MANAGEMENT CONTROL SYSTEM

An Integrated Framework to drive an organization on a Growth track.
Recommended Text Book : ―Management Control Systems‖ Robert Anthony & Vijay Govindrajan (11th /12th Edition.)
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strategy formation process in a firm

Internal Analysis Technology/Marketing/ Manuf./Supply Chain

Environmental Analysis Competitor/Customer/ Supplier/Laws/Political

S.W O.T. K.S.F.

―Strategy‖
Strategy implementation process
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Why Management control in an organization
Ambitious Growth plan

Well planned & controlled strategy execution
Achieve sustainability & inorganic growth in a competitive market place.

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monitoring and controlling of the financial resources committed for execution of growth strategy by management to ensure that management achieves the desired out put.Management control is a process of evaluating. 4 .

however. Policies Implementation of Strategies Performance of specific Tasks • Management control does not necessarily require that all actions are as per the previously determined Plan. It. requires inducing people to act in pursuit of own goals in ways that organization’s goal are also met: Goal Congruence.Management Control Focuses primarily on Strategy Implementation. Strategy Formulation Management Control Task Control Goals. 5 . Strategies.

Cybernetic framework for management control.
External & Internal Decision Maker environment To which organization has to respond Sensors

Goal ( Desired
Result)

Perception
(Actual result )

Comparator

Effectors

Behavior Choice
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Conceptual model of Management Control Systems.
Control Device
Detector: Assessor:

Effector: Behaviour Alteration, if needed.

Controlled Entity

Desired performance by the management

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Building blocks for
Management Control System
(Financial ) Controls Organization Structure Culture H. R. Practices

Performance

• Org. Structure specifies creating roles, reporting relationships, responsibilities that shape decision making; • Culture refers to the set of common beliefs, attitudes that guide management actions; • HR Management drives performance related career progression , compensation which enable people to execute strategy more efficiently.
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Strategy

Measure organizational performance using financial & non financial parameters. ( Balance Score Card .Build control measures on critical resources( Financial control) for sustained growth 3.) 9 .Build a culture of shared vision.Management control Objective : 1. ( Goal congruence ) 2.

McKinsey 7-S Framework to support control system Of an organization. STRUCTURE STRATEGY SHARED VALUES SKILLS STYLE SYSTEMS STAFF 10 .

Internal Control process “A process effected by an entity‟s board of directors. designed to provide reasonable assurance regarding the achievements of objectives in the following categories:  Effectiveness & efficiency of operations.  Compliance with applicable laws and regulations. management and other personnel.  Reliability of financial reporting.‖ 11 .

 It can help ensure compliance with laws. It can help an entity get to where it wants to go. 12 .( Financial Guideline )  It can help prevent loss of resources.Objective of Internal Control :  It can help achieve performance & profitability targets.  It can help ensure reliable financial reporting. ( Goal ) and avoid pitfalls and surprises along the way.

 Internal control can be expected to provide only reasonable assurance. but people at every level of an organization. It is a means to an end. Internal control is a process. not an end in itself. not absolute assurance. It’s not merely policy manuals and forms.  Internal control is effected by people.  Internal control is geared to the achievement of objectives in one or more separate but overlapping categories. to an entity’s management and board. 13 .

 Define Risk Assessment process .  Create Control Activities. profit . ( Control deviation at cost . 14 . productivity ) Management Information system should form the back bone of internal control process to build decision support at management decision stage. how )  Monitoring. investment . when . expense .  ( Who .Steps for Internal Control  Create Control Environment. process defects .

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ethical values and competence of the people.Control Environment  Sets the tone of the organization.the way management assigns authority and responsibility and organizes and develops its people. and the attention and direction provided by the board of directors.  The foundation for all other components.  Reflects management‘s philosophy & operating style. 16 .  It includes the integrity.

Risk Assessment  Every entity faces internal &external risks.  Every entity sets objectives.  Risk assessment is the identification and analysis of relevant risks to achievements of the objectives. 17 .

18 .  They include activities such as approvals .reconciliations and segregation of duties.Control Activities  The policies and procedures that help ensure management directives are carried out.  Control activities occur throughout the entity at all levels and in all functions. authorization.  They help ensure that necessary actions are taken to address risks.

Information & Communication  Relevant information must be identified .  Effective communication must occur in a broader sense. captured and communicated in a form & timeframe that enables people to carry out their responsibilities. 19 .  Information systems produce reports containing operational.across and up the organization.flowing down.financial and compliance –related information that make it possible to run and control the business.

20 .  Types of monitoring: .evaluation for which the scope and frequency will depend primarily on an assessment of risks and the effectiveness of ongoing monitoring procedures. .ongoing during the course of operations.Monitoring  Internal control systems need to be monitored.

can provide only reasonable assurance to management regarding achievements of an entity‘s objectives.no matter how well designed and operated.Internal controls . 21 .

When MV is in excess of invested capital . All management action & strategies are guided by SVC . shareholder's value . MVA is said to be positive . 22 . Hence firm is said to have created value for its shareholder. Shareholder Value Creation can be explained as excess of market value over book value.Management of an organization is responsible for creating wealth for it‘s shareholders.

Market value per share = Market value of equity Number of shares outstanding Book value per share = Invested equity capital Number of shares outstanding 23 .

“Rules” •Task Control •Safeguards Periodic Review Management decision “Reward” Y Strategic Planning Budgeting Resp Center Performance Reports: “A vs P” Analysis/ Actions OK? Revision Measurement N 24 . An idea or strategy is more glamorous and sexy compared to actual execution.Formal Management Process. When not executed well it just remain as a great idea. Goals & Strategies Other Info.

Budgets are integral part of management control system . When administered systematically .Budgeting & Budgetary Control. •Budget estimates the profit potential of a BU . 25 . budgets Promote Coordination & communication among sub units with the company. •Provides framework for judging the performance •Creates motivation & involvement within managers .

•Revenue budget 26 .It provides monetary & non monetary indicators to the managers for effective decision making in line with the goal of the BU. It is reviewed periodically by the concern managers for necessary action & strategy. It forms the basis for Financial budgets like : •Capital expenditure budget • Budgeted balance sheet •Cash Budget & Budgeted cash flow statement .

it is desired that the budgets are made for peak & lean season. Once approved .An operating budgets is prepared for a fiscal year . or monthly for easy administration & control. Budgets are compared with the actual financial performance achieved during the period for taking necessary financial control. 27 . It is split in to half yearly. it is only changed under specific conditions. quarterly. If the business is highly driven by seasonality .

Marketing . Distribution . Manufacturing overhead COG Sold Budget R&D .Revenue Budget Inventory Budget Production Budget Direct Manufacturing labor. Material cost . Customer Service Administrative cost Budgeted Income Statement Financial Capital Budget Cash Budget Budgeted cash flow 28 .

which is used for planning capital expenditure budget . Outcome of operation budgets is budgeted income statement for the fiscal year. The decision of the organization as how much to source fund ( Source of fund : External equity .Preparation of master budgets : operation Budget. Cash budget is prepared from this statement . Cash flow statement & budgeted balance sheet . Debt. created after taking & having debated sufficiently with the line managers & functional managers are used for preparing master budget . 29 . Reserve fund ) for capital expenditure can only be known form budgeted income statement .

Operational budgets include : I. an in accurate sales forecast leads to upset the budget plan of the BU. non financial budgets etc. BU finance head reports the variation in plan Versus actual to the profit center head for necessary action. Action : Revise overhead budgets . 30 . Control : Measured periodically by revenue center head ( Sales & Marketing Head ) . Revenue budgets : Projected Sales Projected volume ( Non Financial ) FY08-09 Product 1 Product 2 Vol Av selling price Revenue X Y XxY A B AxB ___________________________ Total Since input for revenue budgets is drawn form sales forecast.

