MBA - FMG404 - Management Control Systems PDF

Introduction to
Management Control
Systems
FMG404
NOTES
Management Control Systems
Unit 1: Introduction to Management Control Systems

Unit 2: Approach to Management Control
Unit 3: Designing Management Controls
Unit 4: Key Success Variables and Performance Measurement
Unit 5: Behaviour in Organisations
Unit 6: Responsibility Centres
Unit 7: Performance Evaluation of Responsibility Centres
Unit 8: Profit Centre
Unit 9: Transfer Pricing
Unit 10: Issues in Transfer Pricing
Unit 11: Measuring and Controlling Assets Employed
Unit 12: Budgets, Responsibility Accounting and Budgetary Control
Unit 13: Multinational Organisations
Unit 14: Management control process in service organizations
Unit 15: MCS in Project Management
Unit 16: Role of Audit in Control Systems
:1
Introduction to
Management Control
Systems
NOTES
Yashwantrao Chavan Maharashtra Open University
Vice-Chancellor : Prof. Dr. E. Vayunandan
Director,School of Commerce & Management : Dr.Pandit Palande
NATIONAL ADVISORY BOARD
Dr. Pandit Palande Prof.Devanath Tirupati, Dr. Surendra Patole Assistant

Director , School of Dean Academics, Professor,
Commerce& Management Indian Institute of Management - S chool of Commerce &
Y. C. M. Open University, Nashik (IIM-Bangalore) Bangalore Management,
Y. C. M. Open University, Nashik
Prof.Sudhir K. Jain Prof. Karuna Jain,
Vice Chancellor Director, Dr. Latika Ajitkumar Ajbani
Shri Mata VaishnoDevi University N I T I E, Vihar Lake, Mumbai Assistant Professor,
(SMVDU) Katra -400087 School of Commerce &
Jammu and Kashmir. Management,
Prof. Vinay K. Nangia
Ex-Head
Department of Business Studies,
Indian Institute of Technology, (IIT-
Roorkee) Roorkee.
Authors Editor
Dr. K.S.Ranjani FCA,CWA,M.Phil(Comm)PhD Dr.Varadraj Bapat, M.com,FCA,CWA,PhD

Dr.Varadraj Bapat, M.com,FCA,CWA,PhD
Instructional Technology Editing & Programme Co-ordinator
Dr. Latika Ajitkumar Ajbani

Assistant Professor
School of Commerce &Management
Production
Shri. Anand Yadav

Manager, Print Production Centre, Y. C. M. Open University, Nashik-422 222
:2
Unit 1: Introduction to Management Control Systems 4 Introduction to
Management Control
Unit 2: Approach to Management Control 21 Systems
Unit 3: Designing Management Controls 37 NOTES
Unit 4: Key Success Variables and Performance Measurement 50

Unit 5: Behaviour in Organisations 66
Unit 6: Responsibility Centres 87
Unit 7: Performance Evaluation of Responsibility Centres 104
Unit 8: Profit Centre 122
Unit 9: Transfer Pricing 143
Unit 10: Issues in Transfer Pricing 160
Unit 11: Measuring and Controlling Assets Employed 180
Unit 12: Budgets, Responsibility Accounting and Budgetary Control
206
Unit 13: Multinational Organisations 232
Unit 14: Management control process in service organizations 250
Unit 15: MCS in Project Management 267
Unit 16: Role of Audit in Control Systems 284
Management Control Systems- An Overview
Have you heard of great organizations rise and fall? Or small organizations rise to pinnacles
of glory? What might be the triggers for an organisation to rise or fall? They could be the
global factors in which businesses operate, local factors, market factors or the internal
factors. Global factors usually cover events like rise or fall in fuel prices, currency disruptions
such as sharp rise or fall in currencies with respect to the dollar or global economic cycles.
Local factors usually relate to the country specific factors such as political instability,
natural calamities, policy changes or economic conditions. Market factors relate to the
industry or market in which the business operates and usually mean competition, trade
cycles, technology changes or changes in consumer behaviour. While it cannot be disputed
that external environment plays a major role in rise and fall of organizations, internal factors
also contribute significantly to the rise and fall of businesses. An analogy can be drawn by
visualizing a road full of potholes (not too difficult, isn’t it?) and choc a bloc traffic. It is
very difficult to drive in such a road, similar to steering a business in an environment of
tough competition. However, if the driver has good control over his vehicle, it is not impossible
to drive on such a road. Similarly good controls within the organization, helps businesses to
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manage the challenges created by forces in the external environment.
Introduction to However, one must understand that though the focus of control systems is internal to
Management Control the organization, the control systems themselves are to be designed considering the
Systems dynamics of the environment in which the business operates. An example of this could
be the sales budget- the sales that the business wants to achieve is a number that comes
NOTES
from within the organization, but the factors that determine this are the market share,
level of competition, availability of new and substitute products in the market, etc.
Therefore, though budgeting is a control exercise internal to the business, the exercise
itself is ineffective, if external factors are not accounted for.
The book focuses on how to make control systems effective by balancing the internal
and the external environment.
Management Control Environment

Units 1,2 and 3 deal with the management Control environment and discusses the
meaning and purpose of Management Control Systems, the need for control,
approaches to management control, steps in designing management control and how
organization structure influence control.
Units 4 and 5 discuss the critical success factors which relate the control
environment in an organization to the externally driven factors and how goal
congruence is of critical importance in balancing conflicts within and with respect to
external environment.
Responsibility Centers
The organization structure depends upon the management control environment.

Decentralised structures are organized as responsibility centers. Units 6, 7, 8, 9, 10
and 11discuss responsibility centres namely cost centres, revenue centres, profit
centres and investment centres and also the evaluation of responsibility centers and
the application of transfer pricing in profit centres.
Management Control Process

Units 12 discusses the management control process of budgeting and responsibility
accounting and evaluation of performance through budgetary control
Variations in Management Control

Variations in types of organisation and the control systems in such environments is
brought out in Units 13, 14 and 15. These Units discuss multinational organisations,
service organisations and controls in execution of projects.
Role of Audit in management control

Units 16 discusses the role of audit in management control and the various types of
audit that are useful to business in control.
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Introduction to
Unit 1: Introduction to Management Control Systems Management Control
Systems
Structure
NOTES
1.0 Introduction
1.1 Unit objectives
1.2 Meaning
1.3 Evolution of Management Control Theories
1.4 Purpose of Management Control System
1.5 Elements of Control Systems
1.5.1 Detector
1.5.2 Assessor
1.5.3 Effector
1.5.4 Communication network
1.6 Need for Control
1.7 Complexities in designing management control
1.8 Activities in Management Control
1.9 Scope of Management Control
1.10 Strategic Planning
1.11 Operational Control
1.12 Management Control
1.13 Output of Management Control Systems
1.14 Summary
1.15 Key Terms
1.16 Questions
1.16.1 Multiple choice questions
1.16.2 State whether true or false
1.16.3 Theory questions
1.16.4 Business cases
1.17 Further Reading and References :5
Introduction to 1.0 Introduction
Management Control
Systems In this unit we get an overview of what control systems are all about. We discuss the
elements of control, why organisations need control and why designing control is not a
NOTES
simple and straightforward process. We also identify the activities involved in the control
process and the scope of management control.
1.1 Unit objectives

After reading this unit, you should be able to:
· Understanding meaning and purpose of Management Control Systems
· Define elements of control systems
· To analyse need for control in organizations
· To explain complexities in designing management controls
· Toillustrate activities in management control
· Outline scope of management control
1.2 Meaning
Control is perceived as the ability to wield considerable influence on something or
someone. When we say that things are under control we imply that nothing untoward
has happened. Simply put, it means that things are happening as planned. Therefore
control can be viewed as everything that happens between planning and achieving planned
objectives. What could happen between plan and result? Well, for starters, plans could
simply go wrong. You might be planning for a hot summer picnic and it might begin to
rain! A company may plan to launch a revolutionary feature in the key board and touch
screen may hit the market before the key board variant does. So while a good plan is a
good start, a good control system needs to be in place to ensure success in organisations.
So what exactly is this control? Control can be viewed as a process by which

resources are obtained and utilized effectively towards accomplishment of
organisational objectives (Anthony, 1965). Simon (1995) views control systems as
formal information based procedures and routines that are used by management to
measure and alter patterns in organizational activity. Resource management and
information management constitute such procedures and routines. Merchant and
Otley (2007), identify the main objective of Management Control System as
information management for the purpose of planning, evaluation and decision making
in an organization.
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Maciariello and Kirby define management control system as a “set of interrelated Introduction to
Management Control
communication structures that facilitates the processing of information for the purpose of Systems
assisting managers in coordinating the parts and attaining the purpose of an organisation
NOTES
on a continuous basis”.
The definition of control has evolved over years from one focussing on quantifiable
information to assist management decisions to include a much broader scope of information
that links the organisation to the external environment. From being passive tools which
merely provided information, newer approaches embracing sociological orientation make
management control systems dynamic and interactive.
1.3 Evolution of Management Control Theories

The traditional financial accounting measures such were useful for book keeping and
compliance while management accounting measures were useful for operational or tactical
controls. But the body of management control evolved further as business structures
evolved in both scope and scale. While economic framework played a central role in
structuring Management Control Systems (MCS) decision models, other subject areas,
such as management science, organization theory and behavioral sciences came to be
included in theorizing management control systems. Mechanical systems are dependent
on techniques and technology. However the human and machine interplay in organisations
accord a strong role to behavioural theories. MCS recognize foundations in other disciplines,
such as:
a) Organizational theory - the strongest influences are the organizational chart, the line
and staff relationships, and the role of the controller in the organization. Management
accounting followed organizational theory evolution through classical, neoclassical (behavior
or human relations), systems, and contingency approaches.
b) Behavioral approaches capture the effect of motivation, habits and culture on the
behavior of individuals. For example, incentive plans can affect different people in the
organisation in different ways.While for some roles monetary incentives help in better
performance, certain other roles may require different kind of motivation. Similarly, while
sales team can be incentivized by commission on volumes, an audit team may need different
kind of incentives. Management control systems’ explicit aim is to positively affect the
behavior of individuals through identifying the behavioural impact of decisions. :7
Introduction to
Management Control
1.4 Purpose of Management Control System
Systems
The purpose of management control system is to assist the management in the coordination
NOTES of the parts of an organisation and the steering of the parts towards the achievement of
its overall purposes, goals and objectives. A control system is designed to bring unity out
of the diverse activities of an organisation as it seeks to fulfil its overall purpose.
Management Control Systems enables various parts of an organisation to function as
one and ensure that the sum of all parts is greater than the parts themselves.
· Each part of an organisation is driven by a goal or purpose- for example, a sales

division in an organisation may be driven by maximising sales volume while the
production division may aim for minimum rejections.
· Different parts of the organisation functions for different purposes-some parts

of the organisation interface with customers, while other parts of the organisation
may be support functions. Hence the purpose of each part of the organisation
may be different.
· Autonomy is granted to various parts of the organisation to fulfil their respective

purpose-unless every division has explicit powers or authority, they may not be
able to function independently or effectively.
· Management Control System plays the role of bringing about unity of purpose
to these diverse parts of the organisation.
1.5 Elements of Control Systems

To help ensure that the data/information supplied is of high quality, the control systems
must have certaincharacteristics. Every control system has certain generic components.
There must be a reliable performance measurement system. Realistic standards should
be planned and maintained. The standards should beconsistently and regularly compared
with performance measurement data. Any variances that exceed predeterminedthresholds
should be enthusiastically investigated and reported to the people who have responsibility
and authority to make appropriate and timely adjustments. All adjustments should be
controlled, especially any adjustments thataffect predetermined standards and thresholds.
Hence the elements of a control system can be explained as follows:
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Introduction to
1.5.1 Detector Management Control
Systems
Performance measurement involves the process of measuring what is actually happening.
NOTES
In all control systems, the device that measures what is happening in the process is called
a Detector. For example, a thermometer measures the actual temperature of the body.
Similarly in organizations, daily sales report, weekly cash balances etc. are used to actually
measure what is happening.
1.5.2 Assessor
An assessor is a device that determines the significance of what is happening by

comparing it with the expected performance or the standard performance. A weekly
appraisal in the sales function of a business can be an example of this.
1.5.3 Effector
When the actual performance is measured and compared against the desired or expected
performance, then the actual performance may exceed expectations or fall short. In
case performance falls short of expectations, then the effector alters behaviour if assessor
so desires.To continue with the same sales example, if the sales of biscuits has come
down, the advertisement can be modified to reach out to the children as target audience.
1.5.4 Communication network
The transmission of information between the detector and the assessor and between the
assessor and the effector is achieved by Communication network. For example, the
sales team may decide to meet once in two weeks to review performance and take
desired corrective actions. This can be achieved only if a meeting is organized and members
of the team communicate with each other.
Check Your Progress

What are the elements of
control system ? What
would happen if one of the
element is missing ?
Figure 1.1: Elements of Control System :9

Introduction to
Management Control
1.6 Need for Control
Systems
Several control systems are used by us to make our day to day life more comfortable.
NOTES For example, a regulator is a control system that helps us to adjust the speed of the fan.
A voltage stabilizer helps to protect devices from damages caused by voltage fluctuations.
However, the basic difference between a completely automated and controlled machine
and the controls in organizations is that the automatic machines have fail safe control
systems because there are no unpredictable reactions. However organization also has a
human element thereby rendering the control system prone to failure, if sufficient care
is not taken. Therefore developing control systems in organization is extremely
complicated and involves coordination between several people, several functions, several
time frames and several aspirations. Some of the difficulties in developing a good control
system are:
· It is expensive to design controls and implement them in organizations. For

example, inventory management system is a control. It may be quite
expensive to actually operationalise it. There could be software costs, training
cost, maintenance and so on.
· It is cumbersome to make investment in systems and processes. Several

systems are very complex and may take a long time to implement. Change
in management can cause old systems to be abandoned in favour of new
systems thus resulting in duplication of efforts.
· There are possibilities of failure of controls considering the complexities

involved.
Do these difficulties make a case for absence of controls in organizations? Not at all!
Despite the difficulties associated with framing and maintaining controls in organizations,
several factors are at play in the current business environment. Globalised nature of
competition, availability of real time information, accelerated technological changes and
shorter life cycles of products and technology have made the business environment
extremely complex, thereby making effective controls inevitable. Some of the advantages
that good control systems can bring to organizations are as follows:
: 10
· Controls provide strategic advantages for a business. Good controls systems Introduction to
Management Control
are usually designed in the context of each organization’s uniqueexternal Systems
environment, technology, strategy, orga-nization structure, culture, and top
NOTES
management style.
· Controls facilitate “management by exception”. Regular feedback, which is a

part of control, ensures that basic operational activities are taken care of. A
good feedback usually reports variances and the top management needs to
attend only to the exceptional variances, therefore leaving them free to take
care of their strategy and be freed from day to day operations.
· Systems and processes are facilitators of efficiency. Whenever systems are

created, they bring in efficiency. For example, an outward register is maintained
in many organizations to track movement of people outside. This automatically
brings in a sense of discipline and unnecessary movement is cut down.
· Controls provide for a self-correcting mechanism. For example if sales return

record is maintained and it is always tracked as percentage of sales, then an
alarm is raised as soon as the sales return exceeds the normal percentage.
1.7 Complexities in designing management control

The control process used by management control uses the same processes that any
mechanical control would use- that is detector, assessor, effector and communication
network. However, management control is more complex because unlike automatic
machines where all inputs can be controlled, management control involves a combination
of organisation, systems, people and processes.
The reasons why management control may be more complex as compared to simpler,
mechanic controls are discussed as follows: Check Your Progress
Why do you think
management control is self
· Difficulties in setting standards .Standards are not objective in real business - control ? Can you think of
an example ?
environment. While it is easy to set an ideal room temperature and get your
machine to give the desired level of cooling, there are no such ideal standards
readily available in several areas of business. For example, if an organization
: 11
Introduction to wants to exceed the preceding years sales by ten percentage points that may
Management Control
Systems be a subjective decision of the management. It may not be the ideal or standard.
NOTES · Management control is not automatic. It involves lot of discretionary

decisions of the manager. Though several control systems are automatic, there
are some systems which need to be monitored. Also several systems may need
changes to be made from time to time. Also external changes may require
change in preset standards, hence requiring manual intervention.
· Unlike simple control systems, management control involves coordination

among individuals. Several people may be working to the best of their abilities,
yet if there is no coordination among various individuals, divisions or departments
within the organization, then the best minds cannot produce best results. Hence
it must be ensured that people work for a common cause and that common
cause is communicated to them.
· The connection from perceiving the need for action to determining the
action required for the desired result may not be clear. While driving a car,
when the driver senses an obstacle ahead, he pulls the brake and the car stops
or slows down. Once the obstacle is cleared speed can be restored. Therefore
the driver knows clearly that pulling the brakes will slow down the car. However
in a business environment, suppose a manager senses obstacles in terms of
increased competition, then he may decide to increase marketing efforts.
However increasing marketing efforts is no guarantee that sales will not decline.
Therefore the need is to face competition; but the course of action is not as fool
proof as pulling the brakes in the car.
· Most of Management Control is self-control. Unlike devices that have clear

indicators, for example, a car has a speedometer; managers do not have
indicators. Judgement is the key for any manager. Sometimes, they may even
have to go beyond instructions or established procedures and use gut feel to
navigate situations.
: 12
1.8 Activities in Management Control Introduction to
Management Control
There are several activities involved in the management control process. Systems
NOTES
· Planning- Management Control begins with planning. Planning is closely linked
to the strategic theme of the organization. Once the planning process is kick
started, the various agencies involved in implementing the plan are identified
and their role is defined.
· Coordination- For the plans to be implemented successfully, a great degree of

coordination is required. Most of the processes in a business are interrelated
and have to be coordinated with each other. For example, the launch of a new
product requires coordination between marketing and product development
teams. Similarly any business plan needs a great deal of coordination to ensure
that the plan kicks off from the ground.
· Communicating plans and the process controls using suitable information

systems is the next activity in management control. For example, budget is a
communication tool to convey the expectations of top management to the
operational or task managers. It breaks down the overall goals of the organization
into specific functional budgets giving a clear indication of what the functional
teams are expected to achieve.
· Management control process not only involves communication of information

to the lower levels of management but also evaluating and processing
information received from the functional level to ascertain whether activities
are proceeding as per plan.
· Control process is incomplete without initiation of corrective actions, financial

as well as others. Hence the control process continues with corrective actions
and if necessary, resetting goals.
One must remember that the control process is not finite, does not have definitive
boundaries or a clear starting and an end point. It is an ongoing process that has
to run as long as the business is running.
: 13
Introduction to
Management Control
1.9 Scope of Management Control
Systems
The scope of management control includes strategic planning, management control and
NOTES operational control. Strategic planning involves drawing a road map covering the medium
to the long term of the business. Management control converts these plans into action
points and communicates them downwards to the operational team and also reports the
results from operation back to the top management. Operational control involves
implementation of the plans so that themes envisioned in the strategy are realised as
planned.
1.10 Strategic Planning

Strategic plan covers some aspects or part of business at any given time. Strategies are
usually mutually exclusive rather than inclusive and broad based. For example a low
cost strategy rules out differentiation and therefore will involve completely different set
of activities by the organization. By its nature strategy is therefore infrequent and need
based. It is not revisited or tinkered too often unless any drastic change in the external
environment necessitates change in the organisation’s strategy. Strategy therefore is
more a function of the external environment and is closely linked to external environment.
Data used for decision making are approximate and not current data. The function of
strategy is limited to the top management. Usually communication involves conveying
policies, rules and instructions to the lower management.
1.11 Operational Control

Operational control relates to the performance of tasks. Hence planning is task specific
and output is attempted to be defined. Operational control relates to the near term
activities of the business. Whenever operational activities are related to direct activities
of production, the input to output relationship is attempted to be quantified. However,
when such relationship cannot be quantified non quantitative measures are developed.
Repetitive and measurable activities are called as task control and are as such, a part of
the operational control process. All the line functions come under operational control.
Communication involves reporting to the middle management.
: 14
Introduction to
1.12 Management Control Management Control
Systems
Indirect activities come under the purview of management control. Indirect activities
involve staff functions such as human resources, marketing etc. However management NOTES
control also involves line activities. As such, management control involves a combination
of long term and short term. The strategy of the top management is broken down into
functional budgets and communicated to the operational teams. This is a function of
management control.Hence management control involves line and staff functions.
Management control is also a two way process where communication happens from
top management to the operational teams and vice versa. Also management control
function is all pervasive since it spans across all levels of management. Otley, Broadbent
and Berry (1995) consider management control as an activity that links operational
control and strategic planning.
The scope of management control is also not limited since it involves reciprocal functions
of conveying instructions to the lower management and reporting the operational results
to the top management.
Management control occurs between the top and the lower levels because it involves
communication of strategies to lower level and reporting operational efficiencies to the
top management. Strategy has long run focus and operations have short run focus.
Management control is a combination of both planning and control.
Check Your Progress

Is management control
different from operational
control ? How is it different
?
Figure 1.2: Scope of Management Control

: 15
Introduction to
Management Control
1.13 Output of Management Control Systems
Systems
While the output of management control can be reliably measured by measuring its
NOTES effect on the bottom line using measures such as Return on Investment (ROI) and
Economic Value Added (EVA), non-financial measures are also equally significant.
Financial measures are objective and help in measuring the short to medium term
performance in an organisation. However, in order to measure the firm performance
over a long term, non-financial measures are very useful. Non-financial measures include
product quality, market share, customer satisfaction, employee morale etc. The preference
for financial measures essentially arises from the fact that they are quantifiable. However,
non-financial measures are also sought to be measured through the use of various tools
and techniques such as Balanced Score Card. We will study in later units about these
tools in more detail.
1.14 Summary
A set of interrelated communication structures that facilitates the processing of information
for the purpose of assisting managers in coordinating the parts and attaining the purpose
of an organisation on a continuous basis is called as Management Control System. The
purpose of management control system is to assist the management in the coordination
of the parts of an organisation and the steering of the parts towards the achievement of
its overall purposes, goals and objectives. The elements of a control system are detector
which measures what is happening in the process; assessor which determines the
significance of what is happening by comparing it with the expected performance or the
standard performance; in case performance falls short of expectations, then the effector
alters behaviour if assessor so desires; the transmission of information between the
detector and the assessor and between the assessor and the effector is achieved by
communication network. Developing control systems in organization is extremely
complicated and involves coordination between several people, several functions, several
time frames and several aspirations. Yet Controls are important because they provide
strategic advantages for a business, facilitate “management by exception”, facilitate
efficient functioning in the business and provide for a self correcting mechanism.
Management control is more complex because unlike automatic machines where all
: 16 inputs can be controlled, management control involves a combination of organisation,

systems, people and processes. There are several activities involved in the management Introduction to
Management Control
control process which are Planning, Coordination, Communicating plans, evaluating Systems
and processing information received and initiation of corrective actions. The scope
NOTES
of management control includes strategic planning, management control and operational
control. Strategic planning involves drawing a road map covering the medium to the
long term of the business. Management control converts these plans into action points
and communicates them downwards to the operational team and also reports the results
from operation back to the top management. Operational control involves implementation
of the plans so that themes envisioned in the strategy are realised as planned. Output of
MCS is both financial as well as non financial.
1.15 Key Terms

A set of interrelated communication structures that facilitates the processing of
information for the purpose of assisting managers in coordinating the parts and
attaining the purpose of an organisation on a continuous basis is called as
Management Control System.
Strategic plan covers some aspects or part of business at any given time and is
infrequent and need based. Strategy is more a function of the external environment
and is closely linked to external environment.
Operational control relates to the performance of tasks where planning is task

specific and output is attempted to be defined. It relates to the near term activities of
the business.
1.16 Questions
1. Management Control is different from operational control because:
i. Management Control is a function of the top management
ii. Management Control includes both short term tasks as well as long
term activities
iii. Management Control involves communication from the top

management
: 17
Introduction to
2. Which of the following statements describes the function of control
Management Control
Systems well?
NOTES i. Control process is not finite, does not have definitive boundaries or
a clear starting and an end point
ii. It involves the control of all activities by not allowing any external
influences
iii. It starts with planning and ends with action
3. Developing control systems in organization is extremely complicated

because,
i. It involves sophisticated equipment and investment
ii. It involves extensive human interface and cannot be completely

automated
iii. It is very expensive to implement and does not justify the cost
involved
4. The device that measures what is happening in the process is called
i. Assessor
ii. Detector
iii. Effector
5. This involves drawing a road map covering the medium to the long
term of the business
i. Strategic planning
ii. Operational Control
iii. Management Control
1. Controls are not necessary because they are expensive to design and
cumbersome to maintain.
2. The element which determines the significance of what is happening

by comparing it with the expected performance or the standard
performance is called the assessor.
: 18
3. The output of management control is always measured by the financial Introduction to
Management Control
measures. Systems
4. Operational control relates to the near term activities of the business. NOTES
5. Budget is a communication tool to convey the expectations of top

management to the operational or task managers.
1. What is the purpose of Management Control Systems in organizations?
2. What are the elements of control systems?
3. What is the need for control in organizations?
4. What might be the complexities in designing management controls as against

simpler controls?
5. What are the activities in management control?
6. Identify the scope of management control.
Hindustan Vyapar Limited is considering the launch of herbal products including

soaps, shampoo and face cream. Their production processes are completely
based on traditional and indigenous knowledge and they do not use preservatives
or chemicals. Their processes do not emit harmful wastes and they have
succeeded in embracing a clean and green production process. They are looking
at creating control systems for their business.
Identify the major elements in their control system, the set of activities that may
be involved and set out a scope for the control system to be designed.
Your report should identify the strategy, operational reports and a

recommendation for the control system.
7. MSM Himachal Limited manufactures fruit juices and syrups. The sales have
decreased since the last three years and there has been serious competition in : 19
Introduction to this segment making survival difficult. They have been operating with informal
Management Control
Systems control systems since a formal system of controls may be difficult and expensive
to install.
NOTES
Can a good control system improve things for the company? How will it help?
1.17 Further Reading and References

Merchant, K. A., & Otley, D. T. (2007). A review of the literature on control and
accountability.
Handbook of Management Accounting Research. (Ed.) C. S. Chapman, A. G. Hopwood,

and M.
D. Shields, 785-804, Amsterdam: Elsevier Press.
Otley D, Broadbent J, Berry A. Research in Management Control: An Overview of its

Development. British Journal Of Management [serial online]. 1995;(SPEISS):31.
Available from: General OneFile, Ipswich, MA
Anthony and Govindarajan, Management Control Systems, 12th Edition, Tata McGraw
Hill
Hanzlick and Bruhl, Management control systems as a package, CIMA Journal, Volume
13, Issue 2, April 2013
Maciariello and Kirby, Management Control Systems- Using Adaptive Systems to Attain
Control, 2nd Edition, Prentice Hall India, pp-1
Simons, R. Levers of Control: How Managers Use Innovative Control Systems to Drive
Strategic Renewal. Boston: Harvard Business School Press, 1995.
: 20
Introduction to
Unit 2: Approach to Management Control Management Control
Structure Systems
2.0 Introduction NOTES

2.1 Unit Objectives
2.2 Evolution of control
2.3 Contingency Theory
2.4 Contingency variables
2.5 External Environment
2.6 Work Technologies
2.7 Organization Structure
2.7.1 Organization Size:
2.7.2 Organizational strategy
2.7.3 National Culture
2.8 Cybernetics Paradigm
2.9 Business Strategy and Approach to Control
2.10 Hierarchy and Control Process
2.11 Summary
2.12 Key Terms
2.13 Questions and Exercises
2.14 Further Readings and References
: 21
Introduction to
Management Control 2.0 Introduction
Systems
So far, we discussed themeaning and purpose of Management Control Systems, elements
NOTES
of control systems, need for control in organizations, complexities in designing
management controls, activities in management control and the scope of management
control. In this Unit we discuss the approaches to management control. We learn the
evolution of each of the approaches and the role of business strategy in control systems.
2.1 Unit Objectives

· To learn approaches to management control
· Understanding meaning of Contingency theory
· Discuss Cybernetic Approach to Management Control
· Analysing Role of Business Strategy in Management Control System
· Explain Hierarchy in Control
2.2 Evolution of control

Understanding the approaches to management control is essential because different
types of organisations will need different approaches to control. A mature organisation
may need a different approach as against a start-up. A large manufacturing organisation
may have different requirements from that of a service organisation and so on.
Controls in organisation are not made to order. There is no organisation that has a
perfect control system in place, to begin with. A good control system begins with planning.
Examples of failed enterprises on account of lack of planning are several. Studies have
shown that lack of planning is a key factor in explaining failure of a start-up business
(Lussier, 1995).1
(Footnotes)
1Lussier, R. N. (1995). ¯A ,Nonfinancial Business Success
Versus Failure Prediction, Model for Young Firms,Journal of Small Business
Management , 33(1), 8-20.
: 22
Approaches to management control are varied in perspective. In fact, one of the most Introduction to
Management Control
popular approaches to management control is that there is no best approach to controls. Systems
This is popularly known as the Contingency approach or contingency theory, which
NOTES
would be discussed later in this Unit.
Merchant and Otley (2007) opine that “MCS is designed to help an organization adapt to
the environment in which it is set and to deliver the key results desired by stakeholder
groups”
Approaches to management control can be broadly classified as proactive controls and

reactive controls. Each of these has its place in organisational controls. Proactive controls
are suited for organisations that have reached scale and maturity and reactive controls
are useful when firms/products or businesses are relatively new and there are no
established standards and procedures.
Contingency theory approach is reactive in its broad approach and the other popular
approach is the cybernetic paradigm which is proactive.
Figure 2.1: Approaches to Management Control
: 23
Introduction to
Management Control
2.3 Contingency Theory
Systems
The name simply means that structure and process depend, or are contingent upon
NOTES various internal and external factors. This theory was developed in the 1960s by Tom
Burns and G. M. Stalker in Britain and Paul Lawrence and Jay Lorsch in the United
States.
Contingency theory is a core-element and assumes that the environment or the internal
and external context of a system or an organization has a strong impact on the
performance and efficiency of the system. It is assumed that there is no such thing as
universally applicable systems but often the situation that systems have to adapt to a
specific context to be efficient (Schreyögg& Steinmann, 1987).
The contingency-based view is a combination between the decision-based approach

and the system-theory. The decision-based approach has a very narrow perspective
whereas the system theory is strictly formalistic. Resulting from this combination, the
contingency theory represents an open system with “if then”-relationships focusing on

relations within and around the corporation as the defined system. Contingency theory
is guided by the general hypothesis that organizations whose internal features best match
their situation-specific demands will achieve the best adaptation. (Scott, 2005)
Referring to MCS, contingency theory argues that the design of control systems is
contingent upon the context of the organizational setting and the strategic focus in which
these controls operate. A better match between the control system and the contingency
variables is hypothesized to result in increased organizational and individual performance.
Contingency theory in this context arose in response to a broad approach which argued
that optimal control design can be applied in all settings and firms.
2.4 Contingency variables

The factors that usually influence the control design are known as contingency variables.
Some of the common contingency variables have been identified through several studies.
Prominent contingency variables identified by Chenhall, R. H. (2003) are external
environment, work technologies, organisation structure, organisation size, organisational
: 24
strategy and national culture.
Introduction to
2.5 External Environment Management Control
Systems
According to the contingency perspective, stable environments suggest mechanistic
structures that emphasise centralization, formalization, standardization, and specialization NOTES
to achieve efficiency and consistency. Certainty and predictability permit the use of
policies, rules, and procedures to guide decision making for routine tasks and problems.
One can easily imagine some structures that have the characteristics of mechanistic
structures. State owned businesses, monopolistic businesses etc., would have certainty
and predictability. This also results in rule based organisations resulting in what is commonly
called as “red tape” or delayed decision making owing to such rigid structures.
Unstable environments suggest organic structures which emphasize decentralization to

achieve flexibility and adaptability. Uncertainty and unpredictability require general
problem solving methods for non-routine tasks and problems. To understand this in
perspective one can visualise the business environment in India pre and post liberalisation.
Several industries came under severe competition and were faced with extremely
challenging and unstable business environment. Paul Lawrence and Jay Lorsch suggest
that organizational units operating in differing environments develop different internal
unit characteristics, and that the greater the internal differences, the greater the need
for coordination between units.
2.6 Work Technologies

Different work technologies would require different organisational forms. Large
manufacturing firms with varying degrees of automation might require different hierarchies
and organisational forms. Small customized and batch size manufacturing might require
a different organisational form.
2.7 Organization Structure
Complex organization structures require complex control systems. Lean organisations

depend heavily on organisation controls since escalation of problems take relatively
longer and are far more difficult to detect in such organisations as compared to
organisations that have multiple layers of reporting. Examples of complex organisations
include multi product or multinational organisations which are faced with operational
: 25
Introduction to complexities as well as regulatory complexities. Operating in several nations would
Management Control
require organisation to comply with different regulatory environment which vary across
Systems
countries.
NOTES
2.7.1 Organization Size:
Small organisations may have informal structures. Owner driven organisations might
have random controls and power centres while large organisations might have more
layers and have more formalized structures. Hence organizational size is another
contingency variable thought to impact the effectiveness of different organizational forms.
2.7.2 Organizational strategy
The contingency approach in strategy literature holds that the appropriateness of differ-
ent strategies are contingent on competitive settings of businesses. The competitive
setting is typically defined in terms of environmental and/or organizational contingen-
cies. Firms operating in highly competitive business environment needs to have differ-
ent types of controls. They need to have controls which are external to the organization
such as customer feedback, competing product analysis etc. However, firms operating
in less competitive environments need to have internal controls such as inventory man-
agement, performance management etc.
2.7.3 National Culture
Organizations operating within a country may have to adapt to variations in local, state,
Check Your Progress and federal laws and regulations. Organizations operating internationally may have to
How does organisation size adapt their organizational structures, managerial practices, and products or services to
influence the control system
? differing cultural values, expectations, and preferences. The availability of support
institutions and the availability and cost of financial resources may influence an
organization’s decision to produce or purchase new products.
Each of the above variables discussed have an influence on the control systems designed
by the organisation.
2.8 Cybernetics Paradigm

Griesinger, in 1979, coined the idea of cybernetic paradigm. The cybernetic paradigm
helps in capturing the essential elements of the repetitive control process economically.
: 26
Introduction to
This approach helps the management in analyzing complex activities and managing the Management Control
repetitive control process in the organization. Systems
NOTES
Meaning of cybernetics
• Cybernetics is the science of communication and control, dealing with the self-
regulating properties in different systems (machines, human body).
• A cybernetic control system is a self-regulatory control system; once it is put into

operation it can automatically monitor the situation and take corrective action
Check Your Progress
when necessary (thermostat; radar control; AI and robotics; computerized What is the role of feedback
inventory systems). in the cybemetic paradigm?
• Cybernetic control systems have built-in monitoring systems designed to alert if

things are not progressing as intended.
The essential elements of cybernetic control process can be enumerated as follows:
1) Establishing goals and performance standards
2) Measuring and assessing the actual achievements
3) Comparing actual achievements with the goals
4) Computing variances
5) Inform the variances by way of reporting
6) Identifying the reasons for variances
7) Taking appropriate action to stop adverse variances in future
8) Constant follow up actions to ensure compliance of the goals or objectives
Using ABC Corporation, a hypothetical company, let us understand the various

processes discussed above. Let us assume that ABC Corporation wants to evaluate
the performance of a new equipment that has been purchased by them that is expected
to increase process efficiency and output.
1) Establishing goals and performance standards

: 27
Introduction to ABC Corporation has to set measurable goals which need to be achieved. For
Management Control
Systems example, the expected percentage increase in production should be stipulated. Also
the number of units of increased production should be identified and incorporated
NOTES
into the budgeting exercise in as much detail as possible.
2) Measuring and assessing the actual achievements
Now ABC Corporation can measure the performance of the equipment by

measuring the actual output and recording it periodically.
3) Comparing actual achievements with the goals
Check Your Progress The next step in this process is to compare the actual number of additional units
What is the role of feedback
in the cybemetic paradigm? produced by the equipment and comparing it with the anticipated increase.
4) Computing variances
In case the actual number of units exceeded the expected output, then there
would be positive variances. In case the expected output exceeded the actual
output, then there is an unfavourable variance. Computation of variance is an
important step because it is at this stage that the organisation is alerted about
need for corrective action.
5) Inform the variances by way of reporting
There are two important parameters in reporting requirements. To whom should

these variances be reported and by whom? Obviously, the records for the output
is maintained by the production department and the equipment purchase has
been sanctioned by functional head and the budgetary approval has been obtained
from the Finance team and the Product team. Therefore these reports should
be informed to the Product Head who would then proceed to identify the reasons
for the variance.
6) Identifying reasons for variances
The reasons for the variance could be several. One of the possible reason
could be the performance of the equipment itself, but other reasons could be
improper installation, handling, improper inputs or scale inefficiencies which do
: 28
not necessarily relate to the equipment. Once the reasons have been identified, Introduction to
Management Control
then corrective actions can be taken. Systems
7) Taking appropriate action to stop adverse variances in future NOTES
The corrective action would depend upon the root causes identified. There could
be several corrective measures possible including training the staff to handle
the equipment so that the results are optimized, or re-evaluate the performance
and get the vendor’s inputs on improving the performance.
8) Constant follow up actions to ensure compliance of the goals or objectives
A positive variance or better than expected performance implies that continuous

Check Your Progress
What is the role of feedback
monitoring is required to ensure that it is not a chance happening. Unfavourable in the cybemetic paradigm?
variances would mean that the causes are identified and corrected immediately.
Once the corrective action is taken, the loop goes back to Stage 3- that is
comparing actual achievements with the goals.
From the analysis of the essential elements we can say that the cybernetic paradigm
starts with the assumptions that decision are made after the interaction between the
manager (decision makers) and the external environment. The manager scans and
observes the external environment from the data collected by the “sensors” through
reports and informal discussion with the members of the organization. The managers
build up their perceptions based on the “factual premises” drawn from the data collected.
In the next process, the factual premises are compared with the goals and objectives set
by the organization. Every possible step is taken by the management to eliminate/ minimize
the gap between value premises of the managers and the factual premises drawn from
the external environment, by analyzing the variance between the actual performance
and the desired result. In case of the adverse variance or shortfall in performance, the
managers take appropriate course of action as implementation process, to eliminate the
variances.
In the implementation stage, the managers put in practice the desired control mechanisms.
In the next stage which is called the “feedback stage”, the required feedbacks are
gathered to find out the reaction of the implementation action. If there is a positive
: 29
feedback, same action is repeated again in similar situation in future.
Introduction to
Management Control
Systems
NOTES
Figure 2.2: Cybernetic Paradigm- Simplified Representation
2.9 Business Strategy and Approach to Control

Strategy is an important variable in creating controls within organizations. Businesses
may be facing environmental contingencies or organizational contingencies. Environmental
contingencies usually affect all the players in that industry- for example; there could be
stagnation in the industry, hostile environments; fragmented, mature and declining
industries; different stages of the product’s life cycle etc. The controls would vary
depending upon the type of contingency facing the industry at a given point of time.
Some examples of environmental contingencies relate to tobacco industry which is heavily
regulated by the government. Similarly polluting chemicals, toxic substances etc. come
under stringent regulation. These will affect all the businesses operating in that industry.
Several countries have banned asbestos owing to its perceived threat on the environment.
Such risks affect all businesses in that industry.
Organisational contingencies usually is the position of the organization vis a vis its
competitors. Mobile Handset manufacturers, for example face severe threat from
competitors forcing them to evaluate their competitive strategies periodically.
Strategies for high market share businesses; low market share businesses; effective
low market share businesses; market leaders, challengers, followers and nichers may
: 30
be different from one another. An entrant into an untested market may have different Introduction to
Management Control
strategies as compared to players who enter a mature market. An extremely interesting Systems
example of late entrant into a market is being witnessed in the Indian market today-
NOTES
Patanjali products which have used competitive pricing to acquire rapid growth in the
Indian fast moving consumer goods (FMCG) category.
The kind of controls that organisations would devise would depend upon each of the
variables as discussed above.
2.10 Hierarchy and Control Process

Organisations having centralized decision making-that is all decisions made by the top
management, the control process also is centralized. The information flow in this kind of
organization follows a hierarchy of instructions from the top management and reports
from the line function.
However, decentralized organizations have a different control process. Budgets are

usually made in consultation with the line function and goals are negotiated between
various levels of management. Performance evaluation happens on a continuous basis
and instead of mere reports of what went wrong; there is a continuous feedback
mechanism and a cybernetic model involving planning, decision making and controls.
Hence the control process depends upon the hierarchical structure present in the
organization.
Concept in Action
Teddy Oswari(2000) analyzed comparative financial performance of 97 commercial

banks during the period 2004 - 2008 in Indonesia to analyze the influence of contingency
variables (competing strategies, corporate culture, external environment and
organizational structure) to the credit risk management system of commercial banks in
Indonesia. He found evidence of competitive strategy, corporate culture and
organizational structure influencing credit risk management system of commercial banks
in Indonesia.
: 31
Introduction to
2.11 Summary
Management Control
Systems
This Unit gives an overview of the basic approaches to management control. Controls
NOTES could be reactive and dependent on the external environment, or proactive and follow a
systematic approach. The former, known as contingency theory also proposes that control
depends upon the contingency variables such as organisation environment, size, and
work force technologies etc. Cybernetic paradigm suggests an eight step approach in
controls beginning with establishing goals and performance standards, measuring and
assessing the actual achievements, comparing actual achievements with the goals,
computing variances, inform the variances by way of reporting, identifying the reasons
for variances, taking appropriate action to stop adverse variances in future and constant
follow up actions to ensure compliance of the goals or objectives. Controls also vary
depending upon the business strategies and organisational hierarchy.
2.12 Key Terms

Contingency theory is a core-element and assumes that the environment or the internal
and external context of a system or an organization has a strong impact on the
performance and efficiency of the system.
Cyberneticsis the science of communication and control, dealing with the self-regulating
properties in different systems (machines, human body).
A cybernetic control system is a self-regulatory control system; once it is put into

operation itcan automatically monitor the situation and take corrective action when
necessary.
2.13 Questions and Exercises
1. Which of the following statements best describes the cybernetic paradigm?
(a) The cybernetic paradigm helps in capturing the essential elements

of the repetitive control process economically
(b) Cybernetic paradigm believes that environmental variables influences
the control process
: 32
(c) Cybernetic paradigm believes that the owner of a small organization Introduction to
Management Control
may directly control most things, but large organizations require Systems
more complex and indirect control mechanisms.
NOTES
2. Contingency theory can be best described using which of the following
statements?
(a) It is assumed that there is no such thing as universally applicable
systems but often the situation that systems have to adapt to a
specific context to be efficient.
(b) Control systems should be homogenous and standardized across
organization structures
(c) Control systems do not depend upon the size or external
environment in which an organization functions
3. Export and import based businesses heavily rely on the currency exchange
rate. Suppose rupee is fluctuating against the dollar very heavily, for the
export import business it can be described as:
(a) Organizational contingency
(b) Business contingency
(c) Environmental contingency
4. For an advertising agency which creates campaigns for the customer, the
following are the important controls required:
(a) Good inventory management practices
(b) A mechanism to receive constant feedback from customers for
whom the campaigns are created and the viewers of the
advertisements
(c) Monitoring receivables from the customers
5. Definition of goals, measurement of actual performance with the goals and
a corrective mechanism is best suited for the following kind of organizations:
(a) A new startup venture with no historical data
(b) A small advertising agency that develops creative content for
larger agencies
(c) An organization that manufactures several models of mobile
handsets
: 33
Introduction to 2.13.2 State whether true or false
Management Control
Systems i. The extent of centralization in an organization determines the kind of
NOTES controls in an organisation

ii. Environmental contingencies usually affect all the players in that industry
iii. Small organizations can have formal work controls while larger
organizations have informal work controls
iv. Contingency theory argues that optimal control design can be applied
uniformly across all organizations without any other contextual variables.
v. A cybernetic control system is a control system in which frequent
external monitoring is required since it is not built into the system
1. Explain contingency theory. Do you think it is a reactive control? Why?

2. Explain contingency variables and how they influence the control system in the
organization.
3. What does the cybernetic paradigm propose? Explain the framework of
cybernetic paradigm with suitable examples.
4. Why cybernetic approach is considered proactive? Give reasons.
5. What is the role of business strategy in control?
6. MMM Enterprises want to measure the performance of employees after putting
them through a strategy training programme. Explain how the cybernetic
paradigm can be used to evaluate the efficacy of the training programme.
7. Environmental contingencies affect all the players in the industry. Explain this
in the context of the tobacco industry which has been experiencing a worldwide
slowdown.

Merchant, K.A. and Otley, D.T. (2007): A Review of the Literature on Control
and Accountability. In: C.S. Chapman, A.G. Hopwood and M.D. Shields (eds.):
Handbook of Management Accounting Research, Elsevier 785-802.
Paul R. Lawrence and Jay W. Lorsch, Organization and Environment

: 34 (Homewood, Ill.: Irwin, 1969).
Tom Burns and G. M. Stalker, The Management of Innovation (London:Tavistock, Introduction to
Management Control
1961). Systems
Scott, W. R. (2005). Institutional theory: Contributing to a theoreticalresearch NOTES
program. In K. G. Smith & M. A. Hitt (Eds.), Greatminds in management: The

process of theory development Oxford: Oxford University Press.
Chenhall, R. H. 2003. Management control system design within its organizational

context: Findings from contingency-based research and directions for the future.
Accounting, Organizations and Society 28(2-3): 127-168.
Griesinger, Donald W., Management Theory: A Cybernetic Perspective, Graduate

management Centre, The Claremont Graduate School, Claremont, Calif, January
1986
Teddy Oswari, Contingency Variable Interaction Model: Implementation on Credit

Risk Management System of the Commercial Banks In Indonesia, Gunadarma
University, Indonesia,2000
Mintzberg Henry, The structuring of organisations. Englewood Cliffs, N.J, Prentice

Hall,1979
Schreyögg, G. and Steinmann, H. (1987). ‘Strategic control: a new perspective’.

