounts even though intraperiod averages (ould be preferable conceptually. If the company uses
%I1# 4last in first out5 for financial accounting purposes, a different valuation method usually is used for
business unit profit reporting because %I1# inventory balances tend to be unrealistically lo( in periods of
inflation. In these circumstances, inventories should be valued at standard or average costs, and these same
costs should be used to measure cost of sales on the business unit income statement
If (or-0in0process inventory is financed by advance payments or by proress payments from the customer,
as is typically the case (ith goods that re*uire a long manufacturing period, these payments either are subtracted
from the gross inventory amounts or reported as liabilities.
For e.g. (ith manufacturing periods a year or greater, +oeing received progress payments for its
51
airplanes and recorded them as liabilities.
&ome companies subtract accounts payable from inventory on the grounds that accounts payable represent
financing of part of the inventory by vendors, at zero cost to the business unit. !he corporate capital re*uired for
inventories is only the difference bet(een the gross inventory amount and accounts payable. If the business unit
can influence the payment period allo(ed by vendors, then including accounts payable in the calculation
encourages the manager to see- the most favorable terms. In times of high interest rates or credit stringency,
managers might be encouraged to consider forgoing the cash discount to have, in effect, additional financing
provided by vendors. #n the other hand, delaying payments unduly to reduce net current assets may not be in the
companyMs best interest since this may hurt its credit rating.
7eased 6ssets
&uppose the business unit (hose financial statements are sho(n in )hibit 8 4see page 685 sold its fi)ed
assets for their boo- value of 9;77,777, returned the proceeds of the sale to corporate head*uarters, and then
leased bac- the assets at a rental rate of 9J7,777 per year. As )hibit 6 4see page 685 sho(s, the business unitMs
income before ta)es (ould decrease because the ne( rental e)pense (ould be higher than the depreciation
charge that (as eliminated.
Nevertheless, economic valued added (ould increase because the higher cost (ould be more than offset
by the decrease in the capital charge. +ecause of this, business unit managers are induced to lease, rather than
o(n, assets (henever the interest charge that is built into the rental cost is less than the capital charge that is
applied to the business unitMs investment base. 4/ere, as else(here, this generalization oversimplifies because, in
the real (orld, the impact of income ta)es must also be ta-en into account.5
Many leases are financing arrangements0that is, they provide an alternative (ay of getting to use assets that
other(ise (ould be ac*uired by funds obtained from debt and e*uity financing. 1inancial leases 4i.e., long0term
leases e*uivalent to the present value of the stream of lease charges5 are similar to debt and are so reported on
the balance sheet. 1inancing decisions usually are made by corporate head*uarters. 1or these reasons, restrictions
usually are placed on the business unit managerMs freedom to lease assets.
)dle 6ssets
If a business unit has idle asset that can be used by other units, the business unit may be permitted to e)clude
them from the investment base if it classifies them as available. !he purpose of this permission is to encourage
business unit managers to release underutilized assets to units that may have better use for them. /o(ever, if the
fi)ed assets cannot be used by other units, permitting the business unit manager to remove them from the
investment base could result in dysfunctional actions 1or e)ampleB it could encourage the business unit manager
to idle partially utilized assets that are not earning a return e*ual to the business unitMs profit objective. If there is
no alternative use for the e*uipment, any contribution from this e*uipment (ill improve company profits.
)ntangi(le 6ssets
&ome companies tend to be $V. intensive 4e.g.@ pharmaceutical firms such as Novartis spend huge amounts
on developing ne( products5B others tend to be mar-eting intensive 4e.g.@ consumer products firms such as
Inilever spend huge amounts on advertising5.
!here are advantages to capitalizing intangible assets such as $V. and mar-eting and then amortizing them
over a selected life. !his method should change ho( the business unit manager vie(s these e)penditures. +y
accounting for these assets as long0term investments, the business unit manager (ill gain less short0term benefit
from reducing out lays on such item. 1or instance, if $V. e)penditures are e)pensed immediately, each dollar
of $V. cut (ould be a dollar more in preta) profits.
#n the other hand, if $V. costs are capitalized, each dollar cut (ill reduce the assets employed by a dollarB
52
the capital charge is thus reduced only by one dollar times the cost of capital, (hich has a much smaller positive
impact on economic valued added.
/U+E,)C67 = 6/6/<6 7td. 1!33#4

Exhi(it !

2e -no( that formula for $eturn on Investment is:
$#I < N! 3$#1I!
INL&!MN!
No(, Investment < 1i)ed assets = Net (or-ing "apital
42e assume "urrent Assets as the Net 2or-ing "apital as there are no "urrent %iabilities given in the *uestion5
!herefore, Investment for:
M < 7 = 677 < 677
53
3 < 677 = 8777 < 8677
" < 677 = ?77 < :77
No(, Net 3rofit for M, 3 and ":
3articulars M 3 "
3rofit before .epreciation V #perating
)penses
>77 >77 >77
%ess0 .epreciation 4NI%5 48775 4?75
%ess0 #perating )penses 46775 48775 48?75
!#!A% !33 !33 !33
!herefore,
$#I for:
M < 677 < 877 N
677
3 < 677 < 8J.J: N
8677
" < 677 < 6@.?: N
:77
&ince there are no fi)ed assets in mar-eting division, the $#I is higher, but the operating e)penses are much
higher for these division.
/ence, any further increase in op e)p is li-ely to drag the $#I do(n
&ince the asset is depreciated for87 years as per &%M method, the depreciation rate is 87 N.
&o going ahead if the operating e)penses for div 3 V " remains at the same level, reduction in the value of an
asset due to depreciation is li-ely to have a positive impact on $#I.
ven the rate of increase in $#I for .iv 3 (ould be higher since the asset of a higher
value is depreciated than the .iv ".
What do you understand (y 0oal Congruence? What are the informal factors that influence goal
congruence?
54
!his term is used (hen the same goals are shared by top managers and their subordinates. !his is one of
the many criteria used to judge the performance of an accounting system. !he system can achieve its goal more
effectively and perform better (hen organizational goals can be (ell aligned (ith the personal and group goals
of subordinates and superiors. !he goals of the company should be the same as the goals of the individual
business segments. "orporate goals can be communicated by budgets, organization charts, and job descriptions.
0oal Congruence2 +eaning
Individuals (or- in different hierarchies and handle different responsibilities V may have different goals. +ut
they must come together as far as "ompanys Goal is concerned 4there action must spea- "os language.5
0oal Congruence
Example /A !he /$ manager has devised a /$ training program to enhance the s-ills of its sales personnel,
(ith an objective to enhance their productivity +ut if company is in strategic need of attaining a certain sales
volume in a given *uarter, it can not do so on account of non availability of personnel.
Example 01 !he mar-eting department has planned an impressive advertising campaign, (hich promises good
returns, +ut say due to cash crunch "ompanys current financial position may not let to lose the strings
Example 2 A 3roduction Manager may get a good applause for reducing cycle timeB +ut at (hat costG +uilding
up the high inventory i.e. higher investment in current assets. 2hile doing so he just overloo-ed the financial
interest of the company. Y After completing the given activity in more efficient manner the concerned manager
scores the pointDs on his score card. Y 2hether his actions are leading to scoring of points on the organizations
score card tooG if it is so then only one can say the organization is marching to(ards a common goal.
very individual (or-ing in an organization has got his o(n motive to do the (or-. Individuals act in their o(n
interest, based on their o(n motivations. And it is al(ays not necessarily consistent (ith the "os goal. In a goal
congruence process, the actions the people are led to ta-e in accordance (ith their perceived self interest are also
in the best interest of the organization i.e. Goal congruence ensures that the action of manager ta-en in their best
interest is also in the best interest of the organization.
Informal factors that influence goal congruence:
)ternal factors A set of attitudes of the society, (or- ethics of the society
Internal factors A 41actors (ithin the organization5
"ulture0"ommon beliefs, shared values, norms of behavior V assumptions
Implicitly accepted and e)plicitly built into.
Mgt. &tyle A InformalD1ormal
!he "ommunication "hannels
3erception and "ommunication A e.g. +udget 4meaning5 strict profit.
55
>rganizations with %usiness *i'isions 1.rofit Centre4 format ha'e o(ser'ed that *i'isional Controllers
experience di'ided loyalty in carrying out their functions@ causing a possi(le dysfunction. Aow could
such a situation (e resol'ed? *efine role of controller which suits your suggestion.
!o the e)tent the decision are decentralized top management may lose some control. $elying on control
reports is not as effective as personal -no(ledge of an operation. 2ith profit center, top management must
change its approach to control. Instead of personal direction senior management must rely to a considerable
e)tent on management control reports.
"ompetent units that (ere once cooperating as functional units may no( compete (ith one another dis
advantageously. An increase in one managers profit may decrease those of another. !his decrease in cooperation
may manifest itself in a manager un(illingness to refer sales lead to another business unit, even though that unit
is better *ualified to follo( up on the lead in production decision that have undesirable cost conse*uence on
other units or in the hoarding of personnel or e*uipment that from the overall company standpoint (ould be
better off used in another units.
!here may be too much emphasis on short run profitability at the e)pense of long run profitability. In the desire
to report high current profits, the profit center manager may s-ip on $V., training, maintenance. !his tendency
is especially prevalent (hen the turnover of profit center managers is relatively high. In these circumstances,
manager may have good reason to believe that their action may not affect profitability until after they have
moved to other job.
!here is no complete satisfactory system for ensuring that each profit center by optimizing its o(n profit , (ill
optimize company profits.
If head*uarter management is more capable or has better information then the average profit center manager the
*uality of some of the decision may be reduced.
.ivisionalization may cause additional cost because it may re*uire additional management staff personnel and
record-eeping and may lead to redundant at each profit center.
+usiness units as profit centers:
+usiness units are usually set up at profit centers. +usiness unit managers tend to control product development,
manufacturing, and mar-eting resources. !hey are in a position to influence revenue and cost and as such can be
held accountable for the bottom line. /o(ever as pointed out in the ne)t section a business unit manager
authority may be constrained such constrained should be incorporated in designing and operating profit center.
Constraint on (usiness unit authority
!o realize fully the advantage of the profit center concept the business unit manger (ould have to be as
autonomous as the president of the independent company. As a practical matter ho(ever such autonomy is not
feasible. If a company (ere divided into completely independent units the organization (ould be giving up the
advantage of size and synergism. Also senior management authority that a board of director gives to the chief
e)ecutive. "onse*uently business unit structure represents trade off bet(een business unit autonomy and
corporate constraint. !he effectiveness of a business units organization is largely dependent on ho( (ell these
trade off are made.
56
!he performance of a profit center is appraised by comparing actual results for one or more orf these measures
(ith budgeting amounts. In addition, data on competitors and the industry provide a good cross chec- on the
appropriate of the budget. .ata for individual companies are available from the securities and e)change
commission for about -ey business ratiosB standard V poor computer services, IncB $obert Morris associates
annual statement studiesB and annual survey published in fortune, business (ee-, and 1orbes. !rade associations
publish data for the companies in their industries.
,e'enues
"hoosing the appropriate revenue recognition method is important. &hould revenue be recognized at the time as
order is received, at the time an order is shipped, or at the time cash is receivedG
In addition to that decision, issues related to common revenues may need to be considered. !here are some
situations in (hich t(o or more profit centers participate in the sales effort that results in a saleB ideally, 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. !hey ta-e 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 (or-ing not only for their o(n profit center but also for the overall good of the company. !hey for
e)ample, may credit the business unit that ta-es an order for a product handled by the another unit (ith the
e*uivalent of a bro-erage commission or a finder fee. In the case of a ban- the branch performing a service may
be given e)plicit credit for that service even though the customer account is maintained in another branch.
,ole of controller
It should publish procedure and forms for the preparation of the budget.
It should provide assistance to budgetees in the preparation of their budget.
It should administer the process of ma-ing budget revision during the year.
It should coordinate the (or- of budget departments in lo(er echelons
It should analyze reported performance against budget, interprets the result, and prepares
summary report for senior management.

Part of a multinational group, Sundaram Shoe Company(SSC), estalished its o!n fa"ilities in #ndia
o$er %& years ago and en'oyed an e("ellent re"ord)high mar*et share for its di$erse range of shoes,
gro!th and profits+ SC mar*ets its produ"ts through "ompany o!ned shops and its o!n personnel+
,rgani-ation stru"ture is fun"tional+ Sin"e 2001, profitaility, mar*et share are slipping+ Pressure from
"heap Chinese shoes and also premium shoes li*e .i*e has made the "ompany thin*/ of organi-ational
restru"turing and introdu"ing Comensurate Control System to regain its position+ 0lthough SSC
outsour"es, 102 of produ"ts, it is seen as a produ"tion oriented "ompany+ SSC !ants to adopt measures
to redu"e "osts, strengthen mar*eting and e in a position to produ"e and meet une(pe"ted and unusual
"ustomer demands+ 3o! should the "ompany reorgani-e to a"hie$e 4oal Congruen"e+ 5efine
Performan"e 6etri"7
In a goal congruent process, te act!ons people are led to ta"e !n accordance #!t te!r perce!$ed self%
!nterest are also !n te best !nterest of te organ!&at!on. ' f!r()s strateg* as a (a+or !nfluence on !ts structure.
,e t*pe of structure !n turn !nfluences te des!gn of te organ!&at!on)s (anage(ent control s*ste(s. -undara(
-oe .o(pan*)s (--.) organ!&at!on structure !s funct!onal #!c !n$ol$es te not!on of a (anager #o br!ngs
57
spec!al!&ed "no#ledge to bear on dec!s!ons related to a spec!f!c funct!on, $!s%/%$!s a general purpose (anager
#o lac"s te spec!al!&ed "no#ledge. ' s"!lled (ar"et!ng and product!on (anager #ould be able to (a"e better
dec!s!ons !n te!r respect!$e f!elds. 0e #ould also be able to super$!se #or"ers !n te sa(e funct!on better tan
te general!st #ould. ,us an !(portant ad$antage of te funct!onal structure !s eff!c!enc*. ' (a+or d!sad$antage
of t!s structure !s tat tere !s no una(b!guous #a* of deter(!n!ng te effect!$eness of te separate funct!onal
(anagers because eac funct!on contr!butes +o!ntl* to te organ!&at!on)s f!nal output. ,erefore, tere !s no #a*
of deter(!n!ng o# (uc of te prof!t #as earned respect!$el* b* te se$eral product!on depart(ents.
-undara( -oe .o(pan* #!c #as a (ar"et leader for a per!od of o$er 75 *ears as been los!ng
(ar"et sare, #!c as !(pacted !ts prof!tab!l!t*. 'lso !t needs to be seen tat te co(pan* outsources about
301 of !ts products. ,e co(pan* a!(s to strengten (ar"et!ng, reduce costs and #ants to be !n a pos!t!on to
custo(!&e products as per te de(ands of te custo(er. ,us, -undara( needs to re%organ!&e !ts organ!&at!on
structure #!c !s funct!onal to a 2us!ness 3n!t for( of organ!&at!on. ,e benef!ts of te re%organ!&at!on #ould
be tat te bus!ness un!t or te d!$!s!on #ould be respons!ble for all te funct!ons !n$ol$ed !n produc!ng and
(ar"et!ng a spec!f!ed product l!ne. ,e bus!ness (anagers act al(ost as !f te!r un!ts are separate co(pan!es.
,e* are respons!ble for plann!ng and co%coord!nat!ng te #or" of te separate funct!ons. ,e!r perfor(ance !s
(easured b* te prof!tab!l!t* of te bus!ness un!t. ,!s !s a $al!d cr!ter!on because prof!t reflects te act!$!t!es of
bot (ar"et!ng and product!on.
,oug bus!ness un!t (anagers e4erc!se broad autor!t* o$er te!r un!ts, ead5uarters reser$es certa!n
"e* prerogat!$es. 0ead5uarters are respons!ble for obta!n!ng funds for te co(pan* as a #ole and allocat!ng !t
to te bus!ness un!t, as #ell as appro$!ng budgets and +udg!ng te perfor(ance of bus!ness un!t (anagers, sett!ng
te!r co(pensat!on.
' (a+or ad$antage of te 2us!ness un!t structure of organ!&at!on !s tat because !t !s close to te (ar"et
for !ts products tan te ead5uarters, !ts (anager (a* (a"e sounder product!on and (ar"et!ng dec!s!ons tan
ead5uarters (!gt and te un!t as a #ole reacts to ne# treats or opportun!t!es 5u!c"l*. ,!s re%organ!&at!on
#ould elp !n ac!e$!ng goal congruence !n te organ!&at!on.
Performance Metrics are high-level measures what you are doing; that is, they assess your overall
performance in the areas you are measuring. ,e* are e4ternal !n nature and are (ost closel* t!ed to outputs,
custo(er re5u!re(ents, and bus!ness needs for te process.
,e perfor(ance (easure(ent s*ste( sould co$er te follo#!ng areas at a (!n!(u(6
CUS&>+E,S
1. 7erfor(ance aga!nst custo(er re5u!re(ents
2. .usto(er -at!sfact!on
.E,F>,+6/CE >F )/&E,/67 W>,B .,>CESSES
1. .*cle t!(es
2. 7roduct and ser$!ce 5ual!t*
3. .ost perfor(ance (could be product!$!t* (easures, !n$entor*, etc.) 8
SU..7)E,S
1. 7erfor(ance of suppl!ers aga!nst *our re5u!re(ents
F)/6/C)67
58
1. 7rof!tab!l!t* (could be at te co(pan*, product l!ne, or !nd!$!dual le$el)
2. 9ar"et sare gro#t and oter standard f!nanc!al (easures
E+.7><EE
1. 'ssoc!ate sat!sfact!on
0nanaya 8 Company "omprises of fi$e di$isions 0, 9, C, 5 and : and the present performan"e+ metri"
is return on assets+ 3o!e$er, the "ontroller has suggested management to s!it"h o$er to e"onomi" $alue
added (:;0) as the "riterion rather than return on assets+ Compute and taulate oth return on assets
and :;0 on the asis of follo!ing information (<s+ la*hs) and "omment on di$isional performan"e+
:!$!s!on 7rof!t ;!4ed 'ssets .urrent 'ssets
%%
' 300 800 160
% % %%%%
2 220 400 1600
. 100 600 1000
<<<<<<<<
: 110 400 800
%
= 180 200 800
.ontroller feels corporate f!nance rates on current assets and .f!4ed assets sould be 51 and 101 respect!$el*.
Solution: =or*ing .ote>
>eturn on 'ssets ? 7rof!t @ 100
,otal 'ssets
' ? 300A960@100 ? 31.251
2 ? 220A2000@100 ? 111
. ? 100A1600@100 ? 6.251
: ? 110A1200@100 ? 9.171
= ? 180A1000@100 ? 181
=cono(!c Balue 'dded (=B') ? 7rof!t C (D.'.....@ .ap!tal =(plo*ed)
In t!s case,
59
=B' ? 7rof!t C (D.'..... on ;!4ed 'ssets @ ,otal ;!4ed 'ssets) E (D.'..... on .urrent 'ssets @ ,otal .urrent
'ssets)
' ? 300 C (0.10@800) E (0.05@160) ? 212 la"s
2 ? 220 C (0.10@400) E (0.05@1600) ? 100 la"s
. ? 100 C (0.10@600) E (0.05@1000) ? %10 la"s
: ? 110 C (0.10@400) E (0.05@800) ? 30 la"s
= ? 180 C (0.10@200) E (0.05@800) ? 120 la"s
Summary
5i$ision <eturn on 0ssets (<+,+0+) :"onomi" ;alue 0dded (:+;+0+) (<s+
la*hs)
' 31.251 212
2 11.001 100
. 6.251 %10
: 9.171 30
= 18.001 120
Comments>
1. It appears fro( te abo$e anal*s!s tat d!$!s!on ' as perfor(ed te best a(ong te f!$e d!$!s!ons.
2. 'lso, !t can be clearl* not!ced tat d!$!s!ons . and : see( to be !n trouble.
3. :!$!s!on ' as perfor(ed te best #en seen !n ter(s of return on assets and econo(!c $alue added.
4. ,e reason #* d!$!s!on ' as perfor(ed te best !s tat !t as te best #or"!ng cap!tal (anage(ent tat can
be reflected !n te total a(ount !n$ested !n current assets and #!c !s te least a(ong te f!$e d!$!s!ons.
5. ,e abo$e reason olds true for te poor perfor(ance of d!$!s!ons . and : as can be seen tat te* a$e a
uge a(ount !n$ested !n current assets #!c does not !nd!cate good s!gns about te!r operat!onal eff!c!enc*.
6. ' co(pan* #!c !s !nto an e4pans!on and o$erall gro#t (ode pr!(ar!l* !n$ests !nto f!4ed assets and t!s !s
also one of te (a+or reasons #* te perfor(ance of d!$!s!on ' !s te best a(ongst all.
7. ,oug d!$!s!on . as also !n$ested a uge a(ount !n f!4ed assets te ad$antage !s offset due to te fact tat !t
peraps as a larger !n$est(ent !n current assets.
8. :!$!s!on = !s te second best bot !n ter(s of >.F.'. as #ell as =.B.'.
9. ,oug d!$!s!on = as te sa(e a(ount !n$ested !n current assets as tat of d!$!s!on : and peraps a lesser
a(ount !n$ested !n f!4ed assets !ts prof!tab!l!t* !s (uc better and ence !t as del!$ered a better perfor(ance.
10. :!$!s!on 2 !s a better perfor(er tan d!$!s!ons . and : !n ter(s of >.F.'. as #ell as =.B.'. but te (a+or
proble( #!t t!s d!$!s!on !s tat !t as a terr!ble #or"!ng cap!tal (anage(ent. Its current assets are te
!gest and t!s reflects tat !t as uge su(s of (one* eld up e!ter !n debtors or !n$entor* or rater !t !s
old!ng a large a(ount of cas #!c !s not a good s!gn.
Factors which impact ser'ice organization
60
6(sence of )n'entory %uffer:
Goods can be held as inventory, (hich is a buffer that dampens the impact on production activity of
fluctuations in sales volume. &ervices cannot be stored. !he airplane seat, hotel room, hospital operating room,
or the hours of la(yers, physicians, scientists, and other professionals that are not used today are gone forever.
!hus, although a manufacturing company can earn revenue in the future from products that are on hand today, a
service company cannot do so. It must try to minimize its unused capacity.
Moreover, the costs of many service organizations are essentially fi)ed in the short run. In the short run, a hotel
cannot reduce its costs substantially by closing off some of its rooms. Accounting firms, la( firms, and other
professional organizations are reluctant to layoff professional personnel in times of lo( sales volume because of
the effect on morale and the costs of rehiring and training.
*ifficulty in Controlling Puality:
A manufacturing company can inspect its products before they are shipped to the consumer, and their *uality
can be measured visually or (ith instruments 4tolerances, purity, (eight, color, and so on5. A service company
cannot judge product *uality until the moment the service is rendered, and then the judgments are often
subjective. $estaurant management can e)amine the food in the -itchen, but customer satisfaction depends to a
considerable e)tent on the (ay it is served. !he *uality of education is so difficult to measure that fe(
educational organizations have a formal *uality control system.
7a(our )ntensi'e:
Manufacturing companies add e*uipment and automate production lines, thereby replacing labor and
reducing costs. Most service companies are labor intensive and cannot do this. /ospitals do add e)pensive
e*uipment, but mostly to provide better treatment, and this increases costs. A la( firm e)pands by adding
partners and ne( support personnel.
+ulti2Unit >rganizations:
&ome service organizations operate many units in various locationsB each unit relatively small. !hese
organizations are fast0food restaurant chains, auto rental companies, gasoline service stations, and many others.
&ome of the units are o(nedB others operate under a franchise. !he similarity of the separate units provides a
common basis for analyzing budgets and evaluating performance not available to the manufacturing company.
!he information for each unit can be compared (ith system (ide or regional averages, and high performers and
lo( performers can be identified. /o(ever because units differ in the mi) of services they provide, in the
resources that they use, and in other (ays, care must be ta-en in ma-ing such comparisons.
Explain special characteristics of professional organization which would ha'e a (earing on their control
system.
0oals:
A dominant goal of a manufacturing company is to earn a satisfactory profit, specifically a satisfactory
return on assets employed. A professional organization has relatively fe( tangible assetsB its principal asset is the
s-ill of its professional staff, (hich doesnMt appear on its balance sheet. $eturn on assets employed, therefore, is
essentially meaningless in such organizations. !heir financial goal is to provide ade*uate compensation to the
professionals.
In many organizations, a related goal is to increase their size. In part, this reflects the natural tendency to
associate success (ith large size. In part, it reflects economies of scale in using the efforts of a central personnel
staff and units responsible for -eeping the organization up to0 date. %arge public accounting firms need to have
enough local offices to enable them to audit clients (ho have facilities located throughout the (orld.
.rofessionals:
3rofessional organizations are labor intensive, and the labor is of a special type. Many professionals prefer
to (or- independently, rather than as part of a team. 3rofessionals (ho are also managers tend to (or- only part
time on management activitiesB senior partners in an accounting firm participate actively in audit engagementsB
61
senior partners in la( firms have clients. ducation for most professions does not include education in
management, but *uite naturally stresses the s-ills of the profession, rather than managementB for this and other
reasons, professionals tend to loo- do(n on managers. 3rofessionals tend to give inade*uate (eight to the
financial implications of their decisionsB they (ant to do the best job they can, re0 I regardless of its cost. !his
attitude affects the attitude of support staffs and nonprofessionals in the organizationB it leads to inade*uate cost
control.
>utput and )nput +easurement:
!he output of a professional organization cannot be measured in physical terms, such as units, tons, or
gallons. 2e can measure the number of hours a la(yer spends on a case, but this is a measure of input, not
output. #utput is the effectiveness of the la(yerMs (or-, and this is not measured by the number of pages in a
brief or the number of hours in the courtroom. 2e can measure the number of patients a physician treats in a day,
and even classify these visits by type of complaintB but this is by no means e*uivalent to measuring the amount
or *uality of service the physician has provided. At most, (hat is measured is the physicianMs efficiency in
treating patients, (hich is of some use in identifying slac-ers and hard (or-ers. $evenues earned is one measure
of output in some professional organizations, but these monetary amounts, at most, relate to the *uantity of
services rendered, not to their *uality 4although poor *uality is reflected in reduced revenues in the long run5.
1urthermore, the (or- done by many professionals is non repetitive. No t(o consulting jobs or research and
development projects are *uite the same. !his ma-es it difficult to plan the time re*uired for a tas-, to set
reasonable standards for tas- performance, and to judge ho( satisfactory the performance (as. &ome tas-s are
essentially repetitive: the drafting of simple (ills, deeds, sales contracts, and similar documentsB the ta-ing of a
physical inventory by an auditorB and certain medical and surgical procedures. !he development of standards for
such tas-s may be (orth(hile, although in using these standards, unusual circumstances that affect a specific job
must be ta-en into account.
Small Size:
2ith a fe( e)ceptions, such as some la( firms and accounting firms, professional organizations are
relatively small and operate at a single location. &enior management in such organizations can personally
observe (hat is going on and personally motivate employees. !hus, there is less need for a sophisticated
management control system, (ith profit centers and formal performance reports. Nevertheless, even a small
organization needs a budget, a regular comparison of performance against budget, and a (ay of relating
compensation to performance.
+ar?eting:
In a manufacturing company there is a clear dividing line bet(een mar-eting activities and production
activitiesB only senior management is concerned (ith both. &uch a clean separation does not e)ist in most
professional organizations. In some, such as la(, medicine, and accounting, the professionMs ethical code limits
the amount and character of overt mar-eting efforts by professionals 4although these restrictions have been
rela)ed in recent years5. Mar-eting is an essential activity in almost all organizations, ho(ever. If it canMt be
conducted openly, it ta-es the form of personal contacts, speeches, articles, conversations on the golf course, and
so on. !hese mar-eting activities are conducted by professionals, usually by professionals (ho spend much of
their time in production (or-0that is, (or-ing for clients.
In this situation, it is difficult to assign appropriate credit to the person responsible for EsellingE a ne( customer.
In a consulting firm, for e)ample, a ne( engagement may result from a conversation bet(een a member of the
firm and an ac*uaintance in a company, or from the reputation of one of the firmMs professionals as an outgro(th
of speeches or articles. Moreover, the professional (ho is responsible for obtaining the engagement may not be
personally involved in carrying it out. Intil fairly recently, these mar-eting contributions (ere re(arded
subjectively0 that is, they (ere ta-en into account in promotion and compensation decisions. &ome organizations
no( give e)plicit credit, perhaps as a percentage of the projectMs revenue, if the person (ho EsoldE the project can
be identified.
62
E'ery S%U is a profit center (ut e'ery profit center is not a S%U? What are the conditions that should
(e fulfill for an organization unit to (e con'erted into a profit center? What are the different ways to
measure the performance of profit center? *iscuss their rele'ant merits and demerits.
Conditions for an organization to (e con'erted into a profit centre:
Many management decisions involve proposals to increase e)penses (ith the e)pectation of an even greater
increase in sales revenue. &uch decisions are said to involve e)penseDrevenue trade0offs. Additional advertising
e)pense is an e)ample. +efore it is safe to delegate such a trade0off decision to a lo(er0level manager, t(o
conditions should e)ist.
!he manager should have access to the relevant information needed for ma-ing such a decision.
!here should be some (ay to measure the effectiveness of the trade0offs the manager has made.
A major step in creating profit centers is to determine the lo(est point in an organization (here these t(o
conditions prevail. All responsibility centers fit into a continuum ranging from those that clearly should be profit
centers to those that clearly should not. Management must decide (hether the advantages of giving profit
responsibility offset the disadvantages, (hich are discussed belo(. As (ith all management control system
design choices, there is no clear line of demarcation.
Ways to +easure .erformance:
!here are t(o types of profitability measurements used in evaluating a profit center, just as there are in
evaluating an organization as a (hole. 1irst, there is the measure of management performance, (hich focuses on
how well the manager is doing. !his measure is used for planning, coordinating, and controlling the profit
centerMs day0to0day activities and as a device for providing the proper motivation for its manager. &econd, there
is the measure of economic performance, (hich focuses on how well the profit center is doing as an economic
entity. !he messages conveyed by these t(o measures may be *uite different from each other. 1or e)ample, the
management performance report for a branch store may sho( that the storeMs manager is doing an e)cellent job
under the circumstances, (hile 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. .