It provides a good understanding of the effectiveness of the account receivable collection policies and staff in charge of executing on those policies. 31 . DSO reveals how many days worth of sales are outstanding and unpaid within a specific period.” DSO delinquent balances should not exceed 33% of the selling terms.Days Sales Outstanding (DSO) is the number of days it takes to collect your receivables in a given amount of time. Less the money that is being tied up in accounts receivable. If terms are 30 days. the more money that can be used for company investment or dividends.( credit term) Having a high DSO is harmful for the business . It is an important financial indicator as it shows both the age of a company‘s accounts receivable and the average time it takes to turn those receivables into cash. then an acceptable DSO or the “Safe Collection Period” is 40 days. As a “Rule of Thumb.

Total Receivables.365 days 32 .90 days Bi-Annually (6 months).000/90.00.The most common method is to take the Total Receivables divided by the Total Credit Sales multiplied by Days in Sales.000 Days In Sales = 90 for a quarter for the quarter DSO= (50. Example: Total Receivables = 50.The number should only include only credit sales.00.00.000) x 90 = 50 Total Credit Sales.180 days Annually (1 year).000 Total Credit Sales = 90.The total receivables in the Days Days in Sales.00.Is a period in time as defined by the following: Quarterly (3 months).

The days payable outstanding formula is a financial ratio and is calculated by taking the accounts payable divided by the cost of sales and then multiply that number by the total number of days. 33 . DPO is calculated on a quarterly and yearly basis.The Days Payable Outstanding (DPO) calculates the total time it takes a business to pay back its creditors.

34 . Dell leveraged on internet to transform its business online . Average DSO ( annualized ) for Dell in 2007 was 10 days .430/47. ( calculated annually ) Calculate the days payables outstanding (DPO) for Dell ? (10. In B2B business. Dell’s supply chain practice ensured 90 days credit from all vendors as a corporate policy. it operated on 15 days credit sales.430 (number in millions) and the cost of sales was 47.Why was Dell Computers so cash rich? In 2007 Dell's accounts payable was 10.433.433) * 365 = 80. This means that it takes Dell roughly 80 days to pay back its creditors. As a result 100% of it B2C transactions were through online payment .25.

The calculation of the days’ sales in inventory is: the number of days in a year (365 or 360 days) divided by the inventory turnover ratio. Generally. It can also be interpreted as the number of days of sales that was held in inventory during the specified year. 35 .Days Sales Of Inventory . if applicable) into sales. the lower the DSI the better. The average DSI varies from one industry to another.DSI A financial measure of a company's performance that gives an idea of how long it takes a company to turn its inventory (including goods that are work in progress. How is DSI calculated: DSI = Inventory Cost of Sales X 365 The days’ sales in inventory tells you the average number of days that it took to sell the average inventory held during the specified one-year period.

Ratios are most powerful tool financial analysis & control. It provides basis to investigate such issues in micro detail. •It helps to know the division‘s ability to meet current obligation. •Firms ability to use long term solvency borrowing funds. 36 . •Efficiency with which the firm is utilizing it‘s asset in generating sales revenue •Overall operating efficiency & performance of the firm. managers must do trend analysis & competitive analysis before arriving at any conclusion. Control role of ratios: Ratio analysis raise pertinent questions on a number of managerial issues. To prevent from being misled by ratio .

Asset utilization : How effectively the company utilize the assets in generating sales.given the competitive environment & operating efficiency.What mangers should focus while using Ratios : Profitability analysis : Is return on equity due to ROI . Are the levels of debtors & inventories relative to sales acceptable . 37 . What is the trend of profitability & compare it with like market factors . Financing mix or capitalization for reserves. Is it improving because of better utilization of resources or curtailment of expenses.

the managers may use : Liquidity ratio Leverage ratio Activity Ratio Profitability ratio 38 . What is the desired mix of debt & equity . given the nature of the business. Accordingly .Liquidity analysis : What is the level of CA relative to CL . How fast it converts it current asset in to cash. Is it acceptable .

39 . a deviation statement ( flexible budget statement ) is prepared & reported to the concern managers. This also forms a basis for variable compensation component of the managers & his team popular in industry as MPLC. Management by Exception is the practice of concentrating on areas not operating as expected. Budgeted revenue & budgeted costs are compared against the actual in the same budget period. On the basis of this.Flexible budgets must help the mangers to evaluate & control variances in price & efficiency with respect to cost measures. Information gained out of variances are used for reallocating resources & seek manager explanation for early correction.

000 units. At the end of the month sale is 10000.If budgeted selling price is Rs 1200 /unit & budgeted variable costs are Rs 880 & budgeted Fixed costs are 2. the variance analysis can be as follows: Direct Material cost = Rs 600/unit Direct labour = Rs 160/ unit Overhead = Rs 120 /unit 40 .000. for planned volume of 12.60.

000 income .01.000U 3.000 3.4 L 27.40.50.20.000 Total 95.000U 1.05.4 L 88.8L 41 Units sold Revenue 1.000 operating 1.60.01.00.25.44 Cr 60.16.00.000F 19.2 L 12.20.000 Cont 29.000U 2.000 2.80.00.00.91.00.00.00.01.00.60.000 6.000 17.000 12.000U 1.000 32.000 F 14.Sales.000 0 6.000F 2.000 Margin Fixed cost 28.16.40.05.99.000 24.40.000 U 7. flexible Sales –Vol Static budget Variance budget ___________________________________________________________ 10000 0 10000 2000U 12000 Actual Variance 5.Volume Variance analysis report for Q1 – April 2008 .00.60.000 D-M-L 19.000U 1.05.80.000U 38.000 Dir Mat 62.000U 27.000U 2.000F 1.000 4.00.40.000 U 90.6 L 10.000 Mfg O/H 13.49.000F 72 L 16.

he feels division should operate more efficiently & eliminate operating inefficiency. The division is operating at sustained current ratio of 2. It‟s Current liabilities: Rs 96000 Current asset 1 Inventories Rs 48000 II Cash Rs 16000 Average inventory carried by the division : Rs 1.40. While there is much scope to increase the price .000 & its gross profit margin is 15% . BUH has a guideline for maximizing he profit . 42 .5 . You have been asked to analyze & prepare a financial report .000 & competitive analysis by ETIG shows that average collection period for cement business is 60 days .The total sales of cement division of India Cement is Rs 6.000 Inventory turnover : 5 Opening balance of debtors is 80.20.

Inventory turn over = Average collection Period = COG Sold / Av Inventory (Av Debtors / Credit sales )x 365 Av debtors = (OP Debtor + Cl Debtors) / 2 For closing balance of debtor . Less Inventory & Cash 43 . find Current asset .

• Management control is the process by which managers at all levels ensure their team align themselves to the goal of the BU. 44 . division or organization referred as ―Goal congruence or Goal alignment‖ • Challenges of building good control system are: • • Unlike the simpler systems. the standard is not pre-set . keep changing in dynamic market • Control requires coordination amongst individuals. • Much of control is self control. • The link between ‗need for action‘ and determining the action is not always clear.

organizing for control and generic responsibility and control devices in the behavioural context. Evaluation and start of next cycle of control. – The Process – how control is effected within organizations. 45 . Management planning & Control requires to be done in 3 areas. Budget preparation. – The Developments – variations to the theme of Control.  The Environment – focusing on the characteristics of organizations and individual behaviour. interactions. Execution & budgetary control. formal and informal. to effect control and systems: • • • • Strategic planning for goal setting.