Academy of Management Review,12, 91–103.
: 35
Introduction to
Management Control Unit 3: Designing Management Controls
Systems
Structure
NOTES
3.0 Introduction
3.1 Unit objectives
3.2 Designing Management Controls
3.3 Steps in designing Management Control System
3.4 Role of Information Technology in Management
Control Design
3.5 Application of Information Technology in Organization
3.5.1 ERP Software
3.5.2 Email
3.5.3 CRM Software
3.5.4 Inventory management Software
3.6 Summary
3.7 Key Terms
3.8 Questions
3.8.3 Business case
: 36
Introduction to
3.0 Introduction Management Control
Systems
In this Unit we look at designing managing controls and the important factors that
influence the design of management controls. We also understand the role of information NOTES
technology in designing controls for organisations.
3.1 Unit objectives

· To learn about the steps in designing management controls
· Explaining the Factors influencing design of Management control
· To Analyse Role of Information Technology in Management Control Design
3.2 Designing Management Controls

Natural biological and physical systems come with their own in built controls. For example
to help the body grow, human beings need to eat and hunger is a mechanism by which
the body signals that it needs food. However, organisations are contrived social systems.
Hence controls and control systems should be designed for organisations, because there
is no self-driven mechanism which would automatically steer organisations towards
achieving their purpose. We know of several organisations which were overtaken by
competition and pushed into oblivion because they could not frame timely responses to
the changes around them.
If organisations are left to their own devices, there is resultant disorder and chaos. A
Check Your Progress
Give an example of key
managerial control system seeks to reduce this chaos by bringing unity out of the diverse result and its measurement.
efforts of the various parts of the organisation. A purely mechanical control system can
achieve control only within the range of disturbance that it was designed to handle. An
air conditioner for example will regulate the temperature of air at the set parameters -
not more, not less. However, managerial control systems, on the other hand must be
designed to handle problems which are not known at the time of design. Therefore
managerial controls should be adaptive.
: 37
Introduction to Management Control design should reflect the basic elements of control namely proper
Management Control
Systems goal setting, timely control and a good corrective and feedback mechanism.
NOTES
Figure 3.1: Management Control Design
Some key factors which are of paramount importance while designing a management
control system are discussed as follows:
1. Constructive versus punitive controls: Constructive controls create enabling

environment to follow pre-established systems and guidelines. They strive to
create an environment of trust and compliance and analysis of variance is done
so as to improve results. Some organizations have a system of recognizing
“Employee of the month” for someone who achieved maximum energy savings
by being efficient. This is an example of constructive control which rewards
efficiency and incentivizes people by rewarding them for optimum behaviour.
Punitive controls on the other hand are more focused on deviations and are
mechanisms which seek to punish errors or deviation. Late attendance record
is an example of punitive control.
While punitive controls have their place, organizations should strive to minimize
Check Your Progress punitive controls and establish constructive control to induce the desired
What is the role of
behaviour from the participants. Therefore while designing controls incentives
accountability in
management control ? could be built into the feedback that creates a healthy environment for the
controls to achieve the desired purpose.
: 38
2. Measurable Objectives: Control processes should have variables that are Introduction to
Management Control
measurable. If the variables are not measurable then the outcome is also not Systems
likely to be measurable and the control process is bound to fail. Let us assume
NOTES
that a company is tracking the sales performance of a new product that it has
launched in the market. Then the variables will have to be broken down as daily
sales off take, region wise, depot wise break up of daily sales etc. Otherwise it
would be impossible to track the sales performance of the product. When the
variables are more specific and measurable, the control also tends to be more
effective. Hence, wherever feasible, the objectives must be broken down into
measurable variables.
3. Key results: Controls must focus upon a few defined and specific key results
of an activity. If we continue with the example of the new product launch, some
of the key variables would be region wise sales figures and percentage increase
in sales volume for a given period. These would be the key result areas on
which the company would focus with respect to the new product. Significantly,
key results must be limited in number. Otherwise there is the danger of losing
the significant results and having a lot of unwanted data in hand.
4. Balance among various aspects: While establishing controls the organization

must seek to balance between various aspects of the activity being controlled.
For example while measuring productivity of equipment; the variables can be
completely quantitative. The variables can be the number of machine hours
required for production, the cost savings achieved vis a vis the old machine etc.
However if employee productivity is being measured all variables used cannot Check Your Progress
Measurable objectives are
be quantitative alone. Some of the qualitative variables would be the employee
key to designing good
morale, job satisfaction etc. Hence a balance between short term measures controls. Do you agree ?
and long term measures, strategic and tactical measures etc. should be aimed
for while designing a control process.
5. Accountability: The outcome of any process should be the responsibility of a

single person in the management. The reason is because unless a process has
an owner, the outcome would also be an orphan. While there could be several
claimants to success there would be no one to take ownership of failures.
: 39
Introduction to Therefore the responsibility of achieving desired results from an activity should
Management Control
Systems be assigned to an individual.
NOTES 6. Goals to be set pre activity: Goals or the projected performance should be set
ahead of the activity. Only when pre-established goals are in place there can be
comparison between the actual and the goals or the actual performance and the
projected performance. In the example of the new product launch expected
sales or projected sales should have been drawn up prior to the commencement
of sales. That would help the management to know which region matched the
projections, which of them exceeded expectations and which of the regions
could not meet the projected sales.
7. Early warning predictors: While designing a control system, early warning

predictors must be built into the system. Early warning predictors help the
management to understand whether the existing set of activities are executed
as per plan. Some examples of early warning predictors are the quarterly financial
statements. Instead of waiting for the year end, businesses prepare reports every
quarter so that corrective actions, if required can be taken quickly.
8. Sample control variables: It is very important to sample the chosen control

variables. Sampling can be done by direct observation or by using statistical
techniques. For example if the efficiency of equipment is to be measured then
the average break down time or idle time could be a good indicator.
3.3 Steps in designing Management Control System

We have already understood that a good control system is paramount to be able
to meet the stated goals of an organisation. Therefore it is important that care
should be taken to design a good control system. Some of the important steps in
designing a good control system are as follows:
Check Your Progress 1. Identification of role of employees

Briefly outline the steps in de-
signing management control. 2. Identification of key actions
3. Identification of role demands and Key Result Areas (KRAs)

: 40
4. Understanding likely results of role demands Introduction to
Management Control
Systems
5. Choice of controls
NOTES
1. Identification of Role of Employees
While designing a control system, the design should identify the role of the
employees cutting across all levels of the organisation. It should factor in the
levels of control, the reporting design and most importantly, the employee
responsible for the results of a process.
2. Identification of key actions
All controls have key action areas as well as key result areas. For example, if
the revenue on sales of a product is a key result area, then the key action area
would be region wise fortnightly sales report. The key action areas and the
frequency of monitoring will depend upon the criticality of the process chosen.
3. Identification of role demands and Key result Areas
The expected outcome from each process and the process owner should be
identified while designing control systems. Identification of key action areas
leads to identification of the role demands. For example if revenue is to be
increased then the regional sales heads will be owners as far as the key action
area is concerned. The key result is the sales revenue.
4. Understanding likely results of role demands
The next step in designing the control is the understanding of likely result of role
demands. The control should be designed so that each level of facilitator in the
control system understands what the desired results are and the control system
delivers these results. A control would be successful only when the goals are
understood and the results are as close to the goals as possible.
5. Choice of controls
Check Your Progress
How does action control
The next step in designing the control system is to choose the appropriate control. differ from result control ?
Controls usually are aimed at attaining work efficiency which are called action
control or to control employee behaviour which is called result control. : 41
Introduction to Action controls work on the standard set of procedures and are directly linked
Management Control
Systems to the tasks to be performed. Number of calls attended per hour, number of
units produced per hour or number of customers serviced per day etc., fall
NOTES
under the purview of action control.
Result control, on the other hand, seeks to modify the behaviour of employees
by incentivising employees for achieving the desired goals. The controls in this
case are broader and require frequent communication between various levels
of management to ensure that the desired goal is achieved. Fixing higher incentive
slabs for selling new products, for example, will motivate the sales force to
aggressively push the new product.
Action controls are useful in case of repetitive jobs or tasks, while result control
is useful when the output cannot be defined objectively.
Choice of controls depends upon the type of organisation and the level of
innovation required in the processes.
Attempt to design a control system, using the above steps in the following
situation-
1. A company wishes to introduce a special health drink for women. What

controls will you build in?
2. A company wishes to improve its existing mobile handset by

introducing a new “movie with surround sound” feature. What
controls will you build?
3.4 Role of Information Technology in Management

Control Design
Technology includes hardware, materials, people, software, and knowledge. The majority
of studies examine complexity, task uncertainty, and interdependence as contingent factors
related to control system. When using complexity as a factor, the technology relates to
the complexity of the production function. There is also a focus on the complexities of
the value chain and their implications for MCS design. The business value of information
: 42 technology is to automate business processes, provide information for decision making,

connect business with their customers, and provide productivity tools to increase Introduction to
Management Control
efficiency. Systems
Managing responsibilities within a business entails many of the basic management NOTES
functions, like budgeting, staffing, and organizing and controlling, along with other aspects
that are unique to technology, like change management, software design, network planning,
technology support etc. Overall, the more complex a process is, the more likely the
MCS will be organic and less traditional. This implies that the complex processes will
also require technology intervention for effective management. Technology enablers
encompass software, hardware and telecommunication networks used for managing
information.
3.5 Application of Information Technology in

Organization
Information technology plays a major role in reengineering most business processes.
The speed, information processing capabilities and connectivity of computers and internet
technologies can substantially increase the efficiency of business processes, as well as
communications and collaboration among the people responsible for their operation and
management.
Information systems are a vital support in the following areas:
a. Businesses Processes and operations: From accounting to tracking

Check Your Progress
customers’ orders, information systems provide management with support in- How does a good control
design help in decision
day to day operations. Billing systems that are present in malls help businesses making ?
to improve process time and service more customers within a limited time span.
b. Decision making: Just as information systems can combine the information to

help run the business better, the same information can help managers identify
trends and to evaluate the outcome of previous decisions. In the example of the
billing system that we saw, organisations also find it easier track inventory.
They can identify slow moving inventory and decide the products on which
discounts would be offered.
: 43
Introduction to
Management Control c. Support strategic advantage: Competitive advantage is created or maintained
Systems when the company succeeds in performing some activity of value to customers
NOTES significantly better than its competition and information technology gives this
competitive advantage to businesses. One only needs to look at how banking
has been brought into the palm of the customer to understand the differentiation
advantage that technology provides. Several banks now focus on giving a mobile
phone enabled application to enhance customer experience and save the travel
time to the bank.
Some of the business applications for which software support is available are as follows:
Customer Service
Online customer-service software saves time in much the same way as automated
phone systems. Examples of software for online customer service include Kayako,
Parature and Zoho. Several companies now adopt online customer service which not
only helps in acquisition of new customers but also helps in retention of existing customers.
3.5.1 ERP Software
This software contains different modules designed to handle a particular facet of the
Check Your Progress business. Enterprise Resource Planning (ERP) examples include 3i InfoTech, Oracle
Technology is a key enable E-Business Suite and Sage ERP X3. True to its name, this software helps in planning
in designing and maintaining
an efficient control mecha- enterprise resources. By aligning various functions of the business, these software help
nism in organisation.
in optimising resources and help better planning and control. For example, a completely
Justify.
integrated software will help the manger to identify how much purchases can be made
in cash and how much through credit. So when a purchase transaction is triggered the
effect of the transaction on inventory, payables and cash position can be identified.
Similarly
3.5.2 Email
Businesses use email to disseminate information to anyone in the world with an Internet
connection. Bulk e-mail is used for cheaper and better reach. The costs of these have
dropped making it a more affordable as well as preferred solution for businesses.
: 44
3.5.3 CRM Software Introduction to
Management Control
Systems
Software for customer relationship management, or CRM, streamlines the sales process.
This saves time on data processing. CRM examples include Oracle’s Siebel and Microsoft NOTES
Dynamics.
3.5.4 Inventory management Software
The Inventory Management System is now available as ready modules. It is an application

targeted at businesses who require a simple inventory management or stock control
system. The product is equipped with modules, which helps its users to manage stocks
at their warehouses, keep track of their inventory, monitor and regulate stock movement.
Transactions to receive and move stock are modelled in a way that creating purchase
orders, tracking inbound stocks, transferring stocks or sending them to customers becomes
very simple.
This system also helps in managing inventories when Purchase Orders are raised or
receipts are created. With efficient and comprehensive reports Inventory Management
System provides businesses a new perspective on handling stock.
Extensive Inventory handling systems help in maintaining customers, managing products

and the respective inventories. Information of the stock and its control across warehouses,
with the linked information is possible with good inventory management systems.
Transferring stocks and tracking adjustments can be initiated thereby easing the
management of inventories.
Good inventory management system helps the business in the following ways:
1. It helps in efficient customer and vendor management
2 Web hosted application keeps data safe in the Internet and facilitates remote
management of inventory.
3.6 Summary
Control systems should be designed for organisations, because there is no self driven
mechanism which would automatically steer organisations towards achieving their
: 45
purpose. Controls in business Management Control design should reflect the basic
Introduction to elements of control namely proper goal setting, timely control and a good corrective and
Management Control feedback mechanism. Key factors while designing a management control system are
Systems
that controls must be constructive; objectives should be measurable; Controls must
NOTES
focus upon a few defined and specific key results; controls must have balance between
various aspects of the activity being controlled; accountability must be created; there
must be pre established goals;. Controls should have early warning predictors and
sampling must be done of control variables. The important steps in designing a good
control system are Identification of role of employees; Identification of key actions;
Identification of role demands and KRAs; Understanding likely results of role demands
and Choice of controls. Also with increasing levels of complexity, information technology
plays a major role in designing controls.
3.7 Key Terms

Constructive controls create enabling environment to follow pre-established
systems and guidelines
Punitive controls are more focused on deviations and are mechanisms which
seek to punish errors or deviation
Action controls work on the standard set of procedures and are directly
linked to the tasks to be performed.
Result controlseeks to modify the behaviour of employees by incentivising

employees for achieving the desired goals.
3.8 Questions
1. The need to design good control systems arises because organisations

that are left to their own devices, result in disorder and chaos
2. A purely mechanical control system can achieve complete control even

outside the range of disturbance that it was designed to handle.
3. Constructive controls create enabling environment to follow pre-

established systems and guidelines
4. Measurable variables and outcome is not required for a control process.

: 46
Introduction to
5. Controls must focus upon long term goals and broad strategic outcomes Management Control
rather than focus on specific key results of an activity. Systems
NOTES
6. Early warning predictors help the management to understand whether
the existing set of activities are executed as per plan.
7. Action controlsseeks to modify the behaviour of employees by

incentivising employees for achieving the desired goals.
8. The more complex a process is, the more likely the Control Systems
will be organic and less traditional.
9. Result control, work on the standard set of procedures and are directly
linked to the tasks to be performed
10. While punitive controls have their place, organizations should strive to
minimize punitive controls and establish constructive control to induce
the desired behavior from the participants.
1. What are the key factors to be borne in mind while designing a control system?
2. What are the steps in designing a good control system?
3. Business value of information technology is to automate business processes,

provide information for decision making, connect business with their customers,
and provide productivity tools to increase efficiency- Justify the statement with
examples.
3.8.3 Business case
1. SI Cycles is in the business of manufacturing cycles. They manufacture two

variants of cycles- the regular model which is a standard model and a deluxe
model which has features such as gear, light weight body, larger tire
circumference and choice of trendy colours. The sales have picked up after the
introduction of the deluxe model. However, since the entire operations are new,
: 47
Introduction to they would like to design a control system for production to sale of the new
Management Control
Systems model.
NOTES Required:
a. What are the key factors to be considered in designing the control

system?
b. What are the steps in designing the control system?

Subhash Chandra Das, Management Control Systems-Principles and Practices, PHI
Learning Private Limited pp 22-28
Maciariello and Kirby, Management Control Systems- Using Adaptive Systems to Attain
Control, 2nd Edition, Prentice Hall India, pp 38-76
Katz Daniel and Robert L Kahn, The Social Psychology of Organisations, 2nd Ed.
New York, John Wiley and Sons,1986
: 48
Introduction to
Unit 4: Key Success Variables and Performance Management Control
Measurement Systems
Structure NOTES
4.0 Introduction
4.1 Unit Objectives
4.2 Meaning of Key Success Variables
4.3 Process for identification of critical success factors
4.4 Source of Key Success Variables
4.5 Types of key success variables
4.6 Examples of Key Success variables in Industries
4.6.1 Restaurant Chain
4.6.2 Magazine Publishing firm
4.6.3 Health care Sector
4.7 Performance Measurement Framework
4.7.1 Importance of Performance Measurement
4.7.2 Role of performance Measurement in Organisation
4.7.3 Prerequisites of a good Performance Measurement
framework
4.8 Key Steps in Performance Measurement
4.9 Summary
4.10 Key Terms
4.11 Questions
4.11.2 Substitute the statements with a single word
: 49
Introduction to
Management Control
4.0 Introduction
Systems
Control systems are designed to achieve certain outcomes for organisations. Such
NOTES outcomes or goals can be achieved only when the critical attributes required for
success is identified. These critical attributes are known as key success variables.
We will examine why these key success variables are important in performance
measurement of organisations.
4.1 Unit Objectives

· Understanding Key Success Variables
· To explain Process for identification of critical success factors
· To illustrate Source of Key Success Variables
· Identify Types of key success variables
· Discuss Examples of Key Success variables in Industries
· Evaluating Performance Measurement Framework
· Outline Prerequisites of a good Performance Measurement framework
· Analysing Key steps in developing a performance measurement framework
4.2 Meaning of Key Success Variables

Key success variables are those variables in the external environment to which the
goals, objectives and strategy of managers are most sensitive. These are critical to
the success of business and are also known as critical success factors.
Key Success Variable is the term for an element that is necessary for an organization or
project to achieve its mission and is a critical factor or activity required for ensuring the
success of your business. They usually encompass those few things that must go well to
ensure success for a manager or an organization, and, therefore, they represent those
managerial or enterprise area, that must be given special and continual attention to bring
about high performance. Key Success Variables include issues vital to an organization’s
current operating activities and to its future success.
Critical success factors represent performance areas that must meet expectations if
: 50 the organization is to flourish. Measurements are used to track performance in each

Introduction to
critical success area. Critical success factors are both internal and external. For example,
Management Control
comparison of budgets to actual would be internal while percent of market share would Systems
be external. NOTES
4.3 Process for identification of critical success factors

Identification of key success factors is not a simple job. The complexity increases because
of the interrelationship between various variables. For example, increase in selling price
could increase margins, but will have an impact on the sales volume. Improving quality
will impact cost. Therefore the choice of success factors entails careful consideration
of several factors.
Key success factors are usually a combination ofinternal as well as external factors.
They could be influenced by the strategy of the business, cost models, customer
segmentation or product differentiation.
Customer segmentation offers an excellent starting point in competitive environment,

identifying their preferences and distinguishing gaps both with respect to their expectations
and competitor’s performance.
An alternate approach could be to compare the company’s performance on each aspect

of value chain of the industry with that of the competitors in terms of cost, quality, and
cycle times etc. and zero down on few critical areas, which can provide quantum leap in
the performance of the company.
Deliberations among top management team regarding the importance of the factors
identified and their impact analysis on the desired results, may bring out the real critical
success factors to the fore front. Also deliberations regarding obstacles that can be
foreseen in the way of accomplishing the business objectives of the company may
provide insights into the understanding of critical success factors.
Consequently, critical success factors are an important link between strategic plans and
performance measurement systems.
: 51
Introduction to
Management Control 4.4 Source of Key Success Variables
Systems
Key success variables can reliably be derived from five sources:
NOTES
1. Industry Characteristics
There are several characteristics peculiar to an industry and therefore key
success variables would vary according to industry characteristics. Costs are
often critical for manufacturing organisations; advertisement revenues are
very important for newspapers and television channels; investment performance
is critical for insurance companies; demand for value added services is crucial
for telecom companies. Transactions, customer expectations, performance
metrics, dependence on debt and several other factors lead to great diversity
between several industries and key success variables also differ accordingly.
2. Competitive Strategy
The choice of strategy further determines the variables that must be monitored
and emphasized. If a business has decided to be a low cost producer then the
focus would be upon detailed cost analysis. If a business is high on innovation
Check YourProgress
How do environmental then the focus might be on cutting edge technology. Hence the strategy is an
forces help in identifying important determinant to key success variables.
key success variables?
3. Environment forces
The environment in which a business operates often determines the key success
variables. Economic and political climate are key components of the business
environment. Fluctuation currency exchange rates, changes in interest rate
and the outlook of economy are key determinants of success factors. Similarly
a stable political and regulatory environment can result in a different set of
key variables as compared to an unstable or uncertain political environment.
During periods of political instability, businesses may not venture into new
products, new territories or heavy capital investment. Success factors tend to
be defined as a function of the environment in which the business functions.
4. Significant problems
: 52
Introduction to
Unusual problems having to do with key stakeholders such as customers, Management Control
executives, suppliers or creditors also changes business outlook. An example Systems
for this was the experience of Tata Motors at Singur, West Bengal when the NOTES
government could not assure safe operations for the business. Tata Motors had
to relocate the business and restate several of its success variables on account
of this significant problem.
5. Functional issues
Business has several functional units and each of the functional manager would
define key variables relating to their function. For the human Resources
Department, it might pertain to bringing down attrition rates while for the
marketing department it might be to increase product visibility. The most important
thing however, is that the functions should work for common organisational
goal even if each of them define success differently.
4.5 Types of key success variables

Key success variables can be classified as strategy variables, structural variables, process
variables and environmental variables.
1. Strategy variables
Check Your Progress
Strategy variables refer to the variables linked to the long term choices of a How is structural variable
different from process
firm. A firm may decide to be a differentiated producer in which case the variables variable ?
would be product design, innovation, research, technology etc. Suppose the

firm decides to be a cost leader, the focus would be to manage input variables
such as cost, production process and technology, efficiency, reduction in wastage
etc.
2. Structural variables
Structural variables would depend upon the structure of the organisation. If the
organisation is vertically divided then the SBU (Strategic Business Units) would
have goals for their respective divisions. In a functionally divided organisation,
the variables would depend on the function performed by the Divisions. For
: 53
Introduction to example, the human resource function would identify quality of personnel,
Management Control
Systems employee satisfaction and attrition rate as key variables.
NOTES
3. Process variables
Process variables refer to the processes that influence the behaviour of the
employees towards achievement of organisational goals. They could be the
performance measurement variables which could be the rewards, responsibilities
and the powers and authority to be given to employees.
4. Environmental variables
Environmental variables help in understanding the scope, diversity and uncertainty
with regard to a firm. Key variables and performance have a positive correlation
if these variables induce goal congruent behaviour among stake holders.
4.6 Examples of Key Success variables in Industries

Key success variables depend heavily upon industry characteristics. Accordingly they
may differ for different industries.
4.6.1 Restaurant Chain
Calfas (1990) designed a financial simulation model of growing restaurant chains and
the model identified the following critical success factors for restaurants:
Customer focus:
Success comes by focussing on the changing needs and preferences of customers.

These environmental variables need to be monitored carefully.
Excellence in human relations:
Growing restaurant chains need a growing number of competent managers. The success
of these chains is contingent upon recruiting and retaining competent store managers.
This requires good recruitment techniques as well as good incentive programmes to
motivate the employees.
: 54
Adaptability: Introduction to
Management Control
Systems
This business requires constant reinvention and keeping track of changing tastes and
sensibilities of customers. This is a very fundamental requirement of this business NOTES
Value
The ratio of value to price is a key success variable because customers need to leave
the restaurant with the feeling that the restaurant delivered value.
4.6.2 Magazine Publishing firm
Roger Hall (1973) developed a model after empirically testing 20 years’ data of Saturday
Evening Post magazine. The key success variables that were identified were:
· Number of annual subscriptions
· Number of regular subscriptions
· Advertising Sales
· Total pages in the magazine
· Advertising expenses
· Trial subscriptions
The inter relationship between the above variables were studied to understand how
these ultimately affected the profitability of the business.
4.6.3 Health care Sector
A Survey had been conducted in USA during 2012-13, on behalf of a healthcare sector,
to identify the success factors for a change initiative. Based on the responses of 64
leaders in health care sector, the top three success factors are identified as given below
: 55
Introduction to · Culture and values
Management Control
Systems
· Business processes and
NOTES
· People and engagement
Two unique success factors were also identified only pertaining to the healthcare sector
and not common in the literature of change models. They were service quality & client
satisfaction, and access to information.
4.7 Performance Measurement Framework

Performance Measurement is the process whereby an organization establishes the
parameters within which programs, investments, and acquisitions are reaching the
desired results. Fundamental purpose behind measures is to improve performance;
number of measures that are not directly connected to improving performance (like
measures that are directed at communicating better with public to build trust) are
measures that are means to achieving that ultimate purpose.
4.7.1 Importance of Performance Measurement
Performance measurement is very important to an organisation and no good

control system can be designed without factoring in performance measurement.
Performance measure helps the organisation in the following ways:
1. To Evaluate how well public agency is performing.
2. To Control how managers can ensure their subordinates are doing the right thing.
3. To Budget Budgets are critical tools in improving performance.
4. To Motivate Giving people significant goals to achieve and then use performance
measures, including interim targets, to focus people’s thinking and work, and to
provide periodic sense of accomplishment.
5. To Celebrate organizations need to commemorate their accomplishments- such

rituals tie people together and give them a sense of their individual and collective
relevance.
: 56
6. To Promote how public managers can convince political superiors, legislators, Introduction to
Management Control
stakeholders, journalists, and citizens that their agency is doing a good job. Systems
7. To Learn Learning is involved with some process, of analysis of information provided NOTES
from evaluating corporate performance and identifying what works and what does
not.
8. To Improve what exactly should be done and by whom- differently to improve

performance
4.7.2 Role of performance Measurement in Organisation

Check Your Progress
In the cycle of never-ending improvement, performance measurement plays an important Why is performance
role in: measurement important ?
• Identifying and tracking progress against organisational goals
• Identifying opportunities for improvement
• Comparing performance against both internal and external standards
Reviewing the performance of an organisation is also an important step when formulating

the direction ofthe strategic activities. It is important to know where the strengths and
weaknesses of the organisation lie.
4.7.3 Prerequisites of a good Performance Measurement

framework
A good performance measurement framework will focus on the customer and measure
the right things. Performance measures must be:
• Meaningful, unambiguous and widely understood
• Owned and managed by the teams within the organization
• Based on a high level of data integrity
• Such that data collection is embedded within the normal procedures
• Able to drive improvement
• Linked to critical goals and key drivers of the organization : 57

Introduction to
Management Control
4.8 Key Steps in Performance Measurement
Systems
There are four key steps in a performance measurement framework.
NOTES
1. The strategic objectives of the organization are converted into desired
standards of performance
2. Metrics are developed to compare the desired performance with the actual
achieved standards
3. Gaps are identified
4. Improvement actions are initiated.
The above mentioned steps are continuously implemented and reviewed:
Figure4.1: Performance management framework
1. Setting standards of performance
Initially, the firm needs to focus on a few key goals that are critical to the success of
the organization or business, and ensure they are SMART, i.e.:
Specific
Measurable
Achievable
Relevant
Timely
Organisational objectives could be long term goals- for example, to attain market
leadership. Such objectives, however, cannot fructify unless they are converted into
desired standards of performance. A contemporary example to understand this could
: 58
Introduction to
be the initiative of the Ministry of Power of the Government of India. In order to shift Management Control
towards conservation of energy the Government decided to distribute LED bulbs. Targets Systems
have been set towards the same. Note that the objective of conservation has been NOTES
converted into something more measurable, namely LED bulbs. Use of these over
conventional bulbs should theoretically result in energy conservation.
Now the target is both specific and measurable. The website of the Government of
India has a dashboard which displays on a real-time basis, the number of LEDs that
have been distributed. It also shows a state wise break-up of the same. Note that LED
is a relevant measure for energy conservation and it is also measurable. To see how the
entire system works, one can log on to the portal of the Ministry of Power. Several
measures such as the number of villages electrified, the number of grids electrified etc.,
are available giving a glimpse into how objectives can be broken down into meaningful
and measurable indicators.
2. Development of performance metrics
Goals by themselves would not serve any purpose unless followed up with definite
outcome metrics. Outcome metrics are the translation of goals into measurable attributes.
The outcome measure for an effective Human Resources process, for example could
be reduction in attrition rate, while the goal could be happier employees. If it is difficult
to define outcome metrics for a particular goal, it is possible that the goal is either not
“SMART” or critical to the success of the business.
Good or bad performance cannot be established unless clear cut metrics are developed
to measure performance. Let us assume that a firm is selling in a competitive, but
growing market. If the market is growing at the rate of 20% the firm has to set the
desired target accordingly. Once the metrics are developed either region wise or product
wise, it becomes easier to compare it with the actual performance.
The Performance Measurement system:
(1) assesses the effectiveness of the Strategy and its supporting programs,
(2) Provides information to the entire organization on what needs to be done to refine
policy and programmatic directions, and
(3) Assists with budget management.
: 59
Introduction to The Performance Measurement system fulfills guidelines that the organization contains
Management Control
Systems measurable objectives and specific targets to accomplish long-term quantifiable goals.
These targets and annual reports are intended to inform appropriations and authorizing
NOTES
committees as they restructure appropriations in support of the Strategy to ensure that
resources necessary to attain ambitious long-term performance goals are provided.
3. Identification of gaps
Gaps are identified by comparing the budgeted performance or the targeted performance
with the actual performance. For example the projected income statement is compared
to the actual income statement to identify the gaps in anticipated performance to the
actual performance. Variances are calculated and the major variances are identified.
It is certainly neither necessary nor possible that all standards will be achieved. Gaps
are bound to occur and can be both positive as well as negative. Identification of gap is
not to be a fault finding exercise, but to understand the source of the variance or the
cause of the gap. This exercise helps the firm in either correcting the standards if the
standards are unrealistic or significant changes have occurred in the business environment
since the standards were first set, or to embark on a course correction in case there
have been major deviations from the set course.
4. Improvement Actions
Once the gaps are identified, improvement action plan is put in place. The entire process
of control is meaningless without a standard or goal in place. The reason why
Check Your Progress organisations set standards is because that gives a clear action plan. Improvement actions
How do improvement
are initiated depending upon the stated goals of the business. Even though all businesses
actions help inactieving
goals of business ? exist to maximise wealth through increase in profits, near term goals could be technology
improvement, customer delight or increase in product profile. Therefore any improvement
measures are suggested keeping in mind both the long term as well as short term objectives
of the business.
In conclusion one can say that processes can be measured effectively and measurements
may be applied to many aspects and attributes of processes. Some of the critical measures
are could be quality of output, timeliness, cost (financial), and scale. These measures
act hierarchically within all organizations at three levels of performance.The three levels
of hierarchy are organisation level, process level and the individual manager level. This
: 60
combination of measuring different attributes of the organization within a hierarchical Introduction to
Management Control
structure is called an integrated performance measurement framework (PMF). The Systems
most important aspect of this for management accountants is that measurement of
NOTES
performance of all attributes can be directly traced to financial goals and results, and
vice versa. Therefore, if the purpose of all commercial organizations is to increase
wealth, the establishment of a tightly integrated PMF is highly desirable. This is not to
say that only financial goals need to be measurable or can be measured. However
every objective has to ultimately be linked to performance and therebytg5 value
maximisation.
4.9 Summary
goals, objectives and strategy of managers are most sensitive. Identification of key
success factors is not a simple job. The complexity increases because of the
interrelationship between various variables. Critical success factors are an important
link between strategic plans and performance measurement systems. Key success
variables can reliably be derived from five sources-Industry Characteristics, Competitive
Strategy, Environment forces, significant problems and Functional issues. Key success
variables can be classified as strategy variables, structural variables, process variables
and environmental variables. Performance Measurement is the process whereby an
organization establishes the parameters within which programs, investments, and
acquisitions are reaching the desired results. A good performance measurement
framework will focus on the customer and measure the right things. There are four key
steps in a performance measurement framework - strategic objectives of the organization
are converted into desired standards of performance, metrics are developed to compare
the desired performance with the actual achieved standards, gaps are identified, and
improvement actions are initiated.
4.10 Key Terms

goals, objectives and strategy of managers are most sensitive. These are critical to the
success of business and are also known as critical success factors.
: 61
Introduction to Performance Measurement is the process whereby an organization establishes the
Management Control
Systems parameters within which programs, investments, and acquisitions are reaching the desired
results.
NOTES
4.11 Questions
1. Critical success factors are always internal to the organisation.
2. There are several characteristics peculiar to an industry and therefore

key success variables would vary according to industry characteristics
3. Even though business has several functional units and key variables
are common across all functions
4.11.2 Substitute the statements with a single word
1. The process whereby an organization establishes the parameters within

which programs, investments, and acquisitions are reaching the desired
results.
2. The processes that influence the behaviour of the employees towards

achievement of organisational goals
3. This refers to the variables linked to the long term choices of a firm
4. These are an important link between strategic plans and performance

measurement systems.
5. This helps to measure performance in all dimensions and functions can

be directly traced to financial goals and results, and vice versa.
1. What do you mean by Key Success Variables? Explain with simple examples.
2. What is the process for identification of critical success factors?
3. Explain briefly the source of Key Success Variables.

: 62
Introduction to
4. What are the main types of key success variables? Management Control
Systems
5. What is Performance Measurement Framework?
NOTES
6. What are the prerequisites of a good Performance Measurement framework?
7. Explain the key steps in developing a performance measurement framework.
1. “Wayfarers VadaPav” is a chain that offers VadaPav, a popular street food in

Mumbai. They opened shop last year and their clientele is growing at a steady
pace. They have plans to expand, initially in the Western parts of India. Identify
the key success variables for this business model.
2. MSW Enterprises are in the business of manufacturing pens. They have a
product range catering to student’s and office executives. Their products are in
the affordable price range and they have a good share of the market. They are
considering the introduction of a festival range of pens which are significantly
more expensive than the current range of pens manufactured. They want to
position it as a gift for special occasions and want to place it for the corporate
customers as well as the retail customers.
Required:
i) Prepare a performance measurement plan incorporating the standards
to be set for performance measurement.
ii) Assume that the product has been launched and the sales in the first
month are 10% less as compared to the target sales. How will you use
the performance measurement system to identify the gaps and put in
place the improvement actions?

Andrea Rangone (1997),Linking organizational effectiveness, key success factors
and performance measures: An analytical framework, Management Accounting
Research, Volume 8, Issue 2, June 1997, Pages 207–219
Calfas, Robert A., Why Growing restaurant Chains can Fail: A computer Simulation
Model, Ph D Dissertation , Claremont Calif:, Clarimont Graduate School,1991 : 63
Introduction to De Vasconcellos E Sá, J. A. S. and Hambrick, D. C. (1989), Key success factors: Test
Management Control
Systems of a general theory in the mature industrial-product sector. Strat. Mgmt. J., 10: 367–
382.
NOTES
Hall Roger I, “ A systems Simulation Model of a Magazine Publishing Company”,

Proceedings of the Summer Computer Simulation Conference, Montreal Canada, 1973.
Kash B, Spaulding A, Johnson C, Gamm L. Success factors for strategic change

initiatives: a qualitative study of healthcare administrators’ perspectives. Journal Of
Healthcare Management / American College Of Healthcare Executives [serial online].
January 2014;59(1):65-81. Available from: MEDLINE, Ipswich, MA
: 64
Introduction to
Unit 5 : Behaviour in Organisations Management Control
Systems
NOTES
Structure
5.0 Introduction
5.1 Unit Objectives
5.2 Meaning of Goal Congruence
5.3 Importance of Goal Congruence
5.4 How Conflict arises in organisations
5.5 Role of Controls in Goal congruence
5.6 Factors affecting goal congruence
5.6.1 External factors
5.6.2 Internal factors
5.7 Formal Control process
5.8 Types of organisations
5.8.1 Functional Structure
5.8.2 Divisional Structure
5.8.3 Adaptive Structure
5.9 Functions of the controller
5.10 Management controls for differentiated strategies
5.11 Summary
5.12 Key terms
5.13 Questions
: 65
Introduction to
Systems
We saw how controls are designed differently for different organisations. In order to
NOTES
have effective controls organisations need to have well defined and clear focus. Individual
focus should be subservient to organisation focus. In this Unit we see how a common
focus or goal congruence contributes to better outcomes in organisations. We also
understand how controls are designed for differentiated strategies.
5.1 Unit Objectives

· To Infer Meaning of Goal Congruence
· Understanding Importance of goal congruence
· Analysing How conflict arises in organizations
· Illustrating Role of Controls in goal congruence
· Evaluating Factors affecting goal congruence
· Explaining Formal Control Process
· Define Types of Organisations
· Examine Functions of Controller
· Demonstrate Controls for differentiated Strategies
5.2 Meaning of Goal Congruence

Goals are defined as broad statements of what the organisations aim to achieve in the
long run. Hence they are fairly stable and are not subject to frequent changes.
Measurement of the performance in the organisation is not possible if the goals are not
clearly defined. Once goals are defined, then it becomes important to ensure that everyone
in the organisation understands and acts on these goals in a similar manner.
Goal congruence means a meshing of objectives, in which the managers in an organization

strive to achieve goals that are consistent with the goals set by top management. Every
: 66
Introduction to
individual working in an organization has got his own motive to do the work. Individuals act in Management Control
their own interest, based on their own motivations. Such motivations are always not necessarily Systems
consistent with the organisational goals. Goal congruence is the process of integrating individual NOTES
goals to the organisational goals and ensuring that individuals or groups within the organisation
do not work at cross purposes. To ensure goal congruence is the central purpose of a
management control system.
Goal congruence is achieved when individuals in the organization strive or are induced
to strive towards the company goals. This assumes, of course, individuals are aware of
company goals and the derivative performance criteria. The essence of company’s
goals is conveyed by planning process, which expresses these goals in terms of budgets,
standards and other formal measures of performance. Management must tailor the
planning activities to encourage goal congruence at various levels of management. To
achieve goal congruence the following ideas are important –
· The firm should be viewed as pluralist entity where coalitions of individual seek
Check Your Progress
to express their own aspirations within the structure of the firm.
Why is it difficult to achieve
goal congruence ?
· Personnel cannot be viewed as people sharing the same goal, but also as people
striving for such rewards such as power, security, survival, and autonomy.
Example 1– The HR manager has devised a HR training program to enhance the skills
of its sales personnel, with an objective to enhance their productivity. But if company is
in strategic need of attaining a certain sales volume in a given quarter, it cannot do so on
account of non-availability of personnel.
Example 2– The marketing department has planned an impressive advertising campaign,

which promises good returns, but due to cash crunch the budget for the same may not
be sanctioned.
5.3 Importance of Goal Congruence

Individuals work in different hierarchies and handle different responsibilities and may have
different goals. But they must come together as far as organisation goals are concerned and
their actions must uphold the interests of the organisation. The goals of sub units of an
: 67
Introduction to organisation may also conflict with one another, with individuals and group objectives. A
Management Control
Systems bargaining process may be necessary to reduce these conflicts in the goal setting process.
NOTES Goal Congruence is achieved when the same goals are shared by top managers and their
subordinates. This is one of the many criteria used to judge the performance of an accounting
system. The system can achieve its goal more effectively and perform better when
organizational goals can be well aligned with the personal and group goals of subordinates
and superiors. The goals of the company should be the same as the goals of the individual
business segments. Corporate goals can be communicated by budgets, organization charts,
and job descriptions. In fact the budget may be considered as the key mechanism for stabilization
Check Your Progress of that process, that is, a bargaining medium through which individuals and groups try to
How does goal congruence
help in motivating the further their own goals.
employees ?
Needless to say achieving goal congruence is very important for organisations. In the absence
of goal congruence, organisations will be conflict ridden and it would be impossible to achieve
the organisational objectives. Goal congruence helps the organisation in the following ways:
· Helps in achieving organization’s goal/strategic objective
· Motivates and involves employees in their work
· Gives fair chance to its employees to achieve their personal goals
· Helps in Management Control System
5.4 How Conflict arises in organisations

Let us take the example of an organisation which has several functional departments such as
marketing, Human Resources, production etc. Now the organisation may emphasize multiple
goals by stressing that organizational performance be measured in the following areas:
(i)profitability, (ii) market position, (iii) productivity, (iv) product leadership, (v) personnel
development (vi) employee attitude, (vii) public responsibility, and (viii) a balance between
short-range and long-range goals.
Problems of goal congruence could arise in the following manner:
: 68
Introduction to
· The marketing Department will be concerned about market position, but not Management Control
necessarily about productivity. Systems
NOTES
· The Human Resources Department may be concerned about employee attitudes,
but not profitability.
· Production department may be concerned about productivity, but not necessarily

public responsibility.
· Hence it is obvious that the concern of a set of people is not necessarily the
concern of a different set of people.
To achieve the goals of each of the Departments, they all may need resources. Check Your Progress
What is problem of shared
Organisations may have limited resources. Therefore problems of shared resources
resources ?
could be as follows:
· Human Resources Department is concerned about personnel development and

therefore would like to spend money on some training programmes and that
may impact the profitability.
· Production department may want resources for improving processes;
· Marketing would like to utilise the resources for product promotion.
· Therefore each group is pursuing different goals to improve the outcome of

their activities but not necessarily that of the organisation.
To induce goal congruence, it may be necessary to take the following steps:
1. All the various stakeholders who might be performing different functions will
first meet to agree on the common goals.
2. Each of the objectives, namely (i)profitability, (ii) market position, (iii) productivity,
(iv) product leadership, (v) personnel development (vi) employee attitude, (vii) public
responsibility, and (viii) a balance between short-range and long-range goals must
be discussed with all the stakeholders namely the marketing department, production
department and the human resources department.
: 69
Introduction to 3. A budget process must be put in place so that the amount of resources available
Management Control
Systems to various departments to fulfill their respective objectives is clearly
communicated to them. This way, neither would there be mismanagement of
NOTES
resources, nor will conflicts arise owing to limited resources.
4. To reach goal congruence may be more difficult in decentralized organizations where

operational autonomy is greater.
Hence in order to achieve goal congruence, the organization has to work in a way that
it reviews its operations and activities to ensure that none of them limit or inhibit the
organization’s ability to reach its goals, whatever they may be. Any system can achieve
its goals more effectively when the organizational goals are well aligned with the personal
and group goals of the subordinates and superiors. Essentially, the goals of the organisation
should be the same as the goals at individual business segment levels. These corporate
goals can be communicated by budgets, organization charts, and job descriptions.
5.5 Role of Controls in Goal congruence

Perfect congruence between goals of individuals and those of organizations do not
exist. One of the critical reasons for the same is that in terms of individual goals, more
stress is on factors like salary, growth etc. However from the perspective of an
organization, there is an upper limit to salaries, beyond which profits will be adversely
affected.
Thus, the system should not encourage the individual to act against the best interests of
the company. The management control system may suggest that it is extremely crucial
and critical that costs be reduced, however if a manager responds by reducing costs at
the expense of minimum quality requirement or if he responds by reducing costs in his
own responsibility centre by measures that leads to an effect which increased costs in
some other responsibility centre, it means that although motivated, his action is not
towards organizational goal congruence.
There is a possibility for anyone to relate goal congruence with motivation. There is a
close link, however, as motivation involves desire for a selected goal and the drive or
pursuit towards the goal, it has two aspects, namely congruence and effort. The
: 70 achievement of goal congruence may also be affected by the degree of freedom to
make decisions, i.e., autonomy given to the managers. Therefore, while designing a Introduction to
Management Control
control system, the three important aspects related to goal congruence, managerial effort Systems
and autonomy should be given due consideration, with a view to motivating managers to
NOTES
achieve organizational goals.
5.6 Factors affecting goal congruence

Goal Congruence is a term used when the same goals are shared by top managers and
their subordinates. This is one of the many criteria used to judge the performance of an
accounting system.
Goal congruence is present when individuals, departments and divisions focus their efforts
on meeting organisational goals. To ensure as far as possible that managers and their
subordinates work toward the achievement of organisational goals requires attention
being paid to their levels of motivation.
The degree of goal congruence that exists between the goals of the subunits and the
overall organisational goals will be much or little, depending upon the rationality of the
control structure including responsibility centre designations and the efficiency with which
the sub unit manager attends to key success factors affecting his or her goals.
Factors affecting goal congruence are classified into external and internal factors.
5.6.1 External factors
External factors are norms of desirable behaviour that exists in a society of which the
organisation is a part. These norms include a set of attitudes, often collectively referred
to as the work ethic, which is manifested in the employees’ loyalty to the organisation.
Example:
Indian businesses, especially the non-corporate ones often function on the basis of faith
and goodwill. The World Development Report 2001 reveals as to how the majority
community of Tirupur was able to succeed in the knitted garment industry due to the
transfer of capital through community networks. In the Indian context, community
relationships provide certain benefits and cost advantages in business. Such communities
: 71
Introduction to festered high degree of entrepreneurship, high ambition and used community based
Management Control
Systems relationships to increase efficiency and reduce costs.
NOTES Being part of such business infuses the work force with certain work ethic which is
derived from the external environment.
5.6.2 Internal factors
1. Culture: Organization culture refers to the set of common beliefs, attitudes,

norms, relationships, and assumptions that are explicitly or implicitly accepted
and evidenced throughout the organization. It influences morale—the attitude
Check Your Progress
What are the internal of the individual toward his or her work and his or her environment.
factors affecting goal
congruence ?
2. Management style: Management style is the attitude and conclusive behaviour
of the superiors towards their subordinates. Usually the attitude of subordinates
reflects in a general way their perception of the attitude of their superiors,
modified, of course, by each subordinate’s own attitude. It can be management
by walking around or by strictly adhering to reports.
5.7 Formal Control process
A formal Control process is generally followed by organisations. It is devised keeping in

mind the internal and external factors, employees’ behaviour and needs. It starts with
goals and strategies formulation and ends with evaluation and taking corrective actions.
Figure 5.1: Formal control process
: 72
Introduction to
5.8 Types of organisations Management Control
Systems
Different types of Organization structure can be created on the basis of arrangement of
activities. Accordingly, three broad types of structural forms are: NOTES
5.6.3 Functional Structure
When units and sub-units of activities are created in organization on the basis of functions,
it is known as functional structure. All activities connected with each such function are
placed in the same unit.
Figure 5.2: Functional Organisation Structure- An Illustration
Advantage: Functional specialization in each unit, which leads to operational efficiency

of people engaged, and the organization as a whole derives the benefit of specialized
operations. Disadvantage: Personal contact between superiors and subordinates
become rare, and flow of communication is slow leading to problems of coordination
and control.
5.6.4 Divisional Structure
The divisional organization structure is more suited to every large enterprise particularly
those which deal in multiple products to serve more than one distinctive markets. The
organization is then divided into smaller business units which are entrusted with the
business related to different products or different market territories. Each divisional
manager is given autonomy to run all functions relating to the product or market segment
or regional market.
: 73
Introduction to
Management Control
Systems
NOTES
Figure 5.3: Divisional organisational structure
5.6.5 Adaptive Structure
Organizational structures are often designed to cope with the unique nature of undertaking
and the situation. This type of structure is known as adaptive structure. There are two
types in structures.
i) Project Organization: When an enterprise undertakes any specialized, time-

bound work involving one-time operations for a fairly long period, the project
Check Your Progress
Can you think of an example organization is found most suitable.
of matrix organisation ?
ii) Matrix Organization: This is another type of adaptive structure which
aims at combining the advantages of autonomous project organization and
functional specialization. In the matrix organization structure, there are functional
departments with specialized personnel who are deputed to work full time in
different projects sometimes in more than one project under the overall guidance
and direction of project
manage
: 74
Introduction to
Management Control
Systems
NOTES
Figure 5.4: Matrix Organisation Structure
5.9 Functions of the controller

The person who is responsible for designing and operating the management control
system is considered a controller in the organization.
The controller usually performs the following functions:
· Designing and operating information and control systems. Check Your Progress
Identify any two important
· To regulate, supervise and implement a timely, full and accurate accounting set of functions of a controller ?
books of the firm reflecting all its activities subject to internal guidelines set from
time to time by the BOD.
· Preparing and analyzing performance reports, interpreting those reports for managers
and analyzing the program and budget proposals from various segments of the
company.
· Supervising internal audit and accounting control procedures to ensure the validity
of information, establishing adequate safeguards against theft and fraud, and
performing operational audits.
· To monitor the performance of the firm, its flow of funds, the loyalty to the budget,
the expenditures, the income, the cost of sales and other budgetary items.
· To prepare and present for the approval of the BOD an annual budget, other budgets,
: 75
Introduction to financial plans, feasibility studies, investment memoranda and all other financial and
Management Control
Systems business documents.
NOTES · To meet the terms with all the accounting, reporting and audit requirements imposed
by capital markets or regulatory bodies of the capital markets in which the securities
of the firm are traded or are about to be traded or otherwise listed.
· To maintain a working relationship and to develop additional relationships with banks,

financial institutions and capital markets.
· To initiate and engage in all manner of activities, whether financial or other, conducive
to the financial health, the growing prospect and the fulfilment of investment plans
of the firm.
5.10 Management controls for differentiated strategies

Business units have missions that can be classified as “build,” “hold,” or “harvest,” and
their managers can also decide to build competitive advantage based on low cost or
differentiation. The appropriate management control pro-cess is influenced by which of
these strategies is selected for a given business unit. In fact, control systems should be
Check Your Progress designed in the context of each organization’s unique external environment, technology,
How are incentive
compensations designed ? strategy, orga-nization structure, culture, and top management style.
Cost Leadership Strategies
An integrated set of actions designed to produce or deliver goods or services at the

lowest cost, relative to competitors with features that are acceptable by consumers –
relatively standardized products, lowest price,etc.
Differentiation Strategy
An integrated set of actions to produce or deliver goods/ services that customers perceive
as being different in many ways that are important to them.
Focused Business Strategy
A focus strategy exploits a narrow target’s difference between the balances in the
industry by isolating a particular buyer group, isolating a unique segment of product line
: 76 or by concentrating on a particular geographical segment.

Integrated Cost Leadership and Differentiation Strategy Introduction to
Management Control
Systems
A firm successfully uses an integrated cost leadership and differentiation strategy to be
in a better position to: adapt quickly to changing environment, learn new skills and NOTES
effectively leverage its core competencies while competing with rivals.
The logic for linking controls to strategy is based on the following line of thinking:
· Different organizations generally operate in different strategic contexts.
· For effective execution, different strategies require different priorities,

different key success factors and different skills, perspectives and
behaviours. Check Your Progress
How are incentive
compensations designed ?
· Control systems are measurement systems that influence the behaviour
of those people whose activities are being measured.
Thus, a continuing concern in the design of control system should be whether the behaviour
induced by the system is consistent with the strategy. Specific tendencies in the design
of control systems corresponding to varia-tions in corporate strategies are:
Strategic Planning
Given the low level of interdependencies, conglomerates tend to use a vertical strategic
planning system. Business units prepare strategic plans and submit them to senior
management for review and approval.
Budgeting
In a conglomerate, it is nearly impossible for the chief executive to rely on informal

interpersonal interactions as a tool of control. Much of the communication and control
has to be achieved through the formal budgeting system.
Transfer Pricing
Transfers of goods and services between business units are more frequent in single
industry and related diversified firms than between business units in conglomerates. In
: 77
Introduction to a conglomerate, the usual transfer pricing policy is to give sourcing flexibility to business
Management Control
Systems units and to use arm’s-length market prices.
Incentive Compensation
NOTES
The incentive compensation policy tends to differ across corporate strategies in the following
ways:
· Use of formulas: Conglomerates, in general, tend to make more use of for-mulas

in the determination of the business unit managers’ bonus, that is, they may
base a larger portion of the bonus on quantitative, financial measures such as X
percent bonus on actual economic value added (EVA) in excess of budgeted
EVA. Formula-based bonus plans tend to be used in conglomerate because of
the inevitable lack of familiarity on the part of senior management with what
goes on in a variety of disparate businesses
· Profitability measures: The incentive bonus of the business unit, managers

tends to be determined primarily by the profitability of single unit rather than the
profitability of the firm—in the case of unrelated diversified firms. Its pur-pose
is to motivate managers to act as though the business unit were their own
company. In contrast, single industry and related diversified firms tend to base
the incentive bonus of a business unit manager both on the performance of that
unit and also on the performance of a larger organizational unit (such as the
product group to which the business unit belongs or perhaps even the overall
corporation), When business units are interdependent, the more the incentive
bonus of general managers emphasizes the separate performance of each unit,
the more the possibility of inter unit conflict.
Top Management Style
Management control function in an organization is influenced by the style of senior

Check Your Progress
management. The style of CEO affects the management control process in the entire
Give an example of
impersonal control. organization. Eg. Jack Welch at General Electric.
· Tight versus Loose Controls. The man-ager of a routine production
responsibility centre can be controlled either rela-tively tightly or relatively loosely,

: 78 and the actual control reflects the style of the manager’s superior. Thus, the
degree of tightness or looseness often is not re-vealed by the content of the Introduction to
Management Control
forms or aspects of the formal control documents, rules, or procedures. It depends Systems
on how these formal devices are used.
NOTES
· Personal versus Impersonal Controls:Presence of personal versus im-personal
controls in organizations is an aspect of managerial style. Managers differ on the
relative importance that they attach to formal budgets and re-ports, contrasted
with informal conversations and other personal contacts. Some managers are
“numbers-oriented”; they want a large flow of quantitative information, and they
spend much time analyzing this information and deriv-ing tentative conclusions
from it. Other managers are “people-oriented”; they look at a few numbers, but
they usually arrive at their conclusions by talking with people, and they judge the
relevance and importance of what they learn partly on their appraisal of the other
person. They spend much time visiting various locations and talking with both
management people and hourly em-ployees to obtain a feel for how well things
are going.
5.11 Summary
In the real scenario, senior management wants the organization to attain its goals whereas
members of the organization have personal goals, and these are not in all respects consistent
with the organization’s goals. The central purpose of the management control system is
to assure goal congruence; that is, the systems should be designed in such a way that
actions it leads people to take in their perceived self-interest are also in the best interest
of the organization.Informal factors have an important influence on goal congruence.
The most important of these is an organization’s culture or climate.Designers of
management control systems should take explicit notice of the strategic context in which
the controls are being applied. The strategies that a firm selects can be arrayed along a
continuum, with single industry firms at one extreme and unrelated diversified firms
(conglomerates) at the other. The management control process differs according to the
firm’s strategy in this dimension.Business units have missions that can be classified as
“build,” “hold,” or “harvest,” and their managers can also decide to build competitive
advantage based on low cost or differentiation. The appropriate management control
pro-cess is influenced by which of these strategies is selected for a given business unit.The
: 79
Introduction to concept of linking controls to strategies should not be used in a mechanistic manner; the
Management Control
Systems suggestions made in our report are tendencies, not universal truths. The control systems
should be designed in the context of each organization’s unique external environment,
NOTES
technology, strategy, orga-nization structure, culture, and top management style.
5.12 Key terms

Goal congruence means a meshing of objectives, in which the managers in an
organization strive to achieve goals that are consistent with the goals set by top
management.
When units and sub-units of activities are created in organization on the basis of functions,
it is known as functional structure.
5.13 Questions
1. Corporate goals can be communicated to the employees across organization by:
a. Budgets, organization charts, job descriptions and such other control designs
b. By frequently calling people and meeting with them
c. By identifying a few people and communicating goals to them so that they

would spread the message to others
2. The degree of tightness or looseness of controls can be determined by:
a. Content of the forms or aspects of the formal control documents, rules,

or procedures
b. The frequency of meetings called by the top management with various

divisions or functional teams
c. The manner in which formal control devices are put to use
3. The following functions are not performed by a Controller:
: 80
a. Designing and operating information and control systems. Introduction to
Management Control
Systems
b. Regulate, supervise and implement a timely, full and accurate accounting
set of books of the firm reflecting all its activities subject to internal NOTES
guidelines
c. Setting goals for the functional teams and ensuring proper performance
of the teams
4. Identify which of the following statement best describes a functional form of

organization;
a. Units and sub-units of activities are created in organization on the basis

of functions
b. Sub units are responsible for end to end delivery, cutting across various
functions of the business
c. Each sub unit performs all the functions of the business
5. The appropriate management control pro-cess isnot influenced by the following:
a. Strategies selected for a given business unit
b. Context of each organization’s uniqueexternal environment, technology,

strategy, orga-nization structure, culture, and top management style
c. The operational processes followed in the recent past
6. Central purpose of the management control system is
a. To induce people to take decisions in their perceived self-interest
b. To ensure that decisions made in self-interest are also in the best interest
of the organization
To encourage people to take decisions which serve the organization purpose

but not individual goals
: 81
Introduction to 5.13.2 Theory questions
Management Control
Systems
1. Explain the meaning of Goal Congruence with situational examples.
NOTES
2. Why is goal congruence important in an organization?
3. How do conflicts arise in organizations? Explain with examples.
4. What is the role of Controls in goal congruence?
5. What are the factors affecting goal congruence?
6. Explain formal Control Process.
7. What are the types of Organisations?
8. What are the important functions of Controller?
9. What Controls do organizations use for differentiated Strategies?
1. YRC Technologies have developed a model of smart phones. Since several

reputed players offer smart phones in the market, YRC has come with cutting
edge features in their product and have created a platform in which several
applications can run simultaneously.
They want to identify the strategy that would make their product successful
and also help them create controls on the basis of the strategy. You are required
to advise YRC.
2. Red Rose manufactures gift articles and sell to both retail customers and
corporate clients. They are awaiting the Diwali season when corporate place
bulk orders to distribute gifts to their customers and employees. The demand
for differentiated gifts is very high in the corporate sector and hence they cannot
mass produce gifts.
Gifts are made to order and customized according to the customer requirements
in case of corporate gifts. Retail items, in contrast are mass produced. The
Sales team which handles the Corporate Clients wants to offer the clients a
: 82
discount in price so as to push sales volumes. The Production team however Introduction to
Management Control
informs the Sales team that the rising input costs and the need to customize Systems
gifts results in increased costs.
NOTES
What are the goal congruence issues that you can identify in this case? How
would you ensure that everybody at Red Rose work towards common goals?

William Bennot ,”Creating Seamless Behavior”, Leadership Advance Online – Spring
2008
Witt, L. A., Enhancing organizational goal congruence: A solution to organizational

politics. Journal of Applied Psychology, Vol 83(4), Aug 1998, 666-674
: 83
Introduction to
Unit 6: Responsibility Centres
Management Control
Systems Structure
NOTES 6.0 Introduction
6.1 Unit Objectives
6.2 Meaning of Responsibility Centre
6.3 Types of Responsibility Centers
6.3.1 Cost Centre
6.3.2 Revenue centre
6.3.3 Profit Centre
6.3.4 Investment Centre
6.4 Summary
6.5 Key Terms
6.6 Questions
6.6.1 State whether True or False
6.6.3 Business case
: 84
Introduction to
6.0 Introduction
Management Control
Organisations have to align to the vision and function as goal congruent entities. While Systems
organisation sub units perform for organisation goals, the functions performed by each NOTES
vary. Consequently the deliverables for each sub unit in the organisation varies. In this
Unit, we identify these sub units, popularly known as responsibility centres and identify
the roles, functions and performance measures of each of the responsibility centre in an
organisation.
6.1 Unit Objectives

· Understanding Meaning of responsibility Centre
· To explain types of Responsibility Centres
6.2 Meaning of Responsibility Centre
Responsibility Centre is an organizational unit that is headed by a responsible manager.

An entity can function only when there is collective responsibility. Responsibility centre
can be viewed as an “organizational segment” (Caraiani C., Dumitrana M., 2005).
Each of the organisational segments have a specific set of aggregate tasks to be
performed. Mere performance of tasks can, at best, be execution. The difference between
executing a set of tasks and being responsible for delivery would rest in the fact that the
set of people who engage themselves in obtaining the results have a certain decisional
autonomy.
In order to maximise the organisation efficiency and performance, Ionaºcu I., Filip A.T.,
Stere M., (2007) propose a three tier structure in organisations:
(i) Top of the hierarchy with managers in charge of the strategy;
(ii) At the base, are the operational staff that reiteratively fulfil current tasks?
(iii) An intermediary link between the top and the base, namely, responsibility centres,
In a manufacturing company, for instance, the lowest level of hierarchy might be the
workshops or production units. These units are responsible for production or output. At
the higher levels are departments or Strategic Business Units that consist of the smaller : 85
Introduction to
Management Control units, staff and management. They are usually responsible for middle management
Systems functions such as budgeting, marketing and human resource management. At the level
NOTES of senior management and Board of Directors, they are responsible for the functioning
of the whole of the enterprise.
An entity within an organization that holds responsibility for the management of revenue,
expenses, and investment funds is known as Responsibility Center. This center is
controlled by a responsibility manager that works with other individuals in the organization
to establish procedures and accounting practices to ensure that the necessary expense
and revenue information is reported accurately. The responsibility center will also work
with accountants to make sure that the organization is meeting requirements set by the
Internal Revenue Service.
6.3 Types of Responsibility Centers

Responsibility centers are the divisions in the corporation that has control over costs,
revenues, or investment funds. Responsibility centers are classified into four different
centers. They are:
Check Your Progress · Cost centre
How is a cost center
different from a profit · Revenue centre
center ?
· Profit centre
· Investment centre
Cost Centre
A cost center is a part of the company that does not generate any profit for the company,
but they add cost to the company. The manager of a cost center incurs costs and the
center is evaluated on how well they control their costs. In any business enterprise, an
example of a cost center would be the Research and Development department. They
add to the costs of the enterprise and in an indirect way add profit to the company.
Revenue Centre
The revenue center is responsible for generating revenue for the company by selling
goods or services. A good example of a revenue center is the Sales department. The
sales department is responsible for knowing the product and being able to sell it to the
customers.
: 86
Profit Centre Introduction to
Management Control
A profit center is a department that directly adds to its profit. Profit centers measure the Systems
profitability of business units or departments. Profit centers are responsible for revenue NOTES
and costs. A good example of a profit center is the business unit as a whole. There are
many companies that are a division of the corporation. Each business unit is responsible
for maintaining their costs and revenues and generating profit for the corporation.
Investment Centre
Investment centers are a part of responsibility center involved in utilising the capital
directly to contribute to the profits of the organization. An investment center is responsible
for both profits and investments.
Responsibility centres are similar to small businesses. Each manager in charge for the
individual responsibility centre is asked to run effectively to maximise the output of the
respective responsibility centre while still keeping the interests of the organization in
mind.
Let us now discuss each of the above responsibility centres in detail. Consider a
hypothetical company ABCD Corporation. ABCD Corporation manufactures steel pipes
for various applications such as industries, construction, automobiles and infrastructure.
They procure steel and cut it to various sizes and shapes depending upon the requirement
of the customer. They have several equipment varying in levels of sophistication
depending upon the output. For example, automobile applications and industrial applications
require far more inputs in terms of product design and quality control compared to
construction and infrastructure. Let us understand how responsibility centres would
apply to ABCD Corporation.
6.3.1 Cost Centre
A cost centre or an expense centre is a responsibility centre in which manager is held

responsible for controlling cost inputs. There are two general types of cost centres:
· Engineered expense centres or Standard Cost Centres
· Discretionary expense centres.
: 87
Introduction to Engineered costs are usually expressed as standard costs. Standards can be set because
Management Control
Systems the input is usually relatable to the output.
NOTES
Input related to output
Input WORK Output
Figure 6.1: An illustration of Engineered Expense Centres.
For ABCD Corporation, production Department is an engineered expense centre. This

is because the output can be related to input. Steel pipes are the output and steel is the
input. Standards can be reliably set to fix a standard output for a given input.
Standard cost centres are responsible for controllable costs, efficiency, timeliness of
delivery and quality of output.
In the context of responsibility centres, costs can be divided into controllable and
uncontrollable cost. Standard cost centres are usually responsible for the controllable
cost in the responsibility centre.
A cost is said to be controllable when it may be regulated by a person at a given level of

responsibility during a specified time period. For example, if the production supervisor is
responsible to hire labour on a daily basis, then labour cost is said to be controllable by
the supervisor. Non controllable or uncontrollable costs are those costs over which a
Check Your Progress person, at a given level of authority has no control. Suppose the factory is operating out
Can you think of some of rented premises, and management decides the place out of which factories operate
examples of discretionary
expenses ? and the factory head has no authority in that decision, then factory rent will be
uncontrollable cost as far as the factory head is concerned.
It must be remembered that every cost that is uncontrollable at some level is controllable
at a higher management level. So for the business as a whole, no cost will be classified
as uncontrollable for the purpose of responsibility accounting.
A discretionary expense centre is a responsibility centre whose budgetary performance

is based on achieving its goals by operating within predetermined expense constraints
: 88
set through managerial judgement or discretion. Discretionary expense can be explained Introduction to
Management Control
with the help of following two important features. Systems
· They arise from periodic (usually yearly) decisions regarding the maximum NOTES
outlay to be incurred.
· They are not tied to a clear cause and effect relationship between inputs and
outputs
We can think of several examples to illustrate a discretionary expense centre. For ABCD
Corporation, the design department could be a discretionary expense centre. This is Check Your Progress
Can you think of some
because depending upon the number of new designs or requirement for designs the
examples of discretionary
output of this division may vary. There is no specific input output ratio. There could be expenses ?
several other examples for the Discretionary expense centre. Marketing Department
could be another example. There are expenses incurred for marketing but there is no
defined output that is relatable to the expenses incurred.
Because of the nature of Discretionary Expense centres, it is difficult to evaluate the
performance of these responsibility centres. A detailed discussion on the difficulties in
evaluation of Discretionary expense centres is discussed in the next Unit.
When an organisation is organised by responsibility centres, each responsibility centre is

individually responsible for deliverables. Responsibility is decentralised to each individual
division.
The following illustration demonstrates how each action results in bringing accountability
down to a Division level when the organisation is divided as responsibility centres.
Illustration 6.1
1. Mr. Arun had to catch a flight to Singapore to attend a “Strategic Selling Conference”
organized by Oasis Corporation, which operates across 14 countries in the world.
Mr.Arun is the marketing manager handling the India region, headquartered at
Mumbai. Oasis Corporation is decentralised and each Division operates
independently.
On the expected date of departure, riots broke out in the city and Arun was unable
to reach the airport. The ticket could not be rescheduled on the same date and
: 89
Introduction to hence had to be cancelled. The airline does not allow return flight if the onward
Management Control
Systems journey is not undertaken on the same airline.
NOTES Although the firm has a policy of booking tickets on refundable basis for all foreign
travel, this was a non-refundable ticket owing to the oversight of the Department in
charge of booking the tickets. The loss on account of this transaction amounted to
Rs.30,000/-
On the basis of the information give your views on the following:
a. Suppose the marketing department had an annual budget for foreign travel and
all expenses had to be met out of that account, how will this loss be treated?
b. Suppose the entire transaction is being handled by the Administration Department,
how will you treat this loss?
c. Suppose the transaction was handled by an in-house Travel Department, which

handled travel arrangements both inside and outside the organization, would
your answer be different?
d. What if the transaction was outsourced by the Administration Department to an

external travel agency?
Solution
The situation has resulted in a loss of Rs.30,000/- and the problem is to whom this
amount of money will be charged or who is responsible for this loss.
a. This means the marketing department is responsible for all travels done by
them. This loss will be charged to the marketing department and they will have
to explain the budget variance caused by this mistake.
b. In this case, the Administration Department is responsible for the loss and the
ticket cost will be charged to marketing, but the loss of Rs.30,000/- will be
charged to the Administration department.
c. In this case, the Travel is a separate department and is responsible for the loss.
: 90
d. Since the external travel agency is a different organisation, the loss will not be Introduction to
Management Control
borne by any department of Oasis Corporation. It will be borne by the travel Systems
agency.
NOTES
6.3.2 Revenue centre
A revenue centre is the part of organization in which organization gets revenue from sales
of products or providing of services. It is the business operation responsible for generating
a company’s sales revenue. Revenue centres may be departments, divisions or business

units that have direct interaction with consumers to sell goods and services. For example,
a hotel might add a snack bar or a coffee counter to generate extra sales. Businesses
usually break down their business operations into revenue centres to determine the
profitability of each good or service it produces. The size of the business, the number of
product or service lines and industry standards are all factors companies use when choosing
or adding revenue centres for their operations.
While retail and wholesale companies are traditional revenue centre businesses, service
companies may also add revenue centres to improve the profitability of current business
operations. For example, hotels may add a small restaurant or snack bar for guests, gas
stations may add convenience stores stocked with various food and sundry items, and
gyms or health clubs may add small shops marketing trendy workout clothes or vitamin
supplements. Each revenue centre addition adds a potential profit line to the company’s
overall profit potential.
Companies may add revenue centres as a means to enter new markets or industries.
Starting small is usually a better way to build and expand business operations without
incurring large amounts of debt or other expenses. Revenue centres may also take time to
become profitable and recover the initial start-up expenses. For this reason, starting multiple
revenue centres may exacerbate the potential downside to these new business operations.
For ABCD Corporation Sales Division which understands customer requirements and
carries out the final selling process is the revenue centre. Revenue centres are responsible
for revenue generation, increase in sales volume, adding new customers etc.
: 91
Introduction to Concept in Action
Management Control
Systems
In the highly competitive call centre industry environment of 2004, some companies
NOTES successfully differentiated themselves by converting their service centres into revenue
centres. The revenue streams were generated through “after sale service”. The call
centre agents would address the calling customer needs and request, provide the
necessary services, and then offer some type of new product or services that would
further meet the needs of the customer. To do so, the companies reworked their hiring
process, expanded training the encompass sales, and changed their incentive structure
from fixed pay to acombination of fixed pay and sales commission for their service
agents.
6.3.3 Profit Centre
Profit centre is a distinctly identifiable department or unit that contributes to the

overall financial results of a firm. Where adequate cost accounting systems are in place,
profit centres are given responsibility to target certain percentages of the total
revenue and are given adequate authority to control their costs to achieve those targets.
When using profit centres, costs and revenues should be allocated to each centre. While
Check Your Progress revenues are easy to allocate, costs are a tad bit harder.
Why should the output be
measurable in a profit
centre ? In the example of ABCD Corporation, they could have four profit centres namely
industries, construction, automobiles and infrastructure.
Businesses can also be divided vertically along geographic lines. For example if ABCD
Corporation had businesses in North, South, East and West of India, then they could
operate each of these zones as profit centres. For a responsibility centre to operate as
a profit centre, the following conditions should be met:
1. Output and profit should be measurable
2. Complete autonomy and authority in business decisions should be granted to the

profit centre manager.
While profit centres help businesses to improve quality of decision and speed, they may
also result in friction within organization and focus on short run decisions.
: 92
Introduction to
Concept in Action Management Control
Systems
Nokia Corporation faced a considerable slowdown in sales in 2001. As part of turnaround
NOTES
strategy, Nokia Corporation split its $21 billion mobile phone unit into nine profit centres,
each with responsibility for a specific market segment. Profit centres helped the company
to break itself into smaller and accountable units each of which had an entrepreneurial
thrust. ABB(Asea Brown Bovery), a European multinational in the business of power
generation, transmission and distribution, was organized into 4500 profit centres-each
with profit/ loss responsibility and meaningful autonomy.
6.3.4 Investment Centre
Investment centres are a part of responsibility centre involved in utilising the capital
directly to contribute to the profits of the organization. An investment centre is
responsible for both profits and investments. The investment centre manager has
control over revenues, expenses and the amounts invested in assets. He also
formulates the credit policy which has a direct influence on debt collection, and the
inventory policy which determines the investment in inventory
The focus is on increasing this return, both in total dollars and as a percentage of
sales. This can be achieved with a combination of increasing sales, reducing expenses,
and reducing the investment in assets. The investment centre concept is most useful in
situations where there is a large investment by a business unit in fixed assets and/or
working capital.
In the example of ABCD Corporation, the entire organisation can be evaluated as an

investment centre. They can decide on which of the profit centre should be invested into
on the basis of the Return on investment generated by each of the Division. Objective of
investment centre is to make sound investment decision. Simply speaking “Profitable the
case then invest else disinvest.”
The investment centre is a superset of all other responsibility centres. It is concerned
with the profit earned against the assets employed. It is not only interested in earning
profit but earning it by using assets at its disposal in most effective manner. That means
in totality it is concerned with costs, revenue and the assets utilization factor. For an
investment centre, the investment which returns maximum per rupee of investment is
: 93
Introduction to considered the best. So the role of the investment centre is to identify the potential
Management Control
Systems projects and rank them by the maximum return. There are of course, several issues for
consideration while ranking the projects which we will see in detail in the later Units.
NOTES
Cost Centre
(Concern for cost)
Profit Centre Investment Centre

(Concerned with (Effective
profit) utilization of
Revenue Centre assets)
(Concerned with
sales)
Figure 6.2 – An Illustration of Responsibility Centres in Organisations
Investment Centre aims at efficient utilization of the resources. To earn a satisfactory

return on the investment made is an important objective of the profit oriented company.
Investment centre is expected to evaluate the profits earned i.e. output with respect to
the assets employed to earn that profit i.e. input. Just focusing on the profits without
concerning about amount of resources being used will mislead the performance evaluation
and lead to ineffective control. Comparing the absolute profit performance of different
business units is meaningless unless one considers the amount of assets employed to
generate the profits
Figure 6.3: Investment Centre explanation

: 94
Performance measures used to evaluate the investment centre are: Introduction to
Management Control
Systems
· ROI – return on Investment
· EVA (Economic Value Added or Residual Income) NOTES
It compares Division’s profits with assets employed to earn that profit. The prime
concern of an investment centre is how efficiently it uses its assets. Profit centres
measure the profit in absolute terms whereas investment centre measure it in terms of
assets utilization efficiency. Thus investment centre acts as special type of profit centre.
This approach satisfies both the goals of business organizations i.e. to earn adequate
profit and profits earned and assets employed must have optimal relationship. Usually
the business unit manager has two performance objectives, first to generate adequate
profits from the assets/ resources at his disposal and second he should invest in additional
assets/resources, which provide the desired returns.
Implementation of Investment centres poses following hurdles:
Ø Measuring the asset base for assessing the performance of the investment Check Your Progress
centre i.e. Tangible and/or intangible assets, controllable uncontrollable and/or What are the difficulties in
measuring the performance
partially controllable assets, Total assets and/or total assets minus liabilities etc. of investment centres ?
Ø Valuation of assets to be measured? Whether it is gross block or net block,

book value or
market value or replacement value etc.
We have understood about the various responsibility centres in an organisation. How do

we classify different functions as responsibility centres? The following illustration
demonstrates how classification of responsibility centres is done.
Illustration 6.2
Radio Masala is an extremely hip and happening channel and has a large listener base,
predominantly the youth. The radio channel is constantly on the lookout for programmes
and product offerings for the young generation.
The organisation has several popular radio jockeys who present various programmes.
Each of the programme, depending on the popularity, gets advertisement revenues. The
: 95
Introduction to advertisement revenues are directly traceable to the programmes and programmes are
Management Control
Systems taken off the air if they do not attract sufficient advertisement revenues.
NOTES There are support staffs that arrange music and handle other administrative functions
like fixing appointment with celebrities, arranging interview schedules, etc.
Administration and payroll is handled by a separate Establishment Department. Training

is a separate function and handles, most importantly, training new RJs and helps them
with voice training and imparts other skill sets required by them. Training is largely an in
house function, but lately, there is a clear demand in the market for training aspiring
radio jockeys and the same can be offered as a 6 month course in the market.
All of the above departments have support assistants who perform most of the errand
functions.
Trace each of the above mentioned function to its responsibility centre and justify your
choice.
Solution
The various functions can be identified as follows:
Programme: Programme is a revenue centre and revenues are directly traceable to

each programme.
Check Your Progress
Can you give an example Administration and payroll: Costs are incurred but revenue is not directly attributable to
each for cost centre,
revenue centre and profit this department. So it is a cost centre or an expense centre
centre ?
Training: Training is also a cost centre since costs are incurred for training. However
since training function can be extended beyond the organisation and revenues can be
earned, training function has the potential to become a profit centre.
We have understood that there are different responsibility centres in an organisation.

Do they perform similar functions? Obviously not. Should they have the same evaluation
measures. The answer to this is a clear “No”. Let us understand the performance
evaluation for various responsibility centres in the forthcoming Units.
: 96
Introduction to
6.4 Summary
Management Control
Systems
Responsibility Centre is an organizational unit that is headed by a responsible manager.
Responsibility Centres are classified into cost centre, revenue centre, profit centre and NOTES
investment centre. A cost centre is a part of the company that does not generate any
profit for the company, but they add cost to the company. The revenue centre is
responsible for generating revenue for the company by selling goods or services. A
profit centre is a department that directly adds to the profit of an organization. Investment
centres are a part of responsibility centre involved in utilising the capital directly to
contribute to the profits of the organization. Different Responsibility centres are
responsible for different outcomes and the evaluation parameters for each of them
vary.
6.5 Key Terms

An entity within an organization that holds responsibility for the management of revenue,
expenses, and investment funds is known as Responsibility Center.
A cost center is a part of the company that does not generate any profit for the
company, but they add cost to the company.
The revenue center is responsible for generating revenue for the company by
selling goods or services.
A profit center is a department that is responsible for the profit earned by the
organisation.
Investment centres are a part of responsibility centre involved in utilising the
capital directly to contribute to the profits of the organization.
6.6 Questions
6..6.1 State whether True or False
a. If Revenues are matched to cost, the resultant responsibility centre is a

revenue centre.
b. It is necessary for a profit centre to generate profit, else it is called as

cost centre.
: 97
Introduction to c. Cost centers are not responsible for generation of revenue.
Management Control
Systems
d. Revenue centers are not responsible for control of costs.
NOTES
1. If output of a department is not measurable, such an expense centre is called a

—————————————————
2. Where input output ratio is measurable, it is feasible to have a
________________ cost centre.
3. Explain the concept of responsibility centers in an organization.
4. How is a Standard Cost Centre different from Discretionary Expense Centre?
5. What are controllable costs/ Give some examples.
6.6.3 Business case
1. Furniture Bazaar is India’s leading back-end furniture manufacturer that caters

to the growing retail furniture business. Furniture Bazaar manufactures custom-
made office chairs and supplies to all retail furniture chains which sell them
under different brands. Within a short span of 5 years since its inception in
2004, Furniture Bazaar has grown from strength to strength and today employs
over 800 carpenters alone to satiate the hunger for furniture in Indian metros
and mini-metros. The company sells around 100,000 units per annum.
The company is concerned that the operations, integrated as they may seem, do
not give them an idea about their strong areas or the weaknesses in their
production processes. To address this concern and also to assess opportunities
for outsourcing, as well as in sourcing, they have decided to create responsibility
centres within the organisation and define the goals of each of these individually.
There are five production departments- Assembly 1, Assembly 2, machining,

finishing and polishing. There is a sales office which also takes care of
warehousing order processing and negotiations with various retail stores who
want to stock the products.
: 98
There is no machining facility available around the vicinity, hence there is lot of Introduction to
Management Control
demand for machined products (Machining). These are demanded by both end Systems
users as well as producers. The finished and unpolished units do not have a
NOTES
ready market.
The Administration Department takes care of all other functions such as payroll,
accounts, payment follow up from retail stores and payment processing to
suppliers.
You are required to categorize the various departments and functions as

responsibility centres.
Caraiani C., Dumitrana M., (coordinators), Contabilitate de gestiune & Control

de gestiune [Management accounting & management control], Second Edition,
Publishing House, Bucuresti, 2005
Daniel W. Lang(1999), Responsibility Centre Budgeting and Responsibility

Centre Management in Theory and Practice, Higher Education Management
Vol. 11, No. 381 OECD
Ionascu I., Filip A.T., Stere M., Control de gestiune [Management control],
Publishing House Economica, Bucuresti, 2007.
: 99
Introduction to
Management Control Unit 7: Performance Evaluation of Responsibility
Systems Centres
NOTES
Structure
7.1 Introduction
7.2 Unit Objectives
7.3 Overview of Responsibility Centres
7.4 Measuring performance of Engineered Expense
Centers/Standard Cost Centers
7.5 Performance Evaluation in Discretionary Expense
Centre
7.6 Difficulties in evaluating Discretionary Expense Centre
7.7 Zero Based Budgeting
7.8 Balanced Scorecard (BSC)
7.9 Activity Based Costing
7.10 Summary
7.11 Key Terms
7.12 Questions
7.12.1 State whether true or false:
: 100
Introduction to
Systems
We understood the type of responsibility centres in the previous Unit. We will now
understand how the performance of various responsibility centres are evaluated. We NOTES
will understand that not every responsibility centre can be evaluated using similar
measures because the function performed by each of them is different.
7.2 Unit Objectives

· To assess Performance Evaluation of Standard Cost Centres
· Understanding Variance Analysis
· Identify Performance Evaluation of Discretionary expense centre
· To measure Difficulties in performance evaluation of Discretionary

Expense Centre
· Illustrating Zero based Budgeting, balanced Score Card and Activity

Based Costing as tools to evaluation of Discretionary Expense Centres
7.3 Overview of Responsibility Centres

We have already understood that responsibility centers are classified into:
· Cost center
· Revenue center
· Profit center
· Investment center
A cost centre or an expense centre is a responsibility centre in which manager is held
responsible for controlling cost inputs. There are two general types of cost centres:
· Engineered expense centres or Standard Cost Centres
· Discretionary expense centres.
Engineered costs are usually expressed as standard costs. Standards can be set because
the input is usually relatable to the output.
: 101
Introduction to
Management Control Discretionary expense centres cannot be expressed as standard costs since the output
Systems cannot be measured reliably as a function of input.
NOTES
7.4 Measuring performance of Engineered Expense
Centers/Standard Cost Centers
“Standard costs” are costs that are established in advance to serve as targets to be
met and, after the fact, to determine how well those targets were actually met. They
are the predetermined cost based on the estimates for materials, labour and overheads
for a particular period of time. One of the most important uses of standard costing is to
compare the actual costs with the standard costs and analyze the reasons for the variations
with the view of maximizing efficiency of production. Variation is the difference between
standard cost and actual cost.
Variance analysis based on standard costs and flexible budgets would be a typical tool
for control of a cost center such as a production department.
General Model for Variance Analysis
Two general types of variances can be calculated for most cost items-
a. Price variance
Check Your Progress b. Quantity variance.
How is the performance of
a profit centre measured ? [a] Price Varianceis calculated as:
Price variance =Actual quantity x [Actual price - Standard price] (1)
Price variance = AQ x (AP - SP) Price variance = (AQ x AP) - (AQ • SP) (2)
[b ]Quantity Varianceis calculated as:
Table 7.1 shows a general model [a three-column model] for variance analysis that
incorporates items (1), (2), and (3) from the above equations.
Actual Quantity of Inputs, Actual Quantity of Inputs at Standard Quantity allowed for
at Actual price (AQ-AP) Standard price(AQ-SP) Output, at Standard Price(SQ-SP)
(1) (2) (3)
Price Variance(1)-(2) Quantity Variance(2)-(3)

: 102
Total (Flexible budget) Variance(1)-(3) Introduction to
Management Control
· Material Purchase Price variance · Materials quantity(usage) variance Systems
· Labour rate variance· · Labour efficiency variance
· Variable overhead spending variance · Variable overhead efficiency variance NOTES
Table 7.1: General model [a three-column model] for variance analysis
Illustration 7.1
Calculate material cost variance from the information given below:
Particulars Units(kg)
Standard output 1,200 units
Actual output 1,000 units
Standard quantity for standard output 1,200 kg.
Actual quantity used 1,100 kg.
Standard price Rs. 7.00 per kg.
Actual Price Rs. 7.50 per kg.
Solution:
The actual production (output) is 1,000 units. So, entire calculation is to be made for
1,000 units.
Standard output (production) = 1,200 units
Check Your Progress
Standard quantity to be used = 1,200 kg
What is Material Usage
So, for one unit of production (output), standard quantity to be used is one kg. Variance? Why is it
calculated ?
Actual Output = 1,000 units
Standard quantity to be used = 1,000 kg
Actual quantity used = 1,100 kg
Material cost variance =
Standard cost – Actual cost or
Standard Quantity x Standard Rate - Actual quantity x Actual Rate
MCV = (SQ × SR) – (AQ × AR)
: 103
Introduction to = (1,000 × 7) – (1,100 × 7.50) = 7,000 – 8,250
Management Control
Systems = 1,250 (U)
The calculation is for actual production and not for planned production.
NOTES
So here the Material Cost Variance is Rs.1250
Material Price variance= Actual Quantity used× (Standard Rate-Actual Rate)
=1100× (7-7.5)
=550(U)
Material usage Variance= Standard Rate× (Standard Quantity-Actual Quantity)
=7× (1000-1100)
=700(U)
Material cost variance is the sum of Material quantity (usage) variance and Material
price Variance.
Similarly, variances can be calculated for wages and overheads and these variances are
analysed to evaluate the performance of a Standard Cost Centre.
It is important to make four observations:
1. A price variance and a quantity variance can be calculated for all three variable cost
items—direct materials, direct labor, and the variable portion of factory overhead. The
variance is not called by the same name, however. For example, a price variance is
called a materials price variance in the case of direct materials, but a labor rate variance
in the case of direct labor and a variable overhead spending variance in the case of
variable factory overhead.
2. A cost variance is “unfavorable (U) “if the actual price (AP) or actual quantity (AQ)
exceeds the standard price (SP) or standard quantity SQ; a variance is “favorable (F)”
if the actual price or actual quantity is less than the standard price or standard quantity.
3. The standard quantity allowed for output—item (3)—is the key concept in variance
analysis. This is the standard quantity that should have been used to produce actual
output. It is computed by multiplying the actual output by the number of input units
allowed.
4. Variances for fixed overhead are of questionable usefulness for control purposes,
: 104
since these variances are usually beyond the control of the production department.
7.5 Performance Evaluation in Discretionary Expense Introduction to
Management Control
Centre Systems
In discretionary cost center the budgets are given to improve the working of different NOTES
departments but there is no variance analysis for these budgets, only control systems
are implemented.
Budget Preparation
Management formulates the budget here by determining the magnitude of the job that
needs to be done, and not the volumes of the output. The work done here falls into two
general categories:
Continuing work- This is workwhich is done consistently from year to year, such as
preparation of financial statements.
Special work, which is a one shot project – for example, developing and installing a
system in a newly acquired division.
Check Your Progress
What is Material Usage
The technique used in this budgeting is Management By Objectives (MBO) and a formal variance? Why is it
process in the department ask for the budget on the basis to accomplish the specific jobs calculated?
and activities. MBO is a formal process in which a budgetee proposes to accomplish

specific jobs and suggests the measurement to be used in performance evaluation.
The planning function for discretionary expense centre is usually carried out in one of
the two ways- Incremental budgeting and Zero base review
1. Incremental budgeting
In this model, discretionary expense center’s current level of expenses is taken

as a starting point. This amount is adjusted for inflation, anticipated changes in
the workload of continuing job, special job and the cost of comparable jobs in
similar units. This model has two drawbacks.
· Firstly, the center’s current level of expenditure is accepted and not

reexamined during the budget preparation process.
· Second, managers of these centers want to increase the level of services,

and thus tend to request additional resources, which are usually provided. : 105
Introduction to
Management Control Despite these limitations most budgeting in discretionary expense centre is
Systems incremental.
NOTES
2. Zero base review:
An alternative budgeting approach is to make a thorough analysis of each of
discretionary expense centre on a rolling schedule so that all are reviewed at
least once every five years. This is called zero base review. In contrast with
incremental budgeting, this review attempts to ascertain from the scratch the
resources actually required to carry out each activity within the expense centre.
This is discussed detail in the later part of this Unit.
Check Your Progress Each responsibility centre has different evaluation measures, which are summarised as
How is the performance of follows:
a profit centre measured ?
Responsibility Centre Responsible for Evaluation measure
Standard Cost Centre Cost control, Efficiency, Variance Analysis- Comparison

Quality of Output,Timeliness of Actual with Standard
Discretionary Expense Quality of Output Qualitative output measures,

Centre Compliance with pre-approved
budget spending limits
Revenue Centre Increase in sales volume, Compare budgeted output to

Addition of new customers actual output
Profit Centre Profit maximisation Compare budgeted income

statement with actual income
statement
Investment Centre Investment of resources to Return on Investment,

achieve organisation goals Economic Value Added
7.6 Difficulties in evaluating Discretionary Expense

Centre
Organizations often have difficulty managing discretionary cost, which may include
those for R&D & accounting systems, because costs do not clearly relate to output. For
the same reason, firms have difficulty evaluating the performance of a discretionary
manager. Companies have tried many methods of identifying appropriate relation between
discretionary costs & activity levels & comparison with other firms. But relating costs
to activity levels remains primarily a matter of management judgment or discretion.
: 106
Consequently, companies typically give managers of discretionary cost centres a budget Introduction to
Management Control
and instruct them not to exceed it without higher level of authorization. Systems
NOTES
The word discretionary means that management has decided on certain policies that
should govern the operations of the company. By definition therefore, no relationship
can be reliably established between the input and output.
Some of the salient features of Discretionary Expense Centres are listed below:
1. Staff units, including general & administrative departments, such as finance,

HR, legal, R&D departments; and marketing units such as those performing
advertising and promotion, are usually treated as discretionary expense centre.
2. Some functions for which output is not easily measurable or where the outputs
are not causally and deterministically related to the inputs expended cannot be
controlled by the use of traditional techniques such as standard cost or budgets.
3. These functions are usually organized as discretionary expense centres in which

the level of expenditure and the number of personnel are determined by
negotiation with central management to determine appropriate levels of quality
and service.
4. The output from these units is not easily measured in financial terms, and the
relationship between the resources they expend (inputs) and the outcomes they
produce is weak.
5. Companies control these discretionary expense centres by negotiating and

eventually authorizing an annual budget and then monitoring whether their actual
spending remains with the budgeted amounts.
Since output measurement is difficult, the performance evaluation of a Discretionary

Expense centre could pose several difficulties which are as follows:
1. First, the management control system helps only in expense control. The budget : 107
Introduction to for this type of expense centres represents the planned inputs to the expenses
Management Control
centre.
Systems
NOTES
2. Second, the difference between budgeted and actual expense is not a measure
of efficiency. It is simply the difference between the budgeted input and actual
input.
3. Third, the financial control system measures neither the efficiency nor the
effectiveness of these responsibility centres. It is necessary therefore, that
nonfinancial measures and judgments be employed in evaluating their
performance.
Several techniques have been evolved in the past few decades to evaluate performance
when there is a problem of output measurement or when there are no quantitative
output measures. Some such techniques are Zero Based Budgeting, Balanced Score
Card and Activity Based Costing. A brief understanding of these concepts follows.
7.7 Zero Based Budgeting

Zero-base budgeting requires expenditure proposals to compete for funding on an equal
Basis – starting from zero. In theory, the organization’s entire budget needs are to be
justified and approved, rather than just the incremental change from the prior year.
Expenses or costs of the prior year are not taken into consideration when establishing
expense or budgetary levels looking forward. Each expense category starts from zero.
All expenses or cost levels within the budget must be justified or re-justified as being
necessary; thus “zero-base”.
Application of Zero-base budgeting in business
The practical application of ZBB involves the use of the “Decision Package”. All
Check Your Progress
budgetary procedures involve an identification of organizational objectives. Where it is
What is Zero Based
Budgeting ? difficult to compare the resources allocation with output, ZBB is more appropriate in
controlling. If the past projects were allowed to continue, without justification, the past
inefficiencies would continue, automatically. So, manager has to justify, why he wants
to continue to spend.
Advantages of ZBB:
: 108
· Zero based budgeting is used to help justify expenses throughout each budget Introduction to
Management Control
cycles. This prevents programs that are ineffective from continually getting Systems
funded without justification for their expenses.
NOTES
· It also helps prevent waste, fraud and abuse within the system. This is because
the budget starts at zero and each charge is accounted for.
· Zero Based Budgeting ensures efficient allocation of resources.
· It is especially useful for service departments where the output is difficult to

identify.
Concept in Action- Nokia
In 2010, Nokia was asked to cut spending from their IT department while continuing to
meet demand for new business. In order to accomplish this, they began a Zero Based
Budgeting program. This helped them analyze the benefits of the management framework
and determine which demands and supplies should be prioritized. Once this was
accomplished, they were able to decide which IT processes were critical to the success
of the company and should be continued.
7.8 Balanced Scorecard (BSC)

The Balanced Scorecard (BSC) was developed at the beginning of the 1990s by Kaplan
and Norton. It is a conceptual framework for translating an organization’s vision into a
set of performance measures distributed among four perspectives: financial, customer,
internal business processes, and learning and growth.
By balancing the quantitative (financial) perspectives with the qualitative(customer,

business process and learning and growth) perspectives, BSC makes it easy to evaluate Check Your Progress
How is internal process
the outcome of processes with focus on quality. Output measurement in non-quantitative
perspective important in
terms is made easier using the Balance Score Card. creating a Balance Score
Card ?
The Balanced Scorecard is a performance measurement tool that uses a strategy map
to connect an organization’s day-to-day processes to its organizational goals. It is
concerned with creating a strategy to drive future direction, building in cause and effect
linkages while simultaneously taking into account both financial and intangible resources
that can determine success or failure.
: 109
Introduction to While retaining traditional financial measures the Balanced Score Card focuses on building
Management Control
future value through investment in customers, suppliers, employees, processes, technology,
Systems
and innovation The balanced scorecard suggests viewing the organization from four
NOTES
perspectives, and to develop metrics, collect data and analyze it relative to each of the
following perspectives:
· Financial perspective: This stands for identifying financial objectives of an

organization. It is always important for BSC as the financial objectives stand
for the long-term goals of an organization
· Customer perspective: This stands for identifying the customer and market
segments in which they are going to compete, as they are the basic pillars for
gaining revenue components of the company’s financial objectives. It mainly
focuses on gaining high customer satisfaction and leveraging customer
relationships
· Internal process perspective: This stands for identifying key business processes
by which an organization has to excel to meet the objectives of customers and
shareholders
· Learning and innovation perspective: This stands for identifying ambitious

objectives in the other three perspectives to be achieved. It highlights the ability
to change and brings improvements for achieving sustainable business goals.
Concept in Action- Nerolac Paints and Infosys
Nerolac Paints Limited: It adopted the concept of BSC for deploying its business
strategy and managing enterprise performance. The very purpose of implementing the
BSC in the Company is its endeavour to grow its business profitability over the next few
years. The scorecard framework addresses the decorative and industrial paints business
of Nerolac and creates a strategy deployment system which will monitor month-on-
month achievement against defined strategic objectives.
Infosys Technologies: Infosys also implemented the concept of BSC. It helps this
organization to track its initiatives and also measure the impact it has on the organization’s
growth and profitability. It also enables Infosys to move towards a data-based decision
making culture.
: 110
7.9 Activity Based Costing Introduction to
Management Control
The concepts of Activity Based Costing (ABC) were developed in the manufacturing Systems
sector of the United States during the 1970s and 1980s.It is a practice in which activities NOTES
are identified and all related costs of performing them are calculated, providing actual
costs chargeable. The focus of activity based costing is activities. The basis of activity
based costing is that activities, rather than products, add to cost. Thus identifying activities
is a logical first step in designing an activity based costing. An activity is an event, task
or unit of work with a specified purpose. Some examples are designing products, setting
up machines, operating machines and distributing products.
Cooper and Kaplan described ABC as an approach to solve the problems of

traditional cost management systems. These traditional costing systems are often unable
to determine accurately the actual costs of production and of the costs of related services.
Consequently managers were making decisions based on inaccurate data especially
where there are multiple products.
Peter F. Drucker in the book Management Challenges of the 21st Century defines
ABC as that traditional cost accounting focuses on what it costs to do something, for
example, to cut a screw thread; activity-based costing also records the cost of not
doing, such as the cost of waiting for a needed part. Activity-based costing helps to
record the costs that traditional cost accounting does not do. The overhead costs assigned
to each activity comprise an activity cost pool.
A powerful tool for measuring performance, Activity-Based Costing (ABC) is used to

identify, describe, assign costs to, and report on agency operations. ABC identifies
opportunities to improve business process effectiveness and efficiency by determining
the “true” cost of a product or service. Activity Based Costing is a method for developing
cost estimates in which the project is subdivided into discrete, quantifiable activities or a
work unit. ABC systems calculate the costs of individual activities and assign costs to
cost objects such as products and services on the basis of the activities undertaken to
produce each product or services. It accurately identifies sources of profit and loss.
Advantages of Activity Based Costing
: 111
Introduction to ABC has proven its applicability beyond academic discussion. ABC is applicable
Management Control
throughout company financing, costing and accounting:
Systems
· ABC is a modelling process applicable for full scope as well as for partial
NOTES
views.
· ABC helps to identify inefficient products, departments and activities.
· ABC helps to allocate more resources on profitable products, departments and activities.
· ABC helps to control the costs at any per-product-level level and on a
departmental level.
· ABC helps to find unnecessary costs that may be eliminated.
Check Your Progress
Identify any two advantages · ABC helps fixing the price of a product or service with any desired analytical
of Activity Based Costing.
resolution.
Furthermore, time-driven ABC systems can measure the unit costs of the repetitive
processes done within HR (training, employee benefit counseling, and performance
management appraisals) and IT (providing CPU capacity, storage capacity, and connect
time). The ABC innovation enables the resource costs of corporate support departments
to be charged out to operating units just as the outputs from manufacturing units are
charged out, via standard costs, to marketing and sales units.
In effect, ABC enables discretionary expense centers to become cost centers with a
financial goal to break even—to recover their expenses through cost-recovery pricing
schemes based on the actual demands made by operating units on the support units’
resources.
Illustration 7.2
XYZ Company is considering Activity based costing to allocate Overheads. Following
Information is given for the production of two products A and B.
Activity Cost
Set-up 200000
Machine maintenance 90000
Total Manufacturing Cost 290000
product A B Total
Number of setups 40 60 100
: 112 Machine Hours 1500 3500 5000

XYZ Company plans to produce 350 units of product A and 250 units of product B. Introduction to
Compute the manufacturing cost for each product. Management Control
Systems
Solution:
NOTES
First, we will identify the activities perform by the company and assigning cost to
each activity then choosing the cost driver for calculating the allocation rate .After
calculating the allocation rate we can allocate the coat to product.
In above case company performs two activity i.e. Setup and maintenance of
machine.
Now, we will calculate Allocation rate for each activity
1. Setup Cost:
Total Cost /Total No.of Setups = 2, 00,000 = Rs 2000 per setup
100
2. Machine Maintenance:
Total Machine Maintenance cost/ Total Machine Hour
= 90000 / 5000 hrs = Rs 18 per hour
Since, we have calculated the Allocation Rate; next step is to allocation of cost to
each product,
Following table shows the allocation of cost.
Activity Product A Product B
Setup No.of Setup *cost 40*2000 = 80,000 60*2000 = 1,20,000
per Setup
Machine Machine Hour*Cost 1500*18 = 27000 3500*18 =63000
Maintenance per Hour
Total Cost Rs 107000 Rs 183000
Calculation of Manufacturing Cost per Product:
Product A = Total Cost/No.of units produced , Product B = Total Cost/No.of

units produced
= 107000/350 = 306 = 183000/250 = Rs 732
: 113
Introduction to In the above illustration we see that costs are allocated according to the activities
Management Control
Systems performed instead of a traditional volume based approach.
NOTES Activity based costing is hence very useful when different products are
manufactured and when there is a mix of simple and complex products. Activity
Based Costing would also be helpful in identifying costs which do not necessarily add
value to any process or activity and hence does not get allocated directly to any
activity. These costs have to be ultimately weeded out. Hence the application of
Activity Based Costing is wide and vast.
When direct costs reduce due to increasing product or technological complexities,

discretionary spends increase and hence all the techniques discussed in this Unit
would address this issue.
7.10 Summary
For a Standard Cost Centre the expected outcomes are cost control, efficiency, quality
of output and timeliness of delivery. The evaluation measure is the Variance Analysis
which is the comparison of Actual with Standard. For a discretionary expense centre,
Quality of Output is necessary and performance is measured by checking compliance
with pre-approved budget spending limits. For a revenue centre the desired outcome is
increase in sales volume and addition of new customers and the performance is mea-
sured by compare budgeted output to actual output. A profit centre has to aim for profit
maximisation and performance is evaluated by comparing budgeted income statement
with actual income statement. An Investment Centre has to ensure investment of re-
sources to achieve organisation goals and performance is measured by calculating Re-
turn on Investment and Economic Value Added. Of all responsibility centres it is most
difficult to evaluate the performance of Discretionary expense centre. So techniques
like Balanced Score card, Zero based budgeting and Activity Based Costing are used.
7.11 Key Terms

When expenses or costs of the prior year are not taken into consideration when
establishing expense or budgetary levels looking forward and each expense category
starts from zero, such a budgeting is called as Zero Based Budgeting.
: 114
Introduction to
Activity Based Costing is a method for developing cost estimates in which the Management Control
project is subdivided into discrete, quantifiable activities or a work unit. Systems
7.12 Questions NOTES
7.12.1 State whether true or false:
a. All negative variances are necessarily problematic.

b. Any cost centre exceeding budgetary allocation is not performing well.
c. Zero Base Budgeting assumes all base costs to be zero.
d. Profit centres are not responsible for Return on Investment.
e. The basis of Activity Based Costing is that products add to cost
f. Pricing distortions can happen when costs are distributed without tracing
the activity drivers.
g. When most of the costs are direct, Activity based costing is very useful.
Activity Based Costing helps in bringing down product costs in the long run
by identifying non value added costs.
1. How is the performance of various responsibility Centres evaluated?
2. Explain how performance evaluation is done in a standard cost Centre.
3. Why is performance evaluation in Discretionary expense Centre difficult?
4. Explain Zero Based Budgeting and how it helps in performance evaluation of a

Discretionary Expense Centre?
5. How do we evaluate an Investment Centre?
6. Explain Activity Based Costing.

Wetherbe, J. C. and Montanari, J. R. (1981), Zero based budgeting in the planning
process. Strategic Management. J., 2: 1–14.
Schmidtlein, F. A. (1999). Assumptions underlying performance based budgeting. Tertiary
Education & Management, 5(2), 159-174. : 115
Introduction to
Management Control Unit 8: Profit Centre
Systems
Structure
NOTES
8.0 Introduction
8.1 Unit Objectives
8.2 Meaning
8.3 General Considerations in creating Profit Centers
8.4 Criteria for creation of profit center
8.5 Advantages or Benefits of Profit Centers
8.6 Disadvantages of profit Centres
8.7 Evaluation of Profit Centre
8.8 Summary
8.9 Key Terms
8.10 Questions
8.10.2 Business case
: 116
Introduction to
8.0 Introduction
Management Control
Systems
In the previous Unit we understood the meaning of responsibility centre. The organisation
unit responsible for generation of profit is called a profit centre. In this Unit we take a NOTES
detailed look at profit centres, why and how they are created and the evaluation of
performance of profit centres.
8.1 Unit Objectives

· To understand the meaning of profit centre
· Analysing General Considerations in creating profit centres
· Evaluating Merits and Demerits of profit Centres
· To examine Evaluation of profit centres
· Can expense centres be converted to profit centres?
8.2 Meaning
A responsibility centre whose financial performance is measured in terms of profits
(i.e., by the difference between the revenue and expense), is called a profit centre. This
is a sub unit or a Division which is accountable for generation of profits.
Each profit centre is a relatively independent unit and the manager must have significant
control over the operating decisions that affect profit. Some examples for these kinds of
decisions are selling price, sales mix, production volume, sourcing of inputs etc. Simply
put, the profit centre head is responsible for cost control as well as revenue generation.
Therefore he must have control over cost and revenue decisions.
Financial control systems for profit centres should measure inputs, outputs and profit
versus a standard performance.
8.3 General Considerations in creating Profit Centers

Profit Centres are also known as Strategic Business Units (SBU). Profit centres are
vertical divisions in the organisation. As opposed to a functional Division, which performs
a specialised function (for example production, marketing, Research etc), profit centre
or SBU performs all the business functions from production to after sales service.
: 117
Introduction to Profit centres can usually be created or carved out of businesses on the basis of:
Management Control
Systems
1. Products
NOTES 2. Clientele
3. Geographic Location
4. Other Criteria
1. Products- A business may be dealing with several products and profit
Check Your Progress centres can be created out of products or product groups. For example
If R Limited sells toys, books
and electronics, which of Procter and Gamble has Beauty & Grooming segment, the Household Care
these can be assessed as
segment as well as the Health & Well Being segment based on the products.
profit centres ?
2. Clientele-Profit centre can also be created out of the type of customers or
clientele. A business may serve various groups or segments of customers
based on which profit centre can be created. For example, Central bank of
India has three verticals, namely retail, agriculture and small and medium
enterprises on the basis of the clientele that are served.
3. Geographic Location-Businesses could be operating across different
locations and business decisions may be made in each of these locations. In
that case, profit centres can also be created on the basis of business locations.
Lakme Beauty Salon, for instance has 110 salons all over India. Each of
these would function as a profit centre.
4. Other Criteria- There are several other basis on which profit centre
could be created. Besides products, customers or locations, profit centres
can be carved out of functions. When a function evolves in a business in
such a way that it can start contributing to the profits of the business, then
it could become a profit centre. For example, training function in a business
could become a profit centre. Logistics function could also become a profit
centre. We will learn more about this in the later part of the Unit.
8.4 Criteria for creation of profit center

In order to create a profit centre the output should be measurable. Let us take an
example of a bank. If this bank creates a Division for public relations and the main
function of this Division is to create awareness about banking habits among prospective
customers, there is no revenue creation in the activity. The only way the performance
: 118
Introduction to
of this Division can be measured is to see how many people they reach out to in a given
Management Control
period of time. Since there is no revenue creation it is difficult to evaluate this Division Systems
as a profit centre. NOTES
However, let us assume that the Division was extremely effective and they reached
out to a lot of people and consequently a new business area was developed and a new
branch was opened there. This branch will bring in measurable revenues and have
Check Your Progress
measurable cost. Therefore while it is possible to evaluate the branch as profit centre, it
Can an R & D division in an
is still not possible to evaluate the public relation Division as a profit centre. FMCG be assessed as a
profit centre ?
Therefore in order to create a profit center:
• Manager needs relevant inputs for decision making
• Revenues and cost must be measurable and traceable
• There must be effective ways of measuring the performance of the manager
• Profit maximization should be one of the important requirements in creating and

running the Division
8.5 Advantages or Benefits of Profit Centers

We have already understood that Profit centres are vertical divisions in the organisation.
As opposed to a functional Division, which performs a specialised function (for example
Check Your Progress
production, marketing, Research etc), profit centre or SBU performs all the business Identify the features of
profit centres.
functions from production to after sales service. The profit centre approach gives an
opportunity to expand both revenue and profit. Profit centres or Strategic Business
Units look at new, entrepreneurial ways to grow the business. Since profit centre does
not perform just a business function like production or sales but takes care of the entire
business from production to sales, the focus is on generating profits for the business
through the Division. This forces managers to think like entrepreneurs and develop the
Division as whole rather than focus on individual functions. Some of the advantages or
benefits of having a profit centre approach to business are discussed below:
1. Quality of decisions
: 119
Introduction to The decisions in a profit centre are usually guided by profit motive. Therefore every
Management Control
Systems situation is evaluated to ensure that the overall profitability of the Division increases on
account of that decision. This ensures that not only the Division but the organization as
NOTES
a whole benefits because of that decision. For example, the Division may be considering
up gradation of technology which is recommended by production department. In a profit
centre such a decision may be taken only after the marketing department confirms that
there is demand for the product and it is worthwhile to upgrade technology and that this
will bring in additional revenues.
2. Speed of decision making

A decentralized set up ensures that decisions are taken fast since there are no layers in
decision making. The decentralized units are empowered to take their own decisions
thereby speeding up the process of decision making.
3. Management by exception through effective decentralization
Check Your Progress In any organization, there may be several issues requiring the urgent attention of the top
What is management by
management. However, when the organization is decentralized and lower down units
exception ?
are empowered, then several issues and problems are solved at that level itself. The top
management can focus its attention on critical issues alone. This is known as
“management by exception”-that is the top management only focuses on exceptional
issues and the day to day problems are handled by the middle and lower management.
4. Better information systems in place

When authority is to be delegated and power is decentralized, there have to be proper
reporting systems in place to ensure that reports reach the top management and policies
and operational issues get conveyed to the middle and lower management. The
communication between various levels of management has to be in place and proper
information systems are required to ensure this.
5. Initiative
When managers are responsible for generation of profits, they tend to be more
entrepreneurial in their thinking and look for newer opportunities to improve revenues or
innovative ways to manage cost. Therefore managers tend to take initiative rather than
wait for things to happen.
: 120
6. Innovation Introduction to
Management Control
When there are constraints on resources and profits have to be improved, then the Systems
managers need to be more innovative and creative. As the old saying goes, “Necessity is
NOTES
the mother of invention”, managers will need to come up with better ideas for improving
profit since they need to keep improving profits in order to be favourably evaluated as
compared to other Divisions.
8.6 Disadvantages of profit Centres

In spite of the several advantages that the decentralized organisation structure offers
there are certain limitations or some practical difficulties in running the vertical units or
SBU or Business Divisions. Some of them are discussed below:
1. Loss of control
Since powers are delegated and authority is decentralized, there is a possible loss of
control for the top management. Unless information systems are in place and
communication between various functions and levels are perfect, it may be difficult for
the top management to understand what is happening at the Divisions. This may make it
difficult for the top management to exercise adequate control on the Divisions.
2. Short run goals

Since Divisions would be evaluated on profits that they earn there is lot of emphasis on
profit maximization. In order to boost near term profits Divisions may resort to uneconomical
business decisions which may result in increasing income in the near term but might have
adverse implications in the long term. For example, investment into research may be
postponed. This may result in saving costs in the near term, but the Division may miss out
on future business opportunities by not launching new products or failing to make product
innovations.
3. Generalist outlook for the specialist

Since the Divisional managers are not required to be functional experts, they might have
to adopt a generalist outlook for managing the Division. Suppose a product specialist is
asked to head a profit centre, he may no longer be able to focus exclusively on product
attributes, technology, design or innovation. He will have to start thinking about profitability
at every stage, thereby forcing him to have a business outlook rather than a specialist
view. : 121
Introduction to 4. Pursuing Divisional goals at the expense of organisational goals
Management Control
Systems Since Divisions within a business also compete against each other, sometimes they may
take decisions that are in the interest of the Division but may not necessarily be in the
NOTES
interest of the organisation. In order to avoid this, it is important for the business to
create information systems which will promote goal congruent behaviour. Incentives
should be designed in such a way that Divisions work for themselves and at the same
time, do not compromise the interest of the organisation as a whole.
Check Your Progress
What are the limitations of Illustration 8.1
a profit centre?
Bharat Company has three operating divisions. The managers of these divisions are
evaluated on their divisional net income before taxes, a figure that includes an allocation
of corporate overhead proportional to the sales of each division. The operating statement
for the first quarter of 2013 appears below:
Particulars DIVISION(Rs. in lakhs)
A B C Total
Net Sales 2,000 1,200 1,600 4,800
Unit and batch related cost 1,050 540 640 2,230
Division capacity related costs 250 125 160 535
Division margin 700 535 800 2,035
Allocated corporate expenses 400 240 320 960
Net Income before taxes 300 295 480 1,075
The manager of Division A is unhappy that his profitability is about the same as Division
B’s and much less than Division C’s even though his sales are much higher than either
of these other two divisions. The manager knows that he is carrying one line of products
with very low profitably. He was going to replace this line of business as soon as more
profitable product opportunities became available but has retained it until now, because
the line was still marginally profitable and used facilities that would otherwise be idle.
: 122
The manager now realizes, however, that the sales from this product line are attracting a Introduction to
Management Control
fair amount of corporate overhead, which is allocated at the rate of 20% of net sales, and Systems
maybe the line is already unprofitable for him.
NOTES
This low margin line of products had the following characteristics for the quarter:
Net Sales 800
Unit and batch related costs 600
Division capacity related costs 100
Division margin 100
Thus the product line accounted for 40% of the divisional sales but less than 15% of
divisional profit.
Required
1. Prepare the operating statement for Bharat Company for the second quarter of
2013 assuming that sales and operating results are identical to the first quarter
except that the manager of Division A drops the low margin product entirely
from his product group. Is the Division A manager better off from this action? Is
the Bharat Company better off from this action?
2. Suggest changes in the Bharat Company’s Divisional reporting and evaluation

system that will improve local incentives for decision making that is in the best
interests of the firm.
Solution
1. Currently the product that is intended to be dropped has a contribution of

Rs.100,000. If Division A drops the product, then the Income Statement of Bharat
Company will be as follows:
: 123
Introduction to Current After dropping the product
Management Control
Systems Net Sales 4,800 4,000
NOTES Unit and batch related cost 2,230 1,630
Division capacity related costs 535 435
Margin 2,035 1,935
Allocated corporate expenses 960 9601.1
Income Statement of Division A will be as follows:
Current After dropping the

product
Net Sales 2,000 1,200
Unit and batch related cost 1,050 450**
Division capacity related costs 250 150**
Division margin 700 600
Allocated corporate expenses 400 240
Net Income before taxes 300 360
**After deducting the costs relating to the product to be dropped.
Therefore Division A will decide to drop the product. However the margin of Division
A has reduced from 700 to 600. The income has increased because the allocated
corporate expenses have reduced. However since these expenses are only allocated-
that is these are corporate expenses which are unavoidable, so the total expenses for
the organisation as a whole has not decreased. Only the allocation has changed thereby
increasing the reported income of a Division.
If A drops the product, the income of the organisation as a whole will go down by
Rs.100,000 as is evident from the income statement of Bharat Company.
1. The current reporting is wrong because expenses are allocated as a percentage

: 124 of sales. This means the higher the sale a Division reports, the more the overhead
allocation for the Division. This will prompt Divisions to report lower sales Introduction to
Management Control
figures so that the allocation will also reduce. Systems
Therefore the allocation of corporate expenses should be done on a rational
NOTES
basis. They could use Activity Based Costing to allocate the common costs.
8.7 Evaluation of Profit Centre

Suppose an organization has five profit centres A, B, C, D and E, how can it be reliably
established as to which is the most efficient profit centre? The performance of a profit
centre is usually judged by the income generated by the profit centre. However, income
or profit can be defined at several levels. Profit could begin with contribution which is
revenue net of variable expenses. We could also define profit as the direct profit earned
in the Division which is the contribution net of the fixed expenses incurred in that Division.
Similarly the Divisions also earn controllable profit and profit before taxes. We can compare
the performance of various profit centres using this Income Statement. However, since
there are several levels of income, we need to understand how to read this income
statement and what level of income should be compared to assess the performance of a
profit centre. The following is the Income Statement of a profit centre.
Income Statement of Profit Centre
Revenue
Less: Cost of Goods Sold
(Variable costs)
Contribution Margin
Less: Fixed expenses incurred in the profit centre
Direct Profit
Less: Controllable Corporate Charges
Controllable Profit
Less: Other Corporate Allocations
Income before Taxes
Less: Taxes
Income after taxes : 125

Introduction to The income of various profit centers within an organization can be compared at the
Management Control
Systems following levels of income:
NOTES
Contribution margin
Contribution margin is the spread between revenue and variable expenses. Therefore
Check Your Progress
What is contribution the question is, whether the Division earning the highest contribution be evaluated most
margin ?
favourably. The answer to this question would be in the negative because contribution is
a function of revenue. Increase in revenue would automatically result in increased
contribution. Therefore that would only be the function of the revenue centre. Profit
centre also needs to effectively control fixed expenses to increase profits. If we evaluated
a revenue centre by the contribution generated, then the Division could always show
increased contribution by keeping variable costs low and incurring higher fixed costs
than required.
Direct profit
Direct profit is calculated by netting off the direct fixed expenses incurred in the Division.
If direct profit is to be used as a measure to evaluate performance of the Division, then
other indirect corporate allocations would not be considered in evaluating performance

of the Division. This would absolve the Division of any other costs incurred on its behalf
by the headquarters. Therefore if direct profit is used to evaluate the performance of a
Division, then that might be an incentive for the Division to reduce costs incurred at the
Division and transfer all expenses to the Corporate Headquarters.
Controllable profit
The profit earned by the division after adjusting for direct fixed costs incurred in the
Check Your Progress Division and the expenses incurred on behalf of the Division by the Corporate
What are the various Headquarters. Many a times, expenses are common across several Divisions and the
measures of profit evaluation
in profit centres ? Corporate Headquarter incurs these expenses on behalf of all the Divisions. Some of
these expenses are traceable to Divisions. For instance, if the Headquarter has defended
a suit pending against the product of a particular Division, the legal expenses should be
allocated to that Division. These are called as “Controllable Corporate Charges”, wherein
: 126
the Corporate Headquarter incurs certain overheads on behalf of the Division. These Introduction to
Management Control
costs are then allocated to the respective Division. The income earned after adjusting for Systems
Controllable Corporate Charges is called as Controllable profit.
NOTES
If controllable profit is used as performance evaluation measure for the Divisions then it
means that there is no ownership of costs incurred at the Headquarter level which are not
specific to any Division.
Income before Taxes
This is the profit after adjusting for “Other corporate allocations”. These are expenses
incurred at the Corporate Headquarters which are allocated to Divisions on the basis of
certain logical assumptions. However, these are not so easy to apportion and are mostly
done on some approximations.
Income after Taxes
This is the profit after adjusting for taxes. This may not be the most appropriate evaluation
Check Your Progress
because taxes are a corporate function and are usually levied on the entire organization’s What is controllable profit ?
profits. Also some Divisions may operate in tax free zones because of which it may
become difficult to evaluate after tax profits of Divisions.
Considering the factors discussed above, Income before Taxes is the better measure of
evaluation of income for Divisions since it makes managers accountable for all the costs
incurred whether at the Divisional level or at the Headquarter level. Therefore Divisions
can be reliably evaluated on the income they earn before taxes.
Illustration 8.2
The following is the Income Statement of SBUs of Hindustan Company Ltd. The income
statement forms the basis for the incentive plan for the head of the SBUs. There is some
thinking about what the ideal measure for rewarding the SBU heads should be.
: 127
Introduction to Particulars SBU1 SBU2 SBU3
Management Control
Systems (All figures in Rs.000’s)
Sales 12,000 14,000 18,000

NOTES
Variable Cost 5,000 6,000 8,000
Contribution 7,000 8,000 10,000
Direct fixed cost 1000 3,000 6,000
Direct Profit 6,000 5,000 4,000
Controllable corporate charges 1,500 500 600
Controllable Profit 4,500 5,500 3,400
Other corporate allocations 600 1,200 1,200
Income before taxes 3,900 4,300 2,200
Required:
Rank the profit centres as per the performance on each of the parameters indicated in
bold.
Solution:
Particulars SBU1 SBU2 SBU3
(All figures in Rs.000’s)
Sales 12,000 14,000 18,000
Variable Cost 5,000 6,000 8,000
Contribution 7,000 8,000 10,000
Rank 3 2 1
Direct fixed cost 1000 3,000 6,000
Direct Profit 6,000 5,000 4,000
Rank 1 2 3
Controllable corporate charges 1,500 500 600
Controllable Profit 4,500 5,500 3,400
Rank 2 1 3
Other corporate allocations 600 1,200 1,200
Income before taxes 3,900 4,300 2,200
Rank 2 1 3
As is evident from the solution given above, each of the SBUs gets ranked differently
: 128 according to each parameter.
Illustration 8.3 Introduction to
Management Control
Systems
The following is the Income Statement of SBUs of M ltd. The income statement forms
the basis for the incentive plan for the head of the SBUs. There is some thinking about NOTES
what the ideal measure for rewarding the SBU heads should be.
Particulars SBU1 SBU2 SBU3 SBU4
(All figures in Rs.’000)
Sales 6,000 7,000 9,000 8,000
Variable Cost 2,500 3,500 4,000 3,500
Contribution 3,500 3,500 5,000 4,500
Direct fixed cost 900 1,000 2,100 1,400
Direct Profit 2,600 2,500 2,900 3,100
Controllable corporate charges** 400 600 1,100 2,000
Controllable Profit 2,200 1,900 1,800 1,100
Other corporate allocations*** 600 200 600 600
Income before taxes 1,600 1,700 1,200 500
** Of the controllable corporate charges, 5% is allocated on sales turnover since the

headquarter feels that sales related expenses accounts for about 5% of the costs incurred
at the Headquarter level
*** Other Corporate Allocations consist of corporate charges allocated to SBUs. Rural
branches get a lesser share of these allocations because several initiatives of M Ltd. are
urban based. Hence SBU 2 is charged a lesser share of the corporate allocations.
Required:
a. You are required to advise the management on which of the above

measures (highlighted in the income statement in bold) you consider
: 129
Introduction to appropriate for the purpose of judging the efficiency of the SBUs and
Management Control
Systems attribute appropriate reasons for the same.
NOTES b. Should Income taxes be considered in the calculations above? Why/

Why not?
Solution:
a. The purpose of a profit centre is generation of profit.

Sales cannot be a reliable measure to evaluate a profit center since it is the
function of a revenue center to maximize sales. The scope of a revenue center
is limited as compared to that of a profit center.
Direct Profit does not include the expenses incurred by the Corporate Headquarters.
So it is not an appropriate measure.
Controllable profit does not include other expenses incurred at Headquarters. If profit
centers are not made accountable for these costs, eventually these costs will not be
controlled at any level and there would be no accountability for costs incurred in this
head.
Income before Taxes is the better measure of evaluation of income for Divisions
since it makes managers accountable for all the costs incurred whether at the Divisional
level or at the Headquarter level. Therefore Divisions can be reliably evaluated on the
income they earn before taxes.
b. Taxes should not be considered because taxes are a corporate function and are
usually levied on the entire organization’s profits. Also some Divisions may
operate in tax free zones because of which it may become difficult to evaluate
after tax profits of Divisions.
Can Expense centres be converted to profit centres?
A decentralized environment results in highly dispersed decision making. As a result, it

is imperative to monitor and judge the effectiveness of each manager. This is easier said
than done. Management is responsible for ensuring the optimum relation between input
and output. In some center responsibility is casual and direct, as in the case of production
: 130 department, for example input of raw material become part of finished goods, hence,
Introduction to
the control focus on using the minimum input necessary to produce the required output
Management Control
according to the correct specification and quality standards. Systems
Not all units are capable of being evaluated on the same basis. Some units do not generate NOTES
any revenue; they only incur costs in support of some necessary function. Other units that
deliver goods and services have the potential to be assessed on the basis of profit generation.
Can Divisions that operate as cost or expense center be converted to profit center?
Cost centre may actually provide services that could generate profits if they were offered
outside the organisation. Companies may want to convert their cost centres to profit
centres since that may improve the efficiency of a Division and help the overall growth of
the business. Sometimes it may also help them to gain competitive advantage over
competitors.
Let us take an example of Information Technology (IT) services. Usually, IT Division is

considered as expense centre to the company. If IT department provides service to its
internal customers and the cost of this Division is borne by all the Divisions using IT
service, then IT Division would operate as an expense centre. However, if this Division
starts charging other Divisions for service rendered, then it can be evaluated as profit
centre. Also IT department can sell its services to outside customers which will generate
revenue for company.
Let us consider another example of a hospital. Flower Hospital is a reputed hospital in the
city and has a several famous surgeons visiting the hospital to perform surgeries as also in
house doctors. The Hospital has State of art facilities for pathological testing, surgery and
recovery post-surgery. The Hospital was reputed for its humane care and the success
rate of surgeries and the recovery rates post-surgery were very high. The Hospital however
was highly renowned for its testing services of the pathology department. There were
several tests for which facilities were not available anywhere else in the city.
Flower Hospital therefore, decided to operate the pathology department as a profit centre
with operational autonomy. This has contributed to the bottom line of the Hospital and
helped the Division to fund newer equipment and technology.
: 131
Introduction to
From the discussion above, it follows that here are two very important criteria for an
Management Control
Systems expense centre to be converted as profit centre:
NOTES 1. The output should be measurable- in the example above, the IT Division should
be able to quantify the service rendered in monetary terms.
2. The Division should be free to sell its products or services outside the organisation
also.
The profit centre approach gives an opportunity to expand both revenue and profit, as
well as build the leverage base.
8.8 Summary
A responsibility centre whose financial performance is measured in terms of profits
(i.e., by the difference between the revenue and expense), is called a profit centre.
Profit centres can usually be created or carved out of businesses on the basis of Products;
Clientele; Geographic Location or other criteria such as function. In order to create a
profit centre the output should be measurable. Some of the advantages or benefits of
having a profit centre approach to business are better quality of decisions; quicker
decision making; facilitation of management by exception; better information systems;
more initiative from lower management; innovation. However there are some limitations
of profit center like loss of control for top management; pursuit of short term goals
which may impact the organization adversely in the long term; generalist outlook for the
specialist and pursuing divisional goals at the expense of organisational goals. While
profit centres could be evaluated at many levels such as contribution, direct profit,
controllable profit or profit before taxes, the most comprehensive evaluation would be
the profit before taxes. Sometimes cost centre may actually provide services that could
generate profits if they were offered outside the organisation. Companies may want to
convert their cost centres to profit centres since that may improve the efficiency of a
division and help the overall growth of the business.
: 132
Introduction to
8.9 Key Terms Management Control
Systems
A responsibility centre whose financial performance is measured in terms of
NOTES
profits (i.e., by the difference between the revenue and expense), is called a
profit centre
As opposed to a functional Division, which performs a specialised function profit

centre or Strategic Business Unit (SBU) performs all the business functions from
production to after sales service.
Contribution margin is the spread between revenue and variable expenses.
Direct profit is calculated by netting off the direct fixed expenses incurred in the
Division
The profit earned by the division after adjusting for direct fixed costs incurred in the
Division and the expenses incurred on behalf of the Division by the Corporate
Headquarters is called controllable profit.
8.10 Questions
1. On what basis can profit centres be created? Explain with examples.
2. What are the benefits of profit centres?
3. Are there any disadvantages in a profit centre? Explain.
4. Can an expense centre be converted to profit centre? Explain with examples.
1. In a belt tightening measure, the Blueberry Company is taking a close look at its
four divisions with an eye toward closing any unprofitable ones. Common costs
incurred at the corporate level have been distributed to each division in proportion
to sales revenue. Division level costs are considered to be avoidable if a Division
is shut down. The Corporate costs, however cannot be avoided as long as some
: 133
Introduction to of the Divisions continue operation. The Corporate headquarters costs amount
Management Control
Systems to 995,000 (semi-annual). The following data represents semi-annual results:
NOTES Divisions (‘000s)
Total North South East West
Sales 4800 2115 1060 695 930
Costs (Direct 4450 1820 770 1240 620
and allocated)
Profits/(Losses) 350 295 290 -545 310
Required:
a. Based on the above Information, what recommendations would you

make concerning possible division closes?
b. Since the above data represents semi-annual information, what other

variables should be included in the decision to close down a division?
1. Following is the information on Paragon Company’s three product lines:

Product Lines
1 2 3
Revenue 71,60,000 19,00,000 42,00,000
Flexible cost percentage of sales 60% 50% 40%
Other costs 8,59,200 2,37,500 6,93,000
Allocated avoidable corporate 3,49,000 1,56,000 6,98,000
costs
Allocated unavoidable corporate 5,70,800 2,06,500 24,000
costs
· Construct a profitability margin for the divisions to enable

performance evaluation.
· At what levels should the profitability between divisions be

compared? Give reasons.
: 134
Introduction to
8.11 Further Reading and References Management Control
Systems
Lemke, K. W. (1970), In Defence of the ‘Profit Centre’Concept. Abacus, 6: 182–189.
NOTES
Mottis, N., & Ponssard, J. P. (2001). Value based management and the corporate profit
centre. In European Business Forum (Vol. 8, pp. 141-7). Prentice Hall.
: 135
Introduction to
Management Control Unit 9: Transfer Pricing
Systems
Structure
NOTES
9.0 Introduction
9.1 Unit Objectives
9.2 Background
9.3 Definition of Transfer price
9.4 Objectives of Transfer Pricing
9.5 Implementation of transfer pricing
9.6 Methods of transfer price
9.6.1 Market based
9.6.2 Cost plus
9.6.3 Negotiated Transfer Pricing:
9.7 Pricing Corporate Services
9.8 Control over amount of service
9.9 Summary
9.10 Key Terms
9.11 Questions
9.11.1 State whether True or False:
: 136
9.0 Introduction Introduction to
Management Control
In the previous Unit we understood all about profit centres. In this Unit we understand Systems
how responsibility centres transact with each other. The pricing mechanism for internal NOTES
transfer between responsibility centres is referred to as transfer price. Will responsibility

centres buy and sell for a profit? Or would the transactions happen without any cost
considerations? We will try to identify the answers to these questions in this Unit.
9.1 Unit Objectives

· To understand the meaning and definition of transfer pricing
· Illustrate the fundamentals and objectives of Transfer pricing
· When transfer pricing can be successfully implemented in organizations
· To understand methods of transfer price and application of these methods
9.2 Background
We have heard of number of business enterprises which have multiple products. We also
know businesses which produce raw material as well as finished products. Some of the
businesses that you might quickly recall are Tata who produce iron and steel as well as
automobiles. So the output of one business becomes input for another. Another Indian
business house that we all know is Reliance Industries who have interest in number of
businesses from oil to plastic, many of which are fully integrated. So integrated business
Check Your Progress
simply means that they produce from raw material to finished goods (though it is possible Can you define transfer
that they may not be producing all of them). pricing ?
Such integrated businesses usually transact within each other. These inter business
transactions may not be necessarily market driven. However if each of the transacting
unit is a profit centre, then they need to maximise their divisional profits. Transactions
between two autonomous business units give rise to two questions:
1. Would the transaction have been similar if the units were not autonomous, but
were part of a centralized organisation?
: 137
Introduction to
2. Had the transacting units been unrelated to each other, would the transactions
Management Control
Systems have been similar?
NOTES The questions above result in an interesting situation, wherein the transacting entities
have to arrive at a consideration for transacting with each other, usually called transfer
price.
Transfer price can be described as the value placed on goods or services between two
entities, of which at least one is a profit centre. The reason is simple. The pricing
resembles a transaction conducted with an unrelated entity. Such pricing involves analysis
of the transactions and adjustment of charges between related parties for goods or
services, whether tangible or intangible.
Some issues arise in transfer pricing because of such adjustments. We will discuss them
in detail in the forthcoming sections.
9.3 Definition of Transfer price

The transfer price is the value (or price) placed on the goods, services and intangibles
that are transferred within the firms, as it moves from one organizational entity (e.g., a
Check Your Progress
What is sourcing decision ? division, an unit, a subunit) to another within a corporate group (Eccles, 1985; Cravens,
1997) Hence, while the role of prices is to efficiently allocate resources in the market,
the role of transfer prices is to efficiently allocate resources within the firm.
According to CIMA (Chartered Institute of Management Accounting), “the value placed

on intra company transfers is called transfer price. The value that would be placed on
goods and services that would otherwise be cost and this can still be used as a transfer
price. An alternative however that reflects the autonomous nature of Divisions, would
be for the selling division to transfer at a price above cost, and thus record a profit.”
If two or more profit centres are jointly responsible for product development,
manufacturing and marketing, each should share in the revenue generated when the
product is finally sold. The transfer price is the mechanism for distributing this revenue.
: 138
Introduction to
Fundamentals of transfer pricing
Management Control
Systems
Transfer price should be similar to the price charged if the buying or selling were done to
outside units. NOTES
Periodic review must be made of the following:
· Sourcing Decision
· Transfer Price Decision
Sourcing decision is taken to determine whether the sourcing should be done from within
or from any other external vendor.
In case the sourcing is sought to be done from within the organization, then what might be
the price at which the transfer might happen is called the transfer price decision.
9.4 Objectives of Transfer Pricing

Objectives of transfer pricing are many. However transfer pricing is done chiefly to
ensure:
1. Distribution of revenue between Division when they are responsible for jointly
developing and marketing a product
2. To induce goal congruent decisions to improve profits of the profit centre as well
as organization as a whole
3. To measure the economic performance of individual Division
9.5 Implementation of transfer pricing

Though the concept of transfer pricing sounds simple enough, it is not very easy to put
into practice. There are certain requirements in an organization for successful
implementation of transfer pricing. Those are listed as follows:
1. Free flow of information
Proper information management and free flow of information is essential for a

good transfer pricing mechanism to run in an organisation
: 139
Introduction to
2. Atmosphere of cooperation
Management Control
Systems
A fiercely competitive environment will hinder the fairness in transfer pricing
NOTES mechanism. It will result in a lot of negotiations and arbitration and ultimately
defeat the purpose of transfer pricing.
3. Autonomy to Divisions
Check Your Progress Transfer pricing requires that Divisions function in a reasonably autonomous
Why is autonomy required
for implementation of environment. If the central leadership is negotiating in all transfer pricing
transfer pricing?
transactions, it is counterproductive. Guidelines can be stipulated for transfer
pricing transactions where there is similar nature of transactions.
9.6 Methods of transfer price

By definition, transfer price is the value at which goods and services are transferred.
How is this value arrived? Is this value fixed? Or does it depend on a number of factors?
Yes, you guessed right. The ultimate transfer price is a function of some factors such as
available capacity to produce the product, the market forces in that product or service
and the information transmission between the divisions involved in the transfer.
Basically we identify three methods of fixing transfer price. It can be fixed on the basis
of market price or cost plus margin or on the basis of negotiation with transacting
Divisions.
Transfer Pricing Methods
Market- based Cost- based Negotiated Transfer
Transfer Pricing Transfer Pricing Pricing
Figure 9.1: Methods of Transfer Pricing
9.6.1 Market based

Check Your Progress Transfer prices can be fixed on market basis when the products or services are
When is variable cost used
for fixing transfer prince ? commodities which have unlimited buyers and sellers and have a market price. In case
of intermediary products or made to order products, it may not be possible to arrive at
comparable market price. In the presence of competitive and stable external markets
: 140
for the transferred product, many firms use the external market price as the transfer Introduction to
Management Control
price. Systems
Market price serves the interest of both buying and selling division and maximises the NOTES
profits of the entity. Such transfer would become possible when the buying division does
not have a better supplier or all suppliers quote similar prices and hence the buying
division is indifferent between internal and external entities. Similarly the selling division
would be willing to sell at market price when all buyers are willing to offer market price
and the selling division is indifferent between the internal and external buyers
Illustration 9.1
Arnold Limited manufactures ball point pens and refills. They have two different profit
centres-one is the ball point division and another is the refill division. The refill division
sells refills directly in the market and also supplies to the ball point division. Similarly, the
ball
point division also buys refills either from within Arnold Limited or from external sources.
Currently the ball point division is able to source refills at Rs.400/- for 500 pieces. What
is the maximum price that they would be willing to pay for an order of 2000 units if they
buy from the refill division?
Solution:
1. The ball point division will not be willing to pay more than Rs.1,600/- for 2000
pieces. Similarly, the refill division will not be willing to sell at anything less than
Rs.1,600/-
2. This is because the buying division (ball point) has unlimited sellers and the selling
division (refill) has unlimited buyers.
3. Also the firm profit will not suffer if refill sold their output in the open market and
if ball point purchases from outside the firm.
: 141
Introduction to
9.6.2 Cost plus
Management Control
Systems
Another very common method of fixing transfer price is on the basis of cost plus standard
NOTES margin. One very important aspect to remember is that the basis of cost used to fix the
transfer price should be the standard cost and not the actual cost. The reason is that the
actual cost may factor in inefficiencies which might affect the competitiveness of the
final product.
This method is usually used when:
· Market price is not available because the product might be customised and may
be produced as per requirements of the purchasing division.
· A Division creates capacity for another and is looking for a minimum margin
built over the cost of producing the product. The transfer price is based on the
production cost of the upstream division. A cost-based transfer price requires
that the following criteria be specified:
· Actual cost – Actual cost is the cost of producing the unit. Usually this
can be calculated only at the end of the accounting period.
· Budgeted (standard) cost- This is the expected cost if the product or

service is delivered as per the standard set.
· Full cost- This is the cost of producing a unit comprising fixed cost and
the variable cost
· Variable cost- This is the incremental cost of producing an additional

unit
The amount of mark up, if any, is added to cost to allow the upstream division to earn a
profit on the transferred product. The choice of any of the above price will depend on
various factors. Suppose the product is new or is being developed for the first time, then
historical costs may not be available. The division may have to go with the budgeted or
projected cost. If the division produces only a single product then they may not be able
to spread their fixed costs across many units. Also if there are installed capacities that
the firm cannot minimise- for example they cannot operate the equipment for less than
: 142
Introduction to
a shift, then the division may want to be compensated for full cost. In case the division
Management Control
operates with flexible costing structure, (that is, they can hire equipment if they wanted) Systems
then they can charge on the variable cost. NOTES
Suppose the upstream division sells the intermediate product to external customers as well
as to the downstream division. In this situation, capacity constraints are crucial. In case
there is excess capacity, the upstream division can use a cost based transfer price. But
unless there is a mark up to the cost, the division will not be incentivised to sell it to the
downstream division.
Suppose there is no external market for the upstream division, and this division is to be
treated as a profit centre, it must be allowed the opportunity to recover its full cost of
production plus a reasonable profit. If the downstream division is charged the full cost of
production, there is still an incentive for the upstream division and the downstream division
will refuse the transfer under only two circumstances:
· First, if the downstream division can source the intermediate product for a
lower cost elsewhere
· Second, if the downstream division cannot generate a reasonable profit

on the sale of the final product when it pays the upstream division’s full
cost of production for the intermediate product.
Illustration 9.2
X Ltd. has two divisions A and B. A produces output which is entirely consumed by
Division B. A’s produce has a market outside provided A makes considerable changes in
its output. This will increase the variable cost of A by at least 30%. Division B can
source the material from outside, but will again have to incur additional conversion costs
to make it suitable for their uses.
Which of the following, do you think is ideal for the organization so that any sourcing
decision taken by division B will be in the interest of the organization?
1. Merge Divisions A and B and assess them as a single unit.
2. Keep A and B as separate, identifiable profit centers.

: 143
Introduction to 3. Convert A into a cost center and get them to transfer their output to B at
Management Control
Systems cost.
NOTES Solution:
If we merge A and B and assess them as a single unit, the concept of a

responsibility center is not fulfilled since we are not looking at maximum level
of accountability.
If A is a profit center, then there is no motivation for them to reduce prices

and supply to B. this in turn, will enable B to source from outside and the
organization will be at a loss.
If A is a cost centre, then they are motivated to reduce cost and B will be
motivated to buy from A.
In this case, A will initially supply at cost. Eventually they can start supplying
at cost plus when more buyers, other than Division B start entering the
market.
9.6.3 Negotiated Transfer Pricing:
When divisions cannot agree on a common price, negotiation is resorted to. A negotiation
may not result in the best transfer price since the buying or selling division may have an
upper hand. While each of the division tries to maximise its own gains the process of
negotiation, the managers try to emulate a free market so as to create transactions that
closely resemble an arm’s length price. When divisions are not able to negotiate
successfully, or come to an agreement on the transfer price, the senior management
may intervene. Though such an intervention may benefit the company in the short run,
it may be counterproductive in the long run since divisions need to communicate efficiently
with each other in the true spirit of decentralisation.
When either the buying or the selling division has options, then negotiation takes place.
For example, assume that there are two Divisions A and B in an organisation and Division
A supplies to Division B. If Division A has more than one buyer, but Division B has only
one supplier namely Division A, then Division A might want to negotiate for better
: 144 prices with Division B.
Management Control
The Sather Corporation manufactures and sells 10,000 boom boxes per year. The Assembly Systems
Division assembles the boom boxes. It buys the cassette deck for the boom box from the NOTES
Cassette Deck Division. The Cassette Deck Division can manufacture at most 12,000
cassette decks. The demand for cassette decks is strong. Any Cassette Deck not sold to
the Assembly Division can be sold in the outside market at $35 per unit. The Cassette
Deck Division currently sells 10,000 cassette decks to the Assembly Division and 2,000
cassette decks in the outside market. The incremental cost of manufacturing the cassette
deck is $25 per unit.
A crucial component for producing high-quality cassette decks is the cassette head
mechanism. The Cassette Deck Division manufactures the head mechanism for its cassette
decks. Many outside suppliers have offered to supply cassette decks to Sather. To ensure
quality, Sather requires that any outside supplier wanting to supply cassette decks to
Sather must purchase the head mechanism from the Cassette Deck Division. The Cassette
Deck Division will charge $18 per unit for the head mechanism. The incremental cost of
manufacturing the head mechanism is $12 per unit out of the total incremental costs of
$25 per unit to manufacture the cassette deck. The Cassette Deck Division has unused
capacity for manufacturing the head mechanism. That is, even if the Cassette Deck
Division manufactures the head mechanism for outside suppliers, it will still be able to
manufacture 12,000 cassette decks for sale in outside market at $35 per unit.
Johnson Corporation, an outside supplier, is currently negotiating to supply 10,000 cassette

decks to the Assembly Division at $34. If Johnson gets the business, it will buy the head
mechanism from the Cassette Deck Division for $18 per unit.
Consider each question independently.
a. From the standpoint of Assembly Division, is the offer acceptable?
b. From the point of view of Sather Corporation, is it beneficial to accept

Johnson’s offer?
c. What transfer price for the Cassette Decks will result in the Cassette
Deck Division and the Assembly Division taking actions that are optimal
: 145
for Sather Corporation as a whole? Explain your answer.
Introduction to Solution:
Management Control
Systems
Q1. Yes, it is acceptable because they get the component at 34 and Cassette
NOTES Deck Division can sell it at the outside market for 35. Net gain
$1*10000=$10,000
Q2. Yes. For reasons above, In addition the Cassette Deck Division also earns
contribution of (18-12) = $6
Q3. Any price above $25 which is the variable cost. But two points to be noted:
a. Cassette Deck has unlimited outside market, so transfer price is market

price.
b. But if price falls to 34 outside, eventually Cassette Deck has to drop to 34.
Students should note that the element of negotiation arises when there is a disruption.
Buying and selling divisions may have agreed on a given price and may be transacting
among themselves, but when a new player emerges, it disrupts the existing quilibrium
and results in negotiation. In the example that we saw, the entry of Johnson Corporation
is bringing down the price from $35 to $34 thus resulting in negotiations and change in
vendor.
Issues in Transfer Pricing
Several issues could arise in fixing and administering transfer prices. These issues could
be broadly identified as follows:
· Problems on account of capacity utilization in Divisions- Capacity Constraints
Check Your Progress · Problems of information exchange

What is an arbritation
committee necessary for
· Problems of goal congruence
fixing transfer price ?
All of these issues are discussed in significant detail in the following Unit.
Administration of Transfer Pricing
On account of the issues and complexities in transfer pricing administration of the same
is not always simple or straight forward.Implementation of transfer pricing in organisations
: 146
Introduction to
happens through negotiated settlement, arbitration and conflict resolution and fixing thumb
Management Control
rules for repetitive transactions. A single department or division is usually not made Systems
responsible for the administration. Usually a committee is set up consisting of product NOTES
specialists as well as finance executives to arrive at acceptable solutions in transfer
pricing conflicts.
9.7 Pricing Corporate Services

Corporate services are activities that combine or consolidate certain enterprise-wide
needed support services. Such services are usually provided based on specialized
knowledge- for example audit or business advisory services, compliance services, legal
department or Information Technology. These divisions obviously incur a cost. Can these
costs be passed on? Can these be passed on with an additional element of profit? In other
words can services also be charged with transfer price like products?
There are two types of transfers in central services:-
· Central services that the receiving unit must accept but can at least partially
control the amount used.
· Central services that the business unit can decide whether or not to use
Let us understand this in some detail. Regulatory or legal compliance is usually not a
matter of choice for a business. So the costs of these services will be passed on to all the
business units which receive these services. Information technology or business advisory
services, on the other hand offer scope for choosing as to whether and to what extent
these services need to be availed.
9.8 Control over amount of service

In certain situations like when business units are required to use central services such as
information technology, research and development etc, the managers of these units cannot
control the efficiency with which these activities are performed but can definitely control
the amount of service received. There are three schools of thought about pricing such
services:
: 147
Introduction to Ø The first school of thought states that a business unit should pay the standard
Management Control
Systems variable cost for the discretionary services. If it pays less than this, then it will
be motivated to use more of the service than is economically justified and if it
NOTES
has to pay more than the standard variable cost, then it might not use the central
service that senior management believes worthwhile from the company’s
viewpoint.
Ø The second school of thought advocates that a price equal to standard variable
cost plus a fair share of the standard fixed costs that is full cost should be paid
for central service. If the business units feel that the services are not worth this
amount, then something is wrong with the quality or efficiency of the service
unit. Full cost represents the company’s long-run costs and therefore this is the
amount that must be paid.
Ø The third school of thought proposes a price equivalent to the market price if it
is available or standard full cost plus profit margin (return on investment) as it is
of the opinion that the capital employed by service units should earn a return
just as the capital employed by manufacturing units does.
Optional use of services:
Sometimes, business units may decide to obtain central services from outside or develop
their own capability or even choose not to use the service at all. In this situation, the
business unit managers control both the amount and efficiency of the central services.
The central service centres are independent and if they are found to be incompetent,
then either the scope of their activity will be contracted or their services may be
outsourced.
Transfer pricing fundamentals do not vary too much between products and services.
Transfer of services between divisions can happen on the basis of a transfer price
: 148 provide the following conditions are fulfilled:

a. The division buying the services must be able to control the amount of services Introduction to
Management Control
used Systems
b. The buying division must have a choice to source services from outside. Similarly, NOTES
receiving unit must have an option to sell services outside.
Some examples of services required that are purchased within the business organisation Check Your Progress
are Information Technology, Research and Development etc. Can services be priced like
products ?
Prices are fixed by the selling Division on the basis of variable cost, full cost or market
price.
Illustration 9.4
MSM Limited is an integrated business advisory offering services in Taxation, Consulting

and Financial Services. The Consulting Division also advises clients on related areas
which require them to use services from Taxation as well as Financial Services. All the
Divisions also independently offer services to clients.
Taxation currently has 4 consultants, all of whom are fully engaged. They charge on
hourly basis and their billable hours are 140 per month per consultant. The charges are
Rs.5000/- per hour. The Consulting Division approaches the Taxation Division with a
work that requires 20 hours and offer them a consolidated remuneration of Rs.90,000/-
1. Will the Taxation Division accept or reject the offer?
2. What are the minimum conditions for accepting the offer?
Solution:
1. The Taxation Division charges Rs.5000/- per hour. So the expected remuneration
is Rs.1,00,000/- Since all the consultants are fully occupied, it stands to reason
that the offer will be rejected unless they are paid at least Rs.1,00,000/-
2. The only situation when the offer is likely to be accepted is when there is surplus
capacity in the Taxation Division- that is there are some consultancy hours that
are unutilised. If there is not enough work available for the consultants then this
situation could arise. In this case, the Division may consider accepting the offer
in order to meet the establishment expenses or the fixed costs of the Division.
: 149
Introduction to
Management Control
Systems Students are advised to revisit this illustration after understanding the next Unit
NOTES which discusses the implications of capacity utilisation in pricing of products.

The concept is the same in services also.
9.9 Summary
Transfer pricing refers to the setting, analysis, documentation, and adjustment
of charges made between related parties for goods, services, or use of property
(including intangible property). Transfer prices among components of an
enterprise may be used to reflect allocation of resources among such
components, or for other purposes. Transfer price should be similar to the price
charged if the buying or selling were done to outside units. Objectives of transfer
pricing are distribution of revenue between Divisions, to induce goal congruent
decisions to improve profits of the profit centre as well as organization as a
whole and to measure the economic performance of individual Division.
Requirements in an organization for successful implementation of transfer pricing
are free flow of information, atmosphere of cooperation and Autonomy to
Divisions. Transfer prices can be fixed on the basis of market price or cost plus
margin or on the basis of negotiation with transacting Divisions. Issues that
arise in transfer pricing are problems on account of capacity utilization in
Divisions, problems of information exchange and problems of goal congruence.
9.10 Key Terms

Transfer price is the value (or price) placed on the goods, services and intangibles that
are transferred within the firms, as it moves from one organizational entity (e.g., a
division, an unit, a subunit) to another within a corporate group.
Market based transfer prices are those that are fixed on market basis when the
products or services are commodities which have unlimited buyers and sellers and have
a market price.
Cost plus transfer price is the price fixed on the basis of cost plus standard margin.
: 150
Negotiated transfer price is fixed by the divisional managers who negotiate a mutually Introduction to
Management Control
agreeable price. Systems
NOTES
9.11 Questions
1. Transfer price is effective when divisions perform as cost centres.

2. Transfer price should always be equal to the market price in order to give the
best return.
3. Market price as transfer price is ideal when the products have a market
outside the firm and the divisions are performing at optimum capacity.
4. Market price is not effective when a division produces exclusively for captive
consumption.
5. Transfer prices are highly dynamic and related more to the external
environment of the business.
6. Transfer pricing is a mechanism which enables profit sharing across

various contributing divisions within an organization.
7. Transfer price can never be below the variable cost of producing a unit.
1. What is the meaning of transfer pricing?
2. When is negotiated transfer pricing used?
3. Should cost based transfer price be based on actual or standard cost? Why?

Eccles, R. G. (1985). The transfer pricing problem: A theory for practice.
Lexington. MA:
Lexington Books.
Cravens, K. S. (1997). Examining the role of transfer pricing as a strategy for

: 151
multinational firms. International Business Review, 6 (2), 127-145.
Introduction to
Management Control Unit 10 : Issues in Transfer Pricing
Systems
Structure
NOTES
10.0 Introduction
10.1 Learning Objectives
10.2 Issues in Transfer Pricing
10.3 Capacity Constraints
10.4 Information exchange
10.5 Goal congruence
10.6 Summary
10.7 Key Terms
10.8 Questions
: 152
Introduction to
Systems
We understood the meaning of transfer pricing, the basis for fixing transfer prices and
also how corporate services are priced. We also understood that issues could arise in NOTES
transfer pricing due to various problems. We will discuss these problems and how they
are addressed in detail in this Unit.
10.1 Unit Objectives

· To analyse capacity constraints and their effects on transfer pricing
· To understand the role of information asymmetry in transfer pricing
· To identify how goal congruent decisions are made in transfer pricing
10.2 Issues in Transfer Pricing
Several issues could arise in fixing and administering transfer prices. These issues could
be broadly identified as follows:
· Problems on account of capacity utilization in Divisions- Capacity Constraints
· Problems of information exchange
· Problems of goal congruence
Let us discuss these issues and understand how transfer price can be fixed in such a way
that these problems are addressed.
10.3 Capacity Constraints

Capacity constraints arise on account of inadequate capacities. Divisions could have an
order for 50,000 units, but they could have the capacity to produce only 40,000 units. This
results in capacity constraint. However, the reverse situation results in surplus capacity.
To understand the problems of capacity utilization and how it affects transfer pricing, let
us consider an illustration as follows:
: 153
Introduction to XY Limited has two Divisions, X and Y. Division X has a capacity to produce 5000 units
Management Control
Systems of output per month. Division Y wants to place an order for 5000 units from X. The cost
structure is as follows:
NOTES
Variable cost per unit- Rs.100/-
Fixed cost-Rs.200,000/-
Division X cannot sell these units outside since it has no demand. They would like to
charge Rs.200/- per unit. This includes the variable cost of Rs.100/-, fixed expenses of
Rs.40/-(Rs.200,000/- allocated to 5000 units) and Rs.60/- towards profit.
Division Y can source a similar product from outside for Rs.160/- and spend an additional
Rs.100,000/- to modify the product to suit their requirements.
The total cost to Y in this case would be Rs.160/- and another Rs.20/-(Rs.100,000/-
allocated to 5000 units) totalling Rs.180/- Y would obviously choose to buy it from
outside rather than from Division X.
This decision of Division Y results in the following:
1. Division X cannot recover the fixed overheads of Rs.200,000/-
2. Division Y spends Rs.180/- to purchase a product that could have been sourced
from X at Rs.100/-
What should be done in this case? Should the top management force X to sell to
Y at a discounted price? Should they force Division Y to purchase at a price
higher than the market rate?
Both of these decisions will not augur well for the functioning of a decentralised
business. So how should transfer price be fixed so as to encourage the divisions
to take goal congruent decisions?
Transfer price would be fixed by using the following thumb rule:
Transfer price= Incremental cost+ Opportunity cost
The incremental cost to Division A in producing a unit of the product is Rs.100/-

: 154
Introduction to
What might be the opportunity cost? In fact, X has no opportunity cost attached to this Management Control
because these units cannot be sold outside. Hence X can sell at any price over Rs.100/- Systems
. This would also help X to recover a part of its fixed cost and therefore benefit the NOTES
organisation.
This concept of charging divisions on the basis of incremental or marginal cost was Check Your Progress
pioneered by Hirshleifer (1956). He demonstrated that when there is no separate market What problem does surplus
capacity cause ?
for intermediate inputs, the transfer price should be set to the marginal cost of the producing
division. In contrast, if there is a perfectly competitive market for intermediate inputs, the
transfer price should be set at the market price for the intermediates. Aside from these
simple cases, however, the optimal transfer price depends on a number of economic
fundamentals, including the nature of competition in intermediate and final good markets,
the structure of firm costs, and whether there is demand or technical dependence between
separate divisions of the firm.
Illustration 10.1
Division A of AB Limited produces and sells 10000 pairs of glasses to be used in spectacles.
Division sells its output at Rs.120/- a pair. They are able to sell their entire output to their
various customers, currently.
Division B of AB Limited has a requirement to use this glass in kaleidoscopes that they
produce and sell as toys.
Suppose Division B wants to purchase the glass from Division A, what is the minimum
price that Division A would charge?
Solution
In this case the minimum selling price that can be offered by Division A is Rs.120/- per
pair which is their market price.
This is because Division A has no surplus capacity and is able to sell their entire output at
Rs.120/-
: 155
Introduction to In case they want to supply to Division B they will have to divert capacity from their
Management Control
Systems existing orders which they could have sold at Rs.120/- per pair. So in case they sell at
any price below Rs.120/- their profit margins will drop.
NOTES
Illustration 10.2
Division A of AB Limited produces and sells 10000 pairs of glasses to be used in

spectacles. Division sells its output at Rs.120/- a pair. They are able to sell 6000 pairs to
various customers, currently.
The incremental cost of producing one pair is Rs.90/-
Division B of AB Limited has a requirement to use this glass in kaleidoscopes that they
produce and sell as toys.
Suppose Division B wants to purchase 3000 pairs from Division A, what is the minimum
price that Division A would charge?
Solution
In this case the minimum selling price that can be offered by Division A is as follows:
Incremental Cost+ Opportunity Cost
We are using this formula here because Division A has surplus capacity.
Incremental Cost=Rs.90/-
Opportunity Cost=0
So minimum transfer price=Rs.90/-
This is because Division A has surplus capacity and is not able to sell their entire output.
In case they want to supply to Division B they can do so from out of their current
capacity without incurring any additional fixed cost. So in case they sell at any price
above Rs.90/- their profit will increase.
Illustration 10.3
MM Ltd. has two Divisions R and D. The unit cost structure of Division R is as follows:
: 156
Material- 6/- Introduction to
Management Control
Systems
Labour- 7/-
NOTES
Variable overhead-9/-
Unit fixed cost at 10,000 units is Rs.8/-
The market price of the output of R is Rs.35/-
Using the transfer price rule, what is the minimum price R should charge D if:
1. Division R is utilizing 55% of their capacity
2. Division R has no surplus capacity
3. Division R is utilizing 70% of its capacity. It has an outside offer for

supply of 2000 units which will yield contribution of Rs.3/- per unit.
Division D requires 3000 units to be supplied and it cannot split the offer.
Solution
Transfer price rule is:
Incremental cost+ Opportunity Cost
In Situation 1, Division R has surplus capacity. Usually surplus capacity indicates that the
Division has incurred fixed costs to create capacity and therefore will have unabsorbed
fixed costs.
This also indicates that the opportunity cost for the Division is Zero since they have no
market elsewhere.
Hence transfer price= Incremental cost+ Opportunity Cost
Incremental cost=Material cost+ Labour cost+ Variable overhead= Rs.22/-
Opportunity Cost=0
Hence minimum Transfer price= 22/-
In Situation 2, Division R has no surplus capacity. This indicates that they have an adequate
market size to absorb their output, Hence minimum Transfer price= Rs.35/-
: 157
Introduction to
In Situation 3, Division R can produce 3000 additional units without incurring any additional
Management Control
Systems fixed cost. Hence incremental cost is Rs.22/-(as calculated above) However, there is
NOTES an opportunity cost of Rs.6000/-(2000*3/unit). This is because Division R will have to

forego the order of 2000 units from the outside offer to be able to supply to Division R.
Opportunity cost per unit= Rs.6000/3000=Rs.2/-
Minimum Transfer Price= Rs.22+Rs.2= Rs.24/-
Illustration 10.4
Two divisions A and B of M&S Enterprises operate as profit centres. Division A normally
purchases 10,000 units of Component M12 from Division B, annually. Division B has
recently revised its price list and has fixed a selling price of Rs.1,100 per unit of M12. A
similar component is available in the market at Rs.1,000 per unit. The cost structure of
Division B is as follows:
Variable cost per unit of M12 Rs.950/-
Fixed costs of the Division(unavoidable) Rs.5,00,000/-
Installed capacity 20,000 units
Required:
1. Assuming that no alternate uses are available for capacity in Division

B, is it advisable for Division A to source the components from outside?
2. If the market price reduces by Rs.80/- per unit, what would be the
effect of sourcing the component from the market?
3. Independent of Question 2, if excess capacity of Division B can be

used to earn a contribution of 7.5 lakhs per annum, should the company
decide to source the component from outside market?
Solution
1. Using the transfer price rule:
: 158
If no alternate uses are available for capacity in Division B, then opportunity cost Introduction to
Management Control
to Division B is zero. This is because, there is no other opportunity available for Systems
Division B to earn profits.
NOTES
So, the minimum transfer price= 950+0= Rs.950/-
If Division A sources it from outside at Rs.1,000/- the loss to M&S Enterprises is

Rs.50/- per unit.
Therefore the component should be sourced from Division B at any price over
Rs.950/- but under Rs.1000/-
2. If the market price reduces by Rs.80/-, then the cost to Division A is Rs.920/-
However, the minimum cost of producing the unit is Rs.950/- Therefore there
would be a saving of Rs.30/- per unit if it is sourced from the market.
3. If the excess capacity can be used to earn a contribution of Rs.7,50,000/-, then

the contribution per unit will be= 750,000/20,000=Rs.37.5
Therefore the opportunity cost is Rs.37.5

Check Your Progress
The minimum price at which Division B can transfer to Division A would be: What is the transfer pricing
rule ?
=950+37.5= Rs.987.5
The price at which it is available outside is Rs.1,000/- Therefore Division A can

still source it from Division B.
10.4 Information exchange

Transfer pricing can create problems in fully or even partly integrated companies. The
final profit center may not be aware of the intermediary fixed costs and profit mark up.
When a division produces something to transfer to another division, the total cost would
consist of the variable cost, fixed cost and the margins of the division. When this is
transferred to the receiving division, the transferred in cost consists of fixed costs, but the
receiving division would not be aware of the break up. This distorts the overall cost
: 159
Introduction to information to the divisions and the fixed cost that are included in the cost to the receiving
Management Control
Systems division is called the upstream fixed costs.
NOTES Let us look at a hypothetical situation to understand how the distortion happens.
Assume that Divisions X and Y are two divisions and X produces and transfers to Y.
The total cost to X is Rs.500/- of variable cost and Rs.200/- per unit of fixed cost and
margins. The number of units transferred to Division Y is 100. So X will fix a price of
Rs.700/- per unit and transfer the output to Y. Y might incur additional processing cost
of Rs.300/- This would add up to an incremental cost of Rs.1,000/- per unit plus the
divisional fixed cost of Y.
Suppose Division Y has excess capacity (that is, they can produce more units without
incurring additional fixed cost) and the market price for the output has dropped to Rs.900/
- per unit, Division Y will decide not to supply the product in the market. This is because
they would not even be able to recover their incremental cost of producing one unit.
Now assume that the Divisions are not functioning as independent profit centres. Then
the total variable cost of producing the product would be Rs.800/-(Rs.500/- for Division
X and Rs.300/- for Division Y). Now the selling division would compare the selling price
to this incremental cost of Rs.800/- and may decide to sell the product at the current
market price of Rs.900/- resulting in a contribution of Rs.100/- per unit.
The problem in the situation as described above was that the selling division was not
aware of the breakup of the cost of the product and could not therefore take the decisions
best suited to the organization at large.
Therefore there have to be systems in place to make all entities in the organization
aware of the various components of cost so that decisions can be taken that benefit the
organization. One of the methods that we use towards this end is called two step pricing.
Two step pricing
Check Your Progress Two step pricing includes two charges. First, for each unit sold, a charge is made that is
How does two step pricing
help in resolving information equal to the standard variable cost of production. Second, a periodic (usually monthly),
asymmetry ?
charge is made that is equal to the fixed costs associated with the facilities reserved for
: 160 buying the unit.

This gives the buying divisions an understanding as to what component is fixed and what Introduction to
is variable. Management Control
Systems
Illustration 10.5
NOTES
UV Enterprises operates a decentralized business unit with three divisions A,B and C.
Division A transfers output to Division B and Division B in turn transfers output to Division
C. Division C’s cost structure is as follows:
Particulars Amount
Transferred in cost from Division B 440/-
Variable cost incurred in Division 350/-
Fixed Expense 100/-
Capacity 10,000 units
Current capacity utilization 80%
Divisions A and B have an expectation of 10% return on investment on Divisional

Assets. The following other information pertain to A and B:
Particulars Division A Division B
Transferred in cost from Division A 220/-
Fixed Expense 70/- 70/-
Investment 5,000,000/- 10,000,000/-
Capacity 10,000 units 10,000 units
Current capacity utilization 75% 85%
Division C has received an order for 1000 units at an expected selling price of
Rs.750/- per unit.
Required:
a. Is C likely to accept the order? Why/Why not?
: 161
Introduction to b. Assuming that Divisions A, B and C were not profit centres, what
Management Control
Systems might be the expected contribution from the order?
NOTES c. Would you classify the issues arising between departments on account
of the order as:
i. Problem of goal congruence
ii. Problem of decentralization
iii. Problem of information transmission
d. What is the minimum selling price at which C can accept the order, on
the basis of your calculations in b as above assuming 100% capacity
utilization Division C?
e. How would your answer in d change if Division B had 100% capacity

utilization (Answer this independent of Question d)?
Solution:
a. C is not likely to accept the order since their variable costs amount to
790/-(440+350) which is below the offer of 750/-
b. Cost to A:
Transferred to B can be broken down as follows:
Rs.220/- consists of Rs.70/- of fixed cost and 50/- of margins

(5,000,000*10%/10000). That leaves us with variable cost of Rs.100/-
(220-(70+50))
Similarly transfer to C can be broken down as:
Rs.440/- consisting of Rs.220+70+100+50
Therefore Rs.50/- is the variable cost at Division B
Variable Cost of the product is=100+50+350=500/-
: 162
Since all divisions have excess capacity, contribution from the order is Introduction to
Management Control
Rs.750-500=Rs.250/- Systems
c. It is a problem on account of information transmission NOTES
d. 500+Fixed cost at C Rs.100/-=Rs.600/-
e. 500+Fixed cost at B Rs.70/-=Rs.570/-
10.5 Goal congruence

Another important issue in transfer pricing is the problem of goal congruence.
Divisions may not agree on what to produce or how much to produce because
each of them is working to maximise its own profits. Some of the negotiated
methods of transfer pricing intended to induce goal congruent behaviour are
discussed below:
Agreement among Business units
This is a process of negotiation among business units with representatives from

buying and selling units working on profit sharing and the same is reviewed
periodically.
Profit Sharing
The product is transferred to the marketing unit at Standard variable cost. After
the product is sold, the business units share the contribution earned, which is the
selling price minus the variable manufacturing and marketing costs.
Illustration 10.6
A ltd has two divisions, M and N. Division M is proposing a new variant of an

existing product and N has to purchase the same from M, process it and then
sell it in the market. Division N is reluctant because this may bring down their
profits. Which of the following solutions proposed by A ltd., seems best to you?
i. Transfer the output at market price or an equivalent of market price by

M to N
: 163
Introduction to ii. Transfer the output at cost by M to N
Management Control
Systems
iii. Transfer the output at cost, and then share profits after output is sold
NOTES between M and N
iv. Compensate M for product development cost and transfer output of

M at cost
Solution
Since the market for the product is yet untested and success rate is not
known, Division N is reasonable in being reluctant. However, since M has
Check Your Progress proposed the product, they are already motivated to produce the same. In
What are the goal
congruence issues in order to incentivize Division N to produce it, a good beginning would be to
transfer pricing ? allow Division M to transfer at cost and then arrive at a profit sharing
between the Divisions. Option C seems to be the most reasonable.
Two Sets of Prices
Manufacturing unit is credited with market price and buying unit is debited with
standard cost. The differential is charged to the headquarters.
10.6 Summary
Issues that arise in transfer pricing are problems on account of capacity utilization in
Divisions, problems of information exchange and problems of goal congruence. To over-
come the problem of information exchange, there must be systems in place to make all
entities in the organization aware of the various components of cost so that decisions
can be taken that benefit the organization. One of the methods that we use towards this
end is called two step pricing. Two step pricing includes two charges. First, for each unit
sold, a charge is made that is equal to the standard variable cost of production. Second,
a periodic (usually monthly), charge is made that is equal to the fixed costs associated
with the facilities reserved for buying the unit. This gives the buying divisions an
understanding as to what component is fixed and what is variable. Some of the
negotiated methods of transfer pricing intended to overcome problems of goal
congruence are -facilitating agreement among Business units, profit Sharing between
: 164
divisions and having two Sets of Prices. Implementation of transfer pricing in organisations Introduction to
Management Control
happens through negotiated settlement, arbitration and conflict resolution and fixing thumb Systems
rules for repetitive transactions.
NOTES
10.7 Key Terms
Two step pricing includes two charges. First, for each unit sold, a charge is made that is
equal to the standard variable cost of production. Second, a periodic (usually monthly),
charge is made that is equal to the fixed costs associated with the facilities reserved for
buying the unit.
10.8 Questions
1. Large Scale operations Ltd., pursues the policy of permitting each of its Divisions
to operate essentially as an independent unit. Division managers are free to
determine their own sources of supply and to set their own prices.
The manufacturing division had redesigned many of its products. Consequently it

will now need 60,000 units per year of part no.3477. This part number is on the
production list of the Components Division who market it at a price of Rs.30 a
piece. This part requires 2 hours of production time and has a unit material cost
of Rs.8/-
The Component Division has a productive capacity of 8,00,000 labour hours per
year. It is operating at 80% capacity now. Total conversion cost in the division
amounts to Rs.6/- per labour hour plus Rs.17,50,000/- per annum.
Required:
a. Calculate the incremental contribution to Component Division at a price of

Rs.28/- per unit for 60,000 units.
b. If Rs.24/- is the price that manufacturing Division is willing to pay, is it a goal

congruent transfer price?
: 165
Introduction to c. Suppose Component Division gets a special order to supply 50,000 units to
Management Control
Systems an outsider, at a price of Rs.28/- and their raw material cost in this case
goes down by Re.1/- what is the minimum price that Component Division
NOTES
should charge the manufacturing division so that they are not at a loss.
Assume that Manufacturing Division will source the entire 60,000 units
from a single supplier.
2. X Ltd. has two divisions A and B. A produces output which is entirely consumed
by Division B. A’s produce has a market outside provided A makes considerable
changes in its output. This will increase the variable cost of A by at least 30%.
Division B can source the material from outside, but will again have to incur
additional conversion costs to make it suitable for their uses.
Which of the following, do you think is ideal for the oragnisation so that any
sourcing decision taken by division B will be in the interest of the organisation?
a. Merge Divisions A and B and assess them as a single unit.
b. Keep A and B as separate, identifiable profit centres.
c. Convert A into a cost centre and get them to transfer their output to B
at cost.
3. A ltd has two divisions, M and N. Division M is proposing a new variant of an

existing product and N has to purchase the same from M, process it and then
sell it in the market. Division N is reluctant because this may bring down their
profits. Which of the following solutions proposed by A ltd., seems best to
you?
i. Transfer the output at market price or an equivalent of market price

by M to N
ii. Transfer the output at cost by M to N
iii. Transfer the output at cost, and then share profits after output is sold
between M and N
: 166
Introduction to
iv. Compensate M for product development cost and transfer output of M Management Control
at cost Systems
NOTES
4. A company is organised into two large divisions. Division A produces a component
which is used by Division B in making a final product. The final product is sold at
Rs.400/- each. Division A has the capacity to produce 2000 units and Division B
can purchase the entire quantity.
Division A informed that due to installation of new machines, its depreciation

cost has gone up and hence wanted to increase the price of the component
supplied to Division B to Rs.220/-Division B, however, can buy the component
from the outside market at Rs.200/- each. The variable costs of Division A is
Rs.190/- and the fixed costs Rs.20/- per component. The variable costs of Division
B in manufacturing the final product using the component is Rs.150/-(excluding
the component cost).
Present a statement indicating the position of each Division and the company as a whole,
in each of the following situations:
a. If there are no alternative uses for the production facilities of A, will the company
benefit if Division B buys from outside suppliers at Rs.200/- per component?
b. If internal facilities of A are otherwise not idle and the alternative use of the
facilities will give an annual cash operating savings of Rs.30,000/- to Division A,
should Division B purchase the components from outside?
c. If there are no alternative use for the production facility at Division A and the
selling price for the component in the outside market drops by Rs.15/-, should
Division B purchase from outside suppliers?
d. What transfer price would you fix in each of the above circumstances?
5. Omega Co. has divisions-M and N. Products required by Division N are currently
outsourced at Rs.20/unit. Division M also makes these products and can sell
either to Division N or to outside markets. Current capacity of Division M is
: 167
Introduction to
50,000 units. Div. N sells its products at Rs.40 per unit in the market. Income
Management Control
Systems statement for both divisions and the company is as under:
NOTES Div M (Rs.Lacs) Div N(Rs. Lacs) Omega Co.(Rs.Lacs)
Sales
50,000 units @Rs.20/unit 10 - 10
20,000 units @Rs.40/unit - 8 8
Total 10 8 18
Expenses
Variable
50,000 units @Rs.10/unit 5 - 5
20,000 units @Rs.30/unit - 6 6
Fixed 3 1 4
Total Expenses (8) (7) (15)
Gross Income 2 1 3
Div M may be in a position to create an additional capacity of 20,000 units at no

additional fixed expenses. However, it can only continue to sell 50,000 units in the
market.
(a) What should be done by the company as a whole? Justify with figures.
(b) What would be the approach of Managers of Divisions M and N towards the
possible capacity increase? What should it be? Why?
(c) If you recommend inter unit sale, what would be the recommended selling price?
Why?
6. Ananya Ltd. has two divisions. Div A manufactures an intermediate product

for which no external market exists. Div B incorporates the intermediate product
into final product (in the ratio of one unit to one unit) and sells in the market.
Estimated number of units which Division B can sell at various prices is tabulated:
: 168
Introduction to
Selling Price Expected Sales (Units)
Management Control
90 2000 Systems
80 3000 NOTES
50 6000
Costing Div A Div B
Variable Cost(unit) Rs. 11 7
Fixed cost per annum 60,000 90,000
Transfer price to Div B for intermediate product is Rs.35/- per unit.
(a) Define profit in this case and prepare a statement for both Division and
overall company.
(b) State the Selling price which maximizes profits for Division B and the
company as a whole. Comment on why the latter selling price is unlikely
to be selected by Division B.
7. Johnson Chemicals Company manufactures a wide variety of industrial chemicals

and adhesives. It purchases much of its raw material in bulk from other chemical
companies. One chemical, T-Bar, is prepared in one of Johnsons’ own plants.
T-Bar is shipped to other Johnson plants at a specified internal price.
The Johnson adhesive plant requires 10,000 barrels of T-bar per month and can
purchase it outside the firm at $150 per barrel. Johnson’s T-bar unit has a capacity
of 20,000 barrels per month and is presently selling that amount to outside buyers
at $165 per barrel. The difference between the T- Bar’s unit selling price and
the market price is due to short term pricing strategy only; the materials are
equivalent in quality and functionality. The T-Bar unit’s selling cost is $5 per
barrel and the unit variable cost is $90 per barrel.
Required:
a. Should the adhesive unit purchase T-Bar from outside the firm?
b. Based on your answer in requirement a, what is T-Bar’s proper transfer

: 169
price?
Introduction to c. How would you answers to requirements a and b change if the T-bar unit had
Management Control
Systems a capacity of 30,000 barrels per month.
NOTES 8. Alpha, Beta and Gamma are three divisions in Chandra Ltd. All of them are
profit centres and follow an extremely market driven approach towards all inter
divisional transactions.
Alpha transfers its output to Beta, Gamma and several external businesses.
Beta’s output is mostly consumed by Gamma. The Alpha Division is working
under severe capacity constraints and cannot supply to anybody unless a firm
order is placed. They have a markup of 20% over their full cost. The Beta
Division is constrained only by the capacity of Alpha. Sometimes they source
from outside when Alpha declines to supply to them. Beta is always on the
lookout for new orders in order to fill their capacity.
Gamma is considering a tender to be submitted for a major order from one of

the Government Departments for the supply of 10,000 units of their output and
the following is the unit cost structure:
Material (supplied by Alpha) Rs.540/-
Material (supplied by Beta) Rs.975/-
Processing costs at Gamma Rs.700/-
Fixed costs at Gamma Division Rs.20,00,000/-
Required:
a. Assume that Alpha’s variable costs are Rs.400/- and Beta’s

variable costs are Rs.750/-. If Gamma has surplus capacity,
what is the minimum per unit selling price(required margin 10%
on cost) that they can quote for this tender?
b. Assume that Gamma has no excess capacity. How will your

answer be different?
c. If Beta refuses to reduce their price below Rs.975/- per unit to
: 170 Gamma, what dysfunctions could occur on this account?

Introduction to
10.9 Further Readings and References Management Control
Systems
Eccles, R. G. (1985). The transfer pricing problem: A theory for practice.
NOTES
Lexington. MA:
Lexington Books.
: 171
Introduction to
Management Control Unit 11: Measuring and Controlling Assets
Systems Employed
NOTES Structure
11.0 Introduction
11.2 Meaning of Investment Centre
11.3 Historical Perspective to Investment Centre
11.4 Objectives of Investment Centre
11.5 Performance measurement of Investment Centers
11.5.1 Return on Investment
11.5.2 Residual Income- is the difference between operating
income and the minimum dollar return required on a
company’s operating assets.
11.5.3 Economic Value Added
11.6 ROI vs EVA
11.7 Precautions while using ROI
11.8 Choice of Depreciation method
11.9 Choice of Asset Base
11.10 Summary
11.11 Key Terms
11.12 Questions
11.12.1 Objective questions
: 172
11.0 Introduction Introduction to
Management Control
We learnt that profit centres have to meet their expenses and generate a surplus. Now we Systems
raise the question-surplus on what? Is profit an absolute measure or is it relative? In this NOTES
Unit we learn to measure profit as a function of investment. We understand various ways

to evaluate divisional performance and identify suitable performance measures.

· To understand Meaning of Investment centre
· To infer Historical perspective
· Define Objectives of Investment Centre
· Analysing Performance measurement in investment centre
· Evaluating ROI vs EVA
· Which of the methods is a better performance measure
· To illustrate Disadvantages of ROI
· To highlight Precautions while using ROI
11.2 Meaning of Investment Centre

Management of a profit center involves managing revenues and expenses. When revenues
exceed the expenses the profit center earns a profit. When profits are maximized, it can
be reasonably assumed that a profit center performs well. However, unless the profit is
measured as a function of capital invested to earn the profit, the measure remains
incomplete.
The concept of measurement of return on asset is based on the philosophy that the true
test of whether the profit is too great or too small is the rate of return on the money
invested in the business and not the percent profit on the cost. Such measurement of profit
against the investment is the function of an investment center. The essential element of an
investment centre is that it is treated as a unit which is measured against its use of capital,
as opposed to a cost or profit centre, which are measured against raw costs or profits.
: 173
Introduction to Investment centres are a part of responsibility centres involved in utilising the capital
Management Control
Systems directly to contribute to the profits of the organization. This is a responsibility centre,
which aims at efficient utilization of the resources. To earn a satisfactory return on the
NOTES
investment made is an important objective of the profit oriented company, except in
some service organization where the capital investment is insignificant. The performance
of this centre is evaluated by comparing the profits earned i.e. output with the assets
employed to earn that profit i.e. input. Just focusing on the profits without concerning
about amount of resources being used will mislead the performance evaluation and lead
to ineffective control. Comparing the absolute profit performance of different business
units is meaningless unless one considers the amount of assets employed to generate
the profits.
11.3 Historical Perspective to Investment Centre
In the 1900s businesses had single focus- textile or railroad or steel etc. For the business
to be profitable, costs needed to be controlled. Control of costs naturally resulted in
better profits. When businesses stabilized then the most important decision was that of
scale. As a business grew in size and produced more units of output, then it experienced
falling average costs of production (i.e. on average, each unit of output costs less to
produce). This came to be known as benefiting from economies of scale. In other
words, the business was becoming more efficient in its use of its inputs to produce a
given level of output.
Economies of scale can be divided into internal and external economies.
· Internal economies of scale benefit a single business as it grows- increase in

output results in decrease in cost
· External economies of scale, however, benefit all the businesses in a particular

industry- for example, a common service or technology made available to all
businesses in a given industry causing costs to decrease across board
Du Pont Powder Company, formed in 1903, had a new organizational challenge not
faced by the nineteenth century organizations- to coordinate and allocate resources to
the manufacturing and selling of units performing quite different activities. Integrated
: 174
Introduction to
business units created alternative uses for capital thus making it imperative that returns Management Control
generated from capital should exceed the cost of capital. The concept of measurement of Systems
return on asset was that “the true test of whether the profit is too great or too small is the NOTES
rate of return on the money invested in the business and not the percent profit on the
cost”. In order to know which of their activities returned maximum profits as percentage
of the capital employed, Du Pont developed a scale that is today popularly known as
“Return on Investment” to measure performance of their divisions.
Similarly, Matsushita Corporation of Japan developed an Internal Capital System in the

1930s.
Internal Capital was defined as the Standard Working Capital+ Fixed Assets-Reserves.
Interest charged for internal Capital was 1% per month, paid to Central Office, each
month. Central Office levied3% of Divisional Sales to cover headquarters expenses, paid
to Central Office each month. After deducting this payment, divisional net profit was
expected to be equal to 10% of sales which was the target goal for profit management.
If divisional funds fell short of required amounts, the division could borrow temporarily
from the Central Office. Any excess cash could be deposited in the Matsushita Bank,
where it earned a competitive rate of interest. When a division required large funds for a
major new investment, the proposal was submitted to the Central Office for approval and
funding.
Thus businesses had evolved from merely deciding the scale of production to allocating
capital to their various businesses based on the return generated on each of the business.
11.4 Objectives of Investment Centre

Objective of investment centre is to make sound investment decisions. That means in
totality it is concerned with costs, revenue and the assets utilization factor. Therefore the
objectives of investment centre can be listed as follows:
1. Measurement of profit against investment
One of the most important objectives of the investment centre is to measure the
ofits not in absolute terms, but as a function of investment.
: 175
Introduction to For example, if Division A has earned a profit of Rs.1,00,000/- and the assets
Management Control
Systems relatable to Division A is Rs.50,00,000/-, then the profit in relation to the
investment is 2%. However, if Division B has earned Rs.1,00,000/- on an asset
NOTES
base of Rs.10,00,000/- then the profit earned by Division B is 10%. On a relative
basis, Division B would be more profitable even if the absolute profits earned
by both the Divisions are the same.
2. Control on cost, revenue and asset utilization
For a profit centre to perform well, the vital parameters are profitability and
Check Your Progress
What are internal and asset utilisation. Profitability is a function of cost control and revenue
external economic scale ?
eaximisation. However, an investment centre also seeks to measure the profit
against assets utilised. Hence the objective of an investment centre is not only
control of cost and maximisation of revenue but also proper asset utilisation.
3. Deciding the priority of deployment of capital
When a business has an opportunity to invest into multiple projects, then the
project which promises the most return on the investment or assets deployed
will be the preferred investment. Also when there are multiple profit centres in
a business the capital will be used in that profit centre where the returns are
better than the other profit centres.
11.5 Performance measurement of Investment Centers

Performance measure used to evaluate the investment centre is ROI (Return on
Investment) and/or EVA (Economic Value Added or Residual Income). It compares
business units’ profits with assets employed to earn that profit. The prime concern of
an investment centre is how efficiently it uses its assets. Profit centres measure the
profit in absolute terms whereas investment centre measure it in terms of assets utilization
efficiency. Thus investment centre acts as special type of profit centre.
This approach satisfies both the goals of business organizations-
· To earn adequate profit and
· Profits earned and assets employed must have optimal relationship.

: 176
Introduction to
Usually the business unit manager has two performance objectives, first to generate
Management Control
adequate profits from the assets/ resources at his disposal and second investment in Systems
additional assets/resources, which provide the desired returns.
NOTES
11.5.1 Return on Investment
(ROI) measures profits earned per rupee of investment. ROI is calculated as:
Profitability* Sales Check Your Progress

x What are the important
Sales Assets Employed objectives of investment
centre ?
OR
Earnings Before Interest and Tax/Capital Employed*100
· Profitability to sales represents the margin which is the ratio of operating income
to sales
· Sales to Assets employed represents asset turnover which shows how productively
assets are being used to generate sales Advantages of using ROI-
a) It encourages managers to pay careful attention to the relationships among sales,

expenses, and investments.
b) It encourages cost efficiency by focusing on reducing no value-added activities

and/or improving productivity.
c) It discourages excessive investment in operating assets and, thus, encourages

efficient investment
11.5.2 Residual Income is the difference between operating

income and the minimum dollar return required on a
company’s operating assets.
Residual Income =Operating income - (Minimum rate of return ×Operating assets)
: 177
Introduction to
Advantage of residual income:
Management Control
Systems
A manager will accept any project that earns above the minimum rate of return because
NOTES they will increase the company-wide profitability
11.5.3 Economic Value Added
Economic value added (EVA) is after-tax operating profit minus the total annual cost of
capital. EVA =After-tax operating income, that is:
Profit- (Weighted average cost of capital ×Total capital employed)
Illustration 11.1
Calculate return on sales, asset turnover, return on investment and residual income from
the following data:
Sales 80,00,000/-
Net book value (beginning) 25,00,000/-
Net book value(ending) 28,00,000/-
Net Income 6,40,000/-
Minimum rate of return 12%
Solution
Return on Sales= Profitability/Sales*100
=640000/800000*100
=8%
Asset turnover= Sales/Average Assets
=8000000/{(2500000+2800000)/2}
=3.01 times
Return on Investment= Profitability * Sales
: 178
Sales Assets employed Introduction to
Management Control
Systems
=8*3.01
NOTES
=24.08%
Residual Income= Operating income - (Minimum rate of return ×Operating assets)
= 640000-(12%*2650000#)
=640000-318000
=Rs.322,000/-
# Average assets= (Beginning Book value+ Ending Book value)/2
Illustration 11.2
The following are the operating result of A Ltd. Calculate EVA assuming weighted average
cost of capital at 8%, 10% and 12%
Profit before interest and after tax Rs.500,000/-
Fixed Assets Rs.32 lakhs
Working Capital Rs.18 lakhs
Solution
EVA (Economic Value Added) = Post tax Profit- (Weighted average cost of capital
×Total capital employed)
8% 10% 12%
Profit 500000 500000 500000
Weighted Average Cost of Capital 400000 500000 600000
EVA 100000 - (100000)
: 179
Introduction to Illustration 11.3
Management Control
Systems
Divisions M, P and C of Little Lotus Limited are respectively engaged in activities of
NOTES Marketing, Manufacturing and both. Control is through Return on Investment. Fixed
assets are depreciated on straight line basis assuming asset life of 10 years. The
performance of the divisions is as follows:
(All figures in lakhs)
Div M Div P Div C
Profit before depreciation and operating exp. 400 200 400
Current Assets 200 200 200
Fixed Assets nil 1000 500
(a) Compare ROI for each division
(b) Analyse and comment on relationship, if any, between ROI achieved and divisional
activities.
Solution
Div M DivP DivC
Profit before depreciation and operating exp. 400 200 400
Operating expenses 200 100 150
Depreciation 0 100 50
Profit after Depreciation and Operating Expenses 200 100 200
Current Assets 200 200 200
Fixed Assets nil 1000 500
Return on Investment(Profit/Total Assets less 100% 9.09% 30.76%
depreciation*100)
: 180
(b) Relationship between ROI and divisional activities Introduction to
Management Control
Systems
Division P which undertakes manufacturing activity has the least ROI whereas, Division
M which does only marketing activities reports the maximum ROI. The reason for this is NOTES
not difficult to guess because Division P employs more assets as compared to Division M
and Division C.
Therefore when the activity requires heavy investment ROI will be relatively less.
However, ROI is not a measure of efficiency for Division M. this is because service
activities will deploy lesser assets and the ROI is not a true measure of performance for
such Divisions.
For Division C however, ROI is an ideal measure of performance since there is sufficient
deployment of assets.
Illustration 11.4
X company’s cost of capital is 12%
Div A Div B
Capital invested 2400 4000
Net Income 480 720
(a) Which division is more profitable?
(b) Suppose the Manager of Division A were offered a one year project that would
increase the investment by Rs.1000 and generate a return of Rs.150, would the manager
accept the project if he were evaluated by the ROI he generates for his division?
(c) Would the decision take by the manager correct? Why/ Why not?
(d) At what cost of capital will the Divisions be equally profitable?
Solution
(a) Division A generates a better ROI as compared to Division B.
However, if the EVA is calculated, then the results of the divisions would appear as
follows:
: 181
Introduction to
Management Control DivisionA DivisionB
Systems
Capital invested 2400 4000
NOTES
Net Income 480 720
ROI 20% 18%
EVA 480-(2400*12%)=192 720-(4000*12%)=240
When EVA is compared, Division B’s performance is better.
(a) If Division A is offered a project that would increase investment by Rs.1,000/-

and the income by Rs.150/- then the revised ROI will be as follows:
Income= 480+150=630/-
Investment=2400+1000=3,400/-
ROI=630/3400*100=18.53%
If the Divisional manager were evaluated by ROI he generated, he would not

accept the project.
(b) The decision would be incorrect because the cost of capital is 12% and the new
project gives a return of 15% (150/1000*100). Since the cost of capital is less
than the return on the project, it should be accepted since it would increase the
profits of the business.
(c) The Divisions would be equally profitable when the cost of capital is 15%. This
is explained as follows:
480-(2400*cost of capital)=720-(4000*cost of capital)
-(2400*cost of capital)+ (4000*cost of capital)=240
1600* cost of capital=240
Cost of Capital=240/1600=0.15 or 15%
: 182
Introduction to
11.6 ROI vs EVA Management Control
Systems
There are several differences between ROI and EVA. They are:
NOTES
1. Economic value added is an absolute measure, whereas ROI is a percentage
measure.
2. Since EVA is an absolute measure, it can account for scale differences. For
example, if ROI is 10%, then it can be Rs. 10 earned on 100 or Rs. 1 crore
earned on a base of 10 crore. ROI cannot account for the differences in scale,
whereas EVA can account for it. EVA of Rs.100,000/- would imply a certain
scale of activity, whereas EVA of Rs.100,00,000/- will imply a larger scale of
activity.
3. EVA represents the returns for the owner of the capital since it is interest adjusted,
whereas ROI represents the return for the specific project, since interest costs
are not deducted.
Check Your Progress
What is the difference
4. EVA is the measure of profits whereas ROI is a measure of efficiency since it between residual income
and Economic value added?
measures the return generated from an asset without reference to the source of
capital.
Is EVA preferable to ROI?
Even though EVA is a superior measure as compared to ROI, ROI is a preferred measure
by most of the managers for practical purposes. The reasons why ROI is preferred to
EVA are as follows:
1. The thrust for the manager is to maximise returns and not maximise accounting
based measures
2. The cost of capital was a figure that divisional managers are not willing to commit
on
3. There would be no uniformity between published reports and EVA
4. A percentage measure is more comfortable than an absolute measure
: 183
Introduction to 5. Despite the long time lack of acceptance of EVA most of the bonus plans for
Management Control
Systems senior executives is based on EVA
NOTES Disadvantages of ROI
ROI is a very useful method in calculating return of a division. It also has a wide appeal
because it is an easy measure to administer and understand. However, there are demerits
of the method which are discussed as follows:
1. Cannot account for differences in scale
Since ROI is a percentage measure, it does not account for scale differences.
When percentage is calculated, then a small return on a small asset base may
return a larger percentage than a large return on a large asset base. For example
if a business has an investment of Rs.10,00,000/- and the profit earned is
Rs.2,00,000/- then the ROI is 20%. However if the investment is Rs.100,00,000/
- (1 crore) and the profit earned is Rs.15,00,000/-. In this case the ROI would
be 15%.
Check Your Progress
Are absolute measures When 15% and 20% are compared, it does not give us an idea of the scale at
better than relative
measures ? Why/Why not? which the division operates. Hence the ROI percentages could be misleading.
2. Does not represent future performance
ROI is an indication of the current returns that a division is generating. If the

ROI of a division is 20%, then it may not mean that they would be able to
sustain a return of 20% on all future activities. Hence current ROI cannot be
an indicator for future performance.
3. ROI is susceptible to manipulation
ROI is calculated as profit earned in proportion to the assets employed. Profit is

an accounting figure which can be manipulated. Also assets employed can be
subject to differences in definition. They could be tangible and/or intangible
assets, controllable uncontrollable and/or partially controllable assets, total assets
and/or total assets minus liabilities etc. Valuation of the assets also could vary
as it could have variety of meanings such as gross block or net block, book
: 184
value or market value or replacement value etc.
Introduction to
11.7 Precautions while using ROI Management Control
Systems
Even though ROI is a very popular measure for measuring performance of an
NOTES
investment centre, it gives ample scope for manipulations. Some of the specific
instances where ROI could be adjusted by making accounting adjustments are
discussed below:
Expense versus capitalize
Intangible expenses do not create assets. They create benefits for a Division for
the future period. For example, research expenses. For such expenses on
intangibles, discretion exists as to whether the expenditures should be capitalized
or expensed in the same year in which they are incurred. The division may decide
to write off the expense in a single year even though the benefits may accrue
over several future years. Such failure to capitalize expenses with future benefits
will penalize earnings in the short run until the steady state is reached and will
overstate the ROI in the steady state.
For example, if research expense of Rs.100,000/- is written off in a single year,

but the benefit of the expense is available for a period of three years, then the
year in which the money is spent will reflect a low ROI. However, in the next two
years in which no expense is incurred but benefits are received, the ROI will be
overstated. This is because the expenses on intangibles will not be included in the
asset base but have been written off as expense in the year in which it was
incurred.
Leasing of Assets
Sometimes firms decide to lease assets rather than purchase them. The effect of
this on the ROI is that the profit will reduce because of the lease rentals paid, but
the asset base reduces disproportionately since the cost of the asset is not included
in the denominator. Therefore ROI may be grossly overstated thereby giving an
incentive to managers to lease assets rather than purchase them even if no
economic benefit arises on account of the same.
: 185
Introduction to
Illustration 11.5
Management Control
Systems
GR limited operates some of its divisions as Investment Centers and accordingly
NOTES their performance is measured by the ROI that they generate.
Typically they consider lot of projects that require capital investment and the
ROI generated by each of these investments will be a major factor in identifying
the favourable projects.
R Division has an average investment of Rs.1,00,00,000 presently. This is not

expected to change for the next 4 years.
The Division is considering an additional capital investment of Rs.1,00,00,000 in

the beginning of the year 2008. The project is expected to generate a cash flow
of Rs.40,00,000 every year for the next 5 years before tax. The company uses
the sum of year digit method to provide depreciation of the asset for income tax
purposes and wants to write off the entire asset in the first four years itself.
Alternatively, there is a proposal that the company need not own the assets but
lease them. Leasing has clear advantages in terms of the number of years for
which the asset needs to be held. The division can surrender the asset, provided
it is used for at least three years. Under these terms the company can pay a
lease rent of Rs.35,00,000/- per annum.
The Division manager is keen that in the initial years of the project, there must
be a higher ROI so that it will reflect positively in his appraisal.
Required:
Calculate the post-tax earnings under both purchase and lease options assuming
tax rate of 50%. Also calculate the ROI under both options for the years ending
2008,09,10 and 11 and 12 assuming that the division uses Straight line method(
for the full five years) to depreciate the assets of the Division.
At a cost of capital of 5%, which of the options is better for Division R? You
may assume that the assets will be used for 5 years under both options.
: 186 What are the dysfunctions that the ROI approach throws up in this case?
Solution Introduction to
Management Control
In case Systems
equipment
is purchased NOTES
Cash Depreciation Income Tax (50%) Asset value ROI Cash flow
Flow (st.line dep
method) adjusted
4000000 4000000 0 0 18000000 0 4000000
4000000 3000000 1000000 500000 16000000 3.125 3500000
4000000 2000000 2000000 1000000 14000000 7.142857 3000000
4000000 1000000 3000000 1500000 12000000 12.5 2500000
4000000 4000000 2000000 10000000 20 2000000
In case
is leased
Cash Flow Lease Rent Net cash Tax adjusted Asset value ROI
flow cashflow
4000000 3500000 500000 250000 10000000 2.5
4000000 3500000 500000 250000 10000000 2.5
4000000 3500000 500000 250000 10000000 2.5
4000000 3500000 500000 250000 10000000 2.5
4000000 3500000 500000 250000 10000000 2.5
Differential cash flow Discounted at 5%

3750000 3571429
3250000 2947846
2750000 2375553
2250000 1851081
1750000 1371171
12117079
Since differential cash inflow is more than outflow, purchase is beneficial. : 187
Introduction to Note:
Management Control
Systems 1. Differential cash flow is calculated as cash inflows from purchase minus cash
NOTES inflows from lease. For example, it is Rs.40,00,000 in Year 1 in case of purchase
and Rs.250,000/- in case of lease. So the differential cash flow is
Rs.37,50,000/- in Year 1
2. These differential cash flows are discounted using a discount rate of 5%. For
better understanding of this concept, students are advised to go through
information on “time value of money”
Discounted cash flow is calculated as Cash Flow* (1/(1+Discount factor/100))

for year 1; for subsequent years, the denominator is raised to the power of n
where n is the time period. So for year 2, it is Cash Flow* (1/(1+Discount
factor/100)^2) and so on.
3. The dysfunctions that arise on account of use of ROI is that the economic
benefit of the decision is overlooked. Purchase is a better economic decision,
whereas, leasing results in better ROI in Year 1 because the asset base is low.
Purchase decision looks better in the later years when the asset is depreciated.
So a manager who looks at a one or two year frame is likely to choose lease,
whereas in the long run it is not a good choice.
11.8 Choice of Depreciation method

The choice of method of depreciation also has an effect on the asset base.
Some methods of depreciation have the effect of depreciating the asset faster
than other methods. For example, sum of the year digit method1 has the effect
of depreciating the asset differently than say, original cost method. Different
methods of depreciation can result in different ROI being reported. For example,
if sum of year digit method is used, then the ROI in the earlier years are likely
to be high and later years will reduce. So a manger wanting to increase the
near term profits of his division is likely to choose this method of depreciation
: 188
over others.
Introduction to
11.9 Choice of Asset Base Management Control
Systems
The choice of asset base for assessing the performance of the investment centre
could be tangible and/or intangible assets, controllable uncontrollable and/or partially NOTES
controllable assets, total assets and/or total assets minus liabilities etc. Each of
these will have the effect of changing the ROI. Similarly, the asset value could be
gross block or net block, book value or market value or replacement value etc.
When the gross block of asset is used to calculate ROI, then the choice of method
of depreciation does not affect the ROI.
When the net value of assets are used in the base to calculate ROI, it might result
in using a higher rate of depreciation or a method of depreciation that might result
in quick write off of asset values so that ROI is high.
1
Sum of the year digit method works as follows:
Suppose the equipment costs Rs.5000/- and the life of the equipment is 3 years,
depreciation for year 1 is 1/(3+2+1)*5000; Year 2 is 2/(3+2+1)*5000 and year 3 is 3/
(3+2+1)*5000. This method ensures that the depreciation in the initial years is faster
than the depreciation in the later years.
Replacement value of assets can be used to calculate ROI, of a Division that

operates with old equipment and written off assets which need to be replaced in
the near future.
Illustration 11.6
Namo Enterprises Limited operates some of its divisions as Investment Centers

and accordingly their performance is measured by the ROI that they generate.
Division R has an average investment of Rs.1,00,00,000 presently. This is not

expected to change for the next 4 years.
The Division is currently operating on fairly old assets, some of which are run
down and nearing the end of useful life.
Replacement of such assets is expected to cost the Division an additional capital investment
of Rs.30,00,000 in the beginning of the year 2011. Additional cash flow on account of
savings in maintenance and enhanced productivity is expected to be Rs.10,00,000 every
: 189
Introduction to year for the next 5 years before tax. The company uses the sum of year digit method to
Management Control
provide depreciation of the asset for income tax purposes.
Systems
The cash flows and income statement of the Division appears as follows:
NOTES
Particulars Current After
Replacement(Projected)
Income from investment 10,00,000 20,00,000
Depreciation( On new asset) - 10,00,000
Net Income (after adjusting 50% tax) 10,00,000 10,00,000
Investment(Net) 1,00,00,000 1,20,00,000
ROI (Calculated on EBIT) 10% 8.33%
On seeing the calculations as above, the Division manager is not too keen to work
with new assets; there are talks of melt down and downsizing all around and he was
not willing to take flak for lower ROI. He had his bonus at stake and therefore he
decided not to press for any asset replacement.
Required:
1. Assuming a cost of capital of 10%, is the Division manager justified in

deciding not to replace the assets? Assume 50% tax rate.
2. Suggest any two performance incentives that may incentivize managers to
take decisions that are economically feasible in the wake of falling ROI.
Solution
Cash Dep Profit Profit Depreciation Present value

adjusted at 10% cost
cashflow of capital
flow Loss after tax
Outflow (Year 0) -3000000
Inflow-Year 1 1000000 1000000 0 0 1000000 909090.9
Year 2 1000000 800000 200000 100000 900000 743801.7
Year 3 1000000 600000 400000 200000 800000 601051.8
Year 4 1000000 400000 600000 300000 700000 478109.4
Year 5 1000000 200000 800000 400000 600000 372552.8

3104607
: 190
Note: Introduction to
Management Control
1. At a cost of capital of 10% the inflows amount to Rs.31,04,607 which is more Systems
than the investment of Rs.30,00,000/- Therefore the manager is not justified
NOTES
in rejecting the purchase of assets.
2. a. Managers can be incentivized on capital purchases which result in cash
flows in excess of cost of capital.
b. Managers can be incentivized for identifying best opportunities to increase
cash flow rather than on the ROI.
Sometimes when land and building are eliminated from assets, then the effect of
that would be that return is calculated without reference to place of operation
and therefore there would be no incentive for Divisions operating out of backward
areas or relatively underdeveloped areas. Also including land and building in the
asset base may have the effect of pulling down the return of divisions who have
a high cost of real estate.
11.10 Summary
Investment centres are a part of responsibility centres involved in utilising the capital
directly to contribute to the profits of the organization. This is a responsibility centre,
which aims at efficient utilization of the resources. Integrated business units created
alternative uses for capital thus making it imperative that returns generated from capital
should exceed the cost of capital. The concept of measurement of return on asset was
that “the true test of whether the profit is too great or too small is the rate of return on the
money invested in the business and not the percent profit on the cost”. Objectives of
investment centre are measurement of profit against investment, Control on cost, revenue
and asset utilization and deciding the priority of deployment of capital. Return on Investment.
The performance of investment centre can be measured using Return on Investment
(ROI), Residual Income and Economic Value Added. Economic value added is an absolute
measure, whereas ROI is a percentage measure. Even though EVA is a superior measure
as compared to ROI, ROI is a preferred measure by most of the managers for practical
purposes ROI is a very useful method in calculating return of a division. It also has a wide
appeal because it is an easy measure to administer and understand. However, there are
also demerits of the method such as not accounting for differences in scale , not being
: 191
Introduction to
Management Control representative of future performance and also being susceptible to manipulation. Some
Systems of the specific instances where ROI could be adjusted by making accounting adjustments
NOTES are in the choice of Expensing versus capitalization, Leasing of Assets, Choice of
Depreciation method and Choice of Asset Base.
11.11Key Terms
Investment centre is concerned with costs, revenue and the assets
utilization factor in order to make sound investment decisions.
Performance measure used to evaluate the investment centre is ROI

(Return on Investment) and/or EVA (Economic Value Added or
Residual Income).
11.12 Questions
11.12.1 Objective questions
1. When ROI is 15% and cost of capital is 10%, then the project should be
rejected.(T/F)
2. When ROI is 15% and a new project yields 13%, the investment proposal can
be accepted or rejected on the basis of _______________________.
3. Inflation affects ROI by bringing down the percentage of ROI over a period
of time.(T/F)
4. Replacement value of the asset is used for ROI calculations when the division
is intended to be sold.(T/F)
5. If Return on sales is low and asset turnover is high, it means that profit can be
improved by increasing margin on sales.(T/F)
6. Cost of capital is not included in residual income.
7. ROI will decrease if the incremental investment gives the same return as the
existing return.
: 192 8. ROI and EVA are understated under inflationary conditions.

Introduction to
9. When cost of capital is high, leasing assets will give a lower return on investment Management Control
and hence is not preferable. Systems
NOTES
10. Interest is always included in calculation of ROI because the real return on
investment is after adjustment of interest.
11. Since depreciation is only an accounting measure, the choice of method of

depreciation does not influence ROI calculations.
12. Since input costs increase simultaneously with selling prices, the adjustment for
inflation happens automatically and therefore does not affect ROI calculations.
13. Capitalizing expenses with future benefits ensures that ROI is even and relatable
to the income earned.
14. Stating assets at historical costs gives an unrealistic ROI during inflationary period.
15. Since EVA is an absolute measure, it cannot even out differences in the scale of
operation.
16. Replacement cost of assets is considered as an objective measure of the value of

assets for calculation of ROI.
17. Gross Book Value adjusts for the age of the asset and method of depreciation
used for the purposes of ROI calculation.
1. What is an Investment centre?
2. What are the objectives of an Investment Centre?
3. What are the performance measures used in investment centre?
4. How does ROI compare with EVA?
5. Which of the methods is a better performance measure-ROI or EVA?
6. What are the disadvantages of ROI as a performance measure?
: 193
Introduction to
7. What precautions must be exercised while using ROI to measure the
Management Control
Systems performance of a Division?
NOTES
CASE 1 There are four divisions located in various geographic locations of Western
India Components Limited. These divisions operate out of Mumbai, Nasik, Ahmedabad
and Goa. Each of these divisions have complete autonomy in most of the critical business
decisions. Capital requirement of these divisions is evaluated by the top management
and a project evaluation is made before approving funds for projects. When divisions
request for capital infusion at the same time, projects are ranked using various criteria
including NPV and Pay back period.
The following is a tabulation of the division wise assets and income for 2012.
Particulars Mumbai Nasik Ahmedabad Goa
Assets
Equipment(Gross) 40 45 45 30
Equipment(Net)* 20 10 30 27
Land and Building 150 40 35 25
Accounts Receivable 8 12 4 9
Inventory 12 13 8 6
EBIT 38 20 16 17
Return on Assets
Rank
Incentive
*Adjusted for Depreciation
: 194
Required: Introduction to
Management Control
Systems
1. Rank the divisions by Return on Assets
NOTES
2. Assume that the minimum desired return on assets (gross) is 15%. Incentive is
calculated as 10% of base salary on every 1% of Return over and above the
minimum return. Calculate the return for each of the Divisional Manager as % of
his base salary.
3. Suppose the return is calculated on net value of assets this might result in:
a. Requesting frequent replacement of assets by the Divisions
b. Using a higher rate of depreciation or a method of depreciation that might

result in quick write off of asset values
c. Better maintenance of equipment
d. Not replacing assets even when they are fully scrapped
4. Suppose Divisional managers are incentivized on assets purchased or replaced in

divisions-that is, in the year in which the asset is bought the Manager gets a
commission on assets purchased, this might result in
a. Frequent replacement of assets
b. Replacing assets just before quitting the Division, even if the replacement
was not entirely necessary
c. Purchasing assets that cost more
d. All of the above
5. Suppose Land and Building are eliminated from the asset base in calculating the
return and gross value of assets are used instead of net value, it might indicate the
following(you can choose more than one answer in this case):
a. Return is calculated without reference to place of operation
b. The higher the rate of depreciation, better the returns look

: 195
Introduction to
Management Control c. There is no incentive for Divisions operating out of backward areas or
Systems relatively underdeveloped areas
NOTES
d. Divisions operating with older assets look better in terms of returns
e. The method or rate of depreciation plays no role in calculation of returns
f. High cost of real estate pulls down the return of the Division
6. CASE 2 The Randolph Teweles Company (RTC) has decided to acquire a new
truck. One alternative is to lease the truck on a 4-year guideline contract for a
lease payment of Rs.10,000 per year, with payments to be made at the beginning
of each year. The lease would include maintenance. Alternatively, RTC could
purchase the truck outright for Rs.40,000, financing the purchase by a bank
loan for the net purchase price and amortizing the loan over a 4-year period at
an interest rate of 10 percent per year. Under the lease arrangement, RTC
would have to maintain the truck at a cost of $1,000 per year. The truck is
depreciated at 20% per annum using Straight Line Method. It has a residual
value of Rs.10,000, which is the expected market value after 4 years, when
RTC plans to replace the truck irrespective of whether it leases or buys. RTC
has a tax rate of 40 percent.
Depreciation is allowed only on purchase and the tax shield becomes

available on depreciation. Interest cost is also tax deductible and profit on
sale of asset is taxed at the marginal tax rate of 40%
For convenience, you can assume that maintenance costs are incurred at the
beginning of the year (in case of lease).
a. Evaluate the options to see whether it is better to buy or lease.
b. Since capital purchases depress ROI, how can businesses evaluate

lease or buy more objectively (so that the performance measure does
not discourage buying of the asset)?
: 196
Introduction to
11.13Further Reading and References Management Control
Systems
Anthony and Govindarajan, Management Control Systems, 12th Edition, Tata McGraw
Hill NOTES
Robert Kaplan, Anthony Atkinson, Advanced management Accounting 3rd Edition, Pearson
“An overview of the implementation of Economic Value Added (EVA™) performance
measures in South Africa “ by H.M. van der Poll, N.J. Booyse, A.J. Pienaar, S.
Büchner & J. Foot Hand Book(F-6) on EVA published by United States Postal
Service
: 197
Introduction to
Management Control
Unit 12: Budgets, Responsibility Accounting and
Systems Budgetary Control
NOTES Structure
12.0 Introduction
12.2 Meaning of Budgeting
12.3 Budget Preparation Process
12.4 Components of Budget
12.5 Classification of Budgets
12.6 Advantages of budgets
12.7 Limitations of budgets
12.8 Meaning of Responsibility Accounting
12.9 Principles of Responsibility Budget Management
12.10 Advantages of Responsibility Budget
12.11 Meaning of Budgetary control
12.12 Objectives of budgetary control
12.13 Budgetary control techniques
12.14 Budgetary variance using flexible budget
12.15 Reconciliation of Actual and Budgeted profits
12.16 Summary
12.17 Key Terms
12.18 Questions
12.18.3 Practice Problems
: 198
Introduction to
Systems
We have understood the meaning and importance of Responsibility centres in organisations.
We will understand how the concept of responsibility centre can be incorporated into the NOTES
budgeting process and such budgets help the process of control in organisations.

· To understand Budgeting-meaning and process of preparation
· Define Components of Budgets
· Classification of Budgets
· To illustrate Advantages and limitations of budgets
· To understand Responsibility Accounting
· Explain Steps involved in Responsibility Accounting
· Define Principles of responsibility accounting
· Highlighting Advantages of Responsibility Budgeting
· To understand Budgetary Control
· Analysing Techniques of Budgetary control
12.2 Meaning of Budgeting
Budget is one of the important and powerful tools available to the organization to have
estimates about expenses and income for a definite period of time. In this present scenario
it is very necessary to reduce the cost in regard of all terms to sustain in the market.
The modern approach is towards a comprehensive budget plan and control. Of all business
activities, budgeting is one of the most important aspects and, therefore requires detailed
attention.
A budget is a financial and /or quantities a statement prepared prior to a definite period of
time, of the policy to be pursed during that period that for the purpose of attaining a given : 199
Introduction to objective. A budget is a pre-determined statement of management policy during a given
Management Control
Systems period which provides a standard for comparison with the results actuality achieved.
NOTES
12.3 Budget Preparation Process
There are certain essential components which are necessary for the successful
preparation and implementation of a budgeting system. They are discussed as follows:
1. Budget centers
2. Budget officer
3. Budget manual
4. Budget committee
5. Budget period
6. Determination of key factor.
1. Budget centers
A budget center is that part of the organization for which the budget is prepared.
A budget Centre may be a department, section of department or any other part
of the department.
2. Budget officer
The chief executive, who is at the top of the organization, appoints some persons
as budget officer. The budget officer is empowered to scrutinize the budgets
prepared by the various departmental heads and carry out changes in them, if
the situation so demands. The actual performance of different departments is
communicated to the budget officer. He determines the deviations in the budget
and takes necessary steps to rectify the deficiencies, if any.
3. Budget manual
A budget manual is a document which spells out the duties and also the
Check Your Progress responsibilities of the various executives concerned with the budgets. It specifies
What is meaning of budgets
? the relations among various functionaries.
4. Budget committee
In small scale concerns, the accountant is made responsible for preparation and
implementation of budget. In large scale concerns a committee known as a
: 200 budget committee is formed. The heads of all important departments are made
Introduction to
members of this committee. The committee is responsible for preparation and
Management Control
execution of budgets. The budget officer acts as coordinator of this committee Systems
5. Budget period NOTES
A budget period is the length of time for which a budget is prepared. The budget
period depends upon a number of factors. It may be different for different industries
or even it may be different in the same industries or business
6. Determination of key factor

A factor which influences all other budgets is known as key factor or principle Check Your Progress
What is meaning of budgets
factor. There may be limitations on the volume of sales. In this case sales volume
?
will be a key factor and all other budgets will be prepared by keeping in view the
amount of the sales that can be achieved. If the limiting factor is raw material
then production, sales and cash budgets will be decided according to raw materials
budget. Similarly, plant capacity may be a key factor if the supply of other factors
is easily available.
12.4 Components of Budget

Budgets have a wide application in business and are not restricted to specific areas or just
quarters and half years. A comprehensive budget that begins with anticipated demand and
ends with a projected Balance Sheet is called a master budget. The components of a
master budget are:
1. Operating Budgets
2. Financial Budgets
3. Capital budgets
Operating Budgets relate to the planning of operations or activities or operations of the
enterprise. Usually the starting point of such a budget is the anticipated demand. There
are two approaches to an operational budget- a budget of an activity or a programme or a
budget from the point of view of responsibility.
· Programme or activity budget specifies the operations or functions to be

performed during the next year. Each programme or activity is budgeted according to the
expected revenues and costs.
: 201
Introduction to
Management Control · Responsibility budget specifies plans in terms of individual responsibilities.
Systems From the point of view of control this is an extremely significant budget and a
NOTES detailed discussion about responsibility budgeting follows later in this Unit.
Financial Budgets
Financial budgets are concerned with the financial implication of the operating budgets.
The important components of financial budgets are the cash budget, projected income
statement and the projected balance sheet. This helps the business for planning the
financial resources of the firm and the firm can accordingly decide the payment of
dividends and plan capital inflows and outflows.
Capital budgets
Capital Budgets involves planning for the long term and involves higher cash outlays.
The fundamental difference between operational budget and capital budget is that capital
budgets are prepared for activities that are expected to have longer life. Operational
budgets are meant for activities that usually commence and finish within the same
accounting period. Considering the significant cash outlay involved capital budgets usually
have a committee and the budget is prepared to ascertain whether a project should be
accepted or rejected.
12.5 Classification of Budgets

Budgets can be classified on several bases. However, we must understand that these
classifications are made so as to be able to use the budgets for the intended purpose.
a. On the basis of time

b. On the basis of function
c. On the basis of level of activity
On the basis of time budgets can be classified as long term budgets and short term
budgets. This classification helps businesses to plan cash flows for short and long term.
On the basis of function, budgets are classified as revenue budget, production budget,
raw material budget, labour budget, overhead budget and cash budget. These budgets
usually help to plan the operational activities of a business.
: 202
Introduction to
On the basis of level of activity, budgets can be classified into static and flexible budgets.
Management Control
Static budgets are used to manage activities whose outcome is not dependent on the Systems
inputs and flexible budgets are useful when the output can be related to the input. NOTES
12.6 Advantages of budgets

A budget compels management to think about the future, which is probably the most
important feature of a budgetary planning and control system. It forces management to Check Your Progress
Why do organisations need
look ahead, to set out detailed plans for achieving the targets for each department, operation capital budgets ?
and (ideally) each manager, to anticipate and give the organization purpose and direction.
It brings about efficiency and improvement in the working of the organization and is a
way of communicating the plans to various units of the organization. By establishing the
divisional, departmental, sectional budgets, exact responsibilities are assigned. It thus
minimizes the possibilities of buck passing if the budget figures are not met. The advantages
of a budget process can be summarized as follows:
1. Budgeting promotes coordination and communication.

2. It clearly defines areas of responsibility and requires managers of budget centers
to be made responsible for the achievement of budget targets for the operations
under their personal control.
3. It provides a basis for performance appraisal (variance analysis). A budget is
basically a yardstick against which actual performance is measured and assessed.
Control is provided by comparisons of actual results against budget plan.
Departures from budget can then be investigated and the reasons for the
differences can be divided into controllable and non-controllable factors.
4. Enables remedial action to be taken as variances emerge.
5. Motivates employees by participating in the setting of budgets.
6. Improves the allocation of scarce resources.
7. Economizes management time by using the management by exception principle.
8. It is a way or motivating managers to achieve the goals set for the units.
9. It serves as a benchmark for controlling on-going operations.
10. It helps in developing a team spirit where participation in budgeting is encouraged.
11. It helps in reducing wastage and losses by revealing them in time for corrective
action.
: 203
Introduction to
Management Control 12. It serves as a means of educating the managers
Systems
12.7 Limitations of budgets
NOTES
Whilst budgets may be an essential part of any proper control plan they do have a
number of disadvantages, particularly in perception terms.
1. Budgets can be seen as pressure devices imposed by management, thus resulting in:
a) Bad labour relations
b) Inaccurate record-keeping.
2. Departmental conflict arises due to:
a) Disputes over resource allocation.
b) Departments blaming each other if targets are not attained.
3. It is difficult to reconcile personal/individual and corporate goals.
4. Waste may arise as managers adopt the view, “we had better spend it or we will lose
it”. This is often coupled with “empire building” in order to enhance the prestige of
a department.
5. Responsibility versus controlling, i.e. some costs are under the influence of more
than one person. e.g. power costs.
6. Managers tend to overestimate costs so that they will not be blamed in the future
should the actual costs exceed the budgeted costs. This is called as building a
“slack” in the budget.
12.8 Meaning of Responsibility Accounting

Under traditional budgeting and accounting systems, top management exercises control
“by the numbers” from a small corporate headquarters, using financial targets, which it
sets for the operating divisions. This kind of control is called diagnostic control. Diagnostic
control severely restricts the upward flow of operating information within organizations
making decentralization a necessity as well as an ideal.
: 204
The essence of responsibility accounting is the collection of costs according to responsibility Introduction to
Management Control
centres in order that variances from standard cost and budgets can be identified with Systems
persons, based on the causes of variances corrective actions may be initiated. Suppose
NOTES
variance is calculated for material purchase, then the purchase department will have to
explain these variances. To be effective control must enable effective utilization of scarce
resources by identifying process owners and fixing responsibility. When responsibility is
fixed, there is more attention to details, ensuring proper utilization of resources and an
attempt to keep variances at its minimum.
Since it specifies plans in terms of individual responsibilities this is extremely significant

from the point of view of control. Responsibility accounting helps to assign responsibilities
and helps identifying the cause of variances down to specific divisions, departments or
individuals.
Steps involved in Responsibility Accounting
Responsibility accounting usually involves the preparation of annual and monthly budgets
for each responsibility center -
· A responsibility center is a part or subunit of a company for which a manager has

authority and responsibility.
· The company’s detailed organization chart is a logical source for determining

responsibility centers.
· The most common responsibility centers are the departments within a company.
· When the manager of a responsibility center can control only costs, the
responsibility center is referred to as a cost center. Check Your Progress
What is responsibility
accounting ?
· If a manager can control both costs and revenues, the responsibility center is
known as a profit center.
· If a manager has authority and responsibility for costs, revenues, and investments
the responsibility center is referred to as an investment center.
: 205
Introduction to
· Then the company’s actual transactions are classified by responsibility center
Management Control
Systems and a monthly report is prepared.
NOTES · The reports will present the actual amounts for each budget line item and the
variance between the budget and actual amounts.
Responsibility accounting allows the company and each manager of a responsibility

center to receive monthly feedback on the manager’s performance.
Illustration 12.1
The following information relates to the various departments of Kamal & Company,
who produce three different types of fans. The types of fans produced are table fans,
ceiling fans and exhaust fans.
The cost per unit is as follows:
Particulars Table fans Ceiling fans Exhaust fans
Material 350 600 450
Labour 150 200 250
Variable overheads 50 75 95
Other expenses incurred are as follows:
1. Head Office incurs brand promotion expenses of Rs.30,000/- per month which
is divided between the products in the proportion of sale units.
2. Fixed expenses incurred at the product level are Rs.3,000/-;4500/- and

Rs.3800/- for table fans, ceiling fans and exhaust fans respectively.
3. A special incentive of Rs.20/- per unit is paid for exhaust fans in addition to the
10% sales commission paid on the sales price of each unit of any product sold.
4. Book keeping and administration cost is divided between the products equally.
This amounts to Rs.15,000/- per month.
5. Number of units sold per month are as follows:
: 206
Introduction to
Table fans 50
Management Control
Systems
Ceiling fans 100
NOTES
Exhaust fans 50
6. Selling price of table fan is Rs.800/-; ceiling fan is Rs.1050; exhaust fan is
Rs.1050/-
Required:
a. Suppose each of this product is handled by different managers, how will you
prepare a performance budget?
b. How will you evaluate performance?
c. How does the preparation of the budget help in fixing responsibility for each
manager?
Solution:
Budget will be prepared as follows:
Particulars Table Ceiling Exhaust

fans fans fans
Sales(Units) 50 100 50
Sales(In Rs) 45000 115000 62500
Unit Selling Price 900 1150 1250
Unit variable costs
Material 250 500 400
Labour 100 150 250
Variable overheads 50 75 95
: 207
Introduction to
Particulars Table Ceiling Exhaust
Management Control
Systems fans fans fans
NOTES Sales Commission 80 255 125
Unit Contribution 320 70 180
Total Contribution 21000 35500 19000
Product specific fixed cost 3000 4500 3800
Product level profit 18000 31000 15200
Head quarter cost(uncontrollable)-Brand Promotion 7500 15000 7500
Head quarter cost(uncontrollable)-Administration 5000 5000 5000
Net Profit 5500 11000 2300
. Performance evaluation will be done by comparing the budgeted performance

with the actual performance.
c. The sales units, selling price, variable cost and fixed cost is reflected clearly in
the budget.
The respective managers will be responsible for all the controllable aspects in the budget.
For example, if the manager is allowed to give discount on selling price, he will be
responsible for variances in sale. Similarly, all costs that fall within the authority of the
managers will be controllable costs and hence they will be responsible for it.
Hence such a responsibility budget helps to fix the accountability for performance on a
single person and therefore the response time taken for any feedback or correction also
is quick.
12.9 Principles of Responsibility Budget Management

1. Best operating decisions are made closest to point of implementation
2. Degree of decentralization is positively related to the size and complexity of the

organization
: 208
3. Correct decisions are more likely in an information-rich environment Introduction to
Management Control
Systems
4. Authority should be commensurate with responsibility, and vice versa
NOTES
5. Responsibility and authority require clear rewards and sanctions
6. Good planning and performance are facilitated by stable environments
7. The relationship of the parts to the whole should be reflected in the assignment
of responsibility
8. The legitimacy of institutional and local responsibility has to be recognized
9. The existence of a mutually supportive academic and administrative plan is

assumed
12.10 Advantages of Responsibility Budget

· In responsibility budget execution, operating performance is monitored and
subordinate managers are evaluated and rewarded.
· Operating performance targets must be expressed in financial terms. This makes

it possible to make comparisons across unlike responsibility centers, thereby
permitting the relative performance of managers to be evaluated and increasing
the motivational efficacy of internal competition.
· In traditional responsibility budgets this also has the effect of keeping higher levels
of administration ignorant of operating details, thereby discouraging them from
meddling in the affairs of their responsibility center managers.
12.11 Meaning of Budgetary control

Budgetary control is a tool of management used to plan, carry out and control the operations
of the business. The business finds it quite handy in planning the growth of his business or
enterprise. While budgeting is the process of preparation of budgets, the subsequent control
of these budgets by comparing the budgets with the actual performance is called as
budgetary control. Budgetary control involves the use of budget and budgetary reports,
throughout the period to co-ordinate, evaluate and control day to day operations in
accordance with the goals specified by the budget. : 209
Introduction to In the post liberalization environment, the subject of budgetary control has become far
Management Control
Systems more complex than what it was in the last century. Now-a- days, budgetary control is
one of the most vital and critical area of business management. The content of budgetary
NOTES
control is also changing at a rapid pace and quantitative techniques are also incorporated
in its field which have shifted emphasis from the episodic cost control and cost reduction.
The concept and procedures under budget plan and control have wide application not
only in profit oriented enterprises but in every enterprise where the resource are limited
and have to be properly applied. This, in a sense is ‘managerial budgeting’. It applies to
public and private enterprises, government departments and charitable organizations.
Budgetary Control is a strong tool of business to maximize profits. The management is

therefore always trying to focus on the proper planning, effective coordination and
control in order to maximize profits. There are various managerial tools and techniques
useful for management to plan and control businesses operations. Budgeting is also
used for plan and control business operations and it is widely used as a standard device
of planning and control.
12.12 Objectives of budgetary control

Budgetary control is essential for policy planning and control. It also acts as an instrument
of coordination. The main objectives of budgetary control are as follows:
1. To assist in policy formulation on the basis of proper and reliable data.

2. To ensure planning for future by setting up various budgets.
3. To determine short-term and long-term financial and physical targets.
4. To operate various cost centers and departments with efficiency and economy.
5. To classify expenses according to their nature such as direct and indirect
expenses; fixed, variable and semi-variable expenses, etc.
6. To help administration as under this system, executives perform their functions
according to pre-determined budgets.
7. To anticipate capital requirements and to make necessary arrangement for it.
8. To make cost accounting more reliable and systematic.
9. To promote research in order to bring down cost, to increase efficiency and to
achieve the targets of sales.
: 210
10. To develop co-ordination and co-operation among employees and executives. Introduction to
Management Control
11. To eliminate wastes and increase profitability. Systems
12. To correct the variations from the established standards.
NOTES
13. To fix the responsibility of various individuals in the organization.
12.13 Budgetary control techniques

The process of comparing the budgets with the actual is done by using several techniques.
Some of the most common techniques that are used have been discussed in the following
section of the Unit. They are:
a. Variance analysis
b. Budgetary variance using flexible budget
c. Reconciliation of Budgeted profit with actual profit
Variance Analysis
Variance is the difference in the actual result and the standard result. It is a controlling
technique in which the standard result is first set in the beginning of the month or year
according to the accounting rules or company standards. The actual results are processed
after the period. Then the actual results are compared with the expected or set standard
results. When there is a difference in the result, this difference is known as variance.
This difference is studied by the cost accountant to understand why this gap was formed
and the reasons for it.
This study or the reasons found out by the accountants on the basis of variance is known
as variance analysis, which is the most common budgetary control technique. This is
usually done on a monthly basis, with a summary closing process every quarter. Variances
(differences between the budget and actual results) are noted and accounted for. A decision
can be made to reduce expenses or reallocate resources. This technique greatly reduces
the need for comprehensive review cycles.
If the actual result is better than the set result then it is known as a favourable result and
if the actual result is worse than the standard result then it is unfavourable or adverse
result.
: 211
Introduction to
Management Control In accounting, a variance is defined as the difference between the expected amount
Systems and the actual amount of costs or revenues. From a revenue perspective, if actual
NOTES is more than expected then the resultant is a favourable variance and from a
cost perspective, if actual more than expected then the resultant is an
unfavourable variance.
Variance analysis uses this standard or expected amount versus the actual amount to
judge performance. The analysis includes an explanation of the difference between
actual and expected figures as well as an evaluation as to why the variance may have
occurred. The purpose of this detailed information is to assist managers in determining
what may have gone right or wrong and to help in future decision-making.
Favourable Variance
A variance can be put into the favourable category when the results are better than
expected. This means that revenues were more than the expected amount or costs
were below the budgeted amount. In accounting practice, a favourable variance is
shown by noting a letter F in parenthesis on the reports. A favourable variance might
earn a bonus for a manger, or perhaps a move up the corporate ladder.
Unfavourable Variance
In contrast, the variance can be judged as unfavourable if the results are worse than
expected. If the revenues were below expectations or the costs were higher than
standard, the variance would be termed unfavourable or adverse. This would be denoted
on the reports with the letter A or U. Consistently creating an unfavourable variance
might result in a manger being reprimanded or losing their job. However, the analysis is
typically used to help mangers prevent a negative situation from recurring by providing
information about what went wrong.
Variance analysis is commonly used in several aspects of business accounting. One of

the most common is in the purchase of manufacturing materials. The variance is the
price paid for the materials less the expected cost and then multiplied by the actual
number of units used in the process. Another commonly seen usage is the selling price
variance or the actual sales price minus expected, times the number of units. The analysis
: 212 is also used with overhead and labour spending and efficiency.
Issues in using variance analysis Introduction to
Management Control
Systems
Not all companies use variance analysis in their managerial process. There are several
reasons for this, one of which is that it can be quite complex for the accountants to NOTES
process all of the information necessary to discover why there may have been a problem
or benefit that caused the variance. Finally, the standard figures used to calculate the
variance may not be as accurate as the actual figures, thus the analysis may have little
usefulness.
Many people think that adverse result is not good for the company but it is not true. Many
a time it happens that the sales crosses the expected so in case of revenue there is a
favourable result, and obviously the costs incurred will be more than expected i.e. adverse.
So one cannot say that the results were bad, the results eventually were better than
expected. Therefore adverse effects are not always bad.
Item Budget Actual Variance Favourable
Rs.’000 s Rs.’000s Rs.’000 s or Adverse
Sales revenue
Standard product 75 90 15 F
Premium product 30 25 -5 A
Total sales revenue 105 115 10 F
Costs
Wages 35 38 3 A
Rent 15 17 2 A
Marketing 20 14 -6 F
Other overheads 27 35 8 A
Total costs 97 104 7 A
Profit 8 11 3 F
: 213
Introduction to In the given illustration
Management Control
Systems
1) The actual sales of the standard product are better than the expected sales.
NOTES Thus the result is favourable
2) The actual sales of the premium products are less than expected. Therefore the
variance is unfavourable.
3) Overall sales are better than expected.
4) Wages, rent and other overheads have exceeded the expected cost; thus adverse
variance.
5) Actual marketing cost is less than the expected cost; thus favourable variance.
6) Overall cost is more than the expected, causing an adverse variance.
7) The overall revenue is better than the overall cost structure in actual condition
thus the total profit is favourable.
In the given illustration though the cost is adverse the total profit is more than expected,
thus the total variance has a positive effect on the cost account.
Variance analysis helps in finding out where the actual results have been increased or
decreased and thus corrective action can be taken by the managers to improve the
profitability of the company by doing variance analysis. They can see where the costs
have increased and thus they can either increase the sales value or reduce other costs
to keep the profit per unit of the product same.
12.14 Budgetary variance using flexible budget

The flexible budget is a tool for performance evaluation. It is prepared at the end of
the period. A flexible budget adjusts the budget as per the actual level of output. While
preparing flexible budget then the basic underlying idea is to flex or adjust the budget to
the output volume (units produced or units sold). The motivation for the flexible budget
is to compare apples to apples. If the factory actually produced 10,000 units, then
management should compare actual factory costs for 10,000 units to what the factory
should have spent to make 10,000 units, not to what the factory should have spent to
: 214
make 9,000 units or 11,000 units or any other production level.
Management Control
Systems
The Proud Parents Company sells children’s garments. Their anticipated sales for the
NOTES
month of May were 1000 units. However, owing to demand fluctuations the actual units
sold were 1200. The budget at 1000 units and the actual performance at 1200 units is
given below.
Prepare a flexible budget.
Amt in Rs
Per unit Fixed Budget Actual Result
Sales volume 1,000 1,200
Sales 900.00 9,00,000 9,60,000
Purchases 500.00 5,00,000 5,76,000
Packing cost 80.00 80,000 97,000
Other variable cost 5.00 5,000 6,000
Fixed Cost
Water Charges 1,000 1,000
Shop Overheads 1,20,000 1,23,000
Solution:
Per Fixed Flexible Actual

unit Budget Budget Result Variance
Sales volume 1,000 1,200 1,200
Sales 900 9,00,000 10,80,000 9,60,000 120,000 A
Less variable costs
Purchases 500 5,00,000 6,00,000 5,76,000 24,000 F
Packing cost 80 80,000 96,000 97,000 1000 A
Other variable cost 5 5,000 6,000 6,000 0
5,85,000 7,02,000 6,79,000
Contribution 3,15,000 3,78,000 2,81,000 63000 F
Less Fixed costs
Water Charges 1,000 1,000 1,000 0
Shop Overheads 1,20,000 1,20,000 1,23,000 3000 A
1,21,000 1,21,000 1,24,000
Net profit 1,94,000 2,57,000 1,57,000 37000 A : 215
Introduction to 12.15 Reconciliation of Actual and Budgeted profits
Management Control
Systems Budgeted Profit is the profit which financial analysts of a company expect to have in a
NOTES specific period of time (which normally is one year) in the future and actual Profit is the
profit which is actually earned by the company. Reconciliation is the process of analyzing
two related records and, if differences exist between them, finding the cause and bringing
the two records into agreement. Thus more closer the Budgeted profits are to the actual
profits, better the accuracy of estimated utilisation of resources as per with actual.
A variance is the difference between an actual result and a budgeted amount. We

classify a variance as favourable or unfavourable based on their effect on current profit.
A favourable (F) variance means that performance exceeded expectations—actual
revenue exceeded budgeted revenue or actual cost was less than budgeted cost. An
unfavourable (A) variance or adverse variance means that performance fell short of
expectations—actual revenue was less than budgeted revenue or actual cost exceeded
budgeted cost.
Relationship between the budgeted and actual profit
Particulars Amount(Rs)
Budgeted Profit
Add: Favourable variances
Less: Adverse Variances
Actual Profit
The following illustrates the reconciliation between the budgeted and actual profits on
the basis of the illustration of Proud Parents Company discussed above:
: 216
Particulars Amount(Rs) Amount(Rs) Introduction to
Management Control
Systems
Budgeted Profit 194000
NOTES
Add: Favourable variances
Purchase price variance 24000
Contribution variance 63000 87000
Less: Adverse Variances
Sales price and volume 120000
Packing cost 1000
Shop Overheads 3000 124000
Actual Profit 157000
Although the budget report shows variances, it does not explain the reasons for the
variance. The budget report is used by management to identify the sales or expenses
whose amounts are not what were expected so management can find out why the
variances occurred. By understanding the variances, management can decide whether
any action is needed. Favourable variances are usually positive amounts, and unfavourable
variances are usually negative amounts.
12.16 Summary
Budget is one of the important and powerful tools available to the organization to have
estimates about expenses and income for a definite period of time. Budget preparation
involves budget center, appointment of a budget officer, preparation of Budget manual,
appointment of a budget committee, identification of the budget period and identification
of key factors. The components of a master budget are Operating Budgets, Financial
Budgets and Capital budgets. Budgets can be classified on the basis of time, on the
basis of function and on the basis of level of activity. There are several advantages in
having budgets essentially because a budget compels management to think about the
future, which is probably the most important feature of a budgetary planning and control
: 217
Introduction to system. It forces management to look ahead, to set out detailed plans for achieving the
Management Control
Systems targets for each department, operation and (ideally) each manager, to anticipate and
give the organization purpose and direction. Whilst budgets may be an essential part of
NOTES
any proper control plan they do have a number of disadvantages, particularly in perception
terms. Budgets can be seen as pressure devices imposed by management, thus resulting
in bad labour relations, inaccurate record-keeping, departmental conflicts, empire
building etc.
Responsibility budget specifies plans in terms of individual responsibilities. From the

point of view of control this is an extremely significant budget. The essence of
responsibility accounting is the collection of costs according to responsibility centres in
order that variances from standard cost and budgets can be identified with persons,
based on the causes of variances corrective actions may be initiated. Suppose variance
is calculated for material purchase, then the purchase department will have to explain
these variances. Responsibility accounting usually involves the preparation of annual
and monthly budgets for each responsibility center. Responsibility accounting allows
the company and each manager of a responsibility center to receive monthly feedback
on the manager’s performance.
Budgetary control is a tool of management used to plan, carry out and control the
operations of the business. The business finds it quite handy in planning the growth of
his business or enterprise. The process of comparing the budgets with the actual is
done by using several techniques. They are Variance analysis, budgetary variance using
flexible budget and Reconciliation of Budgeted profit with actual profit.
12.17 Key Terms

A budget is a pre-determined statement of management policy during a given
period which provides a standard for comparison with the results actuality
achieved.
The components of a master budget are Operating Budgets, Financial Budgets

and Capital budgets.
Operating Budgets relate to the planning of operations or activities or operations

: 218
of the enterprise.
Financial budgets are concerned with the financial implication of the operating Introduction to
Management Control
budgets. Systems
Capital Budgets involves planning for the long term and involves higher cash outlays NOTES
Responsibility accounting helps to assign responsibilities and helps identifying

the cause of variances down to specific divisions, departments or individuals.
A variance is defined as the difference between the expected amount and the
actual amount of costs or revenues
A flexible budget is prepared by adjusting the budget as per the actual level of
output.
12.18 Questions
i) A budget is a pre determined statement of management policy during
a given period which provides a standard for comparison with the results
actuality achieved.
i) Planning of operations or activities of the enterprise is called financial budgeting
ii) Preparation of master budget involves operational as well as financial planning
iii) Capital Budgeting is an exercise to address the short term financial needs of a
business
iv) Responsibility Budget helps to fix accountability on an individual or a department

or a Division and helps in control.
v) Budgets can be seen as pressure devices imposed by management, thus

resulting in bad labour relations
vi) Budgets should be completely at the instance of the top management so that
there is no conflict in implementation of the budget
: 219
Introduction to
Management Control vii) Responsibility accounting usually involves the preparation of annual and monthly
Systems budgets for each responsibility centre
NOTES
1. Define Budgeting and explain the process of budget preparation.
2. How are budgets classified and how do these classifications help?
3. Briefly explain the advantages and limitations of budgets.
4. Enumerate the basic principles of Responsibility Accounting.
5. Briefly explain how variance analysis helps in control.
6. MSM Enterprises has a number of requirements in terms of planning

their quarter ahead. Help them to identify the kind of budget that they
need to prepare for the different kinds of requirements listed below:
a. To identify their short term cash needs
b. To identify raw material requirement for the year
c. To create a budget that would help to fix accountability on individuals
A budget that would help evaluate performance when the actual output is
known
12.18.3 Practice Problems
1. The following information relates to the various departments of Pink Lotus &
Company, who produce offer financial consultancy services. They usually arrange
for loans, undertake credit rating of businesses and identify venture capitalists
and help small businesses to get capital investment. Each of these services are
kept independent of each other and whenever a client is offered multiple services-
for example, if a client approaches them for credit rating and eventually also
seeks venture capital, then the venture capital division pays referral fee to the
credit rating division.
The divisional budgets are sought to be prepared and the following information is made
available to you (All values in Rs.’000)
: 220
Introduction to
Particulars Loan Division Venture Capital Credit rating Management Control
Systems
Division Division
NOTES
Salaries 350 600 750
Incentives 150 200 250
Client Entertainment 70 100 15
Other expenses incurred are as follows:
i. Common expenses of Rs.30,000/- per month which is divided between the Divisions
which are divided in the proportion of revenue earned
ii. Fixed expenses incurred at the Division level are Rs.75,000/-. Rs.82,000/- and
Rs.60,000/- respectively
iii. A special incentive of 10% on revenue is paid to the staff of venture capital
division in addition to the salaries and incentives mentioned above.
iv. Establishment expenses are divided between the Divisions equally. This amounts
to Rs.105,000/- per month.
v. Number of hours of billing for each division per month and the billable rate per
hour is anticipated to be as follows:
Loan Division 1000 800
Venture Capital 1200 1000
Credit rating 5000 400
Required:
a. Suppose each of this Division is handled by different managers, how will you
prepare a performance budget?
b. How will you evaluate performance?
: 221
Introduction to
c. How does the preparation of the budget help in fixing responsibility for each
Management Control
Systems manager?
NOTES 2. The Magic Mattress Company sells children’s garments. Their anticipated sales
for the month of October were 600 units. However, owing to demand fluctuations
the actual units sold were 550. The budget at 600 units and the actual performance
at 550 units is given below.
From the information given below,
a. Prepare a flexible budget.
Prepare a statement showing variances and a reconciliation between budgeted and

actual profit
AmountinRs
Per unit Fixed Budget Actual Result

Sales volume 600 550
Sales 4200.00 2520000 2365,000
Purchases 3000.00 1800000 1705000
Packing cost 250.00 150000 137500
Other variable cost 150.00 90000 77000
Fixed Cost
Shop salaries 30000 32000
Shop Overheads 1,20,000 1,24,000
: 222
Introduction to
Systems
I.M.Pandey, Management Accounting, 3rd Edition, Vikas Publishing House
NOTES
Abernethy, M. A., & Brownell, P. (1999). The role of budgets in organizations facing
strategic change: an exploratory study. Accounting, organizations and Society, 24(3),
189-204.
Brownell, P. (1981). Participation in budgeting, locus of control and organizational

effectiveness. Accounting Review, 844-860.
: 223
Introduction to
Management Control Unit 13: Multinational Organisations
Systems
Structure
NOTES
13.1 Introduction
13.3 Multinational organisations
13.4 Advantages of multinational organisations
13.5 Disadvantages of multinational Organisations
13.6 Distinguishing Features of Multinational Organisations
13.7 Why is it challenging to comply with different statutes?
13.8 Control Environment in Multinational Organisations
13.9 Multinational Transfer Pricing
13.10 Methods of Transfer Price
13.11 Exchange rate Differences
13.12 Measuring the exchange rate
13.13 Foreign Exchange Risk
13.14 Issues in design of Control Systems for Multinational
Organisations
13.15 Summary
13.16 Key Terms
13.17 Questions
13.17.3 Practice problems
: 224 13.18 Further Reading and References

Introduction to
Systems
Business units can be of varied types. There are some special types of Business units
which require special controls owing to the nature of business transactions or activities in NOTES
which they engage. A multinational organisation operates out of several countries thus
exposing them to larger variation in environment, compliance with varied statutes at different
countries and more variation in cultures and affiliations. This Unit discusses the distinguishing
characteristics of multinational organisations and some of the special control systems that
may be required for the same.

· To understand Meaning of Multinational Organisations
· Explain Advantages of Multinational Organisations
· Highlight Disadvantages of Multinational Organisations
· To illstrate Distinguishing features of Multinational Organisations
· Analysing Control Environment in Multinational Organisations
· To understand Multinational transfer Pricing
· Understanding Exchange rate Differences
· Analysing Issues in design of Control Systems for Multinational Organisations
13.2 Multinational organisations

A multinational corporation (MNC) or multinational enterprise (MNE) is a corporation
that is registered or operating in more than one country. It is a large corporation which
may produce and sell goods or services in various countries. A multinational organisation
may have headquarters in one country but can have assembly or production facilities in
other countries. Coca Cola, Nike and BP are examples of multinationals. One of the
oldest Multinational Corporation is British East India Company that came into India in the
year 1600.
Businesses expand into other nations and operate as multinational corporations for the : 225
Introduction to following reasons:
Management Control
Systems
1. To increase market share
NOTES
Businesses may reach a saturation point in the domestic market and need a
new outlet. They may start by exporting to other countries but eventually they
will want to have production facilities in several countries and so expand into
profitable markets.
2. To expand talent pool and resource base
Different nations have different kind of resources and talent. For example India
has plenty of technically proficient and English speaking work force which makes
it an attractive destination for software businesses. Australia has good quality
coal making it an ideal destination for electricity projects.
3. To mitigate risk
When businesses operate out of a single country the economic cycles of that
country affect the business greatly. Also the product may go out of demand or
input costs could suddenly increase. When the business operates out of several
countries, economic risk and political risk gets spread out thereby increasing
the sustainability of the business.
13.3 Advantages of multinational organisations
1. Job Creation
Multinational Corporations bring expertise and skill sets which may not be
available in the host country. Many times they also bring in technology and
innovation.
2. Economies of Scale
Multinationals organisations can be benefitted from economies of scale due

to standardization of demand. This means the cost per unit can be lowered
through specialisation – with a large workforce concentrating on the tasks on
their area of expertise.
: 226
Introduction to
Technical economies or standardization can be achieved through automated
Management Control
equipment, when volumes are high. Systems
Purchasing economies can be realized by adopting processes like bulk buying, NOTES
pooling suppliers and efficient inventory management. This will help in creating
options to purchase desired quality at minimal cost.
3. Technology transfer
Operating in many countries offers an advantage of being able to transfer
technologies to different nation. It also makes new and different varieties of
products available in the host country.
4. Cost Equalization
Multinational Enterprises help in equalizing of cost of factors of production around
the world. They provide an efficient means of integrating economies.
13.4 Disadvantages of multinational Organisations
Multinationals’ profits are not usually kept in the host country. For example the money
made and saved by Hindustan Unilever in India may go back to the headquarters in the
United Kingdom.
Multinational companies can be environmentally irresponsible. They could bring in products

and technology that are not culturally acceptable in the host country.
Multinationals have been accused of cutting corners. Social responsibility may be ignored
by most of the organisations due to lack of cultural bond with the host country.. Numerous
firms have been accused of exploiting the workforce or providing detrimental working
environment. Workers can work below minimum wage and for longer hours.
Since they have a lot of access to capital, they could bull doze their way into several
countries by intense lobbying. Recently Walmart has been accused of lobbying in Mexico
using unethical means and getting clearance for putting up Walmart stores dangerously
close to Heritage sites.
: 227
Introduction to
Management Control
13.5 Distinguishing Features of Multinational
Systems Organisations
NOTES (1) Size of Operations
Several of the Multinational Organisations are extremely large in size. Some of the
multinationals have a turnover that equals the GDP of smaller nations! Hence the size
of operations leads to increased complexities difficult to control as compared to
smaller organisations that operate from a single geographic location.
(2) Cultural Differences
One of the main contextual variable that influence management control within a
multinational enterprise is the cultural differences across countries. While culture itself
is believed to mean shared values, assumptions and norms of behaviour, cultural
differences result in conflicted values and assumptions. A study conducted by Hofstede
in 1983 identifies some very important cultural dimensions, namely:
· Power Distance
Power distance is the gap between the degree of acceptance and the expectation of
the less powerful members of organizations and institutions (like the family) that power
is distributed unequally. Cultures that endorse low power distance expect and undertake
power relations that are more consultative or democratic. People relate to one another
more as equals regardless of formal positions.
· Individualism/Collectivism
The degree to which individuals are integrated into groups determines individualism. In
individualistic societies, the stress is put on personal achievements and individual rights.
People are expected to take a stand for themselves and their immediate family, and to
choose their own affiliations. In contrast, individuals act predominantly as members of
a lifelong and cohesive group or organization in collectivist societies. Uncertainty
avoidance
This refers to a society’s tolerance for uncertainty and ambiguity. It reflects the extent
to which members of a particular society attempts to cope with anxiety by minimizing
: 228
uncertainty. People under cultures which avoids high uncertainty tend to be more emotional. Introduction to
Management Control
They try to minimize the occurrence of unusual circumstances and proceed with cautious Systems
step by step changes, planning by implementing rules, laws and regulations. In contrast,
NOTES
people in low uncertainty avoidance cultures acquire and feel comfortable in unstructured
situations or variable environment condition and try to have as few rules as possible.
People in these cultures tend to be more pragmatic, they are more tolerant of change.
· Masculinity versus Femininity
The distribution of emotional roles between the genders defines the masculinity or
femininity of a culture. Masculine cultures’ values are competitiveness, assertiveness,
materialism, ambition and power, whereas feminine cultures grants more value on
relationships and quality of life. In masculine cultures, the disparity between gender
roles are more dramatic and less fluid than in feminine cultures where men and women
have the same values emphasizing modesty and caring.
Multinational Organisations operate in varying cultures and hence face a huge

challenge in terms of integration as well as interpretation of these cultures.
(3) Compliance with different Statutes

Check Your Progress
Multinational Organisations operate out of different countries, each with their own legal Why is it challenging to
comply with different
regulations and laws. The legal environment in different countries is different and the law statutes ?
enforcement also varies from country to country. Multinationals have to deal with different
sets of stakeholders including trade unions, local authorities of the states and provinces in
which they operate and the country specific laws, thus making the management control
environment complex.
(4) Collective Transfer of Resources
Multinational organisations facilitate multilateral transfer of resources. Usually this transfer

takes place in the form of a “package” which take account of technical know-how,
equipment and machinery, materials, finished products and managerial services. MNCs
are composed of a complex of widely varied modern technology ranging from production
and marketing to management and financing. This makes some of the transactions complex
and unstructured therefore making control design more challenging. : 229
Introduction to
Management Control
13.6 Control Environment in Multinational Organisations
Systems
There are two important control issues that arise in multinational organisations:
NOTES
1. Transfer of goods and services between subsidiaries or branches operating out
of different countries involving transfer pricing
2. Different currencies in different countries resulting in exchange rate variations

and issues arising out of such transactions
These are discussed below in detail.
13.7 Multinational Transfer Pricing

Companies with production facilities in multiple locations or countries use transfer pricing
to reduce their global tax bills or to have better control over the costs incurred at each
stage of the production. When transfer pricing is used by Multinational companies based
Check Your Progress in different countries, it is referred as Multinational Transfer Pricing. Transfer pricing is
Why is it challenging to the general term for pricing cross border, intra firm transactions between related parties.
comply with different
statutes ?
Hence “Transfer pricing” refers to the setting of prices at which transactions occur
inclusive of transfer of property or services between associated enterprises. Transfer
Price is the price charged by individual entities for goods or services supplied between
multi-department, multi-office, or multinational firms. Transfer price policy is generally
aimed at evaluating financial performance of different business units (profit centres) of
a conglomerate.
In setting a multinational transfer pricing however, a company will usually concentrate

on satisfying a single objective, namely: “minimize income taxation”. The following four
objectives are stressed for domestic transfer pricing:
a. Goal congruence,
b. Motivation,
c. Autonomy, and
d. Performance evaluation
: 230
Introduction to
However these are considered secondary in the case of multinational transfer pricing. In Management Control
multinational transfer pricing, the objectives are as follows: Systems
NOTES
(1) Evaluating financial performance of different business units (profit centres) of
a conglomerate, and/or
(2) To shift earnings from a high tax jurisdiction to a low-tax one.
For the Multinational firms operating in different tax jurisdictions, transfer prices serve
more than tracking internal transactions for managerial accounting purpose. They also
determine tax liability of affiliates in various countries- that is the overall tax liability of the
multinational enterprise. For example, a multinational with an affiliate in country B may
purchase goods from an affiliate in country A. If the tax rate in the country A is lower than
the tax rate in country B, the multinational will have incentives to set a high transfer price
to shift profits from country B to country A.
Tax authorities usually discourage transfer pricing aimed at tax avoidance and insist that
each internal part of the firm deals with the other on ‘arm’s length’ (market price) basis.
“Arm’s Length Price” is the price charged in comparable transactions between independent
parties, where price is not influenced by the relationship or business interest between the
parties in the transaction.
The Transfer Pricing policies of several countries are based on the OECD (Organization
of Economic Cooperation and Development) Guidelines on the subject.
Illustration 13.1
An item is produced by Division A in a Country with a 25% income tax rate. It is transferred
to Division B in a country with a 50% income tax rate. An import duty equal to 20% of the
price of item is assessed.
The full unit cost is Rs100/- and variable cost is Rs.60/-. Which of these should be chosen
as transfer price?
Solution
Whenever the tax rates differ, the country having a lower rate of tax should charge a high
price so that maximum income is booked in that country.
: 231
Introduction to Therefore in this case since Division A is situated in the low tax regime, it should charge
Management Control
Systems a higher transfer price of Rs100/-.
NOTES Therefore, income of Division A is Rs.40/- higher than if it had chosen Rs.60/- as the
transfer price.
25% x 40 = Rs.10/- is the additional tax liability
Consequent to the transfer price of Rs.100/- income of Division B is Rs.40/- lower:
50% of 40 = Rs.20/- is the tax saving
Import duty paid by B:
20% of 40 = Rs.8/-
Therefore, Net Savings = Rs.2/- for the organisation if they choose the transfer price of
Rs.100/-
13.8 Methods of Transfer Price

Companies can use several methods to set transfer prices on the basis of information
they have about similar transactions on the open market.
· Cost plus method (CPM): Under this method the standard cost plus mark-up
cost is added to arrive at the transfer price. It is generally used where semi-
finished products are transferred.
· Comparable Uncontrolled Prices Method (CUP): Most systems consider
a third party price for similar goods, services, or property under identical conditions,
called as comparable uncontrolled price (CUP), to be the most trusted indicator
of an arm’s length price. All systems permit testing using this method, but it is
not always applicable. Further, it may be possible to adjust CUPs reliably where
the goods, services, or property are identical but sales terms or other limited
items can be different. As an example, an interest adjustment could be applied
where the only difference in sales transactions is payment period (e.g., 30 days
vs. 60 days). CUPs are based on actual transactions. For commodities, actual
transactions of other parties can be reported in a reliable manner. For other
: 232
Introduction to
items, “in-house” comparables, i.e., transactions of one of the controlled parties Management Control
with third parties, may be the only available reliable data. When applying the Systems
CUP method, an uncontrolled transaction is considered comparable to a controlled NOTES

transaction if:
1. There are no differences in the transactions being compared that would materially
affect the price; or
2. Reasonably accurate modifications can be performed to account for material

differences between the controlled and the uncontrolled transaction.
· Resale Price Method (RPM): In this method the vendor adds comparatively
small or no value to goods taken from associate enterprises.
· Profit Split Method (PSM): In this method, the end profits are split between
the transacting entities using an agreed ratio and the transfer is carried out at
cost. It is used when associate enterprises are so combined that it turns into
difficult to make transfer pricing analysis on transactional methods basis.
13.9 Exchange rate Differences

Check Your Progress
An exchange rate is the price of one currency in terms of another – in other words, the What is Comparable
Uncontrolled Prices method
purchasing power of one currency with respect to the other. Exchange rates are important ?
instrument of monetary policy. They are also an important element in settling transactions
between subsidiaries or branches of a multinational organisation.
13.10 Measuring the exchange rate
Exchange rates are expressed in various ways:
· Spot Exchange Rate - the current market’s price of the currency is called as
spot exchange rate
· Forward Exchange Rate - a forward exchange rate is an agreement today to

buy the currency on the defined price at the specified point of time in future.
Companies willing to reduce risks due to exchange rate volatility can buy their
currency ‘forward’ on the market
: 233
Introduction to · Bi-lateral Exchange Rate - The rate at which one currency can be traded
Management Control
Systems against another. Examples include: US Dollar/DM, Sterling/US Dollar, US
Dollar/YEN or Sterling/Euro
NOTES
· Effective Exchange Rate Index (EER) - a weighted index of sterling’s value

against a basket of currencies; the weights are based on the importance of
trade between the UK and each country.
· Real Exchange Rate - this is the ratio of domestic price indices between two
countries. A rise in the real exchange rate implies a worsening of competitiveness
for a country.
13.11 Foreign Exchange Risk
Foreign exchange risk (also known as exchange rate risk or currency risk) is a financial
risk posed by an exposure to unexpected fluctuations in the exchange rates between
two currencies. Investors and multinational businesses having business activities varying
from exporting, importing goods and services to making foreign investments throughout
the global economy are prone to exchange rate risks. This can have serious financial
consequences if not managed properly. The following are the types of exchange risks
that multinational organisations have to manage and control:
· Transaction Exposure
A firm has transaction exposure whenever it has contractual cash flows (receivables
and payables) whose values are subject to volatility in the exchange rates due to a
contract being denominated in a foreign currency.
· Economic Exposure
A firm has economic exposure (also known as operating exposure) to the degree that
its market value is influenced by unanticipated exchange rate fluctuations. Such exchange
rate adjustments can severely affect the firm’s market share respect, firm’s future
cash flows, and ultimately the firm’s value with respect to its competitors. Economic
exposure can affect the present value of future cash flows. Any transaction that exposes
the firm to foreign exchange risk also bind the firm with associated economic risks, but
: 234
Introduction to
economic exposure can also be caused by other business activities and investments which
Management Control
may not be mere international transactions, such as future cash flows from fixed assets. Systems
A shift in exchange rates that influence the demand for a good in some country will also NOTES
result in economic exposure for a firm that sells that good.
· Translation Exposure
A firm’s translation exposure is the degree to which its financial reporting is affected by
exchange rate volatility. As all firms generally must prepare consolidated financial statements
for reporting purposes, the consolidation process for multinationals entails translating foreign
assets and liabilities or the financial statements of foreign subsidiary/subsidiaries from
foreign to domestic currency. While translation exposure may not affect a firm’s cash
flows, it could have a significant impact on a firm’s reported earnings and therefore its
stock price. Translation exposure is distinguished from transaction risk as a result of
income and losses from various types of risk having different accounting treatments.
· Contingent exposure
A firm has contingent exposure when bidding for foreign projects, negotiating contracts
Check Your Progress
or making foreign direct investments. Such an exposure arises due to the probability that What are the various risks
in transacting in foreign
a firm could suddenly face a transactional or economic foreign exchange risk, contingent currency ?
on the outcome of some contract or negotiation. For example, a firm could be waiting for
a project bid to be accepted by a foreign business or government that, if accepted, would
result in an immediate receivable. While waiting, the firm faces a contingent exposure
from the uncertainty as to whether or not that receivable will happen. If the bid is accepted
and a receivable is paid to the firm then faces a transaction exposure, so a firm may
prefer to manage contingent exposures.
13.12 Issues in design of Control Systems for Multinational

Organisations
Some of the most important issues arising in evaluating the performance of a subsidiary
or branch of a multinational is that the profits or losses are not affected by the actions of
the business alone, but also on account of exchange rate fluctuations as discussed above.
Some of the issues that arise on account of this are:
: 235
Introduction to 1. How to treat exchange losses and who should be accountable- the subsidiary/
Management Control
Systems branch or the Head Office?
NOTES 2. Should the local currency be considered for performance evaluation or should a
common currency be considered across all subsidiaries/Divisions/Branches of
the organisations?
3. Should the losses arising on account of currency be bifurcated into controllable

and uncontrollable losses and to what extent should branches or subsidiaries be
held responsible?
In addition to the above there are also issues of local economic, political and
seasonal cycles that affect the performance of subsidiaries.
A huge challenge for these organizations lies in how these issues are factored
in while attempting to evaluate performance of the subsidiaries. The control
systems must be designed so that the issues discussed as above are addressed
and a fair and proper performance evaluation system is in place.
13.13 Summary
A multinational organisation operates out of several countries thus exposing them to

larger variation in environment, compliance with varied statutes at different countries
and more variation in cultures and affiliations. A multinational organisation may have
headquarters in one country but can have assembly or production facilities in other
countries. Businesses expand into other nations and operate as multinational corpora-
tions to increase market share, to expand talent pool and resource base and to
mitigate risk. Advantages of multinational organisations are job creation, Economies
of Scale, technology transfer and cost equalization of factors of production. However
Multinationals’ profits are not usually kept in the host country. Also they could bring in
products and technology that are not culturally acceptable in the host country. Since
they have a lot of access to capital, they could bull doze their way into several countries
by intense lobbying. Some of the distinguishing features of Multinational Organisations
are the huge size of its operations, difficulty in reconciling to the cultural differences,
compliance with different Statutes and collective transfer of Resources. There are two
: 236 important control issues that arise in multinational organisations which are transfer of
goods and services between subsidiaries or branches operating out of different countries Introduction to
Management Control
involving transfer pricing and difference in currencies in different countries resulting in Systems
exchange rate variations and issues arising out of such transactions. The control systems
NOTES
must be designed so that the issues discussed as above are addressed and a fair and
proper performance evaluation system is in place.
13.14 Key Terms

A multinational corporation (MNC) or multinational enterprise (MNE) is a
corporation that is registered or operating in more than one country.
When transfer pricing is used by Multinational companies based in different

countries, it is referred as Multinational Transfer Pricing.
“Arm’s Length Price” is the price charged in comparable transactions between

independent parties, where price is not influenced by the relationship or business
interest between the parties in the transaction.
An exchange rate is the price of one currency in terms of another – in other

words, the purchasing power of one currency with respect to the other.
13.15 Questions
1. The objectives of international transfer pricing are different as compared to

normal transfer pricing
2. Multinational Enterprises help in equalizing of cost of factors of production

around the world.
3. Multinational Organisations need to be compliant with a single set of rules

and laws, which are the laws of the country in which they are headquartered.
4. Comparable Uncontrollable Price method can be used only when reasonably
accurate adjustments can be performed to account for material differences
between the controlled and the uncontrolled transaction.
: 237
Introduction to
Transfer price policy is generally aimed at evaluating financial performance of
Management Control
Systems different business units of a conglomerate
NOTES
1. What are Multinational Organisations? State the advantages and disadvantages

of Multinational Organisations?
2. What are the objectives of Multinational transfer pricing?
3. What are the common methods used in Multinational transfer pricing?
4. How do exchange rate differences create difference in income of subsidiaries

to the Multinational Organisations?
5. What are the issues in design of Control Systems for Multinational Organisations?
13.16.3 Practice problems
1. An item is produced by Division A in a Country with a 30% income tax rate. It

is transferred to Division B in a country with a 45% income tax rate. An import
duty equal to 15% of the price of item is assessed.
The full unit cost is Rs.200/- and variable cost is Rs.110/-. Which of these
should be chosen as transfer price?
2. Orange Juice Inc., is headquartered in the United States of America. They sell
fruit juices at various countries. They also manufacture the fruit juice extract
and sell it to other subsidiaries or sell it locally to other juice manufacturers.
A ton of fruit juice extract is available at Rs.35,000/- in India. After incurring a
processing cost of Rs.15,000/- a ton, it is sold at Rs.70,000/- per ton. The same
could be sourced from the USA at $500 a ton. The headquarter mark up on
selling price for this product is 20% on selling price. The import duties are 20%.
Assume the following:
a. The price at which the product can be sold in the USA is $550 per ton
because it can be sold under the Orange Juice Brand.
b. The tax rate (hypothetical) in the USA and India is 50% and 30% respectively.
: 238
c. The exchange rate for rupee/dollar is Rs.50/- a dollar. Required: Introduction to
Management Control
a. Should the product be sourced locally or should it be imported, from the perspective Systems
of India?
NOTES
b. What decision would be in the best interest of the organization as a whole- to buy
from the USA or to source it locally?
Solution:
a. Profits for India is calculated in Rs. and for the USA it is calculated in $
Assuming that the product is sourced locally:
Particulars Amount (in Rs.) USA(In $)
Material Cost 35,000/- 400
Processing Cost 15,000/-
Total Cost 50,000/-
Selling Price 70,000/- 550
Profit 20.000/- 150
Tax rate as applicable 6,000/- 75
Profit after tax 14,000/- 75
Total profit= Rs.14,000+75*50=Rs.17,750/-
Assuming that it is sourced from the USA:
Particulars Amount (in Rs.) USA(In $)
Material Cost 25,000/- 400
Import Duty 5,000/-
Processing Cost 15,000/-
Total Cost 45,000/-
Selling Price 70,000/- 500
: 239
Introduction to
Profit 25.000/- 100
Management Control
Systems
Tax rate as applicable 17,500/- 50
NOTES
Profit after tax 17,500/- 50
Total Profit= Rs.17500+50*50=Rs.20,000/-
It is better to source the material from USA in the best interest of the organization.
Profits earned in the US are taxed at a higher rate. Therefore it is better to sell the
fruit juice extract to India at $500 than locally in the USA at $550.
Note: The impact of exchange rate fluctuation has not been discussed as part of
this solution. Exchange rate fluctuations could have different implications to the
solution.

Hofstede, G. (1983). National cultures in four dimensions: A research-based theory of
cultural differences among nations. International Studies of Management &
Organization, 13(1/2), 46-74.
Grubert, H., & Mutti, J. (1991). Taxes, tariffs and transfer pricing in multinational
corporate decision making. The Review of Economics and Statistics, 285-293.
Sundaram, A. K., & Black, J. S. (1992). The environment and internal organization of
multinational enterprises. Academy of Management Review, 17(4), 729-757.
: 240
Introduction to
Unit 14: Management control process in service Management Control
organizations Systems
Structure NOTES
14.0 Introduction
14.2 Control Systems in Service Organisations
14.3 Basic differences in Characteristics of Service
Organizations
14.4 Professional Service organisations
14.5 Control Environment in Service Organisations
14.6 Profit Centres & Transfer pricing
14.7 Strategic Planning & Budgeting
14.8 Control of operations
14.9 Performance Evaluation
14.10 Controls in specialised organisations
14.10.1 Financial Service Organizations
14.10.2 Healthcare Organizations
14.10.3 Non-Profit Organization
14.10.4 MCS in small businesses
14.11 Summary
14.12 Key Terms
14.13 Questions
14.13.2 Substitute with a single word
14.14 Further Readings and References : 241

Introduction to
Systems
We have understood control systems in product and process organisations. Do
NOTES
service organisations differ from manufacturing organisations? Would that require
a special or different set of controls? What features distinguish service
organisations and what are the controls required? We will understand in detail in
this Unit

· To understand role of Management control process in service organizations
· Analysing Basic differences in Characteristics of Service Organizations
· To explain Professional Service organisations
· Evaluating Control Environment in Service Organisations
· Understanding Financial Services Organisations
· Understanding Healthcare Organizations
· Understanding Non Profit organizations
· Analysing Performance Evaluation
· Understanding MCS in small businesses
14.2 Control Systems in Service Organisations

The concept of Management control process in service organisations was introduced
by Anthony in 1966. However, there is limited focus on the design and use of management
control systems in service organizations despite significant growth of service sector in
most economies.
Management control system can be helpful in providing a systematic approach for

monitoring and assessing the need of the organization to bridge the inefficiencies in cost
and use of resources. In an aggressive growth paradigm of service organizations, there
is a need to systematically review the working process to achieve desired success rate
of the objectives. The key driver in the rapid growth of service sector is the digitization
that is the utmost need to survive in the ever-changing environment. The introduction of
digitization has resulted in new information services such as web-based banking and e-
: 242 postal services. For many service industries, digitization can serve as the part of
technological offerings and processes that underpin the extent of value creation and Introduction to
Management Control
basis of exchange in the organizations. Systems
The service organisations are different in terms of the dependence on human capital and NOTES
process oriented framework. Management information system will be able to help in

terms of co-ordination and planning process in the organization. Also, it will help to bring
all the employees on a common platform to share information and learning in the
organizations.
14.3 Basic differences in Characteristics of Service

Organizations
For Several reasons, management control systems in service industries are somewhat
different from management control in the manufacturing companies.
· Absence of Inventory
Manufacturing organisations tend to have inventory which can be stored. Goods can be
held as inventory, which is a buffer that helps to regulate the impact on production activity
due to fluctuations in sales volume. However, services cannot be stored. A manufacturing
company can earn revenue in the future from products that are on hand today, a service
organization is dependent on the real time services produced for the same. Service
organizations should try to minimize their unused capacity to maximize the number of
services produced at a current state of time. The costs of many manufacturing
organizations are essentially fixed in the short run. However, service industries operate
with long term costs and it is very difficult to tweak costs by temporary reduction in
capacity. A slow moving product can be withdrawn from the market or production can
be temporarily stopped, but if an airline suspends operations on a route even temporarily,
it may have a long run effect on its goodwill.
· Absence of uniform quality control measure

A manufacturing company can run quality checks before its products are shipped to the
consumer, and their quality can be measured in terms of tangible changes (elasticities,
purity, size, colour, and so on). A service company cannot perform quality checks before
it is delivered, and then the judgments are often subjective. Service organiszations lacks
: 243
Introduction to
formal quality measurement systems and even when they seek to measure them, they
Management Control
Systems tend to be mostly subjective.
NOTES · Key Personnel

Service organisations are dependent on key personnel. When huge modern equipment
is installed, it is fail safe. However, the same cannot be said about service organisations
which are labour intensive. Therefore service organisations heavily depend upon key
personnel and they invest heavily into training people rather than equipment.
· Absence of scale economies

Unlike manufacturing organisations that tend to benefit from scale economies, service
organisations cannot function on scale economies. For example, a restaurant cannot
operate out of a twenty storey building like a retail mall. They can have similar joints in
multiple locations. Expansion can be achieved more sensibly by multiplying or replicating
facilities.
Therefore service organizations operate many units in various locations; each unit
Check Your Progress relatively small. Some of the units are owned; others operate under a franchise. The
Why are scale economies
absent in service firms ? similarity of the separate units provides a common basis for analyzing budgets and
evaluating performance not available to the manufacturing company. The information
for each unit can be compared with system wide or regional averages, and high performers
and low performers can be identified. However because units differ in the mix of services
they provide, in the resources that they use, and in other ways, care must be taken in
making such comparisons.
Therefore controls should be designed bearing in mind the different nature of the service
industries and measurement of output should be done with lot of care.
14.4 Professional Service organisations

The fundamental difference between service organisations and professional service
organisations is that service organisations provide services that are generalised- for
example a restaurant, car service station, insurance company etc. However professional
service organisations derive their identity from a core skill. A doctor, lawyer, architect or
: 244
Introduction to
a Chartered Accountant are professionals and their characteristics may slightly differ Management Control
from that of normal service organisations. Systems
NOTES
· Unlike service industries who replicate the same facility at multiple locations, say by
using a franchise agreement, professionals increase the scale of operations by increasing
the number of skilled personnel. For example, a Chartered Accountant can increase the
size of operations by roping in a few more professionals who bring in core competencies
in various areas within the same field. One of them may have expertise in corporate
taxation, while another partner may specialize in indirect taxation.
This kind of expansion makes it difficult to evaluate the service organization like a
manufacturing organization or another service organization operating with assets and
human resources rather than only human resources.
Check Your Progress
· Investment into expansion of business happens through training and learning rather Why are scale economies
absent in service firms ?
than acquisition of assets.
· Control is extremely difficult since performance measurement is not driven through input
output measures. A doctor’s performance cannot be measured by the number of patients
alone but also by the quality of service given to the patient. Similarly a lecturer’s
performance cannot be assessed just by the number of hours taught but also the quality
of lectures.
a. The real issue in performance measurement is that the service quality is intangible
unlike a product quality.
b. The measurement of service quality itself requires expertise. For example, a
patient cannot judge a doctor’s skill sets. He can only judge whether he felt
better after receiving the treatment. Similarly students cannot evaluate the
intellectual prowess of a lecturer; they can only evaluate their understanding.
c. The work performed by professionals is non repetitive thereby making it difficult
to come up with an evaluation scale.
14.5 Control Environment in Service Organisations

Management Control Systems used in manufacturing organisations begin with definition Check Your Progress
Why is it difficult to
of output. Output is usually comparable in case it is a commodity or the cost incurred to evaluate the work done by
create the output can be tracked down easily. This gives a tangible and definitive base for professionals ?
the control systems that are designed in manufacturing organisations. However since this
: 245
Introduction to
Management Control kind of output definition is more subjective in case of service organisations, the control
Systems
system begins with pricing rather that the output.
NOTES
Pricing
· The Selling Price of work is set in a traditional way in many professional

firms.
· The hourly billing rate is usually based on the remuneration of the grade of
the professional
· Prices vary among professions.
14.6 Profit Centres & Transfer pricing

Support units, such as maintenance, transportation, information processing, and telecom
etc. charge consuming units for their services, based on established transfer pricing
principles.
14.7 Strategic Planning & Budgeting

Check Your Progress
Why is it difficult to evaluate In professional organizations though, the principal assets are people, and there is more
the work done by flexibility in this regard. Changes to the size and composition to the staff are easier to
professionals ?
make and decisions in this regard are effortlessly reversed. However professional
organizations avoid short term variations in personnel levels.
14.8 Control of operations

Since output control is difficult in service organisations operation control is complicated.
It is difficult to control through task management. For example, in manufacturing
organisations, the number of units of output from a particular machine is a very useful
indicator in control. However, in service organisations repetitive tasks are not the
value adding tasks. It is the creative and non-repetitive tasks that usually add value.
Hence qualitative measures should be used in operation control.
14.9 Performance Evaluation

It is not difficult to hazard a guess that performance evaluation is extremely difficult
where output is difficult to determine. Hence the focus in these kind of organisations
: 246
should be on the input rather than the output. In a firm of lawyers, the kind of training Introduction to
Management Control
programmes that a professional opted for, the number of training hours he or she put Systems
himself through and contribution to new processes and thinking in the organisation would
NOTES
be more significant measures of performance evaluation rather than say, just the number
of cases handled.
14.10 Controls in specialised organisations

Some of the other specialised service organisations and their controls are discussed
below:
14.10.1 Financial Service Organizations
Financial service organizations include commercial bank, insurance companies, and

securities firms. These companies are in business primarily to manage money. Some act
as intermediaries; that facilitate lending of funds from depositors to individuals or
companies. . Others act as risk shifters; they acquire money in the form of premiums,
invest these premiums, and accept the risk of the occurrence of specific events, such as
death of an individual or damages to the property. Still others are traders; they buy and
sell securities, either for their own account or for customers.
Controls in Financial Organisations
Some of the issues that arise in the control for these kind of organisations is:
· Absence of fixed assets or insignificant fixed assets-therefore Return on

Investment is not a meaningful performance evaluation method
· Increase in customer base is a clear indicator of growth so it is important to

Check Your Progress
Personnel budgeting is the
track down customer satisfaction on a regular basis most important in service
firms. Explain.
· Information tracking is the most important activity in these kind of organizations
and therefore investment planning is required for managing information.
· Risk measurement and management are extremely important activities and hence
control is important on these
· Investment into technology needs to be evaluated often and controls should be

adequate to track such requirements.
: 247
Introduction to 14.10.2 Healthcare Organizations
Management Control
Systems
Health care in India is divided between public health care management by the Central
NOTES and State Governments and the privately run hospitals. While the public health care
system will be covered in the non-profit organisations discussed later in the Unit,
private health care would fall under commercial or for profit activity.
Hospitals usually require huge investment on health care equipment. The annual budget
preparation processes is conventional. Huge quantities of information are available
quickly for the control of operating activities. Financial performance is analyzed by
comparing revenues, and expenses with allocated budgets, identifying important
variances, and taking appropriate actions on them.
Controls in Health care Organisations
· Quality control is of paramount importance in health care organizations

· Since insurance is becoming an integral part of all private health care providers
it is important to keep in place systems and processes for convenient tracking
of third party administrations in reimbursing bills. Insurance and third party
administration management is becoming a cause of huge concern for both the
hospitals as well as insurance companies due to absence of sufficient controls.
· Social concerns should be addressed even if hospitals run for profit
14.10.3 Non-Profit Organization
A non-profit organization are formed for the purpose other than generating profit and
in which no part of the organization’s income is distributed to members, directors, or
officers. Non-profit organizations are often termed “non-stock corporations” or “Not-
for-Profit Organization.” NPOs are usually grant tax exclusion and contributions to
them are often tax deductible. Non-profit organizations are designated as non-profit
when they are created which also pursue purposes permitted by statutes for non-
profit organizations. This include religious outfits, public schools, dispensaries and
hospitals, political parties, legal aid societies, volunteer services organizations, labour
unions, professional groups, research groups, museums, and some governmental
agencies. The initial funding is provided by the member, trustee, or others who do not
expect repayment, or who do not share in the profit and loss of the organization which
: 248
are retained.
Performance Measures in Non- Profit Organizations Introduction to
Management Control
Systems
As donors and fund providers in non-profit organizations want to know how well the
funds are spent, measurements of some kind need to be made. For this purpose, evaluation NOTES
can be a useful tool focusing on organizations’ programs with the objective of recommending
whether these programs should be expanded, contracted, redirected, or discontinued.
The ideal evaluation process is one that provides indisputable evidence that what was
intended to be done, is actually done. The question an evaluation process seeks to answer
can be which program can make the greatest contribution for a given cost, or which
program can achieve a given level of effectiveness at the least cost. These value-for-
money questions are keys in the minds of fund providers who want to see the greatest
return on the funds they provide. For example, a funder with only a limited amount of
money to devote to the cause of helping the blind wants to put that money to work in a
way that will have the greatest impact on that cause.
Evaluation is carried out through examining results of past actions, and in order to do that
the evaluator must work through several stages in the evaluation process:
1. Designing the evaluation system by answering questions such as:

a. What is to be evaluated? e.g. programs, functions, or organizations.
b. What type of evaluation should be used? Outcome, process, input?
c. Who would perform the task? Operations managers, top management, Check Your Progress
or outside evaluation experts? What are non-profit
organisations ?
2. Choosing data collection methods by deciding what kind of data is required and
what means should be used to collect them. For example quantitative data such
as numerical counts and statistics or qualitative data such as interviews, focus
groups and observations?
3. Developing standards for assessing the data, choosing between two basic kinds
of standards:
a. Absolute standards – These are previously identified targets, against
which the program is measured. Comparison of outcomes against these
standards indicates how close the program corresponds to the specified
set targets.
: 249
Introduction to b. Relative standards – Instead of using pre-determined targets results
Management Control
Systems are compared with the results of similar activities or results from
previous periods.
NOTES
4. Interpreting and using the results of the evaluation by answering the questions:
a. What do the results tell us about what can be done better?
b. Should something be changed?
c. Should the program be dropped?
d. Should more money be invested?
And in case of poor results to find out:
a. Was it because evaluators were poorly selected or trained?

b. Was it because of a change in conditions beyond their control?
c. Was it due to inadequate funding?
d. Was it due to poor management?
Different Types of Evaluation
· Outcome evaluation: The ultimate objective of this kind of evaluation is to
Check Your Progress make a statement about outcomes, the end result of the activities that are being
Do non-profit organisations
evaluated. To achieve this, the evaluation effort is focused directly on getting
need control ? Why ?
information on specified outcomes.
· Process evaluation: Evaluation attempts to measure the occurrence of a
specific set of recommended activities undertaken by the evaluated. For example,
if the evaluator’s focus is on a leadership function, such as the way the board of
directors governs the organization, a process evaluation would seek to measure
various aspects of the way it runs its meetings, how it goes about setting goals
for the organization, or the roles and responsibilities of its committees.
· Input evaluation: Processes cannot be ensured without the initial investment
of financial, human and technological resources to make them happen. It is,
therefore, possible to perform an evaluation of these inputs. For example, how
much money can be allotted to a project, how many labor hours were devoted
to it, how much information technology and infrastructure was put in place,
how much managerial quotient was invested in developing the project, etc.
: 250
Introduction to
· Subjective Evaluation: The large majority of program measurements is
Management Control
subjective; as they are judgments arrived at by personal observations by an Systems
individual or a small committee. The validity of such evaluations depends heavily NOTES
on the expertise of those involved. Findings are also influenced by the situations
which the evaluators happen to observe; that is, they may be unduly impressed
by what appears to be either excellent or poor results in particular cases. For this
reason, it is desirable that the evaluators develop statistical or other data as a
means for adding credibility to their opinions.
· Statistical Evaluation: In this method relevant data about the programs is
collected routinely and the focus is placed on the development of performance in
order to determine whether and how much performance has improved or
worsened; current results of the programs are compared with the results of others,
presumably similar ones, or current results are compared with the results that
were anticipated when the program was started.
· Sample Survey Evaluation: This kind of measurement deals with an investigation
of samples of the target group, for example, the people that the program is intended
to benefit, or the ones that can provide useful information on the subject. The
survey may be either in the form of a written questionnaire or of oral interviews.
In order to provide valid results, survey questions must be worded so that the
respondents could give clear and understandable answers, and the sample of
selected people must be representatives of a much bigger population under
investigation.
14.10.4 MCS in small businesses
There is large number of small enterprises in most of the countries. However, their
management accounting (MA) and management control systems (MCS) are rarely
Check Your Progress
explored. Traditionally, it has been stated that small firms don’t need MCS due to their What is statistical
evaluation ?
simple structures and scarcity of resources. On the other hand, a few studies on high
technology firms have shown that these firms have developed their customized MCS and
are also adopting sophisticated management accounting practices and information.
Contrary to popular perception as well as established literature, that small businesses do

not have or need formal control systems (e.g. Anthony & Govindarajan 2001, Merchant
1997, Simons 2000, also Day & Taylor 2002), Jankala(2007) has done a survey of 183 : 251
Introduction to
small scale Finnish firms and concluded that small businesses had shown adoption of
Management Control
Systems control measures in their businesses classified as follows:
NOTES Of the total firms surveyed, 95% (high adoption) of them reported that the following
measures were adopted in their firms:
· Use of financial ratios analysis like profitability, leverage and liquidity ratios
· Analysis of business strengths and weaknesses etc.
· Estimates and plans for the number of employees
· Calculations of product or service-level costs
· Comparisons of financial ratios to industry averages and competitors’ ratios
· Employee analysis (performance, satisfaction etc.)
· Pricing based on full-costing approach
· Monthly or quarterly income statements including depreciation methods used
and highlighting change in stock
· Analysis of working capital and its parts (stocks, debtors, creditors) etc. including
use of ratios
· Fund flow statements of the financial year deciphering sources and uses of
earnings and capital
· Competitor analysis and forecasts
· Product and/or service profitability analysis
Close to 80% (moderate adoption) of the respondents adopted the following control
measures in their businesses.
· Pricing based on contribution margin and variable costing

· Monthly or quarterly income statements excluding determination of depreciation
and change in stock
Check Your Progress · Quality improvement analysis

Why are small organisations
· Customer analysis (satisfaction etc.)
difficult to control ?
· Productivity and operational efficiency analysis (levels of actions, lead-times,
labour hours, delivery etc.)
· Calculations of project costs
· Reports relating to the alternatives for production/operation processes
· Monthly or quarterly budgets of cash flows
: 252
· Evaluations of the effects of investment proposals on the future economic Introduction to
Management Control
development of the firm Systems
· Budgets for the capital structure of firms(equity and liabilities)
NOTES
· Project follow-ups and reports
· Budgets (annual, flexible or rolling)
· Budget follow-ups, at least quarterly, and variance analysis
· Customer profitability analysis
· Calculations for cost centers
· Analysis of alternative capital investment possibilities for the firm’s asset holdings
· Business partner analysis and reports
· Analysis of buy-or-make/produce alternatives
· Reports about non-financial arguments and criteria for investment proposals
Almost 45 to 80% (low adoption) of the respondents used the following control
measures in their organizations.
· Market surveys and other marketing reports alike

· Investment follow-ups with calculations and analysis
· Calculations of investment opportunities over their life time also including economic
evaluations of alternative proposals (using capital budgeting methods like net
present value, IRR or payback)
· Calculations and analysis of financial risks Check Your Progress
Why are small organisations
· Cash flow statement for the financial year difficult to control ?
· Calculations based on target costing (price and target profit are known, so
planning is
· used for reaching allowed producing costs)
· Weekly forecasts or budgets for sources and uses of cash
· Calculations of customer costs
· Calculations of quality costs (for example, failures and their prevention)
· Market share analysis and forecasts
· Shareholder value analysis/ EVA
· Calculations based on activity-based costing (e.g. selling, purchasing, delivering
etc.)
· Analysis and scenarios for the development of external business environment
: 253
Introduction to
· Reports and analysis of innovation and development
Management Control
Systems · Analysis and scenarios for alternative strategies
NOTES · Analysis and forecasts of customer’s value added

· Long-run budgets (for example, including 2–5 years)
· Value chain analysis
· Calculations of environmental costs
· Product life-cycle analysis (all costs from product development to the end of
production and exit from markets)
· Benchmarking reports and analysis (for example, comparisons to a respective
top-firm for learning purposes)
The above measures also serve as a template for firms from which they choose
the control measures relevant for them.
14.11 Summary
The concept of Management control process in service organisations was introduced
by Anthony in 1966. An important feature of service firms relevant to the design of
management control system is the significant human participation in the “production
process” which presents challenges to researchers when presenting conceptual
framework in the design of management control system. For several reasons,
management control systems in service industries are somewhat different from
management control in the manufacturing companies. The service industries are
Check Your Progress
Why are small organisations characterised by absence of Inventory, absence of uniform quality control measures,
difficult to control ?
dependence on key personnel rather than equipment or technology and absence of
scale economies. Therefore controls should be designed bearing in mind the different
nature of the service industries and measurement of output should be done with lot of
care. The fundamental difference between service organisations and professional service
organisations is that service organisations provide services that are generalised- for
example a restaurant, car service station, insurance company etc. However professional
service organisations derive their identity from a core skill. A doctor, lawyer, architect or
a Chartered Accountant are professionals and their characteristics may slightly differ
from that of normal service organisations. Some other specialised service organisations
are financial service organisations, healthcare organisations, non-profit organisations
: 254
and small businesses. The Control systems for each of these have been discussed in Introduction to
Management Control
detail in the Unit. Systems
14.12 Key Terms NOTES
Characteristics of Service Industry are absence of Inventory, absence of

uniform quality control measures, dependence on key personnel rather than
equipment or technology and absence of scale economies.
Service organisations provide services that are generalised
Professional service organisations derive their identity from a core skill
14.13 Questions
a. Service industries operate on short term fixed costs; hence it is easy to tweak
costs in the short run.
b. Service organisations heavily depend upon key personnel and they invest
heavily into training people rather than equipment.
c. Small firms do not need and use MCS due to their simple structures and poor
resources.
d. A service company cannot judge product quality until the moment the service
is rendered, and then the judgments are often subjective.
e. As non-profit organizations runs on the money provided by donors and fund

providers, performance evaluation is irrelevant in these type of organizations.
f. Owing to the absence of fixed assets or insignificant fixed assets, Return on

Investment is not a meaningful performance evaluation method in financial
service organizations.
g. A reliable measure of a doctor’s performance is the number of patients that

come to him every day for treatment.
: 255
Introduction to
Management Control 14.13.2 Substitute with a single word
Systems a. A group organized for purposes other than generating profit and in which no
NOTES part of the organization’s income is distributed to members, directors, or
officers
b. Service Organisations that derive their identity from a core skill.
c. Relevant data about the programs is collected routinely and the focus is
placed on the development of performance in order to determine whether
and how much performance has improved or worsened.
d. In these organizations, the control system begins with pricing rather that the
output.

1. What are service organizations and what are the basic differences in
characteristics of Service Organizations?
2. What are Professional Service organizations?
3. Explain the performance evaluation applicable in:
a. Healthcare Organizations
b. Non Profit organizations
c. Performance Evaluation
d. MCS in small businesses
4. What are the different types of evaluation used while evaluating nonprofit
organizations?

Anthony, R. N. (2007). Management Control Systems 12/E. Tata McGraw-
Hill Education.
Anthony RN & Govindarajan V (2001) Management Control Systems (10th

ed). McGraw-Hill, New York.
Day J & Taylor P (2002) Accounting: SMEs – The accounting deficit.

Accountancy (UK)
129: 1.
: 256
Introduction to
Jänkälä, S. (2007). Management control systems (MCS) in the small business Management Control
context. Linking effects of contextual factors with MCS and financial Systems
performance of small firms. NOTES
Merchant KA (1997) Modern Management Control Systems: texts and cases.

Prentice
Hall, New Jersey, US.
: 257
Introduction to
Management Control
Unit 15: MCS in Project Management
Systems
Structure
NOTES
15.0 Introduction
15.2 Meaning of Project Management
15.3 Unique features of Project Management
15.4 Difference between project Control and operational
control
15.5 Project Organisation Structure
15.6 Project Planning and Scheduling
15.7 Project Audit
15.8 Cost Management in Projects
15.9 Summary
15.10 Key Terms
15.11Questions
15.1.2 Substitute with a single word:
: 258
Introduction to
Systems
We have understood about controls for organisations so far. While these controls are
highly suited to operations, which are repetitive and perennial, we may have to view NOTES
other kind of activities that firms may undertake. In this Unit, we understand all about
controls for projects. A project is time bound and has a definite set of activities therefore
requiring different sets of controls.

· Highlighting Unique features of Project Management
· To illustrate Difference between project Control and operational control
· To explain Project Organisation Structure
· Analysing Project Planning and Scheduling
· Understanding Project Audit
· Understanding Cost Management in Projects
· Understanding Project Evaluation
15.2 Meaning of Project Management

Project Management is the art of managing all the aspects of a project from inception to
closure using a scientific and structured methodology.
The term project may be used to define any endeavour that is temporary in nature and
with a beginning or an end. The project must create something unique whether it is a
product, service or result and must be progressively elaborated. As the definition implies,
not every task can be considered a project. It would be worthwhile to keep this definition
in mind when categorizing projects and studying their role in the success of the organization.
Management control system is an essential element in project management. It is a process

which supports the project management team throughout a project life cycle. It helps the
project team in managing the project scope, cost and schedule.
: 259
Introduction to
Management Control 15.3 Unique features of Project Management
Systems
Project management is somewhat different from the regular operations of a business. It
NOTES
is a fact that all activities of an organization can be divided into projects and operations.
Operations are ongoing, continuous and repetitive activities in any organization such as
accounting, finance, or production. On the other hand, projects are specific tasks that
have a beginning and an end such as working on developing a new product. All efforts
and energies of an organization are distributed between these two categories of work.
Let us see how project management differs from operation management.
To illustrate, let’s use the example of a company that produces plastic tubes for product
packing in the FMCG industry. Their analysis revealed that the profit margin for tooth
paste tubes was declining rapidly. As such, the senior management formed a project
team to look into developing another product to shore up profits. The project team did a
market research and discovered that margins were better in the beauty segment which
looked promising and it was for the face creams and gels. Based on the research
findings, the senior management decided to reduce the production output for toothpaste
tubes and decided to allocate more resources for the tubes for the beauty and personal
care segment and also sent more quality specialists to control the new product operation
to ensure that the new product meets the high quality standards required by the industry.
When the restructuring was completed, the two product line helped the organisation to
improve their corporate strategy of diversifying into other products and securing an
increase in profit margin.
15.4 Difference between project Control and operational

control
Some of the aspects that make project control different from normal operational control
are explained below:
Check Your Progress
What are the unique 1. Dynamic Decision making
features of projects ?
One thing that becomes clear with the definition of project and operations is
that unlike projects, in operations one has to stick with his decisions for a very
long time. In project management, decisions take shape according to the size
and nature of the project and can be changed in between also. This is because
: 260
Introduction to
project managers start afresh as and when they complete a project. However, Management Control
this differentiation is only a matter of perspective and in reality; the styles of both Systems
project management as well as operations management can be combined to be NOTES

more efficient and productive.
2. Temporary nature of projects
One more difference that is self-evident between project management and
operation management is that operations have permanence while projects are
rather temporary in nature. Continuous operations of purchasing and selling goods
in the shop can be categorized as operations whereas, the process of renovation
of the shop may be a project. The project will end as soon as the renovation is
done.
3. Specific Budget
Check Your Progress
A project manager is given a budget within which he has to carry out the task What are the unique
features of projects ?
whereas in the case of operations, it is the duty of the operations manager to
perform operations in a manner so as to generate maximum profits.
4. Specific time frame
A project manager needs to be skillful in handling the workers as he has to finish
the task with the given team in a given timeframe within a budget that he has to
maintain and not overrun. In operations management, a thorough knowledge of
the work process is crucial to have better productivity and efficiency.
5. Less reliable Standards
Performance standards tend to be less reliable for projects than for normal
operations. Projects have a lot of variables and time frame is pre-defined. Hence
the iterative processes of setting a standard, measurement of actual with standard
and a feedback is usually not possible in the case of projects. Operations are
similar and repetitive in nature. Hence a historical perspective is available for
setting standards. Projects, however, are different from each other making it
difficult for standards to be set.
6. Greater Environmental influence
Projects are usually executed on site and hence environmental factors affect
them a lot. Sometimes projects are also executed in the premises of the client
: 261
Introduction to
Management Control and therefore projects are more sensitive to the environment in which they function
Systems rather than a function of the organisation controls.
NOTES 15.5 Project Organisation Structure

Since projects have several distinguishing features as compared to operational control,
project control is different from the normal operational controls. The project organization
structure would consist of staff assigned to the project till it is completed. Project teams
could be completely recruited from outside as a specialist team or could be assembled
from within the organization from various teams. A project has four organization structures
available for design and all are defined by the level of organizational authority given to
the project manager.
· Programmatic based, in which project managers have authority only within the
program focus or area
· Matrix based, in which the project manager shares responsibility with other
program unit managers
· Project based, in which project managers have total authority.
· Mixed Organisations which could be a combination of two or more of the above
stated structures
1. Programmatic Based
The programmatic focus refers to a traditional structure in which project
managers have formal authority over most resources. It is only suitable for
projects that require a homogenous specialization. For example if an activity is
to be automated, the Information Technology (IT) team carries it out as a
standalone project and everybody is from the IT team. However, it is not suitable
for projects that require a diverse mix of people with different expertise from
various program sectors. In a programmatic based organization, a project team
Check Your Progress is staffed with people from the same area. All the resources needed for the
Who are matrix project team come from the same unit.
organisations complex ?
Some of the advantages of programmatic based projects are:
· There are clear lines of authority, in large projects the project managers tend to
also be the program unit manager. There is no need to negotiate with other
: 262
Introduction to
program units for resources, since all of the staff needed for the project will
Management Control
come from the same department or division. Systems
· Another advantage of this type of organization is that the team members are NOTES
usually familiar with each other, since they all work in the same area.
· The team members also tend to bring applicable knowledge of the project.
However, a major disadvantage of the programmatic based organization is that the all of
the specialists needed to work on a project may not be available from that Division or
Department.
2. Matrix Based
Matrix based project organizations allow various divisions in the organisation to
focus on their specific technical competencies and allow projects to be staffed
with specialists from throughout the organization. For example, a project or task
team established to develop a new product might include engineers and design
specialists as well as those with marketing, financial, personnel and production
skills.
These teams can be temporary or permanent depending on the tasks they are asked to
complete. Each team member can find himself/herself with two managers - their normal
functional manager as well as the team leader of the project.
It is common for people to report to one person in the programmatic unit, while working
for one or two project managers from other projects in different programmatic units.
The main advantage of the matrix based organization is the efficient allocation of all
resources, especially scarce specialty skills that cannot be fully utilized by only one project.
For instance, monitoring and evaluation specialists may not be utilized full-time on a
project, but can be fully leveraged by working on multiple projects. The matrix based
organization is also the most flexible when dealing with changing programmatic needs
and priorities. The matrix allows companies to leverage vast resources while staying
small and task-oriented. The matrix encourages innovation and fast action, and speeds
information to those who know how to use it (Sy, Thomas; D’Annunzio, Laura Sue,
2005). Some of the significant advantages to matrix management are:
: 263
Introduction to · It allows team members to share information more readily across the unit
Management Control
Systems boundaries, allows for specialization that can increase depth of knowledge and
allow professional development and career progression to be managed.
NOTES
· It is easier for a program unit manager to loan an employee to another manager
without making the change permanent. It is therefore easier to accomplish work
objectives in an environment when task loads are shifting rapidly between
programmatic units.
Some of the control issues that arise in a matrix organization form
1. Competing or conflicting objectives between matrix dimensions

2. Inadequate processes to align goals and detect possible misalignments.
3. Lack of coordination, synchronization and poor timing of work plans and
objectives
4. Insufficient communication and consultation between matrix dimensions.
The main disadvantage is that the reporting relationships are complex. Some people
Check Your Progress might report to programmatic unit managers for whom little work is done, while actually
Who are matrix working for one or more project managers. It becomes more important for staff members
to develop strong time management skills to ensure that they fulfill the work expectations
of multiple managers.
This organization also requires communication and cooperation between multiple

programmatic unit managers and project managers since that all be competing for time
from the same resources. Matrix management can put some difficulty on project
managers because they must work closely with other managers and workers in order to
complete the project.
The programmatic managers may have different goals, objectives, and priorities than
the project managers, and these would have to be addressed in order to get the job
done.
An approach to help solve this situation is a variation of the Matrix organization which
includes a coordinating role that either supervises or provides support to the project
managers. In some organizations this is known as the Project Management Office
(PMO), dedicated to provide expertise, best practices, training, methodologies and
: 264 guidance to project managers.

The PMO unit also defines and maintains the standards of project management processes Introduction to
Management Control
within the organization. The PMO strives to standardize and introduce economies of Systems
scale in the implementation of projects. The PMO is the source of documentation,
NOTES
guidance and metrics on the practice of project management and implementation. The
PMO can also help in the prioritization of human resources assigned to projects.
3. Project Based
In this type of organization project managers have a high level of authority to manage
and control the project resources. The project manager in this structure has total authority
over the project and can acquire resources needed to accomplish project objectives
from within or outside the parent organization, subject only to the scope, quality, and
budget constraints identified in the project.
In the project based structure, personnel are specifically assigned to the project and
report directly to the project manager. The project manager is responsible for the
Check Your Progress
performance appraisal and career progression of all project team members while on Who are matrix
the project. This leads to increased project loyalty. Complete line authority over project
efforts affords the project manager strong project controls and centralized lines of
communication. This leads to rapid reaction time and improved responsiveness.
Moreover, project personnel are retained on an exclusive rather than shared or part-
time basis. Project teams develop a strong sense of project identification and ownership,
with deep loyalty efforts to the project and a good understanding of the nature of
project’s activities, mission, or goals.
Pure project based organizations are more common among large and complicated
projects. These large projects can absorb the cost of maintaining an organization whose
structure has some duplication of effort and the less than cost-efficient use of resources.
In fact, one major disadvantage of the project based organization is the costly and
inefficient use of personnel. Project team members are generally dedicated to one
project at a time, even though they may rarely be needed on a full-time basis over the
life cycle of the project. Project managers may tend to retain their key personnel long
after the work is completed, preventing their contribution to other projects and their
professional development.
: 265
Introduction to
Management Control In this type of organization, limited opportunities exist for knowledge sharing between
Systems projects, and that is a frequent complaint among team members concerning the lack of
NOTES career continuity and opportunities for professional growth. In some cases, project
personnel may experience a great deal of uncertainty, as organization’s or donor’s
priorities shift or the close of the project seems imminent.
One disadvantage is duplication of resources, since scarce resources must be duplicated

on different projects. There can also be concerns about how to reallocate people and
resources when projects are completed. In a programmatic focus organization, the people
still have jobs within the program unit. In a project-based organization it is not always
clear where everyone is reassigned when the project is completed. Another disadvantage
is that resources may not be needed as a full time for the entire length of the project,
increasing the need to manage short term contracts with consultants and other subject
matter experts.
A variety of this pure project approach is temporarily project-based organizations. This

organization consists of a project team pulled together temporarily from their program
unit and led by a project manager that does not report to a programmatic unit. The
project manager has the full authority and supervision of the project team.
4. Mixed Organisations
Another design is based on a mixed structure that includes a matrix, programmatic
Check Your Progress focus and project based; this mix reflects the need for more flexibility in a development
Who are matrix
organisations complex ? organization to accommodate different requirements. These type of organizations are
more situation based and when an organization has multiple projects having varying
time frames, deliverables and specialization a mix of structures could be useful.
15.6 Project Planning and Scheduling
Project planning starts by setting a goal for the project that’s consistent with the SMART
(specific, measurable, achievable, realistic and timed) goal-setting principle. The goal
should be narrowed down to a very specific purpose and there should be a way to
gauge the team’s progress toward that goal. The steps required to reach the goal needs
to be listed. Once the project is planned, each planned activity is broken down and fit
: 266
into time slots. Each specific point on the project plan is entered into the project Introduction to
Management Control
management or calendar software that is used in the business. This scheduling technique Systems
is used by many companies because it allows the team to keep track of progress on the
NOTES
project. The access to the project management software or calendar should be shared
with the project team so that each member can stay abreast of the project as well.
Project Scheduling is an important activity in project management. The project scheduling

is usually done using varying techniques. They are as follows:
1. Gantt or bar charts

A Gantt chart provides a graphical illustration of a schedule that helps to plan,
coordinate, and track specific tasks in a project. It was developed in 1917 by
Henry L. Gantt. A Gantt chart is constructed with a horizontal axis representing
the total time span of the project, broken down into increments (for example,
days, weeks, or months) and a vertical axis representing the tasks that make up
the project
2. Network based scheduling
A network depicts the sequence of activities necessary to complete a project. Check Your Progress
Segments of a project are represented by lines connected together to show the What are mixed
organisation ?
interrelationship of operations and resources. When duration is associated with
each segment, the model shows the time distribution of the total project and its
operations. This information can be used to coordinate the application of resources.
There are two very well known techniques for network scheduling:
CPM (Critical Path Method) is used to assist the project manager in scheduling the
activities (i.e., when should each activity start). It assumes that activity durations are
known with certainty.
PERT (Program Evaluation and Review Technique) is used to assist in project

scheduling similar to CPM. However, PERT assumes that activity durations are random
variables (i.e., probabilistic).
Check Your Progress
They both focus on the path of critical activities that control the projects duration and When is CPM used and
when is PERT used ?
can be considered under the general title Critical Path Scheduling (CPS).CPS is a
: 267
Introduction to management control tool for defining, integrating and analysing what must be done
Management Control
Systems to complete a project economically and on time.
NOTES
15.7 Project Audit
Projects usually run independently and therefore it is difficult to identify any problems
until it becomes obvious that there are problems with schedule, cost or quality. At that
point (when it is obvious) it is usually too late to meet the original expectations. In order
to avoid situations such as what has been described, organisations undertake project
audits.
Project audits can help determine the true state of a project, and whether the project
looks to be on track to finish successfully. Audits can also specifically point out whether
good project management rigour and structure is in place
The scope of project audit includes the following:
· Compliance with policies, procedures and controls built into the chosen project
Check Your Progress methodology

When is CPM used and
when is PERT used ? · The effectiveness of risk management procedures and risk mitigation
· The adequacy and effectiveness of controls built into operations
· The ongoing financial viability of projects
· The achievement of user requirements and other project benefits and outcomes
· The reliability that can be placed upon project assurance
A number of project management reviews within the annual internal audit plan may be
combined to provide a process review of the project methodology provided this is agreed
with management at the outset.
A typical approach to project management reviews is for the internal auditor to join a
Project Board or team with the inclusion of time in the audit plan for meetings. The
advantages of having an auditor in the project can be described as follows:
: 268
· It enables quick responses in case of overruns in a project. Introduction to
Management Control
Systems
· Decisions can be evaluated decisions as they are made. In a fast moving
project this may be extremely useful NOTES
All the advantages notwithstanding, sometimes the presence of internal audit can slow
down, even delay progress. Internal audit may not always need to be part of Project
Board meetings to provide advice through their consultancy role. They could provide audit
advice even from outside the team. This will enable the project to have audit advice, yet
the project itself will not slow down on account of the need for audit clearances.
15.8 Cost Management in Projects

Cost management is a very important aspect in projects. Any overruns in project cost
could reduce profits or sometimes push the projects into loss. Some of the techniques for
cost estimation for a project are discussed as follows:
1. Analogous Estimation
Analogous estimating relies on historical information to predict the cost of the
current project. It is also known as top-down estimating. The process of analogous
estimating takes the actual cost of a historical project as a basis for the current
project. The cost of the historical project is applied to the cost of the current
project, taking into account the scope and size of the current project as well as
other known variables. Analogous estimating is a form of expert judgment. This
estimating approach takes less time to complete than other estimating models, but
is also less accurate. This top-down approach is good for fast estimates to get a
general idea of what the project may cost.
2. Parametric Modeling
Parametric modeling uses a mathematical model based on known parameters to
predict the cost of a project. The parameters in the model can vary based on the
type of work being completed. A parameter can be cost per cubic yard, cost per
unit, and so on. A complex parameter can be cost per unit with adjustment factors
based on the conditions of the project. In addition, the adjustment factors may
have additional modifying factors depending on additional conditions. To use
parametric modeling, the factors the model is based on must be accurate. The
: 269
factors within the model are quantifiable and don’t vary much based on the
Introduction to
Management Control effort applied to the activity. And finally, the model must be scalable between
Systems project sizes.
NOTES
There are two types of parametric estimating:
% Regression analysis This is a statistical approach to predict what future values

may be, based on historical values. Regression analysis creates quantitative predictions
based on variables within one value to predict variables in another. This form of estimating
relies solely on pure statistical math to reveal relationships between variables and predict
future values.
% Learning curve This approach is simple: the cost per unit decreases the more units
workers complete; this is because workers learn as they complete the required work.
The more an individual completes an activity, the easier it is to complete. The estimate
is considered parametric, as the formula is based on repetitive activities, such as wiring
telephone jacks, painting hotel rooms, or other activities that are completed over and
over within a project. The cost per unit decreases as the experience increases because
the time to complete the work is shortened.
3. Bottom-Up Estimating
Bottom-up estimating starts from zero, accounts for each component of the
work breakdown structure (WBS), and arrives at a sum for the project. Estimates
are created for all tasks at the lowest level of the WBS and then these are
Check Your Progress accumulated to determine the estimates for the whole project. It is completed
How do you estimate cost with the project team and can be one of the most time consuming methods to
in projects ?
predict project costs. While this method is more expensive, because of the time
invested to create the estimate, it is also one of the most accurate. A fringe
benefit of completing a bottom up estimate is the project team may buy-into the
project work as they see they cost and value of each cost within the project.
Project Evaluation
Project Evaluation is the process of evaluating the performance and progress of a project
and comparing it to what was planned. Project evaluation assists the organization in the
following ways:
: 270
· Evaluating performance of project manager and create a suitable incentive and Introduction to
Management Control
reward plan Systems
· To identify budget overruns
NOTES
However since each project is unique the project evaluation has no historical data to
compare against. Only current data can be used to evaluate and review a project. This
makes project evaluation complex. Yet unless proper evaluation mechanisms are in place
it may be difficult to run the project as envisaged. Different projects require different
evaluation techniques. However a proper evaluation at the completion of each project is
as important as the project itself making it a very important part of the successful
completion of the project.
15.9 Summary
Project Management is the art of managing all the aspects of a project from inception to
closure using a scientific and structured methodology. Project management is some-
what different from the regular operations of a business. It is a fact that all activities of an
organization can be divided into projects and operations. Operations are ongoing,
continuous and repetitive activities in any organization such as accounting, finance, or
production. On the other hand, projects are specific tasks that have a beginning and an
end such as working on developing a new product. Some of the aspects that make
project control different from normal operational control are the dynamic decision mak-
ing environment in which a project functions, temporary nature of projects, budget con-
straints in which projects operate, limited time frame available to complete a project,
absence of reliable Standards and the greater environmental influence on the project. A
project has four organization structures available for design and all are defined by the
level of organizational authority given to the project manager. Programmatic based, in
which project managers have authority only within the program focus or area; Matrix
Check Your Progress
based, in which the project manager shares responsibility with other program unit manag- How do you estimate cost
ers; Project based, in which project managers have total authority; Mixed Organisations in projects ?
which could be a combination of two or more of the above stated structures. Project
Scheduling is an important activity in project management. The project scheduling is usu-
ally done using varying techniques such as Gantt or bar charts and network scheduling.
The two very well known techniques for network scheduling are CPM (Critical Path
Method) which is used to assist the project manager in scheduling the activities and
PERT (Program Evaluation and Review Technique) which is used to assist in project
: 271
Introduction to scheduling similar to CPM. Project audits can help determine the true state of a project,
Management Control
and whether the project looks to be on track to finish successfully. Audits can also
Systems
specifically point out whether good project management rigour and structure is in place.
NOTES
Cost management is a very important aspect in projects. Any overruns in project cost
could reduce profits or sometimes push the projects into loss. Some of the techniques for
cost estimation for a project are Analogous Estimation, Parametric Modeling and Bot-
tom-Up Estimating. Project Evaluation is the process of evaluating the performance and
progress of a project and comparing it to what was planned. Project evaluation assists
the organization in evaluating performance of project manager and create a suitable
incentive and reward plan and to identify budget overruns.
15.10 Key Terms

Project may be used to define any endeavour that is temporary in nature and
with a beginning or an end.
Project Management Office (PMO), is a dedicated unit that provides

expertise, best practices, training, methodologies and guidance to project
managers.
Project planning starts by setting a goal for the project that’s consistent with
the SMART (specific, measurable, achievable, realistic and timed) goal-setting
principle.
Project audits can help determine the true state of a project, and whether the
project looks to be on track to finish successfully.
Cost management is the process of measuring and managing cost overruns

in project.
Project Evaluation is the process of evaluating the performance and progress

of a project and comparing it to what was planned.
: 272
Introduction to
15.11 Questions Management Control
Systems
NOTES
a) Performance standards tend to be less reliable for projects than for normal
operations.
b) In project management, decisions take shape according to the size and nature of
the project and can be changed in between also.
c) Operational activities have permanence while projects are rather temporary in
nature and therefore performance measures are difficult to identify.
d) Any overruns in project cost could reduce profits or sometimes push the projects
into loss.
e) Operations are ongoing, continuous and repetitive activities in any organization
such as accounting, finance, or production
15.11.2 Substitute with a single word:
a. This organization form allows team members to share information more readily
across the unit boundaries, allows for specialization that can increase depth of
knowledge and allows professional development and career progression.
b. Specific tasks that have a beginning and an end such as working on developing
a new product.
c. A traditional structure in which project managers have formal authority over

most resources and this form is usually suitable for projects that require a
homogenous specialization.
d. This type of cost estimation starts from zero, accounts for each component of
the WBS, and arrives at a sum for the project.
e. The factors within this cost estimation model are quantifiable and don’t vary
much based on the effort applied to the activity.
: 273
Introduction to 15.11.3 Theory questions
Management Control
Systems
1. What is project management and what are the unique features of Project
NOTES Management?
2. What are the essential differences between project Control and operational
control?
3. What are the different types of Project Organisation Structure?
4. What is the importance of Project Planning and Scheduling and what are
the common techniques for the same?
5. What is the importance of Project Audit?
6. What are the Cost Management techniques used in Projects?
1. RR Limited wants to automate their payroll accounting and are considering

the use of the in-house Information Technology (IT) Services Division to
carry out the same. The requirements in the automation are as follows:
· Creation of an accounting software to incorporate the salary structure
and the various constituents of the salary namely the Dearness

Allowance, Travel Allowance, Employee benefits and perquisites etc.
· Calculation of tax to be deducted at source
· Value added services to be offered to employees such as tracking their

salary increase, giving them tax consultancy and investment advisory
services.
RR Limited wants to create a cross functional team to accomplish the

same.
Required:
i) Suggest an appropriate organization structure that would help carry out
the payroll automation project successfully.
ii) On successful completion of the project, what strategic advantages
might be available to RR Limited?
: 274
Introduction to
Systems
Phillips, Project Management Professional Study Guide 2E W/Cd, Tata McGraw Hill
Education NOTES
Paola Diaz, Project Management Organizational Structures, Project Management for

development Organizations
Sy Thomas and Laura Sue D Annunzio, 2005,Challenges and Strategies of Matrix

Organisations: Top level and mid level Managers’ Perspectives, Human Resource planning.
: 275
Introduction to
Management Control
Unit 16: Role of Audit in Control Systems
Systems
Structure
NOTES
16.1 Introduction
16.3 Types of Audit
16.4 Internal Control
16.5 Responsibility for internal controls in Organisation
16.6 Role of Audit in Controls
16.7 Internal Audit
16.8 Cost Audit
16.9 Efficiency audit
16.10 Measuring efficiency
16.11 Management Audit
16.12 Energy Audit
16.13 Ethics in Business and Role of Control
16.14 Summary
16.15 Key Terms
16.16 Questions
: 276
Introduction to
Systems
We know that control is any action taken by management, the board, and other parties to
manage risk and increase the likelihood that established objectives and goals will be NOTES
achieved. We also know that management plans, organizes, and directs the performance
of sufficient actions to provide reasonable assurance that objectives and goals will be
achieved. Controls play an important role in keeping businesses on track and audit plays
an important role in ensuring controls. In this Unit, we will understand the role of audit in
controls and the application of various audits to ensure proper control mechanisms in
organisations.

· Understanding Internal Control
· Analysing Role of Audit in Controls
· Explaining Internal Audit
· Analysing Application of Internal Audit in Business
· Understanding Cost Audit
· To explain Application of Cost Audit in Business
· Understanding Efficiency Audit
· To Analyse Role of Efficiency Audit in Business
· Energy Audit
· Types of Energy Audit
· Social Audit- Objectives, Beneficiaries and Advantages
· Role of Ethics in Control and Business
: 277
Introduction to
Management Control 16.2 Types of Audit
Systems
Audit can be carried out for the purpose of ensuring compliance with the statute-for
NOTES
example, in India compliance with the provisions of the Companies’ Bill (2012). Such an
audit is called financial audit. As per Standards on Auditing (SA) 200 issued by Institute
of Chartered Accountants of India- “Auditing is the independent examination of financial
information of any entity, whether profit oriented or not, and irrespective of its size or
legal form, when such an examination is conducted with a view to expressing an opinion
thereon.”
Audit is also carried out to identify processes, ensure compliance with set standards
and report in a periodic manner when such standards are not met with. These are called
non-financial audits. The types of non-financial audits are discussed later in the Unit.
16.3 Internal Control
Businesses usually put in place certain controls effected by an entity’s board of directors,
management and other key personnel of the organization. These controls are designed
to provide reasonable assurance regarding effectiveness and efficiency of operations,
reliability of financial reporting, and compliance with applicable laws and regulations in
terms of attaining desired objectives. Such controls are known as internal controls.
. Internal control system comprises of accounting control as well as administrative control.

Accounting controls mainly aims at safeguarding assets and ensuring reliability of financial
records. It provides reasonable assurance that all the transactions authorized by the
management are promptly and properly recorded. E.g. Stores Department can issue
materials only against requisition slip duly produced. Administrative controls are basically
regarding improving operational efficiency and adherence to management policies.
The key features of internal control are as follows:
· It is a process.
· It is achieved by people.
· It can only provide reasonable assurance.
: 278 · It is geared to the achievement of objectives.

Generally, internal controls are of two types: Introduction to
Management Control
Systems
Preventive Controls — Designed to avert errors or prevent irregularities from occurring.
They are usually aimed to prevent losses by implementing a proactive approach by removing NOTES
flaws in the system. Examples: Separation of duties, proper authorization, adequate

documentation, and physical control over assets.
Detective Controls – It is an approach that helps to find out flaws or shortcomings that
reduced the efficiency or system after the objective is achieved. The main aim of detective
controls is to contribute to the success of future projects by substituting inefficient processes
by efficient and tested processes. Examples: Reviews, analyses, variance analyses,
reconciliations, physical inventories, and audits.
16.4 Responsibility for internal controls in Organisation
Internal Controls are usually designed by the auditors of an organization. However, ev-
eryone plays a part in the organization’s internal control system. The responsibility to
each area of operation is delegated to ensure that internal controls are established, prop-
erly documented, and maintained. Responsibilities are disbursed to each and every em-
ployee for making this control system functional and effective. Therefore, all employees
need to be aware of the concept and purpose of internal controls.
Internal controls are effective and desirable for organizations. However, they alone are
not sufficient. Most businesses take the help of auditors to perform several types of audit
that help in the process of control. By definition, an audit is an official, professional,
independent examination and verification of a company’s financial statements and Check Your Progress
accounting documents in accordance to generally accepted auditing standards. Systematic Give examples for
and regular audit has the potential to give rise to valuable ideas for increasing operations preventive controls ?
efficiency, raising profitability and strengthening internal controls. This is accomplished
by the audit team working in tandem with the management to understand their risks and
goals along with maintaining a continuous and close relationship throughout.
16.5 Role of Audit in Controls
Traditionally audit has been used to monitor a company’s financial performance by

evaluating it against a set of standards imposed by the government’s regulators or by the
: 279
Introduction to professional standard groups. Financial audit has been part of the management system
Management Control
Systems for a long time. However, there are several other types of audit, which are not financial
which facilitate effective controls in organizations. Periodic audit, both financial and non
NOTES
financial, helps businesses in several ways.
· They bring in a semblance of systematic functioning of business processes
· They help formulate a systematic set process for various business functions
· They give timely warning whenever required and hence help course correction
· They create a feedback loop and help in quick corrective actions
Some popular types of auditing include internal audit, cost audit, efficiency audit,
management audit and lately even energy audit. A brief overview of each of these
follows.
16.6 Internal Audit
Internal audit is an independent, objective assurance and consulting activity developed

to add value and improve an organization’s operations. It helps an organization accomplish
its objectives by bringing a systematic, disciplined approach to evaluate and improve the
effectiveness of risk management, control, and governance processes.
The internal audit activity evaluates the adequacy and effectiveness of controls
encompassing the organization’s governance, operations, and information systems.
Internal audit reviews include the reliability and integrity of financial and operational
information, effectiveness and efficiency of operations, safeguarding of assets, and
compliance with laws, regulations, and contracts. These reviews also ascertain the
extent to which operating and program goals and objectives have been established and
conform to those of the organization, as well as the extent to which results are consistent
with established goals and objectives and whether operations and programs are being
implemented or performed as intended.
Consequent to internal audit function becoming a routine and non-value added activity
in business, many business organizations started ignoring the internal audit function. The
: 280
Introduction to
internal audit staff came to be deployed for other activities as well. This resulted in
Management Control
weakened controls leading to several systematic frauds in business. Notable among these Systems
were the accusations of fraud in Enron Corporation, an energy company based in Houston, NOTES
Texas. Enron’s auditor firm, Arthur Andersen, was accused of applying reckless standards
in its audits because of a conflict of interest over the significant consulting fees generated
by Enron. During 2000, Arthur Andersen earned $25 million in audit fees and $27 million
in consulting fees (this amount accounted for roughly 27% of the audit fees of public
clients for Arthur Andersen’s Houston office). The auditor’s methods were questioned
as either being completed solely to receive its annual fees or for its lack of expertise in
properly reviewing Enron’s revenue recognition, special entities, derivatives, and other
accounting practices.
In July 2002, the United States Congress passed the Sarbanes- Oxley Act (“the Act”/
SOX) into law. The Act was primarily designed to restore investor confidence following
well-publicized bankruptcies that brought chief executives, audit committees, and the
independent auditors under heavy scrutiny. The Act is applicable to all publicly registered
companies under the jurisdiction of the Securities and Exchange Commission (SEC).
SOX is a far reaching legislation, effecting significant changes to laws affecting officers,
directors and reporting obligations of public companies, and mandating a myriad of new
regulations to prevent securities fraud and other abuses.
The Sarbanes Oxley Act called for the formation of a Public Company Accounting
Oversight Board (PCAOB) and specified several requirements (“sections”) that include
management’s quarterly certification of the financial results (Section 302) and
management’s annual assertion that internal controls over financial reporting are effective
(Section 404) among others. The Act has largely ignored the differences in practices and
corporate governance regimes between the United States and other countries, and has
extended the reach of the United States’ laws to many aspects of the internal affairs and
governance regimes of foreign companies and their auditors. There are of course certain
reliefs for Foreign Private Issuers (“FPI”) in the act.
Internal audit plays a more proactive role in non-financial reporting matters, risk
management and key emerging risks. Most businesses engage external auditors to review
the work done by their employees and check for errors or irregularities. An internal
: 281
Introduction to
Management Control auditor is a person employed by a business to do the same thing. The difference is that
Systems while the external auditor has many clients and does this work for a fee, the internal
NOTES auditor is an employee and works within the business alongside other employees. The
standard method for conducting an audit is to examine a transaction or process, compare
how it was done with the way it is documented in an operating procedure and report to
management on any differences.
Concept in Action
The CAG(Comptroller and Auditor General) reported in 2011 that there was a revenue
leakage of Rs.4543.83 crores owing to lack of coordination between the various wings
of Income Tax Department in India. Consequently the Income Tax department had
started internal audits for its various tax collection arms for non-recovery of tax arrears .
The tax department’s idea through these audits was to plug any leakages owing to various
reasons and better its revenue collection.
16.7 Cost Audit

In India the evolution of cost audit can be traced from the era of the World War II when
practice of assigning cost plus contracts started. It has helped management in decision
making process as it shows the reliable cost and accounting method. Also such audit
system helps to maintain good internal control and internal check, also beneficial for
auditors.
According to the Institute of Cost and Management Accountants of England, Cost Audit
is defined as the verification of Cost Accounts and a check on the adherence to the
Cost Accounting plan. The cost audit therefore comprises:
(a) The verification of the cost accounting records such as the accuracy of the
cost accounts, cost reports, cost statements, cost data, costing techniques and
(b) Examining these records to ensure that they adhere to the cost accounting
principle, plans, procedures and objectives.
According to the Institute of Cost and Works Accountants of India, Cost Audit is defined
as a system of audit introduced by the Government of India for the review, examination
and appraisal of the cost accounting records and attendant information, required to be
maintained by speciûed industries.
: 282
Introduction to
Cost Audit is the process of ascertaining whether the production, marketing and sales Management Control
processes as well as other aspects of a business are managed in the most cost effective Systems
way. This is essentially an Internal Audit and is done as a tool for optimising management NOTES
efficiency.
The most important benefit is the location of unseen leaks in revenues or unproductive or
under- productive employment of resources. It is mandatory if the Business is under
scrutiny by a financial institution or regulator on the basis of complaints of mismanagement.
It is desirable to have a Cost audit done periodically, to prevent the situation getting out of
control, and to help the management to take prompt action where necessary.
Application of Cost Audit in Business
1. Cost Audit is a Management Tool for better Control. Cost Audit is admitted
internationally by business enterprises as a management tool, rather than as a
cost verifying mechanism.
2. Cost accounting techniques, which are prescriptive (e.g. budgeting, standard
costing, variable costing, pricing methods like target pricing etc.), help the Check Your Progress
management in controlling costs. What is cost audit ?
3. Cost Audit helps management in accurate decision-making. Cost Audit is a

Management tool for better control.
16.8 Efficiency audit

Efficiency in general describes the extent to which time, effort or cost is well used for
the intended task or purpose. It is often used with the specific purpose of relaying the
capability of a specific application of effort to produce a specific outcome effectively
with a minimum amount or quantity of waste, expense, or unnecessary effort. “Efficiency”
has widely varying meanings in different disciplines.
An economy and efficiency audit, or simply efficiency audit, focuses on the resources
and practices of a program or department, according to the “Encyclopaedia of Public
Administration and Public Policy,” which provides descriptions of typical audit activities.
An economy and efficiency audit might analyze the procurement, maintenance and
implementation of resources, such as equipment, to identify areas that require improvement.
The objectives of auditing efficiency can include assessing one or more of the following:
: 283
Introduction to
Management Control • The level of efficiency achieved by an organization or operation in relation to
Systems reasonable standards’
NOTES
• The adequacy and reliability of systems o, procedures, tools and techniques
used to measure and report efficiency
• An organization’s efforts to explore and exploit opportunities to improve

efficiency and
• Whether the management processes and information systems, operational

systems, and practices of an organization help to achieve efficiency.
16.9 Measuring efficiency

The best method to measure efficiency and associated factors is by using a family of
indicators like various aspects of quantity, quality, and level of service. The purpose of
using a these indicators is to understand how operational factors influence the efficiency
of an operation. The operational effectiveness can be improved by controlling these
factors.Inputs (e.g., labour, material, or capital) can be measured in either physical or
monetary terms. Labour inputs, for example, can be measured in units of time or rupees.
Materiel and capital resources are generally measured in rupees. Outputs of some
operations are uniform. These outputs can be readily counted and the amount of resources
consumed can also be measured to calculate the efficiency of producing them. If outputs
are not uniform, it is not appropriate to count them as standard units of production
requiring equal amounts of resources for calculating efficiency.
Benefits and application in business
· Help managers and staff to be more sensitive to their obligation of due regard
to efficiency;
· Demonstrate the scope for lowering the cost of delivering programs without
reducing the quantity or quality of outputs or the level of service;
· Increase the quantity or improve the quality of outputs and level of service
without increasing spending; and
: 284
· Identify improvements required in existing controls, operational systems, and Introduction to
Management Control
work processes for better use of resources. Systems
Concept in action NOTES
In 2011, the city in United Kingdom called Southampton started a complete review
of its employees working in government offices, which it called “Performance
Efficiency Audit of Southampton employees working in government offices.”
While the word “audit” is used to explain this initiative, the review was not
intended as an audit in the strictest meaning of theterm. Rather, an “efficiency
audit” uses a range of techniques to identify issues, possible research solutions,
exploring best practices, and develop recommendations – all activities designed
to identify opportunities for its employees, eliminate repetition of work, and to
work smarter. This review was intended to help the state achieve two goals:
1. Producing the best possible outcomes for its managers to improve the
performance
Check Your Progress
2. Receiving the highest return on time management and every effort they put in by How is efficiency audit
the employees important ?
16.10 Management Audit

Management audit is an emerging concept of auditing. It has originated from America. It
is a detailed audit that concentrates on analysis and assessment of management procedures
and the overall performance of an organization.
The objective of a management audit is not to appraise and evaluate the management
team as a whole in relation to their competition Rather than focusing on individual
performance of executives.
The purpose of management audit is establishing seven objectives that are : understand
current practices, relate these to company financials, suggest new procedures which will
improve the efficiency of managers, present a financial gain related to these new
procedures, and create benchmarks and projections for the future.
Management Audit can be defined as “A comprehensive and constructive examination

of an organizational structure of a company, institution or branch of government, or of : 285
Introduction to
any component thereof, such as division or department and its use of human and physical
Management Control
Systems facilities.
NOTES Application of Management Audit in Business
The audit follows a systematic process, step-by-step format, including initial interviews
with key managers. A study team analyse the interview process to define the scope of
the audit. Next, the team requests various forms of documentation, including budgets,
planning documents, corporate reports, financial statements, policy and procedure manuals,
biographical material, and various other documents.
Following this stage, the study team then prepares a schedule and detailed plan of study,
all aimed at proceeding to the internal fact finding step. Fact-finding relies once again on
interviews, documentation, and personal observation of facilities and organizational work
patterns. The team generally turns next to an external review, using interviews to
determine the opinions and attitudes key people outside the organization have about its
operations. These interviews provide the audit team with more objective evaluations,
and lead to an analysis of all the information and data collected. The study team then
develops conclusions and recommendations which are communicated to the organization’s
management for the benefit of the organization.
16.11 Energy Audit

Improving energy efficiency and conservation are essential to achieving environmental
sustainability. They are the simplest ways to reduce greenhouse gas emissions and
other forms of air pollution such as acid rain and smog. Good energy management starts
with an energy audit. The dual benefits of dollar savings and environmental protection
from energy efficiency and conservation improvements are highlighted in such an audit.
Energy audits often address other issues, too, such as indoor air quality, lighting quality
and ways to improve building-occupant satisfaction. The purpose of this guide is to
provide basic information on how to conduct an energy audit, with a focus on building
audits. Buildings consume nearly one third of the energy used in the United States.
An energy audit identifies where energy is consumed and how much energy is consumed
in an existing facility, building or structure. Information gathered from the energy audit
: 286
can be used to introduce energy conservation measures (ECM) or appropriate energy- Introduction to
Management Control
saving technologies, such as electronic control systems, in the form of retrofits. Energy Systems
audits identify economically justified, cost-saving opportunities that result in significantly
NOTES
lowered electrical, natural gas, steam, water and sewer costs. An energy audit, therefore,
is a detailed examination of a facility’s energy uses and costs that generates
recommendations to reduce those uses and costs by implementing equipment and
operational changes.
Types of Energy Audits
There are three types of audits that are described below in order of increasing degree of
detail.
1. Walk-through audit. This is the least expensive. It involves an examination of

the building or facility, including a visual inspection of each of the associated
systems. Historic energy usage data are reviewed to analyze patterns of energy
use and compare them with sector/industry averages or benchmarks for similar
structures. The walk-through audit provides an initial estimate of potential savings
and generates a menu of inexpensive savings options usually involving incremental
improvements in Operations and Maintenance. Information from this level of
audit also serves as a basis for determining if a more comprehensive audit will be
needed.
2. Standard Audit. This involves a more comprehensive and highly detailed

Check Your Progress
evaluation. Facilities, equipment, operational systems and conditions are assessed Does energy audit happen
in India ?
thoroughly and on-site measurements and testing are conducted to arrive at a
careful quantification of energy use, including losses. The energy efficiencies of
the various systems are determined using accepted energy engineering
computational techniques. Technical changes and improvements in each of the
systems are analyzed to determine the corresponding potential energy and cost
savings. In addition, the standard audit will include an economic analysis of the
proposed technological improvements and energy cost management.
3. Computer Simulation. The computer simulation approach is the most expensive

and often is recommended for more complicated systems, structures or facilities.
: 287
Introduction to This involves using computer simulation software for prediction purposes (i.e.,
Management Control
Systems performance of buildings and systems) and consideration of effects of external factors
(e.g., changes in weather and other conditions). With the computer simulation audit, a
NOTES
baseline related to a facility’s actual energy use is established, against which effects of
system improvements are compared. This audit often is used for assessing energy
performance of new buildings based on different design configurations and equipment
packages.
Social audit
Social audit as a term was used as far back as the 1950s. There has been a flurry of
activity and interest in the last seven to eight years in India and neighboring countries.
Voluntary development organizations are also actively concerned.
Social audit is based on the principle that democratic local governance should be carried
Check Your Progress out, as far as possible, with the consent and understanding of all concerned. It is thus
Is social audit relevant and a process and not an event.
necessary ?
Meaning of Social Audit
A social audit is a way of measuring, understanding, reporting and ultimately improving

an organization’s social and ethical performance. A social audit helps to narrow gaps
between vision/goal and reality, between efficiency and effectiveness. It is a technique
to understand, measure, verify, report on and to improve the social performance of the
organization.
Social auditing creates an impact upon governance. It values the voice of stakeholders,
including marginalized/poor groups whose voices are rarely heard. Social auditing is
taken up for the purpose of enhancing local governance, particularly for strengthening
accountability and transparency in local bodies.
The key difference between development and social audit is that a social audit focuses
on the neglected issue of social impacts, while a development audit has a broader
focus including environment and economic issues, such as the efficiency of a project
or programme.
: 288
Background Introduction to
Management Control
Systems
In the United States and Europe during the 60s, public repudiation of the war in Vietnam
triggered a movement to boycott the goods and shares of some companies that were NOTES
associated with the conflict. Society demanded a new ethical attitude and some companies
began to provide accounts for their social actions and objectives. Drawing up and publishing
annual reports containing information of a social nature led to what we now know as “the Check Your Progress
social audit”. In Brazil the idea began to be discussed in the 70s, but only in the 80s the Is social audit relevant and
necessary ?
first social audits were published. From the 90s onward, corporations of various sectors
began to publish their results annually.
The issue only gained national attention in June 1997 when sociologist Herbert de Souza
- Betinho - launched a campaign for companies to publish their social audit on a volunteer
basis. With the support and participation of prominent business personalities, the campaign
took off and led to a series of debates in the media and in seminars and forums. The
initiative has now succeeded and what is now underway is a process of shaping another
mentality and innovative practices amid the business sector.
Objectives of social audit
1. Assessing the physical and financial gaps between needs and resources available
for local development.
2. Creating awareness among beneficiaries and providers of local social and

productive services.
3. Increasing efficacy and effectiveness of local development programmes.
4. Scrutiny of various policy decisions, keeping in view stakeholder interests and

priorities.
5. Estimation of the opportunity cost for stakeholders of not getting timely access
to public services.
: 289
Introduction to
Beneficiaries of social audit
Management Control
Systems The social audit benefits all groups involved with the company’s activities. It provides
NOTES useful information for directors to make decisions regarding the social programs the
company sponsors. Preparing the social audit stimulates the employees to take part in
choosing social actions and projects, thus improving internal communication and
integration between managers and staff.
Suppliers and investors learn how the company faces its responsibilities with regard to
human resources and the environment, which is a good indicator of how the company is
Check Your Progress
run. The social audit shows consumers its philosophy and the quality of the product or
Is social audit relevant and
necessary ? service that is provided, pointing to the way the company chooses to make itself known.
The State also benefits through the identification and formulation of social policies.
Advantages of social audit
(a) Trains the community on participatory local planning.
(b) Encourages local democracy.
(c) Encourages community participation.
(d) Benefits disadvantaged groups.
(e) Promotes collective decision making and sharing

responsibilities.
(f) Develops human resources and social capital
To be effective, the social auditor must have the right to:
1. Seek clarifications from the implementing agency about any decision-making,

activity, scheme, income and expenditure incurred by the agency;
2. Consider and scrutinize existing schemes and local activities of the agency; and
3. Access registers and documents relating to all development activities undertaken

by the implementing agency or by any other government department.
Some examples of social audit have been highlighted by Srivastava and Chandan
Datta(2003) in their discussion about the Panchyati Raj model in India.
: 290
Examples of social audit Introduction to
Management Control
Systems
1. Social audit in Jharnipalli Panchayat, Agaipur block, Bolangir district, Orissa
NOTES
In October 2001, the gram sabha members of Jharnipalli Panchayat conducted a one-
day social audit of development works carried out in the Panchayat over the preceding
three years. This audit took place with the active participation of many individuals and
agencies, including block and district administration officials, MKSS [Mazdoor Kisan
Shakti Sanghatan], NCPRI [National Campaign for People’s Right to Information] and
Action Aid India.
The audit found that:
· Although the works were not carried out, the sanctioned funds were shown in
the records as having been utilized.
· Contractors were banned under government guidelines, but 31 contractors were

working on the project.
· Muster rolls were not maintained by the contractors.

Check Your Progress
Is social audit relevant and
necessary ?
· Instead of the target of 100 man-days of employment for families below the
poverty line (BPL), only 12 half days of work were generated.
· The BPL families could not buy subsidized food from the public distribution system
(PDS) shops as partial wages because they did not possess the needed ration
cards.
2. Micro-development planning as part of social audit
A voluntary development organization Samarthan and PRIA (Society for Participatory

Research in Asia) collaborated in a participatory micro-planning exercise with local officials,
panchayat members, members of different castes, etc. The process endeavors to bring
resources to the local community and increase its involvement in Gram Sabha meetings
which takes place four times a year.
This led to the identification of several goals. One of them was to construct a drain.
Inspired by the participatory local planning process, the community contributed half the
: 291
Introduction to cost of the drain (Rs 50 000). Those who could not give money offered their labour. The
Management Control
Systems rest of the money came from the district office and was mobilized by the Gram
Panchayat and its pro-active woman president, the Sarpanch.
NOTES
Every member of the Gram Sabha developed a sense of ownership of the project. The
Gram Sabha monitors the work. Gram Panchayat representatives also hold regular
ward-level meetings. The relationship between people and their local representatives
developed quickly into one of mutual support.
16.12 Ethics in Business and Role of Control

Ethics in business came into common use in the United States in the early 1970s. The
Society for Business Ethics was started in 1980. European business schools adopted
business ethics after 1987 commencing with the European Business Ethics Network
(EBEN). Business ethics is a form of applied ethics or professional ethics that examines
ethical principles and moral or ethical problems that arise in a business environment.
The control function of management can be a critical determinant of organizational

success. After strategies are set and plans are made, management’s primary task is to
take steps to ensure that these plans are carried out, or, if conditions warrant, that the
plans are modified. This is the critical control function of management and since
management involves directing the activities of others, a major part of the control function
is making sure other people do what should be done. Businesses should eventually
benefit the community and society and certainly not harm them. To ensure this, it becomes
important that they operate within an ethical framework.
Business ethics is usually understood as the study of business situations, activities, and
decisions where issues of right and wrong are addressed.
Implications for Business
Business ethics can be both a normative and a descriptive discipline. As a corporate

practice and a career specialization, the field is primarily normative. In academia
descriptive approaches are also taken. The range and quantity of business ethical issues
reflects the degree to which business is perceived to be at odds with non-economic
: 292
social values. Today most major corporations promote their commitment to non-economic Introduction to
Management Control
values under headings such as ethics codes and social responsibility charters. Systems
Governments use laws and regulations to point business behaviour in what they perceive NOTES
to be beneficial directions. Ethics implicitly regulates areas and details of behaviour that
lie beyond governmental control. The emergence of large corporations with limited
relationships and sensitivity to the communities in which they operate accelerated the
development of formal ethics regimes.
Ethics in actionThe Tata Steel Group is proud of its longstanding reputation as a fair
and caring employer, and respects all human rights both within and outside the workplace.
The Tata Code of Conduct stipulates that all employees have a personal responsibility to
help preserve the human rights of everyone at work and in the wider community.
16.13 Summary
Businesses usually put in place certain controls effected by an entity’s board of directors,
management and other key personnel, developed to provide reasonable assurance
regarding the accomplishment of objective in terms of effectiveness and efficiency of
operations, reliability of financial reporting, and compliance with legal issues and
regulations. Such controls are known as internal controls. Every employee has some
responsibility for making this internal control system function. Therefore, all employees
need to be aware of the concept and purpose of internal controls. There are several
types of audit that help in strengthening controls in a business. Some popular types of
auditing include internal audit, cost audit, efficiency audit, management audit and lately
even energy audit.
Internal audit is an independent, objective assurance and consulting activity designed to

add value and improve an organization’s operations.Cost Audit is defined as a system of
audit introduced by the Government of India for the review, examination and appraisal of
the cost accounting records and attendant information, required to be maintained by
speciûed industries.An economy and efficiency audit might analyze the procurement,
maintenance and implementation of resources, such as equipment, to identify areas that
require improvement.
: 293
Introduction to The objective of a management audit is to appraise the effort of management team as
Management Control
Systems a whole rather than rewarding individual performances.It allows to find out the inefficiency
in terms of collaborative effort of the management team needs to be delivered. A social
NOTES
audit is a way of measuring, understanding, reporting and ultimately improving an
organization’s social and ethical performance. A social audit helps to narrow gaps in
terms of perceived value an organization should have in the eyes of stakeholders and
society.Businesses should eventually benefit the community and society and certainly
not harm them. To ensure this, it becomes important that they operate within an ethical
framework.Business ethics is usually understood as the undefined perceived code of
conduct that needs to be followed in business situations, events, and decisions where
issues of right and wrong are addressed.
16.14 Key Terms

An audit is an official, professional, independent examination and verification
of a company’s financial statements and accounting documents in accordance
to generally accepted auditing standards
Internal audit is an independent, objective assurance and consulting activity

developed to add value and improve an organization’s operations.
Cost Audit is defined as the verification of Cost Accounts and a check on the
adherence to the Cost Accounting plan.
Social audit is based on the principle that democratic local governance should
be carried out, as far as possible, with the consent and understanding of all
concerned.
16.15 Questions
1. Energy audits identify economically justified, cost-saving opportunities that result

in significantly lowered electrical, natural gas, steam, water and sewer costs.
: 294
2. Controls play an important role in keeping businesses on track and audit plays an Introduction to
Management Control
important role in ensuring controls. Systems
3. Internal control system comprises of purely accounting control and does not NOTES
imply control of any other business functions.
4. The social audit benefits all groups involved with the company’s activities by
providing useful information for directors to make decisions regarding profitability
of business.
5. Social auditing is taken up for the purpose of enhancing local governance and
helping government to function profitably.
6. Management audit is always followed up with an external review to determine

the opinions and attitudes key people outside the organization have about its
operations.
7. Information gathered from the energy audit can be used to introduce energy
conservation measures or appropriate energy-saving technologies, such as
electronic control systems, in the form of retrofits.
1. It is a process affected by an organization to provide reasonable assurance

regarding the effectiveness and efficiency of operations, reliability of financial
reporting and compliance with related rules and regulations.
2. These controls are designed to find errors or irregularities after they have
occurred.
3. The verification of Cost Accounts and a check on the adherence to the Cost
Accounting plan
4. The extent to which time, effort or cost is well used for the intended task or
purpose is usually called as
5. A detailed audit that concentrates on analysis and evaluation of management

procedures and the overall performance of an organization.
: 295
Introduction to 6. This audit identifies where energy is consumed and how much energy is
Management Control
Systems consumed in an existing facility, building or structure
NOTES 7. This audit is a way of measuring, understanding, reporting and ultimately improving
an organization’s social and ethical performance.
8. This is usually understood as the study of business situations, activities, and

decisions where issues of right and wrong are addressed.
1. What is Internal Control? