Principles of Management Control Systems

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ICFAI UNIVERSITY

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Principles of Management Control Systems
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ICFAI Center for Management Research
Road # 3, Banjara Hills, Hyderabad – 500 034

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 The Institute of Chartered Financial Analysts of India, January 2006. All rights reserved.
No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means – electronic, mechanical, photocopying or otherwise – without prior permission in writing from Institute of Chartered Financial Analysts of India.

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ISBN 81-7881-995-3 Ref. No. PMCS/A 01 2K6 31
For any clarification regarding this book, the students may please write to ICFAI giving the above reference number, and page number. While every possible care has been taken in preparing this book, ICFAI welcomes suggestions from students for improvement in future editions.

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Contents
PART I: AN OVERVIEW OF MANAGEMENT CONTROL SYSTEMS Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Introduction to Management Control Systems Approaches to Management Control Systems Designing Management Control Systems Key Success Variables as Control Indicators Organizing for Adaptive Control Autonomy and Responsibility Transfer Pricing 3 15 28 42 57 71 87

PART II: MANAGEMENT CONTROL ENVIRONMENT

Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16

Strategic Planning and Programming Budget as an Instrument of Control Reward Systems

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PART III: MANAGEMENT CONTROL PROCESSES

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99 114 139 152 163 177 185 208 221 234 242 258 279 287 295 301 304

Continuous Process Improvement Methods Strategic Cost Management

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PART VI: MANAGEMENT CONTROL IN SPECIFIC SITUATIONS Control in Multinational Corporations Control in Nonprofit Organizations Control in Service Organizations Management Control of Projects Control in the Age of Empowerment Management Control and Ethical Issues Chapter 17 Chapter 18 Chapter 19 Chapter 20 Chapter 21 Glossary Bibliography Index

PART VII: MANAGEMENT CONTROL AND EMERGING AREAS

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Auditing Audit of Management Functions

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PART V: MANAGERIAL COSTING

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Management Control of Operations

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PART IV: MANAGEMENT CONTROL TOOLS

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Detailed Contents
PART I: AN OVERVIEW OF MANAGEMENT CONTROL SYSTEMS
Chapter 1: Introduction to Management Control Systems: Importance of Control Systems: Elements of a Control System – Nature of Management Control Systems: Important Features of Management Control Systems, Management Control Process, Characteristics of a Good Management Control System, Distinction between Strategy Formulation, Management Control and Task Control – Types of Management Control Systems: Formal Control System, Informal Control System – Subsystems and Components of Management Control Systems: Formal Control Process, Informal Control Process Chapter 2: Approaches to Management Control Systems: Cybernetic Approach to Management Control Systems: Characteristics of a Cybernetic System, Cybernetic Paradigm and the Control Process, Designing Management Controls, Control Process Hierarchy – Contingency Approach to Management Control Systems: The Need for the Contingency Approach – Strategy and Control Systems: Corporate Strategy, Business Unit Strategy Chapter 3: Designing Management Control Systems: Steps in Designing Management Control Systems: Choice of Controls, Tightness of Controls – Factors Influencing the Design of Management Control Systems: Managerial Styles and the Design of Control Systems: Corporate Culture and Design of Control Systems, Decentralization and Design of Control Systems, Organizational Slack and Design of Control Systems, Stakeholder Controls and Design of Control Systems, Communication Structures and Control Process – Establishing a Customer-Focussed Total Quality Culture: Implementing Total Quality Management – Impact of Information Technology on Control Systems Design: Providing Information for Operational and Strategic Decision Making Chapter 4: Key Success Variables as Control Indicators: Concept of Key Variables - Identifying Key Variables: Input Variables, Production Variables, Marketing Variables, Asset Management Variables, Sources of Key Variables, Types of Key Variables – Key Success Variables and the Control Paradigm: Dynamics of the Control Process, Identifying Key Variables – Comprehensive Performance Indicators: Limitations of Indicators – Key Variables in Selected Industries: Insurance Industry, Hotel Industry, Sugar Industry, Management Training Institute, Power Industry

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PART II: MANAGEMENT CONTROL ENVIRONMENT
Chapter 5: Organizing for Adaptive Control: Strategy, Structure and Control – Decentralization Vs Centralization – Response of Structure to Strategy: Evolution of the Matrix Structure: Project Organizations, Product Organizations, Service Organizations, The Matrix Structure and the Multinational Firm – Evaluation of the Control Factors in Organizational Design: Matrix Versus Functional – Controller’s Organization – Adaptive Organization: The Need for Adaptive Organization, Adaptive Controls that Support the Adaptive Organization

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Chapter 6: Autonomy and Responsibility: Divisional Autonomy: Management Style and Process, Responsibility Structure, Measurement of Reward Systems – Responsibility Structure: Overall Effectiveness Measures: Return on Investment (ROI) – Responsibility Centers: Nature of Responsibility Centers, Types of Responsibility Centers – Performance Measurement of Decentralized Operations: Measuring Divisional Operations – Inter Profit Center Relations: Setting Transfer Prices Chapter 7: Transfer Pricing: Objectives of Transfer Pricing – Principles of Transfer Pricing: Goal Congruence – Methods of Calculating Transfer Price: Market-Based Pricing Method, Cost-Based Pricing Method, Negotiated Pricing Method – Upstream Fixed Costs and Profits: Two Step Pricing, Profit Sharing, Two Sets of Prices – Administration of Transfer Prices: Negotiation – Arbitration and Conflict Resolution, Product Classification

PART III MANAGEMENT CONTROL PROCESSES
Chapter 8: Strategic Planning and Programming: Elements of Strategy – Characteristics of Strategic Planning: Benefits of Strategic Planning, Organizational Relationships, Top Management Style – Strategic Planning Process: Reviewing and Updating the Strategic Plan, Deciding on Assumptions and Guidelines, First Iteration of the Strategic Plan, Analysis, Second Iteration of the Strategic Plan, Final Review and Approval – Analyzing Proposed New Programs: Rules, Avoiding Manipulation, Acquaintance to Planning Models, Organizing for Analysis – Analyzing Ongoing Programs: Analysis, Activity Based Costing, Expense Center – The Programming Process: Bower's Model of the Investment Decision-Making Process. Parameters of the Programming Process, Mutually Supportive Management Systems for the Implementation of Strategy through Programming Decisions, Formal Programming Procedures Chapter 9: Budget as an Instrument of Control: Need for Budgeting – Forecasting, Budgeting and Strategic Planning – Budgeting Process and Control: Budget Preparation Process, Budgetary Control, Behavioral Dimensions of Budgeting – Master Budget: Steps in the Preparation of the Master Budget, Budget Balance Sheet – Zero Based Budgeting: The ZBB Process, ZBB Vs Traditional Budgeting, Implementing Issues, Advantages and Disadvantages of ZBB – Performance Budgeting: Steps in the Implementation of Performance Budgeting, Performance Budgeting Vs Traditional Budgeting – Participative Budgeting – Variance Analysis for Control Actions: Revenue Variances, Expense Variances, Summary of Variances, Limitations of Variance Analysis

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PART IV: MANAGEMENT CONTROL TOOLS
Chapter 10: Reward Systems: Purpose of Reward Systems:– Components of Incentive Compensation Plans – CEO Compensation – Incentives for Business Unit Managers: Size of Bonus Relative to Salary, Cutoff Levels, Bonus Basis, Performance Criteria, Benchmarks for Comparison – Balanced Scorecard – Design Considerations: Rewards Integrated with MSSM (Mutually Supportive Systems Model), Attainability, Formal Rewards, Informal Rewards – Agency Theory: Concepts of Agency Theory

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Chapter 11: Management Control of Operations: Information used in control of operations: Informal Information, Formal Information, Non Financial Information – Just-In-Time Techniques: Advantages of Just-In-Time Techniques, Implications for Management Control – Total Quality Management: Consequences of Poor Quality, Total Quality Management Approach, Implications for Management Control – Computer Integrated Manufacturing – Decision Support Systems: Nature of Decision Support Systems. Implications for Management Control Chapter 12: Continuous Process Improvement Methods: Target Costing: Planning Stage, Development Stage, Production Stage, Benefits of Target Costing – Benchmarking and Benchtrending: Planning Phase, Analysis Phase, Benchtrending, Process Benchtrending – Quality Improvements: Process Quality Teaming – Activity-Based Costing: Traditional Costing vs Activity Based Costing (ABC)

Chapter 14: Auditing: Benefits of Audit: Identify Opportunities for Improvement, Reality Check, Identify Outdated Strategies, Increase Management’s Ability to Address Concerns, Enhances Teamwork, Increase Commitment to Change – Limitations of Audit – Timing of an Audit – Audit Process: Staffing the Audit Team, Creating an Audit Project Plan, Laying the Ground Work for the Audit, Analyzing Audit Results, Sharing Audit Results, Writing Audit Reports, Dealing with Resistance to Audit Recommendations, Building an Ongoing Audit Program – Audit Tools and Techniques: Budget, Timing, Projectability, Geography, Surveys, Questionnaires, Focus Groups, Interviews, Direct Observation – Management Audit: Objective of a Management Audit, Development of Management Audit, Benefits of Management Audits, Types of Management Audit, Organizing the Management Audit, Conditions for Successful Management Audit – Internal Audit: Need for Internal Auditing – Financial and Cost Audit – Social Audit: Social Accounting versus Social Audit, Definition of Social Audit, Features of Social Audit, Approaches to Social Audit, Types of Social Audit – Audit Evidence: Persuasive, Relevant, Unbiased, Objective – Auditing for Continuous Improvement Chapter 15: Audit of Management Functions: Audit of the Purchasing Function: Purchasing Procedure, Characteristics of an Effective Purchase Department – Purchase Audit Areas – Human Resource Audit: Conducting an HR Audit – Research and Development Activities Audit: Evaluation of R&D Activities – Production Audit: Characteristics of a Good Manufacturing Audit – Marketing Audit: Characteristics of Marketing Audit – Sales Audit: Approaches to Sales Audit, Conducting a Sales Audit, Characteristics of a Sales Auditor, Process of Collecting Data During Sales Audit

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Chapter 13: Strategic Cost Management: Evolution of Strategic Cost Management: Strategic Measures of Success – Three Key Themes of Strategic Cost Management: Value Chain Analysis, Cost Driver Analysis, Strategic Positioning Analysis – Strategic Management and Strategic Cost Analysis

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PART V: MANAGERIAL COSTING

PART VI: MANAGEMENT SITUATIONS

CONTROL

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Chapter 16: Control in Multinational Corporations: Types of Controls Used By MNCs: Personal Controls, Output Controls, Cultural Controls, Result Controls, Bureaucratic Controls – Concept of Strategic Control: Headquarters-Subsidiary Environment, Impact of Global Competition, Impact of Host Government Demands, Impact of Joint Ventures – Factors Affecting Control Systems in MNCs: Cultural Differences Across Countries, Differences in Business Environment – Analysis of Foreign Investment Projects by MNCs: Taxes on Income from Foreign Investment Projects, Political Risks, Economic Risks, Exchange Rate Risk – Transfer Pricing in MNCs: Situation 1-Paying Some Tax, Situation 2-Inflating Profits, Situation 3-Paying No Tax, Situation 4-Getting Tax Rebates, Tax Avoidance Inflates Profits, Methods of Transfer Pricing – Control of Foreign Affiliates: Currency Translation, Budgeting for Foreign Affiliates Chapter 17: Control in Nonprofit Organizations: Mission of Nonprofit Organizations – Key Characteristics of Nonprofit Organizations: Atmosphere of “Scarcity”, Bias towards Informality, Participation and Consensus, Dual Bottom Lines: Mission and Financial, Difficulty in Assessing Program Outcomes, Governing Board with both Oversight and Supporting Roles, Mixed Skill Levels of Staff, Participation of Volunteers – Designing Control Systems for Nonprofit Organizations – Employee Characteristics and Organizational Culture: Rewards, Performance Measurement, Fund Accounting, Programming and Budget Preparation Chapter 18: Control in Service Organizations: Control in Professional Organizations: Characteristics of Professional Organizations, Control Systems in Professional Organizations – Control in Government Organizations: Political Influences, Public Information, Attitude towards Clients, Management Compensation – Control Systems in Government Organizations: Strategic Planning, Performance Measurement – Control in Financial Service Organizations: General Characteristics of Commercial Banks, Regulatory Capital, New Products, Management Control Implications, Basle Committee Principles on Banking, General Characteristics of Insurance Companies – Control in Securities Firms: Management Control Implications Chapter 19: Management Control of Projects: Differences between the Control of Projects and the Control of Ongoing Activities: Single Objective, Focus on Projects, Need for Trade-offs, Less Reliable Performance Standards, Frequent Changes in Plan, Difference in Rhythm, Environmental Influence – Project Planning: Planning Process, Nature of Project Plan, Project Scope, Project Schedule, Project Cost, Project Scheduling – Project Control: Objectives of Project Control, Control as a Function of Management – Reporting for Control: Effective Reporting System, Types of Project Reports – Project Team and Matrix Structure: Matrix Structure – Project Audits: Levels of Audit – Project Evaluation: Evaluation of Performance, Evaluation of Results

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PART VII: MANAGEMENT CONTROL AND EMERGING AREAS
Chapter 20: Control in the Age of Empowerment: Balancing Empowerment and Control: Diagnostic Control Systems, Belief Systems, Boundary Systems, Interactive Control Systems – Control Systems and Conflict Resolution: Conflicts in the Planning Subsystem, Conflicts in the Measuring Subsystem, Conflicts in the Recording Subsystem, Conflicts in the Appraisal Subsystem, Conflicts in the Reporting Subsystem, Conflicts in the Subsystem for Remedial Action – Framework for Conflict Resolution Chapter 21: Management Control and Ethical Issues: Identifying ControlRelated Ethical Issues: Creating Budgetary Slack, Responding to Flawed Control Indicators, Managing Earnings, Using Excessively Tight Control Measures – Designing Control Systems to Regulate Ethical Conduct: Cybernetic Control Process for Developing an Ethics Program – Control System Supporting the Ethics Program: Management Style and Culture, Infrastructure, Rewards, Coordination and Integration – The Ethical Principle of Fairness In the Design of Control Systems

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PART I: AN OVERVIEW OF MANAGEMENT CONTROL SYSTEMS

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Chapter 1

Introduction to Management Control Systems
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In this chapter we will discuss: Importance of Control Systems Nature of Management Control Systems • • •

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Types of Management Control Systems Subsystems and Components of Management Control Systems

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Principles of Management Control Systems

In 2001, Enron Corp., the global energy giant, collapsed in one of the largest cases of bankruptcy filing in U.S. corporate history. Tyco International, a diversified manufacturing and service company, had to abandon plans to split into four parts, because of doubts about its accounting practices. The stunning news that WorldCom, the telecom giant, had artificially inflated its earnings by $3.8 billion rocked the corporate world and shook investors’ confidence in stock markets. WorldCom's accounting irregularities involved the deliberate mis-recording of expenses as capital expenditures, in order to inflate its cash flows. The accounting irregularities included transfers between internal accounts of $3.06 billion in 2001 and $797 million in the first quarter of 2002. As these examples illustrate, the absence or malfunctioning of control systems can lead to huge losses, and even to corporate bankruptcy. Defective products and poor coordination between departments also arise due to weak control systems. This chapter focuses on the importance of control systems, the nature of management control systems, types of management control systems, and the subsystems and components of management control systems.

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Strategic control deals primarily with the broad questions of domain definition, direction setting, expression of the organization’s purpose, and other issues that impact the organization's long-term survival. Strategic control overlaps to some extent with the process of strategy formulation. Strategic control also deals with issues relating to general company objectives and the implementation and monitoring of progress. Management control deals with effective resource utilization, the state of competitiveness of the unit, and the translation of corporate goals into business unit objectives. Operational control is primarily concerned with efficiency issues. Occurring at very specific functional or sub-departmental levels of the organizational hierarchy, this mode of control generally conforms to traditional control models. The time horizon of control is very short, the benchmarks are known and well defined, and the outcomes are tangible and easily measurable.

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The control process in any organization can be undertaken at three levels. These are: the strategic level, the management level, and the operational level. Each type of control occurs primarily at one of the three distinct levels of the organizational hierarchy.

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A control system is a set of formal and informal systems to assist the management in steering the organization towards its goals. Controls help in guiding employees effectively towards the accomplishment of the organization’s goals. Establishing a control system in an environment of distributed accountability, reengineered processes, and local autonomy and empowerment is a challenging task.

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IMPORTANCE OF CONTROL SYSTEMS

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Introduction to Management Control Systems

Exhibit 1.1 Management Control at Kimberly-Clark Kimberly-Clark, the manufacturer of household and health products, is an example of a company that mixed up operational and management control issues. The company has a good reputation as a manufacturer of household and health products. Since 1950s, it also started selling cigarette paper and sheets of pressed, reconstituted tobacco-to-tobacco companies for use in cigarettes. The tobacco reconstitution process used by Kimberly-Clark enabled tobacco companies to manipulate nicotine levels in cigarettes. The state of West Virginia in the US alleged that Kimberly-Clark conspired with cigarette companies to deceive the public about the hazards of smoking. When the company realized that its tobacco business was becoming a legal and financial liability, it spun off the tobacco unit. At the operational control level, the company did not ascertain whether the advertisements claiming that the tobacco reconstitution process allows nicotine levels to be adjusted to a smoker’s individual requirement was indeed misleading. At the management control level, the company did not act immediately once smoking related illness became common. The strategic control failure was not making a conscious determination whether the tobacco business was consistent with the company's mission and values. If the tobacco business was consistent with the mission and values, the company then needed to follow up by instituting proper operational and management control systems that protected the organization against legal liability.
Adapted from Veliyath, Raj; Hermanson, Heather M. “Organizational control systems: Matching controls with Organizational levels” Review of Business, Winter97, Vol. 18 Issue 2, p2.

It is important to recognize that the three levels of control are not mutually exclusive. They represent a nested arrangement. If the control process does not identify and deal appropriately with a problem occurring at a lower level, the problem worsens. The problem then gets kicked up to a higher level of control. This can be illustrated through the example of Kimberly-Clark in Exhibit 1.1. In extreme cases, when the issue gets more complicated, threatening the organization’s survival, the problem needs to be handled from the highest levels, in terms of strategic control. Increased control in an organization will result in reduced creativity and entrepreneurship. Hence it is important for organizations to establish the tradeoff between the amount of control and the level of freedom for employees, and to choose the right mix of controls.

Elements of a Control System
Any control system has four important elements. They are a detector or sensor, an assessor, an effector and a communications network, as can be seen in Figure 1.1. The detector analyzes the situation that is being controlled. An assessor helps in comparing the actual results with the standard or expected results. An effector is used to reduce the gap between the actual and the
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Principles of Management Control Systems

Figure 1.1 Elements of the Control Process
Control device 2. Assessor. Comparison with standard

1. Detector. Observed information about what is happening Entity being controlled

3. Effector. Behavior altering communication, if needed

The process of control usually involves four important steps. They are: • • • Implementing the programs or policies, Measuring and comparing outcomes against targets, and Analyzing whether the achieved targets are in accordance with the goals or objectives.

The role of the management is to organize, plan, integrate and interrelate organizational activities to achieve organizational objectives. The achievement of these activities is facilitated by management control systems. A management control system is designed to assist managers in planning and controlling the activities of the organization. A management control system is the means by which senior managers ensure that subordinate managers, efficiently and effectively, strive to attain the company's objectives. According to Anthony, Dearden and Govindarajan1 (1992), management control is “the process by which managers ensure that resources are used effectively and efficiently in the accomplishment of the organization's objectives”. If the management monitors the activities of the business units frequently, then it is exercising tight control. Limited monitoring of the business units’ activities can be termed as loose control. The difference between tight and loose control thus relates to the degree to which the management monitors the
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Robert N Anthony and Vijay Govindarajan, Management Control Systems, Eight Edition Irwin Publications.

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NATURE OF MANAGEMENT CONTROL SYSTEMS

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Identifying the goals or objectives,

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standard result. The communication network transmits information between the detector, the assessor and the effector.

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Source: Robert N.Anthony, Govindarajan, Management Control Systems, (USA: Irwin, 1995) 5.

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Introduction to Management Control Systems

activities of a unit. When there is tight control by the management, there is extensive involvement of the management in the day-to-day operations of the business unit. The budget is considered a binding constraint with a strong emphasis on meeting the budgeted targets. Deviations from the budget are generally not considered acceptable. Loose control is characterized by limited involvement by the management in day-to-day operations. Under loose control, the budget is regarded more as a tool for planning and communication than as a binding commitment. Management control systems involve a number of activities in an organization, including: • • • • Planning the future course of action Coordinating and communicating the various activities of the organization to different departments Influencing people to work in accordance with the goals of the organization.

Important Features of Management Control Systems

Decisions in management control process are systematic and rhythmic i.e. they are in accordance with the strategies and procedures laid down by the top management. Plans developed for a unit must encompass the whole organization, and the plans for each of the organization’s units must be coordinated with one another, so that there is a balance between different activities. For example, operations and distribution should be balanced with the sales program. Strategy implementation tool Management control helps an organization to move towards its strategic objectives. It is an important vehicle for the execution of strategy. Figure 1.2 explains how strategies are implemented through management controls, organizational structures, human resource management, and culture. Effective execution can take place with the help of an efficient organizational structure, human resource management and culture. All these are influenced by the system of management control, and hence it is an important aspect of strategy implementation.
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Decisions are systematic and rhythmic

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Management control decisions are based on the framework established by the organization's strategies. Management control decisions also take into account the quantity and quality of resources available. Within the constraints of the available resources and the policies of the organization, a manager should be able to implement activities that are best suited for a particular business unit. Decisions are made at the highest level, but their actual implementation may require some time. For instance, employees need time to adapt to a new technology.

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Nature of decisions

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Evaluating information and deciding the various activities; and finally,

Principles of Management Control Systems

Figure 1.2Framework for Strategy Implementation
Implementation mechanisms Management Controls

Strategy

Organization Structure

Human Resource Management

Performance

Source: Robert N Anthony and Vijay Govindrajan, Management Control Systems (USA: Irwin, 1995) 11.

Behavioral considerations

Motivation is important to help employees perform to their full potential. Most of the organization’s problems occur because individual goals and organizational goals do not match. This results in demotivated performance by the employees. At the managerial level too, lack of motivation will result in employees taking decisions that are harmful to the organization. The decisions may be made in order to advance the personal interests of the employees involved. In extreme cases, this could lead to employee fraud and theft. In IT companies, computer-related crime can result in huge losses for the organization. Hence, there is a need to control such behavior in an organization. Another behavioral problem that can have serious consequences for an organization is personal limitations. In spite of high motivation to perform, certain employees may be unable to perform because of their personal limitations. These limitations are specific to individuals, and could also be because of inadequate training, lack of knowledge or information, and inexperience. Job design also plays an important role in performance. Some jobs are designed in a manner that creates stress. This can lead to accidents and errors in decision-making. Training plays an important role in reducing

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Poor performance in organizations can be attributed to lack of direction among employees. Giving employees the required support and direction to accomplish organizational goals is one of the important functions of management control systems.

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People are important assets for an organization. Without the cooperation of the employees, managers cannot implement their decisions. To manage people effectively, control systems are required for the following three reasons- lack of direction, motivational problems and personal limitations.

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Culture

Introduction to Management Control Systems

the severity of limitations at the individual level. Finding effective tools for control of such limitations is an important part of control systems.

Management Control Process
The management control process involves three interrelated activities – communication, motivation and evaluation. First, it involves communication between the superior and the subordinates. Communication helps the subordinates understand the goals of the organization. The superior should make sure that the subordinates understand what the organization expects of them. Second, for the subordinates to put in their best efforts to achieve organizational goals, they have to be motivated. It is the responsibility of the superior to motivate the subordinates. Finally, for effective performance, superiors should evaluate the work of the subordinates and give them feedback periodically. It is essential for the superior to evaluate the performance of subordinates without any bias.

Characteristics of a Good Management Control System

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Clear Objective Good control cannot be established unless the multiple objectives of a particular task are considered separately. For example, to assess the control system relating to production, all major performance parameters like efficiency, quality and asset management, have to be measured. Minimum control losses Control devices are costly and not always economically feasible. So, control devices should be put in place only when the economic benefits exceed the costs. The difference between the performance that is theoretically possible and one that can be reasonably expected is called “control loss.” An organization achieves optimal performance when control losses are minimized.

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Planning is always oriented to the future. The organization should be focused on the future. Employees should be encouraged to be flexible so as to respond effectively to change.

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A good management control system ensures success for an organization. Good management control here implies that the goals of the organization are clearly communicated to the employees, and that the employee is confident about performing his tasks well. For example, good inventory control means that employees have information about the quantity of inventory present and its availability at different locations. An organization does not usually have perfect control. For perfect control all the employees should be working in the best possible way. But this is not always possible as employee behavior is not stable. Good control can be achieved in the following ways:

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Principles of Management Control Systems

Distinction between Strategy Formulation, Management Control and Task Control
It is important to analyze the differences between management control and other types of control. Management control needs to be distinguished clearly from strategy formulation and from task control. While strategy formulation takes place at the highest level in an organization, task control takes place at the individual level. Management control lies at the middle level between strategy formulation and task control. Figure 1.3 explains the distinction between strategy formulation, management control and task control. Distinction between strategy formulation and management control Strategy formulation takes place at the highest level of the management and involves formulation of new strategies, whereas management control involves implementation of these policies. Strategy formulation takes place in accordance with situations, both internal and external to the organization. Hence, strategy formulation may not always follow a clearly defined system. The management control process takes place in a systematic manner, and involves managers and staff at all levels in the organization. Strategy formulation usually involves only those at the highest level of the organization. There may be changes in one or a few strategies, while others remain unaffected. In contrast, the management control process involves the whole organization, and changes affect all the parts since they are linked with one another. Therefore, a high level of coordination is required. Task control involves the control of individual tasks. These tasks are carried out according to the rules and regulations laid down by the management

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Figure 1.3 General Relationship among Planning and Control Functions

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Task control vs. management control

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Strategy formulation

Management control

Task control

Source: Robert N.Anthony, Govindarajan, Management Control Systems, (USA: Irwin, 1995) 9. 10

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Nature of End product Goals, strategies and policies Implementation of Strategies

Efficient and effective performance of individual tasks

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Introduction to Management Control Systems

control process. Usually the techniques in operations research and management science focus on task control. The information important for task control in an organization is usually quantitative in nature e.g. the number of items ordered by the customers, the components used in manufacturing the products, the number of man-hours used in a particular process, etc. The devices used for task control include programmable machine tools, process control computers and robots. In task control, each task requires a different task control system (a production control system is different from a cash management system). Thus, it can be concluded that task control is quantitative in nature whereas management control is oriented towards behavior. In task control, in some cases, such as automated processes, employees may not be involved; in other cases, there may be interaction between a manager and a worker. Management control involves interaction between two managers or between a superior and subordinate.

Formal Control System

Input controls

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These are the actions taken by the company before a planned activity is implemented. These measures help the company to select the right way to undertake the activity. Input controls include selection criteria, recruitment and training programs, manpower allotments, strategic plans and resource allocations. Process controls Process controls involve tracking certain variables and taking corrective action whenever there is any deviation from specified parameters in the variables. The control action takes place before the process of transformation is completed and the output is produced. Process control is exercised when the firm attempts to influence the ongoing activity to achieve the desired ends. The control is applied to the behavior or activities rather than the end results. For example, under a feed-forward system of inventory control, the factors that affect inventory levels of finished goods, such as the rate of sales or
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Formal control systems are written, management-initiated mechanisms that influence the behavior of employees in achieving the organization’s goals. Formal controls can be classified into three types, based on the nature of management intervention. They are:

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Control systems in an organization fall under two broad areas: formal and informal. Formal controls are laid out in writing by the management, whereas informal controls arise as a result of employees’ behavior. Examples of formal controls are plans, budgets, regulations and quotas. Informal controls include group norms and organizational culture. Formal controls are framed by the managers, whereas informal controls often originate with employees and are affected by general socio-cultural factors.

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TYPES OF MANAGEMENT CONTROL SYSTEMS

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dispatch delays, are tracked. When the sales begin to decline or there is a dispatch bottleneck, this information is fed forward, and the level of the finished goods inventory is controlled by reducing production. Thus, the inventory levels are prevented from exceeding required levels. Alternatively, the managers may realize that the original standards for sales or dispatch delays are no longer appropriate and must be revised. This again feeds into a loop, which leads to the inventory objectives or plans being updated. Process control can also be illustrated using the example of a salesperson’s job. The management may direct the salesperson to follow certain procedures for new market development, but may not hold the salesperson responsible for the extent of new business generated i.e. the end result. In such a case, process control has been exercised. Output controls Output control is exercised when performance standards are set and monitored, and the results are evaluated. Output control takes place when the control activity is based on the comparison of actual and planned outcomes. Such controls are applicable when it is easy and inexpensive to measure the output and when there are few elements of uncertainty. In this type of control, the management expects the employee to perform in a result-oriented way, as it believes that the employee has the requisite knowledge to undertake the activities required, in a suitable manner, and to complete the assigned task without management intervention.

It deals with the establishment of the personal objectives by the individual, monitoring their attainment and adjusting the behavior in the organization to attain the goals. Self-control can be beneficial to an organization if the organization’s goals are in congruence with the individual’s goals. But if the goals do not match then the performance of the employee can suffer. Social controls Social control refers to the prevailing social perspectives and patterns of interpersonal interactions within subgroups in the firm. In this type of control, an organization establishes certain standards, monitors conformity with the standard and takes action when deviations occur. Social control arises out of the internalization of values and mutual commitment towards some common goals. Cultural controls According to William G Ouchi, culture is “the broader values and normative patterns that guide worker behavior within the entire organization.” Cultural control can be realized by norms of social interaction, and stories, rituals and legends relating to the organization.

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These are unwritten, typically worker-initiated mechanisms that influence the behavior of individuals or groups in business units. There are three types of informal controls. They are:

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SUBSYSTEMS AND COMPONENTS OF MANAGEMENT CONTROL SYSTEMS
The subsystems and components of control systems can be discussed on the basis of formal and informal processes.

Formal Control Process
The formal control process has two dimensions- formal planning and formal reporting. Formal planning process The formal planning process has two dimensions: strategic planning and operations planning. In most organizations there are two budgets- one for operations and one for strategy; and, there are two sets of reports - one for strategic projects and one for operating activities. The formal planning and control process should support the style and culture of the organization, and should be supported by the infrastructure, the rewards, and the communication systems in the organization. A strategic planning system is necessary to assist the organization in the planning and control of projects. It helps the organization to decide its goals and objectives, and key strategies. An operational planning system undertakes activities that are short term in nature. Detailed reports help the organization to assess the progress of its strategic and operational planning. Monthly, quarterly or yearly reports help the organization to analyze its performance periodically, and to decide on the next set of programs to be undertaken. Although planning and reporting appear to be two distinct processes, there should be a certain degree of integration. Strategic programs are funded out of current operations and grow out of current activities. Further, strategic plans and programs have a great impact on current operations and so, these strategic plans should be adjusted from time to time in line with their effect on operations.

Informal Control Process
Management decisions are based upon experience, intuition and feeling. Informal control processes are formed as a result of interaction between people. The informal control process helps in the development of new goals and objectives. There are a number of mechanisms for control through informal systems. One mechanism is the use of ad hoc teams to solve problems, improve productivity and achieve organizational change. Informal teams usually consist of cross-organizational groups which work in coordination to solve problems related to a particular client, product or market. Informal communication systems evolve as people develop work relationships. Informal communication is helpful in supporting the key values of the organization. Fostering informal communication is critical to the development and maintenance of effective informal controls.
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Informal rewards and recognition are conferred upon the key team members within the informal system. The respect an individual is shown is an informal reward for performance. Communication systems are not highly guarded in informal systems.

SUMMARY
The purpose of control is to ensure that an organization meets desired objectives and that individual members behave in a manner consistent with organizational objectives. In recent times, several companies have lost billions of dollars because the necessary controls were absent. Management control systems are considered essential for the successful attainment of corporate objectives. It is the means by which senior managers effectively and efficiently strive to attain company's objectives. Any control system in an organization has four important elements that help in synchronizing the organization’s various activities. They are – the detector (which provides information about the situation), the assessor (for comparison with benchmarked standards), the effector (which tries to bridge the gap between the actual situation and the standard required), and finally, the communication systems (that help in passing the information between the other three elements). Control systems can be divided into formal and informal controls. Formal control systems can be classified as input controls, process controls and output controls. Informal control systems can be classified into selfcontrol, social control and cultural control. A clear corporate strategy, corporate structure, well-defined centers of responsibility, and reliable information centers are essential for management control systems to be successful. A good management control system is oriented towards the future, has clear objectives, and minimizes control losses. It is important to analyze the distinction between strategy formulation, task control and management control. Strategy formulation takes place at the higher level of the management, and task control involves the control of individual tasks. Management control lies at the intermediate level between the levels of strategy formulation and task control. It helps in the implementation of the desired strategies. The subsystems and components of control systems can also be divided on the basis of their use in formal and informal systems. Managerial style and organizational culture play an important role in determining which components are used, and whether the formal or informal processes are dominant.

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Chapter 2

In this chapter we will discuss: • • •

Cybernetic Approach to Management Control Systems Contingency Approach to Management Control Systems

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In the introductory chapter, we discussed the importance of controls in achieving organizational objectives. In addition to the amount of control, the appropriate mix of controls should be used to maintain the right balance in an organization. In this chapter, we discuss the various approaches to the implementation of management controls. Organizations are complex structures; hence, there is a need to design controls for them to function effectively. The cybernetic approach helps us to understand the elements and design of the control process in an organization. The contingency approach to management control systems provides a potential explanation for the bewildering variety of management control systems actually practiced. Strategies at the corporate and business unit levels have a bearing on the form and structure of control systems in an organization.

CYBERNETIC APPROACH TO MANAGEMENT CONTROL SYSTEMS
Cybernetics has its origin in the Greek work ‘Kybernetes’ which means “steersman.” A steersman is a person who directs the movement of the ship along the planned course or direction. In the 1940s, Norbert Weiner coined the term cybernetics. According to his definition, cybernetics is the study of “the entire field of control and communication theory, whether in the machine or the animal”. Cybernetics deals with the self-regulating principles in a variety of systems ranging from the human biological system to machine systems. The human brain is a complex structure that helps in regulating the body functions and helps the body perform complex activities. Organizations too are complex, as they are made up of different individuals. Cybernetics has been applied in such diverse fields as radar control, animal genetics, inferential automation, cryptography and deciphering, automatic machine tool control, language translation, teaching machines, artificial intelligence and robotics. Due to its broad applicability, it has been popular with general systems theorists as a unifying theory of self-regulation.

The following are the characteristics of a cybernetic system: Complex structures There are number of heterogeneous interacting components in a cybernetic system, making it complex. Mutual interaction The various components of a cybernetic system interact in a way that creates multiple interactions within and among the subsystems. Complementary In cybernetic systems multiple interactions take place as a result of multiple processes and structures. There are a number of subsystems which interact; and hence, there is a need for multiple levels of analysis which complement one another. Evolvability Cybernetic systems tend to evolve and grow in an opportunistic manner, rather than being designed and planned in an optimal manner.

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Characteristics of a Cybernetic System

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Constructivity Cybernetic systems are constructive. They increase in size and complexity by building on their existing characteristics and also developing new traits.

Cybernetic Paradigm and the Control Process
The cybernetic paradigm devised by Griesinger in the late 1970s helps in designing the control process in an organization. The cybernetic paradigm not only helps in capturing the essential elements of the repetitive control process (refer Figure 2.1), but also does it economically. The essential elements of the repetitive control process are the following: • • • • • • • Setting goals and performance measures Measuring achievement Comparing achievement with the results Computing the variances resulting from the preceding comparison Identifying the causes of the variation

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Figure 2.1: The Cybernetic Paradigm of the Control Process
Environment Goals Factual Premises Perception Value Premises Comparator

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• Follow-up to ensure that the goals are met. All goal-oriented controls reflect the basic elements of the cybernetic paradigm. The paradigm begins with the assumption that decisions are made because of the interaction between the decision maker and the external environment. The manager of each business unit scans the external environment for data that could be useful for the organization. The mechanisms through which managers collect data are called sensors. Sensors can collect data through formal methods like reports, or through informal

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Reporting the variances

Source: Joseph A Maciariello and Calvin J Kirby, Management Control Systems, (USA: Prentice-Hall, Inc, Second edition) 42.

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Designing Management Controls
There are many issues to keep in mind while designing controls for an activity: • The process of establishing controls should be seen as a constructive exercise that will help in enhancing the performance of the employees. The standards set should be challenging, but at the same time, attainable. The objectives should be measurable to enable evaluation of performance. Controls should focus on the objectives and key results of an activity. There should be a restricted number of objectives. There should not be too much focus on easily measurable factors and short-run variables. Attention should be paid to all the important variables in a balanced fashion. Responsibility for results should rest with a single individual to avoid duplication of work.

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methods like interactions with the members of the organization. Sensors can be used to collect data with regard to both the internal and external performance of the business unit. Based on the data collected, the manager builds up certain assumptions about the external environment and the present performance of the unit. These assumptions are a starting point for the analysis and are termed as ‘factual premises’. Factual premises are formed on the basis of perceptions, which are affected by past experiences, organizational goals and personal goals. The next step involves comparing the factual premises with the organizational goals and performance measures. When there is difference between the decision maker’s assumptions (value premises) and the assumptions made about the environment (factual premises), then every possible step is taken to bridge the gap. This is done with the help of a comparator that analyzes the difference between performance as measured and performance information desired. When there is a shortfall in performance, the decision maker searches for a course of action that will help to cover the shortfall; this is referred to as behavioral choice. Choice of behavior could involve selecting a solution on the basis of previous experiences. In case there is more than one alternative solution to the problem, the feasible alternative with the highest subjective utility is chosen. In case no suitable alternative is found, the decision maker expands his search for a viable option. After an appropriate method is found to cover the shortfall, the next step is the implementation process. The implementation process starts with the manager (effector) acting as an agent for change by implementing the desired controls. After implementation, the next step is to get the required feedback to determine the effects of the action. This feedback helps the manager to judge whether the chosen behavior or action has helped move towards the desired performance. If the feedback is positive, this action can be selected again when similar situations arise in the future. The feedback also helps in assessing whether the goals set are being achieved. If the goals are not achieved, the manager has to go through the whole process again. Hence all goal-oriented controls reflect the basic elements of a cybernetic paradigm. To achieve goals, organizations need to design effective individual controls for each activity.

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To get the desired results, it is important to compare the actual performance with the desired results. Comparing actual performance with the desired results could be useful for setting controls for the next year. When establishing controls, the factors that could be hampering the work process, such as stress, tiredness at work and absenteeism, should be identified. Good feedback is an indication of the quality of the control process. Early predictors, can help organizations to improve their performance. It is advisable to take a sample of the variables to be controlled. This can be done statistically or through observation. An acceptable range of variation for the value of each variable should be established. While preparing reports there should be exceptions to desired results and these should be promptly reported to the person responsible for the reports. The severity of the problem should be determined by analyzing the cause of the problem and then corrective action should be taken. The results of these actions have to be monitored and compared to the expected values.

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The control process in an organization involves the relationship between the superior and the subordinates. The relationship can be termed as a means-end relationship because the superior communicates the goals of the organization to the subordinates, who, in turn, devise strategies to achieve those ends. The goals of the subordinates should be congruent to the goals of the superior. Congruency in goals can be achieved through negotiation, and depends on the style of management and the communication process in the organization. The hierarchy of the control process can be illustrated with an example. In a hierarchical organization with decentralized decision-making and authority, the control process begins with the superior meeting the subordinates and negotiating goals, objectives and targets for the next year. After the goals are finalized, the performance is tracked at periodic intervals. The superior and subordinates review the overall performance. In areas where performance has been unsatisfactory, they try to find the reasons for the unsatisfactory performance. Once the reasons are identified, a plan of correction is prepared. This plan is prepared on the basis of past corrective actions and the current performance. Thus the targets and course of action for the next year are set. The same process is carried out throughout the organization. A reward system based upon the performance of the employees is designed. First, managers decide on the targets they want to give their subordinates. Next, there is negotiation between the superior and the subordinates with regard to the targets. At this stage, it can be analyzed whether the subordinates’ objectives are in congruence with the objectives of the superior. All the targets should be specific and measurable. There should be a limited number of targets, so that they can be managed well. The targets should cover qualitative variables
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A system of controls requires judgment and insight by those establishing them and interpreting results.

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(employee training and development, and new product development) as well as quantitative variables. To summarize, the goal-oriented control process follows the cybernetic paradigm and involves planning, decision-making and controls. It operates through a hierarchy of control, and its main purpose is the attainment of organizational goals and objectives.

CONTINGENCY APPROACH TO MANAGEMENT CONTROL SYSTEMS
Contingency theory is based on the premise that the design and use of control systems is contingent upon the particular context of the organizational setting in which the controls operate. Contingency theory was propounded in response to the universalistic approach that argues that there is an optimal scheme for control design which is applicable in all settings and firms. In contrast, contingency theory states that the appropriateness of different control systems depends on the business setting. Contingency approach is an extension of scientific management theory The theory also states that the appropriateness of different control systems depends on the setting of the business. The term ‘contingency’ implies that the structure and process are contingent on various external and internal factors. Prior to the contingency theory, the classical theory developed by management scientists like Fayol, Burns and Stalker, and Lussato assumed that people were motivated by economic rewards. It also assumed division of labor based on specialization, and the delegation of routine tasks to subordinates by hierarchical superiors. Contingency theory focuses on the interaction between the organization and its environment. It is assumed that the organization ‘imports’ energy and resources from the environment, and converts them into goods, services and by-products. The goods, services, and by-products are then 'exported’ to the environment, thus changing the environmental circumstances in which the organization operates.

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The Need for the Contingency Approach
Factors such as technology, organizational structure and the environment have led to the emergence of contingency formulations in control systems. Technology It has long been recognized that technology influences the design of control systems. New computer systems enable companies to respond to changes in the environment and refashion corporate policies rapidly. Revision of plans and estimates and new incentive programs can be worked out quickly and passed on to the workforce rapidly. Technology can help managers to use resources more effectively, and to collect data for strategic and operational decision-making. The increased use of technology has brought in new control systems that can help managers identify specific problems in administration or factory operations. The contingency approach is able to utilize the new technology very effectively in control systems.

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Organizational structure A modern organization’s structure should be such that it can cope with a high degree of uncertainty, as new tasks are constantly incorporated into the production or work process. An ‘organic1' organizational structure adapts easily to unstable conditions in rapidly changing environments. As a business grows, the work of the management increases, and the organization’s structure becomes more complicated as new tasks or lines of production are added. The management control system for such organizations is complex. The contingency approach helps in designing a control system that meets the demands of complex organizational structures. Environment In order to survive, organizations have to adapt to the demands of their environment. Management controls in an organization are greatly influenced by the type of competition faced by the firm. The contingency approach helps to develop a highly sophisticated control system in line with the intensity of competition the firm faces. Contingency theory greatly expanded the scope strategy and management control. It emphasizes the “fit” between external environmental factors and the internal resources of the organization. It analyzes the components of the organization, its structure and cultural setting, and its ability to adapt to technological and structural changes. Fisher2 (1998) developed an approach to contingency theory and management control by reviewing- contingency theory, management control systems and firm outcomes. He suggested that the assumptions that underlie contingency theory are too narrow. Fisher's approach focuses not only on the unique, characteristics of control systems, but also on the environment in which some control systems have a better fit. Fisher points out that the contingency approach has enabled researchers to develop generalizations about control systems relative to business and organizational settings. By studying contingency factors in different business settings, Fisher identified five contingent control variables: uncertainty; technology and interdependence; industry, firm and unit variables; competitive strategy; and mission and observability factors. These factors can be either external or internal to the organization, and can affect organizational outcomes, performance, resource allocation and distribution of rewards. He suggested potential research areas in contingency control that include: causal relationships of multiple variables; study of control systems in relation to other organizational aspects; human resources policies and cultural systems. These also included non-financial factors such as cycle time, lead time, frequency of orders and production performance factors. The financial factors included budgeting and standard cost systems. Fisher suggested new directions in contingency control research that would move from financial to operational and production control factors critical to organizational
The organic organization is structured to encourage flexibility and change. The structure also motivates and creates a rewarding work environment. Fisher, Joseph G "Contingency theory, management control systems and firm outcomes: Past results and future direction." Behavioral Research in Accounting 1998 Supplement, Vol. 10, p47

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performance. For example, the contingency approach could be used to explain variations in the adoption of just-in-time and activity-based costing methods in different organizations.

STRATEGY AND CONTROL SYSTEMS
According to Kenneth R Andrews, “strategy is a process by which senior executives evaluate company's strengths and weaknesses in light of the opportunities and threats present in the environment, and decide on a product market that fits the company's distinctive competencies with environmental opportunities.” Organizations usually treat strategy and control as distinct organizational functions. Strategies are developed first, as managers study their current and potential role in the environment and determine the appropriate response. Controls are designed to help organizations to achieve their goals. An organization can gain competitive advantage by integrating the usually separate functions of strategy and control. Management control systems are the tools which help in the effective implementation of strategy. It is important to analyze the different kinds of strategies, as control systems can be designed based on the types of strategies. Strategies can be considered at two levels in an organization. There are strategies for the organization as a whole (corporate strategy) and strategies for each business unit (business unit strategy). For the formulation of corporate strategy, an organization should consider the suitability of the area of business for the firm, and the mission or purpose of each business unit. This analysis will help the firm decide whether to divest or retain a particular business, and the amount of resources to allocate for each business. At the level of the business unit, a firm has to analyze the business unit’s mission, and the steps it should take to accomplish the mission. Corporate strategy is a guide to the individual business units, helping them to function in accordance with the organization goals and strategies.

Corporate Strategy

Corporate strategy relates to the firm as a whole. Corporate strategy involves making plans regarding where and how the firm can compete in an industry. At the level of corporate strategy, controls refer to the mechanism by which corporate executives influence the strategic direction of the firm and the level of achievement of the firm's objectives. Corporate strategy and controls should be integrated in order to keep employee behavior in congruence with managerial goals. An organization has a well-aligned structure, it will not function effectively without a control system in place. The organizational structure of a firm refers to its hierarchies and reporting patterns. For the effective functioning of the structure, appropriate control systems are needed. Since planning and control requirements are different for different corporate strategies, they need to be designed in accordance with the corporate strategies. For example, in the electronics business, channels of communication and transfer of competencies across various business units are critical for effective functioning, and therefore the various departments are interdependent. In such companies, the

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corporate level managers need to have wide range of control across various departments. Managers should also have extensive knowledge about the various departments and their work processes. Control systems can be framed according to the class into which a company fits. Companies can be classified into three categories: a single business firm operating in one line of business; a firm which has undertaken diversification into businesses that are related to one another; and, a firm which has diversified into businesses that are not related to one another, (except in being owned and managed by a common concern.) Corporate strategies of firms are distinctly different in firms with different levels of diversification. Firms can be classified into three categories based on the extent and type of diversification undertaken by them. Single business firm: The firm concentrates on a single business. For example, Apple Computers pursues a single business strategy of manufacturing computers.

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In the case of undiversified firms, there is comparatively less interdependence among various units. As a firm becomes more diversified, control systems should be altered to foster better cooperation among the diverse units and to encourage their entrepreneurial spirit.

There are specific activities that need to be considered when designing a control system for different corporate strategies Strategic planning: Conglomerate businesses usually use vertical strategic plans i.e. the different business units prepare strategic plans, which are reviewed by the senior management. Strategic planning systems for diversified business units are usually both horizontal and vertical. The horizontal process involves the preparation of a plan on behalf of each unit or group by an executive, with synergistic inputs from the different business units of the organization. The managers of the individual business units identify the various linkages to other business units so that they can synergize their operations. These interdependent units also require joint strategic plans.
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Single business firms and firms with related diversification are based on company-wide core competencies. Hence it is important to have good channels of communication that can allow interdependence among the different units.

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The strategic plans of the individual business units are often circulated among the various business units as this helps in getting feedback. Budgeting: In a single business firm, the chief executive can control the budgeting operations through informal methods and personal intervention. In a conglomerate, it is not possible to rely on informal interpersonal relationships, and the chief executive officer may is unlikely to be able to control all the budgeting activities in all the businesses. Hence, business unit managers have greater influence in developing their product/market environments. Incentives and compensation: The plan for employee incentives and compensation in organizations varies according to the level of diversification of the organization. In the case of conglomerates, bonus is usually formulabased. Formula-based plans are not usually popular in highly interdependent firms as their performance is based on the decisions and actions of other units. In a single business firm, bonus is determined on the basis of subjective factors such as the performance of the business. In the case of a business unit manager, the bonus is tied to the performance of the particular unit rather than the profitability of the whole firm. In the case of single business firms and those with related diversification, the compensation is usually tied to the performance of the unit and also the performance of the whole firm. Linking incentives to the overall performance of the organization helps to increase teamwork and interdependencies.

Diversified companies segment themselves into business units and assign different strategies to different business units. Such companies do not have a standardized approach for all their business units, but develop separate strategies for each business. Business unit strategy deals with creating and maintaining competitive advantage in all the businesses the company operates in. Business unit strategy for an organization has two interrelated aspects: mission and competitive advantage. A mission statement is a broad organizational goal, based on planning premises, which justifies an organization’s existence. There should be congruence between the mission statement of the organization and the controls being used. Management control systems help the manager to make decisions on the trade-off between the short term and the long term. In a diversified business, the primary task of the CEO is to make basic decisions on the businesses to undertake, the resources to deploy in each, and the integration of the multiple businesses to make them most effective. There are various planning models that help managers at the corporate level to allocate resources among different businesses. These models of planning also help in identifying the missions of individual business units. The focus of all the planning decisions are based on certain factors: • Concentrating on the internal and external factors of the business that determine the attractiveness of the market opportunities available to business units.

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The competitive ability of the business unit is likely to vary from one unit to another. So a firm has to emphasize on the performance of each business unit before allocating resources. The attractiveness of the industry in which a unit is operating is likely to vary. Hence it has to be considered when allocating resources.

Two of the planning approaches most widely used are the Boston Consulting Group's two-by-two growth share matrix and General Electric Company’s three-by-three industry attractiveness-business strength matrix. While the models differ on the methodologies adopted, they have the same set of missions for a business unit to choose from: Build, Hold, Harvest and Divest. The company should have a clear idea of the type of mission the business units have chosen, as this will help in deciding on the control systems to be used. Build: This mission indicates that the business unit’s goal is to increase its market share, even at the expense of short-term earnings and cash flow. A business unit following this mission is typically a resource user due to the heavy investment required to build a competitive position. Business units with low market share in high growth industries typically pursue a ‘build’ mission. Hold: This strategic mission aims to protect the business unit's market share and competitive position. The cash outflows, for a business unit following this mission, would usually be approximately equal to cash inflows. Typically, businesses with high market share in high growth industries pursue a ‘hold’ mission. Harvest: This mission has the goal of maximizing short-term earnings and cash flow, even at the expense of market share. A business unit following such a mission would be a resource provider in that it generates more cash than that required for further investment. Typically, businesses with high market share in low growth industries pursue a ‘harvest’ mission. Divest: This strategic mission indicates a decision to withdraw from the business either through a process of slow liquidation or outright sale. Typically, business units with low market share in low growth industries are divested. The missions discussed above should not be used in a mechanistic manner. They have to be combined with creativity, innovation and initiative by the managers for effective control systems. Thus while framing control systems a manager has to be aware of the mission adopted by each of its business units. The form and structure of a control system affects business units with different missions. Strategic planning, budgeting, and the incentive/compensation system are the main aspects determining the form and structure of the control system. Strategic planning process: Strategic planning needs to be designed keeping in mind the environment in which the company operates. In an environment where there are greater uncertainties, strategic planning assumes more importance. For this reason, the process of strategic planning is more critical for 'build' business units than for ‘harvest’ business units. A ‘build’ mission is usually undertaken in the growth stage of the product life cycle, and the
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objective of the ‘build’ mission is to increase the market share. Increasing a company’s market share involves uncertainty, particularly with regard to competitors, for ‘build’ units. Budgeting: Budgeting involves deciding on the allocation of resources and targets of each business unit. Budget revisions are more likely in the case of ‘build’ units than for ‘harvest’ units because of frequent changes in the market environment of ‘build’ units. 'Build' managers, however, usually have greater influence on the formulation of budgets, and other important management decisions. For ‘harvest’ units, the environment is usually stable, and so inputs from managers of ‘harvest’ units are less essential. Incentive compensation system: When several elements enter into the design of an incentive compensation system for business units. Managers have to decide on the size of incentive bonus payments, the measures of performance to be considered for incentive bonuses ( sales volume, product development, return on investment etc.), the criteria on the basis of which subjective judgments are to be made, the frequency of incentive payments (annual, monthly, biennial), etc. The mission of the business unit influences the type of incentive package formulated. In many firms, the completion of riskier projects is rewarded by higher compensation. Managers in ‘build’ units are therefore likely to have higher incentive payments than managers in ‘harvest’ units. Performance may be measured either over the short term or the long term. If a firm links incentives to performance in terms of profits, cash flows and returns on investment, it is said to have a short-term focus, whereas if it links incentives to performance in terms of market share, new product development and development of human resources, it is said to have a longterm focus.

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Intensity of rivalry among the existing players Bargaining power of the buyers Bargaining power of the suppliers Threat from substitutes

• Threat of new entrants An understanding of these factors, can help a business unit to frame generic strategies through which it can respond to the opportunities in the external environment. Alternative generic strategies may be developed in terms of: Low Cost: The primary focus of this strategy is to achieve low cost relative to competitors. Cost leadership can be achieved through economies of scale in production, learning curve effects, tight cost control and cost minimization in areas such as research and development, service, sales force, or advertising. Differentiation: The goal of this strategy is to differentiate the product of the business unit, in order to create a product that is perceived by customers as

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In order to accomplish its mission, every business unit should develop a competitive advantage. In order to identify its competitive advantage, a business unit should analyze the competitive structure of the industry in which it plans to operate. Porter’s Five Forces Model analyzes the competitive structure of an industry on the basis of the following factors:

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unique. Differentiation may be based on brand loyalty, customer service, dealer network, product design and features, and product technology. Focus: This strategy requires the business unit to focus on a particular buyer group, segment of the product line, or geographic market. The focus strategy helps the unit to achieve core competency by narrowing its market segment. Additional considerations: Although a firm should adopt different controls for its units, there are some problems associated with this strategy. The external environment of a business unit changes over time and shifts in strategy may be required. If a control system is over-committed to a single strategy or level of diversification, it may become difficult for the manager to shift to a new strategy. Secondly, the control system should be appropriate for both the mission and the competitive advantage of the firm. Trying to design a control system that fits both may result in conflict. In such situations, the manager has to decide whether to give priority to the firm’s mission or to its competitive advantage.

SUMMARY

The cybernetic approach to management control systems helps in analyzing complex activities in an organization. The cybernetic paradigm helps to manage the repetitive control process in an organization. Contingency theory was propounded in response to the universalistic approach that argues that there is an optimal scheme for control design, which applies in all settings and firms. Changes in technology, organizational structure and the need to adapt to the environment of the industry have contributed to the emergence of contingency formulations in control systems. Management control systems are tools that help in effective implementation of strategy. Hence, it is important to understand the types of strategies firms use in respect of diversification and how control systems can be devised for each strategy. Strategies can be considered at two levels: the corporate level and the level of the business unit. Corporate strategy relates to the whole organization and involves decisions on where to compete and how to compete. Strategies at the corporate level can be differentiated on the basis of the level of diversification undertaken by the firm i.e., whether it is a single business firm, a firm with related diversification or a firm with unrelated diversification. Business unit strategies deal with creating and maintaining competitive advantage in all the areas of business in which the company operates. Business unit strategy has two interrelated aspects: mission and competitive advantage. The business unit’s mission could be: to build, to hold, to harvest or to divest; while it can develop its competitive advantage in terms of low cost, differentiation or focus.

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Chapter 3

Designing Management
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In this chapter we will discuss:
• Impact of Information Technology on Control Systems design

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• Establishing a Customer Focused Total Quality Culture

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• Factors Influencing the Design of MCS

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• Steps in Designing MCS

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Designing Management Control Systems

A management control system is a set of interrelated communication structures that facilitate processing of information and coordination between different parts of an organization. Control systems help in the effective implementation of an organization’s strategy. The subsystems and components of management control systems should be mutually supportive so that organizational goals can be achieved. When the subsystems are properly designed, they provide a basis for an organizational control system. The control systems should be designed in such a way that they reflect the goals and strategies of the organization. It is also important to design control systems in such a way that they contribute to the effective implementation of the organization's strategies. This chapter deals with the steps involved in designing control systems, factors that influence the design of management control systems, the relationship between the style, culture and design of control systems, establishing a customer-focussed total quality culture and the impact of information technology on control systems design.

Designing control systems requires an understanding of what the organization wants from each employee individually. This involves identifying the role of each individual from the chief executive officer to each employee at the lowest organizational level in achieving organizational goals. MCS cannot be designed without an understanding of the key actions being controlled. Since the purpose of a control system is to influence actions, identifying the desired actions is important. An organization must find out what knowledge and information it requires to control employees’ actions. Another way to understand what has to be controlled is to identify the key actions (KAs). KAs differ from firm to firm, and from individual to individual. For lower level employees, such as the production line workers, KAs are easy to identify, because they are routinized and mechanical. KAs of higher level employees which involve identification of problems, team building and making investment decisions may not be easily understood as they need professional judgment. It is not easy to judge whether the actions taken are appropriate without close monitoring done by someone who has equal or higher professional knowledge. Most companies have standard sets of actions for employees who prepare investment proposals, business plans, and give justifications for recruitment decisions. These are called action controls. Role demands can also be identified through the Key Results (KRs). Key results are the areas which are important for the growth of an organization. Examples are sales performance, customer orders received etc., Key results change according to the prevailing internal and external environment of an organization. The step that follows the understanding of role demands involves understanding the likely actions or results of the role demands. If the analysis shows that what is desired is not different from what is likely, then it can be concluded that the company has an effective management control system. If the analysis shows a difference between the two, then the reasons would have to be investigated. The reason may be lack of direction, motivational problems
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Principles of Management Control Systems

or personal limitations. Depending on the severity of the situation, different controls should be applied.

Choice of Controls
The choice of controls depends on the severity of the problem. Control mechanisms can be selected from feasible alternatives (that would provide the maximum benefits). While analyzing these alternatives, managers should first consider personal or cultural control, as these have very few consequences and are less costly to implement. Usually in small organizations, most problems are solved by implementing cultural and personal controls. However, these controls work only when employees have clearly defined roles, understand their goals and expected performance levels. Choices among the various actions and results control depend on the advantages and disadvantages each control has in a particular setting. These are controls that work on the standard sets of procedures. The advantages of action controls are:

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Since these controls work on a standard set of actions, they act as a knowledge repository and guide the implementation process even when key managers leave the organization.

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This type of control does not foster creativity and innovation among employees, as employees have to follow rigid rules. Since these controls do not encourage creativity, employees tend to quit their jobs. Because of the rigidity of rules, companies have difficulty in adapting to the changing external business environment.

Result controls These are used to control the behavior of employees. These are effective in addressing motivational problems. They inform employees about what is expected of them and what they should do in order to produce the desired results. Results control can be established by first defining the dimensions on which the control has to be set. The dimensions could be either customer satisfaction or product profitability. The next step involves measuring performance based on these dimensions. Setting performance targets and providing adequate incentives to encourage employees to perform effectively is the final step. The advantages of results control are the following:

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In a positive sense, these controls are means for attaining efficiency, as they are a key element in the bureaucratic form of organization. These controls also have their own disadvantages:

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They direct managerial attention towards the actions being taken within the firm.

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Action controls

Designing Management Control Systems

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These controls are feasible, and provide effective control even where knowledge as to what actions are desirable is lacking. Result control provides on-the-job training and also provides employees an opportunity to learn from their mistakes.

Result control results in motivating employees, and commitment towards the job as it gives employees greater autonomy to perform their task. The disadvantages of result controls are these: • • Often the controllable results that the organization desires and the performance of the individual cannot be measured effectively.

FACTORS INFLUENCING THE DESIGN OF MCS
The design of control systems is influenced by a number of factors: managerial style, corporate culture, organization structure, organizational slack, stakeholders’ control and communication structures. Management style and corporate culture play an important role in designing the control system. While management style is related to the individual manager's whereas corporate culture relates to the overall organizational concept. In fact management style and corporate culture are related to one another. The style of a manager influences the style of other managers in the organization and upon the culture of an organization. Culture consists of shared values and norms of the organization and this influences the prevailing style of the management. Hence management style and culture are intertwined.
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Whether the control should be tight or loose depends on how the organization perceives the following issues-the benefits of tight controls, the costs incurred due to tight controls, and the side effects of tight controls, if any. Some organizations prefer tight control in areas that are most critical to their success. Some forms of tight controls are costly to implement, require a significant amount of the top management's time, and requires new information systems, measuring equipment or extensive studies to gather useful information. All these may add to organization's expenditure. Finally, it is necessary to know whether there are any harmful effects of the control being used. For example, if the environment in which the employees are working is unpredictable, then tight controls will not work, as employees need autonomy to take actions. As tight controls limit adaptability, employees will find it difficult to adjust to changing environment. The best control method would be a combination of tight and loose controls an environment where autonomy, entrepreneurship and innovation are encouraged, and, at the same time, employees share a set of rigid values.

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Any problem that arises as a result of this control is attributed to the employee’s mistake. Result controls and action controls are the major elements of management control systems in all organizations. After the choice of controls the next decision relates to the tightness of controls.

Principles of Management Control Systems

Managerial Styles and the Design of Control Systems
Managers differ in their styles of managing employees. The different styles have an impact on the design of the control systems. If the control systems are not designed with the managerial style in mind, then conflicts might arise between organizational goals and managerial styles. The different managerial styles that influence the design of control systems are external control, internal control and mixed control. External control External control works on the premise that subordinates can be motivated through rewards. This style is authoritative and mechanical as the organizational goals are set by the top management. Exhibit 3.1 shows the prominence of external control style in ITT. The style also establishes that to achieve the goals it is necessary to • • Form strict regulations so that employees are not able to manipulate their tasks.

This type of control has its advantages and disadvantages. On the positive side Exhibit 3.1 External Control Style at ITT Harold Geneen, manager with ITT, adapted an external control style during his tenure as a manager. He was accessible to his subordinates and developed a controller organization. The line managers were supervised by a large staff. Whenever problems arose, task forces were set-up to solve the problems. The movement of inventory, payables and receivables were checked by the corporate controller. Geneen developed a control system for ITT with the following characteristics. • Infrastructure - a highly refined formal system of goals and controls • Rewards - Bonuses were used to motivate the employees for better performance. Bonuses were 30% or more of salary. Managers were paid 12% more than the market rate. This resulted in intense competition among employees. • Communication and integration - Geneen spent the equivalent of three months per year in meetings to solve problems. These meetings helped the employees to build a cordial relationship among themselves and with their boss. • Control process - A control process was used in order to assist managers to submit their report to the top managers found the environment too tensed up to develop and succeed. Further, his style did not encourage innovation. Geneen’s style was not free of problems. There were some significant costs associated with this style. The managers found the environment too tensed up to develop and succeed. Further, his style did not encourage innovation.
Adapted from Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey: Prentice Hall Inc., 1994). 32

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Embed adequate incentives in the performance assessment systems, so that employees are motivated to perform.

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Subordinates may be motivated to perform, as rewards are directly linked to performance.

Because of high control executed by the top management, superior will be able to monitor subordinates work and there would be no manipulations. The disadvantages of this type of control are: • • Employees will not have any commitment towards the organization. They will perform only to obtain rewards and benefits. Employees will concentrate only on one aspect of their job and ignore the rest. An employee may concentrate on increasing the sales volume, and ignore customer service. Only the positive outcomes of a particular task would be informed to the higher authorities. The negative information about it will be withheld, fearing deduction in incentives. Employees will invest all of their potential in their area of work and ignore other aspects that are important for the well-being of an organization as a whole.

Infrastructure- Personal participation was encouraged. Carlson placed his confidence in the trustworthiness and motives of managers. He developed profit centers only after extensive consultation. Small staff was employed and task forces were used to solve problems. Rewards - Bonuses were paid in relation to performance against plan. Communication and Integration - Carlson emphasized teamwork in problem solving. He used the concept of personal communication extensively in order to knit the organization together. Control process - Reports were focused on people. Commitments started at the lower level of the hierarchical structure. Managers were held responsible for their commitments. Carlson's style too was not free from problems. It was extremely difficult to implement the participative style in an organization as big as United Airlines.

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Adapted from Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey: Prentice Hall Inc., 1994). 33

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Internal Control Style at United Airlines Ed Carlson, former CEO of United Airlines, used the internal control style. His style led to the design of a control system with the following characteristics.

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This style works on the premise that subordinates will be motivated and committed to the organization if they are involved in the decision making process. United Airlines has achieved success by adopting this style (refer exhibit 3.2). The style assumes that employees will experience a sense of achievement, recognition and self-esteem if they are involved in the decisionmaking process. The following are strategies that are important to implement internal control style: Exhibit 3.2

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The management style should be participatory in nature as the employees are involved in the process of decision making. The emphasis here is not so much on achieving the goals, but on how well they are set. Strategies are designed to solve problems jointly, and not to blame a particular individual for its occurrence. When an employee's performance moves in an undesired direction, the subordinates and managers meet to identify the reasons for this and to develop appropriate solutions to the problem. Thus this system works in a positive direction to analyze problems at an early stage.

Rewards in this system are not based on one or two specific measures of performance, but on accountability of the overall performance. This management style does not punish an employee for his past actions, but intends to improve his performance in the future. The advantages of the internal control style are the following:

• •

The two types of control discussed above have their own advantages and disadvantages. Hence a manager has to carefully analyze the benefits of each style and carefully choose the style that would be most beneficial for the organization. The characteristics of mixed control style of Litton industries are shown in exhibit 3.3. Sometimes a manager has to balance both types of control styles in the organization. In doing so, he has to consider four important issues. They are: Congruency between control and managerial style: In order to choose the type of control to be adopted for the organization, a manager has to first analyze his style of management. If his style is participatory in nature, than internal control would be a better. If it is authoritative, then adopting the internal control style would not work, as the subordinates may not be used to putting forward their views during the decision-making. They may not be in a position to set realistic goals. Hence, there is a need for congruency between the managerial style and the control style. Analyzing the climate, structure and reward system of the organization: All these factors determine employee behavior. For example, if employees are

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Mixed control

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The information provided in this control is basically meant for identifying the problems and suggesting corrective action. Hence it does not work as an evaluation tool for rewarding employees.

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This type of control encourages accountability towards the work and an open work atmosphere. Employees are free to give their feedback on managerial decisions. This style has certain disadvantages too. They are:

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It inspires high levels of commitment and motivation in the employees. Since the employees also take part in the decision-making process they are more focussed on achieving the targets.

Designing Management Control Systems

Exhibit 3.3 Mixed Control Style at Litton Industries Roy Ash, co-founder and president of Litton industries, made use of the mixed control style. His style consisted of the following characteristics: • Infrastructure - For a diversified organization like Litton, the appropriate approach to decision making and problem solving should be that of an analytical type. Roy Ash used the same approach. He chose people who possessed strong analytical powers and strategic skills. Rewards – Roy Ash selected only the best people and made sure that they were given their dues they deserved. Communication & integration - Roy Ash arranged numerous small meetings in order to communicate with people more frequently. Control process - Though the financial plan at Litton was presented yearly, it was updated monthly and quarterly. Performance reports against plan and cash flow statements were prepared weekly. The numerical reports were fewer in number.

• • •

Adapted from Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey: Prentice Hall Inc., 1994) .

Reliability of job performance measures: In some organizations control systems clearly indicate the performance measures that have to be implemented in the organization. But some control styles do not indicate the performance of the employees clearly. For example, an external control system cannot be implemented if employee's performance is not measured precisely. This requires loose and more internally oriented organizational control. Individual differences among subordinates: It is usually assumed that a manager has a clear understanding of the nature of all the employees and their needs. Some employees may be willing to take part in the decision-making process while others may not be interested in it. A manager should consider all these factors while finalizing his choice of control system for the organization. It may be difficult for a manager to consider all the factors discussed above. Therefore, the manager should sequentially prioritize his decisions. • Firstly, a manager needs to question himself about the managerial style he uses, the strategy of the organization, the accuracy and reliability of the performance measures and the willingness of the subordinates to participate in the decision-making process. The best way for a manager to choose the most appropriate control style is to use the decision tree approach. Also, a manager should consider the trade-off for different styles that can be applied to a particular situation. This trade-off has to be prepared by weighing the desirable and undesirable effects that a control system can have on some subordinates.
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used to a participatory work environment, and the organization adopts a tight control system, then there will be no congruence of goals.

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Just as an organizational strategy is important for the implementation of organizational plans, a control system and the way it is implemented play an important role in making an organization and its employees more productive. Management control is the process by which an organization ensures that its sub-units act in a coordinated and cooperative fashion so that more resources could be obtained and optimally allocated in order to achieve the organization's goals. Corporate culture consists of shared values, common perceptions and common premises that the members of an organization use to achieve goals. Organizational culture influences several basic premises of an organization and, hence, has a major influence on the organizational goals. Thus, while designing management control systems, the heads of an organization should take its culture into consideration. Bureaucracies, markets and clans are three types of corporate control mechanisms that exist in varying degrees in different organizations. Bureaucracies follow strict formal rules, procedures and directives. It has clearly defined roles for each member of the organization. The most important component of a market-based approach is creating incentives to motivate performance. In the case of the clan control mechanism, the organization depends on values and beliefs to boost performance. Values and beliefs are conveyed to the employees at all levels, initially through recruitment and socialization process and subsequently through training and development.

Corporate Culture and Design of Control Systems

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Dedication to work towards excellence Decentralized business Total quality management Empowerment of people

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Employees should also be rewarded appropriately for understanding and implementing the suggestions proposed by the management and achieving new goals. Sometimes, as a result of resistance from the leader certain changes are prevented from being implemented. In such cases, it is better to change the leader. After the change has been implemented, it is important to extend it on to other sub-systems of the control system. Impact of corporate culture upon control system Culture becomes an important asset of an organization when it is properly imbibed in an organization. Conversely, it is a liability when it adapts poorly to the environmental needs of the organization. The strength of culture depends on the following three factors:

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Corporate culture helps in the overall coordination of all the activities of an organization. In an organization when the goals and values are shared by the individual members, problems are minimized and a sense of group loyalty prevails. For example, IBM has designed the following belief system for its employees.

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The assumptions made by the organization The clarity of the assumptions and How well they are shared within the organization.

A control system must be so designed that it fits the existing culture of the organization. This can be done by stressing on the values that the management wants its employees to follow and rewarding them for achieving goals based on these values. In order to foster desirable values in an organization, the subsystems and components of its formal control systems should be so changed as to inculcate these values.

Decentralization and Design of Control Systems
It is necessary for every organization to decentralize the decision-making authority, so that sub-goals can be set. In this way, every decision-maker is made responsible only for a small portion of the overall organizational objective. Decentralization ensures that the decision-maker arrives at the right decision by making use of sufficient information. However, decision-makers should find ways to deal with the complexity in the organizational environment even when the information available to them is limited. The purpose of a control system is to knit the subunits of an organization together. Without a centralized control system, it would be difficult to bring this about. There what is important for an organization is not whether it should be decentralized or not, but to what extent it should be decentralized.

Organizational Slack and Design of Control Systems
Cyert and March define organizational slack as “the disparity between the resources available to the organization and the payments required to maintain the coalition.” Organizational slack occurs when an organization underexploits its environment. This under exploitation results in higher salaries, wages and perquisites than necessary to carry out the goals and objectives of the firm. Dividends may be higher than necessary to maintain the confidence of shareholders. But, in terms of management control systems, slack acts as a cushion against changing the business environment and provides resources for innovation and adaptation in various areas.

Stakeholder Controls and Design of Control Systems
The stakeholders of an organization include investors, customers, employees, suppliers and the public. It is necessary for the organization to determine the goals and objectives, performance measures of each of the above categories. A functional organizational structure is designed keeping these goals in view and then managerial controls are designed for departments of the organization. Based on the relationships and the goals, organizations exercise control over stakeholders. The analysis of stakeholder relationships begins with identifying all the stakeholders. The next step is to distinguish the most important stakeholders. This group consists of stakeholders who are highly influential, powerful insofar as the organization's decision-making process is concerned.
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The next step is the analysis of the inducements that can be offered to the stakeholders. Inducements can include material rewards, power, distinction and participation in the activities of the organization. Next, the contribution for a particular stakeholder has to be analyzed. Contributions include capital, revenue, performance and community support. Finally, the competition for a particular stakeholder is analyzed. All these steps help the company in identifying crucial stakeholder variables that help in monitoring and influencing the control process.

Communication Structures and Control Process
The formal and informal communication within an organization include meetings, day-to-day contacts among managers, body language etc. All these formal and informal communication are crucial in understanding and improving the control process. Let us discuss how communication structures support control process with the help of information systems. The first element of the information system is a formal or informal process, which scans the environment in which an organizational subunit operates. After this the organization requires a planning process. The planning stage is the most crucial of all, as it involves four sub-processes namely strategic planning, business planning, long range planning and operations planning. All these processes would remain incomplete without proper communication across various levels of the organizational hierarchy. Feedback is necessary after the completion of each stage (environmental scanning, planning). The feedback is compiled in the form of a report. This is followed by decisionmaking procedures and implementing them.

Organizations in the present-day competitive environment need to concentrate on customer satisfaction. In markets that offer a number of options to buyers, companies can place themselves in an advantageous position by concentrating on customer-focused total quality culture. While, on one hand, organizations have to respond to the needs of the customer, on the other hand, they have to increase their efficiency to compete with others in the business. Total quality management ensures that organizations attain the required levels of efficiency targets as well as satisfy customers. Thus, TQM can be described as a system that emphasizes customer satisfaction and commitment to continual improvement of its services and products to meet the needs of existing and potential customers, through empowerment and active involvement of all the staff. Control is an integral part of any business. Lack of structured and formal quality assurance and control training adversely affects the progress of the quality improvement program. TQM follows a cybernetic paradigm in solving problems: • First, the top management makes (clear to the rest of the employees) the key philosophical principles of TQM.

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ESTABLISHING A CUSTOMER-FOCUSED TOTAL QUALITY CULTURE

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The top management then sets up a company wide quality improvement program. This program consists of a quality improvement team which is formed according to the mission and targets of the organization. The main task of the team is to communicate the various philosophies and charter subunit teams in a hierarchical fashion. The next step involves each team coming up with ideas about products and services that need to be launched. It also involves covering manufacturing products according to the expectations of the consumers.

Implementing Total Quality Management
Implementing TQM is a long process. It may take as many as seven years to complete the process. It is the responsibility of the top management to implement TQM. The top management should search for expert trainers and organize TQM training programs for the different teams within the organization. The teams should be encouraged to work towards the improvement of TQM objectives. This encouragement may assume the form of rewards and recognition given to the employees for good work. Middle management should ensure that the environment needed for the implementation of TQM is easily susceptible to changes and continuous improvement. Figure 3.1 shows the importance of formal and informal systems necessary to support a TQM program. The subsystems and components of a control system should be so designed as to help a TQM program achieve customer satisfaction.

IMPACT OF INFORMATION TECHNOLOGY ON CONTROL SYSTEMS DESIGN
Information technology has benefitted traditional control systems1 in many ways. • The various departments of the organization can work towards achieving the organization's goals and collaborate for fast decision-making.

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• Data can be collected for strategic and operating decisions. With the help of the new spreadsheet technology, the budgeting process of a company can be speeded up, and the quality of the budgets can be improved. New technology also ensures that managers update the budgets. Data architectures2 help companies adapt to regulatory or other environmental changes. In production facilities, information technology is increasingly being used for speeding up the control process. Prior to the advent of information technology, any faults in the production process could not be detected until there was some
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William J Burns, Jr. and F. Warren McFarlan “Information technology puts power in control systems” Harvard Business Review, Sep/Oct87, Vol. 65 Issue 5, p 89. Data architecture gives the desirable features of the corporate database, such as an integrated, well-formed business view, while overcoming the practical difficulties like customer, order, sales, etc. and the systems in which they appear.

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Data can be managed more easily, and at a reasonable cost.

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Figure 3.1: Management Systems for Total Quality
INFRASTRUCTURE • SBUs • Problem solving teams • Responsibility for quality distributed throughout • Staff support for quality methodology STYLE & CULTURE • Style • Participative/teamwork • Values • Strong customer focus • Continuous improvement • Innovation as a value • Trust

REWARDS • Based on quality performance • Recognition programs • Consistent throughout organization • Skepticism tolerated • Cynicism rejected

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CONTROL PROCESS Statistical quality control Informal active planning Competitive benchmarking Activity-based costing Target costing Other performance measures Customer satisfaction measures • Vendor measurements • Cost of quality measurements

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Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey: Prentice Hall Inc., 1994) 136.

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major breakdown. But with the new technologies even a slight change can be detected. Information technology can also help a company align its control and sales-incentive measures. New inventory tracking systems can help companies update account balances, monitor inventory and alert manufacturers and suppliers for upcoming requirements. As control systems operate all the areas of an organization, any change in them requires changes to be made in the overall structures and strategies of the organization. Therefore, managers should take the right decisions in choosing

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COORDINATION AND INTEGRATION • • • • Training in TQM Problem solving tools Employee involvement Open and candid communication

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what type of technology requirements the organization needs. Technology should be used for making work easier rather than indulging in complex and expensive systems such as costly data, storage systems.

Providing Information for Operational and Strategic Decision Making
The decline in the cost of information processing led to the rise of ABC (activity based costing) systems. These systems provide accurate cost data for the operational and strategic decisions in an organization. The availability of an electronic equipment, called the optical scanning equipment, has improved the efficiency of inventory control techniques. This equipment is also used to conduct market research by noting customers’ demand patterns.

SUMMARY
Designing control systems require an understanding of what the organization wants from each of its employees. This involves identifying the role of each individual from the chief executive officer to the employees at the lowest hierarchical level in achieving organizational goals. While designing a control system, it is necessary that the managerial style and the culture of the organization should be clearly analyzed. There are three types of managerial control systems namely external control, internal control and mixed control. External control is authoritative and mechanical, as the organizational goals are set by the top management. This style works on the premise that subordinates will be motivated and committed to the organization if they are involved in all aspects of decision making. In the case of the mixed control style, the manager analyzes the benefits of each style and carefully chooses the one that would benefit the organization the most. The control process includes the essential elements of planning, decision-making and control. Decentralization ensures that the decision-maker arrives at right decision with the help of sufficient information. Organization slack occurs when the organization under exploits its resources. In such cases, the organization incurs extra costs in all its functional operations.

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Stakeholders are the essence of an organization and it is the duty of every organization to identify key stakeholders variables and monitor their performance. The designer of a control system designer should make use of communication structures to coordinate various activities of the organization. TQM ensures customer satisfaction and commitment to the continual improvement of the organization’s services and products to meet the needs of existing and potential customers, through empowerment and active involvement of the staff. Subsystems and components of control systems should be designed to assist TQM in achieving customer satisfaction. New technology has benefitted control systems in a number of ways by helping companies manage data easily.

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Chapter 4

Key Success Variables as
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In this chapter we will discuss: • • • •

Concept of Key Variables

Identifying Key Variables Key Success Variables and the Control Paradigm Comprehensive Performance Indicators Key Variables in Selected Industries

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A key variable is a significant indicator of business activity, whose sudden and unpredictable change warrants immediate action by management. Key variables are also referred to as key success factors as they help in explaining the success or failure of the organization. A small change in a key variable will have a significant impact on the performance of the organization. The nature of the task, the technology and the environment in which the organization operates are the factors which greatly influence the identification of key variables. An important function of key variables is that they indicate to the management the necessity for prompt action. A manager should identify a few variables that are crucial to the attainment of strategy, goals and objectives of an organization. Once they have been identified, the manager can rely on these key variables to monitor business activities and alert the organization to the changes in the business environment that could significantly affect the attainment of management goals. The top management should analyze the reasons for significant changes in key variables continually. Some examples of key variables are profitability, market position, productivity and employee attitude. This chapter looks at the importance of key variables for organizations, the identification of key variables, and the types of key variables.

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A key variable is a significant indicator of business activity. Any change in its value is expected to have an impact on the performance of the organization. It is the responsibility of every organization to identify key variables as they are indicators as to the likely success or failure of the business. The nature of key variables differs from organization to organization depending on the nature of the task, the technology and the environment of the organization. Key variables have certain characteristics that help the manager to identify them. However, the actual selection of key variables requires a thorough understanding of the business, its operating environment and management goals. The management can identify key variables either for the whole organization or for the major centers of responsibility. Although key variables differ from business to business, they have certain characteristics in common: • They are important in explaining the success or failure of the business unit. A key variable can be identified by analyzing those strategic factors which directly influence the attainment of management goals. The questions to be asked are: “What is the organization trying to achieve, and what factors will cause the organization to achieve or not achieve these goals?” Key variables require examination and in-depth evaluation. At the stage of in-depth evaluation, the manager has to make a subjective judgment as to whether each factor identified is important in explaining the success or failure of attaining management goals. Sometimes it may be necessary to reassess the factors that affect the attainment of goals. For example, a hospital may be particularly concerned about the quality of its services. Factors measuring the number of patients seen by the clinic staff per hour may indicate the staff is over- or under-utilized, but would provide no
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CONCEPT OF KEY VARIABLES

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Exhibit 4.1 Identifying Key Variables • • • • • • • Identifying strategic factors influencing the managerial goal Accept or reject the above factors In-depth examination of each factor Select measurable factors or replace the factors that are not measurable Identifying factors that are volatile Identifying the predictable variables The final step is determining whether appropriate management action is taking place when significant change occurs in a key variable

Source: ICFAI Center for Management Research.

Changes in key variables are not easily predictable. The choice of key variables requires the manager to make a subjective judgment. A long and exacting test to determine the volatility of each factor is not necessary, but the factors selected for further consideration as key variables should be more volatile than those rejected. Management action is required when a significant change occurs in any key variable. The manager should select as many key variables as required to run the business, possibly two or three, but no more than six. If too many key variables are selected, the significance of each one is diminished. Predictable variables are of little use as key variables. Obviously, if an event can be predicted with a degree of certainty, then appropriate management action can easily be taken. Thus, a variable that tells the management something already known or readily predictable is of little value.

IDENTIFYING KEY VARIABLES
The most common method of identifying key variables is the input-throughoutput model. The input variables are related to raw material, the throughput variables to production, processing and manufacturing, and the output variables to marketing.
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Key variables are volatile; they can change rapidly for reasons often beyond the control of the manager.

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They must be measurable, either directly or via a surrogate or substitute. For example, client satisfaction for a non-profit counseling center cannot be measured directly, but a surrogate such as number of follow-up appointments or cancellations, can be selected as a key variable.

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information on the quality of the services provided. A more appropriate factor may be the number of appointment cancellations.

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Key Success Variables as Control Indicators

A generalized list of key variables is given below. However, every organization will have to identify the key variables relevant to it for itself.

Input Variables
Key input variables could include the following: Raw material availability This is an important key variable; its absence leads to lower capacity utilization. Organizations find it difficult to recover their fixed costs, when raw materials are not readily available. Inability to procure raw material may even lead to the closure of the organization. Raw material quality The quality of the raw material is critical for the quality of the end product, and for the profitability of the firm. The quality of raw materials is tested through simple sampling techniques. As payment for a product is made on the basis of quality, the maintenance of quality becomes crucial. Raw material costs The management needs to keep a close watch on raw material costs, particularly when they constitute a large percentage of the total cost.

Production Variables
Capacity utilization

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Capacity utilization is an important variable and is affected by either marketing variables or procurement variables. For example, in the dairy industry, capacity utilization is affected by milk products sold or by milk procured. Capacity utilization reflects the ability of the production staff to schedule and plan what to produce, how much to produce and when to produce. In service-oriented organizations, it is necessary to decide on the appropriate measures to indicate the utilization of resources. For example, in movie theaters and hotels, percentage of occupancy is an indicator of capacity utilization. Losses Another key variable related to production is the percentage of spoilage and wastage in process of manufacturing the product. In manufacturing industries, the management should monitor the yield percentage closely. Quality control The quality of the product is important for all organizations. Most organizations aim at a zero-defect state. It is necessary to identify the measures of quality. The number of complaints from customers and the quantity of goods returned are usually good indicators of quality. Maintenance Maintenance of equipment is crucial to ensure smooth production and better capacity utilization. Maintenance can be categorized as preventive
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The key variables related to production are:

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maintenance and breakdown maintenance. The number and percentage of productive hours lost due to maintenance may be selected as a key variable. Costs It is essential to control costs as they have a significant impact on profits. Appropriate measures indicating the impact of costs should be developed. Delivery Timely delivery is critically important in certain situations. Delays in delivery systems need managerial attention. For example, the production department of a dairy industry has to ensure that the distribution department gets the milk on time.

Marketing Variables

Market share

The market share of a company indicates its performance and its competitive strength. This variable helps the company to monitor its performance. If institutional sales comprise a significant part of total sales, the number of orders received from institutional buyers is a key variable. A decline in institutional sales is a signal of trouble in the marketing area.

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Asset Management Variables
The management of fixed and current assets is important for an organization. Asset turnover The asset turnover denotes the relationship between the total assets in an organization and sales volume. A decrease in asset turnover is not a good sign for the organization and needs immediate managerial attention. Working capital turnover The efficiency of management of working capital is indicated by the working capital turnover. The inventory turnover and accounts receivables turnover can also help in the analysis of working capital. A low inventory turnover indicates building up of inventory – an indication that something is seriously wrong in inventory management.

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The order book position is important for organizations that undertake manufacturing based on orders. It helps the marketing department to decide the planning schedules for marketing and distribution.

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Marketing variables are of crucial importance in a competitive economy. Some important marketing variables are:

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Key Success Variables as Control Indicators

Sources of Key Variables
Key variables arise on the basis of: Industry characteristics In a given industry, there are certain general requirements for success, which apply to all the firms. In the insurance industry, for example, the basic requirement for the success of a firm is a positive investment performance. Similarly, in the hotel industry, the occupancy rate is the criterion for success. Environmental factors The economic and the political climate are the major environmental factors which determine key variables. For example, publishers who depend on the postal services are affected by postal rates. Competitive strategy The strategy that a company adopts usually determines the variables that must be monitored and emphasized. An organization that follows a low-cost strategy will require an analysis of the product cost structure. Stakeholders Aspects of the business that are important to key stakeholders, namely customers, executives, suppliers or creditors, may also be considered as key variables. In an organization with a function-based structure, every manager can identify one or a few key variables related to the function of the unit. A key variable for an operations manager, for example, is the quality of goods produced.

Types of Key Variables

Key variables can be classified broadly into the following categories: strategy, structural, process and environmental. According to a framework prepared by Samuel Paul1 there is a positive relationship between the key variables and the organizational performance. Performance of an organization improves if there is congruence between the different variables. Strategy variables refer to the long-term choices concerning the programs, goals, policies, and action plans that are formulated by an organization. The structural variables can be studied in terms of the structure of the organization: centralized or decentralized form of organization, and the organizational autonomy. Structural variables thus represent the organizational arrangements and the distribution of authority and relationships. Process variables refer to the processes that influence the behavior of the employees towards the achievement or organizational goals. Some examples of process variables are the participation, monitoring and control, human resource development, and motivation. Environmental variables help in understanding the scope, diversity and uncertainty relating to an organization. For example, scope in terms of marketing refers to the area that is being covered by the organization. The
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Samuel Paul, Managing Development Programmes: Westview Press, Colorado, 1982, p. 104

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Significant functions

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scope of the environment also depends on whether the firm is well diversified or deals in a single commodity. In the case of the former, the scope is broader as the interaction between the organization and the environment is complex. When all these variables are perfectly aligned then an organization can achieve congruence of its performance with its goals.

KEY SUCCESS VARIABLES AND THE CONTROL PARADIGM
The control system should be designed to fit in with the hierarchical structure of an organization. Control experts should weigh the pros and cons of different organizational structures. Through decentralization, the management gives autonomy to the managers of the various units of the organization. Responsibility centers are set up to coordinate and control various activities. Each responsibility center has its own goals and strategies. The control system designers should design the control systems in a way that helps managers to achieve their unit’s goals without conflicting with the overall organizational goals. This can be understood more clearly by analyzing the dynamics of the control process.

After identifying the key success variables of a firm, it is important to examine the dynamics of the control system. A control system has two sets of dynamic interactions: reinforcing interactions and balancing interactions. The interactions can be seen as cause and effect relationships in organizations. They are usually circular i.e. the last reaction links back to the initial action, and are called causal loops. As an example, let us consider three employees A, B and C. If A expresses confidence in B’s performance at work, he shows trust and respect for B. This motivates B to perform even more effectively towards the achievement of the organization’s goals. B’s performance is then noticed by C. If C commends B’s performance to A, it is a positive reinforcement and is called a reinforcing causal loop. Causal loops may also be negative, as will happen if there is reduction in trust between A, B and C. This also results in a reinforcing circle but in a downward direction. According to systems theory, a change in one variable causes changes in the secondary variables. For example, if A expresses lack of trust in B, this would be a reinforcing feedback in the downward direction. But if C has a positive opinion of B’s performance and commends his work to A, this checks the downward spiral and acts as a balancing force. The feedback of C with regard to B is a secondary effect. The above example indicates the importance of secondary effects. When one subsystem or element is changed in an organization, there are influences on a number of other subsystems. These are called secondary effects. When a reinforcing process is set into motion, it too has secondary effects that may slow down the process of the work. Delays in the control process may occur for the following reasons: • • When the management overreacts to a problem. When the management is faced with a complex problem that it is unable to solve, the gap between performance and expectations is reduced. This results in a lower level of performance that can delay the work process.

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A dominant team member can block informal planning efforts by bringing in his own solution to a new problem to be solved. This may increase the time taken for planning and further delay the whole process.

The above dynamic control problems can be minimized by creating an organization which “learns” – the type of organization termed as an adaptive organization by Senge and Kirby. An organization that is open to new ideas and encourages employee creativity and continuous learning can be termed as a “learning” or adaptive organization. A participative management style supports a learning organization. The dynamics of controlling a management team A newly formed team must develop a shared vision for its goals or objectives. It must also assess the current situation in terms of vision. The team must gather information to understand the current situation and then take appropriate action. By implementing decisions and getting feedback, members work on common goals and strategies that are aligned with the needs and vision of the organization. A study undertaken by Kirby shows that a reinforcing system of informal activities enables successful teams to achieve their goals. The key findings of the study are: Table 4.1 Key Variables Used in Certain Industries Accounting firm Airline

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Counseling center Electrical utility Health clinic Hospital Leasing company Magazine Professional organization Restaurant Retail store Telephone company

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Key Variable

Billed hours/Available hours Paid seats/Capacity seats Fuel cost/Miles flown Acceptance/Offers made Number of appointments Number of cancellations KWH sold Customer contacts per day Beds occupied/Available beds Number of transactions Renewals/ Subscription expired

Meeting attendance/Total members Labor cost/Revenue, cost/Revenue Gross margin by departments Access minutes of use Raw food

Source: Henry Wichmann. Jr et al “key variables as a management tool,” CMA Magazine, March 1990, p23. 49

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• • •

Successful teams have a culture of trust and openness. The leaders of successful teams develop certain preconceived premises about the best way to perform any given action. The group has a shared vision about the objectives to be achieved, and uses free interchange of ideas to promote better ways of achieving the targets. Further, this sharing of ideas leads to improvement in performance and creates an environment that increases team learning. Providing the right feedback also increases the level of trust and openness in the teams.

Roger Hall identified five key variables for a publishing company: • • • • The advertising rates of the publisher The annual expenditure incurred for the promotion of subscriptions (i.e. advertising the magazine). Annual expenditure for the promotion of the magazine. The size of the magazine i.e. number of pages per issue.

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Hall found four critical relationships in the interaction between a magazine publishing firm and the environment. The first relationship specified the demand for advertising pages as a function of the price or rate charged advertisers per thousand of paid circulation. Hall found a negative relationship between advertisement page sales and price. The second relationship was related to the demand for regular subscription. The demand for regular subscription was related to the number of trial subscriptions and regular subscriptions that were expiring which created a potential for renewal, the size of the magazine, and the rate charged to annual subscribers. The third relationship was concerned with the sales of trial subscriptions. This was a function of promotional expenditure and magazine size. The fourth relationship related to the total cost of producing the magazine. This was a function of the size of the magazine i.e. number of pages delivered to the readers.

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The annual subscription rate.

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Identifying Key Variables – An Example

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This level of trust and openness reduces the gap between current performance and the goals of the team members. This is referred to as “creative tension”. When employees are able to perform effectively in order to fill the performance gaps, the situation is said to be one of “creative tension”. Sometimes team members are unable to achieve the organizational goals because of distractions on account of their ambiguous roles. This referred to as “emotional tension”. The matrix structure usually has this role ambiguity because of the competing and often ambiguous instructions given to program participants by program and functional managers. The way in which teams respond to such ambiguous situations separates the excellent from mediocre teams.

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Implications for the control structure Important parameters on which the control structure is to be based include: • • • • Efficiency and effectiveness Economies of scale Coordination Assignment of responsibility for profit

Publisher

Editor

The hierarchical structure of an organization makes it possible to process all the information pertaining to key success factors in order to make business decisions. Through decentralization, the management gives a degree of autonomy in decision making to subordinates. The designers of the control system establish critical success factors that help managers achieve the goals of their sub-units. Each unit and sub-unit of the hierarchical structure should coordinate and control the various key success factors in pursuit of the overall goals of the firm.

COMPREHENSIVE PERFORMANCE INDICATORS
Every organization needs to identify the variables that influence its success at each level so that it can monitor and predict the values of key variables. The main idea of monitoring the performance of key variables at each level of the organization is to push them to the desired level and, if that is not possible, to
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Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey: Prentice Hall Inc., 1994) 87.

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Circulation manager

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Figure 4.1: Organization Chart for a Magazine Firm

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For an effective control system, a divisional structure with departments divided on the basis of function, is preferred. In a publishing firm, the divisional structure depicted in Figure 4.1 may be adopted. For a publishing firm, the quality of editing is crucial. The editor, thus, has a significant influence on the quality variable, as well as on the long-term future of the business. The control structure put in place depends to a great extent on the divisional structure of an organization. Each success factor is assigned as a goal for a specific responsibility center. Thus, all the responsibility centers together contribute to the achievement of all the goals of the firm.

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Advertising manager

Principles of Management Control Systems

react to the performance of the key variables so as to compensate appropriately. Key variables should be identified at each level and for each responsibility center of the organization. The measurement of key variables is not free from problems. One danger is that of concentrating on the variables that are easy to measure. Variables which are difficult to measure but which are important to the achievement of long-term goals are often ignored. For example, firms often emphasize shortrun profits and encourage managers to produce good ‘numbers’ (production in term of quantity), regardless of the long-term effects on the business. This results in the reduction of expenses on research & development, maintenance, and employee development which may not affect the performance in the short-run, but play a significant role in the accomplishment of long-term goals. A number of precautions have to be taken with regard to the measurement of performance in any responsibility center. First, the variables that are measured should correspond with the goals and objectives of the organization. Second, only those variables that are crucial should be measured, and they should be measured even if they are qualitative. Key success factors should not be omitted from the control system because they are qualitative. Third, the measurement of the factors should be developed in such a way that the measures taken in the short term take account of both short-term objectives and long-term goals. The process for measurement of key performance variables can be observed by looking at the case of General Electric. General Electric divided the task of measuring key success factors in the company into three sub-projects which involved developing performance measures for each of the company’s departments. The exercise focused on: • • • Measuring the whole department as an economic entity. Measuring the functional departments such as marketing, finance etc. Measuring the performance of the management of the departments.

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On the basis of the above measures, the principles for the control program at GE were formulated. The principles focused on providing: • • • Factual knowledge to support judgment in the performance appraisal of departments. Performance information for both short-run as well as long-term goals. The minimum number of measures for use at each level of the organization.

GE developed the following performance measures for each of its departments: 1) Short-term profitability 2) Market share 3) Productivity 4) Product leadership 5) Personnel development

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6) Employee attitude 7) Public responsibility 8) Balance between short-range objectives and long-range goals

Limitations of Indicators
Indicators are used to understand an organization’s current state of affairs and for initiating corrective action. However, there has to be consensus on what the indicator really means and conveys. Performance indicators have the following limitations: (a) The absence of consensus among managers on the use of indicators (b) Problems encountered during the measurement of indicators (c) Lack of clear specification of the unit of measurement These limitations can be overcome by developing systematic and scientific methods to improve the quality of the data on which decision-making is based.

Insurance Industry
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Growth rate in insurance business with respect to each policy

Sugar Industry
• • • Price of sugar sold in the open market Transport cost per ton of cane Fuel cost per kilogram of sugar
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Hotel Industry

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Room occupancy rate Number of complaints by customers Amount of food wasted in the restaurant Percentage of revenue contributed by the restaurant Percentage of absenteeism among employees

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Number of policies processed in a given period of time

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Number of claims settled in a given period of time and number of claims outstanding

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Given below are important critical variables in various industries. They illustrate how key variables or key success factors play an important role in day-to-day operations.

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KEY VARIABLES IN SELECTED INDUSTRIES

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(d) Lack of consistent information leading to incorrect conclusions.

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• •

Number of production days lost Support price by government

Management Training Institute
• • • • • Number of students appearing for an entrance examination Percentage of absenteeism among students Number of research projects undertaken and completed Time spent by faculty on teaching and research Time spent on management development programs

Power Industry

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Availability of wagons for transportation of coal Availability of water Capacity utilization

Preventive and breakdown maintenance

The most common method of identifying key variables is the input-throughoutput model. The input variables are related to raw materials and other inputs, the throughput variables to production, processing, manufacturing, and the output variables to marketing. Key variables arise on the basis of: industry characteristics, competitive strategy, environmental factors, stakeholders and significant functions. The nature of key variables varies from organization to organization depending upon the nature of the task, the technology used, and the environment in which the organization operates. Key variables can be classified broadly as strategy, structural, process and environmental. The control system should be designed to fit in with the hierarchical structure established by an organization. Control experts should weigh the pros and cons of having different organizational structures. Through decentralization, the management gives autonomy and empowers the managers of the various units. Responsibility centers are set up by firms to coordinate and control various activities. Every organization needs to identify the variables that influence its success at each level so that it can monitor and predict the values of key variables. This is done with the help of performance indicators. The main purpose of monitoring the performance of key variables at each level of the organization is to direct them towards the desired levels, and if that is not possible, to take appropriate compensatory action.

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Key variables are those variables to which the goals, strategies and objectives of the management are most sensitive. Every organization should identify the key factors which are important for its success.

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The inputs for a power industry are coal and water. The output variables include transmission losses. The key variables include the following:

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MANAGEMENT CONTROL ENVIRONMENT

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PART II:

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Chapter 5

Organizing for Adaptive
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In this chapter we will discuss: • • • • •

Strategy, Structure and Control Decentralization Vs Centralization Response of Structure to Strategy: Evolution of the Matrix Structure Evaluation of the Control Factors in Organizational Design Controller’s Organization Adaptive Organization.

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For effective implementation of organizational goals, it is necessary to design the elements of control system infrastructure (such as organization structure, responsibility centers, rewards and performance measures) which are mutually supportive and adaptive. An organizational structure should be designed in such a way that it facilitates information processing and communications. In this chapter, we will discuss the infrastructural aspects important for an organizational design. We will also discuss the influence of strategy on organizational structure and control requirements; the evolution of multidivisional structures in response to the changes in control requirements; the importance and organization of the controller's function and the characteristics of an adaptive organization.

STRATEGY, STRUCTURE AND CONTROL
With the rapid changes in business environment, organizations have adopted multidivisional structures. Multidivisional structures are decentralized structures where the divisional managers have a fair degree of autonomy in decision making and are held accountable for the functioning of the firm in terms of profits achieved or assets utilized. Decentralized multidivisional structures improve the managers’ ability to evaluate the performance of enterprises.

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It allows closer control and supervision of subordinates within the division. Since managers are empowered to take decisions, they are motivated to perform better keeping in mind the goals and strategies of the organization. It helps evaluate overall performance of the various organizational units of the business. It also ensures that managers are given right environment and autonomy, wherein they are trained to make the right decisions.

• •

One factor which affects decentralization to a large extent is the development of control techniques. A manager cannot delegate authority without having some way of knowing whether it will be used properly or not. Improvements in statistical devices, use of accounting controls and computers have helped managers to develop better control.

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As analysis of trade-offs among cost, revenue and investment involves lower levels of management, information processing becomes simpler.

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As organizations grow in size, decentralization of operations becomes a critical requirement. Decentralization in the broadest sense means delegation of authority to the lowest feasible level of decision making within a framework of predetermined responsibilities and clearly set goals. The advantages of organizational decentralization are:

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DECENTRALIZATION VS CENTRALIZATION

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This type of organizational structure should be used only when the company is in a position to support functional groups on a continuous basis. Companies managing projects for shorter durations cannot have a decentralized structure as this structure best works when the project is large enough to support on a permanent basis that can achieve technical excellence and economies of scale. However, short duration projects also require the excellence and scale economies of the functional organization and coordination and control of the decentralized organization. Coordination and control problems in a decentralized organization can be achieved, if the management has projects that are large enough to support a permanent functional organization and at the same time allow for economies of scale in the functional organization. This structure will work to achieve the coordination and control required to complete the project and also keep in view the technical excellence and scale economies of the functional organization. In some organizations, decentralization is sometimes associated with dysfunctional performance which results in incremental costs. If the incremental benefits are more than costs involved, the organization maintains a decentralized structure. But if the incremental costs exceed the incremental benefits, the organization reverts to a centralized structure. Centralization pertains to geographic concentration or it may refer to concentration of specialized activities, generally in one department. Centralization restricts the delegation of decision-making authority. In a centralized structure, the overall decision-making power is vested with the top management. When there are few homogenous markets, it is easier to plan, administer and coordinate functional departmental activities, and hence greater the advantage of centralization.

The matrix structure fulfils the requirements for control and functional excellence required in organizations. A matrix organizational form is a mixed organizational form in which normal hierarchy is “overlayed” by some form of lateral authority, influence or communication. There are two chains of command, one along functional lines and other along project lines. The matrix structure evolved in response to needs of organizations that pursue high technology projects, provide complex products and services and have operations in different countries. Organizations pursuing high technology products need to maintain a high degree of technical excellence in multiple disciplines. This can be possible only by having an organizational structure that has a high degree of technical excellence in multiple disciplines. This requires high division of labor and specialization. To utilize each speciality fully, there must be a number of projects where the specialized talents can be employed. Thus, a company will be managing multiple projects simultaneously. The coordination and control cannot be achieved with the functional organizational structure. The incremental benefits of a matrix organization are motivation and coordination. The matrix is an example for a structural change following strategy to improve control.

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RESPONSE OF STRUCTURE TO STRATEGY: EVOLUTION OF THE MATRIX STRUCTURE

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The matrix organization helps avoid coordination problems that arise during the handling of complex programs. This is because the matrix structure places total responsibility in the hands of the manager whose task is to devise plans and coordinate and integrate the activities of the organization. This helps maintain a balance among performance, cost and time variables. In the matrix structure, managers not only achieve the goals and objectives of the project, but also share the resources economically among the various departments for the achievement of the goals and objectives. The matrix form of organization may be appropriate when many interactions between the functions are necessary or desirable. The matrix organization is extensively being used in the management of the defense projects and projects that require complex activities. The form an organization chooses depends on its costs and benefits, economic and control factors. Control systems help calculate the net benefits of each of the three designs (decentralized, centralized and matrix) on a qualitative basis and adopt the best one. The design that is selected should promote communication, cooperation, teamwork, motivation and performance.

There are short-term as well as long-term benefits for each project. They vary according to the time, cost and quality. Hence cost, quality and schedule are the key variables for any project. A matrix structure helps an organization to achieve agreed upon performance with respect to cost, quality and time variables. The matrix structure for a project organization can be explained with the help of a matrix (refer exhibit 5.1). The various functions are represented in rows and the programs undertaken are represented in columns. The total functional output for any period of time is found in the last column. It also lists contributions of each function. In most organizations, the outputs are identified in the columns of the matrix and the inputs are identified in the rows of the matrix (refer exhibit 5.1). Though the product manager assumes responsibility for the delivery of the product in a matrix structure, he does not have a direct control over the functional organizations. Generally, in organizations there are two separate authorities to set goals and direct the work necessary to achieve the goals i.e. knowledge based authority and resource based authority. This sometimes leads to confusion as there is no unity of command. This problem can be resolved to a great extent in a matrix organization where in practice there is a formal and informal relationship among program and functional which leads to distribution of authority and responsibility.

Product Organizations
For developing complex products, organizations require closer coordination among the various functional departments. Product managers are responsible for the planning and coordination of the functional efforts required to introduce new products, modify existing products and make changes to the advertising programs of any existing products (refer exhibit 5.2). The matrix structure allows for such coordination. The matrix structure can also be used for the introducing new products as well as monitoring ongoing projects. It
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Exhibit 5.1 The Structure of a Matrix Organization Program Functions Program 1 Program 2 Program 3 Total functional output

Engineering Procurement Quality Assurance Manufacturing Program Management Total Program Requirements

Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey: Prentice Hall Inc., 1994) 151.

Service Organizations

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Service organizations require employees who are highly skilled in a number of areas. The services offered require close cooperation among the various units. Thus, the structure should be designed in such a way that it leads to cooperation and better control of various activities. The matrix structure may be appropriate for service organizations. The application of matrix structure in a service organization can be best illustrated by taking an example of the tourism industry. In the tourism industry, business agencies and communities can define their overall objectives and monitor their progress. The objectives should provide guidance for all decisions including finance, personnel and marketing. The success of the tourism industry depends on creating an atmosphere where in employees can provide good customer service. This requires close coordination between the various departments like hospitality and guest relations, quality control, personnel selling, customer service etc. Customers can also be served best by providing information through local offices. The matrix structure can be very useful for meeting the desired needs of customers and in providing coordination between the various departments of the organization. As in product management, the functional groups can provide each local office with information and resources. These local offices should have resources and
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can be applied to a product based organization when an organization has too many products to manage, when the products require coordination among specialized disciplines, and when the market size is too small to justify separate divisions for each product. The application of the matrix structure and the control process for the management of products is known as product control system. The matrix structure in a product organization enables economies of scale in each discipline and also provides total management of each product. This ensures high level of efficiency and coordination.

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Exhibit 5.2 Product Matrix Organization
General Manager Controller Treasurer Other Staff

Market Research Manager

Product Research Manager

Advertising Manager

Sales Manager

Manager of Products

Production Manager

Personnel Manager

The Matrix Structure and the Multinational Firm

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It is difficult to coordinate in a multinational (MNC) firm as compared to domestic product organization. This is mainly due to two reasons. Firstly, in an MNC, there is greater geographical dispersion among the various units of the enterprise. Secondly, since each division of an MNC is responsible for the sale and sometimes production of all the company’s products in the given area of the world, little attention can be given to the development, introduction and coordination of a given product for the company as a whole. Due to these factors, the importance of matrix structure in an MNC has increased greatly. Design of organization structure in an MNC is based on the combination of the market area and the product rather than on the product and function. The products and market area are important for the multinational firm as these two conditions can help a firm earn profits by exporting the products even though transportation costs and trade barriers exist. However, it is not always appropriate to apply a matrix structure. For example if an organization is using a standard product design and management focuses mostly on developing a

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plans to market, plan and control client services in a given area. The structure is designed in such a way that the functional personnel report directly to the functional managers, while the local office managers hire the services of functional resources in a manner identical to that of product or project managers.

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Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey: Prentice Hall Inc., 1994) 153.

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better market for the product. A functional organization is better suitable for the same. On the other hand, if an MNC has a worldwide market for the products, the management needs to devote time for the development of the product. These conditions do not occur frequently in multinational organizations as the market characteristics as well as basic labor costs are different for most products in various parts of the world and it becomes necessary to differentiate the various markets. Thus, the matrix structure helps in providing a dual structure for managing both the product and market dimension. The structure consists of a product manager who is responsible for a particular product and an area manager who is responsible for a given geographical area. The product manager is responsible for bringing in profits of a particular product on a world wide basis, but he has no authority over the functional disciplines employed on the product. The area manager has the authority and responsibility of maintaining the overall profitability of his division and control over the functional personnel assigned to that division. Product managers are concerned with current business and technological developments of their product in a particular area. Using their expertise and knowledge, they help the area managers to implement technical and business programs for improving the profitability of their product line on a worldwide basis. The product manager also communicates the benefits of the product to the various area managers and tries to reduce bottlenecks among the various area divisions. Products differ in their key variables while some products require emphasis on marketing others require emphasis on engineering or production. The product manager should therefore ensure that, product lines get the required attention from the different divisions. Moreover, the product manager has to make sure that resources are allocated according to the profitability of the product. Sometimes he or she may have to drop a product in one division and expand its sales in another division. Most importantly, when there are rapid technological changes the product manager has to forecast such changes and incorporate them into the product in each division. For a matrix organization in a multinational firm, it is necessary that there are behavioral adjustments between the area manager and the product manager. Project based organizations therefore, use teams for accomplishing of organizational goals.

EVALUATION OF THE CONTROL FACTORS IN ORGANIZATIONAL DESIGN
The activities of an organization can be managed by using three types of organizational designs: centralized, decentralized and matrix. In a centralized organization, the authority for all products, projects and services rests with the top management. In a decentralized organization, a division, department or a group is held responsible for the decision it takes. These units are allowed to design their own management policies and have complete authority over the functional organization.
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A matrix structure or a hybrid structure incorporates the advantages of both the above mentioned forms and a new structure is then designed. Organizations should choose a design structure that is likely to benefit them the most. Each design must be evaluated on the basis of efficiency and coordination. The best form is the one which operates at minimum cost per unit of output.

Matrix Versus Functional
While managing complex programs, an organization may face several coordination problems. A matrix organization helps avoid such problems as the total responsibility for the project lies in the hands of a manager who coordinates and integrates the multiple functions within the organization. He ensures that proper balance is maintained among the costs, performance and time variables. The incremental cost of a matrix organization is more than that of a functional organization. This is due to two reasons. Firstly, the organization incurs costs as result of additional layer of management for managing each program. Secondly, difficulties are created by separating responsibility for a program from the authority to direct the work necessary to carry out program goals.

Difference in orientation: The main aim of any program manager is to maintain a balance among performance, cost and time requirements of the program. The priorities of a functional manager are different from that of a program manager. The functional manager can emphasize on quality and competence norms while ignoring the goals of the program. Thus, there is a need to design reward structures and financial controls for both project and functional organizations. If there are tensions between the program and the functional manager’s work it will result in conflict in the workplace, thereby, making it very difficult to achieve the organizational goals. Thus, reward structures can be used for balancing short and long run goals and objectives by rewarding functional work that also helps achieve program goals. The reward structure for programs and functional organizations should reflect a balance between the short and long run profits.

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Diffuse responsibility: In a matrix structure, it is difficult to clearly demarcate the responsibility for a given activity. This is because program managers have program responsibility under the matrix structure, while functional managers have technical responsibility and when problems develop it becomes difficult to isolate responsibility. As the responsibility is distributed between the program and functional personnel, it becomes very difficult to administer systems of accountability. This in turn, could lead to greater instances of conflict. Conflicts usually arise while resolving technical and cost problems and assigning the priorities to various programs. Program personnel in temporary assignments: Unlike the functional personnel assigned to a permanent organizational unit the project structure is

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Problems in the implementation of the matrix structure

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temporary and functions according to the availability of the projects. After the project is accomplished the team is disbanded. The primary aim of a program manager is to complete the project on time. After the completion of the short term projects the staff is temporarily left without any projects. In such a situation the functional personnel will hesitate to take up the program responsibility and program office personnel may attempt to increase the duration of the program artificially at the expense of the program goals, thus increasing, the costs of the organization. This problem becomes severe during adverse economic periods. The actual costs incurred as a result of these potential organizational problems depends upon the ability of the program and personnel managers to build effective informal relationships and design goal congruent reward structures. In addition there is also a need to design reward systems that promote high quality functional performance.

CONTROLLER’S ORGANIZATION
A person who is responsible for designing and implementing the management control system is called the controller. A controller plays an important role in design and operations of the control system. The main responsibilities of a controller are: To design the control system • • • • To prepare financial reports and statements for the clear understanding of shareholders and external parties To develop internal auditing systems for the control of the physical and monetary assets of the firm. To conduct educative sessions and create awareness among employees about the matters relating to the controller's function.

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To analyze program and budget proposals and bring together the various segments of an organization under a single organizational budget.

The advisory and control systems suggest a direct reporting relationship of divisional controllers to divisional general managers since these are very important staff functions performed by the controller. In a matrix organizational structure, the divisional controller has to report to two persons. He has to give functional accountability to the corporate controller and operational accountability to the general manager of the division. These create several problems as in a matrix organization structure. These tensions must be resolved in a manner similar to those of the matrix organization. An empirical study of control functions in large multidivisional US corporations conducted by Vijay Sathe1 indicates that the degree of involvement of the controller in managerial functions depends on the following variables.
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Controller Involvement in Management. Englewood Cliffs, N.J.: Prentice Hall, 1982

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To advice the management on the financial implications of decisions under consideration. To provide functional supervision and training for employees in each of the divisions of the corporation.

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• • • • •

The financial orientation of the company, emphasis on financial goals, and the management of its businesses using a portfolio approach. The importance the organization places upon planning, programming, budgeting and reporting. The importance the organization gives to development of the controller and the employees assisting him. The extent to which the controller is involved in the business decisions. The working capital management of the company. The management development strategy the organization adopts in terms of developing the controller’s function.

Some of the characteristics essential for a good controller have been specified below: • • • • • • • • Personal energy and motivation Personal integrity and professional commitment Accounting knowledge and analytical skill

Understanding business problems and recommending actions that are required to run the business successfully

Ability to analyze management’s actions and plans and not hesitate to question management’s plans and actions.

ADAPTIVE ORGANIZATION

The Need for Adaptive Organization
It is not very easy for an organization to adapt to environmental changes. An organization needs to steer its resources and realign them to meet the changes. Moreover, the culture, and the organizational structure need to be reorganized in accordance with the changes. Let us examine the factors which create the need for an adaptive organization.

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To face the challenges posed by the rapidly changing environment, organizations need to develop ‘adaptability’, and modify their structure at regular intervals. The rapid environmental changes have made it imperative for organizations to gain a global perspective, speed up the decision making process and realign resources rapidly. An organization which is not adaptive to environmental changes will become inefficient in due course of time.

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Recognizing the responsibility towards the division as well as corporate management.

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Building effective interpersonnel relationships and being flexible in meeting management’s demands.

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Ability to judge and grasp information that is important for an organization

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Environmental factors In order to adapt itself to environmental changes, an organization has to speed up the decision-making process, gather large amounts of data that support decisions, and implement the decision at the right time. The organization should also be able to realign resources in order to meet these changes. Moreover, as mentioned earlier, the organizational structure should be designed in such a way that it can adjust to various environmental changes. Mintzberg in 1979 stated that, “Environmental factors are contingency factors in the design of organizational structure.” While the organization is influenced by environmental changes, these changes are influenced by certain other factors that are discussed below: Environmental uncertainty Organizations become more informal in response to environmental uncertainty. Ad hoc teams are developed to cope with uncertainty and to meet the changing needs of the organization. Verbal communication is encouraged so that people can understand the environment better and respond to changes accordingly. Complexity in the environment may sometimes affect the market in which the organization operates as well as the competition prevailing in the market. Due to this complexity management may choose to decentralize into focused market segments to fully understand smaller market niches. Environmental diversity The market is divided into different segments on the basis of customers, products and geographical locations. This diversity helps the organization to develop various business units in each segment. Environmental hostility When the organization is faced with hostility e.g. adverse political changes, the top management decides to centralize decision making. Efforts are made to gather information at the earliest and take suitable action. The control systems designer analyzes these four environmental factors, before taking a decision on redesigning the organizational structure to achieve control.

Adaptive Controls that Support the Adaptive Organization
In the adaptive organization, the control mechanism is more implicit. Every organization tries to instill its own values in its employees through its training programs. In nonprofessional organizations, such an adaptive model can be instituted through extensive acculturation, socialization and training programs. This is traditionally practiced in Japanese firms. The adaptive organization requires high levels of awareness, skill, and integrity within the work group. Given the high degree of employee empowerment today, even one poorly trained or disruptive employee can cause significant damage to an organization. The effectiveness of these controls also may be limited by the subjectivity of the control measures used by workplace politics.
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The informal and formal adaptive control for organizations are shown in exhibits 5.3 and 5.4 respectively. The culture of an organization should be such that it should emphasize global awareness, change and opportunistic actions, continuous learning, and flexibility to adjust and accept new assignments. On the formal side, the infrastructure should be characterized by organization structures that can be easily formed and dissolved, the use of ad hoc teams and projects and the use of worldwide purchasing. The planning and control processes should focus on the organization’s vision, strategy, information systems, information flows and other formal procedures. The reward system should be designed in such a way that it helps the organization to achieve excellence in an uncertain environment. Exhibit 5.3

Informal Control for Adaptive Organization
Infrastructure • Expert emergent roles for local cultures and markets • Acceptance of temporary assignments Management style and culture • Global operating perspective • Opportunistic action oriented • Change oriented • Lifelong learning • Agility in new assignments

Informal control process • Verbal informal actions • Use of multidisciplinary teams for problem solving

Rewards • Based on peer recognition for the adaptive values of the organization

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Coordinating and integration • Use of personal travel for managers to become familiar with worldwide conditions Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey: Prentice Hall Inc., 1994) 173. 68

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Exhibit 5.4

Formal Control for Adaptive Organization
Infrastructure • Organization structure • Easily formed and dissolved • Use of adhoc Teams • Widespread use of outsourcing • Widespread use of teams Management style and culture • • • • • Global operating perspective Opportunistic action oriented Change oriented Lifelong learning Agility in new assignments

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Rewards • Emphasize ability to achieve excellence in uncertain environments Coordinating and integration • Use of management rotation on a global basis • Use of multidisciplinary teams for accomplishing specific objectives Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey: Prentice Hall Inc., 1994) 173.

SUMMARY
This chapter examines the role of control systems in designing the infrastructure of an organization. With companies expanding, it has become important to develop organization structures that support complex
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The emergent roles for local cultures and markets, temporary assignments, constitute the informal infrastructure. The planning and control processes should focus on informal actions to solve problems. The coordination mechanisms should facilitate training of managers in order to help them adapt to worldwide conditions.

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Formal control process • Clear company vision • Integrated information systems • Rapid response times for information flows • Accurate worldwide reporting • Simple and rapid authorization procedures

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multimarket, multidivisional corporations. The matrix structure has proved very useful for product organizations, service organizations and multinational firms. Three organizational designs have been identified which are used to manage the activities in an organization. They are: a centralized organization, a decentralized organization and a matrix structure. The role of the controller in relation to the design and operation of the control system has also been discussed. A divisional controller in a matrix organization has both functional and operating accountability. For a controller to function effectively, there is a need for technical competence, business judgment and communications skills. Due to the rapidly changing environment, there is a need to develop organizations which can adapt themselves to these changes.

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Chapter 6

Autonomy and
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In this chapter we will discuss: • • • • • Divisional Autonomy Responsibility Structure Responsibility Centers

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Performance Measurement of Decentralized Operations Inter Profit Center Relations

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An organization uses a number of structural elements to influence the behavior of managers. These elements interact with the formal control process to influence managerial behavior. These elements play an important role in influencing the autonomy of managers at the divisional control level, of an organization and also influence the way managerial performance is measured and evaluated. This chapter focuses on the autonomy of managers at the divisional level and the determinants of such autonomy. Such autonomy can be categorized into three divisions- management style and process, responsibility structure and reward systems.