!he necessary information for both purposes usually cannot be obtained from a single set of data. +ecause the
management report is used fre*uently, (hile the economic report is prepared only on those occasions (hen
economic decisions must be made, considerations relating to management performance measurement have first
priority in systems design0that is, the system should be designed to measure management performance routinely,
(ith economic information being derived from these performance reports as (ell as from other sources.
&ypes of .rofita(ility +easures
A profit centerMs economic performance is al(ays measured by net income 4i.e., the income remaining after
all costs, including a fair share of the corporate overhead, have been allocated to the profit center5. !he
performance of the profit center manager, ho(ever, may be evaluated by five different measures of profitability:
485 contribution margin, 465 direct profit, 4;5 controllable profit, 4>5 income before income ta)es, or 4?5 net
income
14 Contri&ution Margin:
"ontribution margin reflects the spread bet(een revenue and variable e)penses. !he principal argument in favor
of using it to measure the performance of profit center managers is that since fi)ed e)penses are beyond their
control, managers should focus their attention on ma)imizing contribution. !he problem (ith this argument is
that its premises are inaccurateB in fact, almost all fi)ed e)penses are at least partially controllable by the
manager, and some are entirely controllable. Many e)pense items are discretionaryB that is, they can be changed
at the discretion of the profit center manager. 3resumably, senior management (ants the profit center to -eep
these discretionary e)penses in line (ith amounts agreed on in the budget formulation process. A focus on the
contribution margin tends to direct attention a(ay from this responsibility. 1urther, even if an e)pense, such as
63
administrative salaries, cannot be changed in the short run, the profit center manager is still responsible for
controlling employeesM efficiency and productivity.
1!4 Direct rofit:
!his measure reflects a profit centerMs contribution to the general overhead and profit of the corporation. It
incorporates all e)penses either incurred by or directly traceable to the profit center, regardless of (hether or not
these items are (ithin the profit center managerMs control. )penses incurred at head*uarters, ho(ever, are not
included in this calculation. A (ea-ness of the direct profit measure is that it does not recognize the motivational
benefit of charging head*uarters costs.
1"4 Controlla&le rofit:
/ead*uarters e)penses can be divided into t(o categories: controllable and non controllable. !he former
category includes e)penses that are controllable, at least to a degree, by the business unit manager0information
technology services, for e)ample. If these costs are included in the measurement system, profit (ill be (hat
remains after the deduction of all e)penses that may be influenced by the profit center manager. A major
disadvantage of this measure is that because it e)cludes non controllable head*uarters e)penses it cannot be
directly compared (ith either published data or trade association data reporting the profits of other companies in
the industry.
1#4 )ncome &efore Taxes:
In this measure, all corporate overhead is allocated to profit centers based on the relative amount of e)pense each
profit center incurs. !here are t(o arguments against such allocations. 1irst, since the costs incurred by corporate
staff departments such as finance, accounting, and human resource management are not controllable by profit
center managers, these managers should not be held accountable for them. &econd, it may be difficult to allocate
corporate staff services in a manner that (ould properly reflect the amount of costs incurred by each profit
center.
!here are, ho(ever, three arguments in favor of incorporating a portion of corporate overhead into the profit
centersM performance reports. 1irst, corporate service units have a tendency to increase their po(er base and to
enhance their o(n e)cellence (ithout regard to their effect on the company as a (hole. Allocating corporate
overhead costs to profit centers increases the li-elihood that profit center managerZ (ill *uestion these costs,
thus serving to -eep head office spending in chec-. 4&ome companies have actually been -no(n to sell their
corporate jets because of complaints from profit center managers about the cost of these e)pensive items.5
&econd, the performance of each profit center (ill become more realistic and more readily comparable to the
performance of competitors (ho pay for similar services. 1inally, (hen managers -no( that their respective
centers (ill not sho( a profit unless all0costs, including the allocated share of corporate overhead, are recovered,
they are motivated to ma-e optimum long0term mar-eting decisions as to pricing, product mi), and so forth, that
(ill ultimately benefit 4and even ensure the viability of5 the company as a (hole.
If profit centers are to be charged for a portion of corporate overhead, this item should be calculated on the basis
of budgeted, rather than actual, costs, in (hich case the EbudgetE and EactualE columns in the profit centerMs
performance report (ill sho( identical amounts for this particular item. !his ensures that profit center managers
(ill not complain about either the arbitrariness of the allocation or their lac- of control over these costs, since
their performance reports (ill sho( no variance in the overhead allocation. Instead, such variances (ould appear
in the reports of the responsibility center that actually incurred these costs. .
1$4 *et )ncome:
/ere, companies measure the performance of domestic profit centers according to the bottom line, the amount of
net income after income ta). !here are t(o principal arguments against using this measure:
485 after ta) income is often a constant percentage of the preta) income, in (hich case there (ould be no
advantage in incorporating income ta)es
465 since many of the decisions that affect income ta)es are made at head*uarters, it is not appropriate to judge
profit center managers on the conse*uences of these decisions.
!here are situations, ho(ever, in (hich the effective income ta) rate does vary among profit centers. 1or
e)ample, foreign subsidiaries or business units (ith foreign operations may have different effective income ta)
rates. In other cases, profit centers may influence income ta)es through their installment credit policies, their
64
decisions on ac*uiring or disposing of e*uipment, and their use of other generally accepted accounting
procedures to distinguish gross income from ta)able income. In these situations, it may be desirable to allocate
income ta) e)penses
to profit centers not only to measure their economic profitability but also to motivate managers to minimize ta)
liability.
+erits:
!he *uality of decisions may improve because they are being made by managers closest to the point of
decision.
!he speed of operating decisions may be increased since they do not have to be referred to corporate
head*uarters. . /ead*uarters management, relieved of day0to0day decision ma-ing, can concentrate on broader
issues.
Managers, subject to fe(er corporate restraints, are freer to use their imagination and initiative.
+ecause profit centers are similar to independent companies, they provide an e)cellent training ground
for general management. !heir managers gain e)perience in managing all functional areas, and upper
management gains the opportunity to evaluate their potential for higher0level jobs.
3rofit consciousness is enhanced since managers (ho are responsibleM for profits (ill constantly see-
(ays to increase them. 4A manager responsible for mar-eting activities, for e)ample, (ill tend to authorize
promotion e)penditures that increase sales, (hereas a manager responsible for profits (ill be motivated to ma-e
promotion e)penditures that increase profits.5.
3rofit centers provide top management (ith ready0made information on the profitability of the
companyMs individual components. . +ecause their output is so readily measured, profit centers are particularly
responsive to pressures to improve their competitive performance.
*emerits:
.ecentralized decision ma-ing (ill force top management to rely more on management control reports
than on personal -no(ledge of an operation, entailing some loss of control.
If head*uarters management is more capable or better informed than the average profit center manager,
the *uality of decisions made at the unit level may be reduced.
1riction may increase because of arguments over the appropriate transfer price, the assignment of
common costs, and the credit for revenues that (ere formerly generated jointly by t(o or more business units
(or-ing together.
#rganization units that once cooperated as functional units may no( be in competition (ith one
another. An increase in profits for one manager may mean a decrease for another. In such situations, a manager
may fail to refer sales leads to another business unit better *ualified to pursue themB may hoard personnel or
e*uipment that, from the overall company standpoint, (ould be better off used in another unitB or may ma-e
production decisions that have undesirable cost conse*uences for other units.
.ivisionalization may impose additional costs because of the additional management, staff personnel,
and record -eeping re*uired, and may lead to tas- redundancies at each profit center.
What are different types of Strategic +issions at S%U le'el?
Aow do these missions affect Strategic .lanning process and %udgeting at S%U 7e'el?
*ifferent &ypes of Strategic +issions:
65
%usiness Unit +ission:
In a diversified firm one of the important tas-s of senior management is resource deployment, that is, ma-e
decisions regarding the use of the cash generated from some business units to finance gro(th in other business
units. &everal planning models have been developed to help corporate level managers of diversified firms to
effectively allocate resources. !hese models suggest that a firm has business units in several categories,
identified by their missionB the appropriate strategies for each category differ. !ogether, the several units ma-e up
a portfolio, the components of (hich differ as to their ris-Dre(ard characteristics just as the components of an
investment portfolio differ.
+oth the corporate Moffice and the business unit general manager are involved in identifying the missions of
individual business units. #f the many planning models, t(o of the most (idely used are +oston "onsulting
GroupMs t(o0by0t(o gro(th0share matri) and General lectric "ompanyDMcTinsey V "ompanyMs three0by0three
industry attractiveness0business strength matri). 2hile these models differ in the methodologies they use to
develop the most appropriate missions for the various business units, they have the same set of missions from
(hich to choose: build, hold, harvest, and divest.
.uild:
!his mission implies an objective of increased mar-et share, even at the e)pense of short0term earnings and cash
flo( 4e.g.@ Merc-Ms bio0technology, +lac- and .ec-erMs handheld electric tools5.
$old:
!his strategic mission is geared to the protection of the business unitMs mar-et share and competitive position
4e.g.: I+MMs mainframe computers5.
$arvest:
!his mission has the objective of ma)imizing short0term earnings and cash flo(, even at the e)pense of mar-et
share 4e.g.@ American +randsM tobacco products, General lectricMs and &ylvaniaMs light bulbs5
Divest:
!his mission indicates a decision to (ithdra( from the business either through a process of slo( li*uidation or
outright sale. 2hile the planning models can aid in the formulation of missions, they are not coo- boo-s. A
business unitMs position on a planning grid should not be the sole basis for deciding its mission.
%usiness Unit Competiti'e 6d'antage:
very business unit should develop a competitive advantage in order to accomplish its mission. !hree
interrelated *uestions have to be considered in developing the business unitMs competitive< advantage. 1irst, (hat
is the structure of the industry in (hich the business unit operatesG &econd, ho( should the business unit e)ploit
the industryMs structureG !hird, (hat (ill be the basis of the business unitMs competitive advantageG
)ndustry 3nalysis:
$esearch has highlighted the important role industry conditions play in the performance of individual firms.
&tudies have sho(n that average industry profitability is, by far, the most significant predictor of firm
performance. According to 3orter, the structure of an industry should be analyzed in terms of the collective
strength of five competitive forces.
8. !he intensity of rivalry among e)isting competitors. 1actors affecting direct rivalry are industry gro(th,
product differentiability, number and diversity of competitors, level of fi)ed costs, intermittent overcapacity, and
e)it barriers.
6. !he bargaining po(er of customers. 1actors affecting buyer po(er are number of buyers, buyerMs s(itching
costs, buyerMs ability to integrate bac-(ard, impact of the business unitMs product on buyerMs total costs, impact of
the business unitMs product on buyerMs product *ualityD performance, and significance of the business unitMs
volume to buyers.
;. !he bargaining po(er of suppliers. 1actors affecting supplier po(er are number of suppliers, supplierMs ability
to integrate for(ard, presence of substitute inputs, and importance of the business unitMs volume to suppliers.
66
>. !hreat from substitutes. 1actors affecting substitute threat are relative priceDperformance of substitutes, buyerMs
s(itching costs, and buyerMs propensity to substitute.
?. !he threat of ne( entry. 1actors affecting entry barriers are capital re*uirements, access to distribution
channels, economies of scale, product differentiation, technological comple)ity of product or process, e)pected
retaliation from e)isting firms, and government policy.
We ma?e three o(ser'ations with regard to the industry analysis:
8. !he more po(erful the five forces are, the less profitable an industry is li-ely to be. In industries (here
average profitability is high 4such as soft drin-s and pharmaceuticals5, the five forces are (ea- 4e.g., in the soft
drin- industry, entry barriers are high5. In industries (here the average profitability is lo( 4such as steel and
coal5, the five forces are strong 4e.g., in the steel industry, threat from substitutes is high5.
6. .epending on the relative strength of the five forces, the -ey strategic issues facing the business unit (ill
differ from one industry to another.
;. Inderstanding the nature of each force helps the firm to formulate effective strategies. &upplier selection 4a
strategic issue5 is aided by the analysis of the relative po(er of several supplier groupsB the business unit should
lin- (ith the supplier group for (hich it has the best competitive advantage. &imilarly, analyzing the relative
bargaining po(er of several buyer groups (ill facilitate selection of target customer segments.
4eneric Competitive 3dvantage:
!he five0force analysis is the starting point for developing a competitive advantage since it helps to identify the
opportunities and threats in the e)ternal environment. 2ith this understanding, 3orter claims that the business
unit has t(o generic (ays of responding to the opportunities in the e)ternal environment and developing a
sustainable competitive advantage: lo( cost and differentiation.
7ow Cost:
"ost leadership can be achieved through such approaches as economies of scale in productionB e)perience
curve effects, tight cost control, and cost minimization 4in such areas as research and development, service, sales
force, or advertising5. &ome firms follo(ing this strategy include "harles &ch(ab in discount bro-erage, 2al0
Mart in discount retailing, !e)as Instruments in consumer electronics, merson lectric in electric motors,
/yundai in automobiles, .ell in computers, +lac- and .ec-er in machine tools, Nucor in steel, %incoln lectric
in arc (elding e*uipment, and +I" in pens.
*ifferentiation:
!he primary focus of this strategy is to differentiate the product offering of the business unit, creating
something that is perceived by customers as being uni*ue. Approaches to product differentiation include brand
loyalty 4"oca0"ola and 3epsi "ola in soft drin-s5, superior customer service 4Nordstrom in retailing5, dealer
net(or- 4"aterpillar !ractors in construction e*uipment5, product design and product features 4/e(lett03ac-ard
in electronics5, and technology 4"isco in communications infrastructure5. #ther e)amples of firms follo(ing a
differentiation strategy include +M2 in automobilesB &toufferMs in frozen foods, Neiman0Marcus in retailing,
Mont +lanc in pens, and $ole) in (rist(atches.
5alue Chain 3nalysis '
+usiness units can develop competitive advantage based on lo( cost, differentiation, or both. !he most attractive
competitive position is to achieve cost0cum0differentiation.
.ritam Engineering manufacturers 1+CS2!33$4 /umerical
67
3ritam ngineering manufacturing variety of metal product at many factories. "urrently. It is
e)periencing crisis, Management has, therefore, decided to detailed e)pense control system including
responsibility budgets for overhead e)pense items at each factory. 1rom historical data, "ontroller developed a
standard for each overhead e)pense item 4relating e)pense to volume of activity5. &ummarized e)penses for
November,677? given to concerned 3roduction &upervisor for comments is tabulated. [All figures are in $s.
777\
)tem Standard at nominal 'olume %udgeted at actual 'olume actual
+anagement Super'ision :67 :67 ?@6
)ndirect la(our 86:7J 88;66 86??6
)dle time >67 ;J8 :88
+aterials@ &ools ;J77 ;7QJ ;88>
+aintenance@ scrap 8>@>7 8;Q7Q 8:;6Q
6llocated expenses 687>7 687>7 6868@
&otal per ton 1,s.4 68;;.7> 687;.;Q 6>8;.;
(') )plain (ith justification (hich of the t(o 485 or 465 is more meaningful for e)pense control.
(2) "an the supervisor be held responsible for all overhead e)penses includedG 2hyD(hy notG
Solution
164 !here is t(o general types of e)pense centers: engineered and discretionary. !his label relate to t(o types of
cost. ngineered costs are those for (hich the FrightH or FproperH amount can be estimated (ith reasonable
reliability for e)ample, a factorys costs for direct labor, direct material, components, supplies, and utilities.
.iscretionary costs 4also called managed costs5 are those for (hich not such engineered estimate is feasible.
In discretionary e)pense centers, the costs incurred depend on managements judgment as to the appropriate
amount under the circumstances.
Engineered expense centers
ngineered e)pense centers are usually found a manufacturing operations. 2arehousing, distribution,
truc-ing, and similar units (ithin the mar-eting organization may also be engineered e)pense centers, as may
certain responsibility centers (ithin administrative and support department for instance, accounts receivable,
accounts payable, and payroll sections in the controller departmentB personnel records and the cafeteria in the
human resources departmentB shareholder records in the corporate secretary departmentB and the company
motor pool. &uch units perform repetitive tas-s for (hich standard costs can be developed. !hese engineered
e)pense centers are usually located (ithin departments that are discretionary e)pense centers.
In an engineered e)pense center, output multiplied by the standard cost of each unit produced measures (hat
the finished product should have cost. !he difference bet(een the theoretical and the actual cost represents the
efficiency of the e)pense center being measure.
2e emphasize that engineered e)pense centers have other important tas-s not measured by cost aloneB their
supervisors are responsible for the *uality of the products and volume of production as (ell as for efficiency.
!herefore, the type and level of production are prescribed, and specific *uality standards are set. &o that
manufacturing costs are not minimized at the e)pense of *uality. Moreover, managers of engineered e)pense
centers may be responsible for activities such as training and employee development that are not related to
current productionB their performance revie(s should include an appraisal of ho( (ell they carry out these
responsibilities.
!here are fe(, if any, responsibility centers in (hich all cost items are engineered. ven in highly automated
production departments, the use of indirect labor and various services can vary (ith managements discretion.
!hus the term engineered e)pense center refers to responsibility centers in (hich engineered costs predominate.
+ut it does not imply that valid engineered estimates can be made for each and every cost item.
Discretionary expense centers
68
.iscretionary e)pense centers include administrative and support units 4e.g. accounting, legal, industrial
relations, public relations, human resources5, research and development operations, and most mar-eting
activities. !he output of these centers cannot be measured in monetary terms.
!he term discretionary does into imply that managements judgment as to optimum cost is capricious or
haphazard. $ather it reflects managements decisions regarding certain policies: (hether to match or e)ceed the
mar-eting efforts of competitorsB the level of services the company should provide to its customersB and the
appropriate amounts to spend for $V., financial planning, public relations, and a host of other activities.
#ne company may have a small head*uarters staff, (hile another company of similar size and in the same
industry may have a staff 87 times as large. !he senior managers of each company may each be convinced that
their respective decisions on staff size are correct, but there is no objective (ay to judge (hich 4if either5 is rightB
both decisions may be e*ually good under the circumstances, (ith the differences in size reflecting other
underlying deferences in the t(o companies.
As far as above stated over heads are concern, (e can easily estimate FproperH or FrightH amount (ith
responsible reliability. !here for standard 485 is more meaningful for e)penses control.
1%4 A responsibility center is an organization unit that is headed by a manager (ho is responsible for its
activities. In a sense, a company is a collection of responsibility centers, each of (hich is represented by a
bo) on the organization chart. !hese responsibility centers form a hierarchy. At the lo(est level are the
centers of the sections, (or- shift, and other small organization units. .epartments or business units
comprising several of these smaller units are higher in the hierarchy. 1rom the standpoint of senior
management and and the board of directors, the entire company is a responsibility center, though the term
is usually used to refer to units (ithin the company and there for &upervisor is responsible for the uses of
the Above stated $esources 4over heads5 li-e Indirect labor, idle time, Materials, tools, maintenance, scrape
and Management supervision by proper supervising supervisor can control the listed overhead e)penses.
What is a responsi(ility centre? 7ist and explain different types of ,esponsi(ility Centers.
,esponsi(ility centers:
A responsibility center is an organization unit that is headed by a manager (ho is responsible for its activities. In
a sense, a company is a collection of responsibility centers. ach of (hich is represented by bo) on the on the
organization are responsibility centers for section (or- shifts or other small organization units. 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. And from the stand point of senior management and the board of
directors, the (hole company is responsibility center although the term is usually used to refer to unit (ithin the
company.
/ature of responsi(ility centers
A responsibility center e)ist one or more purpose are its objectives. !he company as a (hole has goals, and
senior management has decided on a set of strategies to accomplish these goals. !he objectives of responsibility
centers are to help implement these strategies. +ecause the organization is the sum of its responsibility centers, if
the strategies are sound and if each responsibility center, if the strategies are sound and if each responsibility
center meets its objectives the (hole organization should achieve its goals. A responsibility center uses inputs,
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and a variety of services. Its (or- (ith these resources and it usually re*uire (or-ing capital, e*uipment, and
other asset to do this (or-. As a result of this (or- the responsibility center produces output (hich is classified
either as goods if they are tangible or as services if they are intangible. very responsibility center has output
that is it does something. In a production plant, the outputs are goods. In staff units, such as human resources,
transportation, engineering, accounting, and administration, the output s are services. 1or many responsibility
centers, especially staff units, outputs are difficult to measureB nevertheless, they e)ist. !he products produced by
a responsibility center or to the outside mar-etplace. In the first case, the product are inputs to the other
responsibility center in the latter case, they are output s of the (hole organization.
&ypes of ,esponsi(ility Centers
a) Cost Center
"ost centers are divisions that add to the cost of the organization, but only indirectly add to the profit of the
company. !ypical e)amples include $esearch and .evelopment, Mar-eting and "ustomer service. "ompanies
may choose to classify business units as cost centers, profit centers, or investment centers. !here are some
significant advantages to classifying simple, straightfor(ard divisions as cost centers, since cost is easy to
measure. /o(ever, cost centers create incentives for managers to underfund their units in order to benefit
themselves, and this underfunding may result in adverse conse*uences for the company as a (hole 4reduced
sales because of bad customer service e)periences, for e)ample5. +ecause the cost centre has a negative impact
on profit 4at least on the surface5 it is a li-ely target for rollbac-s and layoffs (hen budgets are cut. #perational
decisions in a contact centre, for e)ample, are typically driven by cost considerations. 1inancial investments in
ne( e*uipment, technology and staff are often difficult to justify to management because indirect profitability is
hard to translate to bottom0line figures. +usiness metrics are sometimes employed to *uantify the benefits of a
cost centre and relate costs and benefits to those of the organization as a (hole. In a contact centre, for e)ample,
metrics such as average handle time, service level and cost per call are used in conjunction (ith other
calculations to justify current or improved funding.
b) rofit Center
A responsibility centre is called a profit centre (hen the manager is held responsible for both costs 4inputs5
and revenues 4outputs5 and thus for profit. .espite the name, a profit centre can e)ist in nonprofits organizations
4though it might not be referred to as such5 (hen a responsibility centre receives revenues for its services. A
profit centre is a big segment of activity for (hich both revenues and costs are accumulated: A centre, (hose
performance is measured in terms of both 0 the e)pense it incurs and revenue it earns, is termed as a profit centre.
!he output of a responsibility centre may either be meant for internal consumption or for outside customers. In
the latter case, the revenue is realized (hen the sales are made. !hat is, (hen the output is meant for outsiders,
then the revenue (ill be measured from the price charged from customers. If the output is meant for other
responsibility centre, then management ta-es a decision (hether to treat the centre as profit centre or not. In fact,
any responsibility centre can be turned into a profit centre by determining a selling price for its outputs. 1or
instance, in case of a process industry, the output of one process may be transferred to another process at a profit
by ta-ing into account the mar-et price. &uch transfers (ill give some profit to that responsibility centre.
Although such transfers do not increase the "ompanys assets, they help in management control process.
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c) )nvestment Centre
An investment centre goes a step further than a profit centre does. Its success is measured not only by its
income but also by relating that income to its invested capital, as in a ratio of income to the value of the capital
employed. In practice, the term investment centre is not (idely used. Instead, the term profit centre is used
indiscriminately to describe centers that are al(ays assigned responsibility for revenues and e)penses, but may
or may not be assigned responsibility for the capital investment. It is defined as a responsibility centre in (hich
inputs are measured in terms of cost D e)penses and outputs are measured in terms of revenues and in (hich
assets employed are also measured. A responsibility centre is called an investment centre, (hen its manager is
responsible for costs and revenues as (ell as for the investment in assets used by his centre. /e is responsible for
maintaining a satisfactory return on investment i.e. asset employed in his responsibility centre. !he investment
centre manager has control over revenues, e)penses and the amounts invested in the centres assets. !he manager
of an investment centre is re*uired to earn a satisfactory return. !hus, return on investment 4,>)5 is used as the
performance evaluation criterion in an investment centre. /e also formulates the credit policy, (hich has a direct
influence on debt collection, and the inventory policy, (hich determines the investment in inventory. !he Lice
3resident 4Investments5 of a mutual funds company may be in charge of an Investment "entre. In the Investment
"entre, the manager in charge is held responsible for the proper utilization of assets. /e is e)pected to earn a
satisfactory return on the assets employed in his responsibility centre. Measurement of assets employed poses
many problems. It becomes difficult to determine the amount of assets employed in a particular responsibility
centre. &ome of the assets are in the physical possession of the responsibility centre (hile for some assets it may
depend upon other responsibility centers or the /ead #ffice of the company. !his is particularly true of cash or
heavy plant and e*uipment. 2hether such assets should be included in the figure of assets employed of the
responsibility centre and if included, at ho( much value, is a difficult *uestion. #n account of these difficulties,
investment centers are generally used only for relatively large units, (hich have independent divisions, both
manufacturing and mar-eting, for their individual products.
Explain the process of e'aluation of ,esponsi(ility Center from one stage to another with the help of
illustration2cum2experiences of the corporate.
.rocess of e'aluation of ,esponsi(ility Center.
1. !he organization is divided into various responsibility centers. ach responsibility centre is put under
the charge of a responsibility manager.
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2. !he targets or budgets of each responsibility centre are set in consultation (ith the manager of
responsibility centre, so that he may be able to give full information about his department. !he manager
of responsibility centre should -no( as (hat is e)pected of him 0 each centre should have a clear set of
goals. !he responsibility and authority of each centre should be (ell defined.
3. Managers are charged (ith the items and responsibility, over (hich they can e)ercise a significant
degree of direct control.
4. Goals defined for each area of responsibility should be attainable (ith efficient and effective
performance.
5. !he actual performance is communicated to the managers concerned. If it falls short of the standards,
the variances are conveyed to the top management. !he names of persons responsible for the variances
are also conveyed so that responsibility may be fi)ed.
!he purpose of all these steps is to assign responsibility to different individuals so that their performance is
improved and costs are controlled. !he personal factor in $esponsibility Accounting is most important. !he
management may prepare the best plan or the budget and put up before its staff, but its success depends upon
the initiative and the (ill of the (or-ers to e)ecute it
Example of ,esponsi(ility Center
!he &arva &hi-sha Abhiyan emphasizes *uality improvement in elementary education for (hich it
deems necessary that resource groups and responsibility centers from national to sub0district levels are identified.
!hese groups (ould oversee the policy, planning, implementation and monitoring of all *uality related
interventions. !heir major role (ould be to advise and assist at various levels in curriculum development,
pedagogical improvement, teacher educationDtraining and activities related to classroom transaction. In order to
facilitate a decentralized mode of education, these groups (ould need to be constituted at various operational
levels, namely 0 national, state, district and sub district. !he follo(ing could be involved in the groups:
National level 0 N"$!, NI3A, Iniversities, NG#s, e)perts and eminent educationists.
&tate level 0 &"$!, &IMA!, Iniversities, IA&sD"!s, NG#s, e)perts and eminent educationists.
.istrict level 0 .I!s, representatives from .33 .istrict $esource Group, higher educational institutions,
innovative teachers from the districts, NG#s.
&ub0district 0 +$"D+#, representatives from "$"s, innovative teachers.
%riefly define *iscretionary Expense Center@ Engineered Expense Center@ .rofit Centre and )n'estment
Centre? Aow is (udget prepared in *iscretionary Expenses Centre?
Engineered expense centers:
ngineered e)pense center have the follo(ing characteristics:
0 !heir inputs can be measured in monetary terms.
0 !heir output can be measured in physical terms.
0 !he optimal dollar amount of input re*uired to produce one unit of output can be established.
ngineered e)pense center usually are found in manufacturing operations. 2arehousing, distribution, truc-ing
and similar units in the mar-eting organization also may be engineered e)pense center and so many certain
responsibility center (ithin administrative and support department. )amples are accounts receivable account
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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. &uch units
perform repetitive tas- for (hich standard cost can be developed. In an engineered e)pense center the output
multiplied by the standard cost of each unit produced represents (hat the finished product should have cost.
2hen this cost is compared to actual costs, the difference bet(een the t(o represents the efficiency of the
organization unit being measured. 2e emphasize that engineered e)pense centers have other important tas-s not
measured by cast alone. !he effectiveness of this aspect of performance should be controlled. 1or e)ample
e)penses center supervisor are responsible for the *uality of good and for the volume of production in addition to
their responsibility for cost efficiency. !herefore the type and amount of production is prescribed and specific
*uality standards are set so that manufacturing costs are not minimized at the e)pense of *uality. Moreover
manager of engineered e)pense 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 ho( (ell they carry out
these responsibilities. !here are fe( if any responsibility center in (hich all cost items are engineered. ven in
highly automated production department the amount of indirect labor and of various services used can vary (ith
management discretion. !hus, the term engineered costs center refers to responsibility center in (hich
engineered cost predominate but in does not imply that valid engineering estimates can be made for each and
every cost item.
*iscretionary expense center:
!he output of discretionary e)penses center cannot be measured in monitory terms. !hey include administration
and support units research and development organization and most mar-eting activities. !he term discretionary
does not mean that management judgment is capricious or haphazard. Management has decided on certain
policies that should govern the operation of the company. 2hether to match e)ceed or spend less than the
mar-eting effort of its competitorB the level of service that the company provides to the customer. !he
appropriate amount of spending for $ V ., financial planning public relation and many other activities. #ne
company may have a small head*uarter staff another company of similar size and in the same industry may have
a staff that is 87 times as large. the management of both companies may be concerned that they made the correct
decision on staff size but there is no objective (ay judging (hich decision (as actually better manager are hired
and paid to ma-e such decision. After such a drastic change the level of discretionary e)penses generally has a
similar pattern from one year to the ne)t. !he difference bet(een budgeted and actual e)pense is not a measure
of efficiency in a discretionary e)pense center it is simply the difference bet(een the budgeted input and the
actual input. It in no (ay measures the value of the output. if actual e)pense do not e)ceed the budget amount,
the manager has Ulived (ithin the budget U ho(ever ,because by definition the budget does not purport to
measure the optimum amount of spending (e cannot say that living (ithin the budgeted is efficient performance.
.udget reparation.
!he decision that management ma-e about a discretionary e)pense budget are different from the
decisions that it ma-es about the budget for an engineered e)pense center. 1or the latter management decides
(hether the proposed operating budget represent the cost of performing tas- efficiently for the coming period.
management is not so much concerned (ith the magnitude of the tas- because this is largely determined by the
actions of other responsibility centers, such as the mar-eting departments ability to generate sales. In formulating
the budget for a discretionary e)pense center, ho(ever management principal tas- is to decide on the magnitude
of the job that should be done. !hese tas-s can be divided generally into t(o types continuing and special.
"ontinuing tas- are those that continue from year to year for e)ample financial statement preparation by the
controllers office. &pecial tas-s are one shot project for e)ample developing and installing a profit budgeting
system in a ne(ly ac*uired division. !he techni*ue management by objective is often used in preparing the
budget for a discretionary e)pense center. Management by objective is a formal process in (hich a budget
purposes to accomplish specific tas-s and state a mean for measuring (hether these tas-s have been
accomplished. !here are t(o different approach to planning for the discretionary e)pense center increment
budgeting and zero based revie(.
*escri(e inherent difficulties creation of profit centres may cause and ad'antages possi(le?
Under which situation creation of profit centre is not ad'isa(le.
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Under which situation creation of profit centre is not ad'isa(le
.ecentralized decision ma-ing (ill force top management to rely more on management control reports
than on personal -no(ledge of an operation, entailing some loss of control. If head*uarters management is mere
capable or better informed than the average profit center manager, the *uality of decisions made at the unit level
(ay be reduced. 1riction may increase because of arguments over the appropriate transfer price, the assignment
of common costs, and the credit for revenues that (ere formerly generated jointly by t(o or more business units
(or-ing together.
#rganization units that once cooperated as functional units may no( be in competition (ith one
another. An increase in profits for one manager may mean a decrease for another. In such situation a manager
may fail to refer sales leads to another business unit better *ualified to pursue themB may hoard personnel or
e*uipment that, from the overall companys, standpoint, (ould be better off used in another unitB or may ma-e
production decisions that have undesirable cost conse*uences for other units.
.ivisionalization may impose additional costs because of the additional management, staff personnel,
and record -eeping re*uired, and may lead to tas- redundancies at each profit center."ompetent general
managers may not e)ist in a functional organization because there may not have been sufficient opportunities for
them to develop general management competence.
!here may be too much emphasis on short0run profitability at the e)pense of long0run profitability. In
the desire to report high current profits, the profit center manager may s-imp on $V., training programs, or
maintenance. !his tendency is especially prevalent (hen the turnover of profit center managers is relatively
high. In these circumstances, managers may have good reason to believe that their actions may not affect
profitability until after they have moved to other jobs. !here is no completely satisfactory system for ensuring
that optimizing the profits of each individual profit center (ill optimize the profits of the company as a (hole.
What are the challenges faced in pricing corporate ser'ices pro'ided to %usiness Units operating
as Nprofit centers?O
%usiness Units as .rofit Centers
Most business units are created as profit centers since managers in charge of such units typically control product
development, manufacturing, and mar-eting resources. !hese managers are in a position to influence revenues
and costs and as such can be held accountable for the Ebottom line.E /o(ever, as pointed out in the ne)t section,
a business unit managerMs authority may be constrained in various (ays, (hich ought to be reflected in a profit
centerMs design and operation.
Constraints on %usiness Unit 6uthority
!o realize fully the benefits of the profit center concept, the business unit manager (ould have to be as
autonomous as the president of an independent company. As a practical matter, ho(ever, such autonomy is not
feasible. If a company (ere divided into completely independent units, the organization (ould lose the
advantages of size and synergy. 1urthermore in delegating to business unit management all the authority that the
board of directors has given to the "#, senior management (ould be abdicating its o(n responsibility.
"onse*uently, business unit structures represent trade0offs bet(een business unit autonomy and corporate
constraints. !he effectiveness of a business unit organization is largely dependent on ho( (ell these trade0offs
are made.
Constraints from >ther %usiness Units.
#ne of the main problems occurs (hen business units must deal (ith one another. It is useful to thin- of
managing a profit center in terms of control over three types of decisions:
485 !he product decision 4(hat goods or services to ma-e and sell5,
465 !he mar-eting decision 4ho(, (here, and for ho( much are these goods or services to be soldG5, and
74
4;5 !he procurement or sourcing decision 4ho( to obtain or manufacture the goods or services5. If a business
unit manager controls all three activities, there is usually no difficulty in assigning profit responsibility and
measuring performance. In general, the greater the degree of integration (ithin a company,
the more difficult it becomes to assign responsibility to a single profit center for all three activities in a given
product lineB that is, if the production, procurement, and mar-eting decisions for a single product line are split
among t(o or more business units, separating the contribution of each business unit to the overall success of the
product line may be difficult.
Constraints from Corporate Management
!he constraints imposed by corporate management can be grouped into three types:
485 !hose resulting from strategic considerations,
465 !hose resulting because uniformity is re*uired, and
4;5 !hose resulting from the economies of centralization.
Most companies retain certain decisions, especially financial decisions, at the corporate level, at least for
domestic activities. "onse*uently, one of the major constraints on business units results from corporate control
over ne( investments. +usiness units must compete (ith one another for a share of the available funds. !hus, a
business unit could find its e)pansion plans th(arted because another unit has convinced senior management that
it has a more
Attractive program. "orporate management .also imposes other constraints. ach business unit has a EcharterE
that specifies the mar-eting andDor production activities that it is permitted to underta-e, and it must refrain from
operating beyond its charter, even though it sees profit opportunities in doing so. Also, the maintenance of the
proper corporate image may re*uire constraints on the *uality of products or on public relations activities.
"ompanies impose some constraints on business units because of the necessity for Iniformity. #ne0constraint is
that business Inits must conform to corporate accounting and M"& !his constraint is especially troublesome for
units that have been ac*uired from another company and that have been accustomed to using different systems.
Dero %ased %udgeting
Sero0based budgeting is a techni*ue of planning and decision0ma-ing (hich reverses the (or-ing
process of traditional budgeting. In traditional incremental budgeting, departmental managers justify only
increases over the previous year budget and (hat has been already spent is automatically sanctioned. No
reference is made to the previous level of e)penditure. +y contrast, in zero0based budgeting, every department
function is revie(ed comprehensively and all e)penditures must be approved, rather than only increases.
[8\
Sero0
based budgeting re*uires the budget re*uest be justified in complete detail by each division manager starting
from the zero0base. !he zero0base is indifferent to (hether the total budget is increasing or decreasing.
!he term Ezero0based budgetingE is sometimes used in personal finance to describe the practice of
budgeting every dollar of income received, and then adjusting some part of the budget do(n(ard for every other
part that needs to be adjusted up(ard. It (ould be more technically correct to refer to this practice as Eactive0
balanced budgetingE.
Advantages of Sero0+ased +udgeting:
1. fficient allocation of resources, as it is based on needs and benefits.
2. .rives managers to find cost effective (ays to improve operations.
3. .etects inflated budgets.
4. Municipal planning departments are e)empt from this budgeting practice.
5. Iseful for service departments (here the output is difficult to identify.
6. Increases staff motivation by providing greater initiative and responsibility in decision0ma-ing.
7. Increases communication and coordination (ithin the organization.
8. Identifies and eliminates (asteful and obsolete operations.
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9. Identifies opportunities for outsourcing.
10. 1orces cost centers to identify their mission and their relationship to overall goals.
.isadvantages of Sero0+ased +udgeting:
1. .ifficult to define decision units and decision pac-ages, as it is time0consuming and e)haustive.
2. 1orced to justify every detail related to e)penditure. !he $V. department is threatened (hereas the
production department benefits.
3. Necessary to train managers. Sero0based budgeting must be clearly understood by managers at various
levels to be successfully implemented. .ifficult to administer and communicate the budgeting because
more managers are involved in the process.
4. In a large organization, the volume of forms may be so large that no one person could read it all.
"ompressing the information do(n to a usable size might remove critically important details.
5. /onesty of the managers must be reliable and uniform. Any manager that e)aggerates s-e(s the results
)nternal Control
Internal control is defined as a process affected by an organizationMs structure, (or- and authority flo(s,
people and management information systems, designed to help the organization accomplish specific goals or
objectives.
[8\
It is a means by (hich an organizationMs resources are directed, monitored, and measured. It plays
an important role in preventing and detecting fraud and protecting the organizationMs resources, both physical
4e.g., machinery and property5 and intangible 4e.g., reputation or intellectual property such as trademar-s5. At
the organizational level, internal control objectives relate to the reliability of financial reporting, timely
feedbac- on the achievement of operational or strategic goals, and compliance (ith la(s and regulations. At the
specific transaction level, internal control refers to the actions ta-en to achieve a specific objective 4e.g., ho( to
ensure the organizationMs payments to third parties are for valid services rendered.5 Internal control procedures
reduce process variation, leading to more predictable outcomes
Descri&ing )nternal Controls:
Internal controls may be described in terms of: a5 the objective they pertain toB and b5 the nature of the control
activity itself.
#bjective categorization
Internal control activities are designed to provide reasonable assurance that particular objectives are achieved, or
related progress understood. !he specific target used to determine (hether a control is operating effectively is
called the control objective. "ontrol objectives fall under several detailed categoriesB in financial auditing, they
relate to particular financial statement assertions,
[?\
but broader frame(or-s are helpful to also capture
operational and compliance aspects:
1. )istence 4Lalidity5: #nly valid or authorized transactions are processed 4i.e., no invalid transactions5
2. #ccurrence 4"utoff5: !ransactions occurred during the correct period or (ere processed timely.
3. "ompleteness: All transactions are processed that should be 4i.e., no omissions5
4. Laluation: !ransactions are calculated using an appropriate methodology or are computationally
accurate.
5. $ights V #bligations: Assets represent the rights of the company, and liabilities its obligations, as of a
given date.
6. 3resentation V .isclosure 4"lassification5: "omponents of financial statements 4or other reporting5 are
properly classified 4by type or account5 and described.
7. $easonableness0transactions or results appear reasonable relative to other data or trends.
Activity categorization
"ontrol activities may also be described by the type or nature of activity. !hese include 4but are not limited to5:
&egregation of duties 0 separating authorization, custody, and record -eeping roles to limit ris- of fraud
or error by one person.
Authorization of transactions 0 revie( of particular transactions by an appropriate person.
$etention of records 0 maintaining documentation to substantiate transactions.
&upervision or monitoring of operations 0 observation or revie( of ongoing operational activity.
3hysical safeguards 0 usage of cameras, loc-s, physical barriers, etc. to protect property.
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Analysis of results, periodic and regular operational revie(s, metrics, and other -ey performance
indicators 4T3Is5.
I! &ecurity 0 usage of pass(ords, access logs, etc. to ensure access restricted to authorized personnel.
9eena .'t. 7td.@ a small multiproduct company is ta?en o'er (y a multinational company
1 e.g. Aindustan 7e'er.4 What changes in the control system would you expect and why?
&ince Leena is a small multiproduct company it (ould re*uire changes in control system (hich (ould
be related to transfer pricing a, as this company (ould generally provide inputs to /I%. !hus the domestic
operations generally involve transfer of goods and services only In vie( of this difference many other
considerations, in addition to the criteria used in domestic operations for the determination of transfer price, are
involved. !hese include:
4a5 Fair rice: !his is an important factor one needs to consider (hile determining the transfer price for foreign
operations. "ompanies that enter into joint ventures must ensure that the transfer price charged is fair. If such
companies charge a higher transfer price, it (ould reduce the profits of the joint venture and as a result reduce
the foreign partnerMs share of profits.
4b5 4overnment 6egulations: All countries have a regulatory frame(or- under (hich business units operate.
2here government rules and regulations regarding transfer prices are lenient, the parent company should fi) a
higher transfer price for all transfers to countries (ith high income ta) rates. !his approach (ould enable the
parent company to minimize ta)es in such countries.
4c5 Exchange Control 6estrictions: very country has foreign e)change control regulations.
!hese regulations impose a limit on the amount of foreign e)change available for the import of certain goods. !o
accommodate the foreign subsidiary the parent company may have a lo(er transfer price so that the subsidiary is
able to import a larger *uantity of re*uired goods.
4d5 )ncome Tax 6egulations: !he rates of income ta) vary from country to country. !o overcome this difference
the transfer price should be so fi)ed that countries (ith lo( ta) rates sho( profits (hile others end up (ith a
loss. !his helps the parent company to reduce its ta)es on a global basis.
4e5 Desire to accumulate funds: A company that (ishes to accumulate funds in a particular country may fi) the
transfer prices in such a manner that it facilitates shifting of funds into that country.
4f5 Tariffs7 and Duties: No country li-es high imports. In order to restrict imports countries impose restrictions
such as *uantitative restrictions, high duties and tariffs and banning import of products. !he general practice is to
charge import duties as a percentage of the value of products imported, although a lo(er tariff may be levied if
the import value is lo(er. It is seen that the impact of tariffs on the profitability of foreign operations is generally
the reverse of the incidence of income ta)es in transfer pricing. As such a lo( transfer price (ould lead to lo(
import duties on transfer, the profit arising in that country (ould be high. !his results in high income ta)es in
that country. It is therefore advisable that companies must compute the net effect of these factors (hile
determining transfer prices.
In designing performance evaluation systems for ac*uired Leena company,/I% could use the follo(ing
guidelines
&ubsidiary managers should not be held responsible for translation effects. !he simplest (ay to achieve this
objective is to compare budgets and actual results using the same metric and isolate inflation0related effects
through variance analysis. It is pointless for managers to (orry about the appropriate metric. !he MN should
choose (hatever metric is more convenient.
!ransaction effects are best handled through centralized coordination of the MNMs overall hedging needs. !his
is li-ely to be cheaper and simpler, and it prevents the subsidiary manager from becoming a foreign e)change
rate forecaster and speculator.
!he subsidiary manager should be held responsible for the dependence effects of e)change rates resulting from
economic e)posure.
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valuation 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 conse*uences of translation. !ransaction and economic e)posures.

What is a /on 2 .rofit >rganization? Aow is the performance of this organization e'aluated?
A nonprofit organization, as defined by la(, is an organization that cannot distribute assets or income to,
or for the benefit of, its members, officers, or directors. !he organization can, of course, compensate its
employees, including officers and members, for services rendered and for goods supplied. !his definition does
not prohibit an organization from earning a profitB it prohibits only the distribution of profits. A nonprofit
organization needs to earn a modest profit, on average, to provide funds for (or-ing capital and for possible
Frainy days.H
.erformance e'aluation of nonprofit organization
1or any organization, the most important reasons to measure performance are to improve effectiveness and to
ac*uire information that (ill allo( the organization to drive its agenda for(ard. If the motivation for doing
evaluation remains outside an organization, the evaluation (ill have limited impact. !o do performance
assessment effectively, an organization must commit to adopting a culture of measurement, because acceptance
must come from senior management, staff, funders, and board members ali-e.