Responsibility centres for Management Control 46 .

in contemporary Management Systems which leads to Responsibility Centres. cost effectiveness . 47 .Responsibility centres ―Decentralization‖. process efficiency & people effectiveness. “A Responsibility Centre is a business unit that is headed by a business head responsible for planning & controlling of its assets to meet organizational goal in terms of revenue & profit maximization . Responsibility canter enjoys high degree of autonomy in decision making process.

Effectiveness: is determined by the relationship between the responsibility centre‘s output and attainment of its objectives.e. ‗least sacrifice of resources for obtaining the required output‘. 48 . or the amount of output per unit of input.Objective of responsibility center incude planning & control of : Cost /Profit /Revenue : Monetary measure of the amount of resources used by a responsibility centre. i.e. Efficiency: which is the ratio of outputs to inputs. how well is the centre achieving its objectives. i.

Various responsibility centers have clear objectives and tasks to form supported by 'responsible budget' . 49 . The responsible budget is assessed through the 'responsibility accounting around each responsibility center. management responsibility is inseparable. the responsibility of units) called responsibility centers. To ensure the attainment of enterprise goals. enterprise operation and management is divided according to the needs of the various responsibility (ie. Responsibility accounting measure the results on the basis of predefined accounting norms & accountability of the management to ensure tight internal control system.Responsibility accounting system to establish an incentive mechanism To establish a scientific and rational enterprise level performance evaluation system.

it is likely that the Center's work below the level of quality and service business program requirements. not only related to the budget. is to the responsibility of the Center for the object. that is the center of all controllable costs. A cost center's controllable cost does not exceed cost estimates.Area of evaluation of Responsibility center is divided into Revenue center Expense centers. 50 . profit centers and investment centers. Assessment of revenue center would be on pre budgeted revenue plan for the business unit in line with the enterprise objective. but also quality of their work and service. The quality of work and service levels are difficult to quantify. Assessment of the the expense centers would be on pre budgeted cost (standard cost ) compared to actual expense thus to evaluate the performance of its cost control. The performance evaluation of cost centers. only show that cost control performance. with its scope of responsibility for the imputation of the cost. The so-called liability cost. but closely related expenses again.

but also short-term operational decision-making and certain investment decision-making power.Investment Center have autonomy in the formulation of not only the price. 51 .

Investment Center: Profit centres + Investment made in them. 52 . inputs monetary (as costs) 3. Profit Center: Inputs & Outputs monetary (as expenses & revenues) 4. Expense Center : Outputs non-monetary. inputs non-monetary ( MANAGER ACCOUTABLE FOR REVENUE OBJECTIVE ) 2.Types Responsibility Centres: 1. Revenue Center: Outputs in monetary terms.

profit earned .Revenue Centre ( Sales Department ) Traditional view Inputs not related to Outputs Input (money only for direct Costs incurred) Revenue Centre Output (money revenue) Contemporary view : Profit center : Since it‟s performance is measured on revenue generated.sales return . in effective recovery management Low customer retention 53 . Management control on : Cost of sale :. cost control.

54 . Management control through : Monitoring planned production targets Rejection cost Down time cost Low productivity ( Benchmark standard versus actual ) High production cost : Excess overtime.Expense Centres ( Manufacturing function) Optimal Relationship can be established Engineered Expense Centre Input (money) Output (physical) Planned expense on RM Inventory: Capital expenditure planned on long term assets.

g. R & D Function & other service function Optimal Relationship cannot be established Discretionary Expense Centre Input (money) Output (physical) Monitoring & Evaluation of asset is relatively difficult : Long gestation period . 55 .Expense Centres e. No direct correlation Cost allocation under common overhead .

so short-term control is difficult.. a proposed operating budget focuses on efficiently performing the task. There are two approaches: o Incremental Budgeting & o Zero-based Reviews. budget itself is the start of the financial control process.Expense Centres: Control Characteristics Budget Preparation:  For Engineered expense Centre. 56 . • Input Costs tend to be structural (semi-variable) in nature.  For discretionary expense Centre.

The performance of the department is judged in terms of the profit it booked and cost it incurred. 57 .Profit Centre A department /division in an organization responsible for generating specified quantum of profit form the activities it performs. ( Profit target ) In an organization all products / category are treated as independent profit centre. The divisional manager‟s performance are measured on the profit objective they achieve.

Profit & Investment Centre ( Independent BU) Inputs are related to Outputs Profit Centre Input (money as costs) Inputs are related to Capital Employed Investment Centre Output (money in profits) Input (money as costs) Output (money in profits) 58 .

• Delegating responsibility to ―profit centre‖ requires trade-offs between expenses & revenues. 59 . all organizations are ‗functionally‘ structured. therefore pre-requisites are: • relevant information for effecting the trade-offs • a device for measurement of effectiveness of decisions.Profit Centres: General Considerations •At operating levels. • Divisional managers are delegated the responsibilities of cost –benefit decisions .

better focus all around • increased profit orientation: consciousness & measurement. • >70% of multi-product Companies have adopted the “Profit Centre” format within the “BU” structure. • Focused HR practices & resource: specializations and training • specific information on performance of diverse resources • better service to target Customers & markets. 60 . with a focus on financial control as the primary method for strategy implementation.• Benefits of a Profit centre are: • Increased speed & quality of decision making • Greater delegation.

‗legal entity‘. Synergy & control trade-off imposes limitation on BU‘s autonomy • Product/Market independence/interdependence • Financing/company-structure issues • Share-holding. Brand-building. Systems 61 . • PR. • additional costs due to redundancies.Drawbacks of Profit Center •Less top management control at operational end •loss of cohesion within Organization: ―Sibling Rivalry‖ • increased short-term profit focus – unbalanced. tactical • poor and uncertain linkages between sub & overall optimization . Investments. Constraints on long-term issues: R&D. global fit etc. restructuring etc.

Real “Profit” of profit center for shaping Corporate structure “Direct” Profit 130 less “Controllable” Corp Charge 10 “Controllable” Profit less Corp. allocation 120 20 Profit before Taxes less Taxes 100 35 Profit After Taxes 65 Integrated form of “Profit” – highest level of responsibility. 220 90 Discretionary cost for shared services.Measurement of Profitability of profit center Income statement: Revenue 1000 less Cost of Sales ( Variable Cost) 780 Control-level Possibilities Most elementary form of “Profit” – with no control responsibility for “Fixed Costs”. Contribution Margin less Fixed Exp. 62 .

converted to Profit Centre by affixing a price to transfer (internal sale) goods. – Convenient when it has more than one “customer”. the „transfer price‟ mechanism is pragmatic tool.   Service & Support units: – service providing departments as profit centers to support „make/buy‟ decisions. – Allows for competitive functional excellence build-up through aggressive standard setting. 63 . – Allows for revenues (Outside Customers) if “world-class” levels of performance achieved.Profit Centres:  Project Manufacturing Function: – Usually. an expense centre: but for a more „balanced‟ approach (Quality. – Though imperfect.) and for aggressive standard setting. on-time delivery etc.

Human Behaviour & Management Control 64 .

65 .Organizational Behaviour & Management Control Human Behavior must create a favorable organizational climate for Management control to influence employees towards achieving a firm‘s Strategic Objective. Formal & informal organizational System: Strategy which radically influences Organization Structure and in turn. significantly affects design for Control System and its implementation is known as formal system .

Goal Congruence: Employees are led to take in their perceived self-interest in the interest of the firm:  Actions in the best interest of the Organization  Organization‟s Objective Measure through Well defined KPI Define KRA For Employee Define KRA For SBU SBU‟s financial & Non financial Performance Individual employee Performance through P.Formal organizational system for management Control.A system 66 .

“Work Ethic”: Norms of desirable behavior that exist in the society of which the Organization is a part of. Informal processes need to be recognized since they are loosely defined and are both intrinsic and extrinsic to an Organization. 67 .

– (Management) Style – Power distance & centers – Communication & Perceptions – Cooperation & Conflict: 68 .Intrinsic: – Organizational Culture: the set of common beliefs& values explicitly accepted.

69 .Concept of Transfer pricing for management control system.

– towards better goal congruence i.Transfer Pricing A business practice followed for satisfactorily profit accounting of the transfer of goods & services between profit centers in a Company.e. . designed system must support ‗better SBU profit & accountability 70 . Objective of TP practice are : – relevant trade-off between in-company costs and revenues for economic performance of individual profit centers.

71 . Maximize operating unit profitability Identify the areas of inefficiency Build value addition Facilitate & maximize de centralized decision making process Exercise effective management control. Encourage profit consciousness among managers Measure management performance.Benefit of T.P to the organization: Identify the unit contribution to the total profit.

i.P are Divisional mangers tend to become more divisional profit centric than corporate profit centric. or it can be non-market based.P is difficult .P policy . Whenever the market prices are not available to bench mark .Transfer price can be either Market-based. More often transfer pricing is non-market based.P 72 . equivalent to what is being charged in the outside market for similar goods. Prominent issues of T. De motivation arises when personal performance of a division gets affected due to improper T. the decision process of convincing the T. Lengthy disagreements on the T.e.

Top management of the company choose to follow the price for the product or service in accordance with the comparable market price information. ( Arm‘s length pricing policy ) Cost based TP. Full cost of the product is assessed upon calculating all variable & fixed cost . such practice is common in large enterprises. In a highly volatile market . 73 .P : Subunits are given the freedom & autonomy to negotiate the price in line with the ability to earn profit. It may use actual cost or budgeted cost & include markup ( margin ) as return on subunit‘s investment.There are three methods for determining T. It is determined on the basis of the cost of producing the product or service. ( when comparable price is not available ) Negotiated T.P Market based TP.

Transfer pricing is inherent in the way the global economy is structured with sourcing and consuming destinations being different. 74 . achieving an understanding .Transfer price and international business . are some of the challenges companies are facing as they become a global economic community. Nations have to achieve a fine balance between loss of revenues in the form of outflow of tax and making their country an attractive investment destination by giving flexibility in Transfer Pricing. suiting their conditions and pattern of international transactions. with numerous organizations operating in multiple countries and most importantly due to varying tax and other laws in different nations. countries will need to enact legislations on their own. As every country want to increase in total inflow through tax or FDI. Thus. according to the stage of economic development they are in.

causing transfer of economic resources to the related party at less than the comparable price raises issues such as : evasion/avoidance of tax liability . Transfer of resources to and from the related party should comply to arm’s length pricing policy.Issues related to transfer of economic resources in international business. 75 . Transfer pricing practices adopted in international business transaction by the companies could be a possible tool for evasion/avoidance of tax . proper disclosure and effective accountability. Any exception to this should be a subject matter of close scrutiny. A transfer pricing cases.

76 . A similar phenomenon exists in domestic markets where different states attract investment by under cutting Sales tax rates. leading to outflow from one state to another. The implication is moving of one nation‟s tax revenue to another.Transfer price manipulation (TPM) is fixing transfer price on non-market basis which generally results in saving the total quantum of organization‟s tax by shifting accounting profits from high tax to low tax jurisdictions.

MOTIVATIONS FOR TPM It is not just the Corporate Tax differential that induces organizations to manipulations in Transfer Pricing.

Some of the other reasons are:
• High Customs Duty – leading to under-invoicing of goods. • Restriction on Profit Repatriation – leading to over-invoicing of raw materials, etc transferred from parent country, hence compensating for locked forex. • Ownership Restrictions ( E.g. Insurance Sector – 26%) – since this leads to less than justified returns on the technology or knowledge invested in the JV, MNEs circumvent it through over charging on royalties for technology, etc. There can be various other similar motivations for TPM. The transactions most likely disputed by Governments are Administration & Management Fees, Royalties for intangibles and transfer of finished goods for resale. (Source: E & Y Survey)
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From a business perspective, following dimensions influence the decision to TPM , while doing transaction between two countries.
1. Payment of Compensation for services delivered in other country . 2. 2.Low cost of operation raw material in manufacturing country . 3. High Tax slab in operating country .

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Types of transactions between MNE‘s that come under the scope of TPM are :
1 Charges for administrative or management services . 2 Royalties and other charges for intangibles. 3 Transfer pricing for goods for resale. 4 Financing transactions. 5 Charges for technical services.
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2. where tax burden is less. 3. which becomes essential to meet expenditure requirements. Given the objective of maximization of global profits.Loss of Government Tax and Custom Duty revenues. TPM also leads to distortions in Balance of Payments between the host and home country. Another implication is on the location of international production and employment. 80 .EFFCECTS OF TPM ON NATIONS 1. Loss of tax revenues in this form leads to a burden on the rest of the population through over taxation and/or borrowings by the Government. MNEs will open subsidiaries where production is most profitable.

81 . AS-18 came in the effect for the accounting periods commencing on or after 1st April. in case of listed companies. and certain particulars of transactions with the related parties. The Standard provides for disclosure of related party relationships. (AS) – 18. 2001.CHECKING TRANSFER PRICING MANIPULATION Transfer price accounting transaction is an integral part of Accounting Standards.

Separate audit of record of transactions (related party) and expression of opinion thereon. The record of transactions in the prescribed format to form part of the audit report.Transfer Policy Statement (a comprehensive and detailed one). 1956. cost statement of each service (segment-wise and elements of cost) is Required to be given. 1.Under this rules. 2. Verification of the report on implementation on transfer pricing. The cost statement is also required to be submitted to the Audit Committee under Section 292A of the Companies Act. 82 . by the separate auditor. Disclosure in Directors’ Report/Annual Report: 3 .

) 5. therefore. would require to be re-disclosed in the Directors‘ Report.The aforesaid disclosure are to be given in the Director‘s Report along with those required under Accounting Standard –18 (disclosures as per AS – 18 form part of accounts and.Director‘s certificate of compliance on Transfer Pricing 83 .4.

have stated their acceptance of the arm’s-length standard for setting inter-company transfer prices and have set out guidelines for methods that should be used in adhering to the standard.operation & Development (OECD) world’s leading industrialized countries. 84 .Under an agreement of Organization for Economic Co. · The Policy States that a specific transfer pricing methods to be used for different classes of transactions with different parties with special emphasis on those transactions where a Comparable Uncontrolled Price/Transaction (CUP/CUT) method could not be adopted.

85 .

2 Divisions :Thomson Div Northern Div Southern Timber Div Div RM Custom made boxes & label.Birch paper company Case 6. Liner board & corrugated box 86 .

The variable cost incurred by division B is Rs 30 per unit. As B‟s competition dropped the price to Rs 180 .Division “A” manufactures certain item and transfers it to div “B” which in turn add value and sell it in open market at Rs 200 per unit. The competition of B meanwhile approached division A and were ready to pay Rs 115 for per unit. As a profit center head of Division A what decision would you take . “B” buys goods from A at Rs 120 per unit. At what TP will you sell items to division B ? 87 . Competition has assured to take 90% output of division A. sales and distribution overhead estimated is Rs 10 per unit . Division B wants division A to reduce the price to Rs 100 per unit. The cost details of Div A is as follows : Fixed cost : Rs 5 lac VC per unit Rs 15 Production capacity : 10000 units If div A decides to sell to B‟s competition .

000 6.000 65 ( if sells internally ) 115 Case 1 : If 90% output is sold to open market & 10 % internally (115 – 75 =45) Case 2 : If 100 % sold to division B at Rs 100.What action will you initiate from the point of view of SBU head to ensure the corporate objective is being met ? What TP methodology will you recommend.65 = 35 ) 88 .50.000 1 50 000 1.00.00. ( 100. ? Div A Fixed Cost = Rs VC = Sales O/H = Total Cost = unit cost = Market Price = 5.

000-4.40.000/10000 =6 Loss – difference 115 – 6 = Rs 109/unit 109 x 10000 = 10.90.000 Profit difference /unit on the basis of market price : 5.00.000 =60.00.Case 3 : Div A’s ability to earn profit = Rs 115 – 65 =50x 10000 = Rs 5.000 Less 65 x 10000 = 6.000 89 .50.000 Profit = 4.40.

00 Pipeline capacity to transport crude oil/day is 40. Variable cost is computed for each division & fixed costs are based on budgeted annual output of each division.000 barrels . Transport unit supplies crude oil to refinery unit.00 FC/barrel Rs 30. 90 .Illustration: Hindustan Petroleum‘s ( H.P) refinery & transportation unit operates as independent profit center. It takes two barrels of crude to convert one barrel of gasoline. Transportation Unit : Purchase cost of crude oil from oil field: Rs 120/barrel VC /barrel Rs 10. which is processed & transformed in to gasoline by refinery unit.

VC /barrel Rs 80. 91 . Using all three methods calculate TP.00 FC/barrel Rs 60. & compare the operating income of H.P Suggest what should be an appropriate managerial decision .00 Operating capacity /day = 30000 barrels ( Consumes an average of 10000barrels /day supplied by transport division & 20000 barrels /day bought from outside @ R210/barrel locally.Refinery Unit : Refinery unit‘s selling price is Rs 580/barrel.

600 @ Negotiated Price 19200 12000 1000 3000 3.Operating Income of HP with 100 barrels under alternative T.200 (120+10+30)x1.600 12000 1000 3000 1.C 30 x100 210X100=21000 120x100= 12000 1.1 Unit operating income Refining Unit Revenue(580 x 50) Transferred in cost VC FC Operating Income 29000 21000 4000 3000 29000 17600 4000 3000 4400 29000 19200 4000 3000 2800 92 1000 .000 3000 5000 @ full cost with 10% margin 17. @ Market Price Transport unit Revenue Purchase cost VC ( 10X100) F.P Methods.

it will have an impact on the operating income of transportation unit.When market price of crude oil fluctuates( upward or downward) . price . In such a given market situation. 93 . The price per barrel of crude oil drops to Rs 160. both division would like to negotiate an acceptable & stable long term TP.

1 Unit operating income Refining Unit Revenue(580 x 50) Transferred in cost VC FC Operating Income 29000 21000 4000 3000 29000 17600 4000 3000 4400 29000 19200 4000 3000 2800 94 1000 .Operating Income of HP with 100 barrels under alternative T. @ Market Price Transport unit Revenue Purchase cost VC ( 10X100) F.600 @ Negotiated Price 19200 12000 1000 3000 3.C 30 x100 210X100=21000 120x100= 12000 1.P Methods.000 3000 5000 @ full cost with 10% margin 17.600 12000 1000 3000 1.200 (120+10+30)x1.

which has the effect of valuing such transaction at arm‘s length price. having regard to the nature of transaction or class of transaction.Methods Of Computation T. namely :(1) Comparable Uncontrolled Price Method (2) Resale Price Method (3) Cost Plus Method (4) Profit Split Method (5) Transactional Net Margin Method (6) Any other basis approved by the Central Government. being the most appropriate method. 95 .P shall be determined by any of the following methods.

Comparable Uncontrolled Price (CUP) Method : ( Negotiated Transfer price. The adjusted price shall be taken as arm‘s length price. which could materially affect the price in the open market. between the related party transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions. 96 .) The price charged or paid in a comparable uncontrolled transaction or a number of such transactions shall be identified .

The resale price method would normally be adopted where the seller adds relatively little or no value to the product or where there is little or no value addition by the reseller prior to the resale of the finished products or other goods acquired from related parties. 97 . This method is often used when goods are transferred between related parties before sale to an independent party.

The total cost of production referred to above increased by the adjusted profit mark-up shall be taken as arm‘s length price. 98 . shall be determined. The amount of a normal gross profit mark-up to such costs arising from the transfer of same or similar goods or services by the enterprise or by an unrelated enterprise in a comparable uncontrolled transaction or a number of such transactions.Cost based Method : The total cost of production incurred by the enterprise in respect of goods transferred or services provided to a related party shall be determined.

The cost plus method would normally be adopted if CUP method or resale price method cannot be applied to a specific transaction or where goods are sold between associates at such stage where uncontrolled price is not available or where there are long term buy and supply arrangements or in the case of provision of services or contract manufacturing. 99 .

100 .Profit Split Method : The combined net profit of the related parties arising from a transaction in which they are engaged shall be determined. The residual net profit. thereafter. shall be split amongst the related parties in proportion to their relative contribution to the combined net profit. This combined net profit shall be partially allocated to each enterprise so as to provide it with a basic return appropriate for the type of transaction in which it is engaged with reference to market returns achieved for similar types transactions by independent enterprises.

assets employed or to be employed and risks assumed by each enterprise and on the basis of reliable market data which indicates how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances. The profit so apportioned shall be taken into account to arrive at an arm‘s length price . This method would normally be adopted in those transactions where integrated services are provided by more than one enterprise or in the case multiple inter-related transactions which cannot be separately evaluated. .This relative contribution of the related parties shall be evaluated on the basis of the function performed. 101 .

shall be computed having 102 . The net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions.Transactional Net Margin Method : The net profit margin realised by the enterprise from a related party transaction shall be computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base.

This method would normally be adopted in the case of transfer of semi finished goods.. and transaction involving provision of services. This net profit margin shall be adjusted to take into account the differences. which could materially affect such net profit margin in the open market . if any. between the related party transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions. 103 . distribution of finished products where resale price method cannot be adequately applied.regard to the same base.

90 (comparable internal cost ) 284.5 ( 254.5 is the potential market opportunity for Thomson division.284. 430. Using market price as a bench mark .4 .Northern Division Price : $480/ Th Thomson $430/Th West paper $432/Th Eire paper Cost material 280 cost ( 70%) Label 25 Other cost 95 Total cost $ 400 90 30 164. 104 . Thomson division can be much more competitive than the prevailing market price .5 = 145.5 Loading 20% margin on cost . if it is able shed the excess unproductive cost.

ACTIVITY BASED COSTING/ MANAGEMENT 105 .

(3) Customer-related activity costs are rarely isolated and directly charged to the specific customer segments causing these costs. service & customer diversity increased. (2) The in-direct product and non-base-service costs are usually allocated using broad averaging approach ( Peanut – Butter costing ) but not traced to respective products or base services . above approach proved to be inaccurate method of assigning . 106 .Traditional financial reporting does not reveal a separate profits and losses of products or customers for three reasons: (1) It examines and reports department-level expenses but not the work-efforts within a department that matter . As business units have been restructured in profit center & product .

selling. 107 .Today. this manufacturer could alter their own approach to lessen the loss so that a fair profit could be attained. For example. Upon discovering this. That alone is not unusual. merchandising. but it was losing money on half of its customers. it now costs General Motors more to sell its trucks and cars than to make them! A high-tech semiconductor manufacturer discovered that it was making roughly 90 percent of its profits from 10 percent of its customers. and distribution costs are no longer trivial costs—they are sizable.

108 . 3) Customer-related activity costs are rarely isolated and directly charged to the specific customer segments causing these costs.Traditional financial reporting does not reveal the separate profits and losses of products or customers for three reasons: 1) It examines and reports department-level expenses but not the work-efforts within a department that matter. 2) The in-direct product and non-base-service costs are usually allocated but not traced to products or base services.

the costs for selling. As selling. in financial accounting terms. a firm must allocate the expenses to the respective head to analyze the true profit generated by the product line. For General Motors it costs more to sell its trucks and cars than to 109 make them! . advertising. merchandising. marketing. and distribution costs are sizable.Therefore . warehousing. As an example. the accountants are not tasked to trace them to channels or customer segments. Consequently. and distribution are immediately charged to the ―time period‖ in which they occur. logistics.

As an example. Upon discovering this. a high-tech semiconductor manufacturer performed ABC/M and discovered it was making roughly 90 percent of its profits from 10 percent of its customers.‖ asked to take their business elsewhere because it was evident their was little hope their sales would cover their costs. Thus manufacturer‘s sales levels dipped. 110 . That alone is not unusual. this manufacturer explained to some of its unprofitable customers how those specific customers could alter their own behavior to lessen the workload on the manufacturer so that a fair profit could be attained. The remaining unprofitable customers were ―fired. but it was losing money on half of its customers. but profits tripled.

service lines.The lesson from this example is that there is a ―quality of profit‖ associated with sales volume and product mix. 111 . There is a red-flag warning from this: Two traditionally popular measures— market share and growth—can potentially be dangerous in the new order of competition. This is because organizations now realize that there can be a sizable unprofitable segment of products. There should be a focus on the customer contribution margin devoid of simplistic cost allocations. and customers in the mix.

5 = 407.Over costing Under costing Products Category Cost ( Rs) Selling sales Reverse packaging Total overhead promotion logistics 270 110 0 40 120 200 150 140 80 40 40 140 80 60 120 145 165 540 415 405 Lifebuy Liril Lux Dove Total 600 160 320 550 1630 Average 150 + 40 + 80 + 137. 112 . Liril‘s cost getting heavily subsidized by lifebouy.5 Cost allocation Cost analysis revels that average apportion of cost leads to cross subsidization.

4. Identify the direct & indirect cost associated to product . service .Profit center cost Management Peanut butter costing to Activity based costing Profit /Loss incurred in profit center 1. ( Cost Pool) 2. Identify total indirect costs associated to each base. Identify cost allocation bases for allocating indirect cost to cost base. 113 Revenue of a Profit center - Bill of Cost activities of profit center = . staff & cost involved in serving specific customer of the division. 3. Compute cost per unit of product or service.

Revenue of a Bill of Cost activities Profit center .of profit center ( Price X Volume ) Profit /Loss = incurred at profit center 114 .

of trips X Cold chain transport Cost Specialized material handling equipments hired 115 In Direct Cost Pool Bill of activities cost .Direct Costs Total Direct Costs + Cost Allocation Bases Total Hrs X Hrly production Rate no.

See Vision has been a pioneer in cosmetic contact lenses. The produce simple lens called S3 & cosmetic contact lens called CCL 5. Company has historically simple costing system . Annual production of lenses are as follows : 60000 S3 & 15000 CCL5 . As a practice , total material & manufacturing costs are divided by total budgeted production volume. Cost elements for : S3 ( Rs) Cost elements for CCL5 ( Rs) Material : 1,12,50,000 67,50,000 Manufacturing 60,00,000 19,50,000 Labour To allocate the following costs to S3 & CCL5 , company uses manufacturing labour- hour as an allocation base. Estimated manufacturing labour hour is 39750 Hrs. ( 30000 M-L –Hr for S3 & 9750 M-L-Hr for CCL5 )
116

Total budgeted cost for salary , Administration, Sales , distribution Customer service , promotion, adds to Rs 2,38,50,000. SeeVision‘s selling price for S3 is far more than that offered by its immediate rival‘s price of Rs 530. Management countered it by saying that the technology & process are inefficient in manufacturing & distribution. However management is not convinced as they have years of experience in S3 . They often make process improvement . Kaizan initiative is used to drive manufacturing process. However management has less experience in CCL5 as it started it recently . Management is surprised to know that the market finds its CCL5 prices fairly competitive. At its price point , organization earns large profit margin on CCL5. Ever since See Vision restructured it‘s business as profit center units, business managers of S3 are de motivated & has low morale. 117

Revenue breakup from S3 & CCLS5 is s follows : S3 Rs 3,78,00,000 & CCL5 Rs 2,05,50,000 Business unit head is less certain about the accuracy of the costing system & measuring the overhead resources used by each type of lens. The finance manager of the division has been empowered with any system of cost control to improve the profitability of the division. 1. As a finance manger of the division , how would you approach the issue. 2. What additional inputs are required by you to convince CFO & Business unit head. 3. At what operating margin is S3 currently doing their business.
118

000 19.00.000 100 labour Total 287.45.50.80.38.000 300.000 1.5 CCL5 Lens 15000 Units 67.000 Per unit 450 130 580 390 970 58.50.000/60000=300 For CCL5 :600 X 9750 = 58.52.000/ 39750= Rs 600 For S3 : 600 X 30000= 1.50.50.000 187.000/15000=390 119 .00.50.50.12.000 Indirect cost rate = 2.50.80.50.5 Indirect cost 1.000 587.5 Manufacturing 60.S3 Lens Volume : 60000 Units Per unit Material 1.00. Total cost 3.

05.000 970 25.000 630 2.S3 Lens ( 6000units) Revenue: Cost Operating Income Profit margin% CCL5 Lens ( 15000 units) per unit per unit 3.50.000 400 6.00.00.52.50.5 60.5 1.74 29.45.78.000 42.000 587.50.000 1370 3.19 120 .50.

cleaning time . Set up data for : S3 CCL5 Volume 60000 15000 Output/batch 240 50 No of batch 250 300 Setup time 2 hr 5hr Per batch Total Hr 500 1500 121 . like molding machines . Resources required for CCL5.Activity based costing approach for See Vision. Manufacturing labour hour has little effect on overhead resources . small batch production adds to more resources per setup. Identifying indirect cost pool : Set up activity at production for manufacturing each type of lens .

supervisors . (30.000 (30. & equipment used adds to Rs30.50.000/2000) x 1500= 22.00000/2000) x 500= 750. 122 . distribution cost .000 . quality engineers .00.Set up data for : S3 Volume 60000 Output/batch 240 No of batch 250 Setup time 2 hr Per batch Total Hr 500 CCL5 15000 50 300 5hr 1500 Total cost of set up comprises of cost of process engineers .00. administration cost .000 Other cost drivers identified having impact are packing & shipment cost .

50.000 22.000 390 22.00 & Maint Total dir cost 1.00.25.000 Per unit 450 130 100 680 31.000 150 18.000 12.5 Indirect cost Design 13.00.75.84.530 32.000 43.000 1.10.S3 Lens Volume : 60000 Units Per unit Material 1.05.470 27 87 41.000 125 4.50.5 Mold 45.000 75 Operation Shipping 4.24.7 1320.12.50.02.50.00.470 198.000 20.1 Total cost 2.5 Admin 19.000 19.000 6.00.05.50.000 6.000 15.000 13.530 499.50.7 Distribution 26.50.000 187.99.000 307.5 Setup 7.10.00.05.5 Manufacturing 60.8 CCL5 Lens 15000 Units 67.50.7 123 .000 100 labour Mold cleaning 12.89.

Investment center Decisions

124

ROI Problems
 Feed the Dogs

( Over Investment )  Starve the Stars ( Under Investment )
High STAR PROBLEM CHILD DOG Low
125

Relative Market Growth Low
High

CASH COW

Market Share

EVA Basic Premise Managers are obliged to create value for their investors . Investors invest money in a company because they expect returns . There level of return expected by the investors is called capital charge . Capital charge is the average equity return on equity markets; investors can achieve this return easily with diversified, long-term equity market investment . Thus creating less return (in the long run) than the capital charge is economically not acceptable (especially from shareholders perspective) Investors can also take their money away from the firm since they have other investment alternatives
126

The cost of equity needs to be factored into business investment decisions in order to enhance shareholder value. an income statement does not include a charge for the equity capital that was employed during the accounting period. 127 . However. Therefore. EVA goes beyond conventional accounting standards by including a provision for the cost of equity capital.EVA is the gain or loss that remains after assessing a charge for the cost of all types of capital employed. What an accountant calls profits in an income statement includes a charge for the debt capital employed which is commonly referred to as interest expense.

or an individual manager. EVA can be used as a performance measure to evaluate an overall company. a division within a company. its primary purpose is to shape management behavior. a location within a division. By setting goals. EVA can also be used in downsizing decisions.Although EVA is couched in financial analysis. EVA can become a motivational tool at various levels of management. 128 .

To this end. Therefore. Like quality. the EVA‟s popularity parallels the 1980s “total quality management” trend. When EVA-related performance measurement process is implemented throughout your company. value is every employee‟s responsibility. companies that pay for past performance may be unwittingly paying their managers to undermine value creation.EVA and Corporate Culture Paying managers for performance is a backward-looking practice. In this respect. as well as how their actions contribute to meeting it. management and employee training programs are a crucial component of any EVA plan. all affected employees need to understand the goal. but the capital markets assign value on a forwardlooking basis. 129 .

130 .

(ii) Weighted average cost of capital and (iii) Capital Employed. There are three factors to compute EVA. (i) Adjusted earning before interest after tax. 131 . The various factors affecting the EVA can be understood from the chart given . The chart helps the management in concentrating attention on different factors affecting value. It is clear from the above chart that top management can take appropriate decision to create value in the following way: •Deploy more and more funds to those activities where the amount of NOPAT generated by the activities is greater than the cost of capital.Economic Value Added represents value generating power of an organization. •A change in any of the three factors will change EVA.

•Optimize the capital structure through optimum debt equity mix in order to have the lowest possible weighted average cost of capital (WACC). •Improve the operating efficiency of the organization to retain the same amount of NOPAT by possible continuous reduction of existing capital or / and continuous increase of the existing NOPAT with existing amount of capital. 132 .•Withdraw fund from those activities wherein the amount of NOPAT is less than the amount of cost of capital unless there is strategic decision to lose in one activity in order to gain in another.

What is Needed to Calculate Company‘s Economic Value Added (EVA)? Only following the information is needed for a calculation of a company‘s EVA: •Company‘s Income Statement •Company‘s Balance Sheet 133 .

Illustration: Income Statement Net Sales 2.00 200.00 Add Interest 200.600.00 Other Operating Expenses 100.00 SG&A Expenses 400.00 NOPAT 410.00 134 .400.00 350.00 Net Profit After Taxes 210.00 140.00 Cost of Goods Sold 1.00 Operating income Interest : Income Before Tax Income Tax (40%) 550.00 Depreciation 150.

00 Equipment 410.00 Capital Stock 300.00 Other Long Term Assets 490.00 Retained Earnings 430.00 YTD Profit/Loss 210.00 Inventory 235.350.Illustration: Balance Sheet Current Assets Cash 50.00 Total current Assets 800.00 Total Long-Term Liabilities 760.00 Fixed Assets Land 650.00 Total Fixed Assets 1.00 Current Liabilities Accounts Payable Accrued Expenses Short-Term Debt 100.00 300.00 TOTAL LIABILITIES 2.00 135 .00 Capital (Common Equity) TOTAL ASSETS 2.550.00 Receivable 370.350.00 Total Equity Capital 940.00 Long-Term Liabilities Long-Term Debt 760.00 Other Current Assets 145.00 Non Interest Bearing Liabilities Total Current Liabilities 650.00 250.

+ CCREquity = Equity/(Debt+Equity) Capital Cost Rate (CCR) will be : Assume owners expect 13 % return* for using their money because less are not attractive to them.4) of equity with a cost of 13%.6 * 8% = 10% 136 . Company has also 60% debt and assume that it has to pay 8% interest for it.4 * 13% + 0. So the average capital costs would be: CCR ** = Average Equity proportion * Equity cost + Average Debt proportion * Debt cost = 40% * 13% + 60% * 8% = 0.CCRDebt = [Debt/(Debt+Equity)](1-t) Where t represents the company’s tax rate. company has 940/2350 =40% (or 0. therefore.

4) = 8. then CCR would be: CCR = 40% * 13% + 60% * 8% *(1. by adding the tax savings component later in the capital cost rate (CCR) 137 .08 % (Using 40 % tax rate) Companies paying high taxes and having high debts may have to consider tax savings effects.tax rate) = 0.6 * 8% * (1 .** Note: if tax savings from interests are included (as they should if).4 * 13% + 0.0.

00 ---------------------------------Capital : 2.00 Accrued Expenses 250.000.350. ] 138 .00 [ No interest cost incurred on these Liabilities.Identify Company’s Capital (C) Company’s Capital (C) are Total Liabilities less Non-Interest Bearing Liabilities: Total Liabilities 2.00 less Accounts Payable 100.

C * CCR = 410.00 * 0.000 = 67 Q2 Capital costs for 6 months: 6/12 * 10% * 2.then it‟s capital costs will be : Q1 Capital costs for 3 months: 3/12 * 10% * 2.00 This company created an EVA of 210. Note: this is the EVA calculation for one year.00 .000 = 100 Q3 Capital costs for 9 months: 9/12 * 10% * 2.2.000 = 50 Capital costs for 4 months: 4/12 * 10% * 2.10 = 210.000 = 150 139 . If a company calculates & reports EVA in its quarterly report .EVA = NOPAT .000.

. RF can be estimated using a yieldto-maturity rate for government bonds. The CCR for a small company can be estimated as follows: CCRDebt = Prime Rate + Bank Charges Where the average Bank Charges for small companies vary between one to two percent per year. 140 . In contrast. CCREquity can be estimated as follows: CCREquity = RF + RP Where RF is the risk free investment rate and RP is the risk premium investment rate.To estimate the cost of capital for a small company. a method derived from the WACC estimation and the CAPM( capital Asset Pricing ) model is called cost of capital cost rate CCR . RP reflects the risk resulting from investing in a company‟s equity. The riskier the investment. the higher the RP.

Moderate risk.General Guide line for RP 6 % and less Extremely low risk.18 % 141 . established profitable company with moderate fluctuation in cash flow 18 % and more High business risk 12 % .12 % Low risk. established profitable company with relative low fluctuation in cash flow. 6 % . established profitable company with extremely stable cash flows.

Income statement Balance Sheet 142 .

independent if they ask for short-term or long term debt.Cost of Capital Rate (CCR) Assume that the current Prime Rate is eight percent and that Pitt Products is paying one percent by borrowing new money. 143 .

4) + 12 % ´ (600/(600+600)) = 2.In this case.7% + 6% = 8. the pre-tax CCRDebt will be : CCRDebt = Prime Rate + Bank Charges = 8% + 1% = 9% Assume that the yield-to-maturity of 10-year government bonds is five percent. believe that RP of seven percent is adequate because its business . Pitt .7% 144 .0. CCREquity = RF + RP = 5% + 7% = 12% CCR = 9 % ´ (600/(600+600))(1. Products management.

4 = 248. Hence e NOPAT is NOPAT = (Net Profit after Tax + Total Adjustments) – Tax Savings on Adjustments = 192 + (42 +50) – (42 +50) x 0. on interest expenses can be estimated by multiplying the interest expenses by the tax rate. Because Pitt Product‟s income statement does not show categories. Tax shield. marketbuilding outlays. tax savings are lost. less the tax shield on interest expenses. employee training.Assume that in Pitt Product‟s case that all financing will be made using owner‟s equity.4 145 . such as Research & Development. there were no further adjustments needed. owner-managers stated that they regard approximately 50. In addition. no interest expenses will be incurred. However.000 of their salaries as a kind of compensation for their investment in the company. Therefore . or tax savings. unusual write-offs or gains.its profit will increase by the interest savings component. Thus. with this financing approach.

146 . Permanent EVA improvement has to be the main management objective •EVA has to be calculated periodically (at least every three months) •Changes in EVA have to be analyzed •EVA development is the basis for a company‘s financial and business policy •Try to improve returns with no or with only minimal capital investments .Calculation of EVA is must for internal reporting for all investment centers. machines able to cover •capital cost while avoiding investments with low returns •Identify where capital employment can be reduced •Identify where the returns are below the capital cost. divest those investments when improvements in returns are not feasible . •Invest new capital only in projects. equipment.

Employee retention risk. 4. when performance-based compensation may decrease through no fault of the employee. Cost of the compensation plan to shareholders. so employees work hard and make difficult decisions. Align management performance and shareholder value. Create strong wealth leverage. 2. 3.Creating an EVA-based Compensation Plan The four primary factors in creating a compensation plan are: 1. particularly in bear markets or industrial slumps. 147 .

Like other financial performance measures. corrects for inflationary distortions . should be included in regular performance reports to provide early warning signs of problem areas . Other more forwardlooking measures. such as return on investment (ROI). is inadequate for assessing a company‘s progress in achieving its strategic goals and in measuring divisional performance. often non-financial in nature. EVA. the adjusted EVA. Another problem of EVA is that it is distorted by inflation. with the result that it cannot be used during inflationary times to estimate actual profitability. 148 . A superior measure. on its own.

Measure & audit Financial and operational Performance Drive internal Process using IT Clearly define expectation Set role models .INVESTMENT CENTER MANAGEMENT MILESTONES. examples Within the business 149 . Enjoy leadership in business Integrate Long term Financial goal With key process Initiative Initiate necessary changes at business operation process & people level. Control & Compliance Track .

Includes non-project Investments. Creates a bridge between Strategy. 5. 4 . Focuses on organizational affordability and aggregate risk. 2. operational efficiency and outcome measures linked to business objectives and Change Management . 150 . Brings together the process disciplines of integrating Finance. Assists Executives to make choice and trade-offs between competing and non competing options to align with business goals. KPI‘s. operational measures and outcome measures.1. 3.

151 .

Human Resource Value Added 2. Satisfaction Index 3. Research and Development 3. Technology Leadership 2. Cost Leadership 152 . Price 2. Economic Value Added 3. Quality 4.Monetary Value Added 1. Accounting Value 2. Intellectual Value Added Customer Satisfaction 1. Market Value Added Non-Monetary Value Added 1. Market Leadership 4. Service Learning & Growth 1.

Concept of Balance Score Card. 153 .

154 .Competence and Learning perspective.

Audit : Compliance & Control Why Audit ? For Compliance & Control . What is to be audited ? 1. Process Audit 3 People Audit 4 Knowledge Audit 155 .Financial performance Audit 2.

156 . compliance by the Company with legal and regulatory requirements. prepare the audit committee report that Securities and Exchange Commission rules require to be included in the Company’s annual statement. the qualifications. independence and performance of the Company’s independent auditor.The Audit Committee is created by the Board of Directors of the Company to assist the Board in maintaining the integrity of the financial statements and internal controls of the Company. the performance of the Company’s internal audit function.

prior to the filing of the Company‟s quarterly financial statements. including critical accounting estimates analyses of the effects of alternative GAAP methods on the financial statements 157 . The Audit Committee shall review and discuss with management: (a) the annual audited financial statements.Financial Statements. Disclosure and Other Risk Management and Compliance Matters 1. including the Company‟s disclosures under “Management‟s Discussion and Analysis and Analysis of Financial Condition and Results of Operations”. the internal auditors and/or the independent auditor setting forth significant accounting or financial reporting issues and judgments made in connection with the financial statements. (b) any analyses or reports prepared by management.

off-balance sheet structures and related party transactions on the financial statements of the Company. 158 . including any significant changes in the Company’s selection or application of accounting principles .(c) the effect of regulatory and accounting initiatives or actions. and any major issues regarding accounting principles and financial statement presentations.

The minutes of the subsidiary‟s board meetings should be presented at the board meeting of the holding company and the board members of the latter should be made aware of all “significant” (likely to exceed in value 10% of total revenues/expenses/assets/liabilities of the subsidiary) transactions entered into by the subsidiary. 159 . The audit committee of the holding company should review the subsidiary‟s financial statements particularly investment plans.With regard to “material” non-listed subsidiary companies Clause 49 stipulates the at least one independent director of the holding company to serve on the board of the subsidiary.

Internal Audits : » Compliance with management controls » System and process improvements » Financial impropriety and fraud audits » Due diligence for acquisitions and investments 160 .

(iii) risk management procedures. (vii) background and committee memberships of new directors as well as presentations to analysts. 161 . In addition a board committee with a non-executive chair should address shareholder/investor grievances. (iv) proceeds from various kinds of share issues. (ii) accounting treatment. (vi) a Management Discussion and Analysis section in the Annual report discussing different heads of general business conditions and outlook.The areas where Clause 49 stipulates specific corporate disclosures are: (i) related party transactions. (v) remuneration of directors. .

The company is required to provide a separate section of corporate governance in its annual report with a detailed compliance report on corporate governance. 162 .The CEO and CFO or their equivalents need to sign off on the company‟s financial statements and disclosures and accept responsibility for establishing and maintaining effective internal control systems. it needs to get its compliance with the mandatory specifications of Clause 49 certified by either the auditors or practicing company secretaries. It should also submit a quarterly compliance report to the stock exchange where it is listed. Finally.

operational. behaviors and other aspects of a company that. and ensuring that liabilities are identified and managed.The system of internal control An internal control system encompasses the policies. 163 . processes. help ensure compliance with applicable laws and regulations. relevant and reliable information from within and outside the organization. This includes the safeguarding of assets from inappropriate use or from loss and fraud. help ensure the quality of internal and external reporting. taken together: facilitate its effective and efficient operation by enabling it to respond appropriately to significant business. financial. and also internal policies with respect to the conduct of business. This requires the maintenance of proper records and processes that generate a flow of timely. compliance and other risks to achieving the company‟s objectives . tasks.

164 .

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