DIVISIONAL AUTONOMY
With most organizations operating in dynamic and highly competitive markets, it is important for the top management to decide on the right kind of autonomy to be given to the managers. Organizations today require flexibility, innovation and creativity. Thus, it becomes all the more important for the top management to decide on the levels of autonomy. The top management must decide upon the level of decentralization of decision-making. To do this, the top management should design a tool to help it attain congruence between the levels of autonomy it wants to sanction to its subordinates and the extent of autonomy that subordinates expect to get. Vancil1 developed a design tool that helps the management to communicate the desired levels of autonomy. This tool helps the management in designing structures and processes to achieve the appropriate levels of autonomy. In this context, it is important to discuss the variables that influence autonomy in an organization. The variables discussed in the Exhibit 6.1 can be grouped into: •

Measurement of reward systems

Management Style and Processes
Management style plays an important role in influencing the behavior of the employees in an organization. Managers have different notions about how a company’s business can be run. They need to decide whether it can be run in a centralized manner or by striking a balance between centralized control and decentralized action. All these constitute management style and process. There are a number of personal variables that influence the level of autonomy that a corporate manager can sanction a subordinate. These include: • • • The level of involvement of the corporate managers in the business The interactions of the corporate managers with other managers The level of trust and confidence of the manager in the ability of the subordinates

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Vancil, Richard F., Decentralization: Ambiguity by Design. Homewood, III: Dow Jones Irwin, 1979.

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Exhibit 6.1 A Theory of Decentralized Management

CORPORATE MANAGERS Philosophy and Style

DIVERSIFICATION STRATEGY Breadth of Lines of Business

BUSINESS STRATEGY Definition of Market Segments

Intended by Corporate Managers

COST AND ASSET ASSIGNMENT For Shared Resources

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MEASUREMENT METHODS For Assigned Costs and Assets

MANAGEMENT PROCESS Policies and Procedures

AUTONOMY

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Management style influences the decentralization process in an organization. The company’s plans, budgets, meetings, performance reviews, etc., are influenced by the manager’s ‘style.’

Management policies and procedures Policies and procedures help managers decide the way in which decisions are to be made. They help in maintaining uniform behavior among profit center managers with regard to certain decisions. Diversification strategy According to Vancil, there is a fair relationship between the diversification strategy that the management chooses and the autonomy of the profit center managers. In firms that run a single business, the manager’s autonomy seem to be restricted, whereas in firms that grow by acquiring or introducing unrelated businesses, the extent of autonomy is high. When a firm runs a single business, all its functions are centralized which leads to the sharing of
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Source: R F Vancil , Decentralization:Managerial Ambiguity by Design,( Dow Jones-Irwin, Homewood Illinios, 1979) 128.

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RESPONSIBILITY STRUCTURE Custody of Physical Resources

REWARDS Physical and tangible

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resources and, thus, to restricted autonomy. When a firm runs a number of unrelated businesses into unrelated businesses, there is not much synergy between the various businesses and only a few resources are shared. This leads to more managerial autonomy. Business strategy Business strategy is the strategy to be followed in each division of the organization. The kind of business strategy chosen by the management influences autonomy in the organization. For example, a cost strategy leads to less autonomy as there is usually centralization of resources. The four variables discussed above-management style, processes, diversification strategy and business strategy have a major influence on the autonomy of profit center managers. They constitute “the first line of influence” that the top managers have over profit center managers.

The responsibility structure represents the physical, human and financial resources that are entrusted to the profit center manager. These resources represent the functional authority of the project center manager, and the resources in the custody of a manager influences his/her decision-making authority. Responsibility structure can be considered the second line of influence that the top management has over profit center managers. The responsibility structure and types of responsibility centers will be discussed in detail later in this chapter.

Measurement and Reward Systems

Cost and asset assignments convey to the division manager those items of cost and investment that the manager should be concerned about. Measurement methods show how much concerned the divisional managers should be about the costs and assets assigned. These methods help in allocating resources according to the requirement of a particular division. The common methods of measurement are proration, negotiation and metering. Proration refers to allocating resources based on standard rules of the organization. Negotiating and metering give the managers more autonomy in deciding upon the quality and quantity of resources they use. The reward system is determined on the basis of the performance of a particular center. The amount and method of allocating bonuses depends on the manager’s autonomy. Rewards given to managers are either tangible or intangible. Tangible rewards include financial and related compensation. Intangible rewards include power, status, and the feeling of accomplishment. While responsibility structures are the second line of influence that the top management has over the profit center manager, the measurement and reward system constitute the third line of influence.

RESPONSIBILITY STRUCTURE
The responsibility structure of an organization consists of responsibility centers and related performance measurement systems. These responsibility
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centers work towards the achievement of the organizational goals. This hierarchical placement of the responsibility center helps the top management to ensure that decisions made in one part of the organization are congruent with decisions made in other parts. The responsibility structure includes an accounting system. A responsibility accounting system helps managers to record the plans and performances of the center for which the manager is accountable. The measurement of the performance of a responsibility center is done through cost, profit, revenue, investment and quality goals set by the organization. There are three different methods of measuring the performance of a responsibility center. They are: • • • The efficiency measure The process measure Effectiveness measure

RESPONSIBILITY CENTERS
Responsibility center is a unit or function of an organization headed by a manager who is directly responsible for its performance. In a responsibility
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Donaldson Brown of General Motors divided ROI into a number of elements for easy understanding. These elements are helpful in establishing performance measures for various subunits of a division that are goal congruent and would have an influence over the performance measures. ROI= Net profit/invested capital ROI can be divided into two components- net profit, which is a percentage of the sales revenue, and the turnover of investments in relation to the sales revenue. Profit margin = net profit/sales revenue Investment turnover = sales revenue/invested capital Exhibits 6.2 and 6.3 show the computation of profit margin and investment turnover.

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The most important objective of a firm is to achieve a good return on investment. The logic behind the hierarchy of responsibility centers and the responsibility accounting system is to make all the decentralized subunits of an organization responsible for various elements of ROI. The performance of responsibility centers in an organization is based on cost, quality, revenue and investment.

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Overall Effectiveness Measures: Return on Investment (ROI)

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The ‘efficiency measure’ measures performance in terms of inputs received over a specified period of time for a given level of output. The process measure pertains to the production process, and the ‘effectiveness’ measure gauges the output of the organization in terms of its goals and objectives. The above mentioned methods of performance evaluation help in assessing the progress of each subunit, and this is done with those variables for which the manager has reasonable amount of control in mind.

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Exhibit 6.2 Computation of profit margin
sales revenue cost of goods sold

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net profit = operating expenses = Β income taxes Profit margin = ÷ sales revenue
Source: Joseph A Maciariello and Calvin J Kirby, Management Control Systems, (USA: Prentice-Hall Inc, Second edition) 194.

+
period expenses + other expenses

Every organization has its goals determined, and the management decides upon the strategies to accomplish these goals. Responsibility centers help in implementing these strategies. As an organization is a collagium of responsibility centers, the ability of its responsibility centers to meet their objectives help an organization to achieve its goals. Every responsibility center uses inputs (material, labor, etc.) and needs working capital, equipment and other assets to function effectively. The responsibility center produces outputs which are classified as goods and services and hence they can be measured, whereas in human resources, transportation, accounting and administration, the output is services that cannot be measured. Measurement of inputs and outputs It is easy to identify the monetary costs of physical quantities. The amount of money is calculated by multiplying the physical quantity by a price unit of quantity. Therefore, the inputs of a responsibility center are referred to as costs. While the costs of inputs can be easily measured, outputs are not so easy to measure.

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Nature of Responsibility Centers

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Responsibility centers can be assigned very narrowly or broadly in terms of the activities that senior management decides to assign to a particular manager. But the type of responsibility center specifically defines the primary objective of the decisions required when managing the assigned activity. For example, as a cost center, a manager would focus on reducing costs in relation to a standard cost or budget, and would not be concerned about the profit margins of the various products or the implications of these decisions on the company's profitability. However, in designating this center as a cost center, the senior management should have already decided that the profit implications would be controlled by another part of the entire system.

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center, the accounting system generates information on the basis of managerial responsibility, allowing that information to be used directly in motivating and controlling the action of each manager in charge of a responsibility center.

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Exhibit 6.3 Computation of Investment Turnover
sales revenue Φ invested capital = Investment turnover = current assets + fixed assets + other assets + other liabilities
Source: Joseph A Maciariello and Calvin J Kirby, Management Control Systems, (USA: Prentice-Hall Inc, Second edition) 194.

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Types of Responsibility Centers
According to the nature of monetary inputs and outputs, responsibility centers can be classified into the following: Revenue centers Revenue centers are those organizational units in which outputs are measured in monetary terms. These centers are marketing organizations and they are not directly responsible for profits. Revenue centers are also called expense centers, as the revenue center managers are held responsible for expenses incurred by the unit. The main objective of revenue centers is to maximize revenues. For example, a marketing organization is a sales revenue center. Such a center is devoted to increasing the revenue, and assumes no responsibility for production. In this center, the manager is responsible for the level of revenue or outputs of a center, measured in monetary terms, but is not responsible for the costs of the goods or services that the center offers.
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The effectiveness of the unit is decided on the basis of a unit’s outputs and its objectives. The greater the contribution of the outputs to the accomplishment of the organizational objectives, the more effective is the unit. A unit should be both effective and efficient to contribute to the achievement of these goals. The company’s overall profit can be considered as the base for measuring effectiveness and efficiency.

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The performance of a responsibility center can be judged by using the effectiveness and efficiency criteria. Efficiency is the ratio of outputs and inputs. These measures are usually used on a comparative basis. If there are two responsibility centers, A and B, responsibility center A would be considered more efficient than responsibility center B if it uses less resources than B but has the same output, or if it uses the same amount of resources, but produces more output. If both the centers are found to be performing up to the company’s expectations, the center that shows the lower costs is considered more efficient.

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Expense centers In expense centers, inputs or expenses are measured in monetary terms whereas the outputs are not measured in monetary terms. There are two types of expense centers-engineered expense centers and discretionary expense centers. There are two types of cost involved in engineered expense centers and discretionary expense centers respectively-engineered costs and discretionary costs. Engineered costs are costs that can be estimated to a reasonable extent by the management. Examples are direct labor and direct material. Discretionary costs, on the other hand, are costs that cannot be estimated by the management. Engineered expense centers In these centers, inputs or expenses are measured in monetary terms and outputs are measured in physical terms. These centers are usually found in the manufacturing units that use a standard cost system. There are certain responsibility centers within administrative and support departments that actually are engineered expense centers. In these centers, the cost of the product is determined by multiplying the output of each unit with its standard cost. Its efficiency is measured by comparing the actual cost with the standard cost. In discretionary expense centers, the output cannot be measured in monetary terms. Discretionary expense centers include administrative and support units like legal, accounting, industrial and public relations units. Here, the efficiency is not the difference between budgeted and actual expense, but the difference between the budgeted input and actual input. In discretionary expense centers the management decides on certain policies that should govern the company's operation. These relate to the amount of money that should be spent on R&D, financial planning, public relations, etc. The decisions related to such activities depend on the way a company operates. The management control systems for expense centers are discussed, taking into consideration factors like budget preparation, cost variability, financial control and measurement of performance. Budget preparation: The decisions regarding the budget of expenses for a discretionary expense center is different from that for an engineered expense center. In engineered expense centers, the costs are determined by the management, taking into view the operating budget required to perform the task effectively in the future. However, in a discretionary expense center, the principal task is to decide on the magnitude of the job that has to be performed. These tasks are of two types-continuing and special. Continuing tasks take place year after year (like financial statements) while special tasks are one-time tasks, for example, developing a profit budgeting system for a newly acquired division. Management by objectives is a useful technique in preparing budgets for a discretionary expense center. Management by objectives is a technique where the objectives of performance are jointly determined by subordinates and their
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Control characteristics for expense centers

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superiors. The progress towards these objectives is periodically reviewed and the rewards are allocated on the basis of performance. Another method used to understand the appropriate level of spending in a discretionary expense center is sensitivity analysis. According to this technique, the budget has a section which explains the activities that can be undertaken if the budget is increased. Sensitivity analysis is mostly not taken by companies as they think that it is important for a manager to prepare the possible budget for accomplishing activities that should be undertaken. Cost variability: The costs, in a discretionary expense center, tend to vary from one year to another according to the volume. However, these are not influenced by short-term fluctuations in volume within a year. In engineered expense centers, costs vary with short-term fluctuations in volumes. Financial control: The financial control in a discretionary expense center is different from that in an engineered expense center. Here, the operating costs are minimized by setting a standard for the costs and comparing the actual costs with this standard. In discretionary expense centers, costs are controlled by determining the tasks that have to be undertaken and the amount of effort that is required for each task. Financial control is, hence, determined at the planning stage. Measurement of performance: The financial performance report of a discretionary expense center does not help in evaluating the efficiency of the manager, whereas in engineered expense centers the financial report helps in evaluating the efficiency of the manager. If the two centers are not properly distinguished, the management may consider the performance report of a discretionary center as an indication of its efficiency. Administrative and support centers Administrative centers include the senior corporate management, the business unit management and the managers responsible for their staff units. Support centers provide services to other responsibility centers. Problems related to control in administrative and support centers include difficulty in measuring output, as they basically provide service and advice to the responsibility centers. Therefore, it becomes difficult to set cost standards. Hence, their performance cannot be branded as efficient or inefficient. Secondly there is lack of congruence between goals of staff units and responsibility centers. The suggestions that staff departments may provide regarding the development of systems, programs or functions may be too costly when one thinks of the additional profits that these would generate. The severity of the problems is also related to the organizational level. At the operational level, the staff activity is controlled by the plant manager, and at the business unit level, by the business unit manager. When compared to the plant level, there is more discretion of tasks at the business unit level. Support centers charge a particular price for the services they provide to other responsibility centers. Budget preparation: The budget for a support center consists of expenses, and is prepared by comparing with the current year’s actuals. This budget consists of the following components- the basic costs of running a center (for which there is no need of management decisions), costs incurred by the discretionary
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activities of the center, and a section containing proposed increases in budget (other than those related to inflation). Research and development centers Control problems in research and development: The problems in research and development are: Difficulty in measuring quality: The inputs for an R&D activity can be measured whereas the outputs are difficult to measure. For R&D activities, the time taken for a particular research cannot be estimated as it may take months or sometimes years for a particular activity. Also the output is difficult to measure because of its technical nature. Lack of goal congruence: As in administrative centers, goal congruency is lacking in R&D centers, too. Conflict may arise between the research manager and the business unit manager. The research manager may want to build the best research and development center, no matter what the expense be, while it may not be possible for the company to afford it. Also, the researchers may not have sufficient knowledge about the business, in some cases. The research and development costs cannot be controlled on a year-to-year basis because a research project may take years to show results and the organization would have to bear the cost of the project for that period of time, mainly the cost on labor. There are two types of marketing activities in every organization: order filling (logistics) and order getting. Order getting is an actual marketing activity. Order filling activities include transferring goods from the company to the customer, and receiving the appropriate pay from the customer. These are mostly engineered expense centers. Order getting activities include test marketing, training sales force, advertising, sales promotion, etc. Though the output of a marketing organization can be measured, it is difficult to evaluate the marketing effort, as the marketing department has no control over economic conditions or competitors’ actions. These actions may be different from what was expected when the sales budgets were established. In such situations, it is difficult to achieve management control. Also, it becomes difficult to measure the efficiency and effectiveness of these costs. Profit centers When financial performance of a responsibility center is measured in terms of the organization’s profit, then it is called a profit center. In a profit center, performance is measured in terms of the numerical difference between revenues (outputs) and expenditure (inputs). A profit center is given the responsibility of earning profits. It is involved in the manufacture and sale of outputs, and it measures how well the center is doing economically. The profit center also determines the efficiency of the manager in charge of the center. A profit center helps in motivating managers to perform well in areas they control and also encourages managers to take initiatives. The profit center helps the organization to make the best use of specialized market knowledge of the divisional managers, and entrusts the local managers the responsibility of tradeoffs.
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Profit centers have been used as a major management control tool. The major advantages of profit centers are: • • These help in increasing the speed of making operating decisions as they do not have to be referred to corporate headquarters. As the decision-making authority lies with the managers they can make better decisions related to the task they are performing, because they can understand the nature of the work better. Since profit centers make their day-to-day decisions themselves headquarters can concentrate on broader issues of the organization. Managers are motivated to perform more effectively, as they are responsible for increasing the profit of their unit. Managers use their imagination, take initiatives to perform more effectively, to increase the profit of their unit.

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Types of profit centers

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Functional units can be classified as different types of profit centers. A multibusiness company can be divided into independent profit generating units such as marketing, finance, manufacturing etc. The decisions regarding whether a particular functional unit can be a profit center depends on the responsibility center manager's ability to influence, if not control, other activities that affect the company's bottom line. The different types of profit centers are discussed below: Marketing: A marketing activity becomes a profit center if it is charged with the cost of the products sold. A marketing activity can be given the responsibility of making profit when the marketing manager has the authority to make principal cost/revenue trade off in terms of marketing a product, spending on sales promotion, the appropriate time for this expenditure and on which media to spend. Manufacturing: This is an expense center and the management of activities here is based on performance against standard costs and overhead budgets. Problems in measurement may occur because of inadequate quality control, shipping of inferior quality products, and so on, to obtain standard cost credit. At times, there may arise the need to accommodate an order in-between production schedules, and the manufacturing managers may be reluctant to interrupt these schedules. In manufacturing units, when performance is measured against standards, there may be no incentives for manufacturing products that are difficult to produce. These factors may demotivate the
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Organizational units compete with one another, and this may, sometimes, result in conflict between different centers and reduction in cooperation between different units and sharing of resources.

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However, there are certain difficulties associated with the creation of profit centers. The management cannot have considerable control over the different profit centers when decisions are centralized. The top management has to depend on management control reports which may not be as effective as the personal knowledge of an operation. There may be no place for competent general managers in a functional organization because of lack of opportunities for them to develop creative management skills.

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managers, and eventually, they may not try to improve standards. Hence, while measuring the performance of manufacturing activities against standard costs, it is important to take into consideration quality control, production scheduling and the make or buy decisions. Measuring profitability: Profitability measurements in a profit center can be of two types-management performance and economic performance. Management performance focuses on the manager’s performance while economic performance relates to how well a profit center is performing as an economic entity. Management performance is a measure used for planning, controlling and coordinating the day-to-day activities of the profit center. The performance measures of profit centers can be different and hence, the necessary purpose for the information should not be obtained from a single set of data. For example, the management performance report can show excellent performance of a profit center manager. But the economic and competitive forces for that particular report can show poor economic performance. As a result, the center may run into losses and may even have to close shop. Types of profitability measures: The parameters that can be used for measuring the profitability of a profit center are contribution margin, direct profit, controllable profit, income before taxes and net income. Contribution margin: This performance measure is used on the premise that, since fixed expenses are not controllable by the manager, the focus should rest on maximizing the difference between revenues and variable expenses. The problems of using contribution margin is that since many of the center’s expenses may vary according to the discretion of the profit center manager, focus on the contribution margin tends to direct the attention of the profit center manager away from the goals of the center. Direct profit: This measure helps in understanding the contribution of the profit center to the general overhead profit of the corporation. It encompasses all the expenses directly incurred by profit centers or related to profit centers, irrespective of whether the expenses are controllable by the profit center manager. However, it does not include corporate expenses. Controllable profit: The headquarters expenses in an organization can be divided into two categories-controllable and uncontrollable. Controllable expenses include expenses that are controlled by the business unit manager. The advantage of including such costs in the measurement system is that the profit will be calculated after the deduction of expenses that can be influenced by the profit center manager. Hence, these are controllable profits. As uncontrollable headquarters expenses are taken into consideration while calculating controllable profits, controllable profits cannot be compared directly with published data or with trade association data, which report the profits of other companies in the industry. Income before taxes: In this method, all corporate overhead profit is allocated to the profit center. The amount of expense incurred by each profit center forms the basis of allocation of profit. Such allotment has its own drawbacks. Firstly, the costs in departments like finance, and HR are not controllable by the profit center and hence, profit centers should not be held accountable for such costs. Also, it is difficult to quantify the amount that has been spent on human resources in each profit center.
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However there are certain advantages in allocating costs. Corporate service units often have a tendency to spend lavishly to make their units as excellent as possible without paying due attention to the value they create for the company. Once such costs are allocated to profit centers, the profit center managers will try to keep a check on the expenditure. The performance of profit centers is easily comparable to that of competitors’ performance who pay for similar services. Since the profit center can earn profit only when it has recovered all its costs, including allocated corporate overhead costs, the profit center manager will be motivated to make long-term marketing decisions such as pricing, product mix, and so on, because the center will have to recover its share of corporate overhead costs. For profit centers to function with the allocated costs in mind, it is important that they are allocated budgeted costs, and not actual costs. This ensures that the profit center managers will perform without complaining about the arbitrariness of the allocated costs, since there would be no variances in the allocated overheads in the performance reports. Net income: The performance is measured by taking into consideration the net income after the payment of taxes. The disadvantage of using this method is that many decisions that have an impact on the income taxes are made at headquarters, and profit center managers should not be judged by these decisions. If the income after tax payment is constant percentage of the income before tax payment, then there would be no need to measure performance based on this method. This method would be useful if profit centers influence decisions like installing credit policies or disposing of equipment. This method is also useful to motivate the manager to minimize taxes in case the taxable income differs from income, as measured by using generally accepted accounting principles. The performance of profit centers can be measured by comparing actual results with one or more of the measures discussed above with budgeted amounts. In addition, data on competitors and industry provide a good crosscheck on the appropriateness of the budget.

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Investment centers An investment center has control over sales revenues and operating costs, and the assets used to generate profit. An investment unit manager must be in a position to influence the size of the investment and profit variables. An investment center is a measure of economic performance, and it analyzes all elements of profit and investment. The objective of this center is to maximize profit, given the amount of investment required to generate the profit. Cost centers The objective of cost center is to minimize the variance between standard costs and actual costs. A cost center is a production or service function, activity or item of equipment the costs of which may be attributed to cost units. Cost centers are basically related to costs, and not to the revenues or assets and liabilities of the organization. A cost center is a separate organizational unit for which separate cost allocation is done. A cost center
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forms the basis for building up cost records for cost measurements, budgeting and control. From a functional point of view, a cost center is a production cost center (where only production is undertaken like a assembly department), a service cost center (offering service to production departments like personnel, accounting etc.,) or an ancillary manufacturing center (producing packing materials).

PERFORMANCE MEASUREMENT OF DECENTRALIZED OPERATIONS
When a control system designer plans to measure the performance of a decentralized operation, a number of difficulties are encountered, especially in a multidivisional company. The main issues involved in the measurement of the performance with regard to interdivisional transactions are measuring profit and investment performance and setting transfer prices for interdivisional transactions. The techniques for measuring performance discussed below like ROI performance measurement, transfer pricing are all suitable for formal organizations. In informal organizations like a clan-based one, companies rely more on informal control mechanisms. The emphasis here is more on teamwork.

The methods used to measure a divisional operation are based on the responsibility structure and the cost and asset assignments of the firm. ROI- (Return on Investment) as a measurement of performance The objective of any firm is to achieve satisfactory returns on investment. Elements such as cost, quality, revenue and investment are assigned to a responsibility center in appropriate amounts, and these elements are used to calculate the ROI. The design of measurement systems and financial performance of a firm is based on the principles of ROI. ROI is an important organizational issue. Each responsibility center should contribute to the ROI. The contribution of each center of an organization to ROI depends on allocation of resources to the center manager. Hence, ROI is an important investment criterion for the responsibility centers. To calculate the ROI of an investment center, it is important to define the revenue, expense and investment allocated to the center. Expenses can be assigned through cost assignment methods. Investment can be assigned, depending on the assets to be assigned and the methods of measuring the assets. When a firm applies a budgeted ROI figure to a responsibility center to determine expected profits, the divisional manager uses that figure as a criterion for investing in assets. These investments are made keeping in mind the ROI budgeted figure. The ROI measure is important as it helps in establishing corporate objectives and helps the managers to work towards achieving the organizational goals and investment projects that are appropriate for the firm. The cybernetic paradigm helps in understanding the usage of ROI. When a firm functions within the goals of the organization in mind, and attains a
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certain level of return on the total book value of the investment, then the managers of the investment centers can be made responsible for ROI as computed in the divisional income statement and the balance sheet.

INTER PROFIT CENTER RELATIONS
Responsibility centers differ from one another in their activities and performance. It is necessary to integrate the activities of the different responsibility centers. The performance measurement system should be so designed as to encourage the divisional managers to act in the best interest of the company. One major problem encountered during the measurement of the performance of a division is the determination of prices for goods and services that are transferred between divisions. This is referred to as the problem of transfer pricing. The problem of transfer pricing arises when the business conducts transactions with each other. One solution to this problem is to stop business transactions among the divisions. However, this solution has some disadvantages. If the business transaction between the divisions are eliminated, the organization would have to forgo certain benefits, such as economies of scale in manufacturing and management.

Setting Transfer Prices

A transfer price is said to be goal congruent if the buying and selling divisions make decisions regarding the price and quantity of transfers, which would have been the same if they were made by the central management. Fairness in setting transfer prices This means that the profit center gives the divisional managers the required autonomy to pursue their objectives. In a profit center, where each division operates almost as an independent company, one of the most important decisions that the managers need to take concerns the pricing of products manufactured by the division. The buying division usually negotiates with the selling division to decide upon an appropriate price. However, disagreements between divisions on transfer prices is a common occurrence. A transfer pricing system is said to be efficient if it encourages managers to pursue decentralization of autonomy and, at the same time, not forgo the benefits of centralization. It should allow the divisional managers to achieve the goals and objectives of the organization and at the same time these goals should be in congruence with the organizational goals.
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Goal congruence

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Transfer price is defined as the value of transfer of services between two or more profit centers. The transfer pricing system enables the management to enjoy the benefits of centralization and decentralization. Transfer prices are not set by the corporate staff; they are negotiated by the divisions among themselves. The process of determining transfer prices is governed by two criteria-goal congruence and fairness.

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SUMMARY
Assigning the right kind of autonomy and responsibility to employees will result in creative ideas. But a manager should be able to strike the right balance between autonomy and control. To understand autonomy, it is important to identify the variables that influence autonomy. They can be grouped under three heads: Management style and process, responsibility structure and reward systems. Management style, policies and procedures, diversification and business strategy fall in the first group. Reward systems are designed on the basis of the manager's ability to manage costs and investments. Responsibility structure consists of responsibility centers and related performance measurement systems. Responsibility structure establishes the physical, human and financial resources that are entrusted to the profit center manager. The availability of resources influences the decision-making authority of the responsibility center managers. Responsibility centers can be classified into revenue centers, expense centers, profit centers, investment centers and cost centers. Revenue center are mainly responsible for raising the revenue, and assume no responsibility for profits. In expense centers, inputs are measured in monetary terms, whereas outputs cannot be easily quantified. There are two types of expense centers: Engineered expense centers and discretionary expense centers. In profit centers, financial performance is measured in terms of the numerical difference between revenues and expenditures. An investment center is a measure of economic performance and it analyzes all elements of profit and investments. Cost centers are supposed to minimize the variance between standard costs and actual costs. When divisional autonomy is provided to centers, it becomes important to measure the performance of decentralized operations. Factors ROI, are important for measuring performance. Managing inter-profit center relations is a major task in an organization. It is necessary to integrate the activities of the different responsibility centers so that they work towards the accomplishment of the goals of the organization.

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Chapter 7

Transfer Pricing
• • • • • Objectives of Transfer Pricing Principle of Transfer Pricing

Methods of Calculating Transfer price

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OBJECTIVES OF TRANSFER PRICING


Helping to measure the economic performance of profit centers.

Goal Congruence
While designing the mechanism for transfer pricing, the interests of profit centers should neither supersede the interests of the overall organization, nor should there be a clash of interests between the organization and its profit centers. In other words, there should be goal congruency between profit centers and parent organization. Some of the prerequisites for achieving goal congruency are:
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PRINCIPLE OF TRANSFER PRICING
The fundamental principle of transfer pricing is that the “transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside vendors”.2

The concept and functioning of profit centers has been discussed in chapter 6. Management Control Systems by Anthony and Govindarajan, 8th edition, Irwin Publications.

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Minimizing tax liability.

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Inducing goal-congruent decisions, i.e., decisions that improve the profits of business units and also improve the profits of the company (this is discussed in detail below).

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Providing relevant information to the profit centers regarding the trade-off between costs and revenues of the company.

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The main objective of transfer pricing is proper distribution of revenue between profit centers. If two or more profit centers are jointly responsible for product development and marketing, then the resulting profit has to be shared between the profit centers. Some other objectives of transfer pricing are:

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When an organization has a decentralized structure, it has several separate profit centers1. Goods and services are transferred internally from one profit center to another, before the final product/service is brought to the market. Companies find it useful to account for the value of goods and services exchanged, even if the exchange is only internal and does not involve the market at all. This helps the company to assess the contribution of each of the profit centers separately. To help in such assessment, a mechanism called transfer pricing has been developed. Transfer pricing helps to determine the value of goods and services transferred before calculating the profits of the company. A transfer price is defined as “the price that is assumed to have been charged by one part of a company for products and services it provides to another part of the same company, in order to calculate each division's profit and loss separately.” In this chapter we will discuss the objectives of transfer pricing, various methods of transfer pricing and ways of administering these prices.

Transfer Pricing

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Competent people Good organizational atmosphere Details of market prices Freedom to source Availability of information Scope for negotiation

Competent people Organizations need managers who can balance long-term and short-term goals. Managers are often accused of sacrificing long-term gains for shortterm profits. This approach can prove disastrous for the organization. Transfer pricing can be misused for manipulating profits, and this gives a wrong picture of the position of the company. Hence, organizations should have competent people skilled at negotiation and arbitration, who are capable of determining the appropriate transfer prices. This makes goal congruency possible. Good atmosphere In order to achieve goal congruency, managers of profit centers, especially the buying profit centers, should ensure that the transfer prices charged by the selling profit centers are just. This will create an atmosphere of trust between selling profit center and buying profit centers. Details of market prices When a product is transferred from one profit center to another, the normal market price for the identical product can be taken as the basis for establishing the transfer price. The market price should reflect the same conditions in terms of quantity, quality, time for delivery, etc. as characterize the product to which the transfer price applies. The market price can be adjusted to reflect savings due to lower expenses on advertising and marketing as the product is sold within the company. Freedom to source Managers of selling profit centers should be given freedom to sell their goods in the external market, while managers of buying profit centers should be allowed to buy their goods from the external market. Thus the market becomes the main determinant of the transfer price. Availability of information Managers should be fully aware of market conditions and should have all the necessary information available to them, before they take any decision. For example, managers should be aware of the alternatives available and the relevant costs of and revenues derivable from each alternative. Scope for negotiation There must be a mechanism for negotiating contracts, and managers who take transfer pricing decisions should be trained in negotiation. If all the above conditions are met, then companies can devise a mechanism for transfer pricing based on the market price. But quite often these conditions
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are not fulfilled, and it becomes difficult to achieve goal congruency. Some situations that are not favorable for achieving goal congruency are: • • Limited markets Excess or shortage of capacity in the industry

Limited markets Markets for buying and selling the goods of the profit centers may be either very small or nonexistent. Some of the reasons for this are: Firstly, the profit center may have spare internal capacity, but may not wish to make any external sales. Secondly, if the company is the sole producer of a differentiated product then outside capacity does not exist. Thirdly, a company that has invested heavily in facilities will not want to source goods from outside unless the selling price in the market is as low as its own variable cost. There may be situation of excess capacity or shortage of capacity in the industry. The selling profit center does not sell in the outside market when there is excess capacity in the industry. The buying profit center may purchase from outside vendors even though there is capacity available inside the company. Thus the company, as a whole, may not be optimizing its profits. In a situation of insufficient capacity in the industry, the buying profit center may be unable to obtain products it needs from the external market, whereas the selling profit center is able to make profits by selling the product in the external market. This situation occurs when demand is high and industry capacity is low. Here also, the company, as a whole, may not be able to optimize profits. When there is an excess or shortage of industrial capacity, the sourcing decisions taken by the company are vital. A company may allow its buying profit center to buy goods from outside, if the profit center is getting a better deal in terms of quality, price and service. In the same way, a selling profit center may be allowed to sell its products in the open market if it gets a better profit by selling in the market. Whatever be the case, the management should not get bogged down by pressures within the company and should try to take decisions that optimize the profit of the company.

METHODS OF CALCULATING TRANSFER PRICE
Methods used for calculating the transfer price differ from company to company. Companies should evaluate all the methods before adopting one that is most suitable for them. The following criteria should be used to evaluate the methods for calculating transfer price. Goal congruence: As already discussed, transfer prices should balance between goals of enterprise as a whole and its profit centers. Rationality: Transfer prices should not interfere with the process by which the buying center manager rationally strives to minimize costs and the selling center manager rationally strives to maximize revenues.
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Sourcing constraints

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Transfer Pricing

Autonomy: Each profit center manager should be free to satisfy his center’s needs either internally or externally at the best possible price. Performance evaluation: Transfer pricing should aid in objective evaluation of the activities of the profit center. It should be used as a tool for making proper decisions. It should also aid in appraisal of managerial performance and of the enterprise as a whole. The three methods of calculating transfer price that are used commonly are: • • • Market-based pricing method Cost-based pricing method Negotiated pricing method

Market-Based Pricing Method
Companies that use this method price the goods and services they transfer between their profit centers at a price equal to that prevailing for those goods and services in the open market. This is similar to ‘arm’s length’ pricing as intracompany transfers are priced the same as those for external customers. Market-based pricing method has two main advantages for a company. Firstly, business units can operate as independent profit centers with the managers of these units being responsible for their own performance as well as that of the business unit. When managers are made responsible for performance of the business unit, it increases their motivation and it also becomes easier for the headquarters to assess the actual operating performance of its business units. Secondly, tax and customs authorities favor the market price method because it is more transparent and they can crosscheck the price details provided by the company by comparing them with market prices on that date. In practice, however, the use of a market price as a benchmark is difficult because often there is no competitive market which can provide a comparable price. For some types of complex capital equipment, an external market may not exist at all. In some cases, prices may be distorted by monopoly elements. Moreover, a definitive market price may be difficult to determine because of variance in prices from one market to another due to changes in exchange rates, transportation costs, local taxes and tariffs etc. In addition, a company may set its selling price depending on the supply and demand conditions prevalent in a specific market. In sum, these factors mean that a unique market price for companies to follow does not always exist.

Cost-Based Pricing Method
The cost-based pricing method calculates transfer price on the basis of the cost of a good or service. The cost of a good or service is available in the cost accounting records of the company. This method is generally accepted by the tax and customs authorities since it provides some indication that the transfer price approximates the real cost of item. Cost-based approaches are, however, not as transparent as they may appear. A company can easily manipulate its cost accounts to alter the magnitude of the transfer price.
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Companies that adopt the cost-based transfer pricing method have to choose between alternative approaches, which are listed below: • • •

Actual costs approach Standard costs approach Variable costs approach Marginal costs approach

A typical transfer pricing problem is encountered in oil companies, paper companies and other integrated companies in which raw material is extracted and processed further for production of the final product. In such companies, in the absence of proper transfer pricing, the division that sells the final product to outside customers may not be aware of the fixed costs involved in the internal purchase price. For example, an oil company has three divisions: the crude oil division, the refinery division and the sales division. The final product of the company, say petroleum, is sold by the sales division, but before this, the crude oil division sells its crude to the refinery division, from where it is sent to the sales division. In this situation, the sales division may underestimate the costs (particularly the fixed costs) incurred during extraction and processing. So, it might sell the final product at a price that is not sufficient to recover fixed costs. Due to this company may incur losses and there can be a conflict between the two divisions. In order to tackle these kind of problems, companies should adopt following methods. • • • Two step pricing Profit sharing Two sets of prices

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UPSTREAM FIXED COSTS AND PROFITS

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In this approach, buying and selling business units freely negotiate a mutually acceptable transfer price. Since each unit is responsible for its own performance, this will encourage cost minimization and encourage the parties to seek a transfer price which yields them an appropriate profit return. However the tax authorities have their reservations about this method because companies that use this method have greater scope of manipulating transfer prices, to minimize their tax liability.

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Apart from this, companies also have to decide on the treatment of fixed costs, and research and development costs. These issues can prove problematic for the company that adopts a cost-based transfer pricing method. Cost-based methods usually create difficulties for the selling profit center, as their incentive to be cost-effective may fall, if they know that they can recover increased costs simply by raising the transfer price. Without an incentive to produce efficiently, the transfer price may erode the competitiveness of the final product in the market place.

Transfer Pricing

Two Step Pricing
Two step pricing involves charging for the product being transferred twice. First, the product is priced on the basis of the variable cost incurred in producing it. At the second stage of pricing, the fixed costs that are incurred because of certain special facilities used for production are also included. The sum of these two charges constitutes the transfer price for the product.

Profit Sharing
Under this method, the product is transferred to the marketing unit at the standard variable cost. After the product is finally sold, the business units share the profit earned. But, this method may lead to disagreements over the way the profit is divided between the two profit centers. Sometimes, senior management has to intervene to settle these disputes. As the profits between units are divided arbitrarily, it does not reflect accurately the profitability of each segment. Also, as the manufacturing unit's contribution depends on the marketing unit's ability to sell and the actual selling price, this may be treated as unfair by the manufacturing unit.

ADMINISTRATION OF TRANSFER PRICES
Implementing transfer pricing involves long negotiations between heads of various units, classification of products, and arbitration and conflict resolution in case conflicts arise.

Negotiation
Business units of companies negotiate among themselves before taking decisions pertaining to transfer prices. The headquarters does not involve itself in formulating transfer prices and leaves it to the line managers of the respective units to establish the buying and selling prices. There are two reasons for this. Firstly, the line managers of the business units may feel powerless if they are denied any say in the transfer prices, and this may affect
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2. It motivates the managers to concentrate only on internal transfers (where they are assured of a good markup) at the expense of outside sales.

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1. It is difficult to maintain an additional book each time a transfer of good is made.

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The disadvantages of this method are:

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Under this method, revenue is credited to the manufacturing unit at the market sales price and the buying unit is charged for the total standard costs. The difference between the outside sales price and the standard cost is charged to the parent company’s account. These charges are later eliminated while drawing consolidated financial statements. This method is used when there are frequent conflicts between the buying and selling units and they cannot be resolved by any method.

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their motivation. Secondly, if the profits of business units are poor then the unit managers may argue that it is due the arbitrariness in setting transfer prices by the headquarters.

Arbitration and Conflict Resolution
There may be times when business units are not be able to reach an agreement on transfer price easily. In such situations, business units should follow a set procedure for arbitrating disputes relating to transfer price. The responsibility for arbitration rests with the parent company. It may assign a single executive who can talk to the business unit managers and arrive at an agreement over the price. Alternatively, a committee may be formed with the following responsibilities: to settle transfer price disputes, to review sourcing changes, and to change the transfer price rules whenever necessary. Organizations can have a formal or informal system of arbitration to administer the transfer price mechanism and to resolve the conflicts. In a formal system of arbitration, both the parties submit a written case to the arbitrator, who reviews it and decides the price. In an informal system of arbitration, most of the presentations are oral. Irrespective of the formality of the arbitration and the process of conflict resolution in an organization, the goal is to make the system of transfer pricing system effective. The management can use any one of the following ways to resolve the conflicts: forcing, smoothing, bargaining, and problem solving. Forcing and smoothing reflect conflict avoidance, whereas bargaining and problem solving indicate conflict resolution.

Product Classification

Sourcing and transfer pricing are greatly affected by the number of intracompany transfers and the availability of markets and market prices. The larger the number of intracompany transfers and the less the availability of market prices, the greater the need for more formal transfer pricing rules. If market prices are readily available, the headquarters can play a vital role in making sourcing decisions. In some companies, products are classified into various categories to help in determining transfer prices. For example, a company can divide its product portfolio into two classes before taking transfer pricing decisions. Class I products may include all those products whose transfer price the senior management at the headquarters would like to control. Class II products may include those products that can be produced outside the company without disrupting the normal workflow. These products are small in volume and are transferred at market prices.

SUMMARY
A transfer price is defined as “the price that is assumed to have been charged by one part of a company for products and services it provides to another part of the same company, in order to calculate each division's profit and loss separately.” The main objective of transfer pricing is to aid in the proper
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distribution of revenue between profit centers. While designing transfer pricing systems, organizations should aim at goal congruency. Some of the factors which help in achieving goal congruency are: competent people, good atmosphere, freedom to source, market price details, availability of information, and scope for negotiation. Some factors that hamper achievement of goal congruency are: limited markets, excess or shortage of industry capacity, and sourcing constraints. Companies use three methods for establishing transfer prices. They are the market-based pricing method, the cost-based pricing method, and the negotiated pricing method. Integrated companies can use two-step pricing, profit sharing or two sets of prices in order to overcome problems related to upstream fixed costs. Implementation of transfer prices is more difficult than formulating them. Companies need to engage in negotiations, provide mechanisms for arbitration, and classify their products, to overcome problems that can arise during implementation of transfer prices.

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Strategic Planning and
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In this chapter we will discuss: • • • •

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Analyzing Proposed New Programs Analyzing Ongoing Programs The Programming Process

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Strategic planning involves long-term planning, and is usually undertaken by the top management. Strategic planning is the process of deciding on the programs that the organization will undertake and the amount of resources that will be allocated to each program in the next few years. For strategic planning to be effective, it should be accompanied by an appropriate organizational structure, an effective management information system, a budgeting system and a reward system. Decisions regarding strategic planning influence the physical, financial and organizational framework within which the relevant operations are carried out. The programming process is an organizational process for making long-term resource allocation decisions. This chapter examines in detail the significance of strategic planning, the strategic planning process and the programming process.

CHARACTERISTICS OF STRATEGIC PLANNING
Strategic planning is the first step in the management control process. The difference between strategy formulation and strategy planning is this: Strategy formulation is the process of deciding on new strategies, whereas strategic planning is the process of deciding on how to implement these strategies. Strategy formulation essentially involves deciding on the goals of the
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After an organization analyzes the domain and differential advantage, the next step is to plan the strategies required to achieve the goals. This involves issues related to costs, marketing new products and services, planning the training and development strategies required for the staff to work in congruence with the organizational goals. The last stage involves analyzing performance. To know whether an organization is moving in the right direction, it is important to measure at regular intervals the actual results against expected results.

Yavitz, Boris and William H Newman, “Strategy in action: The execution, politics and payoff of business planning,” New York: The Free Press, 1982.

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The domain sought relates to analyzing the environment in which the organization is functioning. It addresses issues related to the changing needs of the business activity, the changes in the business environment, changes in the customer’s perception regarding the company’s products and best practices to deal with competition. All these relate to the domain in which the organization operates. Benchmarking is considered an important tool for comparing the company’s products with those of its competitors.

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organization, whereas strategy planning is concerned with developing programs to implement these goals effectively and efficiently. Strategic planning is systematic; it is usually done annually with prescribed procedures and timetables. Strategy formulation is unsystematic and depends on the threats or opportunities that the environment offers.

Benefits of Strategic Planning
1. Strategic planning takes into consideration the changing business environment which is a foundation for organizational change. 2. It helps in identifying and analyzing the internal business culture and evaluating its impact on the company’s performance. 3. It helps in analyzing available opportunities and potential threats. 4. It helps in allocating resources to the most beneficial activities. 5. It helps managers set realistic objectives that are demanding, and yet attainable. 6. It helps in identifying poor performing areas and eliminating them. 7. It helps in obtaining better information for decision making. 8. It helps in developing a frame of reference for budgets and short-range operating plans.

In short, strategic planning provides a road map of the company's target, and how to reach it.

An important purpose of strategic planning is to improve communication between the corporate and business unit executives, and arrive at a mutually agreed upon set of objectives and plans. In some organizations, the controller organization is involved in preparing the strategic plans while in others, there is a separate planning staff. In organizations where the controller of the organization is involved in the preparation of strategic plans, the plans may not be as successful as other organizations. Analytical skills and broad outlook may not exist in the controller organization. Such organizations may be suitable for fine-tuning the annual budget and analyzing the variances between actual and budgeted costs. Even in organizations that have a separate strategic planning staff, disseminating guidelines and assembling and bringing together the budgeted numbers are done by the controller organization. The staff at the headquarters should facilitate the strategic planning process, but should not intervene too strongly. They must ensure that the process runs smoothly but should not make program decisions themselves. This encourages business unit managers to freely put forward their views in the decisionmaking process.
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9. It helps in bringing about coordination of internal activities and thereby enhances the organization's growth.

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Top Management Style
The way strategic planning is conducted depends largely on the chief executive officer’s style. Some CEOs prefer to make decisions without a formal system. If the controller of such companies attempts to introduce a formal system, it is not likely to succeed. In some companies, the senior executives may prefer an extensive formal analysis and documentation of the plan, and hence, the plan is very elaborate. Thus, in designing the system, it is important that the senior management’s style be clearly diagnosed and the strategic plan be prepared accordingly.

STRATEGIC PLANNING PROCESS
The strategic planning process involves the following steps: • • • • • Deciding on assumptions and guidelines for the plan. First iteration of the new strategic plan Analysis Review and approval Second iteration of the new strategic plan

Deciding on Assumptions and Guidelines
This step involves making broad assumptions about growth in the gross domestic product, cyclical movements, the rate of general inflation, labor rates, prices of important raw materials, selling prices, market conditions, and the government legislation, in each of the countries in which the company operates. All these assumptions are examined and updated with the latest information. This process of updating has implications on revenues, expenses and cash flows of the existing operating facilities. It shows the amount of new capital that is available from the retained earnings and new financing. All these data are clearly analyzed so that it is currently valid (for the present year) and the amounts are extended for another year. This updating provides a rough estimation for the senior management to decide about the key guidelines that are to be observed in planning and for designing of these methods for achieving these objectives. The objectives are presented
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This involves reviewing and updating the strategic plan that was prepared in the previous year. Reviewing and updating takes place every year when the strategic plan is prepared, depending on the decisions the management takes. There is no fixed time limit set for this review. The updating of these plans is done with the help of a computer program. These programs help in incorporating the decisions on revenues, expenses, capital expenditures and cash flow. Updating is usually taken up by the planning staff. The management is involved, only if there are uncertainties or ambiguities in the program decisions.

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separately for each product line and are expressed as sales revenue, or as a profit percentage or a return on capital employed. There also are guidelines regarding wage and salary hikes, new or discontinued product lines and selling prices. At this stage, basically the views of the senior management are presented. To present these objectives to the business unit managers, most companies hold meetings between the corporate and business unit managers. Such meetings continue for several days, and help all business unit managers in the organization know one another. These meetings are held far away from office premises, to avoid distractions.

First Iteration of the Strategic Plan
After the assumptions and guidelines have been framed, the business units prepare the first iteration of the strategic plan. Most of the initial documentation and analytical work is done by the members of the business unit. After this, a final decision is taken by the business unit managers. The staff at the headquarters may also be consulted with regard to drawing up these plans. During the preparatory stage, employees from the headquarters visit the concerned business unit to find out whether the guidelines, assumptions and instructions are being followed. The completed strategic plan consists of income statements (inventory, accounts receivable) and other balance sheet items (sales and production, of expenditures of the plant and other capital acquisitions). These income statements are elaborately explained and justified. The numbers are presented in detail. They are also presented for the next two years, individually, with summary information for the later years. Then these are submitted to the headquarters.

After the plan prepared by a business unit is received at the headquarters, it is integrated into the overall corporate strategic plan, which is analyzed in detail. Employees from all functional areas like marketing and production, and the planning staff take care of the analysis. If there is any problem related to a particular business unit regarding additional funds for research and development, or if any slack is detected, then it is resolved through discussions between headquarters staff and their counterparts in the business units. These discussions form an important part of the strategic planning process, because they help identifying planning gaps. Planning gaps occur when the individual business unit plans do not work towards achieving corporate objectives. The best way to close these gaps is by: • • • Identifying the areas where the business unit plan can be improved on par with the corporate plan Making acquisitions Reviewing the corporate objectives

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Of the three, utmost importance is given to the first method to close the gap. The headquarters should also ensure that there is coordination between the
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different departments. For example, if one business unit manufactures for another unit, then it should be analyzed whether the unit is manufacturing as per the requirements of the other unit. At the planning stage planned cash requirements for the organization as a whole are developed, which include additional financing or possibly increasing dividends.

Second Iteration of the Strategic Plan
The analysis of the first plan leads to revision of the plans of certain business units. Sometimes, the guidelines may be changed, and this leads to a change in the overall plans of all the business units. Technically the revision is simple enough, but implementing such changes within the organization it difficult and time-consuming, because difficult decisions have to be made. In some companies, changes in the business unit plans are negotiated informally, and the results are incorporated into the plan by the headquarters.

Final Review and Approval

Capital investment analysis is important for taking up new proposals. The importance of capital investment analysis is to find the net present value of the project and the internal rate of return. The present value techniques are not used in analyzing the proposals for the project because: • • • If the proposal is not attractive enough then it is not necessary to calculate the net present value. The estimates involved in the project are so uncertain that making present value calculations is not worth the effort. The present value approach concentrates on the increasing profit of the firm. But some projects can be implemented to boost employee morale and to improve the company’s image, or for safety reasons.

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The management control system should look for a systematic way of arriving at a decision on proposals that cannot be analyzed using quantitative techniques. Organizations must look into the following issues before implementing capital expenditure evaluation systems:

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Ideas for new programs may originate anywhere in the organization- from the chief executive to the employees in the organization. Giving employees the freedom to put forward their proposals and paying them management attention plays an important role in implementing new programs. Every organization should have a management system that is flexible enough to encourage new ideas and pay the required attention to the employees. Adoption of new programs should be viewed as a series of decisions, and not a single decision.

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The revised plan is discussed with the senior corporate officials. It can also be presented in the meeting of the board of directors, and the final approval comes from the chief executive officer. The approval process should be completed before beginning the budget preparation process, as strategic planning is an important input for budget preparation.

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Rules
Companies publish rules and procedures for the submission of capital expenditure proposals. These rules specify the requirements for a proposal to be approved (of various magnitudes). The proposals are approved by the business unit manager, the chief executive officer or the board of directors depending on the degree of proposed expenditure. These rules also provide guidelines for the preparation of proposals and the general criteria for approving these.

Avoiding Manipulation
Sometimes projects that have a negative net present value may get approval because they are made attractive by adjusting the original estimates. This can be done by making more optimistic estimates of the sales revenue and reducing the amount of contingencies in some of the cost elements. Detecting such manipulations is one of the important tasks of the project manager.

A team should be formed to evaluate important proposals. The analysis of a project is usually done by a dozen functional and line executives before it is submitted to the chief executive officer. The project then goes through pilot testing and, at times, may not be approved for further analysis by the CEO. New technological systems like the expert systems2 are very handy for analyzing the proposed programs. Several software systems have been developed, that enable each member of the team to vote and rank each of the criteria used to evaluate the program. There is no fixed time for the commencement of such an analysis. It begins as soon as the proposal for the project is received. The projects that are approved are included in that year’s capital budget. If a proposal is not approved that year, then the formal approval may wait until the next year. The capital budget contains the authorized capital expenditures for the budget year and in case additional amounts are sanctioned, the cash plans are revised.

ANALYZING ONGOING PROGRAMS
It is not only important for a company to develop new programs, but also to analyze the ongoing programs. The tools used for analyzing ongoing programs
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An expert system is a computer program that simulates the judgment and behavior of a human or an organization that has expert knowledge and experience in a particular field. Typically, such a system contains a knowledge base containing accumulated experience and a set of rules for applying the knowledge base to each particular situation that is ascribed to the program.

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The staff involved in planning should be acquainted with various aspects of budgeting, such as risk analysis, sensitivity analysis, game theory, option pricing models, contingent claim analysis and decision tree analysis. These aspects will prove useful in situations in which the required data are available.

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are value chain analysis, activity-based costing and discretionary expense center analysis.

Value Chain Analysis
The value chain is a series of activities- from identifying the raw material to delivering the product to the consumer. As a part of the strategic planning process, a value chain helps an organization to understand the entire value delivery system. It highlights three areas for increasing profits-link with suppliers, link with customers and process linking within the value chain of the firm. The link with suppliers should be managed in such a way that both the firm and the suppliers benefit from it. Its relationship with customers is equally important. These two should be mutually beneficial. Apart from maintaining such relationships with suppliers and customers, it is also important for the firm to realize that the value activities in a firm are not independent, but interdependent. As part of the strategic planning process, a company may sometimes require information about the linkages within the value chain to improve efficiency. For this purpose efficiency in value chain should be analyzed. The efficiency of pre-production activities can be improved by reducing the number of vendors, adopting just-in-time delivery systems and establishing quality standards. The efficiency of the production unit can be increased through automation and better production control systems. The efficiency of delivery to the customers can be increased by automating the orders that they place, and by improving the channels of distribution, the efficiency of warehouse operations, and so on. It is important that improvements should be evaluated simultaneously, as all the activities are inter-linked.

Increased automation and computerization have resulted in the implementation of certain systems for collecting and using cost information. The traditional cost system allocated overhead costs to the products based on the direct labor hours or machine hours. The new cost system uses multiple allocation bases. Here, direct labor costs are combined with other costs to obtain the total conversion costs i.e. labor and factory overhead costs of converting raw materials into finished products. In the new system, the word ‘activity’ means cost center and hence, the cost system is called the activitybased cost system. Activity-based costing is discussed in detail in Chapter 12.

Expense Center
Service and support units, R&D centers, administrative centers are examples of discretionary expense centers. The expenses of such units cannot be clearly stated and hence, in the strategic planning process, the trend is to take the current level of expenses in a discretionary expense center as the starting point, and adjusting it upward for inflation and adjusting it further for anticipated changes in the workload. Requests for more funds are granted if a manager finds them really important. Usually, during the strategic planning and budget preparation process, there isn’t sufficient time to analyze the discretionary expenses. The alternative is to make a thorough analysis of the
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discretionary expense center, following a schedule that will cover all expenses over a period of five years. This analysis will provide a new base for estimating the expenses in the future years. Such an analysis is called “zero based review.” However, in the next five years, new expenses may creep up, and require a new base. Usually budgets take into consideration the current level of spending as the base, but zero based review takes into consideration the resources that are actually needed. The importance of the activity is considered after analyzing the importance of the function, the quality level, the methods through which it has to be performed and the costs that have to be incurred. This approach compares project costs and output measures for similar operations. A zero based review follows a strict schedule, and managers are always under tremendous pressure, because their operations are reviewed and they have to justify their current level of expenditure.

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1. Replacement of worn-out equipment to remain ‘competitive.’ 2. Expansion of the firm’s capacity to produce improved goods and offer better services in order to ‘grow.’ 3. Effective adaptation to the changing environmental conditions. 4. Adoption of a policy of mergers and acquisitions in order to close the gaps in planning. Planning and programming go hand-in-hand, as programs are developed as a part of the long-term planning process. The programming process depends on the size and diversity of the organization. The decisions that are made during this process have a significant influence on the ability of the firm's ability to survive and achieve its goals and objectives. In short, the programming process returns a set of feasible programs directed toward achieving long-term goals. Programming is carried out simultaneously with the long-term planning process.
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The decisions involving expenditure in the programming process is crucial to the organization's success. Some difficult decisions that are made during the programming process are:

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As part of the planning process, long-term goals are identified and assigned to responsibility centers. These goals are compared with the expected future performance and the gaps in planning are identified. This helps in designing and implementing programs to close these gaps.

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As stated earlier, some difficult decisions are made during the programming process. Bower's model is a widely cited model for making investment decisions.

Bower's Model of the Investment Decision-Making Process
A ‘discrepancy’ in a performance variable arises when the actual results differ from the desired results. This discrepancy forms the basis of Bower’s model. One important discrepancy is the planning gap that arises during the long-term planning process. The discrepancies that arise in the various systems of the organization, such as the production and planning system, accounting systems and information system, generate the capital expenditure project. The capital expenditure project requires both technical and economic analyses, which are carried out during the first phase of the resource allocation process. During this phase, the discrepancy between the actual and desired values of a key variable is focussed. The key variables include the size of the market, the profit margin, prices, operating costs, quality, and technological competitiveness. The discrepancy is first detected at the lower level of management. Then a project is defined at lower levels of the organization, where technical expertise is likely to be found, to overcome the discrepancy. The project is then subjected to economic analysis. The next step is selling the project. It is at this stage where the greatest discrepancy arises, when it is realized that projects selected are not the right ones. Usually, the major investment decisions are approved by the top management while the projects that are developed at the lower level are approved by the upper-level divisional managers. The duty of the division manager is to evaluate the goals and objectives of his division, and decide whether to approve the project. During the process of evaluation, the division manager keeps in mind the corporate objectives and the reward structure of the organization. If the reward structure is based on the manager’s batting average (quantifiable performance), then he selects the projects with a high probability of short-term returns (low risk) instead of those with a medium probability of extremely large returns. In other words, division managers choose projects which have a short pay-back period than those which have high, but risky, net present value. The projects are ranked according to the speed at which the capital outlays can be recovered. Division managers use the payback period, rather than the net present value method as an economic resource tool. The NPV method is considered only when the reward structure is based on the criteria for maximizing profits. Thus, Bower’s model suggests that project ideas come from the lower levels of management. The middle level of management approves the projects and allocates resources to them. In fact, the middle level of management is responsible for matching management desires of the lower levels with the criteria of the upper levels. The final decision regarding investment is made by the top management, which approves the project and determines the reward. Top management approves the project and establishes rewards. The authority for designing the programming process lies with the top management. This
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includes planning strategy, determining the criteria for acceptance, the approval levels, the process of programming and the reward systems.

Parameters of the Programming Process
Bower’s model has been extended by Kovar3, who has proposed and tested a model of the capital investment approval process, which incorporates factors that influence employees’ behavior during the early stages of the process of making investment decisions. There are three phases of the investment process that involve different levels of the organization. • • • The initiating phase The integrating phase The corporate phase

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iii. Number of steps in approval: If the number of steps in the approval process is high and if the process requires the approval of several people, then the process of approval will move slower. This will delay the investment process and demotivate the employees. iv. Involvement of the line manager and accountability: The responsibility of the programming process should be entrusted to the line management with the staff acting as catalysts. However, there is a possibility that the process may be taken over by the members of the staff and the line managers may not be accountable for the results. This will affect the decision-making process.

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Limits of approval: There should be a limit to the number of projects to be approved, and it should apply to the entire organization.

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Linkage to the strategic plan: The investment projects that are undertaken by an organization should be linked to its strategic plan of an organization. At times, profitable investments help to generate new strategies.

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In the early stages of the investment process, initiating and integrating phases, the plans proposed by managers help in identifying new possibilities. The corporate phase helps in identifying and evaluating opportunities for growth within the organization, and the steps to be taken to effect such growth are determined. Organizational behavior in the programming process consists of the employees’ rational, practical and emotional behavior. These are influenced by the design of the project approval process. The approval process is designed with the rate of return, linkage to strategy and legal constraints in view. The control system designers should be aware that emotional and practical problems of employees influence investment proposals, and the programming process designed should cover all these aspects. None of these elements should be paid excessive attention. There are a number of aspects that are associated with programming process. Kovar has identified nine of them. They are:

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Financial analysis and supporting detail: The programming process is designed in such a way that it will be able to accommodate all kinds of strategic changes any time in the future. If there is too much emphasis on financial analysis, then some significant strategic elements may be ignored. There has to be a balance between all these elements. Discount rate: An organization should have knowledge of its opportunity cost of funds. However, the firm should not be obsessed with it. Many projects that are successful are quite insensitive to opportunity costs and big changes in the discount rates of these costs.

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vii. External environment analysis: The right investment choice can be made with an accurate assessment of the environment in which the firm operates. Formal processes should be introduced to support informal mechanisms, for an accurate understanding of the external environment. viii. Identification and analysis of alternatives: In order to solve problems related to a particular project, similar projects to be identified and analyzed. Since these projects are likely to have come across problems those facing the project in question now. The solutions to the former may apply to the latter, too.

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Is there consistency between the organization's structure and its strategy? Is the control system helpful in implementing the strategy? Have assignments been given to all the managers in the organization to accomplish strategic objectives? What role do performance measurement and reward systems play in encouraging managers to focus on short-term and long-term objectives in the resource allocation process? How do the management style and organizational culture influence the resource allocation process? What role do planning and reporting systems play in the implementation of the organization's strategy? What role does communication mechanisms play in the resource allocation process?

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To examine and redesign the management systems associated with resource allocation, the control systems designer needs to develop a model or framework. This framework would help in deciding making decisions regarding the long-term resource allocation. The framework helps in designing the elements of the programming process. It helps in answering the following questions:

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Education and training: Extensive education and training on the objective of the programming process and the methodology of carrying it out is quintessential.