%oard self2e'aluation
Members of the +oard of .irectors should regularly evaluate the *uality of their activities on a regular basis.
Activities might include staffing the +oard (ith ne( members, developing the members into (ell0trained and
resourced members, discussing and debating topics to ma-e (ise decisions, and supervising the "#. 3robably
the biggest problem (ith +oard self0evaluation is that it does not occur fre*uently enough. As a result, +oard
members have no clear impression of ho( they are performing as members of a governing +oard. 3oor +oard
operations, (hen undetected, can adversely affect the entire organization.
Staff and 'olunteer 1indi'idual4 performance e'aluation
Most of us are familiar (ith employee performance appraisals, (hich evaluate the *uality of an individuals
performance in their position in the organization. Ideally, those appraisals reference the individuals (ritten job
description and performance goals to assess the *uality of the individuals progress to(ard achieving the desired
results described in those documents. "ontinued problems in individual performance often are the results of poor
78
strategic planning, program planning and staff development. If overall planning is not done effectively,
individuals can e)perience continued frustration, stress and lo( morale, resulting in their poor overall
performance. )perienced leaders have learned that continued problems in performance are not al(ays the result
of a poor (or- ethic A the recurring problems may be the result of larger, more systemic problems in the
organizations.
.rogram e'aluation
3rogram evaluations have become much more common, particularly because donors demand them to ensure that
their investments are ma-ing a difference in their communities. 3rogram evaluations are typically focused on the
*uality of the programs process, goals or outcomes. An ineffective program evaluation process often is the result
of poor program planning A programs should be designed so they can be evaluated. It can also be the result of
improper training about evaluation. &ometimes, leaders do not realize that they have the responsibility to verify
to the public that the nonprofit is indeed ma-ing a positive impact in the community. 2hen program evaluations
are not performed (ell, or at all, there is little feedbac- to the strategic and program planning activities. 2hen
strategic and program planning are done poorly, the entire organization is adversely effected.
E'aluation of cross2functional processes
"ross0functional processes are those that span several systems, such as programs, functions and projects.
"ommon e)amples of major processes include information technology systems and *uality management of
services. +ecause these cross0functional processes span so many areas of the organization, problems in these
processes can be the result of any type of ineffective planning, development and operating activities.
>rganizational e'aluation
#ngoing evaluation of the entire organization is a major responsibility of all leaders in the organization. %eaders
sometimes do not recognize the ongoing activities of management to actually include organizational evaluations
A but they do. !he activities of organizational evaluation occur every day. /o(ever, those evaluations usually are
not done systematically. As a result, useful evaluation information is not provided to the strategic and program
planning processes. "onse*uently, both processes can be ineffective because they do not focus on improving the
*uality of operations in the (or-place.
6 Well *i'ersified company = .ritam )nternational 7td. sells one of its di'isions to a group of its own
company managers. Explain what significant changes in systems and control procedures can (e
expected? Why?
As, (e 3ritam International is a (ell diversified company. &ometimes, e)cessive diversification and that too in
unrelated lines of business causes failure in the business operations. #ne of the major reason for failures of many
Mergers and .iversification is e)cessive diversification. As, e)cessive diversification is ominous especially, in
unrelated lines of business. As, there may be no advantage of operating synergy. Neither through:
I) &haring common resources nor
II) &haring common core competencies
!herefore, it may be a strategic decision by the promoters and directors of the company to sell one of its
divisions. As, this may be impacting their core business. &ometimes, your core business tends to get neglected
mainily due to e)cesive diversification. As, the division is being sold to its o(n company managers. !here,
might not be major changes in management control and systems. As, most of its managers (ill be the same. +ut,
they (ill have more autonomy to ta-e decisions independently after ac*uisition. No( there (ill be less red
tapism and managers can ta-e more ris-. !he managers (ill manage the firm in their o(n style. As, they are not
ans(erable to their superiors.
"urrently, they are ans(erable to their sta-e0holders. As, the management is completely in their hands and that
too (ith full autonomy. !he management might have identified the fla(s in the previous controls and systems of
the company because of (hich the company might not be so effective and efficient. As, they have been
associated (ith the company over aperiod of time. !hey have a better understanding about the business
79
dynamics and environment in (hich the firm operates. &o, they can ta-e necessary steps to overcome the fla(s
and improve the management control and systems.
&o, that is (hy there (ill be some significant changes in the management control and systems and procedures if
there is further scope for improvement.
6 &9 dealership 9eena &ele'ision 19&4 is organized into four profit centers. colour &9@ %lac? and
White@ spare parts1S.4 and ser'icing 1S04 each headed (y manager %&9 in addition to %9&9 salesF
also sells old &9 exchanged 1under scheme4 (y customer while purchasing new &9 . in one particular
instance a new &9 was sold for #$31financed (y cash rs!333@ %an? loan K"$3and ,s #:33Fexchange
price for old &9 agreed (y C&9 manager 4cost of new &9 was ,s #!3.Shi'angi +anager of %&9@
examined the old &9 1'alued at ,s "$33 (y &9 trade magazine4 and felt that she could get ,s $333 for
that &9 offer repairing ca(inet@ resulting and ser'icing for which she would use ser'ices of S. and S0
price chargea(le to %&9 (y S. and S0 are at mar?et rates ,s!"$ for parts (y S. and ,s #K3 for
ser'ices (y S0. +ar?et price are arri'ed at after mar?ing up cost (y ".$ times S0 and .# times S..
%&9 pays a ser'ice commission of ,s !$3 per &9 sold .o'erhead fixed per sale are C&9 ,s :"$F%&9 ,s
CC$FS. ,S "! FS0 ,s #.
"ompute the profitability of the transaction assuming sales commission of 96?7 for the trade in on a selling price
of 9?777
"ompute at mar-et price
At cost price
Gross and net profit each
S#8-T)#*:
S. of Ne( !L by "!L < 98>8?7.
>riginal cost< 988>67
498>8?7< 96777 cash do(n payment = 9>@77 trade in allo(ance = 9:;?7 ban- loan5
0uide %oo? 9alue <9;?77
Ms. &hivangi of +!L .ept, believed that she could sell the trade in at 9?777
>ther Cost: $s6;? for parts by &3 and $s >:7 for services by &G
When trade2in is recorded Q R#:33
>@77=>:7=6;?<??7?B ?7770??7?< 40?7?5
Ne( !L #%. !L &ervice 3arts
80
3articulars
&ales 8>8?7 ?777 >:7 6;?
&elling commission 7 6?7 7 7
Gross profit 6:;7 0?7? >:7 6;?
#verhead @;? JJ? 88> ;6
&ervicing 7 >:7 7 7
Net profit before common e)p 8@Q? 08J>7 ?Q8 86;
)f the trade2in is recorded Q R"$33
3articulars Ne( !L #%. !L &ervice 3arts
&ales 8>8?7 ?777 >:7 6;?
&elling commission 7 6?7 7 7
Gross profit 6:;7 87>? >:7 6;?
#verhead @;? JJ? 88> ;6
&ervicing 7 >:7 7 7
Net profit before common e)p 8@Q? 0;>7 ;?J 86;
Why %alance Score Card is considered superior to other methods of .erformance 6ppraisal?
.repare %alance Score Card for any organization you are familiar with.
What is the %alanced Scorecard?

!he rationale for the development of the +alanced &corecard (as a gro(ing dissatisfaction (ith
traditional, financial measures of performance. !hese measures suffer from a number of serious dra(bac-s in
that they ta-e a short0term, lagged 4i.e., historic5 vie( of performance. !he shift to(ards fle)ible, lean
productionDservice systems in many firms has strengthened the re*uirement for performance measurement
systems to become more broadly based, incorporating both non0financial and e)ternal measures of performance.
According to Taplan and Norton, the +alanced &corecard provides a better assessment of performance as it
Eenables companies to trac- financial results (hile simultaneously monitoring progress in building the
capabilities and ac*uiring the intangible assets they need for future gro(thE.
!he original scorecard designed by Taplan and Norton contained four -ey groupings of performance measures.
!hese four groupings, called Uperspectives by Taplan and Norton, (ere considered sufficient to trac- the -ey
drivers of both current and future financial performance of the firm. !he perspectives focused on the
achievements of the firm in four areas: namely the financial, customer, internal business process and
innovationDlearning perspectives. !he four perspectives can be represented as an interlin-ed hierarchy. !he
firms strategy underlies the (hole scorecard, as the measures for each of the four perspectives are dra(n from
this strategy.
81
!o obtain a satisfactory overvie( of performance, the scorecard (ill re*uire a mi) of lagging and leading
4for(ard loo-ing5 measures. 1inancial measures tend to be lagged and conse*uently, the measures chosen for the
other perspectives (ill need to include leading measures. In general, outcome measures tend to be lagged, for
e)ample, current mar-et share is the result of past decisions and conse*uently is a lagging measure. !hus the
challenge in designing a +alanced &corecard is to choose driver measures (hich lead changes in the outcome
measures in the non0financial perspectives and (hich ultimately drive the financial measures.
#nce the firms objectives have been agreed and the appropriate outcome and driver measures chosen for each of
the perspectives, firm and managerial performance is assessed by comparing actual attainment on each measure
(ith the target set for that measure.
#bjective Measure !arget Actual
%enefits from adopting the %alanced Scorecard
!here are several benefits from implementing a +alanced &corecard. #riginally the +alanced &corecard
(as seen as a useful tool for performance measurement. In this role, the +alanced &corecard (as seen as
integrating financialDnon0financial, internalDe)ternal and leading Dlagging information on firm performance in a
coherent fashion.
%ater it (as realised that the +alanced &corecard could play a pivotal role in the strategic management
process. +ecause the +alanced &corecard re*uires management to clarify and obtain consensus on the strategic
objectives of the firm, it can assist in the communication of the chosen strategy, conse*uently aligning the efforts
both of individuals and of departments. In this role, there is a clear lin- bet(een the +alanced &corecard and
management by objectives 4M+#5. ffective implementation of a +alanced &corecard project (ill generally
involve the development of a series of hierarchical 4cascaded5 scorecards. Given the overall corporate scorecard,
supporting scorecards can be developed for each department (ithin the firm. 2ithin each department, a
scorecard can be developed for each manager 4or perhaps even for each individual member of staff5 (hich lin-s
the objectives on each perspective for that manager bac- to the objectives for each perspective outlined in the
scorecard for the department and finally, bac- to the objectives listed in the firms overall scorecard.
!he +alanced &corecard could be used to assist in corporate restructuring. In recent years, many firms have
migrated a(ay from a traditional hierarchical structure to a flatter, team0based organisational structure. !he
+alanced &corecard can support such changes, as it can help clarify the objectives and the critical success factors
for the ne(ly formed teams.
Apart from the communication and co0ordination roles of the +alanced &corecard in strategic implementation,
the +alanced &corecard can be used to lin? strategy to specific critical success factors in the customer@
internal (usiness process and growthJlearning perspecti'es. +y setting both short and long0term targets for
driver and outcome measures and by comparing actual attainment against target, feedbac- is obtained on ho(
(ell the strategy is being implemented and on (hether the strategy is (or-ing.
+uilding on the +alanced &corecards use as a strategic management tool, it has been suggested that the
+alanced &corecard can play a role in the in'estment appraisal process.
!raditional methods of investment appraisal such as discounted cash flo( do not cope (ell (ith
investments (hich generate indirect rather than direct financial returns. )amples of these include investments
82
(hich enhance the future Ufle)ibility of a firm or investments in the firms infrastructure, such as an enhanced
management information system. !he +alanced &corecard can assist managements investment appraisal
decisions as it provides managers (ith a mechanism to incorporate the strategic aspects of the investment into
the appraisal process. !his could be achieved by using a (eighting system developed from a firms +alanced
&corecard measures to evaluate ne( projects. An inde) score (ould be calculated for each investment
opportunity and projects (ould then be ran-ed and selected based on this score.
%alance Score Card of Credit Card Company
Soniya Company has two *i'isions: 6 E %. ,eturn on )n'estment for (oth di'isions is !3H.
6nalyse and comment on di'isional performance of each.
*etails are gi'en (elow.
.articulars *i' 6 *i' %
*i'isional sales #333333 GC33333
*i'isional )n'estment !333333 "!33333
.rofit #33333 C#3333
S#8-T)#*
6s .rofit +argin I .rofit S33
Sales
3rofit Margin for .ivision UA< >,77,777 D>7,77,777 O877 < 87N
3rofit Margin for .ivision U+ < J,>7,777D QJ,77,777 O877 < J.JN
&urno'er of )n'estment I Sales S 33
)n'estment
!urnover of Investment for .ivision UA < >7,77,777D67,77,777 < 6 times
83
!urnover of Investment for .ivision U+ < QJ,77,777D;6,77,777 < ; times
As $eturn on investment for both .ivisions A and + is 67N.
C>++E/&S:2
*i'ision T6U = Although UA has more profit margin than .ivision U+ that is 87N as compared to J.JN of U+, so
it has more profitability but inspite of it, division UA has lo(er turnover of investment that its assets
management is bad than .ivision U+, it can be improved by increased sales or reducing investment.
*i'ision T%U = 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 (ould improve. As it has good
assets management sho(n by its turnoverof .ivision U+ that is ; times (hich is better than .ivision UA. &o it
can become profitable organisation by improving 3rofit Margin.
&wo di'isions 6 and % of sonali enterprises operate .rofit centers. *i' 6 normally purchases annually
3333 nos. of re-uired components from *i' %@ which has recently informed *i' 6 that it will increase
selling price p.u to ,s. 33. *i' 6 decided to purchase the components from open mar?et a'aila(le at
,s.333 p.u *i' % is not happy and Lustified its decision to increase price due to inflation and added that
the o'erall company profita(ility will reduce and decision will lead to excess capacity in *i' %@ whose
9.C and Fixed cost p.u. are ,s. G$3 and ,s.33.
1. 6ssuming that no alternate use exists for excess capacity in *i' %@ will company (enefit
as a whole if *i' 6 (uys from the mar?et.
2. )f the mar?et price reduces (y ,s.:3 p.u. What would (e the effect on the company
1assuming *i' % has still excess capacity4 if 6 (uys from mar?et.
3. )f excess capacity of *i' % could (e use for alternati'e sales at yearly costs sa'ings of ,s.
#.$ lacs@ should *i' 6 purchase from outside?
Mustify your answers with figures.
S#8-T)#*
1) .ivision UA action
+I' #I!&I. 4$s.5 4$s.5 +I' IN&I.
!otal 3urchase "ost 87,77,777 Nil
!otal #utlay "ost Nil Q,?7,777
Net "ash #utflo( !o
!he "ompany As A
2hole
87,77,777 Q,?7,777
&he Company as a whole will (enefit if *i'ision T6U (uys inside from *i'ision T%U.
2) If the mar-et price reduces by $s.@7 p.u
.ivision UA action
+I' #I!&I. 4$s.5 4$s.5 +I' IN&I.
