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Management Control System
Q.1 How is RI (EVA) analysis carried out? Explain advantages and disadvantages. Ans. The EVA method is based on the past performance of the corporate enterprise. The underlying economic principle in this method is to determine whether the firm is earning a higher rate of return on the entire invested funds than the cost of such funds (measured in terms of weighted average cost of capital, WACC). If the answer is positive, the firm’s management is adding to the shareholders value by earning extra for them. On the contrary, if the WACC is higher than the corporate earning rate, the firm’s operations have eroded the existing wealth of its equity shareholders. In operational terms, the method attempts to measure economic value added (or destroyed) for equity shareholders, by the firm’s operations, in a given year. Since WACC takes care of the financial costs of all sources of providers of invested funds in a corporate enterprise, it is imperative that operating profits after taxes (and not net profits after taxes) should be considered to measure EVA. The accounting profits after taxes, as reported by the income statement, need adjustments for interest costs. The profit should be the net operating profit after taxes and the cost of funds will be the product of the total capital supplied (including retained earnings) and WACC EVA= [Net operating profits after taxes – [Total Capital * WACC]
Example; Following is the condensed income statement of a firm for the current year; Particulars Sales Revenue Less: Operating costs Less: Interest costs Earnings before taxes Less: Taxes (0.40) Earnings after taxes Amt (in lakhs) 500 300 12 188 75.2 112.8
The firm’s existing capital consists of Rs 150 lakhs Equity funds, having 15% cost and of Rs 100 lakh 12% debt. Determine the economic value added during the year. Solution (I) Determination of Net Operating Profit After Taxes Particulars Sales revenue Less: Operating Costs Operating profit (EBIT) Amt (in lakhs) 500 300 200
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Less: Taxes (0.40) Net operating profit after taxes (NOPAT)
Determination of WACC Particulars Equity (150 lakh * 15%) 12% Debt (100 lakh * 7.2%) Total Cost WACC (29.7 lakh/ 250 lakh) Cost of debt= 12% (1 – 0.4 tax rate) = 7.2% Amt (in lakhs) 22.5 7.2 29.7 11.88%
Determination of EVA EVA = NOPAT – (Total capital * WACC) Rs 120 lakh – (Rs 250 lakh * 11.88%) Rs 120 lakh – Rs 29.7 lakh = Rs 90.3 lakh
During the current year, the firm has added an economic value of Rs.90.3 lakh to the existing wealth of equity shareholders. Essentially, the EVA approach is a modified accounting approach to determine profits earned after meeting all financial costs of all the providers of capital. Its major advantage is that this approach reflects the true profit position of the firm. RI (EVA) has the following advantages: (i) It avoids suboptimal decisions as investments are not rejected merely because they lower the divisional manager’s ROI. (ii) It maximizes the growth of the company and increases shareholders’ wealth by accepting opportunities which earn a rate of return in excess of the cost of capital. (iii) The cost of capital charge on divisional investments ensures that divisional managers are aware of the opportunity cost of funds.
(iv)Charging each division with the company’s cost of capital ensures that decisions taken by different divisions are compatible with the interests of the organization as a whole.
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RI (EVA) has the following weaknesses: (i) Like ROI it is difficult to have satisfactory definitions of ‘divisional profits’ and ‘divisional investment’. (ii) It may be difficult to calculate an accurate cost of capital. Also, decision has to be taken whether to use the company’s cost of capital or a specific divisional cost of capital. The former enhances divisional goal congruency and the latter reflects each division’s level of risk. (iii) Identifying controllable and uncontrollable factors at the divisional level may be difficult. Q. 2 Discuss the significance of human behavioral pattern in management control? Ans. Management control system influence human behavior same as human behavior influences management control system. Human behavior helps in performing a good management control system by goal congruent manner. Thus following are the ways in which the human behavior influences the management control system. Goal congruence: Senior management wants the organization to attain the organization’s goal. But the individual members of the organization have their own personal goals, and they are not necessarily consistent with those of the organization. The central purpose of a management control system, then, is to ensure a high level of what is called “goal congruence”. In a goal congruence process, the actions people are led to take in accordance with their perceived selfinterest are also in the best interest of the organization. Obviously in our imperfect world, perfect congruence between individual goals and organizational goals does not exists – if for no other reason than that individual participants usually want as much compensation as they get while the organization maintains that salaries can go only so high without adversely affecting profits. Thus an individual should always think on how he can improvise his organizations goal along with his own goal. Work ethics: There are some external factors that influence the desirable behavior that exists in the society of which organization is a part. These norms or factors include a set of attitudes, often collectively known as the work ethic, which is manifested in employees’ loyalty to the organization, their diligence, their spirit, and their pride in doing a good job (rather than just putting in time). Some of these attitudes are local- that is, specific to the city or region in which the organization does its work. Culture: This is the most important internal factor – is the organization’s own culture and how is the individual of the organization are understanding and maintaining the culture. The culture consists of – the common beliefs, shared values, norms of behavior, and assumptions that are implicitly accepted and explicitly manifested throughout the organization. Cultural norms are extremely important since they explain why two organizations, with identical formal management control systems, may vary in terms of actual control.
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A company’s culture usually exists unchanged for many years. Certain practices become rituals because “this is the way things are done here”. Organizational culture is also influenced strongly by the personality and policies of the CEO, and by those of lower level managers with respect to the areas they control. If the organization is unionised, the rules and norms accepted by the union also have a major influence on the organization’s cultures. Attempts to change practices almost always meet with resistant, and the larger and more mature the organization, the greater the resistance is. Management style: The internal factor that probably has the strongest impact on management control is management style. Usually subordinates attitude reflects what they perceive their supervisors’ attitudes to be, and their superiors’ attitudes ultimately stem from the CEO. Perception and communication: In working toward the goal of the organization, operating managers must know what these goals are and what actions they are supposed to take to achieve them. They receive this information through various channels, both formal and informal. An organization is a complicated entity, and the actions that should be taken by any one part to further the common goals cannot be stated with absolute clarity even in the best of circumstances. Rules: Rules means all types of formal instruction and controls, including standing instructions, job descriptions, standard operating procedures, manuals, and ethical guidelines. Rules range from the most trivial to the most important. Some rules are guides; that is organization members are permitted, and indeed expected, to depart from them, either under specified circumstances or when their own best judgement indicates that a departure would be in the best interest of the organization.
Q.3 (a) Explain how different types of expenses centers operates with the help of sketches? Answer: Expense centers are responsibility centers whose inputs are measured in monetary terms whose output are not. There are two general types of expenses centers: engineered and discretionary. These labels relates to two types of cost. Engineered costs are those for which the ‘right’ or ‘proper’ amount can be estimated with reliability. For example, factory’s costs for direct labour, direct material, components supplier and utilities. Discretionary costs are those for which no such engineered estimate is feasible. In discretionary expenses centers, the cost incurred depends on management’s judgment as to the appropriate amount under the circumstances. 1. 2. 3. Engineered expenses centers:- it have following characteristics:The profit input can be measured in monetary terms. Their output can be measured in physical terms.
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The optimum dollars amount of input required to produce one output can be determined.
Diagram:Optimal relationship can be established Input Output
Engineered expense centers are usually found in manufacturing operation, warehouse distribution and similar units within the marketing organization may also be engineered expenses centers as certain responsibility centers within administrative and support departments for instance, account receivable, account payable and pay roll sections in controller department. Such unit performs repetitive task for which standard cost can be developed. These centers are usually located within departments that are discretionary expenses centers. In engineered expenses centers output are multiplied by standard cost of each unit produce measured what the finished products should have cost. Managers of engineered expenses center may be responsible for activities such as training and employee development that are not related to current production. The term engineered expense center refers to responsibility centers in which engineered cost predominate, but it does not imply that valid engineered estimates can be made for each and every cost items.
Discretionary expenses centers:Discretionary expenses centers include administrative and supports units, research and developments operation and most marketing activities. The output of these centers can not be measured in monetary terms. Diagram:Optimal relationship cannot be established Input Output
The term discretionary does not imply that managements judgment to optimum cost is capricious rather it reflects managements decision regarding certain policies, whether to match the marketing effort of competitors; the level of service the company should provide to its customer and appropriate amount to spend for R&D, public relations and other activities. One company may have a similar small head quarter’s staff, while another company of similar size and same industry may have staff 10 times as large. The senior manager of each company may each to be convinced that their respective decision on staff size are correct but their is no objective to judge which is right; both decision may be equally good under the circumstances with the differences in the two companies. In discretionary centers, the differences between budget and actual expenses are not a measure of efficiency. Rather it is simply the differences between the budgeted input and actual does not incorporate the value of output if actual expenses do not exceed the budget amount, the manager has “ lived within the budget”, but since by definition the budget does not to predict the optimum amount of spending living within the budget does not necessarily indicate efficient performance. Q3. (b) Explain the significant features and budget process in these centers? Answer: Features and process of these centers: Budget preparation:-
Managements make budgetary decision for discretionary expenses centers that differ from those for engineered expenses centers. For the later, it decides whether the proposed operating budget represents the unit of performance efficiently. Its volume is not a major concern; this is largely determined by the action of other responsibility centers. The marketing department’s ability to generate sales. This work done by discretionary expenses centers falls into two category; continuing and special. Continuing work is done consistently from year to year, such as preparation of financial statement by controller office. Special work is a “one shot” project for example developing and installing a profit budgeting system in newly acquired division as per the discretionary expenses center budget is a management by objective, a formal process in which budgeter process to accomplish specific job. Incremental budgeting in this model discretionary expenses centers current level of expenses is taken as starting point. This amount is adjusted foe inflation, anticipated change in the workload of continuing job. Incremental budgeting has two characteristics and two drawbacks. The drawbacks are first, the discretionary expenses centers current level of expenditure is accepted and not reexamined during the budget preparation process and second, manager of these center typically want to increase the level of services and tend to request additional resources, which they make a sufficiently strong case are usually provide. Zero base review
An alternative budgeting approach is to make through analysis of each discretionary expenses center on rolling schedule, so that all are reviewed at least once every five years or so. Such an analysis is often called zero base review. In contrast with incremental budgeting this alternative intensive review attempts to ascertain, devolve that is form scratch, the resource actually required to carry out each activity within the expenses centers. This analysis established another new base, at which point the annual budget review simply attempts to keep costs reasonably in line with this base until the next review take place, five year down line. Zero base review is time consuming and they are likely to be traumatic for the managers whose operations are being reviewed. Also managers will not only do their best to justify their current level of spending, but also attempts to thwart the effort, regarding zero base review as something to be put off indefinitely in favour of “ more pressing business” Cost variability
Unlike cost engineered expenses center, which are strongly affected by short run volume change costs in discretionary expenses center are comparatively insulated from such short term fluctuation. This differences stems from the facts that in preparing the budget for discretionary expenses center. Management tends to approve change that correspond anticipated change in sales. Type of financial control
Financial control in a discretionary expenses center is quite different from than the engineered expenses center. The objective become cost competitive by selling a standard actual cost against this standards. The main purpose is to control the cost by allowing manager to participate in planning. Measurement of performance
The primary job of discretionary expenses centers manager is to obtain the desired output spending and an amount that is “on budget “to do this satisfactory. Spending more than that is cause for concern and spending less may indicate that planned work is won’t be done. In discretionary centers as apposed to engineered expense centers, the financial performance report is not a means of evaluating the efficiency of manager. Control over spending can be exercised by required the supervisors approval before the budget is overrun is permitted without additional approval. Q4. What is profit center? Explain condition under which profit center decentralization will most beneficial to an organization. Answer: Profit center: When responsibility centers financial performance is measured in terms of profit the center is called a profit center. Profit is particularly useful performance measure since it allows senior management to use one comprehensive indicator rather than several. Advantages of profit center:-
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The quality of decision may improve because they are being made by manager closest to point of decision. The speed of operating decision may be increased since they do not have to be referred to headquarters. Headquarters management, relived of day to day decision making can concentrates on issues Manager, subject to fewer corporate restraints are free to use their imagination and initiative. Profit center provides top management with ready made information on profitability of company.
• Management style and Decentralized management Management style and culture influence concept of decentralized operations chooses to run the organization. It concern with how control over divisional operation. The control again is largely dependent on the degree of autonomy given to the divisional managers. Autonomy tended to be the highest in the firm that choose to grow by acquiring unrelated business. On the other hand autonomy of profit center managers tended to be the most restricted in firms engaged in single business. In a big company with diversified products manufactured and distributed through number of units scattered over wide geographical locations- there is a danger of responsibility for profit being diffused. Therefore a large integrated multiproduct company is conveniently divided into independent operating unit that act like business entities free to trade outside as well as inside the company the growth of Union Carbide India Ltd. During the year from 1965 to 1980 will bear testimony to the successful application of this concept. Given right incentives, each profit center, by maximizing its own profit contribution, will do what will also maximize the profit of the entire company. In a decentralized organization, divisions are organized on the basis of product line and differentiated by the type of goods or services produced and responsibility for planning and controlling their operations are given to divisional managers. These divisional managers have the authority to make decisions without first seeking the approval of top management. The level of decentralization varies significantly among divisional companies and there are no one best level of decentralization which can be suggested for all decentralized companies. In some companies for example, a divisional manager may have authority over all plant operations, including plant asset acquisitions and replacement. The most appropriate quantum or level of decentralization for divisionalised company can be determined on the basis of benefit and disadvantages of divisionalization as they apply to a company’s specific unique circumstances.
Q5. (a) “Transfer price is not an accounting tool”. Comment.
ANS: Transfer pricing refer to the amount used in accounting for any transfer of goods and services between responsibility centers. This is what a narrow definition and limit the term transfer price to the value placed on a transfer of goods or services in transaction in which at least one of the two parties involved in the profit center. Such a price typically includes a profit element because an independent company normally would not transfer goods or services to another independent company at cost or less. Therefore, the mechanism for allocating cost in an accounting system; such cost do not include a profit element. The term price as used here has the same meaning as it has when used in connection transaction between independent companies. Objective of transfer pricing Profit center are responsible for product development, manufacturing and marketing each share in the revenue generated when the product is finally sold. The transfer price should be designed so that it accomplishes the following objectives:
it should provide unit with the relevant information it needs to determine the optimum trade-off between company cost and revenues It should induce goal congruence decision i.e., the system should be designed so that decision that improve business unit profit will also improve company profits. It should help to measure the economic performance of the individual business units. The system should be simple to understand and easy to administer.
Thus, from the objective, it is understandable that the Transfer price is mainly transferring of goods and services from one unit to another where much important is not given to accounting basis but also to all other effect. Q. 5 (b) State that condition under which transfer price mechanism is likely to induce goal congruence. Ans: A market price- based transfer price will induce goal congruence if all the following condition exists. But it just suggests a way of looking and to improve the operation of transfer price mechanism. Competent people Ideally manager should be interested in the long run as well as short run performance of their responsibility centers. Staff people involved in negotiation and arbitration of transfer prices also must be competent.
Managers must regard profitability, as measured in their income statements, an as important goal and a significant consideration in the judgment of their performance. They should perceive that the transfer price are just. 3. A Market Price
The ideal transfer price is based on a well established, normal market price for the identical product being transferred that is, a market price reflecting the same conditions (quantity, delivery time, and quality) as the product to which the transfer price applies. The market price may be adjusted downward to reflect saving accruing to the selling unit from dealing inside the company. 4. Freedom to source Alternative for sourcing should exist and manager should be permitted to choose the alternative that is in their own best interests. The buying manger should be free to buy from the outside and the selling manager should be free to sell outside. In these circumstances, the transfer price policy simply gives the manager of each center the right to deal with either insider or outsider at his or her discretion. The market thus establishes the transfer price. The decision as to whether to deal inside or outside also is made by the marketplace. This method is optimum if the selling profit center can sell all of its product to either insider or outsider. The market price represents the opportunity cost to the seller of selling the product inside. This is because if the product were not sold inside, it would be sold outside. From the company point, the relevant cost of the product is the market price because that is the amount of cash that has been forgone by selling inside. The transfer price represents the opportunity cost to the company. 5. Full Information Manager must know about the available alternative and the relevant costs and revenue of each. 6. Negotiation There must be a smoothly working mechanism for negotiating “contracts” between business units. If all these condition are present, a transfer price system based on market prices would induce goal congruent decision, with no need for central administration. Q.6. Explain with illustrations the different ways in which the profit objective of a profit centre can be stated and controlled.What role do corporate overhead allocations play in this process? Ans. The different ways in which the profit objective of a profit centre can be stated and controlled can be explained with the help of, types of profitability measurements used in evaluating a profit center.
First, there is the measure of management performance, which focuses on how well the manager is doing. This measure is used for planning, coordinating, and controlling the profit center’s day-to-day activities and as a device for providing the proper motivation for its manager. • Second, there is the measure of economic performance, which focuses on how well the profit center is doing as an economic entity. The messages conveyed by these two measures may be quite different from each other. For eg: The management performance report for a branch store may show that the store’s manager is doing an excellent job under the circumstances, while the economic performance
report may indicate that because of economic and competitive conditions in its area the store is a losing proposition and should be closed. Types of Profitability Measures A profit center’s economic performance is always measured by net income (i.e., the income remaining after all costs, including a fair share of the corporate overhead, have been allocated to the profit center). The performance of the profit center manager, however, may be evaluated by five different measures of profitability : 1. 2. 3. 4. 5. 1) Contribution margin, direct profit, controllable profit, income before income taxes, or net income. Contribution Margin
Contribution margin reflects the spread between revenue and variable expenses. The principal argument in favour of using it to measure the performance of profit center managers is that since fixed expenses are beyond their control, managers should focus their attention on maximizing contribution. The problem with this argument is that its premises are inaccurate, in fact, almost all fixed expenses are at least partially controllable by the manager, and some are entirely controllable. Many expense items are discretionary; that is, they can be changed at the discretion of the profit center manager. Presumably, senior management wants the profit center to keep these discretionary expenses in line with amounts agreed on in the budget formulation process. A focus on the contribution margin tends to direct attention away from this responsibility. Further, even if an expense, such as administrative salaries, cannot be changed in the short run, the profit center manager is still responsible for controlling employees’ efficiency and productivity. 2) Direct Profit This measure reflects a profit center’s contribution to the general overhead and profit of the corporation. It incorporated all expenses either incurred by or directly traceable to the profit center, regardless of whether or not these items are within the profit center manager’s control. Expenses incurred at headquarters, however, are not included in this calculation. A weakness of the direct profit measure is that it does not recognize the motivational benefit of charging headquarters costs. Example: Knight-Ridder, the second-largest newspaper publisher in the United States, measured each of its newspapers based on direct profit. The publisher set specific targets for direct profit at each of its newspapers. For 1996 the Miami Herald had a target of 18 percent and the Philadelphia Inquirer and the Philadelphia Daily (which were operated as one unit) had a target of 12 percent.
Controllable Profit Headquarters expenses can be divided into two categories: controllable and non-controllable. The former category includes expenses that are controllable, at least to a
degree, by the business unit manager - information technology services, for example: if these costs are included in the measurement system, profit will be what remains after the deduction of all expenses that may be influenced by the profit center manager. A major disadvantage of this measure is that because it excludes noncontrollable headquarters expenses it cannot be directly compared with either published data or trade association data reporting the profits of other companies in the industry. 4) Income before Taxes In this measure, all corporate overhead is allocated to profit centers based on the relative amount of expense each profit center incurs. There are two arguments against such allocations. First, since the costs incurred by corporate staff departments such as finance, accounting, and human resource management are not controllable by profit center managers, these managers should be held accountable for them. Second, it may be difficult to allocate corporate staff services in a manner that would properly reflect the amount of costs incurred by each profit center. 5) Net Income Here, companies measure the performance of domestic profit centers according to the bottom line, the amount of net income after income tax. There are two principal arguments against using this measure: • After-tax income is often a constant percentage of the pretax income, in which case there would be no advantage in incorporating income taxes, and • Since many of the decisions that affect income taxes are made at headquarters, it is not appropriate to judge profit center managers on the consequences of these decisions. There are situations, however, in which the effective income tax rated does vary among profit centers. For example, foreign subsidiaries or business units with foreign operations may have different effective income tax rates. In other cases, profit centers may influence income taxes through their installment credit policies, their decisions on acquiring or disposing of equipment, and their use of other generally accepted accounting procedures to distinguish gross income from taxable income. In these situations, it may be desirable to allocate income tax expenses to profit centers not only to measure their economic profitability but also to motivate managers to minimize tax liability.
B) There are three arguments in favor of incorporating a portion of corporate overhead into the profit centers’ performance reports. First, corporate service units have a tendency to increase their power base and to enhance their own excellence without regard to their effect on the company as a whole. Allocating corporate overhead costs to profit centers increases the likelihood that profit center managers will question these costs, thus serving to keep head office spending in check. (Some companies have actually been known to sell their corporate jets because of complaints from profit center managers about the cost of these expensive items).
• Second, the performance of each profit center will become more realistic and more readily comparable to the performance of competitors who pay for similar services. Finally, when managers know that their respective centers will not show a profit unless all costs, including the allocated share of corporate overhead, are recovered, they are motivated to make optimum long-term marketing decisions as to pricing, product mix, and so forth, that will ultimately benefit (and even ensure the viability of) the company as a whole. • If profit centers are to be charged for a portion of corporate overhead, this item should be calculated on the basis of budgeted, rather than actual, costs, in which case the “budget” and “actual” columns in the profit center’s performance report will not complain about either the arbitrariness of the allocation or their lack of control over these costs, since their performance reports will show no variance in the overhead allocation. Instead, such variances would appear in the reports of the responsibility center that actually incurred these costs. Q.7. (a) Explain the concept of “Balance score card”. Ans - The balance score card is a management system (not only a measurement system) that capable organization to clarity their vision and strategy and translate them into action. It provides feedback around both the internal business processes and external outcomes in order to continuously improve strategic performance and results. When fully deployed, the balance scorecard transforms strategic planning from an academic exercise into the never center of an enterprise. Kaplan and Norton describe the innovation of the balanced scorecard: “The balance scorecard retains traditional financial measures. But financial measures tell the story of the past events; an adequate story for industrial age companies for which investments in long-term capabilities and customer relationships were not critical for success. These financial measures are inadequate, however, for guiding and evaluating the journey that information age companies must make to create future value through investment in customers, suppliers, employees, processes, technology, and innovation.” The balance scorecard is an example of a performance measurement system. According to proponents of this approach, business units should be assigned goals and measured from the following four perspectives: Financial (e.g., profit margins return on assets, cash flow). Customer (e.g., market share, customer satisfaction index). Internal business (e.g., employee retention, cycle time reduction). Innovation and learning (e.g., percentage of sales from new products). The balanced scorecard fosters a balance among different strategic measures in an effort to achieve goal congruence, thus encouraging employees to act in the organization’s best interest. It is a tool that helps the company’s focus, improves communication, sets organization objectives, and provides feedback on strategy. Every measure on balance scorecard addresses an aspect of company’s strategy. In creating the balanced scorecard, executives must choose a mix of measurements that (1) accurately
reflect the critical factors that determine the success of the company’s strategy; (2) show the relationship among the individual measures in a cause-and-effect manner, indicating how nonfinancial measure affect long-term financial results; and (3) provide a board-based view of the current status of the company. Q.7 (b) How can Balanced Score card be implemented in an organization ? Ans - The balance score card implement in an organization from four perspectives, and to develop metrics, collected data and analyze it relative to each of these perspectives: o The learning and growth perspective o The Business process perspective o The Customer perspective o The Financial perspective The learning and growth perspective: This perspective includes employee training and corporate culture attitudes related to both individual and corporate self-improvement. In a knowledge-worker organization, people —the only repository of knowledge—are the main resource. In the current climate of rapid technological change, it is becoming necessary for knowledge worker to in a continuous learning mode. Government agencies often Find themselves unable to hire new technical workers and at the same time is showing a decline in training of brain drain that must be reversed. Metrics can be put into place to guide managers in focusing training where they can help the most. In any case, learning and growth constitute essential foundation for success of any Knowledge-worker organization. The business process perspective: This perspective refers to internal business process. Metrics based on this perspective allow the managers know how well their business is running, whether its products and services conform to customer requirements. These metrics have to be carefully designed by those who know these processes most intimately; with our unique missions these are not something that can be developed by outside consultants. In addition to the strategic management process, two kinds of business processes may be identified: a) mission-oriented processes, and b) support processes. Mission oriented processes are special functions government offices, and many unique problems are encountered in these processes. The support processes are more repetitive in nature. The customer perspective: Recent management philosophy has shown an increasing realization of the importance of customer focus and customer satisfaction in any business. These are leading indicators: if customers are not satisfied, they will eventually find other suppliers that will meet their needs. Poor performance from this prospective is thus a leading indicator of future decline, even though current financial picture may look good. In developing metrics for satisfaction, customers should be analyzed in terms of kinds of customers and the kinds of processes for which we are providing product or services to those customer groups.
The financial perspective: Kaplan and Norton do not disregard the traditional need for financial data. Timely and accurate funding data will always be priority, and manager will do whatever necessary to provide it. In fact, often there is more than enough handing and processing of financial data. With the implementation of a corporate database, it is hoped that more of the processing can be centralized and automated. But the point is that the current emphasis on financial needs to the”unbalanced” situation with regard to other perspectives. Q.8. a) “Internal auditing means nothing but policing”. Comment? Ans – Auditing is necessary for every business, corporate and organization. Because if you survive a life to take food, similarly auditing is need for organization. Audit means inspection of past performance of organization. Auditing approved where your business going on profit or loss. If you not make audit his organization, you cannot find it, what your business earn profit or loss monthly or yearly, you will not know. Why organization’s or corporate sector’s owner make audit his organization. Because he want to know his organization staff working right or wrong. If he does wrong his working, they want to know, where is wrong? Why is wrong? What is reason for wrong? Every problem is solved by auditing. There are three types of auditing: a) internal audit, b) external audit and c) concrete audit. Here I am explaining “Internal audit means nothing but policing”. It is rule of government auditing is necessary to every organization. Because government get tax both: organization and one who take contract of auditing. Auditing is necessary checked by as like charter accountant, auditor and highly qualified person. Example: a bank sector make audit by charter account. Charter accountant send staff to bank to audit and that staff called as “auditor”. An auditor check voucher, what customer feels in the voucher? Officer and manager sign is present or not. And an auditor check saving bank a/c, current a/c and d-mat a/c document and do verification. How much money in or out per day. Any type of wrong correct by officer, manager and itself and after send per day report to charter accountant and charter accountant send monthly report to bank. Charter accountant signature is necessary on monthly bank report. Q.8. b) Identify some internal controls. Ans Internal control is not one event, but a series of actions and activities that occur throughout on entity’s operations and on an ongoing basis. Internal control should be organized as an integral part of each system that management uses to regulate and guide its operations rather than as a separate system within an agency. In this sense, internal control is management control that is built into the entity as a part of its infrastructure to help managers run the entity and achieve their aims on an ongoing basis. Five standards for internal control: - Control environment - Risk management - Control activities - Information and communication
Control environment: Management and employees should establish and maintain an environment throughout the organization that sets a positive and supportive attitude toward internal control and conscientious management. Risk management: Internal control should provide for an assessment of the risk the agency faces from both internal and external sources. Control activities: Internal control activities help ensure that management directives are carried out. The control activities should be effective and efficient in accomplishing the agency’s control objectives. Information and communication: Information should be recorded and communicated to management and other within the entity who need it and in a form and within a time from that enables them to carry out their internal control and other responsibilities. Monitoring: Internal control monitoring should assess the quality of performance over Time and ensure that the finding of audits and reviews are promptly resolved. Q 10: The budget vs. actual comparison for the division ABC of the company X at the end of the year 01 is as follows: (All the figures in Rs. lacs) Budget Actual Sales Material and other variable costs Employee and other fixed expenses Sales promotion Operating profit Net working capital Fixed assets 100 120 30 10 40 100 40 185 109 30 07 39 103 37
For this division, which areas of performance would you like to investigate and what would be the corrective action, if any, you would like to out in place?
Solution: Particulars • Profit Margin: 40 / 200 *100 Profit / Sales * 100 • Turnover of Assets: Sales / Investments 200 / 140 = 1.43 times In investments working capital and fixed assets are included. • Return on Investment: 20 * 1.43 = 28.6% Comments: The ROI for the budget is higher than actual ROI is the product of the following Components: • • Profit margin Turnover of Investments 21.08 * 1.32 = 27.83% 185 / 140 = 1.32 times = 20 % 39/185 * 100 = 21.08 % Budget Actual
Profit margin * Turnover of Assets
In case of profit margin actual is higher than budgeted though the profit and the actual sales are in absolute terms as compared to budget but the percentage profit to sales is higher against budget. The following reasons can be associated to: 1. The variable cost as percentage to sales as compared to budget is 60% and actual is 58%. 2. Similarly sales promoting expenses to sales is also lower as compare to budget Budget: 10 / 200 = 5% and actual: 07 / 185 = 3% This above factor contributed higher profit margin as compare to budget. 3. Turnover of investment is lower in case of actual as compare to budget. This is due to the reasons, though the total assets are same in both the cases i.e. budget and
actual. Amount of the sales is lower in case of actual compared to budget. It appears the working capital management in case of actual since to be poor because working capital turnover ratio is low in budgeted (2 times) and act auks (1.2 times). Fixed assets turnover is better than budget. As far as actual is concern improvement in sales and improvement in budget needs to be taken care off. 11. In company XYZ, division B contracted to buy from division A, 10,000 units of a part that goes into the final product made by division B. The transfer price for this internal transaction was set at Rs.12 by mutual consent. This comprised of material cost of Rs.6 per unit, direct and available labour cost of Rs.2 per unit , fixed over heads of Rs.2 per unit (lumsum of Rs.20,000) and Rs.2 per unit as return on investment of Rs.1,00,000 that division A would have had to make for this incremental activity. During the year, division B’s actual off take from division a was 9800 units. Division a was able to effect 5% out back in material consumption but had 10% overrun on investment budgeted for this activity. Make a budget versus actual comparison statement for this activity. Solution: Comparison of Budget & Actuals P'culars Units Material cost Budget Budget as per actuals Actual 10000 9800 60000 58800 9800 55860 19600 20000 22000 117460
D.V.L.cost 20000 19600 F.C. Return Total T.P. 20000 20000 20000 20000 120000 118400 12
Comments: Comparing budget with actuals would not serve the purpose due to different no. of units. Hence, budget as per actual figures has been prepared. The figures show that the actual units consumed were 9800 instead of 10000. Still, Div A was in a position to reduce the material consumption cost. The labour cost was same as budget as per actual units and hence, company was in a position to control the costs. It shows that the company’s control system is efficient. OR
Q. 11. Balance sheet and profit and loss account of ABC ltd. Is given below for year 20002001 where actual figures are in Rs. lacs. Balance sheet Liabilities Equity/ Reserves 360 Assets Fixed assets Investments Inventories 440 40 128
Long term liabilities 200 Current Liabilities 240
Account receivables 160 Cash Miscellaneous 800 20 12 800
Profit and loss account
Sales Other income Materials consumed Labour Factory overheads (including Rs.40 lacs depreciation) Selling and administration Profit before interest and taxes Interest on borrowing Income tax
1120 4 426 291 168
123 116 25 15
1) What is the cash and book return on net worth? 2) What is the operating return on operating investment? 3) How is return on assets related to sales margin and assets turn over? Solution: 1) Cash and Book return on net worth: Profit before interest and tax (+) Depreciation (-) Tax
Share Capital (+) Reserves & Surplus (–) Miscellaneous Expenses 116 (+) 40 (–) 15 Cash Cash = = 360 (-) 12 40.51% Cash = 40.51%
2) Operating Returns on Operating Investment: Operating Returns on operating investment = Profit before interest and tax (+) Depreciation Fixed assets (+) Working capital = 116 (+) 40 400 (+) 68 = 0.33% Operating Returns on operating investment = 0.33% ( Note : Investment is considered as the traded investment.) 3) Return on assets related to sales margin and assets turn over: • Dupont Analysis: Return on Assets = Net profit Margin * Assets Turnover Net Profit Total Assets 76 508 14.96 = = = Net profit * Sales 76 1120 14.96 * Sales Total assets 1120 508 ratio
Q.12 (a) Best and company comprises five divisions A, B, C, D and E and at present measures divisional performance and managerial performance on the basis of return on asset. However the controller has recently suggested to the management that the company should switch over to EVA as the criterion rather than return on asset. From the information given below, compute both return on asset and EVA for each division and tabulate the same. Division Profit Fixed asset Current asset
A B C
150 110 50 D E
400 200 300 55 90 200 100
80 800 500 400 400
Controller suggested using corporate finance rate of 5% for current asset and 10% for fixed asset. Solution Formula EVA =operating profit – (WACC* capital employed)
ROA (return on asset) =NPAT/ total asset
Calculation ROA = NPAT/total asset *100 Division A B C D E ROA=NPAT/total asset*100 150/480*100 110/1000*100 50/800*100 55/600*100 90/500*100 Ans. 31.25% 11% 6.25% 9.17% 18%
EVA =operating profit – (WACC* capital employed) Division A B C D E Conclusion From the above analysis of these division which it notice that division A performed the best in respect of ROA and EVA all division have positive ROA whereas while calculating the EVA division C has negative EVA as against positive ROA 6.25%. Controller has advice evaluation of division can be made on the basis of EVA instead of ROA, EVA has following advantages:Profit 150 110 50 55 90 5% of asset 4 40 25 20 20 current 10% asset 40 20 30 20 20 of fixed Ans. =Column no. (2-3-4) 106 50 (5) 15 60
1. ROA express percentage on return on its investment where as EVA express absolute profit which generates after meeting cost of capital. 2. EVA over comes the optimum behavior of divisional manager i.e. divisional manager could not accept or resist for additional investment generates lower than rate of return 3. Positive EVA creates wealth for organization and also value for future.
A Q.12 (b) sterling associate has three divisions with varying operation characteristics. Division M is exclusively involved in marketing; division P in production while division C is involved in both marketing and production activities. Information about these divisions is tabulated below where in all the figures are in thousand of rupees. Particulars Current asset Fixed asset Division M 300 Nil Division P 300 3000 600 Division C 300 500 600
Profit before 600 depreciation, market development, operating expenses
Depreciation on all fixed assets is on the basis of straight line (10years). Division M must spend Rs. 300000 for market development and division C must also spend Rs. 150000 for same purpose, where as 10% of production facilities are to be replaced in division P, treating these as annual operating expenses, what are the rates of returns achieved by each division? Comment in detail. Solution Formula ROI = operating profit/ investment *100 Particulars Profit before depreciation, development, operating expenses Less depreciation Less operating expenses Total Calculation of ROI for each Division Division M market 600 Nil 300 300 Division P 600 300 300 Nil Division C 600 50 150 400
For division M ROI = 300/300*100 = 100% For division C ROI = 400/750*100 = 53.33% Comments:Division has 100% ROI mainly because it does not have fixed asset to operate as it is a marketing division and division P which involves more fixed asset does not generate profit after fixed and operating expenses and it does not generate any profit because replacement of production facility as treated part of operating expenses. Division C53.33% ROI because of lower depreciation and lower operating expenses as compare to other division. ROI cannot be compare in such situation from one division to another division mainly because the activities involved are different.
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