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Organization structure and strategy The point that should be discussed first is whether the structure of the organization supports its strategy. The second point is, whether the responsibility of achieving the organizational goals has been appropriately distributed within the organization. Performance measurements and rewards The performance measurement and reward systems should be so designed as to achieve both short-term and long-term objectives. Bonuses should be given both to employees for short-term and long-term success. The rewards system should be structured according to the short -term and long-term tasks. Management style and organizational culture The management style and organizational culture influence the way organizational decisions are made. By giving autonomy to the employees and encouraging competition between them, the management facilitates innovation and entrepreneurship within the organization. Planning and reporting The planning process should support the decisions regarding the resource allocation with formal information available within the organization and discussion forums within the organization. The process should also include the financial implications of various programs and link them to short term operating budgets. Communication mechanisms Effective communication is essential for managing conflicts associated with the decision making process for short-term and long-term resource allocation. Committees should be set up and schedules for meeting should be established for making such decisions and to resolve conflicts regarding program alternatives. In evaluating management systems and their impact on the process of making decisions about resource allocation, it is important to recognize the importance of the interdependence of the systems.

Formal Programming Procedures
These are procedures developed by organizations for defining, evaluating and implementing investment projects. These processes may often take a secondary role to the previously identified organizational processes. The different steps in evaluating and implementing investment projects are as follows: Project definition If a project is found to have deviated from the organizational goals, as reported by the information systems of various responsibility centers, than the need for defining the project arises. This helps in identifying the reasons for the above said variances. These variances may be caused by equipment inefficiencies, sales forecast that exceed the plant capacity and so on. To identify these variances, a manager uses information systems to compare the actual performance of the firm with its goals.
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In organizations that have complex structures, the operational level of the enterprise decides on most capital proposals. The controller plays an important role in managing the process of proposing a project and prescribing how the proposal should be defined. Detailing of a proposed project includes a description of the objectives and purposes of the project and the technology to be used. Defining a project also requires the understanding the purpose of each project to be looked closely at, and whether these are congruent to the organizational goals. The project should be analyzed with its influence on the key variables in mind. It should be reviewed, considering the impact it has on costs, quality or market shares of the competitors. Project evaluation In an organization, any employee of any hierarchical level may come up with a project proposal. He should be given detailed, concrete instructions about the whole process of proposing a project. The procedures and paperwork involved in the process of project proposal are usually laid down in ‘capital appropriation manuals.’ There are different procedures based on the category of the project and hence, there is a need for different evaluation criteria and techniques for each category. Each project category has its own characteristics and has to be distinguished from others.

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The investment authorization schedule about the various projects and the levels at which these projects can be implemented. The various forms used in financial evaluation that can be used in project evaluation as well. Forms related to the duration of the project and the capital expenditure incurred. Financial and schedule status report for each project, that includes all activities from giving authorizations to estimating costs at completion. A periodic project audit that analyzes whether the actual results conform to predicted results.

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The formal programming process thus helps to collect, analyze and communicate information about strategic and program alternatives being considered by the organization.

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This consists of details about policies related to project definition, evaluation and implementation. This is taken as a standard procedure for the entire organization. It contains instructions about the following:

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The capital projects manual

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Control over capital expenditures begins in the definition and evaluation phase. Next comes the implementation phase. Projects with major capital investment affect the organization as well as suppliers and subcontractors. Such projects need to be monitored constantly and controlled appropriately so as to ensure that the firm accords performance to the proposal, and that the costs do not exceed the budget.

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Strategic Planning and Programming

SUMMARY
Strategic planning is the process of deciding on the goals of the organization and the resources necessary to attain these goals. It enables managers to prepare for, and deal with, the rapidly changing environment in which their organizations operate. It provides a direction to the organization’s mission, objectives and strategy, thereby facilitating the development of plans for each of the organization's functional areas. The elements of a firm’s strategy are domain sought, differential advantage, necessary strategic thrusts, and expected target results. The strategic planning process involves reviewing and updating the strategic plan form the last year, deciding on assumptions and guidelines, first iteration of the new strategic plan, analysis, second iteration of the new strategic plan, review and approval. The proposal for new programs in the strategic planning process should consider the importance of existing rules and procedures; it should be free of and should be based on existing planning models. Analyzing ongoing programs in the strategic planning process can be done through value chain analysis, activity-based costing and discretionary expense center analysis. The programming process is an organizational process for making long-term resource allocation decisions. Bower’s model of investment decision-making examines the discrepancy between actual results and desired results. The model suggests that ideas, proposals and approval of projects come from the lower levels of the management. The investment process has three phases: initiating, integrating and corporate. The mutually supportive management systems model helps in designing the elements of the programming process. Formal programming procedures are adopted by organizations for defining, evaluating and implementing investment projects.

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Chapter 9

Budget as an Instrument of
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In this chapter we will discuss: • • • •

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Master Budget Zero Based Budgeting Performance Budgeting Participative Budgeting Variance Analysis for Control Actions

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Budgeting Process and Control

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Need for Budgeting

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Organizations prepare plans for the successful execution of strategies. A budget is a financial and quantitative statement, prepared and approved prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective. Budgeting refers to the process of designing, implementing and operating budgets. The budgeting process starts with the dissemination of guidelines approved by senior management. Budgetary control refers to the establishment of budgets that relate the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of the policy or to provide a basis for its revision. Managers should participate in the budgeting process to ensure consistency in the overall adherence to the corporate goals. In this chapter we will discuss the concept of budget, budgetary control, and the variances that arise in the budgetary process.

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Budgets identify weaknesses by finding out the reasons for inefficient performance. They help management trace discrepancies in any activity of the business and take suitable remedial measures. Budgets help managers analyze the expenditure and keep it under check, thereby preventing wastage of all kinds. Budgets help in the establishment of performance standards for operational activities and the adoption of the standard costing technique.

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Budgets help identify deviations from pre-planned courses of action. Management can later analyze the causes for the deviations and implement remedial measures. Budgets help establish standards of performance. Evaluating performance against standards enables employees to analyze their strengths and weaknesses.

To summarize, budgeting is an action plan that is necessary for controlling all aspects of the operations of an enterprise for a definite period of time.
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Budgets increase coordination among the different departments because budgetary control forces executives to think as a group. All the departments in an organization tend to function in a well-coordinated manner in an attempt to implement the planned courses of action systematically. Budgeting also helps management coordinate the activities of business to the economic trends.

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Budgets reduce uncertainty by allowing executives to map out the future course of action. This helps the organization face challenges with confidence.

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Budgets are essential aids in planning because they force management to think ahead and look before they leap. The main reasons for the need for a budget are:

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FORECASTING, BUDGETING, AND STRATEGIC PLANNING
Budgeting is different from strategic planning and forecasting. A Forecast is an estimate of what is likely to happen under anticipated conditions during a specified period of time, whereas a budget shows the policy and programme to be followed under planned conditions during a specified period. Forecasts are statements of future events. A budget, however is a tool of control. Forecasting is a preliminary step in the process of budgeting. Where forecasting ends, budgeting begins. Forecasts have a wider scope than budgets. Forecasts can be prepared for any period of time and updated whenever new information is made available. Finally, variances from forecasts are not analyzed formally or periodically. From the point of view of management, a financial forecast, which includes estimates of revenue, expenses and other items that affect the cash-flow is exclusively a planning tool, whereas budget is both a planning and control tool. Strategic planning is different from budgeting in the sense that strategic planning focuses on activities that extend over many years, whereas budgeting usually focuses on activities that take place within a year. Strategic planning provides the framework for the preparation of annual budgets. Strategic planning is formed on the basis of product lines or other strategic programs while budget is structured on the basis of allocation to responsibility centers.

BUDGETING PROCESS AND CONTROL

Three important aspects of budget process and control must be discussed. They are:

Budget Preparation Process

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Information is essential for preparing a sound budget. Budgets are prepared by managers; the information or the input data needed for budget preparation is developed by people lower in the hierarchy according to their responsibilities and functions. Managerial forecasts and accounting reports are a major source of data for budget preparation. Managerial forecasts provide data on the anticipated level of activity, while accounting reports provide data on the financial magnitude of past and current operations. The formulation of the budget involves the following steps: Organization The budget department The budget department disseminates the information during budget preparation. The members of the budget department report to the corporate controller. The functions of the department include:

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• • • • •

Publishing procedures and forms for the preparation of the budget. Ensuring that the information is communicated in the right way between the different organizational units. Analyzing the proposed budgets and recommendations whenever necessary. making corrections and

Carrying out budget revision at regular time periods Coordinating the work of the business units connected to the budget department.

The budget committee The budget committee consists of the heads of various departments within the organization and members of senior management such as the CEO, financial vice president, etc. The function of the budget committee is to review budgets, approve them, and make adjustments wherever necessary. In some companies, the CEO decides on the budget without the help of any committee. And in some companies, the budget committee meets only the senior operating executives, while in some other companies, the budget committee discusses the budget with the business unit managers. The first step in the budget preparation process is the issuance of guidelines. The main source of these guidelines is the strategic plan of the organization, which is modified from time to time according to the company’s performance. Budget guidelines are developed by the staff of the budget department, and these guidelines are approved by senior management. Sometimes, lower-level managers are also consulted for the finalization of guidelines. After senior management has approved these guidelines, the timetable for budget preparation is disseminated throughout the organization. The guidelines issued by the budget department have to be followed by the responsibility centers. Some guidelines for responsibility centers are based on important issues like inflation, wages, promotions and transfers, compensation etc. These guidelines submitted by the responsibility centers would be a source of input data at the time of budget preparation. However, in many companies the budget preparation process begins as soon as the strategic plan is approved. Initial budget proposal The managers of different responsibility centers within the organization develop a budget ‘request’ for facilities, personnel, and other resources. However, these budget requests are modified according to the guidelines issued to the responsibility centers. The changes responsible for the frequent modifications of budget requests are: Changes in external forces: These include changes in the level of economic activity, changes in the labor rates, changes in the purchased materials and services, changes in the selling price, and changes in the cost of discretionary activities like R&D.
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Changes in internal policies and practices: These include changes in market share and product mix, and changes in production cost and other discretionary costs (which are based on changes in workload). Negotiation The budget planner discusses the budget proposal with his superior. The superior judges the validity of each of the adjustments made in the budget proposal. The major consideration in this step of budget formulation is that the performance in the budget year be an improvement over the performance in the previous year. Slack In most organizations budgetees (the people, who prepare budget proposals) tend to budget revenues lower and expenses higher than their best estimates of these amounts. The difference between the budget amount and best estimate is known as ‘slack.’ It is the duty of the superior to discover and eliminate slack. The budget proposal developed by the budgetee goes up through successive levels in the organization. If at one level the budget is not found satisfactory, it is sent back for reworking. The budget committee presents the fully developed and reworked budget to the CEO. The final approval is made by the CEO. The CEO then submits the approved budget to the board of directors. This process of approval of budgets takes place in the month of December, just before the beginning of the budget year. Budget revisions Budgets are revised from time to time in order to check discrepancies, if any. Generally, two procedures are followed for revising budgets:

Systematic updating of budgets requires extra work by the budgetee. Large Japanese companies generally update budgets. In these companies, the budget is prepared for the whole year. Senior management formally approves the budget during the first six months of the budget period and for the next six months, the budget is revised and approved shortly before the budget period begins. Budgets may provide for activities that are planned months ahead of the time they take place. Thus, management activities should be based on the latest information available. Budgets are revised only when they are no longer useful as control devices. However, it is difficult to get permission from top management to do so. Frequent revision of the budget indicates that the budget is not well prepared. Administration and review of budgets The authority of administration of budgets vests with the top management. A budget can be successful only if it is properly administered. A budget manual is necessary to facilitate the process of administration of budgets. The budget manual contains objectives of budgeting, the process of budgeting, and the tasks and responsibilities of the departmental heads and individual managers

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Procedures that allow revisions under special circumstances.

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in the preparation of the budget. Many organizations set up budget committees at divisional offices as well as at corporate headquarters. The budget committee at corporate headquarters consists of managers of different divisions. When some large autonomous institutions come together to form a federation, a ‘programming committee' is formed. This committee consists of managing directors of the different institutions. The programming committee also coordinates the activities of the individual members of the union. A major aspect of the administration of budgets is the revision of budgets. Budgets can be revised only in extraordinary situations, when not revising will significantly affect the budget results. Budgets are also revised when they become unrealistic, when budget assumptions are proved incorrect, when they are no longer useful as control devices. After the budget has been finalized by the budget committee or senior management, it must be reviewed and approved. Budgets are reviewed and approved to ensure that the departmental and divisional budgets are consistent with overall organizational goals. For example, is the production budget consistent with the planned sales volume? Are service and support centers planning for the services that are being requested of them? The purpose of the review is to ensure that the budget produces a satisfactory profit. Budgets are prepared and finalized in accordance with the standards set by the top management. Since budgets are used to evaluate the performance of various responsibility centers, management must set standards that are attainable. If standards are too difficult to attain the responsibility centers may manipulate figures to please the top management.

Budgetary Control

The purpose of budgetary control is to find out how the activities of an organization are progressing. To achieve budgetary control, actual results are compared and measured with anticipated results as provided in the budget. If any differences are noticed, the budget estimates can be re-examined and necessary corrective actions can be taken. While a budget is a ‘means,' budgetary control is the ‘end result.' According to The Institute of Cost and Management Accountants, London, "budgetary control is the establishment of budgets, relating the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy or to provide a basis for its revision." Budgetary control focuses attention on deviation from budget standards and points out where corrective action is necessary. The budgetary controller, who consults with various heads of departments of the organization is responsible for the budgetary control. Importance of budgetary control Budgetary control has a number of advantages. The following are some of the advantages:

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Presentation of overall managerial view: Budgetary control offers an overall picture of the various functions in an organization. In other words, it presents
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a managerial view of all the activities within an organization structure. Such an overall perspective is essential for management success. Narrows down the gap between planning and performance: In many organizations there is usually a big gap between planning and performance. Budgetary control bridges the gap between planning and performance by anticipating the results of courses of action, by comparing the actual results with anticipated results, and setting up proper standards for performance. Promotes division of work and specialization: Budgetary control helps in the allocation of responsibility and accountability for performance to each member of the organization. It thus promotes division of labor. Division of labor in turn promotes the process of specialization, which helps improve the overall efficiency of the organization. Fosters coordination and integration: Budgetary control helps managers coordinate the activities of the organization. The interaction between the employees during the budget development process helps integrate the activities of the organization's members. The budget controller conducts meetings with the heads of various departments within the organization and thus fosters coordination and integration between various departments. Budgetary control thus brings about the integration of policy, plans, and actions of the different departments. Budgetary control is done systematically as follows: • • • • Establishing the budget centers • Determining the objectives

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Establishing budget committees which consists of key members of the organization, chief executive officers and budget controllers. The main function of a budget committee is to coordinate the budget activities, review the budgets, suggest revisions and approve the budgets.

Preparing the budget manual to develop a schedule to identify who is responsible for what in the organization. The budget manual consists of accounting codes, a budget timetable, budget periods, a budget proforma, etc. Selecting the budget period. This is done keeping in view the nature of the strategic plan, nature of the business, production period, financial aspects of the business, etc. Usually, a time period of one year is considered the budget period. Locating the principal factors that influence the budget. The key factors should be correctly identified and examined. For example, the principal budget factors for a sales budget would be consumer demand, marketing, advertising, etc.

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Preparing a budget organization chart that defines the functions and responsibilities of each member of management.

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Introducing adequate accounting records and assigning verifiable codes to them.

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Determining the budget cost allowance a budget center is expected to incur during a given period of time in relation to the level of activity attained by the budget center.

Organizing budgetary control Systematic administration and successful implementation of budgetary control results in sound budgets for the enterprise. The following steps should be considered to achieve effective budgetary control: • • • • • Organizing for budgeting Assigning responsibility for budgeting Determining the budget period Determining the key success factors Preparing the budget report

Organizing for budgeting

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Functions of various officials connected with the formulation of budgets Steps in the preparation of various budgets Scheduled date of submission of budgets

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Review and approval of various budgets Final adoption of budgets Timetable for budget operations Records, reports, and forms to be maintained for the purpose of budget operations.

Assigning responsibility for budgeting In an organization, the budget controller and the budget committees are responsible for budgeting. Budget controller: The entire process of budgetary control is handled by the budgetary controller. A budgetary controller should be experienced in handling various budgets and should be able to identify and analyze the
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Budget manual: This is a written document that contains standing instructions regarding the procedures to be followed at the time of budget preparation. A budget manual is maintained to inform the concerned executives about the procedures to be followed during budget preparation and to avoid frequent instructions from the controller’s office. A budget manual contains guidelines for the following:

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Budget center: A budget center is a section of an organization developed for the purpose of budgetary control and is intended to facilitate the formulation of various budgets with the help of the heads of the concerned departments. Budgetary control focuses attention on the attainment of the objectives of various departments within the organization or the enterprise. Therefore, the enterprise must have a clear perspective of the objectives that are sought to be achieved through budgetary control. A budget center is established after developing a clear perspective of the objectives that are to be achieved through budgetary control.

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deviations from the set standards and initiate corrective measures for the same. An important function of the budget controller is to advice management on important issues such as budget preparation, revision of budgets, approval of budgets etc. The budget controller reports directly to the chairman. Budget committees: A budget committee consists of the heads of various departments within the organization, viz. production, marketing, finance, administration, and accounts. The members of the committee discuss the budget figures (and probable estimates) before arriving at a final decision before finalizing the budget. Determining the budget period The budget period refers to the time period for which the budget is prepared. A budget can be a long-term or short-term budget depending on the time period. A budget prepared for one year or less is called a short-term budget. A budget can also be prepared on a quarterly, monthly or weekly bases depending on the requirements of certain operations. Examples of short-term budgets are annual sales, income and expenditure budgets. A long-term budget covers a period of five years or more. These budgets are prepared when an organization plans for expansion, modernization, diversification etc., Long term budgets are used for the purpose of planning while short term budgets which are designed to implement these plans are used for control purposes. Examples of long-term budget are capital expenditure budgets and research and expenditure budgets. The time period of a budget can vary depending on the nature of the business, the production period. Electronics and consumer goods industries prefer to prepare annual budgets as they experience a high rate of “change. For industries such as shipbuilding, the time period of budget may vary between 5 to 10 years. The key success factors are those factors that influence the performance of an organization. These factors influence the limit of output and thus have a direct impact on the profitability of an organization. The key success factors include the availability raw material, skilled labor, cash etc. If any of these is in short supply work can be delayed. Due to changes in the internal and external conditions, the key success factors can change from time to time. In some organizations, the critical success factors are consumer demand or expected level of revenue. In such organizations, the sales budget should be prepared first. This budget will determine the content of other budgets. In some other organizations, the most critical success factor can be productive capacity. Preparing the budget report It is essential to compare actual performance with the anticipated budgeting performance; and the results of the comparison should be brought to the notice of management through reports. The reports should furnish details of the responsibility of each department or executive in budget preparation and the reasons for variances in actual and budgeted performance so that corrective actions can be initiated.
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Behavioral Dimensions of Budgeting
The process of budget preparation requires the involvement of managers and other people. Since individuals are involved in the process of budgeting, the behavioral dimensions of budgeting cannot be ignored. Participation in budgetary process A budget can either be set by senior management for the lower levels of the organization or lower-level managers may participate in setting the budget’s targets. When the senior management initiates the budgeting process, the process is said to be a “top down” one; and when the lower level managers are involved, the budgeting process is said to be “bottom-up.” The bottom-up approach to budgeting is more commonly followed than the top down approach. The top down approach rarely works because lower level managers do not show keen interest in working towards already fixed budget targets. Bottom-up budgeting generates commitment among the budgetees to meet the budgeted goals set by themselves. However, the actual process of budgeting is a blend of two approaches. The lower-level managers prepare the budget proposal and submit the first draft to senior management (a bottom-up approach). The senior managers review the budget and suggest certain guidelines for improving the budget (a ‘top down’ approach). Bottom-up budgeting or participative budgeting is considered an effective budgeting approach because it results in greater acceptance of budget goals (due to personal control) and leads to higher personal commitment towards achieving these goals. Participative budgeting also leads to exchange of information between the budgetee and the superiors. Moreover, once the budget has been approved, the budgetee can boast of expertise and personal knowledge in budgeting. Degree of budget goal difficulty A budget's goals should be challenging but attainable. Budgeted goals that are difficult to achieve force managers to take certain short-term actions that are not in the long-term interests of the company. But if the budgeted targets are achievable, managers do not engage in data manipulation (for example, inadequate provision for warranty claims, bad debts etc.) to meet the budget. A winning atmosphere and positive attitude spreads throughout the organization when managers are able to meet and exceed targets. A budget is prepared with the intention of increasing profits in the long-term interests of the company. However, when an overly optimistic sales target has been set, a profit budget is difficult to attain. Thus a budget, whether it is sales budget, profit budget or production budget, should be easily attainable in order to ensure the allocation of resources for the budget activities. Sometimes when achievable targets have been set, managers will not put forth satisfactory effort once the budget has been met. However, this limitation can be overcome by providing bonus payments for actual performance that exceeds the budgeted performance.

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Involvement of senior management A budget is said to be effective only if it is supported by senior management. Senior management should review and approve the budgets. In some cases, the budgetee may resort to certain unhealthy practices during the implementation of the budget, just to meet the budgeted target, if there is no participation and supervision by senior management. Feedback from senior management is necessary in order to motivate and guide the budgetee. The budget department It is the budget department’s duty to collect the input data for the preparation of the budgets, prepare the budgets, and analyze them in detail. The budget department ensures that no excessive allowances are present in the budget. If a manager hides a potential situation during budgeting and the budget department discloses the fact, then the manager will be placed in an uncomfortable position. The manager’s sense of guilt will make him feel inferior to his colleagues. The manager should be warned against repeating the mistake. The budget department should ensure the integrity of the budget preparation system. The members of the budget department should work in a fair and impartial manner. In addition, they should learn how to deal effectively with different types of people.

The following budgets together constitute the master budget: 2. Production budget

5. Direct labor budget

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6. Promotion & advertising expense budget 7. Research & development budget 8. Manufacturing overhead budget 9. Capital expenditure budget 10. Selling and distribution expense budget 11. Financial budget The master budget may take the form of a profit and loss account and a balance sheet at the end of the budget period. It is the duty of the budget committee to approve the master budget. Sometimes more than one master budget has to be prepared before the final one is approved by the committee. The master budget shows the gross and net profits and the important accounting ratios. Thus, the master budget represents the overall plan of the enterprise.

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Steps in the Preparation of the Master Budget
The principal steps in the preparation of the master budget are: 1. Preparation of the operating budget 2. Preparation of the budgeted income statement 3. Preparation of the financial budget Preparation of the operating budget The operating budget consists of the following activities: (a) Sales budget (b) Cash collections from customers (c) Purchases budget (d) Disbursements for purchases

Purchases budget: The budgeted purchases are computed as follows:

Operating expense budget: Operating expenses are influenced by fluctuations in sales volume and cost-driven activities. Examples of expenses driven by sales volume include sales commissions and delivery expenses. Examples of cost-driven expenses include rent, insurance, depreciation and salaries. These expenses are fixed.

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Disbursements for operating expenses: Disbursements for operating expenses are based on the operating expense budget. Disbursements include 50% of the last month’s and current month’s wages and commissions and miscellaneous expenses. Preparation of the budgeted income statement The budgeted income statement is developed on the basis of information provided in preparing an operating budget. The interest expense (calculated after the cash budget has been prepared) is added to the budgeted income statement. The budgeted income statement is often used as a benchmark to judge management performance.
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Disbursements for purchases: Disbursements for purchases are based on the purchases budget. Disbursements include 50% of the current month’s purchases and 50% of the previous month’s purchases.

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Cash collections from customers: These cash collections include the current month’s cash sales plus the previous month’s credit sales.

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Sales budget: It is the responsibility of the marketing managers to prepare the sales budget. The preparation of the sales budget starts with a sales planning exercise. This sales planning exercise develops projections of the expected sales volume in physical and monetary terms. The key factors that are considered during sales planning are the size of the sales force, selling expenses, promotion and advertising expenses, and so on.

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Preparation of the financial budget The financial budget comprises the capital budget, the cash flow budget and ending balance sheet. Capital budget: The capital budget relates to the question of capacity and strategic direction of the firm. It deals with the evaluation of the alternate disposition of capital funds as well as the choice of the best capital structure. Cash flow budget: The cash flow budget is a detailed budget of income and cash expenditure and incorporates both revenue and capital items. It is concerned with liquidity and shows changes in opening and closing debtor balances and between opening and closing creditor balances. It also focuses on inflows and outflows of cash. A cash budget can be prepared by the receipts and payment method, the adjusted balance sheet method. Receipts and payment method: In this method, all the expected receipts and payments for budgeted period are considered. First the cash inflow and outflow of all the functional budgets, including the capital expenditure budgets, are taken. These cash flows are not affected by accruals and adjustments in account. Second, the anticipated cash inflow is added to the anticipated cash inflow to the opening balance of cash and all cash payments are deducted from this to arrive at the closing balance of the cash. This method is commonly used in business organizations. Adjusted income method: In this method, annual cash flows are calculated by adjusting the sales revenue and costing figures for delays in receipts and payments. This method eliminates non-cash items like depreciation. Adjusted balance sheet method: In this method, budgeted balance sheet is predicted by expressing each type of asset and short term liability as a percentage of expected sales. Profits are also a percentage of sales, so that the increase in owners' equity can be forecasted.

ZERO BASE BUDGETING
In zero-base budgeting (ZBB) all the activities are reevaluated each time the budget is prepared. In ZBB, each functional budget assumes that the function does not exist and that the costs are zero. Budget preparation for each function starts with the basic premise that each activity is being performed for the first
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The budgeted balance sheet projects each balance sheet item in accordance with the business plan. It thus indicates the financial status as envisaged at the end of the budget year. The balance sheet also projects the sources and uses of financial resources. The master budget should undergo a follow up process to ensure performance of budget in terms of planned goals and objectives. While the formulation of the budget is a planning process, the follow-up of the budget is a control process. A follow-up is conducted by preparing performance analysis statements on a periodic basis, indicating the budgeted versus actual performance.

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Budgeted Balance Sheet

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time and that the cost of each activity is zero. The assumption is that the budget for the coming year is zero and every process or expenditure has to be justified in order to be included in the budget. The manager is held responsible for identifying the resources required for each activity, and he or she has to justify the reason for spending the money on an activity by explaining what would happen if the proposed activity was not carried out and no money was spent on that activity. In ZBB a number of alternatives for each activity, and the associated costs, have to be identified so that the one that offers the most benefits can be selected. The basic requirements for the application of ZBB in an organization are: the presence of a budgeting system in the organization and the ability of the managers to develop qualitative measures for performance evaluation. The important features of ZBB are: • • • • • The budget requires the manager to explain the need for spending a particular amount on an activity.

The ZBB Process

There are three basic steps in ZBB. These steps are discussed below: Identifying decision units and developing decision packages: Decision units are synonymous with responsibility centers. These units should be given a prominent place in the organizational chart. Examples of decision units are research and development and capital expenditure units. A decision package describes the activities that take place in a decision unit. A decision package describes the goals and objectives of each activity, identifies specific measures of performance, and states the projected costs of the package etc. Evaluating and ranking the decision packages: In this step, the decision packages are reviewed and ranked in the order of decreasing benefit to the firm. Ranking is done on the basis of a cost-benefit analysis. Allocating resources accordingly: Top management allocates resources on the basis of the ranking of the decision packages. The total available resources will determine the acceptable expenditures. Before allocating resources, the available resources are forecasted and matched with the ranked decision packages on a cumulative amount basis.

ZBB Vs Traditional Budgeting
ZBB is not based on the previous year’s budget, whereas traditional budgeting uses the previous year's expenditure level as the base. The main differences between traditional and zero-base budgeting are:
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The budget has the advantage of maintaining the expenditure level according to the operating costs.

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The selection of each activity is made on the basis of what each unit can offer for a specific cost.

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Traditional budgeting is accounting oriented and is based on the previous year’s level of expenditure. The focus of this type of budgeting is determining the additions and subtractions that need to be made in the present budget on the basis of the previous year's budget. ZBB is decision oriented. It relies on the manager’s decision regarding the costs required for carrying out a particular activity. In traditional budgeting the budget is sometimes inflated by managers; but in ZBB, a rational analysis of the budget is made. In traditional budgeting top management is usually involved in the preparation of the budget, whereas in ZBB the responsibility center manager takes the necessary decisions. In ZBB it is easy to identify the important projects that require management attention, whereas in a traditional budgeting it becomes difficult to identify the priority items.

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Since the budget is evaluated on the basis of a cost benefit analysis, unnecessary costs are reduced. An activity is taken up only after detailed analysis of various alternatives in terms of cost allotment. ZBB leads to organizational development because it improves communication and leads to wider participation within the organization. ZBB also leads to a clear identification of the aims of the organization. ZBB encourages cost effectiveness and efficiency and allows for quick budget adjustments if revenue falls short during the year. The involvement of all the managers in the preparation of budget ensures their commitment to the successful execution of the budget. It leads to an increase in paperwork and emphasizes short-term benefits instead of long-term benefits.

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ZBB has been criticized for the following reasons: •

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The successful implementation of ZBB requires the clear statement of the corporate objectives and the identification of decision units on the basis of functions or departments. The function of each division and the targets it plans to achieve must be clearly defined and analyzed. In addition, the performance of each activity must be analyzed. The analysis should include a clear description of each activity, the alternate methods and costs involved in each activity and the ability to evaluate each activity, the alternate methods and the costs involved in each activity. Each activity or decision package must be evaluated through a cost benefit analysis.

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In ZBB decisions are based on the ranking of the decision packages. However, when formulating the budget, management must also consider the opportunities and threats presented by each activity. The managers of the responsibility centers require adequate training to take the necessary decisions and require adequate management skills to take constructive decisions. ZBB does not offer significant advantage when determining the costs of research and developmental activities. Even though ZBB, has been criticized for many reasons it is considered to be highly relevant in a continuous improvement environment as it involves continuous evaluation of activities and results in effective cost-benefit decisions.

PERFORMANCE BUDGETING
The term performance budgeting was first introduced by the Hoover Commission in 1949. It can be defined as a budgetary system in which input costs are related to end results. The cost and production goals are first established and they are later compared to actual performance. This method of budgeting leads to an improvement in management efficiency. It involves analyzing, identifying, simplifying and crystallizing the specific performance objectives of a job to be achieved over a period within the framework of organizational objectives. The budgeting system is aimed at fulfilling the objectives of the business. The main features of a performance budget are: • • • • • It presents the purposes for which funds are required and brings out the programs and accomplishments in financial and physical terms.

It presents the expected level of performance for each activity. It provides additional tools for management control of the organization's finances.

Steps in the Implementation of Performance Budgeting
The main steps in the implementation of the performance budget are: • • • • • • Classification of the activities Specification of objectives Analysis of activities Establishment of control norms Establishment of authority and responsibility Evaluation of the budget.

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Classification of the activities This is the first step in the implementation of the performance budget. The activities in an organization are classified as. These are again divided into
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It acts as an effective performance audit

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It presents the costs for achieving the various activities along with the quantitative data for measuring the accomplishments.

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programs depending on their time frame and resources are divided based on their importance. For example in an organization marketing programme can be classified into public relation activities, advertising activities etc., An activity is thus a subdivision of the programme to which resources are applied. Specification of the objectives In this stage the objective of the individual activity is clearly defined. Then the resources that have to be spent for each activity are clearly outlined. The annual, monthly targets are determined for each activity center. Analysis of activities The long-term strategy and short-term tactics for achieving the desired objectives are considered. Also, the possible alternative activities are identified and their costs and benefits are worked out. Then the activities that come closest to achieving the organizational goals are selected. Control norms are established in the form of productivity ratios and performance ratios. These are compared to actual performances. Norms are also set for non-financial measures of performance. The authority and responsibility for different activities are clearly identified and the functions of the activities are clearly demarcated. Financial rules and accounting systems help in the effective implementation of the activities. Evaluation of the Budget To find out if the projects have been implemented according to the plan, information and reporting systems (related to financial, economic and physical data) are installed to monitor the execution of the activities.

Performance budgeting puts more emphasis on expenditure incurred on functions than on things to be acquired or spent. In performance budgeting each program is further sub classified as an activity. In traditional budgeting system, budget appropriations are made object-wise and clubbed according to the nature of expenditure such as pay and allowances, traveling allowances, transport, traveling allowances etc.

PARTICIPATIVE BUDGETING
Participative budgeting is based on the premise that having better communication and motivation in an organization will lead to better budgeting. Consequently, a participative budget draws on ideas suggested by all the members of the organization. The organization should ensure the following when developing a participative budget: Targets should be achievable: Targets must be realistic and achievable. If targets are high, they will be difficult to achieve; if they are set too low, there
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will be slack in the performance. Unnecessarily high targets results in nonachievement and, therefore, lower performance. Participation of lower levels: If the lower levels of management do not participate actively in decision making, then the whole purpose of a participatory budget is lost.

VARIANCE ANALYSIS FOR CONTROL ACTIONS
Since a budget is an instrument of control, it is necessary to compare the actual results with the budgeted results. A variance occurs whenever actual costs differ from standard costs. The term variance analysis refers to the systematic evaluation of variances in an attempt to provide managers with useful information for measuring efficiency and improving performance. Variance analysis attempts to isolate the impact of each important variable that contributes to the total variation. Variance analysis is done to investigate the underlying causes for deviations in budgets so that management can take corrective measures. Thus, variance analysis examines the amount of difference between standard costs and actual costs and the reason for the difference. If the actual cost is less than the standard cost, the variance is favorable. If the actual cost is more than the standard cost, the variance is unfavorable. A favorable variance indicates efficiency and an unfavorable variance indicates inefficiency. Variances occur due to three reasons. A managerial decision to respond to some new developments which were not initially anticipated, uncontrollable exogenous factors, controllable factors that need to be investigated. The following framework can be used to conduct variance analysis: • • • • • Breakdown of the overall profit variances according to the key causal factors. Focus on the profit impact of the variation for each key causal factor. Determine the specific, separable impact of each causal factor by varying a particular factor while holding all others constant. Add complexity sequentially to determine the impact of several variables on a particular factor. When the added complexity at the newly created level is not justified, the process has to be stopped.

Revenue Variances
Selling price, volume and mix variances come under revenue variances. The variance for each product line is calculated separately and the results are aggregated to calculate the total variance. If the actual profit exceeds the budgeted profit, the variance is positive and favorable, but if the actual profit is less than the budgeted profit, the variance is negative and unfavorable.
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Selling price variance: The selling price variance is calculated by multiplying the difference between the actual price and the standard price by the actual sales volume. Mix and volume variance: Mix and volume variances are not separated in general. The mix and volume variance is the product of the budgeted unit contribution and the difference of the actual and budgeted sales volume. The volume variance results from selling more units than the budgeted. The mix variance results from selling a different proportion of products, as the contribution per unit is different for different products. If the business unit has a ‘richer’ mix (i.e., a higher proportion of products with a high contribution margin), the actual profit will be higher than the budgeted. Mix variances and volume variances can also be calculated separately.

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Market share variance = [(Actual sales) - (Industry volume) x Budgeted market penetration] x Budgeted unit contribution. Industry volume variance = [(Actual industry volume-Budgeted industry volume) x Budgeted market penetration] x Budgeted contribution per unit. The variance for each product is calculated separately, and the sum of variances of all the products gives the total variance. Sales budget variances Sales budgets are prone to variances because actual sales usually differ from budgeted sales. It is the duty of the concerned managers to analyze and understand the factors that have caused the deviation. In most organizations three principal reasons are responsible for deviations in sales budgets:
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Market share variance and industry volume variance are calculated using the following equations.

The actual price realized is different from the price envisaged at the time of budget formulation.

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One extension of revenue analysis is to separate the mix and volume variance into the amount caused by the differences in market share and the amount caused by differences in industry volume. This is because while the business unit managers are responsible for market share, they are not responsible for industry volume as state of the economy decides the industry volume. For this purpose, the industry sales data is also needed to exactly represent the performance of a business unit.

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Volume variance = [(Total actual volume of sales) x Budgeted percentage)] [(Budgeted sales) x (Budgeted unit contribution)]

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Mix variance = [(Total actual volume of sales x Budgeted proportion) (Actual volume of sales)] x Budgeted unit contribution.

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Mix variance: The following equation is used to calculate the mix variance for each product.

Budget as an Instrument of Control (ii) (iii)

The actual volume of product sold is different from the planned volume of sales. The actual sales mix is different from the budgeted sales mix.

Variance in the sales budget is categorized as a price variance and volume variance. Volume variance is analyzed in terms of a sales-mix variance and a quantity variance. The same approach is used to analyze a territory-wise sales performance report. If a sales district projects a high variance, then it is necessary to analyze and understand the reasons for the high variance. Corrective measures must be initiated accordingly.

Expense Variances
Expenses are divided into fixed costs and variable costs. The variance between the actual and budgeted fixed costs is obtained simply by subtraction, as these costs are not influenced by market sales or volume of production. But variable costs vary directly and proportionately with the volume. The material budget variance is categorized as material yield variance and material usage variance. Material yield variance occurs due to differences between the actual yield and the standard yield. These differences are caused by abnormal loss sustained in different processes of production. Thus, yield variance represents the portion of usage variance that is due to the difference between the standard yield specified and the actual yield obtained.

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Labor budget variance Labor budget variance occurs due to the following two factors: i ii Differences between actual wage rate and budgeted wage rate Differences between actual labor hours and budgeted labor hours for a particular activity.

The labor budget variance includes wage rates variance and labor efficiency variance. Wage rates are determined through negotiations between union and management. This wage rate variance is controllable at the supervisor level. The labor efficiency variance is the difference between the standard labor hours specified and the actual hours spent on work. Labor efficiency depends on the skill levels of the workers, the volume of work hours put in by each worker, and the wage rate. Labor efficiency variance occurs due to the following factors.
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Use of inferior materials

Defective tools and materials Setting of improper standards

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Lack of supervision Poor working conditions in the factory Use of sub-standard materials Inefficiency of workers due to inadequate training. Lack of proper tools, equipment, and machinery Higher labor turnover

Manufacturing overhead variance Manufacturing overhead variances are the most complicated to compute in the variance analysis. Fixed overhead variance refers to all items of expenditure that are more or less constant, irrespective of fluctuations in the level of the output. This variance represents the difference between the actual cost and the fixed overhead cost. Variable overhead variance represents the difference between the budgeted and the actual variable overheads.

Some companies use performance for the year to date as the basis for comparison. They use the budgeted and actual amounts for the six months ending June 30, rather than the amounts for the month June. Other companies compare the budget for the whole year. The actual amounts are taken for the first six months and the estimates of revenues and expenses are taken for the next six months. A comparison of the annual budget with current expectation of actual performance for the whole year shows how closely the business unit manager expects to meet the annual profit target. If the performance for the year to date is worse than the budget for the year to date, the deficit is likely to be overcome in the remaining months. However, the forces that caused the actual performance to be below budget for the year to date are expected to continue for the remaining part of the year, and this is likely to make the final figure significantly different from the budgeted amount. Focus on gross margin Though selling prices are assumed to be constant throughout the year, in practice, changes in costs and other factors make it difficult to maintain the same selling price. So, the marketing manager must try to achieve a budgeted gross margin, that is, a constant spread between costs and selling prices. To do so, the ‘gross margin’ variance must be considered. The gross margin is the difference between the actual selling prices and manufacturing costs. Evaluation standards Three types of standards are used for evaluating reports of actual activities: (1) Predetermined standards (2) Historical standards (3) External standards.

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Predetermined standards Predetermined standards (also called budgets) if carefully planned, and coordinated can be excellent standards. Most companies compare actual performance against predetermined standards. But if the budgeted numbers are collected in a haphazard manner then this will not provide a reliable basis for comparison. Historical standards These are records of past actual performance. Results for the current month are compared with results for the last month, or with results for the same month a year ago. There are two disadvantages of using these type of standards: conditions may be different in the two periods (this invalidates the comparison), and the prior periods' performance may not have been considered acceptable performance. Despite these inherent weaknesses, these standards are used by companies where valid predetermined standards are not available. External standards These standards are derived from the performance of other responsibility centers or of other companies. The performance of one branch sales office may be compared with the performance of other branch sales offices. Such a comparison may provide an acceptable basis for evaluation if the conditions in the responsibility centers are similar. In a full-cost system, the manufacturing cost of a product includes both variable costs and fixed costs. Companies under the full-cost system may not be able to make such a separation, or even if they do it, they have to identify the variance in manufacturing costs that result from the difference between actual and standard production volume. A ‘Production volume variance’ is developed when actual volume is different from standard volume. Amount of detail information Revenue variances can be analyzed at various levels: in total; then by volume, mix, price; analysis of volume and mix variance is done by industry volume and market share. At each level, the variances of individual products are analyzed. The process of analyzing the variance from one level to another is called "peeling the onion." Similarly, additional ‘sales and marketing variances’ can be calculated, by ‘sales territories,' by ‘individual sales persons,' by ‘sales originating from direct mail,' by ‘customer calls from other resources’, by ‘sales to individual countries.' Additional information for manufacturing costs can be developed by calculating variances with specific input factors, such as wage rents and material prices. These layers of variances correspond to the hierarchy of the responsibility center managers.

Limitations of Variance Analysis
Variance analysis identifies the occurrence of variance, but it does not tell ‘why’ the variance occurred. When using variance analysis, it is difficult to decide whether a variance is significant or not. Another limitation of variance
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analysis is that, as the performance reports become more highly aggregated, offsetting variances might mislead the reader. For example, a manager might notice that the business unit manufacturing cost performance was as budgeted. However, this may be because good performance at one plant is offsetting poor performance at another plant. If a variance is significant, but uncontrollable (such as unexpected inflation), there may be no point in investigating it. Performance reports show only what has happened, they do not show the future effects of actions that the manager has taken. For example, reducing the budget for employee training increases the current profitability, but may result in adverse consequences later. Since variance analysis is limited to those events that are recorded in the accounts, many important effects of those events are not reflected in current accounting transactions.

Budgets are formal, quantitative statements of resources for carrying out planned activities over a given period of time. Budgeting plays an important role in coordinating the activities of responsibility centers. The master budget is the overall budget for an organization. It represents the overall plan of the organization. The principal steps in the preparation of the master budget are: preparation of the operating budget, preparation of the budgeted income statement and preparation of the financial statement. The budget process and control encompasses the budget preparation process, budgetary control and behavioral dimensions of budgeting. The budget preparation process involves the organization of a budget department, the establishment of a budget committee and the issuance of the guidelines for developing budgets. Budgets may undergo frequent modifications because of changes in external factors, and changes in internal policies. Top management is responsible for administering and reviewing the budget. Zero base budgeting, performance budgeting and participative budgeting can be used to appraise actual performance. Zero based budgeting starts with the premise that each activity is being performed for the first time and that the costs are zero. The manager is held responsible for identifying the resources and has to justify the reason for spending money on a particular activity. Budgetary control focuses attention on deviation from budget standards and points out where corrective action is necessary. The important steps for achieving effective budgetary control are setting up a budget center, documenting a manual, appointing a budget controller and the budget committee. The budget period and the key variables must also be decided on. The budget is responsible for budgetary control. A budget committee is established to assist the budget controller. A budget is an important control mechanism. When actual results do not tally with the budget; a variance is said to have occurred. Variance analysis thus provides managers with useful information for measuring efficiency and improving performance. The overall performance of a business unit is divided into revenue variance and expense variance. The different types of variances that occur in budgets are sales budget variance, material budget variance, labor budget variance and manufacturing overhead variance.

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Chapter 10

Reward Systems
In this chapter we will discuss: • • • • • •

Purpose of Reward Systems CEO Compensation Balanced Scorecard Agency Theory

Components of Incentive Compensation Plans Incentives for Business Unit Managers

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Reward systems are a major motivational tool to secure the participation of individuals to achieve organizational goals. It is a common notion that only the employees of an organization are entitled to rewards. Organizations however, also reward their stakeholders -customers, stockholders, creditors, and the public for their contribution. Reward systems are an important source of communication and feedback. They communicate what the firm values of an individual. Rewards create a sense of belonging which makes an individual feel more committed towards his work. Reward systems harmonize the interests of stakeholders and managers.

COMPONENTS OF INCENTIVE COMPENSATION PLANS

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A manager’s total compensation package is made up of three components: • • Salary Benefits

• Incentives Salaries are usually paid every month. Employees progress through a clearly defined career hierarchy based on factors such as age, qualifications, experience and performance. Factors which affect the administration of salaries in various organizations are as follows: • • Remuneration in comparable industries Firm’s ability to pay

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Picken, Joseph C.; Dess, Gregory G. “Out of (strategic) control,” Organizational Dynamics, Summer 97, Vol. 26 Issue 1, p35.

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Between 1981 and 1991, Bausch & Lomb was a highly successful company. Its sales and earnings had tripled to $1.5 billion and $150 million, respectively and its shares value witnessed a five fold increase. The compensation of Dan Gill, the CEO of Bausch & Lomb had soared from $362,000 in 1981 to $6.5 million by 1991. An aggressive culture and an emphasis on performance and rewards drove the organization too far, too fast. The sole aim of the company was to achieve double-digit annual growth irrespective of the means used. In 19941, the SEC and the shareholders, who filed a class suit accused the company of misleading investors by falsely inflating sales and earnings. Rewards and incentives are clearly important, but organizations also need to set boundaries when deciding the rewards. The more the culture and rewards drive ambition and goal-seeking behavior, the more the need for a system of boundaries and constraints. At Bausch & Lomb, the boundaries were set rather late. Only after the SEC investigation began in December 1994, did Gill and his top executives adopt more conservative practices, reduce distributor inventories, and change bonus guidelines to incorporate broader, long term goals.

Reward Systems

• • •

Cost of living Productivity

Union pressure and strategies • Government legislation Salary administration must follow a systematic approach to ensure that employees are paid in a logical, equitable and fair manner. The objectives of salary administration are: • • • To acquire qualified and competent personnel To retain present employees To reinforce desired behavior-good performance, loyalty, willingness to take additional responsibilities etc.

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To improve the quality of the work environment and work life

• To protect the health of employees and to ensure their safety It is the duty of the senior management to devise the best incentive plan possible for its employees. Incentive plans should be approved by the board of directors before they are implemented. Corporate by-laws and security regulators also make it mandatory for all organization’s to get their incentive plans approved by their shareholders. Incentive compensation plans can be classified as: (a) Short-term incentive plans (b) Long-term incentive plans Short-term incentive plans are usually based on the performance of employees in the current year, while long-term incentive plans relate compensation to long-term accomplishments. A manager can earn a bonus under both the plans. In short- term incentive plans, bonus is paid in cash while in long term incentive plans, the employees are provided with an option of buying the company's common stock. Short-term incentive plans The total bonus pool Bonus pool refers to a system wherein shareholders vote on the formula to be used for deciding the total amount of bonus to be paid in a given year. One simple method is to calculate it as a set percentage of the profits. However, this method is not always acceptable because a company will have
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• To pay the employees in accordance with their efforts and merit Benefits help employees to deal with certain contingencies and meet certain social obligations. They satisfy an employee’s economic, social and psychological needs. Benefits include safety measures, health benefits, pension, perquisites etc. In short, benefits lessen the economic problems of the employee. The objectives of providing benefits are:

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Carryovers

This refers to an annual carryover of a part of the amount determined by the bonus formula to the bonus pool instead of paying the total amount in the bonus pool. The board of directors decides the percentage to be carried every year. The board of directors also decides the amount of accumulated carryover is to be used if the bonuses paid in a particular year are low. This method is flexible as the payment of bonus is not determined by any formula. In a good year, the committee might pay only a portion of the bonus to its employees while in a poor year, it may pay more than the amount warranted by the year’s performance by drawing from the carryover bonus. However, the disadvantage of this method is that the bonus calculated is less related to the current performance of employees. Deferred payments Under this system, the amount of bonus is calculated annually, but the employees receive the payments over a period of years, usually five.

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to pay bonus even if the profits are low. Further, this method does not give a true picture of additional investments. Additional investments can result in increased profits and thus increased bonuses even when the performance of the company has been static or has been deteriorating. Many companies therefore use formulas according to which bonuses are paid only after a specified return has been earned on the capital. One method of accomplishing this is to base the bonus on a percentage of earnings per share after a predetermined level of earnings per share has been attained. This method, however, fails to take into account increases in investment from reinvested earnings. This drawback can be overcome by increasing the minimum earnings per share each year by a percentage of the annual increase in retained earnings. Another method is to calculate it as a percentage of the profit before deducting taxes and interest on long-term debt minus a capital charge on the total of shareholder equity and long-term debt. The fourth method is to define capital as equal to shareholder equity. However, the problem with the third and the fourth methods is that a loss in a year reduces the shareholders’ equity and thereby increases the amount of bonus to be paid in profitable years. There are some companies which calculate the bonus on basis of increase in profitability in the current year as compared to the previous year. One major drawback of this method is that a good performance in a year is not rewarded if it follows an excellent one. Bonuses can also be calculated by comparing the company profitability with industry profitability. However, it is sometimes difficult to collect the industrial data as only a few companies adopt the same product mix or employ identical accounting systems. As a result, a company may end up paying a higher bonus in a year in which performance was mediocre simply because one or more of its industry competitors performed badly. It should be noted that while calculating bonuses using any of the above mentioned methods, adjustments need to be made in the net income and shareholder equity. While determining the bonus, it is also important to exclude certain gains and losses from discontinued operations.

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Employees receive only one fifth of their bonus in the year in which it was earned. The remaining part (four fifths) is paid equally over the next four years. Thus, after five years, employees receive one-fifth of the bonus for the current year plus one-fifth of each bonus for the preceding four years. One advantage of the deferred payment method is that employees can estimate their cash income for the coming year. Another advantage is that it guarantees bonus to those employees who retire, as the payment of bonus is spread out for a fixed year. But this method also has its drawbacks. One major disadvantage is that the deferred amount is not available to the employees the year it is earned. Moreover, an employee loses the deferred amount, if he leaves the company. Long-term incentive plans Long-term incentive plans are designed to reward the performance of an employee over a longer period. The types and characteristics of long-term incentive plans have become increasingly complex over the past several years. Organizations today design and implement plans that are responsive to the needs of both the enterprise as well as their employees. The different types of long-term incentive plans are discussed below. Stock options A stock option gives the employee the right to buy a certain number of shares in the company at a fixed price for a certain number of years. Stock options give the employees the right to buy a number of shares of stock at or after a given date in the future. The manager who obtains stock gains if he sells the stock at a price that exceeds the price paid for it. Managers can retain equity even if they leave the company. They can sell the stock whenever they decide to do so. However, managers are not permitted to sell the stock for a specified period after it has been acquired. A major advantage of this plan is that managers are motivated to direct their energies toward the long-term performance of the company as it is designed to create an employee ownership culture. This incentive plan gives employees the right to receive cash payments based on the increase in the value of stock from the time of the award until a specified future date. The amount of bonus received due to the increase in the value of stock is a function of the market price of the company’s stock. Phantom stock plans This plan awards managers a number of shares of stock-either in the form of cash or shares. At a specified event in future, such as retirement or termination of employment, the employee is entitled to receive an amount measured by the fair market value of phantom shares credited to the employee’s account. There are two types of phantom stock plans, namely “growth” and “basic”. Under the growth plan, at redemption, employees receive an amount equal only to the appreciation in the market value of share. Under a “basic” plan, employees receive the original value of the shares as well as the amount appreciated. Performance shares Under this incentive plan, employees are awarded a specified number of shares when they meet specific long-term goals. This plan aims at achieving
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certain percentage growth in earnings per share over a period of three to five years. The advantage of performance shares over stock options and phantom shares is that they are given on the basis of performance. Moreover, they are not affected by increase or decrease in stock price. However, one major drawback of this incentive plan is that it is based on accounting measures of performance. In certain circumstances, actions that corporate executives take to improve earnings per share may not contribute directly to the economic worth of the firm.

CEO COMPENSATION
The compensation of the Chief Executive Officer (CEO) is decided after a discussion by the board of directors. This takes place after the CEO has recommended the incentives to be paid to his subordinates. The percentage of incentive compensation decided by the CEO for his subordinates, can be taken as the basis for determining his/her compensation. Most people believe that CEO compensation is much higher as compared to other employees in the organization. In most cases, CEOs are paid extraordinary bonuses, lavish perquisites that are not related to the profits of the organization. However, directors of most firms feel that the compensation the CEOs receive is very little as compared to the profits they bring to the organization. However, of late, the exorbitant salaries being paid to the CEOs have come under scrutiny. The recent scandals in Global Crossing, Computer Associates, Xerox have highlighted this issue further. According to some analysts, high CEO compensation is the root cause for collusive practices. In 2000, CEOs in the US, were paid 458 times the salary of an average worker. The problem lies not only with the pay the CEOs receive, but also with the methods they adopt to raise the stock price up in time to cash in their options. Emphasizing on the need to restrict such practices; writes Warren Buffet2: “To clean up their act on these fronts, CEOs don’t need “independent” directors, oversight committees or auditors absolutely free of conflicts of interest. They simply need to do what’s right.” Also, the policy making process should ensure that better representation is given to the investors. The family run businesses in India also pay exceptionally high salaries to their CEOs especially in the manufacturing sector where profits and stock prices have increased continuously. The CEOs award themselves with high salaries by manipulating shareholder meetings and share prices. The CEO compensation which has to be decided by the board of directors now seems to be just a farce with industrialists and professional managers rewarding one another through cross directorships on company boards.

INCENTIVES FOR BUSINESS UNIT MANAGERS
Incentives for business unit managers include financial incentives, psychological incentives and social incentives. Financial incentives are offered in the form of salary increases, bonuses, benefits and perquisites.
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Warren E. Buffett “Who Really Cooks the Books?” New York Times, July 24, 2002

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Psychological and social incentives are provided in the form of promotions, increased responsibilities, increased autonomy, better location, participation in executive development programs etc.

Size of Bonus Relative to Salary
There are two schools of thought on designing the mix between the fixed (salary and benefits) and variable (incentive bonus) portions of a manager’s total compensation. One school states that it is important to recruit good people, pay them well and expect good performance from them. This school emphasizes on salary and not on incentive bonus. The emphasis of this school of thought is on the fixed pay system. In this type of compensation performance is not related to pay. However, this type of compensation raises an important question- what happens if a person does not perform as expected? The other school of thought believes that compensation should be based on performance. Thus, the emphasis is on incentive bonus and not salary. These two philosophies have different implications for business unit managers. While the first philosophy assures employees’ monthly salary it rarely encourages employees to perform efficiently. Whereas the second philosophy encourages managers to put greater effort and perform to the best of their ability. Most organizations emphasize on incentive bonuses for business unit managers.

Cutoff Levels

Another aspect that has to be considered when deciding compensation plans is the cutoff level for bonuses. The upper cutoff indicates the level of performance at which maximum bonus can be earned whereas the level below which there will be no bonus is referred to as the lower cutoff level. When employees realize that the maximum performance level has been attained and they will not be paid any bonus, they may not be motivated to perform well and achieve organizational goals.

The bonus for a business unit manager can be based on the total profits of the company or solely on the performance of the individual business unit or a combination of both. It is important to base bonus on the performance of the individual business unit as the decisions and actions of the manager have a direct impact on the performance of that unit. But such an approach can have a negative impact on the inter unit cooperation. To encourage cooperation among the various units, the managers ability to foster cooperation should also be given due consideration.

Performance Criteria
The bonus of a business unit manager can be decided on the basis of the factors mentioned below. Controllable factors Managers should be rewarded on the basis of variables which values are under their control and influence. Such a reward system can be considered fair. On
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the other hand, when rewards are based on variables that are outside the control of managers, the reward system becomes more arbitrary. Uncontrollable factors Sometimes corporate managers hold the subordinates responsible for variables that are out of their control. These include effects of losses due to earthquakes and floods and accidents not caused by the negligence of the manager. Another uncontrollable factor is the result of decisions made by the executives above the business unit level. These uncontrollable factors have to be taken into account while deciding on the reward systems. Financial criteria In case of a profit center, the choice of financial criteria for the business unit manager are decided on the basis of the unit’s contribution margin, direct business unit profit, income before taxes and net income. However, before considering these factors, it is important to have a clear understanding of the definition of profit, and investment and also the choice between return on investment and residual income. Linking business managers’ bonus to short term financial targets results in managers looking for ways to perform existing operations more creatively and innovatively. However, this can sometimes cause several dysfunctional problems. Managers can encourage short term actions that are not in the long term interests of the company. They could also discourage investments, that promise benefit in the long term but do not contribute to short term financial results. Managers could manipulate data to meet current period targets. Overcoming short-term bias These can be overcome by determining the manager's bonus on multiyear performance. But having such a reward system has its own disadvantages. If the bonus is based on multiyear performance, managers would have difficulty in perceiving the relationship between their rewards and effort. This would reduce the motivational effect of such rewards. Secondly it would be difficult to implement such a reward system in case of transfers. Senior management can thus use non financial criteria like sales growth, market share, customer satisfaction, personal development etc. However, the best alternative would be to have a judicious mix of financial and non financial criteria. Non financial For an effective and efficient control system key variables should be qualitative. These kinds of key success factors include cycle time, measures of quality, on-time delivery, complaints from customers, new product introductions, supplier defects and so on.

Benchmarks for Comparison
The performance of a business unit manager can also be evaluated by comparing the actual budgets with profit budgets, its past performance or even with its competitor's performance. However, when using the profit budget as a motivational tool, it is important for the business unit to set attainable targets.
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BALANCED SCORECARD
In this rapidly changing world of business, the traditional measures of performance appraisal are insufficient for making decisions. The emphasis is not only on measuring financial performance, but also on measuring non financial performance. The growing international competition, the TQM movement have all widened the growing importance of non-financial measures of performance. Thus, it has become important to take into consideration both financial and non-financial measures of performance. A number of studies have been conducted to include both financial and nonfinancial measure of performance. The balanced scorecard (BSC) developed by Robert Kaplan and David Norton takes into account financial and nonfinancial measures, short-term and long-term goals, external goals, internal improvements, past outputs and ongoing requirements, as indicators of future performance. BSC3 acts a strategic planning and communicating device by:

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Internal business processes perspective that focuses on various strategic priorities for various business processes that result in customers’ and shareholders’ satisfaction. • Learning and growth perspective determines priorities to create a climate that supports organizational change, innovation and growth. BSC plays an important role in strategy implementation and performance measurement. The measures of performance should be accurate, objective and verifiable. Performance measurement should motivate employees to improve in the key areas of competition like customer satisfaction, productivity, etc. If performance is not measured accurately, managers may manipulate performances, and thus the credibility of the system may be lost. The target performance level should be challenging and, at the same time, attainable. However, having too many performance measures may reflect the complexity of the organization’s task. Employees’ commitment to achieving goals can be enhanced by linking BSC to well understood rewards and penalties. An organization’s BSC will be effective if it is linked with best rewards and appropriate penalties. An effective management control device
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Mary A Malina and Frank H Selto “Communicating and Controlling Strategy: An Empirical Study of the Effectiveness of the Balanced Scorecard” Journal of Management Accounting Research, 2001.

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According to Kaplan and Norton, by using a BSC, managers can effectively utilize the potential and specific knowledge of the organization’s personnel to achieve long-term goals. BSC measures performance from four important perspectives: • Financial perspective that involves the strategy for growth, profitability, and risk viewed from the shareholder's perspective.

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that promotes desired organizational output should have the following attributes: • • • • • Performance variables should linked to the strategic goals of the organization. Goals should be accurate, objective and attainable, and should effectively guide managers towards achieving the strategic objectives of the organization. To promote positive motivation, an effective management control system should have: Performance measures that are helpful in measuring the manager's actions by relative performance appraisal measures. Targets that are challenging, but should be attainable.

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Integrating rewards with MSSM Attainability Identifying the formal rewards Identifying the informal rewards

The MSSM (Mutually Supporting Systems Model) which consists of infrastructure, management sytle and culture, formal control process, rewards and coordination and integration has the ability to produce incentives or disincentives depending upon its design and performance variables. For example, autonomy may be considered an incentive for a manager. A sense of authority over the organizational resources will motivate him to perform better. The incentives and disincentives are strongly influenced by the values and culture of an organization. Communication and integration structures are strong motivators. Employee participation in decision-making and problemsolving, which is usually highly valued by the employees is considered to be a powerful incentive.

Attainability
It is important to set targets which are challenging but attainable. Targets that can be easily achieved are poor motivators as they do not give individuals the
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The design considerations for developing reward systems follow certain criteria. These criteria whether formal or informal are powerful motivators of people.

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• Achieving targets should be followed by rewards. Feedback is a powerful tool and helps the management to measure and reward performances. Feedback can be both formal and informal. Rewards and penalties help an employee to understand the expectations of the management and work towards the achievement of the goals.

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scope to grow. At the same time, targets which are impossible to achieve can be demotivating.

Formal Rewards
Formal rewards are specified by the definition of goals, responsibilities, performance measures and a number of criteria should be followed by setting formal rewards. • • •

Performance measures which are designed to measure reward systems should be congruent with the goals and objectives of the organization. Performance of the managers has to be evaluated based on the variables over which they have significant amount of control. Performance should be objectively measured and these standards should be challenging but attainable. Rewards should encourage competition and should be simple to understand and administer.

Informal Rewards

The agency theory describes the factors that should be considered while designing incentives and shows how these incentives can be used to motivate individuals. This theory usually uses mathematical models to describe the incentives. Here, we only discuss the main concepts of agency theory and not the mathematical models. The term ‘incentive contract’ has been used here instead of incentive compensation. The theory reestablishes the importance of incentives and self interest in organizational thinking.

Concepts of Agency Theory
According to the theory, a relationship is formed when party ‘the principal’ hires another party ‘the agent’, to undertake some service. In an organization, many such relationships exist. For example, shareholders are considered to be the principals with the chief executive officer as their agent. Similarly, the CEO is the principal while the managers of specific business units are agents. The agency theory assumes that the principals and agents possess divergent preferences and objectives. This divergence in preferences can be reduced through incentive contracts.
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Informal relationships among employees give rise to informal rewards. Informal rewards are usually meant to satisfy the psychological needs of the employees. These rewards promote self-respect, reinforce the values of the organization and encourage self-learning. The reward and recognition dynamics of formal and informal reward systems is shown in Exhibit 10.1. The left side of the exhibit indicates the formal rewards like merit increases and bonus programs. Before motivating an individual, these rewards pass through cultural values, past training etc., The right side represents the informal activities which also passes through cultural activities. When these two loops positively reinforce the employee then he is motivated to perform.

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Exhibit 10.1 CEO Compensation in India In India, CEO compensation is becoming a highly debatable issue. Family run businesses are awarding the CEOs hefty salaries. The late Dhirubhai Ambani, former chairman and founder of Reliance Industries was paid $1.83 million in 2002. Hero Honda, promoted by the Munjal family in partnership with Honda, paid Rs 29.75 crore (Rs 297 million) to its top four executives. Hero Honda's promoters, Brijmohan Lal Munjal, Pawan Kant Munjal, and Honda executives Matsuo Yamasaki and Kazumi Yanagida, took home around Rs 7.50 crore (Rs 75 million) each during 2002. The aggregate salaries of the top five executives of RIL were Rs 27.23 crore (Rs 272 million), Mukesh Ambani and Anil Ambani being paid Rs 7.21 crore (Rs 72 million) each. Nikhil R Meswani and Hital R Meswani was paid Rs 1.93 crore (Rs 19 million) each. Apart from these, Hindustan Lever, the Aditya Birla Group, ITC, Wipro and ICICI have high pay packets that have attracted attention. The compensation is not performance based and industrialists and professional managers reward one another through cross-directorships on company boards.

Divergent objectives of principals and agents The agency theory assumes that financial compensation alone cannot satisfy the agents. Perquisites like greater amount of leisure time, attractive working conditions, flexibility in working hours etc. are also needed. Some agents prefer leisure to hard work (effort) and the preference for leisure over effort is termed as work aversion. Sometimes, agents deliberately try to evade responsibility which is termed as shirking. Another assumption of the agency theory is that although managers prefer more compensation to less, but satisfaction decreases with the accumulation of more and more wealth. The compensation made to managers is usually based on the performance of the firm. Agents try to avert risk when much of their wealth is dependent on the company. On the other hand, owners reduce their risk by diversifying their wealth and becoming owners in many companies. Nonobservability of agent’s actions The principal should monitor the actions of the agents in order to avoid divergence in preferences (between the principals and agents) and to satisfy the agents by offering the best compensation and perquisites. However, due to the lack of adequate information about the activities of agents, the principal cannot ascertain the agent’s contribution to the performance of a firm. This situation is referred to as ‘information asymmetry.’ Sometimes, the agent may have more information about the task assigned to him than the principal. The additional information that the agent may have about performing a particular task is termed ‘private information’. The agent may sometimes misinterpret information to the principal, either due to divergence of preferences or due to the private information available with him. Such a situation is termed as moral hazard.
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Control mechanisms There are two ways of dealing with the problems of information asymmetry and divergence in preferences, namely monitoring and incentive contracting. Monitoring: The principal can design control systems that monitor the actions of its agents. One example of a monitoring system is the auditing of the financial statements. These statements help generate reports about the company’s performance. These financial reports are audited by a third party and then sent back to the owners. Monitoring becomes easy when the task assigned to the agent is well defined and the information used is accurate. Incentive contracting: Incentive contracts are established to limit divergence in preference. Performance measures should be set to measure the rewards granted to the agents. The more the reward depends on performance measures, the more incentive there is for the agent to improve the measures. The principal should define the performance measure in such a way that it furthers his or her interest. The ability to accomplish this is known as ‘goal congruence’. If the agent, to whom the contract is given, is motivated to work in the best interest of the principal, then the contract is said to be goal congruent. A compensation scheme that does not have an incentive contract is demotivating. The CEO who is paid a straight salary, is likely to be less motivated to work diligently than the CEO who gets a bonus along with the salary. This would motivate the CEO to work hard and the organization earns higher profits. Thus, the incentive contract is beneficial for both agents and principals. Contracts help in aligning the interests of the two parties. The asymmetry of information, differences in risk preference between the two parties, costs of monitoring, etc. sometimes make incentive contracts ineffective. These can lead to additional costs. Even an efficient system of incentives can lead to divergence of preferences. This divergence is referred to as ‘residual loss’. The additional costs of incentive compensation, the costs of monitoring and the residual loss is termed as ‘agency costs’.

SUMMARY

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This chapter examined the usefulness of reward systems as a control mechanism that encourages and motivates managers to achieve organizational objectives. The reward system is a major tool for communication and feedback. Reward systems help align the interests of stakeholders with that of managers. The important components of incentive compensation plans are: salary, benefits and incentive compensation. CEO salaries have soared very high and is causing serious concern. Short-term incentive plans are based on performance of employees in the current year while long-term incentive plans are based on performance over a longer period. The balanced scorecard can be used for comparing performances of individuals within an organization. It provides the management with the information that may help to prevent control failures or at least identify them early. The control system is designed to ensure: safeguarding of assets, reliability of information. Feedback is an important motivational tool that helps in assessing the performance of individuals in organizations. The chapter concludes with a description of the agency theory.
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Chapter 11

Management Control of Operations
In this chapter we will discuss: • • • • • Just-in-Time Techniques

Total Quality Management Decision Support Systems

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Operations management is one of the most important managerial functions. In order to bring about efficiency in operations, there is a need to develop techniques that help a manager to establish control. As management control of operations involves working through others, managers should have the right kind of information to understand the different activities that directly or indirectly influence control. This control can be discussed in two sections. The first section is concerned with the information that managers require to carry out the different activities that directly or indirectly influence control and the second section deals with techniques that are useful in management control of operations.

INFORMATION USED IN CONTROL OF OPERATIONS
A manager is responsible for selecting the work force, ensuring that they are adequately trained, deciding where they fit best in the organization, providing advice and suggestions, solving problems and ensuring that the environment in the work place is satisfactory. Managers also need to interact with other managers to obtain their cooperation and resolve problems when their activities impede the work of the responsibility center. Thus, a primary motive of a manager is to create a climate that induces employees to work efficiently and effectively. In order to carry out these activities, managers require information. Hence, it is necessary to discuss the different types of information required in management control of operations.

Informal Information

Information that managers receive in organizations is mostly informal in nature. It is obtained through observation, face-to-face conversations, telephonic conversations, and meetings. ‘Management by walking around’ (MBWA) has gained a lot of importance in the present day business world indicating the importance of informal information. By ‘walking around’, the manager tries to understand the problems of the workers. The information received through this process is informal and cannot be categorized.

Formal Information
In formal information, the manager relies principally on the formal reports. This includes task control information, budget reports, budget signals and internal audit. Task control information Task control information constitutes most of the formal information that flows through an organization in its daily operations (production or other activities). A production control system is one that schedules the flow of material, labor and other resources to ensure that both quality and productivity are maintained. An organization also has systems that control procurement,
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payroll, storage and other activities. Management control information is nothing but a summary of task control information. The emergence of technology has made it easier for managers to acquire day-to-day information. However, the main issue is not of acquiring the information but deciding what information is really useful for them. Budget reports Approved budget is a financial tool which helps in controlling the activities of the managers and comparing actual expenses with budgeted amounts. The budget report serves as an important guide for the manager. The manager is expected to operate in accordance with the budget to get a clear idea of the financial position of the responsibility centers. However, the manager is free to depart from the budget if he feels there is a better way of achieving the objectives of the organization. Budget signals

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Internal audit If too much emphasis is placed on the budget, there is always a danger of managers manipulating numbers to report the attainment of the budgeted profitability in the current period. One way of doing this is to record goods that have, not been shipped to customers during that period. On the other hand, if performance greatly exceeds the budget, the apprehension that reporting a high profit may lead to an increase in the budget amount or a decrease in the following year, may prevent a manager from reporting certain revenue transactions. The internal audit reports help detect such behavior while the audit committee activities ensures that appropriate action is taken on internal audit reports and that there are adequate controls to minimize theft and defalcation. As these activities generally involve high level managers it becomes difficult as well as sensitive task.

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Budget signals help the operating manager to determine the amount of money that has to be spent on various activities. These activities can be grouped under Ceilings and Floors. Ceiling includes activities such as advertising, entertainment expenses on which no more than the budgeted amount should be spent. Floors include activities like training and the manager is expected to spend the amount assigned for a particular activity. Though the expenses are stated in the budget, the manager should be in a position to decide the amount that has to be spent on each activity based on the requirement of the department.

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Non Financial Information
For management control systems to be effective in controlling operations, there is a need for non-financial information. It is reported as a supplement to the financial information. Non financial information includes the identification of key variables and the steps that have to be taken to achieve competency in these key variables. While financial performance shows the end result of an organization's performance, non financial information shows the means to achieve the ends. The relationship between financial and non-financial information in an organization is illustrated in Figure 11.1. The exhibit illustrates that at the lower levels of organizational hierarchy, non financial measures are given greater importance. The emphasis on financial measures is likely to increase with hierarchical levels. Figure 11.1: Hierarchical Levels and Types of Performance Measures

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JUST-IN-TIME TECHNIQUES
Just-in-time is a Japanese philosophy that is used for managing all types of inventory, purchase and production functions in an organization. The main purpose of this philosophy is to reduce inefficiency and unproductive time in the production process.

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Advantages of Just-in-Time Techniques
There are a number of strategic advantages for an organization using just-intime systems. They form an integral part of the corporate strategy by focussing on cutting cycle time, improving inventory turnover and increasing labor productivity. Some of the advantages have been discussed below: Reduces buffer inventory The main aim of just-in-time is to ensure the delivery of raw materials at the right time and in the right quantity and reduce buffer inventory. The need for buffer inventory arises when machines break down or they produce defective parts. The amount of buffer inventory can be reduced if steps are taken to minimize machine breakdown and improvise quality of the inventory. The need for buffer inventory also arises because of bottlenecks in the workplace. These problems can be minimized by taking immediate action whenever a problem arises.

Decreasing procurement costs

Implications for Management Control
Before implementing just-in-time systems a manager has to understand the following aspects. Work-in-process inventory becomes insignificant because of just-in-time systems and can be disregarded. In such cases inventories exist only for raw materials and finished goods, therefore reducing record keeping considerably. In addition to the traditional focus on cost, a just-in-time system focuses management attention on time. A reduction in cycle time may result in
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Traditionally, procurement involved a long process of first inviting bids, then analyzing these bids, and placing an order with the best vendor, followed by an inspection of the incoming goods. This process was time consuming as well as expensive. To avoid this, companies are now establishing relationship with one or two vendors who are expected to inspect the quality of the incoming goods before delivering them. Moreover, with the advent of information technology, orders are being transmitted electronically in many companies. This can help companies to curtail procurement. Relationship with customers Manufacturers use systems through which sales persons can automatically place orders from retailers or other customers. These systems help in providing fast and accurate information to managers and also build strong relationship between the customer and manufacturer. .

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The amount spent on set-up costs is reduced with the introduction of numerically controlled machine tools. Traditionally when a machine was discontinued a sizable production of each part became obsolete and these awaited replacements. With numerically controlled machine tools, the need for this inventory is greatly reduced and orders for obsolete parts can be filled by simply inserting a proper computer program.

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reduction of costs. The progress of just-in-time systems can be effectively monitored through the following ratio: Processing time Cycle time This ratio should ideally be equal to 1. The just-in-time system is an evolutionary system, that seeks to improve the manufacturing process continually. Keeping this ratio in mind, the management can establish targets and monitor progress against the targets.

TOTAL QUALITY MANAGEMENT
Total quality management (TQM) is a management concept that directs the collective efforts of all managers and employees towards satisfying customer expectations by continually improving operations management processes and products. TQM emphasizes three important aspects: customer satisfaction, employee involvement and quality improvement. The Japanese have set an example for other countries paying considerable attention to quality. Quality efforts initiated by the Japanese have now been adopted by several American companies.

Consequences of Poor Quality

The quality of a product can be decided either on the basis of design or its conformance to customer requirements. Design quality can be described as the value that the consumer places on the product. A product is said to achieve conformance quality, if it adheres to the specification of manufacturing the product. If a product does not meet the specifications, than it implies nonconformance to quality. This nonconformance is measured by the number of defective products. Total quality management emphasizes manufacturing products with zero defects. Emphasis is also laid on detecting the problem at the initial stage because if the defect is detected at a later stage, then it results in cost penalty for the organization, which at times can damage the reputation of the firm. Therefore, the earlier a defect is detected; the lower will be the cost penalty.

Total Quality Management Approach
The total quality management approach can be looked at from three aspects: responsibility for quality, product design and relationship with suppliers. Responsibility for quality The traditional view held that most defects occurred at the factory floor and that workers were primarily responsible for them. Hence, the quality control in the traditional method involved inspecting the quality of the products. This was a tedious process and entailed setting up a quality control department. This led to a frequent conflict between the manufacturing department and the quality control department. The main objective of the manufacturing
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department was to maximize output; the quality control department was responsible for detecting problems. Thus, coordination among the various departments became a major problem for the management. This problem was eliminated to a large extent by using the total quality approach. According to the total quality control approach, the responsibility for quality should be shared by all departments as quality is the responsibility of every single department. According to this view, most quality problems occur even before the product reaches the factory floor. According to Edward E. Deming, “Quality is the responsibility of the management and not the workers and management must foster an environment for detecting and solving quality problems.” The production process in an organization can be divided into two parts: the system that is under the control of the management and workers who are under their control. Of the quality problems that arise in an organization, 85 percent can be attributed to the former while 15 percent to the latter. The system that is under the control of management can be faulty due to several reasons like ineffective manufacturing processes, inferior raw materials, poor working conditions etc. The total quality management approach thus, emphasizes ensuring quality while the product is being manufactured rather than inspecting it for quality after it has been manufactured. Most of the quality problems can be avoided by identifying the errors at an early stage. Exhibit 11.1 illustrates the quality control process implemented at Toyota. Employees in every department should ensure that they do not pass on a defective product to the next stage of production. Also, the function of the quality control department should not just be related to inspecting the product after it has been manufactured but inspecting and monitoring the production process. This will eliminate most of the defects. Product design

Most of the quality problems arise in the early stages mainly during the designing of the product. These problems occur when the designers do not work closely with the production people, who are familiar with manufacturing problems. Under total quality control, there is an effort to coordinate the activities of designers and the production engineers. While designing a product, the preference of the customers should be given due consideration. For this it is important that the marketing department and design department work in close coordination. Relationship with suppliers In the traditional method, contracts were awarded to those suppliers who placed the lowest bid. But in total quality management, the supplier is selected not just on the basis price but also the quality, and its timely delivery of the product. Thus, instead of having many suppliers, one or two suppliers are selected and a long term relationship is established with them.

Implications for Management Control
The management can ensure the quality of its products by focusing on two aspects-the financial and non financial.
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Exhibit 11.1 Quality Control at Toyota The cornerstone of Toyota’s quality control system is the role of the team members in the production process. The team members in the Toyota plant are encouraged to play an active role in quality control. Employees’ ideas and opinions are utilized in the production processes, and they are encouraged to practice “kaizen’ — striving for constant improvement. Every team member in the Toyota plant treats the other member as a customer. This way they ensure that no defective product is passed on to the other team members. If a team member finds a problem with a part or the automobile, the team member stops the line and corrects the problem before the vehicle goes any farther down the line. • The planning stage is an important stage where the employees emphasize on manufacturing defect free products. Quality is designed in the automobile with the help of advanced design techniques like computer-aided design that helps in improving the quality. This stage also emphasizes developing a product that is defect free. Quality control involves close cooperation of many production departments. Toyota’s quality control during production ensures that the correct materials and parts are used and fitted with precision and accuracy. This effort is combined with thousands of rigorous inspections performed by team members during the production process. The team members are responsible for any defects in the products they use as they are the inspectors of the products they use. To ensure that the product is defect free a quality audit is done that ensures that the product is manufactured as per quality standards. Encouraging and rewarding people form an important system in quality control. Members in Toyota are rewarded for providing suggestions. Through Quality Circles and a suggestion system that rewards employees for ideas, team members strive to achieve the Toyota principle of kaizen, or continuous improvement. At any time during the production process, any team member who spots a problem can stop production by pulling the “and on cord” located next to the assembly line. “And on cord” lets supervisors know the location of the problem with a blinking light and a distinct musical tone.

Source: www.toyotageorgetown.com

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Financial measures In the financial measures, the costs of doing things wrong are estimated and aggregated. There are certain costs associated with quality management: prevention, appraisal, internal failure costs and external failure costs. The total cost of quality for a firm is the sum of the four costs described below: Preventive costs These are costs incurred to make products defect free the first time they are manufactured. It includes quality engineering, receiving inspection, preventive maintenance, the estimated fraction of manufacturing engineering and design
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engineering. All these ensure prevention of defects and encourage quality training. Appraisal costs These are costs incurred in assessing the level of quality in the manufacturing system. It includes technical services laboratory, design analysis and actual inspection costs. Internal failure costs They fall into two major categories: yield losses (if a defective item has to be scrapped) and rework costs (if an item is routed to previous operations). External failure costs These arise when a defect is discovered after a customer has received a product or service. The costs include cost of returns, marketing expenses dealing with returns, repair costs etc., Total cost of quality and reporting can provide several benefits for an organization.

These reports guide the workers and also the management to work towards quality goals.

COMPUTER INTEGRATED MANUFACTURING
It is a term used for the total integration of product design and engineering, process planning and manufacturing by means of complex computer systems. Expensive computer systems are used to link various stages of production. These systems automatically schedule manufacturing tasks, and keep track of the availability labor. Then they send instructions to computer screens at various workstations along the assembly line. The implications of such systems for management control are:
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Nonfinancial measures These relate to collecting nonfinancial information about the number of defective units delivered by each supplier, number and frequency of late deliveries, number of customer complaints, warranty claims, machine breakdowns, number and frequency of product returns. The major advantages of non financial measures are: • They can be reported on a daily basis • Corrective actions can be taken everyday. Thus non financial measures are important to provide continuous feedback to managers and workers improve quality.

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These reports can help the management to understand the relationship between preventive and failure costs. Specific programs to improve quality can thus be designed.

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They increase the task control for managers as these systems convert certain production activities that once required management control to task control. Hence, managers no longer have to supervise the work of their employees. They are required to handle only unusual situations. The information provided by these systems is accurate and detailed. However, the designers are sometimes overloaded with information and have difficulty in deciding the amount of information they should report to managers. The solution to such a situation is to provide a small quantity of information routinely and permit the manager to access a large database for other information. Some systems are built around work teams that are responsible for all operations. Employees are rewarded on the basis of their contribution to the work team in terms of achieving the quality and quantity.

The term decision support system is broadly used for systems that aid decision-making by providing the answers to a series of “what-if” questions. Decision support systems include expert systems, natural language systems, artificial intelligence systems, and knowledge-based systems.

Nature of Decision Support Systems

“If-then” rules or decision rules that show how an expert in the area would solve a problem, given a certain set of facts, make up a decision support system. The relevant information is provided by a series of questions answered by the decision maker. These questions are asked in plain English and does not require any knowledge of computer programming. That is why they are called “natural language” programs. A course of action is then suggested by the computer. Decision support systems are so called because they help the decision maker to arrive at a decision. The decision maker, however, is free to reject the computer’s recommendation, or to modify it.

Implications for Management Control
With the use of decision support systems, the need for managers may be reduced as they can convert management control activities into task control activities. Managers may also be able to spend a larger fraction of their time on other problems. On the one hand, decision support systems can increase the quality of decisions and reduce (or even eliminate, in some cases) the time that is required to take them. On the other hand, they permit many types of decisions to be made by the computer or by lower-level personnel. Decision support systems thus, reduce the level of expertise required and, in some cases, eliminate jobs entirely.
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SUMMARY
Operations management is being increasingly recognized, at the strategic level, as a potentially rich source from which competitive advantage may be leveraged. To control such a process and make it work effectively, managers use various types of information. The simplest is “management by walking around.” Formal methods through which a manager controls performance include task control information, budget reports and signals. Internal audit is an important method to assess whether the manager is performing as expected by the organization. Apart from financial information, a manager should also have an idea about the non-financial information that is necessary to achieve the organizational goals.

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Total quality management is a management concept that has gained tremendous importance in continually improving operations management processes and products. The other developments include computer integrated manufacturing and decision support systems.

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Recent developments in operations management have helped companies to increase quality at lower costs. Just-in-time is one philosophy that is used to reduce inefficiency and unproductive time in the production process.

Chapter 12

Continuous Process Improvement Methods
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Target Costing Benchtrending and Benchmarking Quality Improvement: Process Quality Teaming Activity Based Costing

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With more and more companies focussing on quality management and customer satisfaction, Continuous Process Improvement (CPI) methods have assumed great importance. Continuous Process Improvement (CPI) is the philosophy of running business in such a way that every member of the organization is encouraged to continuously strive to serve the customer more efficiently. The objective of CPI is to sustain continuous improvement within an organization and align improvement activities to support strategic objectives. This is done through modification in all processes, procedures and task content. Efforts are also made to enhance product quality while maintaining time schedules. However, as a methodology for achieving long-term objectives CPI has some limitations. As it does not lead to major technical breakthroughs or innovations, companies which excessively depend on CPI are likely to lose to other companies which are more innovative. Conversely, companies that rely only on technical innovations may soon lose to other companies that may take to innovation and then continue to refine products and reduce costs through CPI. ‘Innovation’ and ‘CPI’ require different approaches and therefore, have different requirements. While, innovation relies heavily on technical staff, business and investment plans, CPI requires a supportive culture, extensive training and continuous managerial support.

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TARGET COSTING

Target cost is the maximum manufacturing cost of a product. Target costing is done to encourage various design and production departments to find less expensive ways of achieving similar or better product features and quality. It is decided after analyzing market niches, assessing customer requirements, understanding cost drivers, determining elasticity of demand, and analyzing volume-cost relationships. It is calculated by subtracting the expected market price from the required margin on sales. Target costing goes through three stages. They are: • • • Planning stage Development stage Production stage

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The management must concentrate on three improvement methods: target costing, benchmarking and benchtrending, and process quality teaming. The successful implementation of these methods requires a reasonable understanding of the philosophy, focus and techniques of total quality management and an analysis of the entire business environment. Activity based costing and the balanced scorecard can also be useful for CPI.

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Planning Stage
Traditionally, after determining the type of product to be manufactured, the management assigned its development to the Product Design Department (PDD). After finalizing the design, it was sent to the costing department for assessing its costs. The costing department often found it expensive to produce. The ‘design’ then came back to the design department with instructions to reduce costs, usually by compromising on the quality of the product. The product design was sent back and forth between the costing and design department till both the departments arrived at a consensus. The product was then sent to the manufacturing department and the manufacturing department also often declared that it was impossible to manufacture the product as proposed. It was then sent back to the design department. Because of these long procedures, lot of time, money and effort were wasted. All this had a negative impact on the productivity and profitability of the organization. Target costing helps eliminate such problems. Before establishing a reasonable target cost, a market research is conducted to determine what the competitors are doing. Their products are analyzed with regard to price, quality, service and support, promotion, work culture and technology. Once this is done, the important features of the product are finalized by conducting surveys and identifying consumer preferences. The researcher should then determine the significance of various features of the product manufactured by the company so as to, locate a niche market where it may have some competitive advantage. Once, this is done, a target cost is set that is close to that of competitors' products.

Development Stage

After an in-depth study of the competitor’s products and the market has been done, the design department takes care of the design aspects of the product by analyzing the best possible designs. Thus, the company identifies the cost associated with the best possible design as per the internal cost structure of the company. The company also tries to reduce the internal costs by analyzing the internal cost structure of its own products and comparing it with the cost structure of its competitors. The activity based costing (ABC) approach is generally used to estimate the cost structure. Under this approach, the activities related to the product are identified and costs are estimated using multiple cost drivers. Once the cost information is available, the product development team can generate cost estimates under different situations. The designers, manufacturers, marketers, and engineers should conduct a brainstorming session to generate ideas on how to substantially reduce costs or add different features to the product without increasing target costs. Finally, they come up with a complete model of the product, to be manufactured.

Production Stage
Planned production schedules, Just-In-Time (JIT) techniques are helpful in the production phase of target costing. Target costing becomes a tool for reducing costs of existing products if production is carried out with perfect planning and optimal cost-effective processes that are planned are followed carefully.
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This makes it easier for the organization to produce the product at a relatively low and desired price. Target costing ensures less expensive means of production with an even flow of goods.

Benefits of Target Costing
The benefits of target costing are: a) Target costing provides detailed information on the costs involved in producing a new product. It is a better way of estimating different cost scenarios by using activity based costing. b) Target costing reduces the development cycle of a product by reducing the wastage of time and resources and identifying the additional costs at an early stage of product development. c) Target costing provides an excellent understanding of the dynamics of production costs by using activity based costing and it suggests different ways of reducing non-value added activities, and simplifying the production process and costing procedures. d) Target costing increases the profitability of new products, by reducing manufacturing costs and improving quality. Through the use of surveys the preferences of consumers are identified and products are manufactured according to consumers’ requirement. e) Target costing forecasts the future costs and motivates the management and the employees to meet the future cost goals. f) Target costing helps in controlling the costs even before the company has incurred any production cost. Thus, a great deal of time and money is saved during the design phase. However, estimating target the target cost for complex products (that may require subassemblies) becomes difficult.

Benchmarking is a continuous process of comparing products and operations against the best practices in the industry. The general benchmarking process is shown in the Exhibit 12.1 The process of benchmarking consists of four sub-processes: (a) Planning the variables to be benchmarked. (b) Analyzing the current and projected gap in performance. (c) Communicating the benchmark standards to operating personnel and establishing internal goals. (d) Developing implementation plans. All these processes are carried out in two phases, namely: the planning phase and the analysis phase.

Planning Phase
The first step in planning is to identify the products or services that the unit provides. The next step is to identify companies whose performance
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Exhibit 12.1 Generic Benchmarking Process
Benchmarking Process

Benchmark Practices

Benchmark Practices

Management Commitment

Organization Communication

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Source: Joseph A Maciariello and Calvin J Kirby, Management Control Systems, (USA: Prentice Hall Inc, Second edition) 498.

Analysis Phase
The purpose of conducting an analysis is to determine the current gap in performance between the internal operations currently being followed and the best practices. This helps the management to project the gap in the future. Benchmarking studies provide useful information about the gaps in competitiveness for an operation or process at the time the study was conducted.

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How to Close the Gap • Improved Knowledge • Improved Practices • Improved Processes

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Benchtrending
The techniques involved in benchtrending are similar to the ones used in benchmarking. The only difference is that benchmarking has a new structural dimension. The study of benchtrending includes a projection of the critical market conditions and the consumer preference variables. These studies identify consumer preferences, new entrants, innovation threats, and other market critical variables for the long-run success of the firm. By the time the performance gaps have been bridged by a company, competition will move forward, creating new gaps in other areas. Overshooting the gaps in anticipation of improved competitor performance can bring in new problems that can affect competitiveness in different ways. This can be avoided by identifying important trends in the process and evaluating their impact through the process of benchtrending. Strategic benchtrending These methods are used to give a direction for a business unit and set longterm goals and objectives. A study team is formed with representatives from marketing, business development, and engineering department. The process of strategic bench trending comprises of the following steps: 1) Firstly, the market is defined by determining its size, customer preferences, competitors and relative business position of the company within the market. 2) The industry direction, technology shifts, geopolitical changes, consumer changes, and potential threats from outside sources are assessed. 3) The strongest current and potential competitors are then determined by evaluating the trends in the industry. 4) Data on the performance of competitors is gathered and the current and future performance of the business unit is compared with that of its competitor. 5) A performance baseline for the business units is then established, and estimate relative performance for the current and projected competition. 6) A set of initiatives which form the basis of an improvement plan are identified to maintain strengths while reducing projected gaps.

Process Benchtrending
If a company wants to improve a specific function or process, process benchtrending methods are used. For example, a unit that produces electronic circuit boards might want to improve its quality testing process. This involves a process benchtrending study. A typical process oriented unit would use the following steps: 1) Understanding the requirements of the process that is to be bench trended.
2) Understanding the process flow. For a clearer understanding, flow charts, procedures and quality control parameters can be used.

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3) Identifying and evaluating the specific objectives of the benchtrending project.

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4) Identifying the benchtrending methods being adopted by different companies and studying companies that could pose a threat in future. 5) Choosing practices that would be best suited for the organization. 6) Determining specific process gaps. Communication and integration Benchmarking and benchtrending programs can be sustained only through a formal and informal communication. Formal methods are used to acquaint the employees of the organization with the logic of the goals and its competitive necessity. Benchmark findings must be communicated to the people so that they consider themselves a part of the organization and are motivated to perform better. Informal networks should also be established to share the examples of successes, to discuss problems, and to provide assistance in attaining goals. Rewards and informal recognition programs should be instituted to encourage employee communication and integration. Implementation In the implementation stage, action plans are designed to attain the desired goals. Teams are formed and responsibilities are assigned; tasks are specified & sequenced, resources are allocated, and results are monitored.

QUALITY IMPROVEMENTS: PROCESS QUALITY TEAMING
Traditionally, superior quality has been associated with higher costs. Managements spend heavily to achieve high quality, but they virtually do nothing to cut down their costs. Now, the paradigm for improving quality has changed. “Process Quality Teaming” has become a popular concept, as it combines several successful total quality techniques into a cybernetic control system with features like feedback loops, action plans, and environmental scanning. Given the general structure of process quality teaming, it can be applied, with minor modifications, to various situations. This method is effective in improving organizational yields as long as customer and suppliers are satisfied with the management. In the generalized structure of a quality process, as shown in Exhibit 12.2, the control loop involves: Sensing the environment-either the customer or the current yields. ii) Detecting the gap between expectations and results. iii) Performing an analysis to determine appropriate action. iv) Assigning actions. v) Returning to step (i) by sensing the customer's needs or observing the yields. This cycle is repeated several times and each time an improvement results. This structure is applicable to almost any service, production, or support
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Exhibit 12.2 Quality Process Team Cybernetic Decision Structure
Environment Customer Needs Goals Process Limits Improvement Objectives Expectations

Feedback

Perception Team Reviews

Comparator Cause/Effect Analysis

Sensor Process Control Charts Yields Effector

Source: Joseph A Maciariello and Calvin J Kirby, Management Control Systems, (USA: PrenticeHall Inc, Second edition) 511.

process. The key is to focus on improving processes that are used to produce the output. We shall take a manufacturing unit as an example to discuss the implementation of a process quality teaming. Process quality teaming in a manufacturing unit involves coordination of the efforts of the management, support personnel, and workers. The steps involved in this process are: a) The management selects a unit, say, a manufacturing department, within which quality improvement teams are formed, the output to be improved is determined and based on this inputs to the process are added. b) A team of people from all key departments of the firm is formed. c) The responsibility of each department is clarified. The responsibility of ensuring quality should lie with the production supervisors and workers who are directly involved in manufacturing the product. The next four steps together constitute a closed-loop corrective action system. The team tries to identify specific customer requirements. In some cases, maintaining high quality may be critical, while in other cases, reliability is extremely important. The further steps in this process are the following: a) Making a flow chart the process. At each step, critical control parameters and associated measurements are noted.
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b) Establishing appropriate process control limits for each step in the process. c) Running the process normally, and calculating the output after the completion of the major steps d) Performing a cause and effect analysis of the major problems, and determining a specific corrective action. Comparing the current yields to the Process Control Limits (PCL). The implementation of effective CPI methods may be difficult. It requires many other quality tools. Each of these tools may have its own limitations. Therefore, the management should have a good understanding of the various tools.

ACTIVITY-BASED COSTING
In the last few decades, there has been a number of changes in the collection and utilization of cost information because of increased computerization and automation in factories. Traditionally, costs were allocated to products, based on the direct labor hours. But today, companies presently are emphasizing on separating material-related costs from other manufacturing costs. The manufacturing costs are collected separately for individual departments and individual machines which perform a series of operations that are finally integrated to get the final product. Here, the direct labor cost is added to the other costs which results in conversion costs. Conversion costs is constituted of the factory and labor overhead costs of converting raw materials into finished goods. The newer cost systems also include the administrative expenses, R&D expenses and marketing costs. These systems use multiple allocation bases. Here the word ‘activity’ is used to represent “cost center” and “cost driver,” and not the basis of resource allocation. Hence, this cost system is termed as activity-based cost system. (ABC).

Traditional Costing vs. Activity Based Costing (ABC)
The differences between traditional costing and activity-based costing are the following:
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Identify the values of the organization’s activities, business segments, etc., through a comprehensive understanding of costs and related dynamics to help organization's focus attention on target outcomes; Identify opportunities to effectively use delivery channels to enhance outputs; Differentiate between activities provided to different customer segments Identify incremental operating expenses in order to support growth

• • • •

Identify cost management opportunities Provide information to improve process efficiency.

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As a strategic planning tool, ABC helps in understanding the effectiveness and efficiency of products. It has a number of strategic and tactical uses in an organization. It helps to:

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Exhibit 12.3 Contrast in Product Costing
A. Traditional Costing Direct material Product Cost Direct material

Direct Labor

Direct labor Production cost centers (few in number)

Source: Robert N Anthony and Vijay Govindarajan, Management Control Systems (Irwin Publications, Eighth edition) 333.

The traditional cost management systems allocate service overhead costs to services or departments, primarily to distribute the overhead cost for financial reporting purposes. Costs are allocated by a single step process, with the costs per service or customers as the basis. Such methods often produce inaccurate and misleading information. Traditional costing systems take a general view of the costs incurred by all the departments. They fail to understand that costs for each department are marked by unique characteristics. Exhibits 12.3 and 12.4 represent the differences between traditional and activity- based costing. ABC systems focus on the activities performed by each department and allocate costs on the basis of this. An ABC system can gauge the amount of resources that are consumed by individual cost centers and customers, and by the activities and processes that deliver the products and provide services to customers. ABC identifies activities undertaken in an organization, and determines their cost and performance. Let us take an example to clearly understand the difference between traditional costing and ABC. Consider a college, where the major activities of the student administration department involve looking after the administrative activities of the students. The costs of students passing out is at Rs. 50,000 pa, paying salaries (Rs.35,000), spending on occupancy (Rs.10,000) and others (Rs. 5,000). During the year in which 500 international students graduated, the number of

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Exhibit 12.4 Activity-Based Costing
Production cost Material Direct Labor

Material

Factory activities

Production cost centers (many)

Conversion (labor and overhead)

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undergraduate was 300, that of industry funded graduates was 100, postgraduate students who paid the regular fees were 100 in number. A traditional costing approach would have failed to capture the cost of the activity (Rs 50,000) understand the activity cost driver (the number of graduates), highlight the unit true cost of the activity (Rs 100 per graduate), accurately assign this cost to the various types of student and understand which type of students being served by this activity. Traditional cost accounting vs Activity-based Costing Traditional cost accounting Salaries On costs Consumables Travel Depreciation Total Rs 2,00,000 20,000 80,000 20,000 80,000 Rs.4,00,000

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Activity based costing Enrolling students Designing a new course Teaching Subjects (specific) Tutoring students Assessing students Graduating students Total Rs. 1,00,000 50,000 1,50,000 20,000 30,000 50,000 Rs.4,00,000

SUMMARY
Continuous improvements in performance is increasingly being emphasized in most organizations. Continuous process improvement (CPI) is the philosophy of running business, and striving for perfection. The objective of CPI is to align the improvement activities to support the strategic objectives, to serve the customer more efficiently. There are three CPI methods- target costing, benchmarking and benchtrending, and process quality teaming. Target costing aims at reducing the costs of a product over its life cycle, especially design-related costs. It is a market-driven design methodology. It is carried out in three phases-planning, development and production. Benchmarking is a continuous process of comparing a company's products and operations against the best practices in the industry. This can only be done with proper planning and analysis. In benchtrending, a projection of the critical market and consumer structural variables are made, if a company wants to improve a specific function or process. To bring about overall improvement, ‘process quality teaming’ is undertaken. The implementation of effective CPI methods may be complex. The management should have a good understanding of the total improvement process, a support culture, and providing abundant personnel support. There have been a number of changes in the methods for collection and for use of cost information because of increased computerization and automation in factories. Activity-based costing is one such method that helps to prioritize and quantify improvement methods. It is suitable for today’s companies.

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Chapter 13

Strategic Cost Management
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Evolution of Strategic Cost Management Three Key Themes of Strategic Cost Management Strategic Management and Strategic Cost Analysis

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Amazon.com, US-based internet retailing major, is known for its low costs and excellent customer service. It not only created a new business model but also made sure that the model worked. While many firms that had adopted a similar internet-based retailing model perished, Amazon.com made sure it survived. There were two main reasons for its survival: comparatively low cost and excellent customer service. To survive in the market, a company has to provide excellent service at a comparatively low cost. The internal accounting department of a company plays a vital role in cost management. It provides all cost information on a timely basis. This information forms the basis for the company’s future strategies. Companies have started using cost management as a strategic tool. The focus of cost management has shifted from product costing and financial reporting to the development of cost information to help management achieve strategic goals. Hence, cost information is vital not just for achieving operational efficiencies but also for the long term growth of the company. The application of costing information to the development and implementation of a firm’s strategy is called strategic cost management (SCM). In a broader sense, SCM can be defined as the, “managerial use of cost information explicitly directed at one or more stages of the strategic management cycle.” The four stages of the strategic management cycle are: formulation of strategies, the communication of those strategies throughout the organization, the implementation of those strategies, and the evaluation and control of the strategies that have been implemented.

EVOLUTION OF STRATEGIC COST MANAGEMENT
The change in business processes has made it imperative for companies to change the focus of their costing systems. Initially, costing was done mainly to account for product costs and other overheads. Costing was thus like a control measure that enabled line managers to keep costs under control at the departmental level. Rapid changes in the business environment and corresponding changes in product and manufacturing processes forced companies to adopt a more proactive and strategic approach towards costing. They realized that costing systems should be flexible enough to support changes in the business environment and help management take better strategic decisions.

Strategic Measures of Success
Strategic cost management systems produce financial as well as non-financial information. Financial information includes figures pertaining to sales, cash flow and stock price. Non-financial information consists of details such as market share, product quality, customer satisfaction and growth opportunities. Financial information indicates a firm’s current financial position, whereas non-financial information indicates a firm’s competitive position. The competitive position is assessed on the basis of customer satisfaction, internal business processes and innovation and learning. Financial and non-financial measures together constitute Critical Success Factors. These factors are essential for a firm's growth and success.
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Exhibit 13.1 Harnessing the Value Chain Manufacturers such as Boeing and General Electric also use the value-chain concept to find profits downstream. For example, Boeing offers a number of products and services in addition to the aircraft it manufactures: financing, local parts supply, ground maintenance, logistics management, and pilot training. In the cyclical industry in which it operates, Boeing can earn profits from them during the slack manufacturing times. General Electric has connected its locomotive manufacturing business to its financing unit, GE Capital, to provide customer financing for not only locomotives but also boxcars and other rail assets. Other GE units profit by refurbishing and reselling boxcars and by developing advanced rail tracking systems. In effect, GE finds providing a broad range of services to the locomotive customer more profitable than only manufacturing.
Source: Orit Gadiesh and James L. Gilbert, “Profit Pools: A Fresh Look at Strategy,” Harvard Business Review, May–June 1998, pp. 139–47;

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Value chain analysis Cost driver analysis

Value chain analysis is a strategic analysis tool that can be used to identify areas in which value can be enhanced for customers or costs can be reduced. Value chain analysis thus helps a firm gain competitive advantage (Refer Table 13.1 for the value chain of the computer manufacturing industry). According to Michael Porter, the value chain of a company is the linked set of value-creating activities, all the way from basic raw material sources for component suppliers through to the ultimate end product delivered into the final consumers’ hands. The Value chain of a manufacturing firm differs from the value chain of a services firm. The value chain of a manufacturing firm includes activities like design and acquisition of raw materials, manufacturing, assembling, testing, packaging, warehousing, distribution, retail sales and customer service. Every firm can split its operations into a number of activities to analyze its value chain and to identify areas that require improvement. Value chain analysis is centered around a product or service and encompasses all the activities taken up for delivering it. An individual firm positions itself at some point in the value chain, depending upon the competitive advantage it
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Table 13.1: Value Chain for Computer Manufacturing Industry Step in the Value Chain Step 1: Design Step 2: Raw materials acquisition Activities Performing research and development Mining, development and refining Expected Output of Activities Completed product design Silicon, plastic, various metals Desired components and parts

Step 3: Materials assembled Converting raw materials into components and parts into components used to manufacture the computer Stage 1: Stage 2: Step 4: Computer manufacturing Step 5: Wholesaling warehousing and distribution Step 6: Retail Sales Step 7: Customer service Converting, assembling Finishing testing and grading Final assembling, packaging and shipping the final product

Making retail sale

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can have over other firms. For example, in the computer hardware industry, there are a number of players who occupy different positions in the value chain depending on their core competency. Texas Instruments manufactures chips, Intel manufactures processors, Seagate manufactures hard drives, IBM purchases manufactured components, assembles them and sells them. Value chain analysis consists of three steps: Step1: Identifying value chain activities Step2: Identifying the cost driver(s) at each value activity Step3: Developing a competitive advantage by reducing cost or adding value Identifying value chain activities In the first step of value chain analysis, a firm identifies all the activities in its value chain1. The value activities differ from industry to industry. For example, in the service industry the focus is on operations, advertising and promotion rather than purchasing raw materials and manufacturing. All the
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The activities that are necessary to convert raw materials into final products are called value activities.

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Source: higheredmcgrawhill.com

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value activities should be identified and differentiated from other activities to such an extent that they can be regarded as separate business activities. Identifying cost drivers at each value activity Any factor that changes the level of total cost of a product or service is called a cost driver2. In this step, those activities that have potential for cost reduction are identified. For example, in an insurance company the costs of data entry and recording can be reduced. Insurance companies can find ways to reduce costs in this area. They can also outsource this activity to someone who can provide the service at a lower cost. Developing a competitive advantage by reducing cost or adding value In the final step, firms conduct a detailed study of the value activities and cost drivers that have been identified earlier to determine the nature of current and potential competitive advantage. This helps the firm improve its strategic positioning. In addition, analysis of value activities also enables the firm to identify areas in which the company can provide greater value. For example, Wal-Mart uses high-end computer technology to coordinate with its suppliers to quickly restock its stores. This enables it to maintain optimum stocks of all products and thereby reduce inventory costs. Companies like Sony, Compaq and Cisco have tied up with Flextronics International Ltd, Solectron Corp. and SCI Inc. respectively for supply of various computer parts and subassemblies. These companies realized that outsourcing some of the manufacturing would reduce costs and improve speed and competitiveness.

Cost Driver Analysis

Every activity in the value chain is associated with a cost. During value chain analysis, companies try to identify various activities for reducing costs. Cost driver analysis is used to quantify the cost of poor quality and determining the root causes of poor quality or high costs. It is a useful technique that integrates the problem-solving and analytical tools for quality and process improvement. Cost driver analysis combines these tools and techniques to generate information needed to reduce costs and improve the overall financial performance. Daniel Riley3 has categorized cost drivers into two types: structural cost drivers and executional cost drivers. Structural cost drivers There are five structural cost drivers: scale, scope, experience, complexity, and technology. Refer Table 13.2 for the various structural cost drivers, their implications, and the ways in which a company can control these cost drivers.

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A cost driver is a factor that causally affects costs. For variable costs, a change in the level of activity or volume would result in a proportional change in cost. Fixed costs have no short run cost driver but may have a long run cost driver.

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Competitive Cost Based Investment Strategies for Industrial Companies,” manufacturing Issues (Booz, Allen, Hamilton, New York, 1987).

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Table 13.2: Structural Cost Drivers Cost Driver Scale Scope Experience Complexity Technology Controlling structural cost drivers Take decisions concerning Develop scale economies to investments in manufacturing, control costs R&D and marketing Decide on the degree of vertical Enhance vertical integration; integration needed otherwise outsource Identify the repetitive tasks Enhance employee learning and experience Decide about product line and Find sharing opportunities number of products with other business units in the enterprise the use of Take decisions pertaining to Optimize technologies to be used at every technology between value chain activities stage of value chain Implications

Source: ICFAI Center for Management Research.

Executional cost drivers determine a firm’s cost position, which in turn depends on the firm’s ability to execute value activities successfully. Some of the basic executional drivers are: • • • • • • Commitment of workforce to continuous improvement Management’s attitudes towards quality

Strategic Positioning Analysis
The third important theme of strategic cost management is strategic positioning or strategic competitive analysis. Michael Porter, in his book Competitive Strategy, states that a firm can choose to compete in the market either on the basis of cost or differentiation. This means that in order to remain competitive, a firm has to offer its products either at a lower cost or with a greater number of features. Cost leadership If a firm produces its products or services at a cost lower than its competitors, then the firm is said to be following a cost leadership strategy for gaining competitive advantage. To make sustainable profits, such a firm depends on high sales. A company that follows cost leadership strategy has a large market
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Management’s ability to work efficiently with suppliers and/or customers to reduce costs

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share and uses its price advantage to attract customers. Such a firm limits the growth of profit margins within the industry. A company can afford to adopt a cost leadership strategy only when its productivity is high and its manufacturing processes run smoothly. In addition, its selling and distribution costs must be low and its administration expenses should be minimum. Examples of companies that practice cost leadership are: Texas Instruments, Wal-Mart and Compaq (before its merger with HP). Companies that adopt this strategy often do not spend much of R&D. As a result, their products may become obsolete. Differentiation Firms that adopt a differentiation strategy try to make their customers feel that their products are different, qualitatively superior and have a greater number of features than the competitors’ products. This strategy allows a firm to charge a higher price for its products and thereby make profits without major cost cutting. Most firms in the automobile, telecom, and consumer electronics industry use a differentiation strategy. Some of the companies that have adopted this strategy are Rolex, Bentley, Tiffany and Mercedes-Benz. Firms that follow this strategy tend to undermine the importance of cost reduction. If customers do not perceive a great difference between a lower cost product and the firm's product, the firm may lose market share. Table 13.3 shows the differences between cost leadership and product differentiation in terms of strategic emphasis and control. Table 13.3: Conventional Management Accounting Versus Strategic Cost Management Conventional Management Accounting Paradigm

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Which is the best way of analyzing costs?

In terms of products, customers and functions. It has a strong internal focus and believes in value added concept. The objectives are scorekeeping, attention directing and problem solving Cost is a function of output volume. It is cumulative figure of variable cost, fixed cost, step cost and mixed cost.

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Source: John K.Shank, Strategic cost Management: New Wine, or Just New Bottles, Journal of Management Accounting and Research, Fall 1989. 183

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Strategic Cost Management Paradigm In terms of various stages in the value chain. It has an external focus and value added concept is supposed to be a narrow concept. Apart from these objectives, the SCM system changes depending on the basis of strategic positioning Cost is a function of strategic choices. It’s mainly to do with managerial skills needed in executing choices i.e. Structural costs drivers and executional cost drivers.

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STRATEGIC MANAGEMENT AND STRATEGIC COST ANALYSIS
As already discussed, strategic cost management combines three strategic management themes: value chain analysis, cost driver analysis and strategic positioning analysis. These themes can be used by managers as tools for gaining competitive advantage. For each of these themes, conventional management accounting does not provide the needed financial analysis support for successful implementation of strategies. Strategic cost management evolved because conventional management accounting was not able to cater to the information needs of top managers. When costing techniques were used along with strategic management tools, a paradigm shift took place in the field of strategic management. Management accounting and Strategic Cost Management differ in three ways. First, in the way costs are analyzed; second, in the objective behind conducting cost analysis; and third, in the way cost behavior is understood (Refer table 13.3 for differences between management accounting and SCM).

The application of costing information for developing and implementing strategies in firms is called strategic cost management. Strategic cost management combines three strategic management themes: value chain analysis, cost driver analysis, and strategic positioning analysis. Value chain analysis is a strategic analysis tool that can be used to identify areas in which value can be enhanced for customers or costs can be reduced. All the activities of a value chain have costs associated with them. The process of driving up or down the cost of value chain activities is called cost driver analysis. Cost drivers can be of two types: structural cost drivers and executional cost drivers. There are five structural cost drivers: scale, scope, experience, complexity, and technology. Executional cost drivers are those drivers that determine a company's ability to execute value activities. Strategic positioning refers to the way in which a firm positions itself against its competitors in the market. A firm can choose to compete in the market either on the basis of cost or differentiation. Management accounting and Strategic Cost Management differ in three ways. First, in the way costs are analyzed; second, in the objective behind conducting cost analysis; and third, in the way cost behavior is understood.

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SUMMARY

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In this chapter we will discuss: • • • • • • • • • • • Benefits of Audit Limitations of Audit Timing of an Audit Audit Process

Audit Tools and Techniques

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Social Audit Audit Evidence Auditing for Continuous Improvement

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Audit is the examination and verification of records and other evidences by an individual or a body of persons so as to confirm whether the records and other evidences present a true and fair picture of whatever they are supposed to reflect. Audits can be categorized basically into two types- Financial audit and nonfinancial audit. Financial audit is a statutory audit that helps in monitoring the financial performance of the company. Non-financial audit is non-statutory and serves two purposes. Firstly, it checks a company’s compliance to standards and secondly, determines whether a product or service satisfies customers' demands in terms of features and quality. Table 14.1 shows the differences between financial and non-financial audits. Though financial and non-financial audits differ greatly, there are some similarities, too. Both the audits are conducted to measure compliance to a set of standards. Both generate performance data that can be used for benchmarking and performance analysis and both identify opportunities for performance improvement.

Audits can help managers identify job priorities by showing which changes would have the highest impact on overall performance. Audit can be used as a tool for identifying the gap between the desired and actual performance and help the management take steps for the improvement of performance.

Identify Outdated Strategies
When there is a change in the organization's strategy, processes that support the strategy do not evolve automatically. Regular audits of management processes help managers understand when the strategy becomes outdated and needs to be changed.

Increase Management’s Ability to Address Concerns
The compilation of audit information increases the management’s ability to address issues arising from increasing regulation and litigation, and to clarify queries by outside stakeholders in the business. Auditing is a systematic way of clarifying and prioritizing the information.
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Companies prepare formal plans before executing them, but in many cases these plans do not get executed as supposed because the assumptions made by the executives may not have been correct. Systematic collection of data and comparing reality with manager's assumption help companies to be more resilient when faced with change.

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Table 14.1: Financial versus Non-financial Audit Financial Audits Relies primarily on standards set externally (by government or by professional standards groups). Procedures are formalized and consistent from company to company. Compliance with procedures adds credibility to the audit. Standards are essentially the same from audit to audit Focus is on complying with standards set by external groups Audience is often primarily external, with audit standards used as a way of building credibility Generally conducted yearly Non Financial Audits Relies primarily on standards set internally on the basis of customer and competitor information. Procedures are fluid and should be adapted by each company. Measures should be created that suit the company’s needs. Standards should change as performance improves. Focus is on exceeding standards set internally or by industry competitors. Audience is generally internal, with data being used primarily to improve performance. Conducted, on average, every 18 to 24 months. Focuses on measures that affect only Focuses on a broad range of functions that contribute to the success or failure of a financial performance. particular process.

Enhances Teamwork

LIMITATIONS OF AUDIT
Audit has its limitations, too. It is not a cure for all kinds of management problems. Given here are some of the issues that cannot be solved through audit. • An audit can neither help in prioritizing changes nor in allocating resources. At the most, it can provide certain clues regarding changes that are most important. Audit cannot mobilize people to take action. Though audit identifies
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Increase Commitment to Change
The audit process increases the commitment of the employees of an organization to change. Audit results may succeed in convincing the management about the need to re-order its priorities.

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Systematic collection and sharing of audit information enhances the ability of the various segments of an organization to work in coordination. The breaking of barriers between the different parts of an organization enables a company to respond more quickly and effectively to the demands of customers and other stakeholders.

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various problems that exist in the organizational systems and processes, it cannot help the management bring about changes to solve these problems. In order to bring about such changes, there is need for commitment and support from all the people within the organization. • Audit cannot generate better data than the measures used to gather those. For example, if a questionnaire used during audit for collecting data has a flaw, then the results of the audit will also be faulty. Hence, it is important to plan on proper audit tools to be used in the audit. An audit, by itself, cannot improve performance. Since an audit brings out the weaknesses in the system and identifies opportunities for improvement, it should not be conducted unless there is a strong commitment to improve or strengthen the process being studied. Audit should not be used for wrongful purposes. It should not be used for personal indictment and to justify improper actions.

• • •

How does the company fare when compared to its competitors in terms of the efficiency of its systems and processes? What are the types of resources needed for conducting an audit? Does the company have enough human resources to form a separate team for conducting audits?

AUDIT PROCESS

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An audit process consists of following stages: • • • • • • • • Staffing the audit team Creating an audit project plan Laying the groundwork for the audit Analyzing audit results Sharing audit results Writing audit reports Dealing with resistance to audit recommendations Building an ongoing audit program

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The timing of an audit depends on the type of audit. Financial audits are conducted once in every year whereas non-financial audits may be conducted once in every two years. Before deciding on the timing of the audit, the management has to answer the following questions:

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Staffing the Audit Team
The audit team usually consists of three to four people. The number of people may be higher, depending on the volume of data required and the number of customers or employees to be interviewed. The audit team reports either to the CEO or some other senior executive. Quality of an audit report is directly related to the competence of the audit team members. Hence an audit team should consist of people who have substantial knowledge of systems and processes within the company. An audit team should consist of people who have knowledge in diverse areas. Some other aspects that should be considered are: The team should consist of newcomers as well as experienced people. Importance is given to people with prior experience in auditing. In case a particular function is being audited, then functional experts should be included in the audit team. If it is a process that is being audited, then people who are closely associated with that process should be included in the audit team. Team members should possess strong analytical and interpersonal skills. They should be able to communicate well with their peers and establish strong working relationships. They should also possess facilitation and interviewing skills. Finally, they should have an understanding of a company's overall strategy and its goals and objectives. The audit team leader is selected from among the audit team members. He plays an important role in data gathering and is responsible for the overall success of the audit. As the team leader plays a very important role in the audit, the selection should be done after careful consideration. The following are the qualities required in an audit team leader: Excellent interpersonal skills, good relationship with the CEO and other senior executives, strong analytical skills, ability to assimilate and process large amounts of complex data quickly, some knowledge of the function being audited and extensive knowledge of the type of process being audited.

Before starting an audit, it is necessary to prepare plan that explains how an audit is to be conducted in a step-by-step manner. An audit plan helps in better allocation of resources, especially if the resources are scarce. It makes sure that audit tasks are completed on time. It also ensures accountability and responsibility of the management by clearly stating what is to be done, who is responsible for which task and when the audit should be completed.

Laying the Ground Work for the Audit
After preparing the audit plan, the next step is to gather support from the employees for the audit. The following steps will help an audit run smoothly: Garnering executive support There are two benefits of gathering the executives’ support for the audit. Firstly, those involved in the area being audited will cooperate with those who are gathering data and secondly, it ensures executive support for the area being audited and shows a commitment to improve performance in this area.
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Creating an Audit Project Plan

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The executive sponsor of the audit introduces the audit by means of a memo which explains the purpose of the audit and asks for support from everyone in the area being audited. Make arrangements with the area being audited The audit team leader should check with the manager in charge of the process or site being audited if arrangements have been made for on-site visits, interviewing, surveys etc. The manager, and the team leader together should ensure that audit does not affect the normal workflow in the company. Before commencing the audit, the team leader should hold discussions with employees regarding the timing of the audit, the methods of data collection, the availability of required data, etc. Develop a checklist A checklist is used to outline all the issues that are central to the audit. It can help in organizing the audit work. It helps in performing tasks systematically and maintaining a record of those tasks. Exhibit 14.1 shows a sample financial audit checklist. Exhibit 14.1

Sample Financial Audit Checklist Collect all accounting materials. Receipts Deposit slips Invoices Cancelled Checks Bank Statements Check Registers Note lost or Illegible material Last Annual Financial Report Monthly Financial Reports Review Accounts Used. Income Accounts (Should have separate account for each income type) Are all deposits recorded as to income type? Are all deposits reconciled to bank statements? Expense Accounts (Should have separate account for each expense type) Are all expenditures recorded as to expense type? Are all checks reconciled to bank statements? Verify the following: Starting Balance Receipt for every expenditure The officers of the chapter approved all expenditures An approved budget exists for each expense type All expenditures are within approved budget All individual account's starting and ending balances match the chapter's ledger The annual ending balance matches the chapter's ledger
Source:/www.ssq.org 190

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Analyzing Audit Results
When the audit is completed, the gaps between a company's targets and its actual performance can be identified. These gaps usually pertain to specific areas in the various functions of the management. The audit results identify the opportunities for improvement, but arranging the areas in terms of importance is a difficult task. Apart from this, due to limited resources, choices must be made about which options are more important.

Sharing Audit Results
The audit results are presented before the members of the executive team, the managers who work in the area covered by the audit, the audit team members and anyone else who is affected by the audit or is interested in the results, in a feedback meeting. The audit team's objective during the meeting is to present a clear and simple picture of the current situation, as revealed by the audit. The following structure can be followed for conducting a feedback meeting: • • • • Present the audit findings Present audit recommendations Ask others to react to the data Develop preliminary action plans

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Dealing with Resistance to Audit Recommendations
The audit team gives its recommendations when the audit is completed. These recommendations may not be always accepted, especially when they require people to change their way of working. Change is usually resisted because it requires a great deal of energy and effort. Employees’ resistance to change usually inhibits auditors from making recommendations that require transformational changes. Direct resistance to audit recommendations Resistance to audit recommendations can take two forms-direct and indirect. Direct resistance to audit recommendations is easy to identify and address. Direct resistance usually comes from the management in the form of doubts about the implementation of the audit team's recommendations. During the meeting between the audit team members and the management, some people may wish to voice their concerns over these recommendations. It is necessary
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After the audit work is completed, the whole process of auditing, the resultant findings and recommendations are written in a formal report called an audit report. An audit report may be a plain summary of the audit. But such a report is not recommended because the probability of taking action in this case is less. An audit report may supplement a feedback meeting and provide useful guidelines to those who attended the meeting, for future action. An audit report serves as a baseline document for measuring improvement in performance possible in future audits.

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Table 14.2: Differences Between Surveys, Questionnaires and Interviews Surveys Questionnaires Interviews Completed by respondents, May be computed with or Involve the presence of a independent of researcher without researcher researcher, either face-toface or on the telephone Highly structured May be structured or unstructured Usually highly unstructured

Require absence of May or may not capitalize on Capitalizes on the interaction interaction between the interaction between between researcher and researcher and respondent researcher and respondent respondent May be difficult to ensure Rate of response depends on Ensuring a high response rate a high response rate whether the questionnaire is is usually quite easy used like a survey or like an interview Results can be generalized Results can usually not be Results can generally not be to a larger population generalized to a larger generalized to a larger population population Allow researchers to Allow more researcher Researchers have little exercise high control over control than an unstructured control over content of the content of the response interview, but less control response than a survey Results are quite easy to Ease of tabulating results Results are not easy to tabulate depends on type of tabulate questionnaire used

for the audit team members to allow people to do. There should be no attempt to suppress their views. At the same time, audit team members should not become too defensive when someone is vociferous in his/her objections. Some of the ways in which one can deal with direct resistance to audit recommendations are the following: Prioritize the concerns raised by the management. Deal with the serious ones immediately. These concerns should be summarized and the management should be convinced that their concerns would be taken care of. Deal with differences in opinion through free and fair dialogue with an aim of arriving at a resolution.

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Source: ‘The Company audit guide’, Strategic Direction Publishers Ltd., Switzerland.

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Indirect resistance to audit recommendations Indirect resistance to audit recommendations is subtle and difficult to identify. Peter Block has named some specific forms of indirect resistance that come up during meetings between audit team members and managers. Managers during an audit meeting show indirect resistance by frequently asking for more details or by providing unnecessary details to questions. They may also say that there is not sufficient time to implement the audit team’s recommendations. They may question the authenticity of the methods used by the audit team. They may, at times act times pretend to be confused or remain silent, indicating that they are uninterested in audit recommendations. In such a situation, audit team members should encourage those people to write down what they feel about the recommendations and why they are resisting them. Making people talk often solves a lot of problems. Hence, the audit team should encourage people to frankly air their opinions. They should identify people who have reservations against the audit teams recommendations and work with them to address their concerns.

AUDIT TOOLS AND TECHNIQUES
Collection of accurate and comprehensive data is one of the keys to effective audit. Data for an audit can be collected through surveys, questionnaires, interviews, focus groups, and direct observation. The selection of a research method for data collection depends on several factors:

Budget

Timing
Timing, too, has an important role to play in the selection of a research method. Compared to other methods, preparation time and analysis time for surveys is longer. Questionnaires, focus groups and interviews require lesser time for preparation or analysis. While a survey may take several weeks to be completed, there are some methods that can be completed almost immediately.
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In many cases, the funds available for conducting the research is the most important factor in the selection of the research type. When the budget is tight, qualitative research (any method the results of which cannot be communicated or presented to a larger population) is advisable rather than quantitative research (surveys), because it usually involves lower costs.

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With the increasing pace of changes, organizations need to continuously increase their efficiency and effectiveness. In order to accomplish this, organizations must adopt ongoing audit programs. Ongoing audit programs help in monitoring improvement in performance over a specific period of time. They help in systematically monitoring the changes taking place in the company's work environment and also help managers deal with resistance to change.

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Projectability
If the goal of a project is to determine the attitudes or behavior of a large group then the only effective method is to conduct a survey. While a fairly comprehensive picture can be obtained from focus groups, interviews and questionnaires, the results cannot be accurately generalized and presented to the larger population in statistical terms.

Geography
All the sources of data for a project may be found at one location, or may be widely dispersed. This factor tells upon the cost of a research project, both in terms of time and money. Consider the problems related to traveling to various locations, surveys done through mail or telephone seem to be rather cost effective and convenient.

Types of surveys

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The risks of survey research Because surveys are somewhat superficial, there is no way of probing people's responses to determine why they answered in the way they did. Also, respondents’ answers may be based on what is socially or politically acceptable, rather than on the basis of their own attitude, opinions, or behavior. Surveys can be used most effectively when auditors are aware of the following limitations of survey: • A survey assumes that the researcher knows in advance what the important organizational issues are, and thus, what questions should be asked. Surveys assume that people use the same language when they discuss similar issues and interpret survey questions in the same way.

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Surveys are of two types-written survey questionnaires and telephone surveys using a written questionnaire. The difference between a written survey questionnaire and a telephone survey using a written questionnaire is that in the former case, the questionnaire is answered by the individual respondent, whereas in case of the latter, the questionnaire is filled in by the interviewer himself. Written survey questionnaires, which are sent to respondents by direct mail, have the lowest response rate and are likely to provide unreliable data because the researchers have no control over who responds to the survey. Telephone surveys serve are a fast means for collecting data. A telephone survey includes forced choice, scaled questions and open-ended questions.

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Surveys help in collecting information regarding five variables-background data (age, education and income), behavioral data (buying habits, etc.) data about attitudes and beliefs, data about opinions, and data about the knowledge of the products offered by a company.

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Although surveys can provide precise statistical information, they usually reveal only superficial information that is incomplete at best. A survey distorts the political reality of the organization by aggregating responses and implying that all opinions carry equal weight. The use of random samples in a survey assumes that the required information is distributed evenly across the organization or customer group. This can lead to the researcher developing a distorted picture of the company or its customer base. The very process of the survey affects the responses which depend on when and by whom the question is asked. Surveys assume that people have independent opinions, but in reality, these often end up controlling people to give an opinion which they do not hold, because the close-ended questions in a survey impose a response framework on the respondents.

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Structure of a questionnaire The most common problem with questionnaire research is the design of the questionnaire. Since the use of vague and ambiguous terms is the major problem in questionnaire design, Michael Patton, in his book “Practical Interviewing” (1982), suggests the following questions as a guide for framing clear-cut questions. 1. What do we want to find out? 2. Why do we want to find that out? 3. When do we need the information? 4. Who has that information? The purpose of the questionnaire and the topic it covers governs the structure to be used in designing the questionnaire. In most cases, the relatively general questions should be placed in the beginning of the questionnaire and the most specific ones follow them. This enables the respondents to warm up to the issues and prepares them to provide specific data. The use of open-ended or close-ended questions is another important choice to be made in questionnaire design. Effective questionnaires should use easily understandable language, avoid ambiguity, avoid expressing point of view that are likely to make the respondents biased and use short sentences, and avoid using jargons.

Focus Groups
Focus groups serve as yet another approach to data collection. It allows for the collection of more information and the involvement of more people than is possible in one-on-one interviews. The participants in focus groups, at the same time, can be asked to provide more depth than can be obtained from
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In terms of the applications for which they are best suited, questionnaires fall midway between surveys and interviews.

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survey respondents. The dynamics of a focus group may also allow the expression of ideas which might otherwise go unstated. A focus group may have four to ten participants, and the session may last for about two hours. A successful focus group usually has a skilled facilitator, who is responsible for guiding the research and managing group dynamics. The role of a facilitator of a focus group is different role from that of an interviewer. The primary responsibility of a facilitator is to manage the information flow between group members rather than asking questions and documenting responses.

Interviews
Interviewing is a technique to gather data from a conversation with a respondent. It is a highly flexible research tool. Also, it is an effective way of collecting data about sensitive subjects, as skilled interviewers can establish a relationship of trust with the respondent. Moreover, the interviewer probes these responses and elicits information that might otherwise be overlooked. As the rate of responses to interviews is considerably high they are often used in audits.

There are three basic types of interviews:

Structured interviews are an interactive approach to surveys or questionnaires. Interviewees have a set of formalized questions that do not allow for great flexibility in terms of responses.

Direct Observation
For decades, direct observation has been a favorite research tool of anthropologists. However, it has evolved into a sophisticated research method now. Direct observation finds many applications in corporate environments, particularly in the audit process. Direct observation techniques There are several direct observation research techniques. These include the following:
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Unstructured interviews In unstructured interviews, the researcher initiates the interview with a set of basic questions, and then allows the rest of its course to be guided by the responses of the interviewees.

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Participant observation This technique involves the full participation of the researcher in an activity, and requires him to make mental notes of the dynamics of and feelings involved in participating. Field observation Here, an observer closely watches the interaction of a group without being directly involved in it. The detachment of the observer from the group activity makes it difficult for him to understand any particular situation during the interaction from a participant’s point of view.

MANAGEMENT AUDIT
With the continuous growth of firms, the importance of control has increased. Decentralization in organizations is responsible for the fact that control has assumed more importance. The growth of organizations should not lead to laxity in controls. An efficient manager understands the need for an impartial analysis of the firm’s operations and conducts a “management audit.” A management audit is defined as “an examination of the conditions and a diagnosis of deficiencies with recommendations for correcting them.” According to John C Burton, “In a management audit, the auditor will see whether management is getting information relevant to the decisions and actions which it must take. This will require a much more intensive analysis of information needs and the efficiency of the existing system in meeting them. The auditor will not have to decide whether management is making the right strategic and operative decisions but rather whether management has available to it and is using the relevant information and techniques necessary to evaluate rationally the various alternatives that exist.”

The main aim of conducting a management audit is to critically analyze and evaluate management performance. Apart from this, it is conducted to detect and overcome existing managerial deficiencies and resulting operational problems. Management audit helps to evaluate the methods and processes used by the management to accomplish its organizational objectives; it helps to determine the effectiveness of management in planning, organizing, directing, and controlling the organization’s activities. It also helps to ascertain the appropriateness of the management's decisions for achieving the organization objectives.

Development of Management Audit
The very concept of management audit came into being due to the limitations of financial audit. Theo Haimann in his book ‘Professional management’, writes about the need for independent appraisal of management performance. He discusses the importance of management audit and how it can help in overcoming the limitations of financial audit. He was of the opinion that management audit can help in assessing the operations of an enterprise from
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multiple angles. According to Haimann, management audit would become compulsory like the financial audit due to three major reasons. • • • Increasing number of professional managers Increasing separation between management and owners Wider distribution of stockholders

Benefits of Management Audits
• • • As the approach to management auditing is proactive, it provides an earlywarning signal of managerial problems and related operational difficulties. It can be used as a source of information in assisting the organization to accomplish the desired objectives. It helps to objectively and impartially evaluate organizational plans, structure, and the directions that management gives in the form of strategies and management processes in planning, organizing, directing and controlling the organizational resources.

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Complete management audit Program management audit Efficiency audit Propriety Audit

Functional management audit

Complete management audit evaluates the firm’s current activities, and measures the gaps between its existing policies and objectives, and its actual activities. In case its actual practice does not conform to the firm’s policies corrective action is proposed. If the auditor comes across some weaknesses in the policies and objectives, he may suggest changes in them, regardless of the degree of conformation. Complete management audit is however, not designed to punish the inefficient or reprimand people who make honest mistakes. Complete management audit is conducted from a positive, and not a negative viewpoint, that is when weaknesses in operations or people are uncovered, non-vindictive suggestions are given with the hope of improving operational performance and the productivity of the personnel concerned. Compliance management audit According to compliance audit, auditors are asked to identify the gaps between the company’s existing policies and objectives, and its actual practice. However, in this case, the auditors do not make any recommendations for improvements. They simply present their observations

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to the top management. The top management consults its personnel to decide whether, what, or how corrective action should be taken. This type of audit eliminates the fear of directives being imposed on the firm by an outside party. However, the disadvantage of this type of audit is that it fails to utilize the knowledge and experience of the auditors. It also does not avail of the possible benefits of observations made by the trained specialists from outside the organization. Program management audit Program management audit is similar to complete management audit and compliance audit; the only difference being the fact that it focusses on a specific program. Program management audit is designed to appraise performance within a specified program and it does not disturb other operations of the firm.

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To invest the capital in areas that generate optimum returns

Propriety audit is conducted to examine the effect of the management's decisions and actions on the society and public. While conducting this audit, the auditor examines all transactions of the company to find out whether any of the transactions has negatively affected public interests. The audit of public sector companies conducted by the Comptroller and Auditor General of India is a type of propriety audit. The objective of this kind of audit is to identify the loopholes in administrative rules and regulations, and to suggest methods for improving the execution of future plans and projects.

Organizing the Management Audit
The management's approval is essential for establishment of a general program for management audit. If the proposal does not receive the total support of the management, it may face enormous difficulties at later stages. Devising the statement of policy The management’s support should be reflected clearly and categorically in the company's highest policy statement. The statement should be specific in nature. It should clearly describe the scope and status of the
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To plan and invest judiciously in various functions

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Allocation of personnel

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Everyone placed in the audit unit should have good understanding of the theory of auditing, thorough knowledge of the fundamentals of both the organization and the management, the principles and effective methods of control, and requirements for scientific appraisal. The management auditor is expected to evaluate operational performance and non-monetary operational controls. He should possess basic knowledge of the technology and commercial practices of the enterprise, an inquisitive, analytical, pragmatic and imaginative approach and thorough understanding of the control system. The management auditor should also have basic knowledge of commerce, law, taxation, cost accounting, economics, quantitative methods and EDP systems. Those who have a sound background in accounting along with knowledge of other relevant disciplines are best suited for this job. The individuals to whom this job is assigned should have an inclination towards analysis, a high degree of imagination and an ability to write and express themselves clearly and logically. Staff training program A continuous training program is necessary to achieve quality in performing audit assignments. An effective training program enables the staff to assume additional responsibilities in the organization. Training programs act as an incentive for drawing capable people into the department and retaining them. Time and other aspects The time required to complete a management audit varies, depending upon the extent and nature of the assignment. The time and cost will vary for each assignment, depending upon the nature of the assignment, the number of

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management/operational auditing within the enterprise, its authority to hold audits, issue reports, make recommendations, and evaluate corrective action. The statement of policy should lay down very clearly the scope of activities to be undertaken by the management auditor. The statement must give the auditor the extent of authority he needs, but it should not assign to him any task that he cannot conceivably take care of. The statement must categorically state that the management auditor is authorized to review administrative and management controls on any activity within the company. Depending upon the size and nature of their business, organizations set up a separate audit department, the head of which reports directly to the top executive. In certain cases, the audit group may be a part of the management the administrative control department or some other unit of the organizations. However, some analysts feel that the audit function should be free from pressures of various groups in the enterprise. The greater its independence, the greater is its capability to function to work effectively. Therefore, it is necessary to place the audit department in a considerably high position in the organization. The auditing unit should report only to an officer whose status is such that he can command prompt and proper consideration of the auditor's opinion and recommendations. The management auditor's goal therefore, is to attain such a level of operational independence, which will prevent him from having to compromise with his audit objectives.

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auditors assigned to perform the work, and whether more specialists in a particular field are required. Frequency The frequency of conducting audits depends on the organization. When the organization is subject to rapid change or the total resources utilized are expensive, the frequency of management auditing should be greater than when it does not undergo rapid changes or the resources employed are not high in value. In essence, management audits should be conducted often enough to provide protection against growing problems. On the other hand, they should not be so frequent as to lead to repetitious results.

Conditions for Successful Management Audit
A major aspect of a management audit, is related to the selection of the audit personnel. The auditors must be competent, have clear idea about the subject, experience, and professional ability. In addition, they must possess an ability to deal successfully with human relations issues. They must be able to objectively appraise other's actions without generating undue suspicion. Almost every employee's attitude towards an audit is defensive. This attitude must be avoided. For this to happen, auditors should establish a pre-audit condition, expressing their willingness to discuss their observation with the affected personnel before it is reported to the top management. In many cases, this will evolve into a negotiation-discussion process, whereby those concerned begin to view audit as a way in which weaknesses of the system may be pinpointed and their performance be improved. Finally, the willingness of the firm’s employees to accept change is essential for the success of an audit. Several people in managerial positions, particularly those who have risen through many ranks, feel that the current way of running business is good enough. They may be allowed to retain this belief only if the audit supplements it with facts. However, this is rarely the case. The “good enough syndrome” would eventually destroy all desires for continual improvement. Audits are meant to highlight the strengths and weaknesses of the firm’s operations. It is up to the management at all levels to reward employees or to take corrective action. If no action is taken in response to the auditor's findings, then his effort is wasted.

INTERNAL AUDIT

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Internal audit can be viewed from two different perspectives-the traditional perspective and the modern perspective. Viewed from a traditional perspective, internal audit is found to play the following roles: • • Check whether the existing controls are effective and adequate Check whether the financial reports and other records show the actual results of the company • Check whether the sub-units of the organization are following the policies and procedures laid down by the management. The traditional concept of internal auditing has a narrow scope whereas the modern concept has wider scope. The fact that the modern internal auditing is wider is reflected in the new definition of internal auditing given by the
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Institute of Internal Auditors, "An independent appraisal function established within an organization to examine and evaluate its activities as a service to the organization. The objective of internal auditing is to assist members of the organization in the effective discharge of their responsibilities. To this end, internal audit furnishes them with analyses, appraisals, recommendations, counsel and information concerning the activities reviewed." This definition implies that an internal auditor has to go beyond checking the books of account and related records. He has to appraise the various operational functions of an organization and provide recommendations about these. Thus, according to the modern concept of internal auditing, the internal auditor is involved in conducting a review of operations, and internal audit and operational audit are almost synonymous.

Need for Internal Auditing
The need for an internal audit is determined by the increasing size and complexity of organizational operations. Many organizations operate in a number of countries and therefore have a large number of employees. In order to avoid discrepancies from creeping into their systems, processes, and operations, such organizations appoint a team of specialists called internal auditors to monitor, track and report such discrepancies, inefficiencies of personnel in the concerned departments.

Financial audit is defined as “an exploratory critical review by an independent public accountant of the underlying controls and accounting records of a business enterprise that leads to an opinion of the propriety of the financial statements of the enterprise.” It is conducted to examine the correctness of financial statements, and to establish whether they present a true and fair picture of the company's financial position on a particular date. Financial audit is a statutory audit and should be definitely conducted by an independent statutory auditor at the end of every financial year. The statutory auditor has to certify that financial statements have been prepared without violating the accounting rules and principles of accounting. Cost audit is also a statutory audit conducted to report the cost of production of a particular product to the government. A cost and works accountant performs a cost audit of routine operations. A cost audit report follows a prescribed format, and does not offer the much needed flexibility to the professionals to use it as control mechanism.

SOCIAL AUDIT
Companies should not focus only on increasing profitability and improving financial stability, but also on social welfare and uplift of the society. The inadequate reflection of the social performance of the organization has given rise to the concept of social accounting and social auditing. Social accounting and social auditing help in evaluating the contributions made by the company to the society. Social accounting is defined as “systematic accounting and
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reporting of those parts of a company's activities that have a social impact.” Social accounting, unlike financial accounting lacks an accounting structure. Social accounting is rather an approach that can be used for reporting social performance of organizations. Some of the companies that publish social performance reports are Body Shop (See Exhibit 14.2), BP Amoco, Novo Nordisk and British Telecom. A social accounting report contains the following information: • • • • Details of financial performance against the stated objectives of the company An assessment of the impact of the company's operations on the local community A report on the company's environmental performance A report on the company's compliance with statutory and voluntary

Statements
Environmental Statement (1992).

Main characteristics

The Values Report 1995, published in January 1996. It contains three separate statements concerning: • Performance on environmental issues • Animal protection • Social issues

The Values Report 1997, published in January 1998

Environment protection is the main theme of the statement; • Products-focus approach, rather than stakeholder-focus approach • The report comprised of three statements on the company’s performance on environmental, animal protection and social issues; • Each statement has an element of independent verification in line with established best practice; • Included in the publication a paper “The Body Shop Approach to Ethical Auditing” describing the methods underpinning the three reports; • A verification statement indicating an external verification process. • Single statement covering these three aspects: environmental performance; animal protection; and social issues.

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Social Audit Statement of Body Shop

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The European Union Eco management and Audit Regulation (EMAS) Mission Statement Trading Chart Managers’ and Employees Handbooks Community Trade Programme Mission Statement Trading Chart Managers’ and Employees Handbooks Community Trade Programme

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quality and procedural standards • Views of stakeholders about the objectives and values of the company.

Social Accounting versus Social Audit
Often the phrases, ‘social accounting’ and ‘social auditing’ are used interchangeably, which is not correct. The main reason for this confusion is that both social accounting and social audit lead to the compilation of social reports. Audit starts where accounting ends. The social accounting report is prepared by accountants working in a company. Social audit is conducted by an independent auditor who reviews the information given in the social accounting report. Hence, social audit can be conducted only after the social accounting report has been prepared.

Definition of Social Audit
Blake, Fredrick and Myers in their book 'Social Auditing' define social audit as systematic attempt to identify, analyze, measure, evaluate and monitor the effect of an organization's operations on society. Turnbull (1995) defines social audit as “the process whereby an enterprise measures and reports on its performance in meeting its declared social, community or environmental objectives.” The word 'social audit' has been often used wrongly to mean activities pertaining to a company's social programs, social surveys, etc. For example, in India, the MAOCARO1 report given by the company's auditor was wrongly taken as a social audit report.

Features of Social Audit •
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Approaches to Social Audit
Any one of the following approaches can be adopted to conduct a social audit. Inventory approach It is a simple listing and short description of programs which the firm has developed to deal with social problems.

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Social audit is conducted by professionals who have knowledge about the social area being audited.

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Program management approach It is a more systematic effort to measure costs, benefits and achievements of an organization. It is “an extension of a traditional management audit to social programs.” Cost-benefit approach This is an attempt to list all social costs and benefits incurred by an organization in terms of money. Social indicator approach This pertains to utilizing social criteria (e.g., suitable housing, good health, job opportunities) to clarify community needs and then evaluating corporate activities in the light of these community indicators.

Fredrick, Myers and Blake have identified six types of social audit. These audits mainly differ in terms of their scope and coverage. Social balance sheet and income statement This kind of audit requires quantification of social costs and income. It is conducted to reduce social costs in terms of money. Social performance audit This audit is conducted to assess the performance of companies with respect to some area of social or public concern. For example, this audit can assume the form of research-based appraisal, that is conducted to find out the extent of pollution caused by cement and steel industries. Macro-micro social indicator audit This type of audit is conducted to evaluate a company's social performance in terms of social indicators that signify public interest. It evaluates the contribution of the company to the well being of the local community. Constituency group attitudes audit This kind of audit is conducted to ascertain how corporate actions affect employees or the general public in different ways. Depending on the findings of the audit, the policies or actions of companies are modified. Government mandated audits This type of audit is conducted by authorized government agencies to study a firm's performance in areas of social concern. The focus of agencies that conduct this audit is environment protection and equal employment opportunity. Social process or program audit This audit is limited to specific processes and programs of an organization that may have social implications. It aims to appraise a program which has already been initiated by the company.
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AUDIT EVIDENCE
Audit evidence is any kind of information used by the auditor to determine whether the financial statements being audited are in accordance with the established rules and regulations. For audit evidence to be useful for the auditor, it must possess the following four characteristics: • • •

Persuasive Relevant Unbiased Objective

Persuasive

Objective

SUMMARY
Audit involves examination and verification of records and evidences by an independent person or body of persons so as to express an opinion about
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Managers can use audit as a continuous improvement tool. Initiatives for continuous improvement should be undertaken to achieve long-term goals rather than making short term improvements. In order to maximize the benefits of an audit, companies should: • • • • Make the most of audit results Achieve competitive advantage through frequent auditing Identify improvement trigger points Lay down action plans

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To be unbiased, evidence should not unduly influence one alternative over another. Bias can result either from the characteristics of the evidence or from the auditor’s sample selection of items that are to be examined.

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Auditing

whether the company's records and other evidences present a true and fair view of what they are supposed to reflect. Audits are of two types: financial audits and non-financial audits. An audit is conducted for various purposes, some of which are to identify opportunities for improvement, as a reality check, to identify outdated strategies, to measure performance improvements, to increase management’s ability to address concerns, enhance teamwork, to change mind-set and increase acceptance to change. An audit process consists of these stages-staffing the audit team, creating the audit plan, laying the ground plan, analyzing audit results, sharing audit results, writing audit reports, dealing with resistance to audit recommendations and building an ongoing audit program. For collecting data during an audit, auditors use various audit tools- surveys, questionnaires, interviews, focus group methods, the direct observation techniques and the field observation technique. The tool is selected on the basis of budget, timing, projectability and geography of the audit. With the continuous growth of firms, the importance and complexity of control has increased. At this point, an efficient manager acknowledges the need for an impartial analysis of the firm’s operations and conducts a management audit. Management audit is defined as an examination of conditions and a diagnosis of deficiencies of an organization with recommendations for correcting them. It is basically constructive and objective in its approach. It has one purpose-that of helping the management to enhance the position of the company. In short, the main aim of conducting a management audit is to critically analyze and evaluate management performance. Management audits can be categorized into six types-complete management audit, compliance management audit, program management audit, functional management audit, efficiency audit and propriety audit. Setting up a general program for management audit requires the management’s approval and support. The management's support must be reflected clearly and categorically in the company's highest policy statement. Apart from this, management should allocate personnel, train them and decide on the timing and frequency of audits. Internal audit is conducted for systematically examining the records, systems, procedures and operations of an organization. Financial audit is another type of audit conducted to examine and verify the correctness of a company's financial statements. Cost audit is a statutory audit, conducted to report the cost of production of a particular product. Social audit is a systematic attempt to identify, analyze, measure, evaluate and monitor the effect of an organization's operations on the society. There are four approaches of social audit- the inventory approach, the program management approach, the cost-benefit approach and the social indicator approach. There are six types of social audit audit-social balance sheet and income statement, social performance audit, macro-micro social indicator audit, constituency group attitudes audit, government mandated audits and social process or program audit. Audit evidence is any kind of information that is used by the auditor to determine whether the financial statements being audited are in accordance with the rules and regulations of the company. Audit evidence should necessarily possess four characteristics- persuasive, relevant, unbiased and objective.

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Chapter 15

Audit of Management Functions
• • • • • • Audit of Purchasing Function Human Resource Audit Production Audit Sales Audit

Research & Development Activities Audit

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In order to conduct business properly, activities pertaining to a particular domain are clubbed under specific functions of management. For example, all activities related to people come under the personnel function. Similarly, all activities that are performed as a part of manufacturing fall under the production function. Over a period of time, an organization may not be able to perform these activities efficiently due to systemic problems and human inefficiencies and this may affect the performance of the organization. Hence, it is necessary to regularly conduct audits of these functions.

AUDIT OF THE PURCHASING FUNCTION
Purchasing is an important function of the management especially in the case of manufacturing firms. In manufacturing firms, material costs form 50 to 60% of the total cost. If a firm can reduce its purchasing costs, it would lower the material cost as well as the cost of production, thereby earning higher profits. In most of the big companies there is a centralized purchase department that takes care of purchasing needs of other departments. The user departments forward the list of items they need along with the quantity desired and specifications, if any. The purchase department is responsible for negotiating a price and buying items at the lowest possible rate without compromising on quality. If there is some technical help needed, the purchase department can hire technical experts from outside or get them from other departments within the company.

Purchasing Procedure

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Verifying purchase requisition Negotiating price Selecting the source of supply Settling delivery date, mode of dispatch, payment terms etc. Following-up delivery Securing evidence of receipt of materials/services Negotiating adjustments with suppliers Checking invoices Serving as a source of information for user departments. Maintaining the register of suppliers, vendor files etc.,

Characteristics of an Effective Purchase Department
The characteristics of purchasing department determine whether it is innovative or not. The following are the important characteristics of purchasing department:
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Inviting Quotations, tenders, etc.

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Maintaining the continuity of supply of raw materials in support of the production schedule. Purchasing material at the least available price Adhering to the standards of quality while buying goods Formulating and implementing plans for reducing costs through value analysis programs Keeping all the relevant people informed about its activities, market developments, availability of substitutes etc.

Purchase Audit Areas
While conducting an audit of purchase functions, an auditor should look into the following aspects before giving his approval. As a first step, the auditor should determine whether the organization has a system for collecting information pertaining to purchases. If a system exists, he should analyze all the documents that trigger the purchase activity. During investigation, the auditor should look at the adequacy, format and correctness of those documents. He should conduct a critical review of the purchase procedure of the company. After the review, the auditor has the freedom to comment whether the purchase department is playing an innovative role in the organization or not. The auditor should look for failures, if any, on the part of the purchase department to get valid competitive quotations. It should check that there are no loopholes in the quality control measures adopted by the purchase department. An effective purchase department should compare the prices of the market quotations with the prices obtained from new sources of supplies. If there is any discrepancy, it should look for alternative sources of supply.

The Human Resource (HR) Audit is the process of examining policies, procedures, documentation, systems, and practices with respect to an organization’s HR functions. The purpose of an HR audit is to reveal the strengths and weaknesses of the human resources system, and identify any issues which need to be resolved. The main purpose of an audit should be to analyze and improve the HR function in the organization. Some other objectives of an HR audit would include: • • • Examining a company’s compliance with established employment laws and regulations. Determining how to serve the relevant needs of stakeholders, management, employees and customers better. Streamlining company practices and procedures used in carrying out recruitment, wage & salary administration, managing leaves of absence, benefits, training, discipline & termination, etc. Establishing an “early warning system” to spot problems or identify issues before they become crises

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Conducting an HR Audit
An HR audit is conducted by an audit team comprising a cross-section of the organization’s staff, including the line staff, middle and upper management, and the department responsible for HR functions. Using a questionnaire, the team collects information for a number of categories. For example, a questionnaire to collect information pertaining to recruitment would have the following questions. • • • • • • • • • • • • • • • • • • How did the work force increase to its current size? What are the future needs of personnel in your organization? What are the procedures, for hiring in your organization? What are the recruitment sources used? (e.g., advertisements, referrals from other agencies, personal contacts)

By whom is the preliminary screening of candidates done? Is training provided to those who conduct interviews? What is the interview process that is used (e.g., individual, sequential, panel)? Who holds the final authority to hire? Who checks references?

Who negotiates compensation packages? What is the turnover rate (percent of employees leaving each year) in your organization? Has this changed over time? Who gives references for former employees?

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By seeking an answer to these questions one can gain considerable insight into the recruitment activities of the organization. Caution for the HR auditor Conducting an HR audit is not an easy task. An auditor1 should bear the following points in mind while conducting an HR audit. • It is difficult to quantify the human contributions to the success or failure of an organization.
If the HR audit is conducted by an outside consultancy, then the auditor is a senior agency who has experience in conducting the audit. If the audit is conducted internally, then a senior manager would play the role of auditor.

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• • •

It is difficult to develop a yardstick to measure the performance of workers. It is difficult to assess the contribution of workers to the work as they are influenced by fellow workers and their industrial background. It is necessary to have a proper understanding of human behavior in order to keep the workforce motivated to achieve organizational goals. Therefore, the auditor should assess whether the supervisors and managers have leadership qualities to motivate the employees or not. It is not easy to assess the impact of training programs on workers ability. It is necessary for the auditor to understand the importance of the personnel function and its role in optimum utilization of resources available in a firm.

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Set a definite R&D goal

Set aside an R&D budget every year Decide the extent of R&D required for a young company. Select broad research concepts which an organization is capable of developing. Form a consensus on the research project being undertaken. Conduct a pilot project before starting the research project on full scale.

Evaluation of R&D Activities
While conducting an R&D audit, the auditor should look into the following aspects. • • • • The auditor should make sure that the company has allocated a specified amount as R&D budget based on detailed report of each project. The auditor should make sure that the details of expenses of each project are maintained separately and systematically. The auditor should make sure that there is control in material requisition and consumption. The auditor should make sure that R&D personnel are recruited on the basis of merit and competency.

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Due to the tremendous technological progress most of the existing technologies become obsolete within no time. Thus it becomes imperative for companies to come out with innovative concepts, products and procedures so that they can survive. If a company has to constantly innovate, it has to invest heavily in research and development. The following guidelines will help a company monitor its research and development in a better way:

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Every R&D project may not prove to be commercially viable. The auditor should see to it that the company does not incur unnecessary expenses on projects which are not commercially viable. R&D projects can be successful only if the R&D activities are well coordinated and within the overall objectives of the company. The R&D development center should have a well stocked library and necessary equipments for conducting the research. A team of experts should make sure that books and equipments are available and properly maintained.

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PRODUCTION AUDIT
The production audit also referred as manufacturing audit is conducted to measure the effectiveness and efficiency of all production facilities and processes. It is conducted for the primary production activities as well as support activities like maintenance, stock keeping etc. Production audit may include an extensive plant tour utilizing a number of checklists developed specifically for that plant. The plant tour helps the auditor get a general understanding of the manufacturing processes and their inherent problems. • • • To make sure that actual production procedures are in conformance with standard production procedures To study consistency of a process on a day to day basis To demonstrate a proactive approach to process improvement; and encourage ongoing corrective action

A good manufacturing audit has the following characteristics:

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A manufacturing audit is not supposed to be a fault finding exercise. It is rather meant to help people do things more efficiently through evaluation and feedback. It should use rating schemes to classify problems discovered. A rating scheme helps in ranking problems in order of priority so that corrective actions can be undertaken accordingly. It not only helps in discovering problems but also aid in taking corrective actions. It is necessary for the auditor to be familiar with the area he is auditing as well as auditing techniques. It is more than just walking into a work area and looking for trouble. Rather it should be a proactive process wherein problems are identified and eliminated.
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MARKETING AUDIT
Marketing audit is a comprehensive, systematic, independent and periodic examination of a company's or business unit's marketing environment, objectives, strategies and activities. A marketing audit is conducted to determine problem areas and opportunities and recommend an action plan to improve the company's marketing performance.

Characteristics of Marketing Audit
There are four main characteristics of marketing audit. They are: Comprehensiveness A marketing audit is conducted to cover all the marketing activities of a business. If the audit covers only some activities that form a part of the marketing function such as sales force, pricing etc, then it is called a functional audit. Functional audits do not give a fair picture, and can sometimes mislead the management. For example, excess sales force turnover may not always be due to poor training or compensation but due to weak products and poor promotion by company. Thus a comprehensive marketing audit is more effective in locating the real problem.

A marketing audit can be conducted in various ways. It can be a self-audit, audit from across, audit from above, company task force audit, outsider audit etc. Self-audits are conducted by marketing managers themselves by using a checklist to rate their own operations. Self-audit has a number of disadvantages. A self audit lacks objectivity and independence. Hence, it may not reflect the actual performance of the marketing function. To avoid this, it is always better to go for an external agency for conducting a marketing audit. Periodic Marketing audits are usually initiated when there is a deterioration in sales. Conducting a marketing audit after encountering a problem is not of much help. Hence, it is better to conduct a periodic audit both during good times as well as bad times. Marketing audit checklist A marketing audit checklist is a tool used by auditors to conduct internal marketing audits. The checklist gives a list of situations each having three to four options. This checklist is given to all the people within the marketing department to know their views regarding the company's products, price,

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A marketing audit is an orderly examination of both the macro and micro marketing environments, the marketing objectives and strategies, of an organization. The audit shows the areas where improvement is required. The improvements are made with the help of both short run and long run plans.

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promotion activities etc. The data collected gives the management an insight into the marketing efforts and strategies and ways and means of improving them. In exhibit 15.1, a list of situations pertaining mainly to a company’s products and pricing strategy are given in the form of a checklist.

SALES AUDIT
Competitive environment, increasing consumerism and advent of the internet has made it imperative for companies to monitor their sales closely. Sales audit is the process of examining and assessing the current state of sales, the sales environment and the sales objectives, strategies and activities.

Approaches to Sales Audit
For conducting a sales audit, an auditor can use two approaches. •

Separate approach Collective approach Exhibit 15.1

Marketing Audit Checklist Agree Disagree Company has sometimes failed to meet production targets Suppliers are very reliable The majority of our sales are in one product We do not introduce new products as often as our competitors Our product range matches customer wants We monitor new product development in the industry We are aware and comply with current legislation We are aware of how our customers perceive our products We do have a system of quality control We monitor the quality of incoming supplies Level of sales returns is negligible Level of purchase returns is negligible Company collects feedback from after sales complaints Company uses feedback from sales to influence new products Markets are sensitive to price changes Prices are in line with the competition Profit margins are wide enough to meet price competition Credit terms and discounts are in line with competitors An increase in credit sales will lead to cash-flow problems Company follows competitors in pricing the product/services

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Adapted from Marketing Audit Questionnaire, Strathclyde European Partnership Project, Glasgow.

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Separate approach In a separate approach, individual sales executives are interviewed to find out their personal sales experiences and views regarding the existing sales process and ways of improving them. Collective approach On the other hand, when views of a group of sales executives are sought then it is known as the collective approach. For example, if the regional sales manager wants to know the views of all the sales executives in a regional meeting he can use this approach. Questionnaires are generally used for collecting data.

Conducting a Sales Audit
A sales audit can be conducted in-house by the sales manager or by an outside consultant. It is always better to appoint an outside consultant for the sake of objectivity. Before conducting a sales audit, the company should make sure that it has a strong sales foundation and excellent sales relationship (Refer Exhibit 15.2). In the absence of these, the sales audit may not prove to be successful and hence, the purpose of conducting it may be lost.

Characteristics of a Sales Auditor

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He must be detail oriented. He should pay specific attention to the different product aspects when counting inventory and recording information. He should always cross-check to make sure that all sales Pre-requisite for Conducting Sales Audit

The Five Foundations of Sales Attention – Possibly through advertising, the potential customer needs to be attracted. Interest – Generate their interest in the product. Desire – Show off your product; make the customer want it. Conviction – Prove that your product is the best. Tell them about your competition and give them stories from satisfied customers. Action – Persuade customers to decide. If they have any doubts, address those concerns. Establishing Selling Relationships Sales people who are honest and show an actual interest in the client develop the best type of customer-salesperson relationship. To keep these relationships strong, a company has to maintain contacts with the clients and keep several channels of communication open.
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The main characteristics of a good sales auditor are:

Exhibit 15.2

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invoices have been retrieved for the audit period. If an invoice appears to be missing, the auditor should make every effort to retrieve the missing invoice from the stores manager. • An effective sales auditor will always give importance to collecting invoices from a stores manager, and never assume that all the invoices were handed over to him or her. Sales auditors must have exposure to store management while they are doing their job. Auditors not only act as data collectors but also as representatives of the service providing firm. For this reason, they must interact with stores manager and plan store visits in such a manner that they do not disturb the stores manager's schedule.

Process of Collecting Data During Sales Audit
During a sales audit, data is usually collected from sales representatives through questionnaires. The questionnaire may have questions pertaining to different aspects of sales like sales strategy, sales planning, territory allocation, motivating salespersons, performance modeling of salespersons, sales analysis and control etc. For example, some of the questions pertaining to sales control that can be incorporated in the questionnaire are: • • • • • What is the Sales Control (SC) system is used? Which sales activities are controlled? Who sets the sales standards? How? Who uses or gets to see the sales figures? When variances occur, who takes care of these variances?

SUMMARY

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Organizations club activities pertaining to a particular domain under a specific management functions. In order to prevent functional activities form becoming inefficient, organizations conduct functional audit. An audit of the purchase activities is referred as purchase audit. It is conducted to control purchase costs and to identify loopholes, if any, in the purchase function. The Human Resources (HR) audit is a process of examining policies, procedures, documentation, systems, and practices with respect to an organization’s HR functions. The purpose of an HR audit is to reveal the strengths and weaknesses of the human resources system. In order to remain competitive, it has become imperative for companies to develop innovative concepts, products and procedures. For achieving this, companies need to invest heavily in R&D. R&D investment may prove to be a waste if the R&D activities are not monitored and controlled. Therefore, organizations conduct R&D audits to ensure that their R&D efforts are fruitful and not simply a waste of money and resources. The production audit is conducted to measure the effectiveness and efficiency of all production facilities and processes.
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The data collected provides great insight into the sales management function and can help to improve sales processes.

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A marketing audit is a comprehensive, systematic, independent and periodic examination of a company's or business unit's marketing environment, objectives, strategies, and activities. This is done to identify the problem areas as well as opportunities. An action plan is then recommended to improve the company's marketing performance. Sales audit is the process of examining and assessing current state of sales, the sales environment, and sales objectives, strategies and activities.

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MANAGEMENT CONTROL AND EMERGING AREAS

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Chapter 16

Control in Multinational Corporations
In this chapter we will discuss: • • • • • • •

Types of Controls Used by MNCs Concept of Strategic Control

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In the last few decades, companies have grown across borders at a tremendous pace. This growth in business has made it imperative for managers to increase their awareness in relation to the important issues involved in cross-border investments, subsidiary control, global benchmarking practices and cultural diversities of countries. Multinational Corporations (MNCs) have to adapt various control practices used in their home countries (headquarters) to suit the requirements of the host countries (subsidiaries). Improper adaptation of control systems used in the home country for subsidiaries, works against the interests of the organization. As control is one of the most important issues for an MNC, we will discuss the ways and means by which the headquarters exercises control over its subsidiaries.

TYPES OF CONTROLS USED BY MNCs

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Personal controls Output controls Cultural controls Result controls Bureaucratic controls

Personal Controls

Output control relates to the performance of a subsidiary in quantitative and qualitative terms. Performance measures can be established to determine profitability, productivity, quality of the product and market share of a subsidiary. The headquarters often set stiff targets for the subsidiaries especially in terms of profitability and productivity. These targets act as controls for the subsidiary.

Cultural Controls
Cultural controls are exercised by an MNC directly or indirectly in order to uphold, manage and improve the work culture in its subsidiaries. These controls help in regulating the behavior of employees at the subsidiary.

Result Controls
Controls that are used for rewarding individuals or groups for generating good results are called result controls. One of the best examples of result control is
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Personal control is exercised through informal meetings that take place at all levels between the officials of the headquarters and the subsidiary. These meetings help them to establish greater coordination and communication between the headquarters and the subsidiary.

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the “pay for performance” system used in the US. In this system, employees are paid on the basis of their performance rather than the number of hours they have worked. A similar system is often used in MNC subsidiaries in order to control performance.

Bureaucratic Controls
Bureaucratic controls take the form of rules, norms and regulations imposed by the headquarters on the subsidiaries so that the business is conducted properly. For example, a company may have rule that restricts subsidiaries from spending more than 10% of their allocated budget on business-related travel.

CONCEPT OF STRATEGIC CONTROL
Strategic control is defined by Prahlad and Doz as “the extent of influence that a head office has over a subsidiary concerning decisions that affect subsidiary strategy”. In many multi-business, multinational companies, more than 50% of the assets, sales and profits come from overseas operations. As MNCs grow and as their operations become more complex, the headquarters has to devise and implement strategies to control subsidiaries effectively. However, the controls should not hamper the growth of the subsidiaries. Some of the factors that determine the kind of influence the headquarters has over the subsidiary are:

Headquarters-Subsidiary Environment

Impact of Host Government Demands
Often, the host government (i.e. the government of the country in which the subsidiary of the MNC operates) intervenes in the operations of an MNC. Host governments are averse to centralization and may penalize the MNC for excessive controls. Hence, MNCs find themselves in a tricky situation where,
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Impact of Global Competition
Over the last few decades, competition between players in a wide range of industries has intensified. Industries like automobiles, chemicals, and consumer electronics have experienced intense competition. In order to compete in the global market, an MNC should surpass the boundaries of national markets and prepare a global strategy. In order to do so, it has to constantly review and change its sourcing patterns, pricing strategies, product designs, etc. This has led the headquarters of MNCs to exercise greater control over their subsidiaries.

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Earlier, MNCs used to invest and consolidate their position only in their home countries. But with better growth prospects in foreign markets compared to the domestic markets, MNCs have started to invest and create a stronger asset base for their foreign subsidiaries too. For this reason, the headquarters of a company has to exercise greater strategic control over its subsidiaries.

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on the one hand, the government demands greater autonomy for the subsidiaries, and on the other hand, the government itself intervenes in their functioning. Strategic control by the headquarters has gained importance for this reason.

Impact of Joint Ventures
In order to gain entry into certain foreign markets, an MNC may form a joint venture with a local company because the host government restricts the direct entry of MNCs. In recent years, many joint ventures have not proved successful in the long term because of lack of coordination and conflicting interests between the MNC and the local company. Due to lack of coordination and communication between the MNC and the local company, the subsidiary cannot operate properly. The MNC cannot exercise excessive control because it fears that the joint venture may be called off and it may be deprived of a prospective market. Here, established control systems for the subsidiary are useful.

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Cultural Differences Across Countries

Culture and traditions vary from country to country. MNCs need to be sensitive to these differences when designing control systems for their subsidiaries. Culture has a great effect on management control systems (MCSs) because a number of control problems are in fact behavioral problems. A number of studies have been conducted to study the implications of various aspects of culture for MCSs. Geert Hofstede, in his landmark study, identified four types of cultural dimensions, which have distinct implications for control systems. According to Hofstede, the four cultural dimensions are: • • •

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Individualism Power distance Uncertainty avoidance Masculinity

Individualism Individualism is a cultural dimension, which determines how an individual sees himself, i.e. as an individual entity or as a part of a larger group. Cultures that are highly individualistic consist of people who give priority to their selfinterest rather than that of the group. When the culture is collectivist, people

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MNCs need to adapt the control systems practices prevalent in their home country to the conditions prevalent in the foreign country. These control systems should be evaluated on a continuous basis and should be modified when required. Control systems need modification or changes because they are affected by a number of factors such as:

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give more importance to the group interest rather than the individual’s interest. This dimension of culture is important for designing the reward system in an organization- an integral part of MCSs. For example if the culture is highly individualistic, organizations use individual incentives for motivating their employees. If the culture is collectivist, it gives incentives based on group performance. Power distance In an organization different people are vested with different degrees of power and authority. This often creates a feeling of inequality. Power distance means the extent to which employees understand and accept this unequal distribution of power. In the context of MCSs, employees who score high on power distance always prefer centralization and do not like to delegate authority. Employees who score low on power distance prefer greater decentralization and participation. Uncertainty avoidance is a cultural dimension seen in employees who avoid taking risks. Employees who favor uncertainty avoidance, do not take quick decisions and feel uncomfortable when confronted with difficult situations. If an organization has a large number of employees who are averse to risk taking, then it must have clear rules and guidelines for every action. It has to do things in a planned and systematic manner so that employees know beforehand what they have to do in unfamiliar situations. ‘Masculinity’ is defined here as a strong drive for achievement. Employees with this attribute are highly assertive and are often entrusted with responsible roles. They take decisions quickly and are not worried about the results. The implication for MCSs is that such employees demand more autonomy and freedom at the workplace. They do not like excessive controls and cannot perform well in a highly centralized organization. They also prefer performance-based rewards.

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Differences in Business Environment
Business environment is dynamic and differs across countries. Organizations need to learn to adapt to these changes in environment in order to survive and prosper. Some of the elements of business environment that have an effect on control systems are: • • • Inflation Business risk and uncertainty Labor availability and quality

Inflation Inflation refers to a sustained increase in the general price level in an economy. As the rate of inflation increases, the value and purchasing power of money decreases. Rates of inflation vary widely across countries. MNCs need to evaluate the impending financial risk due to fluctuations in inflation rates. An MNC operating in a country which has a high rate of inflation, may
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experience an erosion in the value of its assets. High inflation can also adversely affect the compensation of employees. As the prices of goods increase, there should be a corresponding increase in salaries. This would in turn mean that the management has to make changes in its rewards system -an integral part of the control system. Business risk and uncertainty MNCs operating in different countries are exposed to different types of risks and uncertainty. Business risk and uncertainty is lower in countries which are economically and politically stable than in countries which are politically and economically unstable. Risk also differs across countries depending on the extent of economic development. Companies in economically underdeveloped countries may not have strong and well-developed control systems. A poor and undeveloped MCS is characterized by a poor accounting system, an ineffective information system, limited computerization and excessively subjective performance reviews. A company’s growth strategy also affects the way an organization manages risk. Companies may grow organically (i.e. gradual growth due to increase in profit or returns) or by acquiring other firms. When companies grow by acquiring other firms, they encounter variations in control systems. A company that can adopt the best control system for all its acquisitions will be more adept at managing risks. MNCs operating in underdeveloped countries find it difficult to hire skilled labor due to the lack of quality education and vocational training. This forces the management to have a highly centralized structure and to exercise a high degree of control. Even at the managerial level, there is a marked difference in the quality of managers across the countries. An MNC needs to consider all these factors before designing the control systems for its subsidiaries.

ANALYSIS OF FOREIGN INVESTMENT PROJECTS BY MNCs
MNCs often invest in different countries by taking up a number of projects. They use various methods like Net Present Value (NPV), Pay back period, or Accounting rate of return, for assessing the profitability and viability of a project. They also conduct risk-benefit analysis before initiating a project. There are a number of other issues that should be considered by an MNC before embarking on projects in foreign countries. Some of them are: • • • • • Taxes on income from foreign investment projects Political risks Economic risks Exchange rate risks Different types of exchange rate exposure

Taxes on Income from Foreign Investment Projects
All over the world, host countries levy taxes on MNCs on the income they earn in the host countries. Taxes are levied not only on the income earned but also on the income repatriated to the home country of the MNC in the form of
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dividends. The rate of taxation differs from country to country. At times, an MNC may get tax concessions due to the nature of the project or its location. It may also get concessions because of the employment opportunities the project generates for the local people. MNCs should have a transparent and efficient accounting system in order to avoid complications that may arise due to the incorrect assessment of tax to be paid.

Political Risks
The most extreme form of risk an MNC faces in its overseas operations is the risk of expropriation of the business by the host country due to policy changes. Expropriation can take the form of seizure of property or assets of an MNC. For example, in 1970 in Chile, the government took control of companies like Anaconda, Ford and AT&T as part of its nationalization policy.

Exchange rate is the value of one currency in terms of another. The value of one US dollar can be quoted in terms of another currency like the Euro. The exchange rate of a currency is governed by the laws of demand and supply. The demand and supply of a currency is influenced by many factors including interest rate differentials, relative inflation, export competitiveness and economic growth. Exchange rate fluctuations influence the cash flows of an MNC because they may be denominated in several currencies and the value of each currency relative to the dollar is different at different times. This complicates the problem of measuring the performance of subsidiaries. Apart from this, exchange rate changes also affect costs. If a country’s currency has depreciated, there will be an increase in the prices of raw materials imported from other countries. Moreover, since domestic inflation often accompanies depreciation/devaluation of the currency, prices of raw materials purchased locally will also rise. As costs and prices rise, so will wages. Therefore, if there are risks of exchange rate changes, these risks should get reflected in estimates of project costs and revenues. Different types of exchange rate exposure The sensitivity of a firm’s cash flows to changes in exchange rates is called exposure. MNCs face different types of exchange rate exposures. Some of them are: • • • Translation exposure Transaction exposure, and Economic exposure
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Economic risk can be divided into exchange rate risk and inflation. As we have already discussed inflation in the previous section, here we will discuss exchange rate risk in detail. Political risk has a strong bearing on economic risk. Frequent political changes in a country can adversely affect the economy of the country and the operations of MNCs.

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Translation exposure Fluctuations in exchange rate affect the income statement and balance sheet of companies either positively or negatively. The erosion or appreciation in the value of earnings, assets and liabilities is referred to as translation exposure. This exposure arises because MNCs maintain their accounts in a single currency (usually the currency of parent country) whereas the cash inflows are in different currencies. For example, the accounts of a US-based MNC would be maintained in US dollars, but its cash inflows would be in different currencies. As the value of dollar fluctuates against the value of other currencies, the figures in the income statement and balance sheet are affected. Transaction exposure Transaction exposure indicates the exchange rate exposure that the firm has in its cross-border transactions, when such transactions are entered into at the present time, but payments to settle the transactions are made at some future date. If nominal exchange rates change during the interim period, and the payment or receipt commitments are outstanding, the value of transactions is put at risk. Examples of such transactions are receivables and payables, and debt or interest payments outstanding, in foreign currencies. Economic exposure, also referred to as “operating exposure,” or “competitive exposure,” is the exchange rate exposure of the firm’s cash flows to changes in the real exchange rate.

TRANSFER PRICING IN MNCs

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One of the most controversial and often least understood issues in a multinational's operations is transfer pricing1. In chapter 7, we explained the basic concept of transfer pricing and the way it is used by domestic firms to achieve goal congruence. In the following sections we will study transfer pricing from an MNC perspective and the ways in which MNCs manipulate this system for tax gains. When one subsidiary of an MNC in one country transfers (read sells) goods, services or know-how to another subsidiary in another country, the price charged for these goods or services is called the 'transfer price'.

MNCs can manipulate their income by the use of transfer pricing in following ways: • • MNCs set high transfer prices for subsidiaries in countries with a relatively high rate of taxation. MNCs set low transfer prices when goods are subjected to high import duties in a particular country.
In order to prevent companies from manipulating their incomes using he transfer pricing mechanism, tax authorities may insist on companies adopting the principle of arms length pricing which means that whenever goods are sold by a foreign affiliate to its parent company or vice versa, the transaction should take place as if the two companies were separate entities.

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MNCs set relatively high transfer prices for their subsidiaries in countries experiencing hyperinflation and currency devaluation. MNCs set high transfer prices for goods and services that are purchased by their subsidiaries situated in countries that restrict repatriation of income.

We will see in the following paragraphs that the transfer price can be set at a level which can reduce or even cancel out the total tax which has to be paid by an MNC. Let us assume that ABC Automobile Company, based in the UK, manufactures and assembles automobile components and exports them all over the world. It has its main assembling division in the UK but manufactures a number of other parts in its plants in the US. The US subsidiary transfers certain automobile parts at a transfer price that is fixed by the parent company in the UK. This effectively means that the subsidiary belongs to the parent company and ultimately it is the parent company that takes all the decisions for the subsidiary. The finance director of the parent company explains how income can be manipulated for tax gains in four different situations. The first situation is one in which the MNC pays some tax to the authorities.

However, one has to consider the tax these companies have to pay on their profits. Tax rates (company or corporation tax) are different in the USA and the UK. Assuming the US subsidiary has to pay corporation tax at the rate of 20% on profits, the tax amounts to $20 (20% of $100). The parent company in UK has to pay tax at the rate of 60% on profits which amounts to $60 (60% of $100). Overall, tax paid is $80 ($20+$60). This reduces the overall profit before tax of $200 to profit after tax of $120 ($200-$80). The US subsidiary contributed $80 to this profit, while the parent company in UK contributed $40. The after-tax profit generated by the parent company in the home country, was smaller because of the corporation tax of 60% which is higher than the subsidiary’s tax rate of 20%. However, the parent company can tell the subsidiary what to charge and can fix the transfer price for the subsidiary. The transfer price is arbitrary, and is decided by mutual agreement between the parent company and the subsidiary.

Situation 2-Inflating Profits
Suppose, the US subsidiary manufactures the part for $100 but sets the transfer price at $280 on the advice of the parent company. In this situation the profit made by the subsidiary is $180. Assuming that the parent company sells it for $300, it will make a profit of $20 in the home country. The total profit
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Assume that the US subsidiary manufactures one of the automobile components for $100. It transfers the component to the assembly division in UK at $200 each and hence makes a profit of $100. The parent company in UK sells the same component for $300 in turn making a profit of $100 ($300$200). The overall profit is thus $100 in the host country and another $100 in the home country, a total of $200.

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before tax is again $200 but as the profits of the parent and the subsidiary have changed so will the taxes. Now the tax paid by the subsidiary will amount to $36 (20% of $180) whereas the tax paid by the parent company will be $12 (60% of $20). In total the tax paid is $36+$12= $48. The overall profit after tax now stands at $152 ($200-$48=$152) which is much more than the earlier profit of $120. Hence by merely manipulating the transfer price, the company has been able to inflate its profits by $32.

Situation 3 - Paying No Tax
Now, assume that the US subsidiary has increased the transfer price to $300 on the advice of the parent company. Assume that the parent company buys the product at $300 and sells it at the same price. One may think that this does not make sense at all but in fact the parent company stands to gain a lot from this transfer. When the transfer price is $300, subsidiary makes a profit of $200 ($300-$100) whereas the parent company neither makes profit nor incurs any loss. The tax paid by the subsidiary would be $40 (20% of $200) and $0 by the parent company. The total tax paid is only $40. In this scenario, the profit after tax becomes $160. The subsidiary contributes $160 to this while parent company's contribution is $0. The parent company has successfully shifted all the profits to the subsidiary and hence does not pay any tax in the home country. The parent company can shift even more of its profits to the subsidiary. It can make a loss and get a tax rebate. This is illustrated by situation 4.

Situation 4 - Getting Tax Rebates

Assume that the subsidiary has now set the transfer price at $400. This means that it will make a profit of $300, assuming manufacturing cost remains the same at $100. If the parent company cannot sell the component at $400, then effectively it will incur a loss of $100. In this situation the total tax paid by the subsidiary would be $60. As the parent company has incurred losses, it reduces its tax bill by $60, in effect getting a rebate of $60. It can use this loss to reduce the tax liability on other profitable operations in the home country. Hence the overall result is that the MNC pays no tax at all on this transaction, and its after-tax profit becomes $200.

Tax Avoidance Inflates Profits
So, by arbitrarily increasing the transfer price, the company almost doubled its after-tax profit. This was done by merely changing book entries and not by any change in operations. In other words, it is possible for a multinational company to minimize its tax liability by manipulating transfer price. This is legal until governments enforce laws to prevent this practice. However, in the case discussed above, the tax paid to the host country increased while the tax paid to the home country decreased gradually. In other words, one government's loss was another government's gain. So one government may want to enforce legislation against unfair transfer pricing practices, while the other government may object to such legislation.
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Methods of Transfer Pricing
Basically, there are three methods of transfer pricing used by MNCs. The method adopted depends on the market price of goods that are being transferred, the tax structure of the country in which the subsidiary operates and the position of the affiliate in the industry. The three methods commonly used are: • • • Market price method Resale price method Cost method

Market price method Here, MNCs set transfer prices for their affiliates according to the prevailing market price of the particular good or service. Here, MNCs estimate an appropriate transfer price for a product if it becomes an input for another product within a reasonable period of time. In this case, the transfer price is the difference between further processing cost plus profit markup, and the selling price of the product. Cost method Here, MNCs determine the transfer price on the basis of the costs incurred by the affiliate in producing the goods. For this method to be successful, MNCs need to have sound cost accounting practices and access to the cost structure of the affiliate.

CONTROL OF FOREIGN AFFILIATES
In 1979, Persen and Lessig conducted a survey of the differences between the financial evaluation of domestic firms and foreign affiliates. There were 106 respondents to the survey. The differences as conveyed by the respondents can be broadly can be categorized into the following five types, based on their cause: • • • •

Currency Translation
We shall understand the effect of currency translation on the performance of an affiliate with the help of an example. ABC Inc. is a US-based company
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Currency and exchange rate fluctuation Translation of currencies Variation in inflation Variation in financial and economic conditions Multiplicity of government regulations and controls

Currency translation was found to be the most important issue that an MNC should consider before designing control systems for its foreign affiliates.

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which has a subsidiary in India. The Indian subsidiary produces electric bulbs which are sold only in the Indian market. Suppose the initial exchange rate of the Indian rupee was Rs.50/$ Assuming the subsidiary was given the target of selling goods worth Rs.500, with a corresponding profit of Rs.50 (10% of net revenue as profit). Suppose the Indian rupee depreciates by 10% against the dollar over a period of a year (i.e. it now stands at Rs.55/$). Due to the depreciation, the performance of the subsidiary appears poor in dollar terms, although it has achieved its target in rupee terms. From Table 16.1, we can see that although the budgeted and actual revenues were same in terms of rupees, they were different in terms of dollars. This happened on account of the depreciation of the rupee against the dollar. The loss suffered by the parent company is called ‘Translation Loss’. There is little that parent companies can do to control such exchange rate fluctuations.

One of the best methods of control an MNC can use over its affiliates is budgeting. Budgeting data helps in comparing the actual performance against the budgeted, and helps the management to identify the areas in which greater control is needed. Budgeting can also be used to improve coordination between the affiliates and the parent company. The major problem in budgeting for foreign affiliates pertains to exchange rate fluctuations. Some of the issues involved are: 1. Which exchange rates should be used for budgetary planning?

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2. Which exchange rates should be used for reporting performance? 3. Should the managers of foreign affiliates be held responsible for the effects of exchange rate fluctuation? These issues can be resolved by establishing goal congruence and better controllability. Goal congruence The main concern for an MNC while designing a control system is the returns it gets in terms of the parent company's currency. If the parent company is

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In preparing a report for stockholders, a company has to consolidate the accounts of all its foreign subsidiaries with the accounts of the parent. During this process of consolidation currencies of subsidiary countries are translated into the currency of the parent company. The performance of the subsidiary should not be affected by such translation gains or losses.

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UK-based then it would like to calculate revenues, profits and dividends in the local currency i.e. Pound Sterling. In order to avoid complications due to fluctuations in exchange rates, the parent company can budget using exchange rates projected for the end of the period. Controllability Exchange rate fluctuations cannot be controlled by the management of local subsidiaries. In a survey conducted by Persen and Lessig, it was found that most of the firms used projected exchange rates for budgeting whereas they used actual rates for reporting the performance. This leads to discrepancy and may reflect a poor performance on the part of the subsidiary even though that may not be the case. Hence in order to establish better controllability, it is recommended that the same exchange rates be used for budgeting as well as reporting performance.