84
!otal 3urchase "ost Q,67,777 Nil
!otal #utlay "ost Nil Q,?7,777
Net "ash #utflo( !o
!he "ompany As A
2hole
Q,67,777 Q,?7,777
&he Company as a whole (enefit if T6U (uys from outside supplier at ,s. 13332:34 I G!3
3) If e)cess capacity of .iv + could be use for alternative sales at yearly costs savings of $s. 8>.? la-hs
.ivision UA action
+I' #I!&I. 4$s.5 4$s.5 +I' IN&I.
!otal 3urchase "ost 87,77,777 Nil
!otal #utlay "ost Nil Q,?7,777
$evenue 1rom Ising
!hese 1acilities
8,>?,777
Net "ash #utflo( !o
!he "ompany As A
2hole
@,??,777 Q,?7,777
&herefore@ Company should purchase from outside.
*iscuss and illustrate differences and similarities (etween
Strategy Formulation and +anagement Control
Characteristics Strategy Formulation +anagement Control
a5 1ocus of plan #n one aspect at a time #n entire organisation
b5 "omple)ities Many variables hence comple) %ess comple)
c5 Nature of information !ailor0made for the issue, more
e)ternal and predictive, less
accurate.
Integrated, more internal and
historical, more accurate.
d5 &tructure Instructured and irregular, each
problem being different
$hythmic, definite pattern, set
procedure
e5 "ommunication of information $elatively simple $elatively difficult
f5 3urpose of estimates &ho( e)pected results %ead to desired result
g5 3ersons involved &taff and top management %ine and top management
h5 No. of persons involved &mall %arge
i5 Mental activity "reative, analytical Administrative, persuasive
j5 3lanning and control 3lanning dominant but some
control
mphasis on both planning and
control
-5 !ime horizon !ends to be long !ends to be short
l5 nd result 3olicies and precedents Action (ithin policies laid
m5 Appraisal of job done )tremely difficult %ess difficult
85
+anagement Control and &as? Control
Characteristics &as? Control +anagement control
a5 1ocus of plan &ingle tas- or transaction #n entire organisation
b5 Nature of information !ailor0made to operation, specific,
often non0 financial, real time
Integrated, more internal and
historical, more accurate
c5 3ersons involved &upervisors %ine and top management
d5 Mental activity 1ollo( directives or none as in
case of machines or set objectives
Administrative, persuasive
e5 !ime horizon .ay to day !ends to be short
f5 !ype of cost ngineered0 )istence of objective
standard against (hich actuals can
be compared ma-es control easier.
.iscretionary0 "ontrol is more
difficult due to subjective
consideration.
0irish Engineering 7td. 1/umerical4 1+CS2!33C4
(1) #n the basis of costing, (ill the manager be interested in accepting the mar-et offerG
&olution:
3articulars Amount 4$s.Dunit5 Amount 4$s.Dunit5
"ost of critical component for
division P
667
"ost of other material ?77
1i)ed V processing costs 6Q7
!otal cost for division P 8787
&elling price of final product 8777
Net loss for division P 87
.esired profit for division P J7
86
!hus on the basis of full actual cost incurred by division P, it (ould suffer a loss of $s.87Dunit if it accepts the
mar-et offer (hereas its target profit margin is $s.J7Dunit. &o, division P (ould not accept the mar-et offer.
(2) Is this offer beneficial to the company as a (holeG Rustify (ith figures.
&olution:
3articulars Amount 4$s. %a-h5 Amount 4$s. %a-h5
"ash inflo( 4a5 ?7 4?777 units O $s.8777Dunit5
"ash outlay:
Lariable cost for division ' ? 42or-ing note5
Material bought by division P from
outside
6? 4?777 units O $s.?77Dunit5
!otal cash outlay 4b5 ;7
Net cash inflo( to "ompany as a
(hole [4a50 4b5\
67
!hus, the "ompany as an entity (ould receive cash inflo( of $s.67 la-h. &o, the offer is beneficial to the
company as a (hole.
2or-ing notes:0
Lariable cost for division ':
.esired $oI <87N of $s.6.> "r. p.a. < $s.6> la-h p.a. i.e. $s.6 la-h per month
1i)ed cost assigned to division P < $s.> la-h per month
1i)ed cost p.u. < >77777D?777 < $s.@7
"ontribution per month < $s.J la-h
!otal sales value for division ' < 667 O ?777 < $s.88 la-h per month
&o, total Lariable cost per month for division ' < 88 la-h A J la-h < $s.? la-h
Lariable cost p.u. for division ' < ?77777D?777 < $s.877
An annual investment of $s6.> "r. is assigned by division ' to division P but it does not imply that
a special investment of $s.6.> "r. is made by division ' e)clusively to produce the component re*uired by
division P. !herefore, cash outflo( associated (ith this investment is not relevant for the above concerned
decision regarding accept the mar-et offer.
(3) If yes, ho( should the company organize its transfer pricing mechanismG Illustrate.
&olution:
87
"urrently, Girish ngineering %td. is follo(ing 6 step transfer pricing method (herein the selling division
charges actual variable cost along (ith profit mar-0up V separately allocates a particular amount of fi)ed
costs per month to the buying division. /o(ever, in the case of division P 4buying division5 V division '
4selling division5, this method of transfer pricing is not feasible as division P (ould suffer loss if it accepts
the mar-et offer under this scenario. &o, divisions P V ' can negotiate a transfer price by ta-ing into
account full actual variable cost 4$s.877 p.u.5 V half of fi)ed costs incurred by division ' that is assigned to
division P 4$s.>7 p.u.5 V add a mar-0up of say $s.87Dunit. !a-ing into consideration only half of the fi)ed
costs of selling division i.e. division ' prevents shifting of any operational inefficiencies from selling
division to buying division i.e. division P, (hich (ould unnecessarily increase the costs for division P and
thereby eat up its profit margin. In this case, division Ps total costs (ould turn out to $s.Q>7 4?77 = 6Q7 =
8?75 V (ould earn a profit margin of $s.J7 p.u. 4desired profit margin5. Also, contribution p.u. for division
' (ould be $s.?7 48?7 A 8775. !hus, total contribution for division ' (ould be $s.6?7777 resulting in $oI
of 86.?N 46?7777D67777775 (hich is more than the desired $oI of 87N.
Suresh 7td. 1/umerical4 1+CS2!33K4
(a) .efine profit in this case and prepare a statement for both divisions and overall company.
&olution:
i5 3rofitability statement of .ivision A:0
3articulars Amount4$s.5
&elling price p.u. ;?
Lariable "ost p.u. 88
"ontribution p.u. 6>
"ontribution p.u. )pected sales 4no.
of units5
!otal contribution !otal 1i)ed cost
4$s.5
Net profit 4$s.5
6> 6777 >@777 J7777 4867775
6> ;777 :6777 J7777 86777
6> J777 8>>777 J7777 @>777
ii5 3rofitability statement of .ivision +:0
&elling p.u. !otal variable
cost p.u.
"ontribution
p.u.
)pected
sales 4no. of
units5
!otal
contribution
!otal 1i)ed
cost 4$s.5
Net profit
4$s.5
Q7 >6 >@ 6777 QJ777 Q7777 J777
@7 >6 ;@ ;777 88>777 Q7777 6>777
?7 >6 @ J777 >@777 Q7777 4>67775
[Note: !otal Lariable cost p.u. < Lariable cost p.u. 4$s.:5 = !ransfer price of intermediate product 4$s.;?5\
88
iii5 3rofitability statement of "ompany as a (hole:0
)pected sales Net profit of division A
4$s.5
Net profit of .ivision +
4$s.5
!otal Net profit
6777 4867775 J777 4J7775
;777 86777 6>777 ;J777
J777 @>777 4>67775 >6777
(b) &tate the selling price (hich ma)imizes profits for division + and company as a (hole. "omment on
(hy the latter price is unli-ely to be selected by division +.
&olution:
As per the calculation in part 4a5, selling price p.u. of $s.@7 ma)imizes profit for division + (hereas selling
price p.u. of $s.?7 ma)imizes profit for the "ompany as a (hole. /o(ever, if .ivision + opts for selling
price p.u. of $s.?7 in order to ma)imize "ompanys profit, it (ould suffer a loss of $s.>6777. !herefore,
.ivision + (ould not select &elling price p.u. of $s.?7.
Explain different organizational goals. Comment on goal of shareholder 'alue maximization in
particular.
0oals
Although (e often refer to the goals of a corporation, a corporation does not have goalsB it is an artificial being
(ith no mind or decision0ma-ing ability of its o(n. "orporate goals are determined by the chief e)ecutive
officer 4"#5 of the corporation, (ith the advice of other members of senior management, and they are usually
ratified by the board of directors. In many corporations, the goals originally set by the founder persist for
generations. )amples are /enry 1ord, 1ord Motor "ompanyB Alfred 3. &loan, General Motors "orporationB
2alt .isney, 2alt .isney "ompanyB George astman, astman Toda-B and &am 2alton, 2al0Mart.
Economic 0oals
&hareholderMs value, arning per share and Mar-et value, all relate to ma)imizing shareholderMs value, (hich is
not a desirable goal, because (hat is Mma)imumM is difficult to determine. Although optimizing shareholder value
may be one goal, but there are other sta-eholders in the business also such as customers, employees, creditors,
community and so on. Again, shareholder value is usually e*uated (ith the mar-et value of the companyMs stoc-.
+ut mar-et value is not an accurate measure of the (orth of shareholdersM investments. +esides, such value can
be obtained only (hen the share is traded in the stoc- e)change.
It is interesting to note that /enry 1ordMs operating philosophy (as Msatisfactory profitM, not Mma)imum
profitM. /e said, EA reasonable profit is right, but not too much. &o, it has been my policy to force the price of the
car do(n as fast as production (ould permit and give the benefit to the user and laborers, (ith resulting
surprisingly enormous benefit to ourselvesE
89
#ther goals such as adding ne( products, or product0line or ne( business actually indicate normal
organizational gro(th.
Social 0oals
/o(ever, every organization has its share of responsibility to(ards the local community (here it is
situated, and the public at large. It is very difficult to incorporate in Management "ontrol &ystem such goals as
ta-ing pride in an organization (hich cares for the society and renders service to the public. #f course, any
concrete structural programme indicating its operational e)penses, methods of providing service, personnel
involved in rendering service and the nature of the service in details can, ho(ever, be mentioned through an
appropriate system.
.rofita(ility
In a business, profitability is usually the most important goal.
$eturn on investment can be found by simply dividing profit 4i.e., revenues minus e)penses5 by investment,
but this method does not dra( attention to the t(o principal components: profit margin and investment turnover.
In the basic form of this e*uation, EinvestmentE refers to the shareholdersM investment, (hich consists of
proceeds from the issuance of stoc-, plus retained earnings.
#ne of managementMs responsibilities is to arrive at the right balance bet(een the t(o main sources of
financing: debt and e*uity. !he shareholdersM investment 4i.e., e*uity5 is the amount of financing that (as not
obtained by debt, that is, by borro(ing. 1or many purposes, the source of financing is not relevantB
EinvestmentE thus means the total of debt capital and e*uity capital.
E3rofitabilityE refers to profits in the long run, rather than in the current *uarter or year. Many current
e)penditure 4e.g., amounts spent on advertising or research and development5 reduce current profits but increase
profits over time.
&ome "#s stress only part of the profitability e*uation. Rac- 2elch, former "# of General lectric
"ompany, e)plicitly focused on revenueB he stated that General lectric should not be in any business in (hich
its sales revenues (ere not the largest or the second largest of any company in that business. !his does not imply
that 2elch neglected the other components
of the e*uationB rather, it suggests that in his mind there (as a close correlation bet(een mar-et share and
return on investment.
#ther "#s, ho(ever, emphasize revenues for a different reason: 1or them, company size is a goal. &uch a
priority can lead to problems. If e)penses are too high, the profit margin (ill not give shareholders a good
return on their investment. ven if the profit margin is satisfactory, the organization may still not earn a good
return if the investment is too large.
&ome "#s focus on profit either as a monetary amount or as a percentage of revenue. !his focus does not
recognize the simple fact that if additional profits are obtained by a greater than proportional increase in
investment, each dollar of investment has earned less.
+aximizing Shareholder
9alue
In the 8Q@7s and 8QQ7s the term shareholder value appeared fre*uently in the business literature. !his concept is
that the appropriate goal of a for0profit corporation is to ma)imize shareholder value. Although the meaning of
this term (as not al(ays clear, it probably refers to the mar-et price of the corporationMs stoc-. 2e believe,
ho(ever, that achieving satisfactory profit is a better (ay of stating a corporationMs goal, for t(o reasons.
1irst, Ema)imizingE implies that there is a (ay of finding the ma)imum amount that a company can earn. !his
is not the case. In deciding bet(een t(o courses of action, management usually selects the one it believes (ill
increase profitability the most. +ut management rarely, if ever, identifies all the possible alternatives and their
90
respective effects on profitability. 1urthermore, profit ma)imization re*uires that marginal costs and a demand
curve be calculated, and managers usually do not -no( (hat these are. If ma)imization (ere the goal, managers
(ould spend every (or-ing hour 4and many sleepless nights5 thin-ing about endless alternatives for increasing
profitabilityB life is generally considered to be too short to (arrant such an effort.
&econd, although optimizing shareholder value may be a major goal, it is by no means the only goal for most
organizations. "ertainly a business that does not earn a profit at least e*ual to its cost of capital is not doing its
jobB unless it does so, it cannot discharge any other responsibilities. +ut economic performance is not the sole
responsibility of a business, nor is shareholder value. Most managers (ant to behave ethically, and most feel an
obligation to other sta-eholders in the organization in addition to shareholders.
)ample: /enry 1ordMs operating philosophy (as satisfactory profit, not ma)imum profit. /e (rote let me
say right here that I do not believe that (e should ma-e such an a(ful profit on our cars. A reasonable
profit is right, but not too much. &o it has been my policy to force the price of the car do(n as fast as
production (ould permit, and give the benefits to the users and laborers0(ith resulting surprisingly
enormous benefits to ourselves.
+y rejecting the ma)imization concept, (e do not mean to *uestion the validity of certain obvious principles.
A course of action that decreases e)penses (ithout affecting another element, such as mar-et share, is sound. &o
is a course of action that increases e)penses (ith a greater than proportional increase in revenues, such as
e)panding the advertising budget. &o, too, are actions that increase profit (ith a less than proportional increase
in shareholder investment 4or, of course, (ith no such increase at all5, such as purchasing a cost0saving machine.
!hese principles assume, in all cases, that the course of action is ethical and consistent (ith the corporationMs
other goals.
An organizationMs pursuit of profitability is affected by managementMs (illingness to ta-e ris-s. !he degree of
ris-0ta-ing varies (ith the personalities of individual managers. Nevertheless there is al(ays an upper limitB
some organizations e)plicitly state that managementMs primary responsibility is to preserve the companyMs assets,
(ith profitability considered a secondary goal. !he Asian .financial crisis during 8QQJ08QQ@ is traceable, in large
part, to the fact that ban-s in AsiaMs emerging mar-ets made (hat appeared to be highly profitable loans (ithout
paying ade*uate attention to the level of ris- involved.
+ultiple Sta?eholder
6pproach
#rganizations participate in three mar-ets: the capital mar-et, the product mar-et, and the factor mar-et. A firm
raises funds in the capital mar-et, and the public stoc-holders are therefore an important constituency. !he firm
sells its goods and services in the product mar-et, and customers form a -ey constituency. It competes for
resources such as human capital and ra( materials in the factor mar-et and the prime constituencies are the
companyMs employees and suppliers and the various communities in (hich the resources and the companyMs
operations are located.
!he firm has a responsibility to all these multiple sta-eholders0shareholders, customers, employees, suppliers,
and communities. Ideally, its management control system should identify the goals for each of these groups and
develop scorecards to trac- performance.
Example: In 677?, the Acer Group, head*uartered in !ai(an, (as one of the largest computer companies
!he "ompany subscribed to the multiple sta-eholder approach and managed its internal operations to
satisfy the needs of several constituencies. !o *uote &tan M&hih,0the founder, E!he customer is number 8,
the employee is number 6, the shareholder is number ;. I -eep this message consistent (ith all my
colleagues. I even consider the companyMs ban-s, suppliers, and others (e do business (ith are our
sta-eholdersB even society is sta-eholder. I do my best to run the company that (ay.E
%incoln lectric "ompany is (ell -no(n for its philosophy that employee satisfaction (as more important
than shareholder value. Rames %incoln (rote: E!he last group to be considered is the stoc-holders (ho o(n
stoc- because they thin- it (ill be more profitable than investing more in any other (ay. !he absentee
stoc-holder is notM of any value to the customer or to the (or-er, since he has no -no(ledge of nor interest in the
company other than greater dividends and advance in the price of his stoc-.E .onald 1. /astings, chairman and
chief e)ecutive officer, emphasized that this (as still the companyMs philosophy in 8QQJ.
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Explain and illustrate with one example differences (etween " forms of internal audit
Financial@ >perational E +anagement.
Financial 6udit
1inancial Audit is a historically oriented, independent evaluation performed by internal auditor or e)ternal
auditor for the purpose of attesting to the fairness, accuracy and reliability of the financial data, providing
protection for the entityMs assetsB evaluating the ade*uacy and accomplishment of the system 4internal control5
designed, provide for the aforementioned 1airness and 3rotection, 1inancial data, (hile not being the only
source of evidence, are the primary evidential source. !he evaluation is performed on a planned basis rather
than a re*uestE.
)nstitute of )nternal 6uditor:2
1inancial audit ta-es 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 (hether documentation and flo( of activities arc in conformity (ith the internal control system
introduced and developed (ithin the organization. It helps coordinating (ith statutory auditor to help them in
proper discharge of their function. +esides, financial audit also ensures compliance (ith statutory la(s
especially in financial and accounting matters.
>(Lecti'es of Financial 6udit:
!o see that established accounting systems and
procedures have been complied (ith
!o see that proper records have been maintained for
the fi)ed assets of the "oncern to loo- into correctness of the financial data and records along (ith
correctness of the accounting procedure follo(ed.
!o see (hether scrap, salvage and surplus materials have been properly accounted for etc.
!o see that internal control system has been (or-ing properly.
!o see that any abrupt variation in sales, purchases etc.B (ith respect to immediate previous year are not
due to any irregularity
!o see that the credit control has been strictly follo(ed.
!o see that all payments have been made (ith proper authorization and approval. .
!o see that preparation of salary and (age pay roll has been properly done.
!he opinion e)pressed 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.
+anagement 6udit
It is a comple) tas- closely related (ith the process of management. It is highly result oriented. It re*uires
interDmulti0disciplinary approach as it involves e)amination, revie( and appraisal of various policies and actions
of management on the basis of certain normsDstandards.
It underta-es comprehensive and critical revie( of all organizational activities (ith (ider perspective.
It goes beyond conventional audit and audits the efficacy of the management itself.
.efinition:
ItMs a comprehensive and constructive e)amination of an organization, the structure of a company, institution
92
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 .. 7eonard
ItMs an investigation of a business from the higher level do(n(ards in order to ascertain (hether sound
management prevails throughout, thus facilitating the most effective relationship (ith the outside (orld and
the most efficient and smooth running internally.
7eslie Aoward
It is an audit performed (ith the object of e)amining the efficacy of the institutionDcontrol systems,
management procedures to(ards the achievement of enterprise goals.
Churchill E 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 e)isting and
potential management (ea-nesses (ithin an organization and to recommend (ays to rectify these
(ea-nesses.
Chartered )nstitute of +anagement 6ccountants 7ondon
!hus it can be seen that management audit is an e)amination, revie( 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.
>(Lecti'es
!o 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.
!o reveal defects or irregularities in any of the elements e)amined and to indicate (hat improvements
are possible to obtain the best results of the operations of the company.
!o assist the management to achieve the most efficient administration of its operations.
!o suggest to the management the (ays and means to achieve the objectives if the management of the
organization itself lac-s the -no(ledge of efficient management.
It aims to achieve the efficiency of management and assess the strength and (ea-nesses of the
organization structure, its management team and its corporate culture.
!o 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.
!o reveal defects or irregularities in any of the elements e)amined and to indicate (hat
improvements are possible to obtain the best results of the operations of the company.
!o assist the management to achieve the most efficient administration of its operations.
!o suggest to the management the (ays and means to achieve the objectives if the
management of the organization itself lac-s the -no(ledge of efficient management.
It aims to achieve the efficiency of management and assess the strength and (ea-nesses of the organization
structure, its management team and its corporate culture.
!o help the management at all levels in the effective and efficient discharge of their duties and
93
responsibilities.
!he auditor must apprise managerial performance at all levels of the organization. !he audit starts right at
the top level of the management. It studies the managerial performance at all the levels of management. !he
audit has to study the decision0ma-ing system of the organization and also the level of autonomy granted to the
managers at different levels of the organization. !he authority and responsibility given at the different levels of
the management. #ne of the most important things that the audit must study is that the mangers at various levels
use the authority.
Conducting +anagement 6udit
Management audit re*uires an interdisciplinary approach since it involves a revie( of all aspects of
management functions. It has to be conducted by a team of e)perts because this re*uires ; varieties of s-ills,
(hich one individual may not possess.
!he team may consist of management e)perts, accountants, and the operation research specialists, the
industry e)perts and even social scientists.
!he auditors must have analytical mind and ability to loo- at a management function form the point of vie(
of the organization as a (hole. !hey therefore have to be properly trained in this aspect. !hey need to have
through -no(ledge of the management science and they should be ac*uainted (ith the salient features of various
functional areas.
Inder financial audit, the entire emphasis is on macro0aspect, the individual transactions being0 scrutinized
for chec- of the aggregates. It is concerned (ith e)amination of transactions recorded in the boo-s of account. It
revie(s the procedure and internal chec-s, and scrutinizes individual transactions for the purpose of verification,
of 3rofit and %oss Account and +alance &heet. 1inancial audit is not concerned (ith W avoidance of profiteering
motive. It indicates the financial position and overW performance of the business, regardless of its performance in
various segments. 1inancial audit is applicable to all classes of companies and industries irrespective of size and
.an of operations.
Instead of serving the interest of the management and the Government, it serves interest of shareholders.
1inancial audit is organization 0 oriented. It is conducted under &ections 66> 0 6;6 of the "ompanies Act 8Q?J.
Financial 6udit +anagement 6udit
It is concerned (ith financial aspects of
business transactions of the year under
audit
It is concerned (ith the revie( of the past
3erformance to ascertain (hether it is in tune (ith the
objectives, policies and procedures of the enterprise.
!he auditor e)amines the past financial
records to report his opinion on the truth
and fairness of the representations made in the financial
statements. )amination of the performance of the
management is
beyond his scope
!he management auditor reports on performance of the
management during a particular period and suggest (ays
to remedy the deficiencies, including modification of
objectives, policies etc.
3ast year M41inancial5 transactions are
"overed nterprises such as companies, trust and societies
etc.
No limit as to the period to be covered
1inancial audit is compulsory in the case of certain
enterprises such as companies, trust and societies etc.
!here is legal compulsion as regards management audit.
!he auditor reports to the o(ner, i.e.
shareholders in the "ase of a company
!he auditor reports to the management
94
Explain (riefly 'arious 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. !hese communications aim to(ards attaining the
organizationMs goals. +ut individual managers have their personal goals also. 1or e)ample, a young manager (ith
good education, e)perience, personality and social bac-ground joins a company li-e +ritannia Industries or
$eliance. !he company finds him fit for the position as per job specifications, appoints him and ma-es him
a(are of (hat the company e)pects of him. !he young manager sets his goals of gaining rich e)perience for his
career progress besides ade*uate compensation pac-ages. Naturally, his actions (ill be directed to(ards
achieving his o(n objectives and goals (hile serving the company. !hus, his self0interest and the best interest of
the organization are apparently in conflict. +ut the best results can be achieved by perfectly matching the t(o
interests and this is called Mgoal congruenceM.
It is *uite apparent that perfect congruence bet(een the goals of the individual and the organization individualMs
goals and the organizationMs goals can never happen. 'et, the main purpose of a management control system is to
assure goal congruence bet(een the interest of the individual and the organization as far as practicable.
Formal and )nformal Communication
As mentioned earlier, all the communication of information may be either formal or informal. !he formal
communication system involves strategic plan, budgets, standards and reports (hereas the informal
communication is made through letters and memos, verbally or even by facial e)pression.
1ormal communications are all documented and addressed to the responsible managers for their information and
actions, if necessary. /o(ever, the actions depend on the perception of the individual managers.
Informal communication$ on the other hand, relates to some e)ternal factors0(or- ethics, management style and
culture. Added to these factors is the e)istence of an informal organization (ithin the structured formal
organization.
Informality refers to the rela)ation of sharp differentiation and e)plicit description of behavior as indicated
in the hierarchy and thereby, moving a(ay from superiorDsubordinate relationship. /o(ever, such relations
depend on the personal capabilities of the manager such as education, e)perience, e)pertise, trust and
cooperation. 1or e)ample, Accounts Manager of Nasi- 3lant 4see the organization chart in the diagram ;.65
reports to the General Manager of the 3lant. 2hile visiting the "orporate #ffice for attending a !raining "ourse,
he meets other colleagues, parallel officers and even the 1inance .irector. !he latter communicates some
important matter to him verbally and (ants 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 o(n
perception of the situation, and he mayor may not report to the General Manager.
Wor? Ethics@ +anagement Style and Culture
95
)ternal factors li-e (or- ethics vary from place to place. !herefore, organization (or- culture depends on
the general behavior of the people in the society (here the organization situates. 2or- culture generally differs
because of the life style and the attitude to(ards the (or-. 1or e)ample, people of Mumbai lead very fast life.
!ime has more value at Mumbai as compared to Tol-ata, (here people ta-e things easily and leisurely. Rapanese
and Torean people have reputation for their e)cellent (or- culture.
/o(ever, the most important internal factor is the organizationMs culture and climate. !he culture refers to
the set of common beliefs, attitudes, norms, relationships and assumptions that are e)plicitly or implicitly
accepted and evidenced throughout the organization. !he (riter joined Inion "arbide as an Assistant just three
days before "hristmas ve. #n the very second day, (hen he attended "hristmas lunch, his table (as shared by
none other than the General &ales Manager .r. 2.$. "orrea. /e -ept us amused (ith various stories of his recent
tour abroad and recited Irdu MshairiesM, even sharing jo-es. &uch a situation (as unthin-able in Ressop V "o.,
(here sharp differences (ere maintained at every level of hierarchy.
+anagement control systems
"limate is used to designate the *uality of the internal environment that conditions the *uality of
cooperation, the development of individuals, the e)tent of membersM dedication or commitment to organizational
purpose and the efficiency (ith (hich that purpose is translated into results. "limate is the atmosphere in (hich
individuals (or- help, judge, and re(ard, constrain and find out about each other. It influences moral0the attitude
of the individual to(ards hisDher (or- and environment.
"ulture differs bet(een the organizations, but cultural norms are e)tremely important. !hey are not (ritten
li-e formal communication. +ut the e)istence of a good culture can be felt from the behavior of the members of
the organization. #nce the (riter landed up (ith his family at /yderabad in the early morning to discover that
nobody had come to receive them at the station. /is visit (as arranged through non other than the .irector of the
company himself. /is unit being ne(, telephone directory did not include any number of his unit, but the parent
organizationMs telephone number (as located. 2hen an e)ecutive of the parent company (as contacted, he
immediately sent an officer of the company (ith a car to pic- us up to their Guest /ouse, entertain (ith coffee
and then put up in a /otel. 2hat subse*uently happened is a different matter, but the attitude and treatment of
that member of organization spea- volumes about their e)cellent culture.
In any organization, the culture remains unchanged as long as the "hief )ecutive remains in position.
2hen a ne( e)ecutive replaces him, there is li-elihood of some change in the culture, unless the ne( "hief
follo(s the footsteps of his predecessor and maintains it. Generally, if higher positions are filled in through
promotion of internal e)ecutives, the culture remains unchanged and the traditions are maintained.
!he other important internal factor (hich influences management control system is management style0that
is the attitude of the superior to his subordinates and the latterMs reaction through their perception of the attitude
of their superiors. Again, the attitude ultimately stems from the temperament of the "hief )ecutive, (ho
controls the entire organization. !hat is (hy $. 2. merson said Ean institute is the lengthened shado( of a
manE.

)mportance of )nformal Communication
An organization indulges in informal control process (hen encountering non0routine decision0ma-ing or (hen
see-ing ne( information to increase understanding of some problem areas. .uring a very critical period in an
organization, the (riter found that the "hief )ecutive used to call managers informally at his residence or club
to e)tract information in a rela)ed manner rather than in a tense situation prevailing in the factory.
Formal Control .rocess
96
1ormal communication system is structured as per the Mhierarchy outlined in the organization chart. !he system
has the follo(ing four components:
4a5 Strategic lan and rogramme
!he foundation of management control process lies in the organizationMs goals and its strategies for
attaining these goals. A strategic plan is prepared in order to implement the strategies, after carefully considering
opportunities and threats in the e)ternal environment as (ell as the strengths and (ea-nesses in the internal
environment. !hus, a strategic plan and programme is prepared as a guideline to budgeting.
4b5 .udgeting
!he strategic plan is converted to an annual budget incorporating planned e)penditure and revenues for
individual responsibility centers. )penses and revenues are mar-ed for each responsibility centre period (ise,
say monthly, *uarterly, half yearly, and annually.
4c5 #perations and Measurement
$esponsibility centers operate (ithin the frame(or- of the budget, established standards, standing instructions,
practices and operating procedures embodied in MrulesM, and MmanualsM. !hus, besides budget, the responsibility
centers are also guided by a large number of rules. !hey record the resources actually used and revenue earned.
!hey also classify the data by programmes as (ell as by responsibility centers for performance measurement.
4d5 6eporting
Actual performance is analyzed, measured and reported against plan, indicating variances and highlighting areas
of (ea-nesses. If the performance is satisfactory, feedbac- information is sent to the responsibility centre
concerned for praise or re(ard. If the same is unsatisfactory feedbac- communication is sent to the responsibility
centre concerned for corrective action. If such action re*uires to be included in the budget, then the latter is
revised to give effect to the changed position. If re*uired, then the plan itself can be revised and a ne( basis of
control may be established.
!he aforesaid formal control process has been presented in the follo(ing diagram:
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