MNCs need to control their subsidiaries so that the subsidiaries perform better and achieve higher profits. MNCs make use of different types of control systems. These include personal controls, output controls, cultural controls, action controls, result controls and bureaucratic controls. The headquarters of the company tries to exercise control over the subsidiaries. This is referred to as strategic control. Some of the factors that determine the influence of the headquarters over the subsidiary are: the headquarters-subsidiary environment, host government demands, joint ventures and global competition. Cultural differences across countries, differences in the business environment and local institutions also influence control systems used by MNCs. Geert Hofstede’s cultural dimension reveals the cultural dimensions affecting control in an organization. Hofstede's cultural dimensions are individualism, power distance, uncertainty avoidance and masculinity. The environmental elements that can greatly affect control systems in an organization are inflation, business risk and uncertainty, labor availability and quality. An MNC planning to invest in projects in other countries needs to consider a number of factors before starting operations. Some of the factors are taxes on income from foreign investment projects, political risks and economic risks. MNCs use transfer pricing to manipulate their incomes. Some of the methods of transfer pricing are cost method, resale price method and market price method. Currency translation is an important issue that an MNC should consider before designing a control system for its foreign affiliates. Budgeting is an important tool that an MNC to exercise control over its affiliates. One of the major problems encountered when budgeting for foreign affiliates pertains to exchange rate fluctuations. Exchange rate fluctuations can adversely affect the performance of foreign affiliates. In order to solve the problems arising out of exchange rate fluctuations, MNCs have to achieve goal congruence and ensure better controllability.

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Chapter 17

Control in Nonprofit Organizations
• • • • Mission of Nonprofit Organizations Key Characteristics of Nonprofit Organizations Employee Characteristics and Organizational Culture Designing Control Systems for Nonprofit Organizations

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A nonprofit organization1 is defined as “an organization that does not have owners who profit when revenues exceed expenses”. A nonprofit organization operates in the interests of society. It does not participate in the equity markets since it has no shareholders. The sources of funds for nonprofit organizations are contributions, grants, and operating surplus. The activities of a nonprofit organization uphold the organization’s stated mission, which describes the nature of its contribution to society; profits do not form a part of its mission. Most nonprofit organizations provide services. They are run professionally, by managers who develop objectives, strategies and budgets. Performance reviews are conducted for the employees and they are suitably rewarded. Controlling employees, systems and processes in a nonprofit organization is different from controlling them in profit seeking organizations. In this chapter we will discuss the differences between nonprofit and profit-seeking organizations and their implications for control systems.

The major difference between profit seeking and nonprofit organizations is their mission. The mission of an organization is explained in its mission statement. A mission statement is a written statement of purpose that can be used to initiate, evaluate and refine all organizational activities. According to Peter Drucker, a mission statement should state the following: • •

Opportunities that an organization can exploit or needs that it can meet Strengths of an organization

A mission statement serves as a road map that guides an organization to success. Many organizations recognize the need to have a mission statement and to put this powerful tool into action -- especially nonprofit organizations that sincerely attempt to provide quality services. The basic problem that most nonprofit organizations face is that they find it difficult to measure the success of their mission. But, contemporary research indicates that this can be done. For this purpose, they need first to define their mission clearly. Nonprofit organizations have three options to help determine the organization’s success in terms of its mission. First, the organization can define its mission narrowly so that progress can be measured easily. Second, it can invest in research to show how its activities help in achieving the objectives stated in its mission. Third, it can develop micro-level goals that if achieved, imply success on a bigger scale.

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Though there is no perceived difference between nonprofit and not-for-profit organizations, the legal definition differentiates between the two. “Not-for-profit” refers to an activity, for example, a hobby (like fishing). "Nonprofit" refers to an organization established for purposes other than profit-making. For example, a "nonprofit" organization can be an association of people who like fishing.

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Exhibit 17.1 Mission Statement of Ford foundation Founded in 1936, the Foundation operated as a local philanthropy in the state of Michigan until 1950, when it expanded to become a national and inter-national foundation. Since its inception it has been an independent, nonprofit, nongovernmental organization. It has provided slightly more than $10 billion in grants and loans. These funds derive from an investment portfolio that began with gifts and bequests of Ford Motor Company stock by Henry and Edsel Ford. The Foundation no longer owns Ford Motor Company stock, and its diversified portfolio is managed to provide a perpetual source of support for the Foundation's programs and operations. The Trustees of the Foundation set policy and delegate authority to the president and senior staff for the Foundation's grant making and operations. Program officers in the United States, Africa, the Middle East, Asia, Latin America and Russia explore opportunities to pursue the Foundation's goals, formulate strategies and recommend proposals for funding.

The Ford Foundation is one source of support for these activities. It works mainly by making grants or loans that build knowledge and strengthen organizations and networks. Since its financial resources are modest in comparison to societal needs, it focuses on a limited number of problem areas and program strategies within their broad goals.
www.fordfound.org

KEY CHARACTERISTICS OF NONPROFIT ORGANIZATIONS
After studying a number of nonprofit organizations, seven key characteristics of these organizations have been identified: • • •
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Atmosphere of “scarcity” Bias towards informality, participation and consensus Dual bottom lines: mission and financial

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A fundamental challenge facing every society is to create political, economic and social systems that promote peace, human welfare and the sustainability of the environment on which life depends. Ford Foundation believes that the best way to meet this challenge is to encourage initiatives by those living and working closest to where problems are located; to promote collaboration among the nonprofit, government and business sectors, and to ensure participation by men and women from diverse communities and at all levels of society. Such activities help build common understanding, enhance excellence, enable people to improve their lives and reinforce their commitment to society.

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Difficulty in assessing program outcomes Governing board with both overview and supporting roles Mixed skill levels of staff Participation of volunteers

Atmosphere of “Scarcity”
There are factual and perceptual components to scarcity in nonprofit organizations. Most nonprofit leaders are severely constrained by lack of resources. In addition, many nonprofit organizations rely on altruism. As a result, they often have underdeveloped infrastructures.

Bias towards Informality, Participation and Consensus
Nonprofit organizations are characterized by informality, participation and consensus. They give less importance to hierarchy. Taken too far, informality can limit the appropriate exercise of authority, over-participation can inhibit appropriate division of labor, and the tendency toward consensus can bog down decision making.

Difficulty in Assessing Program Outcomes
Most nonprofit organizations have limited capacity for program evaluation. This is caused partly by the absence of standardized program outcomes in most fields. In childcare for example, standards for adult-child ratios exist, but little is standardized in terms of the quality of care delivered. Similarly, arts groups, advocacy organizations, mental health agencies and community development corporations face substantial challenges in measuring their effectiveness. Furthermore, most nonprofit organizations do not have the benefit of unambiguous market feedback to let them know how well they are serving their clients. Nonprofit organizations exist because neither the market nor government is providing the service; most are funded in part or completely by sources other than the direct beneficiaries of their work. Thus, assessing cost-effectiveness and comparing alternative actions is difficult. Also, different individuals may make different assumptions about the relationship between cost and effectiveness. Some groups essentially ignore the issue assuming their efforts are as effective as they can be.
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Tension between mission and financial results is fundamental for nonprofit organizations. (One can debate to what extent this is unique. For-profit organizations have increasingly focused on the importance of mission, relative to the priority of return on investment. Governmental organizations have increasingly focused on the importance of mission relative to the priority of political impact). Internally, the tension between bottom lines influences many strategic decisions as well as the sense of “how well the organization is doing” at all operational levels. Externally, some stakeholders of a nonprofit organization care about both bottom lines (funders, competitors and regulators) while some stakeholders care primarily about mission (clients and community). The complexity of dual bottom lines figures in many consulting engagements.

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Governing Board with both Overview and Supporting Roles
The governing board of a nonprofit organization has dual roles: it is responsible for ensuring that the public interest is served by the organization, and, -- unlike private sector boards of directors or government boards and commissions -- is expected to help the organization to be successful. The first role is analogous to protecting the interest of stockholders or voters. The second role complicates the distinction between governance and management because, in this role, board members do staff-like work. As helpers, board members may raise funds, send mailings, paint buildings, or do the bookkeeping. This can lead to confusion about when, and how, it is appropriate for board members to be involved in initiatives at work. Furthermore, board members are often not experts in either nonprofit management or in the organization's field of service. They may either be unprepared to make decisions, or may give up their authority inappropriately to staff.

Participation of Volunteers

Many nonprofit organizations rely on the active participation of volunteers. Members of the Board of Directors are normally not paid for their work, and individuals contribute considerable time and effort in delivering services and providing administrative support. The contribution that volunteers make to the nonprofit sector is significant; indeed without volunteerism, many needed social services would not be available to the public. However, volunteers usually have to juggle multiple commitments, and the relative priority they assign to their volunteer job may have to be balanced with their paid job, family responsibilities, and other volunteer commitments. Board meetings are therefore often held in the evenings or on weekends. Finally, there may be resentment on the part of certain volunteers that some people are being paid for work that they are doing for free, and the feeling that everyone should be volunteering.

DESIGNING CONTROL SYSTEMS FOR NONPROFIT ORGANIZATIONS
Designing a control system for a profit seeking organization is different from designing a control system for nonprofit organizations. Some of the reasons are:
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The individual’s passion for the mission, the limited financial resources of the organization, and a shallow pool of candidates often result in nonprofit organizations hiring managers with limited management training and program staff with little program experience. Though the staff is often composed of professionals (e.g. social workers, artists and scientists), since most organizations are small, there is seldom much internal capacity to provide training for staff for the particular roles they are playing.

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• • • • • • •

Absence of profit measure. This makes performance evaluation difficult. Separate tax and legal status. Nonprofit organizations are exempted from taxation and there are no shareholders. Most nonprofit organizations provide services rather than products. It is difficult to measure the quality and quantity of service. Fragmented governance due to numerous sources of influence. Excessive constraints in terms of usage of funds. Differences in senior management. Traditionally nonprofit organizations have had poor management controls because the management consisted of professionals like teachers, priests, doctors, etc. These professionals tended to give greater importance to professional goals and did not give requisite value to managerial skills.

EMPLOYEE CHARACTERISTICS AND ORGANIZATIONAL CULTURE
Employees of a nonprofit organization are different from employees of a profit seeking organization. This can have positive or negative implications for organizational control. Control problems are usually aggravated when employees of nonprofit organizations compare themselves with the employees of profit seeking organizations. For example, compensation of employees in nonprofit organizations is usually not competitive when compared to compensation in profit seeking organizations. A positive aspect for control, seen in nonprofit organizations, is employee commitment. Because of the nature of work, which is quite often philanthropic in nature, employees find it easier to identify themselves with the organization and its goals. High commitment minimizes control problems that may arise due to lack of motivation and direction. Cultural characteristics of profit seeking and nonprofit organizations also differ. Nonprofit organizations which are dominated by professionals, have little regard for management control systems. These people prefer to concentrate on their profession and undermine the value of MCS. Because of poor compensation, nonprofit organizations do not attract the best of managerial talent too. Absence of performance measurement methods compounds this problem. This leads to a culture in which there may be poor coordination and lack of trust among employees.

Rewards
Generally, employees working in profit seeking organizations get better compensation and rewards when compared to employees in nonprofit organizations. In nonprofit organizations, employees feel rewarded when they achieve the goals which form a part of the mission statement of the organization. For example, employees of a nonprofit organization that is working towards preventing the spread of AIDS will feel rewarded when the rate at which the disease is spreading decreases. As financial rewards are negligible in nonprofit organizations, achieving the goals in the mission statement keeps employees motivated. However, there are exceptions to this
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generalization. In certain nonprofit organizations like universities and research organizations, employee compensation is better than in private sector companies.

Performance Measurement
Measuring performance of nonprofit organizations is difficult and arduous because most nonprofit organizations provide services which are measured in qualitative terms rather than quantitative terms. Without a quantifiable performance indicator, it is difficult: • • • • to measure organizational performance in light of the overall goals and to use results control at the broad organizational level; to analyze the benefits of alternative courses of action to decentralize the organization and hold sub-unit managers responsible for specific areas of performance; and

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Success in mobilizing resources Effectiveness of staff on the job

• Progress in fulfilling the mission The way these metrics can be applied differs from organization to organization. For example, for a museum, the performance of its staff will be rated on basis of the number of people who visited the museum. Of these three metrics, the first two are easy to develop but measuring the success of a nonprofit organization in terms of the achievement of its mission, is difficult.

“Fund accounting” is an accounting system used by many nonprofit organizations. In this system, accounts are kept separately for several funds, each of which is self-balancing, with the sum of debit balances equaling the sum of credit balances. Most nonprofit organizations have: (1) a general fund or operating fund, which corresponds to the set of operating accounts; (2) a plant fund and an endowment fund, which account for contributed capital assets and equities and (3) a variety of other funds for special purposes.

Programming and Budget Preparation
Compared to a typical business, programming is a more important and timeconsuming process in a nonprofit organization, where a decision has to be made on how best to allocate limited resources to worthwhile activities. Nonprofit organizations have to work within their budgets and cannot exceed the set monetary limits because they do not market their services to increase
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to compare the performance of sub-units which are performing dissimilar activities. It has been observed that many nonprofit organizations, irrespective of their mission, scope and needs, design three types of performance metrics. They are:

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their revenues. They limit their expenditure and aim to break even at the estimated amount of revenue. Hence, the budget is a very important management control tool for a nonprofit organization.

SUMMARY
A nonprofit organization is defined as an organization that does not have owners who profit when revenues exceed expenses. Nonprofit organizations such as hospitals, government organizations, fraternal organizations and religious institutions play a vital role in society. The major difference between profit seeking and nonprofit organizations is their mission. Nonprofit organizations are passionate about their mission. Their main aim is to achieve the goals listed in their mission statement. Controlling employees, systems and processes in a nonprofit organization is different from controlling them in profit seeking organizations. Nonprofit organizations provide services, not in order to create wealth for their shareholders but to meet a felt need. The reasons why control systems of a nonprofit organization have to be different are: absence of profit measure, difficulty in performance measurement, separate legal status, non-imposition of income tax, provision of services rather than products, and fragmented governance. The seven key characteristics of nonprofit organizations are: the atmosphere of “scarcity”; bias towards informality; participation and consensus; dual bottom lines: financial and mission; difficulty in assessing program outcomes; dual role of the governing board - oversight and supporting; mixed skill levels of staff; and, participation of volunteers. The employee characteristics and organizational culture of a nonprofit organization are different from those of a profit seeking organization. Attributes like rewards, performance measurement, programming and budgeting are also correspondingly different.

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Control in Service Organizations
• • • •

Control in Government Organizations Control in Securities Firms

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Over the years, the industrial landscape has changed drastically. Initially, the focus was mainly on the manufacturing sector but during the later half of the 20th century the focus shifted to the service sector. In the US only, growth of employment in the service sector during the 1980s, was twice as much as the growth of employment in the manufacturing sector. Control in service organizations is different from control in manufacturing organizations due to the following reasons: • •

Absence of inventory buffer Difficulty in controlling quality Multi Unit organization

Service organizations operate through many small units set-up in different locations. These units act as individual profit centers for the service organizations. Fast-food companies, gasoline stations and auto rental companies are some of the examples of such service organizations. The units of a service organization are either wholly owned or franchised. Most of these units are similar in size and operations and hence provide a basis for analyzing budgets and evaluating performance. The information generated from such an analysis can be used to distinguish the high performing units from the low performing units.

CONTROL IN PROFESSIONAL ORGANIZATIONS
Service organizations can be categorized into professional organizations, healthcare organizations, financial services organizations, etc. The characteristics of these service organizations differ from each other and hence the control systems also differ. We will first discuss the characteristics of professional organizations and their implications for control systems.
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The products of a manufacturing company should be inspected for quality before they are released in the market, but this cannot be done in case of a service organization's products. The quality of the products offered by service organizations cannot be judged until it is rendered to the customer. Also, the judgments regarding the quality of the product are often subjective. The management of a restaurant may judge the quality of the food and approve of it, but customer satisfaction also depends on how the food is served.

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Manufacturing organizations maintain an inventory of goods in order to tackle sales fluctuations in future. This does not hold true for service organizations. They cannot store their services. For example, the airplane seat, hotel room, or the service of professionals like lawyers, physicians cannot be stored. Moreover, many service organizations have a fixed cost in the short run which cannot be reduced. For example, a hotel cannot reduce its fixed costs by closing down some of its rooms. Thus, service organizations have to match their current capacity with demand. Organizations match their current capacity with demand in two ways. The first way is to stimulate demand in the off peak seasons by increasing marketing activities and decreasing prices. For example the airlines and hotels offer heavy discounts during the off-season to increase demand. Secondly, companies can also try to right-size their workforce according to the anticipated demand.

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Characteristics of Professional Organizations
Organizations that provide specialized professional services are called professional organizations. They include law firms, consulting firms, engineering firms, sports organizations and so on. These organizations possess special characteristics like the following: • • • • • Small size Labor intensiveness Different objectives and goals Difficulty in measuring output Different marketing strategies

Small size Most professional organizations are relatively small in size and operate in a single location, with the exception of some law and accounting firms. Senior management personally monitors and motivates their subordinates. This brings down the need for sophisticated control systems. Even though professional organizations are small, they still need to prepare budgets, compare the budgeted and actual performance, and compensate employees on the basis of their performance. Labor intensiveness Professional organizations are labor intensive, and they employ individuals who are specialists in respective fields. Professionals who are also managers prefer working independently rather than in teams. Professionals are the most valuable asset of an organization. Due to this, some management thinkers advocate the idea that these professionals should be valued highly and their value highly included in the company's balance sheet. A system called human resource accounting was developed by Likert for valuing the professionals but very few companies used it. Different objectives and goals The goal of a manufacturing organization is to earn a satisfactory return on the assets it employed. As most assets are tangible, they appear in the balance sheet. In professional organizations, as most assets assume the form of the employees' skills it is difficult for the company to set for itself a goal in terms of returns on assets employed. The financial goal of professional organizations is to provide satisfactory compensation to its employees. Another goal of professional service organizations is to increase their sizes and networks. Difficulty in measuring output The output of manufacturing organizations can be measured in terms of units, tons, gallons, etc. but this method cannot be applied to professional organizations. For example, the output of a physician, can be measured in terms of number of patients treated, but one cannot measure whether the service provided by the physician satisfied the patient. In some cases, the revenues earned indicate the measure of output, but only in terms of quantity. In a professional service organization, the non-repetitive nature of work compounds the problem of measuring output. Since no two professionals
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work in the same way, it is difficult to set standards in terms of the time spent for a task and the way in which the task is performed. Different marketing strategy In manufacturing companies, production and marketing activities are clearly demarcated. But no such demarcation is done in professional organizations. These organizations do not market themselves openly. It is done through the use of articles, personal and professional contacts, speeches etc. An auditing firm may market itself through the articles written by its auditors (on contemporary issues) or through the marketing activities done by professionals who spend much of their time working for clients. Thus, it becomes difficult to identify a single employee who is responsible for promoting the organization.

Control Systems in Professional Organizations

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Pricing Strategic planning and budgeting Control of operations

Performance measurement and appraisal

Strategic planning and budgeting Manufacturing organizations have better strategic planning systems when compared to professional organizations of similar size. One of the main reasons for this could be that professional organizations do not need such a system. Strategic planning is important for manufacturing organizations because any commitment relating to the procurement of plant and equipment does effect its capacity and expenditures for years, and such effects are irreversible. In professional organizations, the main assets are people and changes in the size and composition of the staff are irreversible and easier to make. The strategic plan of a professional organization is not as comprehensive as that of a manufacturing organization. It is mainly a longrange staffing plan and does not cover other functions. Control of operations Scheduling the working hours of employees is one of the most important aspects of controlling the operations in professional organizations. The billed time ratio, that is the ratio of hours billed to total professional hours available, should be analyzed thoroughly. Idle time should be minimized and appropriate rates should be used for billing engagements.
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Pricing Most professional firms determine the price of their services in a traditional manner. If the professional service offered is dependent on time, then the fee is fixed on the basis of time spent on the service. Investment banking is an exception to this. In case of investment banking, the service charge is determined on the basis of monetary size of the securities issue. Prices of services offered differ from profession to profession. The prices are high for accountants and physicians compared to research scientists, for instance.

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Performance measurement and appraisal In professional organizations, it is easy to analyze the performance of employees at the top most and the lowest hierarchical level, but it is difficult to analyze the performance of employees who are placed somewhere between the two extremes. The main reason for this is the absence of objective criteria for performance appraisal. But there are exceptions to this too. For example, the performance of an investment analyst can be appraised by comparing his recommendations and the market behavior of securities. In many cases, performance appraisal depends on human judgment. An employee’s performance may be judged by his superiors, peers, subordinates and clients. Professional organizations use a formal performance appraisal system– numerical ratings of specified performance attributes. These ratings are used as deciding factors for wage hikes and promotions.

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Political influences Public information Attitude towards clients Management compensation

favor certain suppliers. Public Information

Attitude towards Clients
The main source of revenues for many profit-oriented and non-profit companies is their clients. The principal source of revenues for government organizations is the general public. In case of profit-seeking organizations, more clients mean more revenues. Every client that is added to the portfolio of
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Government organizations are under the constant vigil of the press and the public. In a democratic society, the public assumes that it has the right to know everything about government organizations. Due to exaggeration by the media, at times, even minor issues appear to be major ones. Therefore, to discourage unfavorable media coverage, managers in government organizations exercise greater control on their tasks and try to limit the outflow of sensitive information about the company that flows through the formal management control systems.

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the company brings in additional profits. But for government organizations, an increase in the client base is a burden. For example, one may draw a comparison between government hospitals and private hospitals. An increase in the number of patients visiting private hospitals result in additional revenues, whereas in case of government hospitals, it may result in deterioration of the quality of service.

Management Compensation
Managers working in profit-seeking organizations are better paid when compared to their counterparts in government organizations. This is because legislators are influenced by the populist perception that “one person is as good as another.” Due to this the best managers do not prefer to work in government organizations. There is, however, an exception to this. University faculty and scientists in certain government organizations are paid as highly as managers in profit- seeking organizations.

The two most important elements of the control system in government organizations are: • Performance measurement

Income is the difference between revenues and expenses. Expenses can be measured accurately in government organizations as well as private organizations. However, the revenue of government organizations is not just a measure of its monetary output. Therefore, governments have developed nonmonetary indicators for performance measurement. These measures can be classified in various ways. On the basis of the purpose of measurement, they are classified as (1) results measures, (2) process measures, and (3) social indicators. A results measure, also known as ‘outcome measure,’ measures the output that is supposedly related to the organization’s objectives. Some examples are, the number of students graduating from high school, the number of miles of road completed, the number of timely arrivals of planes at airports, etc. However, these do not represent an exact measure of output. For example, the number of graduates does not provide any information about the quality of education the students have received. A process measure relates to an activity carried on by the organization, for example, the number of livestock that are inspected in a week, the number of
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purchase orders issued in a day, the amount of data fed into a computer in an hour, etc. Process measures are used to measure current, short-run performance. As there is a close causal relationship between inputs (i.e., costs) and the process measure, the latter are easier to interpret than results measures. Process measures what was done, and not whether what was done helped the organization achieve its objectives. Thus, process measures relate to efficiency, not to effectiveness. In contrast to results measures, which are ‘ends-oriented,’ process measures are ‘means-oriented.’ A social indicator is a broad measure of output, which reflects the overall achievement of the organization. As social indicators are affected by external forces, they are at best only a rough indication of the organization's accomplishments of the organization. For example, although life expectancy indicates the effectiveness of a country’s healthcare system, it is also affected by the standard of living and the dietary and smoking habits of people, and other external causes. Social indicators are useful in long-range analyses of strategic problems. The use of social indicators is limited in day-to-day management, since they are very nebulous, difficult to obtain on a current basis, little affected by current efforts, and greatly affected by external factors.

General Characteristics of Commercial Banks
Commercial banks receive cash deposits from people and pay them interest on the deposited amount. They also lend money in the form of loans and charge a rate of interest on these loans. The difference between the interest paid on deposits and the interest obtained on loans constitutes the bank’s revenue. In most countries there is a central bank that regulates the money lending operations of commercial banks. For example, in India, the Reserve Bank of India (RBI) is the regulatory body. It controls the money-lending operations through cash reserve ratio. Similarly in the US, the Federal Bank is the regulatory body for the commercial banks.

Regulatory Capital

New Products
Apart from accepting money in the form of deposit and giving for loans, banks generate income through other financial products and services. Some of the services which earn them substantial revenue are banks get substantial
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Financial service companies are involved in the business of managing money. They may act as intermediaries-they may take money from depositors and lend it to individuals or companies, risk shifters (commercial banks)-they may earn money in the form of premiums and invest it accept the risk such as damages to property or death (insurance companies) and traders i.e. buying and selling securities (securities firms).

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revenues are credit card fees, accounting services for companies, payroll services, foreign exchange services and so on. The service fees charged by banks help them in increasing their revenues. Banks are exposed to three types of risks: • • • Credit risk, i.e., the risk of loaned money not being repaid Interest rate risk, i.e., the fluctuations in interest rate that is spread between rates paid on deposits and rates earned on loans. Transaction risk, i.e., the risk of theft, embezzlement and numerical errors in the processing of transactions. This risk can be greatly minimized by an effective internal audit and control system.

Management Control Implications
Commercial banks establish a number of branches that function as individual profit centers. These branches need to be controlled. Some of the important control issues are: • • • • • Interest rates Loan losses Transfer pricing Expenses Joint revenues

Interest rates

One of the most important aspects of banking which needs to be controlled is the interest rate exposure. Interest rate exposure is the difference between interest-sensitive assets and interest-sensitive liabilities of the bank. Interestsensitive assets of a bank are the loans on which the bank earns interest, and interest-sensitive liabilities are the deposits on which the bank pays interests. Traditionally, interest rate exposure was managed by buying or selling securities, or by increasing or decreasing the amount of loans. But with the increase in new and complex financial transaction like futures, options, floors, swaps etc., it has become difficult to exercise greater control over interest rates. The control system is responsible for communicating the prevalent rate of interest to the employees responsible for investment decisions. Control system should also see to it that managers adhere to the prevalent interest rates. Loan losses In several cases, banks suffer huge losses because customers do not pay back the loans. The reasons for their not paying back the loans could be numerous and varied. Also this shows the banks incompetence or ethical management. The internal auditors, bank examiners and external auditors should constantly maintain a vigil on the banks loan portfolio. Transfer pricing Banks set up a number of branches for the convenience of their customers.
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The activities of these branches are coordinated and controlled by the headquarters. The headquarters play a vital role in solving problems related to transfer pricing of money. Over a period of time, the branches of the bank may become loan-heavy that is their loans may exceed their deposits while some may become deposit-heavy. The headquarters try to maintain a balance between deposits and loans through intra-branch transfer of money. Branches that are deposit-heavy extend financial help to branches that are loan-heavy and, in the process, charge a transfer price for the amount of money being transferred. The profitability of a bank cannot be assessed unless transfer price is determined fairly. If the transfer price is low then the profitability of loan heavy branches will be overstated, and if the transfer price is too high, then the profitability of deposit-heavy branches will be overstated. Expenses Banks face several problems in controlling their expenses. Unlike manufacturing organizations, most of the expenses of a bank pertain to the personnel. Back-office expenses of a bank can be budgeted and controlled but allocating common costs to all activities is difficult. A bank’s customers carry out transactions in different branches of the bank, depending on their convenience. Employees in one branch are often reluctant to provide service to the customers of another branch and feel unrewarded when they have to do so. They feel that they do not gain anything by providing service to customers of another branch. In this situation it is the responsibility of the top management of the bank to convey to the employees of all the branches that it is necessary for them to strengthen customer relationships through excellent customer service in order to achieve long-term success.

Basle Committee Principles on Banking
In 1975, the Basle Committee on Banking Supervision, a committee of banking supervisory authorities, was set up by the Central-Bank governors from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Sweden, Switzerland, United Kingdom and the United States. The Basle Committee laid down certain principles for better control and governance in banks. These principles pertain to supervision, policies and procedures, measuring and monitoring systems, internal controls and information for supervisory authorities. The role of the board and senior management Principle 1 In order to carry out their responsibilities, the board of directors of a bank should approve strategies and policies with respect to interest rate risk management and ensure that the senior management takes the necessary steps to minimize these risks. The board of directors should be kept informed about interest rate risk exposure of the bank, for the above said purpose.

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Principle 2 The senior management must ensure that the structure of the bank's business and the level of interest rate risk it assumes are effectively managed, that appropriate policies and procedures are established to control and limit these risks, and that resources are available for evaluating and controlling interest rate risk. Principle 3 Banks should clearly define the individuals and/or committees responsible for managing interest rate risk and ensure adequate distinction of duties in key elements of the risk management process to avoid potential conflicts of interest. Functions such as risk measurement, monitoring and control with clearly defined duties that are sufficiently independent from position-taking functions of the bank and which report risk exposures directly to the senior management and the board of directors are quiet essential. Larger or more complex banks should have a designated independent unit responsible for the design and administration of functions like interest rate risk measurement, monitoring and control. Principle 4 It is essential that banks’ interest rate risk policies and procedures be clearly defined and that their nature and complexity of their activities remains consistent. These policies should be applied on a consolidated basis and, as appropriate, at the level of individual affiliates, especially when recognizing legal distinctions and possible obstacles to cash movements among affiliates. Principle 5 It is important that banks identify risks accompanying new products and activities and ensure these are subject to adequate procedures and controls before being introduced or undertaken. Major hedging or risk management initiatives should be approved in advance by the Board or by the committee set up for this purpose.

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Measurement and monitoring system Principle 6 It is essential that banks have interest rate risk measurement systems that capture all material sources of interest rate risk and that assess the effect of interest rate changes in ways that are consistent with the scope of their activities. The assumptions that the system is based on should be clearly understood by risk managers and the bank's management. Principle 7 Banks must determine and enforce operating limits and other practices that restrict their exposures within limits, so that these confirm to their internal policies. Principle 8 Banks should analyze their vulnerability to loss under stressful market conditions, including the breakdown of key assumptions, and ponder the
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results when establishing and reviewing their policies and determining limits for interest rate risks. Principle 9 Banks must have adequate information systems for measuring, monitoring, controlling and reporting interest rate exposures. Reports must be provided on a timely basis to the board of directors, the senior management and, when required to individual business line managers. Internal controls Principle 10 Banks must have an adequate system of internal controls over their interest rate risk management process. A fundamental component of the internal control system involves regular independent reviews and evaluations of the effectiveness of the system and, when required ensuring that the internal control system has been appropriately revised. The results of such reviews should be passed on to the concerned supervisory authorities.

Insurance companies are of two types: life and casualty.
A life insurance company collects premiums from policyholders, invests these premiums, and pays a specified amount to the beneficiary on the death of the policyholder. While term insurance offers a person insurance coverage for a limited number of years in the policy holders life; whole life insurance provides coverage for the insured person until his death. Usually, whole life insurance policies include an investment feature, that is, a part of the premium is devoted to building up the policy’s cash value. Cash is paid regularly over a specified period in the annuity version of such a policy. A casualty company collects premiums, invests them, and makes payments to policyholders for specified losses -- losses to property caused by fire, theft, accidents, or other causes, or losses to individuals caused by malpractice, negligence, illness, accidents, and so on. Casualty policies usually provide short- term coverage not exceeding three years. While some policies pay for claims made during this period, others pay for losses incurred during the period, even though the claims are made later. Usually, insurance policies are sold by agents, some of whom are independent, and work for several companies while some others are employed only by a single company. The income of both the types of agents is a specified
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The supervisory authorities should obtain from banks sufficient and timely information for evaluating the levels of interest rate risk. This information should include the range of maturities and currencies in each bank's portfolio, including off-balance sheet items, and other relevant factors such as the distinction between trading and non-trading activities.

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percentage of premium earned from the policies they sell. Through branch offices, insurance companies exercise some control over the agents' activities. Management control implications A major problem in the management control system of insurance companies is that profits from current policy sales cannot be determined until the next few years. This is especially true in case of life insurance companies. Though premiums are determined on the basis of the best estimate of the inflows and outflows associated with the policy, they may turn out to have been wide off the mark. While profitability cannot be ascertained until the final payment has been made, it may not be possible for the management to wait that long in order to make control decisions, as it would require information immediately. Insurance managers pay considerable attention to the controlling of expenditure unlike investment bankers. A typical insurance company offers dozens of products and the price (i.e., the policy premium) of a given product varies in many respects for different customers. For example, the age of the insured person and, hence, his or her life expectancy, health, smoking habits, and, in some cases, gender, are taken into account to determine the premium. A tentative premium is determined by actuaries, and the final premium is a reflection of feedback from the marketing people about the attractiveness of the policy and their respective premiums offered by the competitors. Because of the importance of determining the premium, the performance of each actuary and the accuracy of and promptness in collecting huge data to furnish current information to the actuaries, is closely observed by the senior management. Is the calculated premium out of line with those of competitors, and if so, why? Is the actuary making use of the updated information? Is the calculation overly conservative or overly liberal? By answering these questions the senior management can analyze whether the actuary is furnishing current information into its data.

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Sales performance There is a wide variation in the actual profitability of various types of insurance policies, partly because of adjustments made in the actuarial calculation for fixing the premium, and partly because subsequent developments made the assumptions included in the actuarial calculation unrealistic. Although management would like the sales organization to concentrate on products that are actually the most profitable, it is difficult to calculate the current profitability of various policies, and to communicate this information to the sales organization. Therefore, there is a tendency to focus on the sales volume, rather than on profitability. Therefore the agent’s commissions are hence based on the first-year or early year premiums, or on the face amount of policies written. Such appraisal methods are used in appraising the performance of branches. Computer programs are being increasingly used to help agents compute the actual profitability of various types of policies.

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Expense control As is done in industrial companies, expenses are controlled through programs and budgets in insurance industries. Productivity measures are used to control clerical and other repetitive operations. The activities of claims adjustors are carefully monitored, although judgments about their performance are somewhat subjective. Control of investing As in other financial services organizations, managing the investment function is important in insurance companies. Traditionally, insurance companies offered conservative investment policies, partly due to the influence of regulatory agencies. In the recent years, insurance companies have also made inroads into direct placement of loans, and investments in real estate and other commercial ventures. This shift involves an increase in risk, and requires a different approach to investment activities the control system of insurance companies is similar to that of other financial services organizations.

Many traditional investment bankers expanded their services which now included all forms of securities underwriting, trading, and investment counseling. Many of them set up branches to offer services to individual investors, including relatively small investors. Firms that specialized in providing expert advice about investment were also set up. The 1970s saw a proliferation of all types of mutual funds and an increasing fraction of securities issues were absorbed by pension funds. The result of all these developments was increased competition among securities firms and reduction in their profit margins. In course of time, financing became more complicated. A variety of issues with different risk / reward characteristics were invented. These were an addition to the already existing issues of long-term debt, preferred stock, and common stock. Foreign investors became an important source of funds. The execution of complicated decision rules for buying and selling huge quantities of securities in a matter of minutes (in some cases, seconds) was made possible through computer programs.

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Firms that deal with shares or securities are called securities firms and include investment bankers, securities traders, securities brokers and dealers, fund managers (investment, mutual, and pension funds), and investment advisors. Best known examples of investment bankers are J.P.Morgan, Drexel and Company, and Kuhn Loeb and Company. The management of the investment portfolio of individuals and companies was done by bank trust departments of the banks. The attitude of bank trust departments towards fiduciary responsibility resulted in an overemphasis on “safe” investments. This reduced the role of bank trust departments thus reducing their returns. Between 1975 and 1985, commercial banks lost one third of their business.

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Management Control Implications
The characteristics of securities firms are different from those of other financial service organizations. These include: 1) The importance of customer relationships 2) Stars and team-work 3) The need of rapid information flow 4) Focus on short-term performance Customer relationships The products of securities firms are intangible, and it is difficult to measure their quality. The skills of the firm’s professionals contribute to the quality of its products in a big way. The quality of these products is difficult to measure as compared to the tangible goods. Earlier, firms could count upon, at least, a group of customers who stayed with the firm for a considerable period of time, but current trends show that customers are now much more aware and switch to another firm when they feel that the latter offers the products of the same quality at a better price. Customers’ opinions about the employees with whom they interact directly primarily determine their attitude towards the firm. Therefore, the management tries to find out what customers’ opinions are, and how well (and also how often) an employee interacts with a customer, especially with a potential customer. Most firms, therefore, require their employees to fill out call reports for every customer contact. These, at least, serve the purpose of measuring the quantity of an employee’s efforts. Stars and teamwork Decisions about buying or selling securities, or recommendations for corporate financing involving huge amounts of money, are made by a few senior employees in securities firms. These senior professional are called 'stars' and constitute a firm’s most valuable assets. Because of the dominance of stars, there are relatively fewer levels in the organizational structure of securities firms. The relationship between superiors and subordinates are typically unstructured and informal. Loose control is, therefore, appropriate in such an environment. Firms acquiring such organizations experience difficulties in adapting their management control systems. Securities traders rely upon the advice of research people and others who have knowledge about securities or industries. These informal, though important relationships are in contrast to the relationships that exist between production departments and support departments in a manufacturing company. In a manufacturing company, production supervisors who need to get some work done by the maintenance departments, fill out a work request form, and wait for the work to be done. In a securities firm, paperwork is minimal, and responses to requests are often immediate. Need for rapid flow of information Many securities are listed in all the three stock exchanges-London, Tokyo and New York, which are located in three different time zones. Therefore, in a
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large securities firm, business takes place 24 hours a day, with responsibility passing from London to New York to Tokyo stock exchanges, as each market closes. Each trader maintains a “book” displaying the firm’s position in each security for which the trader is responsible, and in the buying and selling orders that are to be executed. Computers providing information about worldwide developments that might affect prices are also set up. Securities and commodity market prices are affected due to developments within minutes of their occurrence. Investment bankers also require current and complete information about everything that has a bearing on the deals in which they are involved at present or may be involved in the future. The information systems of these firms must, therefore, fulfill the following requirements: (a) Signal flash news separately, differentiating it from the routine news. (b) Transform mountains of data into meaningful information. Develop comparable data from raw data most importantly, provide accurate data.

Investors tend to rely on information about current performance, and performance in the recent past, of the securities firms they have hired to manage their funds. Data about the firm’s performance over 5-10 years may not be a valid basis for judging its overall performance or the performance of a specific fund that the firm manages, because the decisions of the firm’s stars, who probably were not with the firm over the past few years, heavily influence the performance of a securities firm. Japanese firms, on the other hand, tend to pay more attention to the long term performance. Although many people are convinced that the American emphasis on short-run performance has serious adverse economic consequences, no one seems to be able to change this emphasis. Measuring financial performance Measurement of the financial performance of securities firms and of managers, accounts executives, and others within the firm who trade or deal with customers tends to be primarily in terms of revenue and secondarily in terms of gross profit (the difference between revenue and direct expenses). Account executives’ commissions are based on the revenue or gross profit from the transactions with their customers. Bonuses are based on the firm’s fee for the service, and partly on the judgment of the senior management. These comprise the compensation given to investment banking professionals.

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In spite of this, securities firms, with some important exceptions, have a tendency to focus on short-run performance, and by 'short-run' they mean the current quarter. The reason for emphasis on short-term performance is that no one knows what the distant future if like, but also because it has become more of a tradition to have a short-run emphasis.

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The purchase of a growth stock today may produce satisfactory results three years later, or may never pay off at all. In other words, it may not be possible to observe the actual soundness of investment decisions made today, but only after the elapse of a considerable amount of time.

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Securities firms do not make much use of the profit center idea, nor do they do detailed cost accounting. This is partly because, unlike law or accounting firms, which charge fees according to the actual hours spent on the assignment, securities firms generally charge a fee that is a certain percentage of the total amount involved in the deal. Therefore, the need to collect costs by assignments in case of securities firms is much less when compared to other firms. The informal exchange of advice and other assistance that occurs in securities firms is another reason for the lack of detailed cost accounting in such firms. It is much more difficult to measure the cost of this assistance to the recipient then to measure the cost of a maintenance work order in a factory. A third reason for the absence of detailed cost accounting in securities firms is that expenses are relatively unimportant. The direct expense (i.e., the transaction cost) of a securities trade is small, and a deal that generates many millions of rupees in fees may cost only a few hundred thousand rupees in terms of direct cost. Nevertheless, although the relative amount may not be huge, every rupee of legitimately saved expenses increases the net income by that amount.

Control systems in service organizations are different from control systems in manufacturing organizations due to absence of inventory, and difficulty in controlling quality, and because service organizations are usually multi-unit organizations. Organizations that provide specialized professional services are called professional organizations. These organizations have some special characteristics like: small size, labor intensiveness, different goals and objectives, difficulty in measuring output and different marketing strategies. There are four factors that control MCS in professional organizations. They are: pricing, strategic planning and budgeting, control of operations, performance measurement and appraisal. Government organizations are also a type of service organizations. Some special characteristics of government organizations are: political influences, public information, and management compensation. There are two attributes that have strong implications for control system in government organizations. They are strategic planning and performance measurement. Financial service organizations are different from other service organizations. Some of the control issues that are important for banks are: Interest rates, Loan losses, Transfer pricing, Expenses, Joint revenues. The Basle committee's principles can be used as guidelines for better governance and control in banks. Control systems needed for managing insurance companies differ from those needed for managing commercial banks. Some of the control systems implications for an insurance company pertain to product pricing, sales performance, expense control and control of investments. Firms that deal in shares or securities are called securities firms and include investment bankers, securities traders, securities brokers and dealers, managers of funds and investment advisors. The characteristics of securities firms are different from those of other financial service organizations. The importance of customer relationships, stars and team-work, the need for rapid information flow, and focus on short-term performance, are some of the important characteristics of securities firms that are relevant to management control systems.

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Chapter 19

Management Control of Projects
In this chapter we will discuss:

• Differences between the Control of Projects and the Control of Ongoing Activities • Project Control

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• Project Team and Matrix Structure • Project Audit • Project Evaluation

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• Project Planning

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A project is defined as “a set of activities intended to accomplish a specified end result of sufficient importance to be of interest to management”. There are many different types of projects: constructing physical structures, developing and marketing new products, conducting audits, carrying out financial restructuring, developing and installing information systems. A project is said to have started when management develops a project plan that specifies the work to be done and allocates resources for the completion of the work. Management also determines the timeframe within which the project must be completed. The project ends when its objective has been accomplished or when the project has been canceled. The resources needed for the successful completion of projects vary from project to project. Some projects can be executed with only a few people, while others need thousands of people. Managing people, money, time and quality are of utmost importance for the successful completion of a project. Project control systems are designed by management to achieve targets within cost, time and quality constraints. When a project starts, management sets the desired level of performance for each activity, but the actual performance may not meet the desired levels of performance. Project control systems help management identify performance gaps, understand the reasons for variances between the desired and the actual performance, and take corrective action.

DIFFERENCES BETWEEN THE CONTROL OF PROJECTS AND THE CONTROL OF ONGOING ACTIVITIES
The control of projects is different from the control of ongoing activities. Some of the characteristics of projects that make the control of projects different from the control of ongoing activities are discussed below.

Single Objective

Focus on Projects
The objective of project control is to produce a satisfactory product within the timeframe at a minimum cost. The focus is mainly on the accomplishment of
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Projects usually have a single objective, whereas ongoing activities have multiple objectives. A manager of a responsibility center has to supervise work everyday and also plan for future activities. He has to take decisions that affect the current as well as future operations of the center. A project manager also takes decisions that affect future operations but in his case, all operations conclude at the end of the project. Projects, aim at leveraging the operational efficiencies of a traditional functional structure while remaining flexible enough to take on any eventuality that requires a change in structure. Hence, most projects have a matrix structure. This structure offers flexibility along with efficiency.

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In this chapter, we will examine the various concepts of project planning, and the control mechanisms that help improve the execution of projects.

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the project objective. The control of ongoing activities however, focuses on activities performed during a specific time period and on all the products on which work was done during that period.

Need for Trade-offs
In projects, there is usually a trade-off between scope, cost, and schedule. The schedule of the project can be shortened if extra costs are incurred. Though a trade-off may occur in the control of ongoing activities, but they are not typical of day-to-day activities in an organization.

Less Reliable Performance Standards
Performance standards for projects are less reliable than performance standards for ongoing activities. This is because the project design of each project is unique. Except for repetitive project activities, it is difficult to have common cost and time standards for all activities. For example, while constructing a house, data regarding the unit costs of building similar houses can provide some basis information, but changes in construction technology, materials, building codes may make this information unreliable.

Difference in Rhythm

Environmental Influence

PROJECT PLANNING
Project planning is defined as “the process of developing the basis for managing the project, including the planning objectives, procedures, organization, routines, finance and other chain of activities.” A project plan describes how all the major activities of each project management function are to be accomplished, including overall project control. The project plan evolves through successive stages of the project life cycle.
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The environment has a greater influence on projects than on ongoing activities. For example, work in a factory can go on uninterruptedly even when the weather changes because the work is done within the premises specially built for it. Construction projects, however are adversely affected by climatic conditions since most of the activities take place outdoors.

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Project plans undergo frequent changes due to unforeseen environmental problems or unexpected happenings during the course of the project. Plans for ongoing activities are much more predictable and less likely to require change.

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Project planning takes place at two levels: tactical and operational. At the tactical level, decisions are taken regarding the implementation of these activities. The development of the project plan is not a single stage exercise. It goes through a number of stages before the final draft is prepared. The project plan also describes the various control mechanisms that will be used during the execution of the project. The plan takes into consideration time, cost, quality and the different ways in which these can be overcome.

Planning Process
As the complexity of a project increases, so does the need for planning. Low complexity projects tend to be more action oriented rather than planning oriented. Complex projects require a systematic analysis of the issues involved before the execution of the project. A good project plan can rescue the project manager in the event of failure of the project. A good project plan can help the project manager save face in the event of failure of the project. Such a plan shows that the project failed because of some unexpected event, not because of poor planning. A project plan should be developed systematically which should include the following steps: • • • • • • • • • Determine the logical sequence of activities Facilitate communication Estimate the time and resources required for the project Clearly state reporting relationships Take logically sound decisions Avoid trivial activities and remain focussed on the core activity

Nature of Project Plan
The final plan of a project consists of three related parts: scope, schedule, and cost.

Project Scope
The project scope describes the activities that will be performed and the resources needed for performing those activities. It clearly defines the role of all the people involved in the project. The project scope is prepared after extensive discussion between the client and the project manager. During the course of the discussion, the project manager explains the way in which he will execute the project and the client conveys what he expects from the project manager. The project scope is a part of the project overview statement, which is also sometimes referred to as the statement of work.
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Learn from previous mistakes and constantly revise and refine project management processes and methods

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Project Schedule
A project consists of a sequence of activities which have to be completed in a specific time period. The project schedule is an estimation of the time required to complete each activity (that forms a part of the entire project). It also shows the relationship among different activities and indicates which activity must be completed before starting another activity. The sequence of the activities identified in the project schedule should be properly planned so that the entire project is not affected, when a particular activity is delayed. A project schedule can be in any of the following forms: • • Milestone Deliverables

Project Cost

Total project cost (TPC) is defined as all costs that are specific to a project and are incurred through the startup of a facility, prior to the operation of the facility. Thus, TPC includes Total Estimated Cost (TEC) and Other Project Costs (OPC). TEC + OPC = TPC. Before a project starts, an estimate of the costs that will be incurred during the project is prepared. When estimating the cost of a project, the estimator should not only be aware of the quantity and price of the material and labor required, but also the technical scope and schedule of the project. A good cost estimate should include the following: • • • Description of what is included in the total project cost (TPC). Description of the method used for developing the estimate. This should include information regarding cost databases used, actual quotes, any cost estimating relationships (CERs) used, etc. Description of direct and indirect costs. Field distributable overheads should be given in enough detail to describe what is included and what is not (e.g., site security, on-site trailers, health and safety, etc.). Details of other overhead expenditure that may be incurred at the project site should be provided.

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• Activity A milestone is defined as a “clearly identifiable point in a project or set of activities that commonly denotes completion of a key component of a project.” For example, laying the foundation is a milestone in the construction of a building, A deliverable is a synonym for products, services, processes or plans that are created during the project. Deliverables can be of two types: interim deliverables and final deliverables. Interim deliverables refer to the products or services that are produced during the project, whereas final deliverables refer to the end product that is produced as a result of the completion of the project. An activity is a specific project task that requires resources and time to complete. For example, when constructing a house, laying the floor is a distinct activity that requires material resources and time.

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• • •

Details of operating costs if the estimate is a program estimate that includes operations as well as construction activities. Details of approximate time and cost escalations that may take place during the project should be provided. Details of estimate history if the estimate is a revision of existing estimate or a change order estimate. The name, signature, and/or initials of the preparer and reviewer of the estimate.

Project Scheduling
One of the major activities described in project plan is project scheduling. Scheduling is done well in advance of the beginning of the project. It involves • • •

The allocation of resources (mainly personnel)

Critical path method The Critical Path Method (CPM) is a technique of network analysis that uses network diagrams to identify the sequence of activities that are critical for the project. A critical activity is defined as an activity which can, if delayed lead to a delay in the entire project. Let us study to understand the concept of CPM. Suppose a company is planning to acquire a new machine. This process of acquisition would begin with the approval of the budget for purchasing the machine. Once the machine has been purchased, the company needs to hire an operator to operate the machine. After hiring an operator, the machine must be installed and the operator must be trained to use the machine. Once the operator has been trained, the machine becomes operational. Each of these activities, from getting the budget approved to making the machine operational, takes some time. Table 19.1 shows the time needed for each activity. The immediate predecessors (shown in table) are those activities that must be completed just before the commencement of the next activity. For example activity B can start only when activity A has been completed. Hence activity A is the immediate predecessor to activity B. Using table 19.1 we can draw a network diagram to show how the activities should be scheduled.

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• Program Evaluation and Review Technique (PERT) Both these techniques use network diagrams for sequencing and scheduling project activities. A network diagram is a schematic representation of all the activities that are performed during the course of the project. It helps project managers schedule and sequence the activities of a project. Let us examine the concept and elements of a network diagram through a study of CPM and PERT.

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The time needed for performing each activity is calculated to arrive at the total time needed for completing the project. Two techniques are commonly used in scheduling a project:

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Table 19.1: List of Activities and Precedence Relationships Activity A B C D E F Description Getting budget approval Buying machine Recruiting operator Installation of machine Training operator Produce goods Duration (weeks) 2 5 1 1 6 1 Immediate Predecessor A A B C D, E

Source: ICFAI Center for Management Research

Figure 19.1 Network Diagram

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The circles in the diagram are called nodes. A node indicates completion of an activity. It is important to understand the difference between nodes and activities. An activity is a recognizable part of a project that requires time and resources for accomplishing one or many project tasks. A node is a point in the project that indicates completion of an activity. It requires neither time nor resources. Determining critical path A Path is defined as a set of continuous series of activities through the network from the initial node to the final node. In figure 19.1, the first activity is A and the last activity is F. The start of the project is indicated by node 1 and the end by node 6. Hence the critical path would be the longest path through the network from node 1 to node 6. There are two possible paths for

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traversing the network to reach node 6. The first path is A-C-E-F and the second is A-B-D-F. The total duration of traversing path A-C-E-F is 10 weeks, whereas the total duration of traversing path A-B-D-F is 9 weeks. Path A-C-EF is the critical path because the total duration of traversing this path is more than that of traversing path A-B-D-F. The sum of the duration of this path (10 weeks) also indicates the minimum time needed for completing the project. Program evaluation and review technique (PERT) One of the disadvantages of CPM analysis is that it cannot be used when the duration of activities cannot be predicted correctly. It is often difficult to predict exactly the time required to complete a particular activity of a project. The activities often take more time than originally anticipated. As CPM analysis requires that exact time needed to complete an activity, CPM analysis cannot be used when one is not sure of the exact time needed to complete an activity. To overcome this problem, PERT was developed. PERT uses three time estimates for the likely completion of an activity rather than one estimate (as used in CPM). The three time estimates are: Optimistic time This refers to the shortest possible time in which an activity can be completed. It is often referred to as the ideal time within which an activity should be completed. It is designated as 'a'. Most likely time This refers to the time that the activity would take if it were frequently repeated under exactly the same conditions. It is designated as 'm'. Pessimistic time This is the longest possible time that an activity can take for completion. It is the worst possible time estimate. It is designated as ‘b’. Once the three time estimates have been obtained, one can combine them to a + 4m + b = ei 6 arrive at the expected completion time using the following formula: t where tei = expected time of the ith activity, a = optimistic time m= most likely, or modal time b = pessimistic time The standard deviation I, of the completion time of an activity is calculated b−a σ = i 6 as follows:

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2 2 =  b−a  σi    6  In order to understand PERT better, we will draw a network diagram for a project and calculate the expected time for every activity. Example 19.2 Suppose the owner of a fast food company is planning to install a computerized accounting and inventory control system. He identified four companies that could install the system for the fast food company. One of the companies sent the following data regarding the project (refer table 19.2) On the basis of the data provided by the company, let us construct a network diagram, determine the critical path, and calculate the expected project time and variance. With the help of the data provided in Table 19.2 and the values given in 19.3 (calculated on the basis of the PERT formula discussed earlier), we can draw the network diagram (figure 19.2)

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Table 19.2

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Select the computer Design the system Design system monitoring

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Table 19.3 Activity variance Time a m A B C D E F G H I 1-2 2-3 2-4 4 5 4 6 7 8 b 8 15 12 Expected time
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3-6 15 20 25 3-5 10 18 26 4-6 5-7 6-7 7-8 8 4 1 6 9 8 2 7 16 12 3 8

Figure 19.2 Network Diagram Related to the Computer Project
E 10,18,26 5 3 G (18) 4,8,12 D (8) (20) 15,20,25 H 1,2,3 7 6 (2) F

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PROJECT CONTROL
After the project has been planned, it must be executed. The project plan is implemented during the execution stage. During this stage, the project manager's main concern is the control of performance in terms of time and cost. The project manager uses a number of project control tools to identify deviations from the actual plan and bring them in line with the actual plan.

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Objectives of Project Control
There are three main objectives of project control: • • To regulate a project by altering the way activities or tasks are performed To protect and guard the assets of the company

• To facilitate decision making. In most projects, the emphasis is mainly on regulating and conserving resources, financial or otherwise. The project managers are often seen as conservationists who have to guard the physical assets of an organization, its human and financial resources. For conserving these resources, project managers devise special controls. Controls used by project managers to conserve assets are discussed below: Physical assets control This refers to the process of controlling the physical assets of a project. The process also involves maintenance of assets. Project managers who control the physical assets of projects have to prepare a maintenance plan to ensure that there is no work stoppage due to breakdown of machinery used in the project. Inventory control also falls within the purview of physical asset control. Inventory control refers to the process of receiving, storing, inspecting and recording the materials used or generated during the execution of the project. Human resource control is concerned with making the right kind of human capital available for project execution. It also involves the training and development of people involved in the project. Human resource control is far more difficult than physical asset control. Physical asset control can be established through an audit, but it is difficult to perform a human resource audit. Financial control is a combination of regulatory and conservatory control. The regulatory control of financial resources involves the regulation of capital flows for obtaining better return on investment. Conservatory control mainly deals with capital investment decisions. Current asset control and project budgeting are also part of financial control. The financial controls used for an ongoing activity differ slightly from those used for a project because, unlike ongoing activities, projects are accountable to an outsider-usually an external client.

Control as a Function of Management
Projects are always controlled through people. Project managers exert control over the project team and other people who are associated with different functions of the project. The purpose of control is to ensure that the project is executed within the planned schedule, budget and specifications. So, control is a necessary function of any project. Project managers have to often motivate employees who have been discouraged by managerial control. They have to set controls that encourage
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behavior/results that are desirable. The purpose of control is to motivate individuals to behave in the required manner. Though control systems do not always elicit the desired behavior from employees, individual reactions to the various types of control affect the levels of motivation. The possible responses of employees towards different control systems are:
(i) (ii) Active and positive participation and goal seeking.

Passive participation in order to avoid loss.

(iii) Active but negative participation and resistance.

Control processes and resultant behavior

Cybernetic controls Go/No-go controls Post controls


Cybernetic controls, also known as steering controls, are used to monitor and control tasks on a continuous basis. The main controlling work is done by a sensor that measures one or more aspects of the output and transmits the measurements to a comparator, which compares the measurements with the set standards. After comparing and measuring the variations with the standards, the output is sent to a decision maker to decide on the action to be taken. If the variation is large, the decision maker sends the output to an effecter who makes the necessary changes in the process or the input to control the variation. Cybernetic control systems can be divided into three types, depending on the standards that have been set: A first order control system is a goal seeking device. It is a highly rigid system that does not allow for any alteration in the set standards. In a second order control system, the set standards can be altered according to some predetermined set of rules. In a third order control system, standards can be changed from time to time.
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The concept of cybernetic controls has been discussed in chapter 2. Here we will discuss how cybernetic controls are used in projects.

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Controlling a project is a complex job. Even before the project starts, certain decisions must be taken: Who will control the project? What will be controlled? How will performance be measured? What is the extent of acceptable deviation? Three types of control processes are used to control a project:

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An individual’s reaction to different controls depends on several factors such as the control mechanism used, the nature of the goal being sought, the individual’s self image, the value of the goal, the individual's ability to achieve the goal, and tolerance for being controlled. Generalizing the human response to various controls is difficult. However, some controls and the resultant behavior from the use of those controls can be described. These are discussed below.

Principles of Management Control Systems

This system does not have any pre-programmed instructions and can act independently. Go/No-go controls Cost and time overruns are common in projects. Go/No-go controls are used to ensure that the project is completed within time and budget. These control systems are flexible and are used in most projects. Go/No-go controls are used at periodic and regular intervals, but they can also be exercised at the discretion of the controller. When these controls are used periodically at preset intervals, the intervals are determined on the basis of a clock, calendar, or the operating cycle of machines. Post controls Post controls or post-performance controls (or reviews) are exercised after the project has been completed to see whether the project objectives have been met in terms of cost, quality and time. While cybernetic and Go/No-go controls help a firm accomplish the goals of a current project, post controls help a firm to enhance the possibility of meeting future project goals, on the basis of lessons learned from past projects.

REPORTING FOR CONTROL

Information provided by a reporting system should be complete, timely and accurate. It should clearly differentiate between the planned figures and the actual figures in terms of cost and time. Reports should be easy to understand and should enable senior management to take critical decisions. Cost and time variances should be reported clearly along with the reasons for those variances. The reports should be such that they help the reporter foresee problems that could arise in future. As every project is unique, the reporting system for different projects will vary.

Types of Project Reports
Project status reports are of five types: • • • •
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Current period reports Exception reports Cumulative reports Variance reports

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Stoplight reports

Current period reports Current period reports give details of activities that are in progress or have been recently completed. They focus on the planned and actual completion dates of tasks. They also provide explanations for variances between the planned and actual dates of completion of a project. Exception reports Exception reports contain details of time and cost variances. They are mainly prepared for executive and senior managers. These reports are prepared in such a way that a cursory glance through them provides a lot of information to the senior executives. Most of the details are summarized and presented in the form of tables. Cumulative reports Cumulative reports provide details of all the activities of a project, from its inception to its current status. They indicate the trends in the projects progress. These reports are lengthy and highly informative in nature. Variance reports Variance reports provide details of differences between the planned output and the actual output. It is present in a tabular form and consists of three columns. The column headings are planned output, delivered output and variance. Variance reports can also be presented in a graphical format. In the graphical format, the variance is not reported; only the planned and actual output are reported in the form of two curves or bar diagrams. A consistent format is followed in the report to make it easy to use across all the levels of management. Stoplight reports are different from all other reports. Colors are used in the report to indicate the progress of the project. A green colored sticker is pasted on the top right hand corner of the project report, to indicate that the project is progressing well. A yellow sticker is placed on the top right hand corner of the project, to indicate that though there have been minor problems, plans are in place to tackle them. An additional sheet attached to the report, describes the problems in a detailed manner along with the measures that have to be taken to correct these problems and gives an estimate of the time needed to complete this rectification. A red sticker is placed on the top right hand corner of the report to indicate that the project is not going smoothly and that it has run into problems. It also indicates that no corrective action has been taken to correct the problem.

PROJECT TEAM AND MATRIX STRUCTURE
A project team is assembled for a specific project under the direction of a project manager. The team is temporary and is dissolved once the project is completed.
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The project manager exercises direct and autonomous control over the project team and is responsible for the coordination and monitoring of the activities.

Matrix Structure
In the matrix structure, the personnel and other resources that a project manager requires are obtained from a pool controlled and monitored by a functional manager. Personnel required to perform specific functions in a particular project are engaged for the necessary period, and are then returned to the control of the functional manager for reassignment. Refer Figure 19.3. For example an engineer assigned to a project is responsible to the functional manager for completing the task as scheduled, and to the project manager for providing an acceptable design. The two managers report to a matrix executive. The project manager in the matrix works with the functional manager to establish the resource requirements and to develop a timetable for their utilization in the project. The functional manager is responsible for the optimum utilization of resources. The formal role of the matrix executive (in Figure 19.3 Matrix Structure
PRESIDENT

Manager Project B

Manager Project E

Adapted from Kathryn Bartol and David Martin, “Management”, (McGraw Hill Publication, second edition) 272

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this case, the general manager) is to coordinate the activities of the project manager and the functional managers. The general manager is literally on top of or outside the basic matrix structure, and therefore has a clear perspective of all activities and personnel within the matrix. The general manager leads a dual command structure- the functional and the project hierarchies- which must be balanced through a careful blend of autocratic and cooperative managerial styles. A cooperative style is required to resolve disputes regarding resource allocations. An autocratic style is essential for the establishment, enforcement, and revision of priorities between the functional and project entities within the matrix. This role involves three major managerial concerns: Balancing power The balance of power involves allocating both project and functional budgets, orchestrating personnel assignments, applying schedule pressures on others etc. This is accomplished by establishing strategy, policy, and control systems to ensure that decisions are made to benefit the overall organization rather than the individual functional department or project. Performance standards are set by top management. They must be established and enforced by the general manager, since his position in the matrix enables him to control the performance of both project managers and functional managers. Advantages of the matrix organization

PROJECT AUDITS
Project auditing is defined as “a planned and documented activity performed by qualified personnel to determine by investigation, examination or evaluation of objective evidence, the adequacy and compliance with established procedures or applicable documents, and effectiveness of implementation.” When a project is under progress, a quality audit should be conducted to prevent defects from creeping into the system. The project auditor investigates the underlying records, the working of project management, the project methodology and techniques, and the organization of
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Disadvantages of the matrix organization • Potential for conflict between functional and project personnel. Greater administrative overheads

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controls. It is advisable to conduct an audit while the project is in progress. This way minor discrepancies in the project can be identified before they become major problems. After conducting the audit, an audit report is submitted to the senior managers. This report contains information pertaining to: • • • • • Current status of the project Current status of crucial activities of the project Significant changes in the cost or schedule of the project Project risk and uncertainties Limitations of the project report

Levels of Audit
Time and cost are two major constraints when conducting an audit. Hence, the level or depth of an audit differs from project to project. An audit can be conducted at one of the following levels: • • Detailed audit Technical audit

PROJECT EVALUATION
The process of evaluating the performance and progress of a project in comparison to what was planned is called project evaluation. The primary objective of project evaluation is to measure the success of the project. Such evaluations also help project managers conduct a SWOT analysis of the project. Lessons learnt from the current project help the organization manage its future projects better. The evaluation of project involves 1) An evaluation of performance in executing the project. 2) An evaluation of the results obtained from the project. The former is carried out shortly after the project is completed, and the latter once the results start coming.

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A technical audit is usually conducted when the project manager is unable to identify the technical problems in a project either due to lack of knowledge or complexity of the problem. In technology intensive projects, outside consultants are usually preferred over internal auditors.

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Evaluation of Performance
The evaluation of performance when executing the project comprises the evaluation of project management, and the evaluation of the process of managing the project. The purpose of project evaluation is to help project managers take decisions pertaining to rewards, promotion, reassignment etc. The purpose of the latter is to discover better ways of managing future projects. While evaluating the performance of a project, two more aspects need to be considered: budget overruns and hindsight. Budget overrun When actual costs exceed budgeted costs, a 'budget overrun' is said to have occurred. If higher costs are incurred because of changes in the scope of the project or uncontrollable factors, the costs are said to be underestimated. A common error in analyzing costs is assuming that the budget represents what the costs should have been. Actually, the budget simply estimates what the cost would be on the bases of information that was available at the time it was prepared. Hindsight refers to the process of looking back to assess at how well the project was managed. Hindsight, helps the organization discover instances when the ‘right decision’ was not made while carrying out the project. However, the decisions made at that time may have been entirely reasonable and the manager may not have had all the information required to take the "right" decision at that time. The manager may have taken the decision on the basis of personality considerations, tradeoffs or other factors not recorded in written reports. Hindsight also helps the organization identify other instances of poor management: diversion of funds or other assets for the personal use of the project manager and embezzlement of funds due to project manager's inability to exercise control. The evaluation of the process may indicate that reviews conducted during the project were inadequate, or that timely action was not taken on the basis of the reviews. The review may express that the project should have been redirected. This suggests that thorough analysis of the progress of the project should have been done more frequently. Consequently, requirements for such reviews of future projects should be modified. The evaluation may lead to changes in rules and procedures. It may identify some rules that impeded efficient management of the project. Conversely, it may uncover inadequate controls.

Evaluation of Results
Until one gets the results and benefits of a project, one cannot clearly evaluate its success. The evaluation of results depends on the type of projects being evaluated. This evaluation may take many years to complete. For example, the benefits of the introduction of a new product line can be measured easily, because the revenues and expenses associated with that product line are known. But the benefits of installing a labor-saving machine cannot be easily identified if the resulting costs are associated with a variety of product costs and cannot be separately traced to the new machine. In this case, separate
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counts must be maintained to evaluate the benefits of the labor saving machines. In many cases, the evaluation becomes complicated by the fact that the expected benefits were not stated in the objectives. So a cost-benefit analysis cannot be carried out and the evaluation is based on the judgment of person's conducting the evaluation. R&D projects and projects whose objective is to improve safety or eliminate environmental deficiencies cannot be measured in quantitative terms. Normally, results are anticipated on the basis of certain assumptions. They are documented during the process of approving the project. The evaluation is a comparison of actual results with these anticipated results.

Management control of projects is different from control of ongoing activities. This is because the nature of projects is different from the nature of ongoing activities. The plan of a project consists of three important parts: scope, schedule, and cost. For scheduling a project, two techniques that are commonly used: Critical Path Method (CPM), and Program Evaluation and Review Technique (PERT). Once the project is planned, it has to be executed. During the execution stage, the project manager is concerned about controlling performance in terms of time and cost. The controls exercised by a project manager in a conservationist role are physical assets control, human resource control and financial control. Controlling a project is a complex job. Three types of control processes that are used to control a project: Cybernetic controls, Go/No-go controls and Post controls. Project reports are essential for controlling projects. They prepared on a continuous basis until the project ends. There are five types of project reports: current period reports, exception reports, cumulative reports, variance reports and stoplight reports. A project team structure consists of an autonomous project team, independent of the rest of the organization. A project audit is conducted to identify problems in the project and to prevent minor discrepancies from becoming major problems. There are three levels of audit: general audit, detailed audit and technical audit. The process of evaluating the performance and progress of a project in comparison to what was planned is called project evaluation. The evaluation of a project involves the evaluation of performance and the evaluation of results.

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Chapter 21

Management Control and Ethical Issues
In this chapter we will discuss:

• Identifying Control Related Ethical Issues • Designing Control Systems to Regulate Ethical Conduct • The Ethical Principle of Fairness in the Design of Control Systems

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• Control System Supporting the Ethics Program

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The word ‘ethics’ is derived from the Greek word ‘ethicus,’ which means character or manners. Hence, ethics is the science of morality and recognized rules of conduct. Business ethics is the application of ethical rules and principles to a business environment. Over the years, various economists and management thinkers have given several explanations of the relationship between business and ethics. Milton Friedman has proposed the ‘separatist’ view. According to this view, there is no room for morality and ethics in business. The main aim of business should be to make profits and maximize its shareholders’ wealth. According to Milton, social and moral issues should be tackled by government not by the business organizations. Unitarian view opposes the separatist view. It states that, if a business wants to sustain itself for a long term, then morality and ethics cannot be separated from it. Talcott Parsons proposed a view that integrates business and ethics. He was of the opinion that ethics and business should be combined into a new area, which he referred as ‘Business Ethics.’ Talcott’s idea of business and ethics has been largely accepted by the business community. Nevertheless, it is necessary that managers understand the ethical aspects of business. The focus of this chapter, is to understand ethical issues in business organizations and their implications for control systems. While designing a control system, the manager should have a basic understanding of various relevant ethical issues. Ethics is an important tool for defining how employers should behave and an important component of personnel control. If the ethical and moral standards of employees are high, then they can augment action controls. For example, if employees in an organization are not fraudulent, then the company can do with mild financial controls.

Creating Budgetary Slack
Budgetary slack can be described as the difference between managers’ proposed budgetary expectations and their previously established expectations. This difference appears sufficient to them to achieve their budgetary objectives. Let us take an example. An HR manager ‘feels’ that the training budget should be Rs.10 million, but he is not sure whether this amount will be sufficient. Hence, while fixing the budget he will quote the training budget at Rs.12 million, thus having a cushion of 2 million. This excess amount is referred as budgetary slack.
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• • • •

Creating budgetary slack Responding to flawed control indicators Managing earnings Using excessively tight control measures

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The question that may arise here is this: Is creating a budgetary slack an ethical practice? Budgetary slack provides protection against economic downturn and spiraling costs. According to Cyert and March (1963), budgetary slack provides with the desired freedom to operate and allows smoothing of income. Due to this, managers evaluate budgetary slack as being positive or ethical. Some managers hold a different view on this issue. They feel that creating budgetary slack is unethical, especially in organizations that give performance-linked bonuses. Here the creation of a budgetary slack may lead to show dysfunctional behavior and practice dishonesty, (managers who try to favor their own interests over those of the organization). Budgetary slack may lead to loss of profitable opportunities and an increase in the overall expenses of the organization. Therefore some managers evaluate the creation of budgetary slack as negative or non-ethical.

Responding to Flawed Control Indicators
Employee performance is measured on the basis of the targets they achieve. Organizations need to provide employees with clear guidelines regarding the processes and methods that can be used for achieving the targets. These guidelines act as control measures for monitoring and controlling the behavior and activities of employees. In many organizations, these guidelines are ambiguous, defective or even missing. Defective guidelines encourage employees to act or behave in a way which may prove to be disastrous for the organization. For example, organizational myopia is a flawed control indicator. It occurs when an organization sacrifices long-term stability and growth for short term profits. In this situation, employees may be forced to resort to unethical practices which would help the organization present a better financial picture of itself. Professionals like management accountants face a similar problem. They are bound by an ethical code of conduct that prevents them from adopting unethical accounting practices. But in an organizational setting, they may be forced to adopt certain unethical practices which conforms to the interests of the organization.

Managing Earnings

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Another important ethical issue that affects control systems is management of earnings. The phrase ‘earnings management’ is often associated with manipulation of financial accounts. Examples of earnings management include increasing reported profits to avoid violating debt contracts, underreporting a company’s earnings in order to negotiate a favorable price in a management buyout offer. Company executives can also manage reported earnings in order to increase their bonus compensation, obtain loans on more favorable terms, increase the company’s stock price, or report the smooth flow of annual revenues and earnings growth. Earnings management is one of the most important ethical issues accountants come across in their everyday practices. Investors and creditors depend on accountants for fair and reliable financial information. Companies that engage in earnings management may mislead the public regarding the actual profitability and/or stability of their operations. If a company inflates its profits then this may make investors pay an unduly high premium to purchase shares of the company. Most of the times, it is difficult to find out whether
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earning management actions are ethical or not, because manipulations in accounting are not easy to detect. Only after thorough analysis and auditing can one say for sure that a company has been unethical in managing its earnings. Some of the situational factors that help in understanding the unethical aspects of earning management are: • • • • The direction of manipulation, that is whether the company has increased or decreased its profits. The extent to which the accounts have been manipulated. The timing of manipulation, that is, before the annual statement was published or before the quarterly publication of statements. The method used for manipulation (decreasing reserves, increasing accruals, etc.)

DESIGNING CONTROL SYSTEMS TO REGULATE ETHICAL CONDUCT
Employees are often under tremendous pressure to achieve organizational goals. This makes them adopt unethical practices to expedite the work. A supervisor may ask his subordinate to complete a particular task within a short period of time. Though this may not be possible, he still has to complete a particular task within short period of time. In such a situation, he may be forced to make compromises on the quality of the product. In order to prevent employees from adopting such unethical practices, the organization should conduct ethics programs. The focus of such programs rest on developing a corporate code of conduct, which should be followed by all employees.

Cybernetic Control Process for Developing an Ethics Program
Organizations usually adopt a cybernetic approach to develop an ethics program. Such an approach consists of six steps: • • • The first step is to comply with all laws, ethical codes and policies of the organization. The second step is to sensitize all managers and employees as to what kind of behavior is improper. The third step is to audit the behavior of employees regarding their interaction with all stakeholders.

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Another important ethical issue relates to the use of excessively tight control measures. Advances in technology have enabled companies to use software programs for surveillance and supervision. Apart from these telecom devices and cameras are used for monitoring employees' movements and listening to their conversations. Excessive supervision reduces employees’ freedom and autonomy. Organizations should outline the purpose and need for using such tight control measures before implementing them.

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The fourth step is to report significant deviations from the desired ethical conduct. The fifth step is to investigate violations of the prescribed ethical conduct The sixth and final step is to implement regulations to correct improper behavior.

CONTROL SYSTEM SUPPORTING THE ETHICS PROGRAM
In the earlier sections, we discussed the cybernetic control process for supporting an ethics program. Here, we will discuss the control structures needed for supporting an ethics program. Figure 21.1 represents the various elements of a control system needed for an ethics program. The control system is made up of: • • • Infrastructure Rewards Coordination and integration

Management style and culture have a strong influence on the attitude of employees. A good work culture nourishes the ethical conduct of employees. In Chapter 3, we saw that there are two types of management styles: internal style and external style. Ethical conduct varies depending on the style adopted. If the management adopts an external style that emphasizes formal performance measurement and links rewards to such performance, then employees develop a tendency to adopt unethical practices. Internal management style1 relies more on informal controls. If a firm adopts an internal management style then there is a risk of employees showing indisciplined behavior. External and internal management styles are two extremes. External style is indicative of excessive control whereas internal style indicates lack of control. The management should try and avoid both these extremes in order to instill a sense of discipline in its employees.

Infrastructure
Ethics programs should be ideally looked after by the board of directors. The board should appoint an ethics administrator who should work along with the HR, legal and operations departments to implement the ethics program. The legal department consults employees from time to time to know whether any rules or regulations have been transgressed or whether any ethical policies have been overlooked. The HR department conducts various training programs and helps in implementing the ethical guidelines.

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Rewards
Rewards and punishments play a vital role in enforcing ethical behavior in employees. If an employee sticks to the ethical policies of the company he needs to be rewarded for it; but if he adopts unethical practices then he should be reprimanded. Organizations can use penalties, threat suspension or dismissal to inhibit employees from adopting unethical practices.

Coordination and Integration
Formal communication channels should be established for reporting violation of ethical norms. There should also be channels to protect employees who report such violations. Organizations can set-up ethics hotlines for employees to report violations directly to the top management.

The objective of control systems is to assist managers to achieve the goals and objectives of the organization. A control system in which all subsystems are designed to achieve these goals and objectives, is a goal-congruent subsystem. For a control system to be ethical, it requires an environment conducive to ethical conduct. This requires aligning with each stakeholder an environment that is congruent with ethical behavior, business objectives and stakeholder objectives. Thus, the concept of fairness is stressed to achieve the environment which is conducive to ethical behavior. Managerial controls that do go by the concept of fairness tend to create stress for and resentment among, the employees. Unfair controls result in loss of employees’ goodwill for the organization. One dangerous effect of unfair managerial controls is the distortion of control information. This leads to faulty decisions and misallocation of resources. The ethics administrator should maintain disciplinary records to ensure that the ethics program is perceived as ‘fair’ by the organizational participants. Unfair control systems undermine trust in organizations. Without trust, it becomes difficult to achieve the expected levels of performance. Loss of trust also results in defensive, bureaucratic and dysfunctional behavior. The concept of fairness should not be confined to the employees of the organization; it should be extended to the company’s stakeholders too. For example, a customer is a stakeholder of the company and ‘fairness’ to the customer can be maintained by truthful advertising, to help the customer to make wise decisions. Employees should be informed about the financial condition of the organization and its plans for future. Fair wages and salaries should be paid to the employees to motivate them. Compensation and reward systems (discussed in Chapter-10) should be based on the principle of fairness. Employees should be given appropriate recognition and rewards for their performance.
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Exhibit 21.1 Control Systems for Ethics Program
INFRASTRUCTURE • • • • • Corporate responsibility committee of the board Ethics administrator Human resource department Legal department Operating management MANAGEMENT STYLE AND CULTURE • Dimensions of morality, responsibility and integrity in culture and style

CONTROL PROCESS • Establish standards of conduct using both formal and informal means • Conduct training sessions to impact standards • Periodic reports on compliance

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Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey: Prentice HallInc, 1994) p 651.

SUMMARY
Ethics is the science of morality and recognized rules of conduct. While designing the control systems, a manager should have a basic understanding of various ethical issues. There are a number of ethical issues that have strong implication for control systems within an organization. Some of them are293

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Suppliers are, often, the key stakeholders in an organization. They should be kept informed about the company's future business plans. Organizations should obey local laws and regulations. They should contribute to civic and charitable causes.

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• Penalties and sanctions for violations • Positive reinforcements for outstanding ethical conduct

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creating budgetary slack, responding to flawed control indicators, managing earnings, using excessively tight control measures. In order to inculcate ethical values in their employees, organizations should conduct ethics programs. For developing an ethics program, organizations can adopt a cybernetic approach. Control structures are made up of management style and culture, infrastructure rewards, coordination and integration. For a control system to be ethical, it requires an environment conducive to the ethical conduct. Thus, the concept of fairness is stressed to achieve the environment which is conducive to ethical behavior.

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Chapter 20

Control in the Age of Empowerment
• Balancing Empowerment and Control • Control Systems and Conflict Resolution • Framework for Conflict Resolution

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In this chapter we will discuss:

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A major problem managers face today is maintaining control, efficiency, and productivity while still giving employees the freedom to be creative, innovative and flexible. In other words, managers have to balance empowerment and control. An example of a company that maintains a good balance between control and empowerment is Nordstrom2. In Nordstrom, salespeople are given freedom to tailor their services according to the requirements of the individual customer. In the process, they take decisions that are usually taken by managers. On the other hand, an example of management control failure was that of Kidder Peabody3 and Company, which lost $350 million because of the failure of its control systems. How can managers protect their companies from control failures in an environment where employees are highly empowered? One method is to revert to the bureaucratic system of management. In this system, employees are told how to do their jobs and are monitored constantly by superiors to ensure the instructions are carried out. However, in organizations which operate in a highly complex and dynamic environment, this method of managing employees is not possible except in industries where standardization is critical for efficiency and yield.

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Sears, Roebuck and Company took a $60 million charge against earnings after admitting that it recommended unnecessary repairs to customers in its automobile service business. Standard Chartered Bank was banned from trading on the Hong Kong stock market after being implicated in an improper share support scheme. Nordstrom is one of US leading fashion retailers, offering a wide variety of high quality apparel, shoes and accessories for men, women and children at stores across the country. Kidder Peabody and Company is a readymade garments manufacturer and makes the famous Arrow shirts.

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BALANCING EMPOWERMENT AND CONTROL

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To encourage entrepreneurship and enhance employee initiative, managers need to give greater responsibility and authority to employees. Managers also have to counsel, and coach employees and provide them with the resources needed to accomplish their goals. Facilitating and providing greater autonomy to employees in achieving their goals is called employee empowerment. Several successful organizations have entrusted their employees with decision making authority. However, empowering employees and giving them greater autonomy may have a negative implication for control. In many companies, including well-known names such as Sears Roebuck and Company and Standard Chartered Bank1, management control failures, following greater employee empowerment, were responsible for losses and damaged reputation. Another important aspect for consideration is the conflict that arises out of control systems. Conflict is defined as “a state of disagreement or disharmony.” Empowerment, conflict and control systems are intricately related. Often empowering employees creates a power imbalance that leads to conflicts. In order to overcome these conflicts, an organization needs to have a good control system. In this chapter, we will discuss the implications of employee empowerment and organizational conflict for control systems.

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Managers must find ways to encourage employees to be creative and to initiate process improvements, but must still retain enough control to ensure that employee creativity benefits the company. To avoid a trade-off between creativity and control, managers can use the following four types of control levers or systems (Refer table 20.1): • • • • Diagnostic control systems Belief systems Boundary systems Interactive control systems Potential To achieve To contribute To do right To create Organizational Blocks Managerial Solution Control Lever

Table 20.1: Levers of Control

Belief Systems
Belief systems are used to communicate the tenets of corporate culture to every employee of the company. Belief systems are generally broad and designed to appeal to different groups working in different departments, and to
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Diagnostic control systems use quantitative data, statistical analyses and variance analyses to scan for anything unusual that might indicate a potential problem. Diagnostic systems can be very useful for detecting problems, but they can also result in employees and managers behaving unethically to meet the pre-set goals. Employee rewards are often based on how well performance goals have been met. Diagnostic systems work well if the goals are reasonable and attainable. Diagnostic control systems relieve managers of the task of constant monitoring employees as the employees usually work diligently to meet the agreed-upon goals. However, when goals are unrealistic, empowered employees may sometimes use their creativity to manipulate the factors under their control to live up to their manager’s expectations. Such manipulations have only very short-term positive effects, and can lead to long-run disaster for the company.

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Communicate core Beliefs systems. values and mission.

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inspire and promote commitment to the organization's core values. For belief systems to be an effective lever of control, employees must be able to see key values and ethics being upheld by those in supervisory and other high positions. Senior management must be careful not to adopt a particular belief or mission simply because it is in vogue, but rather because it reflects the true nature and value system of the company as a whole. In the past, a company’s mission was easily understood by employees without any reference to the core values or formal beliefs. With businesses becoming more complex, it has become necessary to establish formal, belief systems. Formal belief systems help in understanding the core values of the organization and what constitutes acceptable behavior in the workplace.

Boundary Systems
Boundary systems are based on the principle that in an age of empowered employees, it is easier and more effective to set the rules regarding what is inappropriate rather than what is appropriate. The effect of this kind of thinking is to allow employees to create and define new solutions and methods within defined constraints. Boundary systems work on the premise that empowered employees should not be given the freedom to do whatever they want. Employees should focus their efforts on areas that are in the interest of the company, in terms of profitability, productivity and efficiency. Boundary systems are thus “minimum standards” that the employees have to maintain. Examples of these kinds of standards include forbidding employees to discuss client matters outside the office or with anyone not employed by the company, and encouraging them not to accept work on projects or with clients deemed to be undesirable. Often companies implement boundary systems only after they have suffered a major crisis due to the lack of such a system. It is important that companies be proactive in establishing boundaries. Boundary systems have an approach to control that is in direct contrast to that of diagnostic control systems or belief systems, in the sense that boundaries are stated in negative terms whereas diagnostic and belief systems are positive and inspirational.

Interactive Control Systems
Small organizations facilitate informal discussion across the table between the managers and the employees. As organizations grow, such personal contact becomes difficult. For this reason, the organization needs a control system which is interactive. For this kind of control system to work, it is critical that subordinates and supervisors maintain regular communication with each other. Companies use different tools to facilitate regular communication. One popular method of doing this is to analyze data from reports that are frequently released (for example, internally generated productions reports). Though this may seem somewhat similar to the diagnostic control system discussed earlier, there are four important characteristics which set the interactive control systems apart: 1) interactive systems focus on constantly changing data that are of a strategic nature, 2) the strategic nature of the data warrants frequent and regular attention from all levels of management, 3) the data generated is best analyzed in face-to-face meetings which include
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employees at all levels, and 4) the system itself stimulates regular discussions relating to the underlying data, assumptions and action plans.

CONTROL SYSTEMS AND CONFLICT RESOLUTION
As organizations grow, they need to decentralize their operations. Along with decentralization, they should delegate authority to the lower levels of the hierarchy. Often this does not happen. Decentralization is not always followed by delegation of authority. Instead stringent control measures are put in place to prevent irregularities. This creates an atmosphere of distrust in which employees feel alienated. They feel that it is because the top management does not have faith in them that they have imposed such control measures. A rift develops between individual objectives and corporate objectives. This rift soon expands into a conflict between individual objectives and corporate goals and objectives. This kind of conflict is highly dysfunctional for the organization and can hamper organizational growth. There are a number of control systems which open up the possibility of conflict. One of these is the planning and control system. Planning and control systems have a number of sub-systems. The sub-systems of planning and control are: • • • • • Measuring Recording Appraising Reporting Remedial action

A large number of conflicts arise during the planning stage particularly during budgeting. Budgets are prepared to evaluate performance of organizational units and employees against the preset standards. Conflicts that arise during the planning stage occur at two levels: • • At the level of the senior managers who form a small minority and who actually participate in the planning process. In interaction between the senior managers and the junior managers who form the majority and who are not involved in the planning process.

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In the first type, conflicts arise when the suggestions or views of a senior manager regarding corporate goals, objectives and strategies, are not accepted by other managers at that level. It is at the second level that conflicts are more common within organizations. Often, strategies and objectives are framed by the top management without taking junior managers into confidence. Junior managers may reject these plans and proposals because they were not involved during the planning
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process. They may reject the standards used during the planning process and question the feasibility of projects.

Conflicts in the Measuring Subsystem
Many conflicts arise due to improper and ambiguous rules in the measurement systems. They also arise due to poor allocation of overhead expenses within an organization. This problem is compounded by accounting conventions used in the measurement process. Most of these conventions, particularly those relating to depreciation and amortization of expenses, cannot be understood by all employees, and hence lead to confusion and conflict within organizations. The fairness of the measurement process is another area which can result in conflicts over a period of time. For example, whether sales should be measured on despatch or on the basis of amounts billed, is a major area of conflict.

Conflicts in the Recording Subsystem

Conflicts in the Appraisal Subsystem

Conflicts arising out of the appraisal subsystem are often violent and bitter. The appraisal subsystem is responsible for the evaluation of the performance of employees. Most of the conflicts begin in the planning subsystem in which targets and goals are set, cost standards are determined and resources are allocated. Conflicts arise again when performance is appraised against the backdrop of the targets and goals set. Employees react negatively and at times violently when their performance is rated against set standards, because they feel that the targets, goals and standards are unrealistic and unfeasible. Another problem arises when the targets, goals and standards are laid down for a decentralized unit. It is possible that when the overall performance of the organization is measured, the performance of the sub-units is not highlighted. This is seen as discriminatory. Conflicts also arise when employees doubt the objectivity and time span of appraisals. The inability of the control experts or the people who conduct appraisals to understand the circumstances or environment in which other employees work, also creates conflicts.

Conflicts in the Reporting Subsystem
Conflicts that arise in this area are of two types: • •
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Conflicts that arise due to reporting delays. Delayed reports are of little value to managers as no remedial action can be taken. Conflicts that arise when reports do not provide the kind of information

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Conflicts that arise due to problems in the recording system are rare. After the rules for measurement are set up, the recording system functions flawlessly. One major problem arises due to the recording of performance in monetary terms. Not all people within the organization feel comfortable when their performance is recorded in monetary terms. For example, production managers prefer to record their performance in terms of volume rather than in terms of money.

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required, in terms of decision made, costs incurred and revenues earned by the subunits. • Conflict may also arise due to improperly demarcated reporting levels. This leads to the control department crossing operational boundaries for the purpose of reporting.

Conflicts in the Subsystem for Remedial Action
Conflicts arising in this area pertain to the inability of the supervisory manager to understand the problems of feasibility and possible levels of achievement. This means that conflicts arise when recorded performance is at variance with expected goals.

FRAMEWORK FOR CONFLICT RESOLUTION
According to Robert Anthony4, organizations should try to achieve goal congruency while designing control systems. Achieving goal congruency will help in reducing conflicts that arise from various control subsystems. A control system can be termed as effective if it encourages managers to take actions that eventually have a positive impact on the company. One of the first steps an organization can take to minimize conflicts and to make managers proactive, is to establish accounting and control departments which are viewed as service departments. Accounting and control department executives should assist and advise the line and staff members in achieving corporate objectives. They should also collate, measure, record and report performance against assigned goals. Secondly, organizations should minimize role ambiguity by having proper delineation of levels of authority and responsibility. Organizations should encourage participative management, encourage teamwork, and break up organizational goals into specific tasks so that performance can be measured objectively. Organizations should try to involve as many people as possible in the planning process. Tasks should not be assigned arbitrarily but on the basis of interest and intellectual capability of the individual. A number of conflicts can be resolved if control departments adopt an information systems approach rather than an overseeing approach while reporting performance. This means that control systems should continuously report progress and variances from the preset standards. When reporting variances, the control department should not demand explanation for the variances; rather it should provide information and insights on the reasons for variances and should show to other departments the extent to which they have varied from predetermined goals or standards. In order to enhance the effectiveness of control systems and reduce conflicts arising in them, employees should be provided cross-functional training. Employees working in functional departments should be provided training in the operation of control systems, whereas accounting and control executives should be trained in the operational aspects of different functions. Finally, it is necessary for large companies to review the mechanisms of their control systems from time to time. They should constantly try to determine the effect of control systems

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4 Robert N. Anthony was the ‘Ross Graham Walker’ Professor of Management Control at the Harvard Business School until his retirement in 1983.

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on employee creativity and motivation. For this purpose, companies can conduct attitude surveys that measure some of the following indices: • • •

Span of control Levels in hierarchy and their appropriateness Ratio of administrative to production personnel Time span for appraisals

The objective of conducting control mechanism reviews would be to report to the top management the effect of control mechanisms on issues such as employee morale, tension, stress, grievances and employee participation.

SUMMARY
A major problem managers face today is maintaining control, efficiency, and productivity while still giving employees the freedom to be creative, innovative and flexible. When managers try to exercise excessive control, the trade-off between creativity and control comes into play. In order to avoid this trade-off, managers can use the following four types of control levers or systems: diagnostic control systems, belief systems, boundary systems, and interactive control systems. Another major issue that managers need to tackle is that of conflict arising in the sub-systems of the planning and control systems. The sub-systems of the planning and control systems that may give rise to conflict are those related to: planning, measuring, recording, appraising, reporting, and remedial action. Organizations should develop a framework for conflict resolution that tries to achieve goal congruency for reducing conflicts that arise in the various control subsystems.

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Glossary
Action controls: These are controls that work on the standard sets of procedures. Administered development program: These programs are initiated and implemented for the benefit of a target group. For example, Government initiates a program of free education in all the Universities. Administrative audit: It is a thorough examination of a project covering all the administration related aspects (other than the detailed examination of technical quality). Agency theory: It explores how contracts and incentives can be written to motivate individuals to achieve goals. It describes the major factors that should be considered in designing incentive controls. Audit evidence: Audit evidence is any kind of information used by the auditor to determine whether the financial statements being audited are in accordance with the established rules and regulations. Audit: A tool used to monitor a company’s financial performance in comparison to a set of standards, which are typically imposed by government regulators or by professional standards groups. Belief systems: Belief systems are used to communicate the tenets of corporate culture to every employee of the company.

Billed- time ratio: The ratio of hours billed to the total professional hours available in a professional organization. Bonus pool: In a short-term incentive plan, the shareholders vote on the formula to be used in arriving at the total amount of bonus that can be paid in given year, which is called bonus pool. Boundary systems: Boundary systems are based on the principle that in an age of empowered employees, it is easier and more effective to set the rules regarding what is inappropriate rather than what is appropriate. Bower’s model of investment decisions: Bower’s model suggests that ideas, proposals, and approval of projects come from the lower levels of management. The lower levels also help in the identification of gaps in the control process. Budget manual: It is a written document that contains standing instructions regarding the procedures to be followed at the time of budget preparation. Budget committee: The budget committee consists of head of various departments within the organization and the members of senior management such as CEO, financial vice president etc. The function of the committee is to review budgets, approve them, and make adjustments wherever necessary. Budget key factor: A budget key factor is a factor whose influence on the various budgets should be assessed in order to ensure that those budgets are capable of fulfillment.

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Benchmarking: It is the process of comparing products and operations against the best practices in the industry.

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Budget signals: These are the budgetary items which signal to the managers the amount required to be spent on the particular item. Budget signals may include expected amounts, ceilings and floors. Budgeting control: It is a device to find out how the activities in an organization are progressing. Business-unit strategy: The business unit strategy of a firm deals with the specific product market strategy for each business. Ceilings: Budget items that signal that the manger is expected to spend no more than the budget amount without obtaining specific approval. Examples are entertainment expense, dues and subscriptions, advertising. Closed loop control mechanism: Corrective actions are initiated automatically when a comparison of the performance measured and the performance standard shows a distinct deviation.

Critical Path Method (CPM): It is a technique in project management which helps the top management to concentrate their attention on the critical activities and their completion in time. This method considers the time-cost estimates of each activity and suggests an optimum schedule for the project. Critical path method: The Critical Path Method (CPM) is a technique of network analysis that uses network diagrams to identify the sequence of activities that are critical for the project. Cybernetic controls: These are also known as steering controls, are used to monitor and control tasks on a continuous basis. Data envelopment analysis: Technique applied for adjusting the differences that arise out of comparison of the information for each unit in multi unit organizations with system wide or regional averages. Diagnostic control systems: Diagnostic control systems use quantitative data, statistical analyses and variance analyses to scan for anything unusual that might indicate a potential problem. DSS: The acronym stands for Decision Support Systems. The term applies broadly to systems that aid decision making by providing the answers to a series of “what-if” questions. Entrapment: A special form of escalation of conflict in which the parties involved expend more of their time, energy, money or other resources than seems appropriate or justifiable according to some external standards.
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Cost-based transfer prices: The transfer prices are estimated on the basis of the costs incurred by the other business center. This is used when market prices are not available.

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Cooperative society: All the producers of the basic commodity form a society called cooperative society. The marketing and distribution activities are carried out by the society for the benefit of all the producers.

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Close-ended questionnaire: Questionnaire consisting of questions in which a list of acceptable responses is provided to the respondent.

Glossary

Expense center: Responsibility centers in which inputs or expenses and not outputs are measured in monetary terms. Management attention is focused on the control of expenses incurred by the center. External information system: It is designed to provide the latest market trends and this information is used to reduce the uncertainty. Floors: Budget items that signal that the manager should spend at least the budget amount. For example, training. Focus group: A focus group is a group of people who jointly participate in an interview that does not use a structured question-and-answer method to obtain information from these people. The interview is conducted by a trained moderator with a group of, ideally, 8-12 willingly recruited participants. The composition of the group varies according to the needs of the client, especially the “problem” under study. Formal control system: Formal control systems are written, managementinitiated mechanisms that influence the behavior of employees in achieving the organization’s goals. Fund accounting: An accounting system used in many nonprofit organizations, wherein accounts are kept separately for several funds, each of which is self-balancing (i.e., the sum of the debit balances equals the sum of credit balances). Go/ No-go controls: These are the most frequent type of control exercised in projects. The project team performance is the primary focus of these controls rather than specific items performed by the individuals. Historical standards: These are prepared on the basis of the actual performance. Results are compared with the results of the past period. Human resource accounting: Refers to the method of reflecting the rupee value of the human asset in the company’s balance sheet. It works on the idea that human assets in an organization are no less important than its material assets. Human resource audit: The Human Resource (HR) Audit is the process of examining policies, procedures, documentation, systems, and practices with respect to an organization’s HR functions. Indoctrination: It is a process used by the organization to socialize members to its values, procedures, and policies. Informal control system: These are unwritten, typically worker-initiated mechanisms that influence the behavior of individuals or groups in business units. Information asymmetry: A station when the principal has inadequate information about the performance of the agent. Therefore the principal can never be certain how the agent contributed to the actual firm’s results. Input controls: These are the actions taken by the company before a planned activity is implemented. Investment center: A responsibility center whose performance is evaluated in terms of profit and assets employed in earning the profit. It is a special type of profit center in which management’s attention is also focused on the assets employed.
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JIT: The acronym stands for Just-In-Time. The purpose of the just-in-time approach is to eliminate the need for a buffer inventory by ensuring that every work station produces and delivers to the next work station the right items in the right quantity at the right time. Key success variables: These are the variables in the external environment to which goals, objectives, and strategies of managers are most sensitive. Loose control: It is based on the philosophy that the people work their best as they know what they are supposed to do and also know how to do. The management never considers that the poor performance of the company is because of the poor performance of the people. Management control system: A management control system is a set of interrelated communication structures that facilities the processing of information for the purpose of assisting managers in coordinating the parts and attaining the purpose of an organization on a continuous basis.

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Open loop control mechanism: In this mechanism, initiation of corrective action lies outside the scope of the system. An external entity is needed to initiate corrective action. Organizational slack: It is defined as the difference between the total payments to organizational participants and total necessary payments. Output control: Output control relates to the performance of a subsidiary in quantitative and qualitative terms. Overview audit: This suggests whether a project is in trouble or not. The project is continued only if the report of the overview audit is positive. Performance shares: A performance share plan awards a specified number of shares to a manager when specific long-term goals have been met. Post controls: These are seen as report cards. These are exercised after completion of project. These serve as a basis for reward or punishment. Process Controls: Process controls involve tracking certain variables and taking corrective action whenever there is any deviation from specified parameters in the variables.

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Moral hazard: A situation when an agent being controlled is motivated to misinterpret private information by the nature of the control system.

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Matrix organization: In a matrix organization, there is one basic structure in which responsibility centers are arranged by functions, and alongside this structure - or superimposed on it- there is another structure in which the focus of responsibility is by projects.

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Master budget: A master budget is defined as the summary budget incorporating functional budgets, which is finally approved, adopted, and employed.

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Marketing audit: Marketing audit is a comprehensive, systematic, independent and periodic examination of a company's or business unit's marketing environment, objectives, strategies and activities.

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Open-ended questionnaire: Questionnaire consisting of questions in which the respondent is free to choose any response deemed appropriate, within the limits implied by the question.

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Glossary

Production audit: The production audit also referred as manufacturing audit is conducted to measure the effectiveness and efficiency of all production facilities and processes. Profit center: Organizational unit that not only measures the monetary value of inputs and outputs but also compares outputs with assets used in producing them. Program Evaluation and Review Technique (PERT): This method considers the uncertain activity times of all the activities of the project and suggests an optimum schedule of the project. Programming: Programming is an organizational process for making longterm resource allocation choices. Project audit: It is a formal and systematic verification of the performance of an ongoing project. Normally, it is carried out along the work. Project planning: Project planning is defined as the process of developing the basis for managing the project, including the planning objectives, procedures, organization, routines, finance and other chain of activities.

Responsibility structure: It consists of responsibility centers and related performance measurement systems. Result controls: These are used to control the behavior of employees. These are effective in addressing motivational problems. Revenue center: Responsibility centers in which outputs are measured in monetary terms. The focus of management’s efforts is on the revenue generated by the center.

Self regulated development program: A group of people who start a development program for the benefit of the group. Self-control: It deals with the establishment of the personal objectives by the individual, monitoring their attainment and adjusting the behavior in the organization to attain the goals. Social accounting: Social accounting is defined as systematic accounting and reporting of those parts of a company's activities that have a social impact. Social auditing: Social auditing help in evaluating the contributions made by the company to the society. Social controls: Social control refers to the prevailing social perspectives and patterns of interpersonal interactions within subgroups in the firm. Social indicators: Non-monetary indicators to measure the output in government organizations. It is a broad measure of output that reflects the result of the work of the organization.
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Sales audit: Sales audit is the process of examining and assessing the current state of sales, the sales environment and the sales objectives, strategies and activities.

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Responsibility center: Any organizational or functional unit headed by a manager who is responsible for the activities for that unit.

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Purchase price: The price at which the organization purchases the basic commodities from the producers.

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Management Control Systems

Social information systems: These are used to indicate the social conditions with an aggregation of organization. Stock appreciation right: It is a right to receive cash payments based on the increase in the value of stock from the time of award until a specified future date. It is also a long term incentive plan. Stock-option: A stock option is a right to buy a number of shares of stock at the given date or in the future. It is a long-term incentive plan. Superordinate (shared) goals: The set of values or aspirations that underscore what an organization stands for and believes in. Superordinate goals are values that genuinely seek congruence between the individual and the organization’s purposes, and encompass the concepts of service to society. Systematic information systems: These are used to appraise the views in making a decision through dialectical approach. Target cost: Target cost is the maximum manufacturing cost of a product. Target costing is done to encourage various design and production departments to find less expensive ways of achieving similar or better product features and quality. Technical audit: This is concerned with the specific technical issues and problems of a project. The auditor examines all the technical aspects of the project. Tight control: It is based on the management philosophy that people work more effectively only when they are forced to meet the specific goals. So, the management monitors each and every work part of the employees. Total quality management: Total quality management (TQM) is a management concept that directs the collective efforts of all managers and employees towards satisfying customer expectations by continually improving operations management processes and products.

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Value chain: Value chain analysis is a strategic analysis tool that can be used to identify areas in which value can be enhanced for customers or costs can be reduced. Variance: The differences that arise between the actual and the budgeted revenues and expenses of a business unit, is called variance. Zero base budgeting: The Zero base budgeting refers to a net budget as the starting point: it starts with the premise that the budget for next period is ‘zero’. This assumption of ZBB is beneficial to the managers as this technique helps them to carry out the cost benefit analysis of each of their responsibility centers.

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Transfer price: It is the value placed on the transfer of goods or services among two or more profit centers of the same organization.

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BIBLIOGRAPHY
Books:
1. Anthony, Robert N. and Govindrajan Vijay. Management Control Systems. Washington DC: Irwin Publications, Eighth Edition, 1995. 2. Bartol, Kathryn M and Martin C. David. Management. New York: Irwin, McGraw-Hill, Third edition, 1998. 3. Blocher J. Edward, Chen H. Kung and Lin W. Thomas. Cost Management: A Strategic Emphasis. McGraw Hill, 1999, Second Edition. 4. Maciarello, Joseph A. and Kirby J. Calvin. Management Control Systems. New Delhi: Prentice Hall of India Pvt. Ltd, Second Edition, 1997. 5. Mamoria, C.B. Personnel Management. New Delhi: Himalaya Publishing House, 1994

11. Wysocili, Robert. K, Beck Jr. Robert and Crane David B. Effective Project Management. New Jersey: John Wiley and Sons, 2000

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12. Yavitz, Boris and Newman, William H. Strategy in Action: The Execution, Politics and Payoff of Business Planning. New York: The Free Press, 1982.

Articles:
1. Allies, Michael and Datar, Srikant. “Strategic Transfer Pricing.” Management Science, Apr 98, Vol. 44 Issue 4. 2. Atkinson, Anthony A. “Organization Control Systems for the Nineties.” CMA Magazine, Jun 92, Vol. 66.

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10. The Company Audit Guide. Zurich: Strategic Direction Publishers Ltd.

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9. Sharma, Subhash. Management Control Systems, Text and Cases. New Delhi: Tata McGraw-Hill Publishing Company Limited, Seventh Reprint, 1997.

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8. Robbins, Stephen P. Organizational Behavior. New Delhi: Prentice Hall of India, Sixteenth Indian Reprint, 1999.

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7. Meredith, Jack R and Mantel, Samuel J. Jr. Project Management – A Managerial Approach. New Jersey: John Wiley and Sons, Fourth Edition, 2000.

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6. Merchant, Kenneth A. Modern Management Control Systems: Text and Cases. New Jersey: Prentice Hall; First edition, 1997.

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Bibliography

3. Barnard, Janet. “The Empowerment of Problem-solving Teams: Is it an Effective Management Tool?” Journal of Applied Management Studies, Jun99, Vol.8, Issue 1. 4. Bhattacharyya, S.K. “Management Control Systems and Conflicts – A Framework for Analysis and Resolution.” International Studies of Management & Organization, Winter73/74, Vol. 3 Issue 4. 5. Buffett, Warren E. “Who Really Cooks the Books?” New York Times, July 24, 2002 6. Burns, William J. Jr. and McFarlan, F. Warren “Information Technology Puts Power in Control Systems.” Harvard Business Review, Sep/Oct87, Vol. 65 Issue 5, p 89. 7. Cross, Rob and Majikes, Matthew. “Activity-based Costing in Commercial Lending: The Case of Signet Bank.” Commercial Lending Review, Fall97, Vol. 12 Issue 4. 8. Dalal, Sucheta. “Operation Clean-up In the US.” The Financial Express, May 27, 2002. 9. Daniel, Shirley J and Reitsperger, Wolf D. “Management Control Systems for J.I.T.: An Empirical Comparison of Japan and the U.S.” Journal of International Business Studies, 1991, Vol. 22 Issue 4. 10. Dearden, John. “Computers: No Impact on Divisional Control,” Harvard Business Review; Jan/Feb67, Vol. 45 Issue 1. 11. Eisenhardt, Kathleen M. “Agency theory: An Assessment and Review.” Academy of Management Review, 1999 Vol. 14. 12. Ezzamel, Mahmoud Willmott, Hugh. “Accounting for Teamwork: A Critical Study of Group-based Systems of Organizational Control.” Administrative Science Quarterly, Jun98, Vol. 43 Issue 2. 13. Fisher, Joseph G. “Contingency Theory, Management Control Systems and Firm Outcomes: Past Results and Future Direction.” Behavioral Research in Accounting, 1998 Supplement, Vol. 10, p47. 14. Fowler, Alan. “Feedback and Feedforward as Systemic Frameworks for Operations Control.” International Journal of Operations & Production Management, 1999, Vol. 19 Issue 2. 15. Gadiesh, Orit and Gilbert, James L. “Profit Pools: A Fresh Look at Strategy.” Harvard Business Review, May–June 1998. 16. Gerhart, Barry and Milkovich, George T. “Organizational Differences in Managerial Compensation and Financial Performance.” Academy of Management Journal 1990 Vol 13 No 4. 17. Gibbs, Jeff. "Control and Audit in an Age of Empowerment.” Internal Auditor; Dec 95, Vol. 52 Issue 6. 18. Jaworski, Bernard J and Stathakopolous, Vlasis. “Control Combinations in Marketing: Conceptual Framework and Empirical Evidence.” Journal of Marketing, Jan 93, Vol. 57 Issue 1.
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Bibliography

19. Jaworski, Bernard J. “Towards a Theory of Marketing Control: Environmental Context, Control Types and Consequences.” Journal of Marketing, July 1998. Vol 52. 20. Kald, Magnus and Nilsson, Fredrik and Rapp, Birger. “On Strategy and Management Control: The Importance of Classifying the Strategy of the Business.” British Journal of Management, Sep2000, Vol. 11 Issue 3. 21. Lebas, Michel and Weigenstein, Jane. “Management Control: The Roles of Rules, Markets and Culture.” Journal of Management Studies, May 1986. 22. Macintosh, Norman and Scapens, Robert. “Management Accounting and Control Systems: A Structuration Theory Analysis.” Journal of Management Accounting Research, Fall91, Vol. 3. 23. Malina, Mary. A and Selto, Frank H “Communicating and Controlling Strategy: An Empirical Study of the Effectiveness of the Balanced Scorecard.” Journal of Management Accounting Research, 2001 24. Pass, Christopher. “Transfer Pricing in Multinational Companies.” Management Accounting: Magazine for Chartered Management Accountants, Sep94, Vol. 72 Issue 8, p44. 25. Picken, Joseph C. and Dess, Gregory G. “Out of (strategic) Control.” Organizational Dynamics, Summer 97, Vol. 26 Issue 1, p35.

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29. Simons, Robert “Control in an Age of Empowerment,” Harvard Business Review, Mar/Apr95, Vol. 73 Issue 2, p80.

30. Snavely, Kay B and Snavely, William B. “Communicating Control: Formal and Informal Sources and Processes.” Academy of Management Proceedings, 1990. 31. Teall, Howard D. “Winning with Strategic Management Control Systems.” CMA Magazine, Mar92, Vol. 66 Issue 2. 32. Vancil, Richard F. “What Kind of Management Control Do You Need?” Harvard Business Review; Mar/Apr 73, Vol. 51. 33. Wichmann, Henry Jr. et al “Key Variables as a Management Tool.” CMA Magazine, March 1990, p23.

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28. Shank, John K. "Strategic Cost Management: New Wine, or Just New Bottles." Journal of Management Accounting and Research, Fall 1989.

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27. Ramanathan, Kavasseri. “A Proposed Framework for Designing Management Control Systems in Not-for-profit Organizations.” Financial Accountability of Management, Summer 1995.

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26. Raj, Veliyath and Hermanson, Heather M. “Organizational Control Systems: Matching Controls with Organizational Levels” Review of Business, Winter97, Vol. 18 Issue 2, p2.

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INDEX
A
Accumulated carryover, 142 Action controls, 29, 30, 31 Activity based costing, 171, 174 Actual costs, 92 Adaptive organization, 66, 68 Need for adaptive controls, 66 Environmental complexity, 67 Environmental diversity, 67 Environmental factors, 67 Environmental hostility, 67 Environmental uncertainty, 67 Administrative expense budget, 124 Agency Theory, 149 Concepts, 149 Objectives, 150 Control mechanisms, 151 Monitoring, 151 Incentive contracting, 151 Amazon.com, 178 Anthony, and Govindarajan, 6 Apple computers, 23 Appraisal costs, 160 Asset management variables, 46 Audit evidence, 206 Audit, 186, 187, 188, 189, 190, 191, 192, 194, 198, 199, 200, 202, 203, 204, 205, 206, 207 Benefits, 186 Limitations, 187 Process, 188 Timing, 188 Budgetary control, 115, 119, 120, 121, 137 Organizing, 121 Budgeted proportion, 132 Budgeting, 25, 26, 115, 116, 123, 127, 128, 129, 130, 131, 137, 233, 234 Behavioral dimensions, 123 Involvement, 124 Participation, 123 Budgeting process, 116 Guidelines, 117 Budget proposal, 117 Budget revisions, 118 Negotiation, 118 Review, 118 Business ethics, 288 Business unit strategy, 24, 27 Competitive advantage, 26, 27 Differentiation, 26 Focus, 27 Low cost, 26 Mission, 24 Build, 25, 27 Divest, 25 Harvest, 25 Hold, 25

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Balanced scorecard, 147 Customer, 147 Financial, 147, 150, 151 Innovation and learning, 147 Internal process, 147 Bausch & Lomb, 140 Belief systems, 281 Benchmarking, 166, 174 Benchtrending, 168 Boston consulting group (BCG), 25 Boundary systems, 281, 282 Bower’s Model, 108 British Telecom, 203 Budget center, 121 Budget manual, 121 Budget report, 154 Budget signals, 154

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Capital expenditure budget, 124 Capital projects manual, 113 Carryovers, 142 Ceiling, 154 Centralization, 59 Class I products, 94 Class II products, 94 Compensation scheme, 151 Competitive strategy, 47 Complete management audit, 198 Compliance management audit, 198 Computer integrated manufacturing, 160 Conglomerate businesses, 24 Contingency approach, 20, 21 Continuous process improvement, 164 Control process hierarchy, 19 Control process, 4 Strategic level, 4 Management level, 4 Operational level, 5 Control systems, 12, 15, 24, 30, 60, 283 Elements, 5 Assessor, 5, 15 Communications network, 6

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Data architectures, 39 Decentralization, 37, 41, 58, 197, 283 Decentralized operations, 84 Performance measurement, 84 Decision support systems, 161 Implications for control, 161 Design quality, 157 Designing management controls, 18 Impact of IT, 39 Managerial styles, 32 External control, 32, 41 Internal control, 33 Mixed control, 34 Diagnostic control systems, 281 Differentiation, 183 Direct labor budget, 124 Direct observation, 196 Divisional autonomy, 72 Variables, 72, 86

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Detector, 5 Effector,5 6, 15 Controller organization, 65 Controls in MNCs, 222 Bureaucratic, 223 Cultural, 222 Output, 222 Personal, 222 Result, 222, Factors influencing controls, 224 Individualism, 224, 225 Masculinity, 224, 225 Power distance, 224, 225 Uncertainty avoidance, 224, 225 Corporate strategy, 22 Related diversification, 23 Single business firm, 23 Unrelated diversification, 23 Cost audit, 202 Cost center, 83, 86 Cost driver analysis, 181 Cost leadership, 27, 182 Creative tension, 50 Critical Path Method (CPM), 263, 276 Critical success factors, 178 Cybernetic control system, 269 Cybernetic controls, 269, 276 Cybernetic paradigm, 18, 19, 27 Cybernetics approach, 16 Characteristics, 16 Cycle time, 157 Cyert and March, 37, 289

Diversification strategy, 73 Management policies and procedures, 73 Management style and processes, 72 Divisional structure, 51 Donaldson Brown, 75

E
Economic risks, 227 Emotional tension, 50 Enron corp, 4 Ethics program, 290, 291, 293 Ethics, 288, 290, 291, 293 Evaluation standards, 134 Exchange rate risk, 227 Economic, 228 Transaction, 228 Translation, 228 Executional cost drivers, 182, 184 Expense centers, 78,107 Discretionary, 78, 79 Engineered, 78 Control characteristics, 78 External failure costs, 160

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Feed-forward system, 11 Financial audit, 188, 202 Fixed costs, 133 Floors, 154 Focus groups, 195 Formal control process, 13 Formal planning, 13 Formal reporting, 13 Formal control system, 11 Input controls, 11 Output controls, 12 Process controls, 11 Formal information, 153 Formal programming procedures, 111 Formal rewards, 149 Full-cost systems, 135 Functional management audit, 199 Fund accounting, 240

General Electric, 25, 52 General Motors, 75 Go/No-go controls, 270, 276 Government organizations, 246, 257 Griesinger, 17 305

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INDEX

H
Historical standards, 135 Human resource audit, 210 Conducting, 211

L
Long-term incentive plans, 141, 143 Stock Options, 143 Stock appreciation rights, 143 Phantom stock plan, 143 Performance shares, 143 Loose control, 7, 35

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IBM, 36, 180 Incentive compensation system, 26 Industry volume variance, 132 Inflation, 225, 226 Informal control system, 12 Cultural controls, 12 Self-control, 12 Social controls, 12 Informal information, 153 Information asymmetry, 150 Innovation, 164 Insurance companies, 252, 253, 254 Interactive control systems, 282 Internal audit, 154, 162, 202 Internal failure costs, 160 Interviews, 196 Semi structured, 196 Structured, 196 Unstructured, 196 Investment bankers, 254

M
Management audit, 198, 199, 209 Management by objectives, 78 Management control systems, 5, 7, 9, 15 17, 22, 28, 30, 32, 37, 38, 79 Features, 5 Management control, 5 , 8, 11, 12, 15, 37 Manufacturing overhead budget, 124 Market penetration, 132 Market share variance, 132 Marketing audit, 214, 215 Materials budget, 124 Matrix structure, 59, 62, 272 Matrix and multinational firm, 61 Control factors, 63 Problems, 64 Milton Friedman, 288 Mix and volume variance, 132 Mix variance, 132 MSSM, 148 Attainability, 148 Formal rewards, 149 Informal rewards, 149

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Job design, 8 Just-in-time techniques, 155 Advantages, 156 Implications for control, 156

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Kaplan and Norton, 147 Kenneth R Andrews, 22 Key actions, 29 Key results, 29 Key variables, 44, 50 Concept, 43 Identification, 44 Input, 44, 45, 54 Marketing, 46 Output, 44, 54 Production, 45 Sources, 47 Types, 47 Environmental, 47, 54 Process, 47, 48, 49, 51, 52, 54 Strategy, 47 Structural, 47, 54 Kidder Peabody, 280 Kimberly-Clark, 5

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Non-financial audit, 186, 188, 208 Nonfinancial measures, 160 Nonprofit organizations, 235, 237, 238, Mission, 235 Norbert Weiner, 16 Nordstrom, 280 NPV, 108

Ongoing programs, 105, 113 Operational control, 201 Operations management, 153, 162 Organizational structure, 58, 59, 66, 67, Organizing, 121

Participative budgeting, 123, 130 Performance budgeting, 129

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INDEX

Implementation, 130 Performance evaluation, 91 Performance reports, 83, 136, 204 Performance criteria, 146 Controllable factors, 146 Uncontrollable factors, 147 Personal controls, 222 Peter Drucker, 235 Phantom stock plans, 143 Planning phase, 166 Political risks, 226 Post controls, 270, 277 Predetermined standards, 135 Predictable variables, 44 Preventive costs, 159 Process controls, 11 Process measures, 248 Process quality teaming, 169 Processing time, 157 Product design, 158 Product organization, 60 Product pricing, 253 Production audit, 213 Production budget, 124 Professional organizations, 244, 245 Profit centers, 81, 128, 156 Types, 81 Program evaluation and review Technique , 263, 264, 265, 276 Program management audit, 199, 200 Programming, 107, 108, 110, 113 Initiating, 109 Integrating, 109 Corporate, 109 Project auditing, 273 Detailed, 274 General, 274 Technical, 274 Project control, 259, 268 Project definition, 111 Project evaluation, 112 Project implementation, 112 Project managers, 268 Project plan, 260, 261 Promotion & advertising expense budget, 124 Propriety audit, 199 Purchase audit areas, 210

R
Research & development budget, 124 Residual loss, 151 Responsibility center, 75, 76, 85 Nature, 76 Types, 77 Responsibility structure, 72, 74, 86 Efficiency measure, 75 Process measure, 75 Effectiveness measure, 75 Result controls, 30, 31, 222 Return on Investment (ROI), 75 Revenue centers, 77 Revenue variances, 131 Roger Hall, 50

Q
Quality control, 45 Questionnaires, 195

Sales audit, 215, 217, 218 Sales budget, 125, 132 Samuel Paul, 47 Scheduling, 263 Scope, 89, 261 Securities firms, 257 Selling and distribution expense budget, Selling price variance, 132 Sensitivity analysis, 79 Service organizations, 243, 248 Short-term incentive plans, 141, 151 Total bonus pool, 141 Carryovers, 142 Deferred payments, 142 Slack, 37, 118, 288 Social accounting report, 203 Social audit, 202 Definition, 204 Features, 204 Types, 205 Social balance sheet, 205 Social performance audit, 205 Macro-micro social indicator audit, 205 Constituency group, 205 Government mandated, 205 Program audit, 205 Approaches, 204 Inventory approach, 204 Program management approach, 206 Cost benefit approach, 205 Social indicator approach, 205 Social controls, 13 Social indicator, 248 Standard costs, 92 Stars, 255

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INDEX

Target costing, 164, 165, 166, 175 Stages, 164 Planning, 165 Production, 165 Development, 165 Benefits, 166 Task Control, 10 Texas Instruments, 180, 183 Three-by-three matrix, 25 Tightness of controls, 31 Total project cost, 262 Total quality culture, 38 Total quality management, 39, 40, Toyota Corporation, 159 Transfer pricing in MNCs, 231 Methods, 231

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Stock appreciation rights, 143 Stock options, 143 Straight salary, 151 Strategic control, 5,223, 224, 233 Strategic cost analysis, 184 Strategic cost management, 178, 179, 183, 184 Evolution, 178 Three key themes, 179 Value chain analysis, 179 Cost driver analysis, 181 Strategic positioning analysis, 182 Strategic planning, 100, 101, 102, 103, 104, 113 Characteristics, 100 Benefits, 101 Planning process, 102 Reviewing, 102 Guidelines, 102 First iteration, 103 Analysis, 103 Second Iteration, 104 Review, 104 Strategy elements, 100 Strategy formulation, 10 Structural cost drivers, 182 Surveys, 194, 195

Cost method, 231 Market price method, 231 Resale price method, 231 Transfer pricing, 88, 89, 91 Calculation, 90 Cost based, 91 Market-based, 91 Negotiation, 92 Administration, 93 Negotiation, 94 Arbitration, 94 Product classification, 94 Two-by-two growth share matrix, 25 Tyco International, 4

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Unfair controls, 292 United Airlines, 33 Upstream fixed costs and profits, 92 Profit sharing, 93 Two sets of prices, 93 Two step pricing, 93

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Value chain analysis, 179, 180, 184 Variable costs, 133, 136 Variable overhead variance, 134 Variance analysis, 131, 136 Vijay Sathe, 65 Volume variance, 132, 133, 135

William G Ouchi, 12 Work aversion, 150 Working capital management, 66 Work-in-process inventory, 156

Zero base budgeting, 126 Process, 127 Implementing issues, 128 Advantages and disadvantages, 128

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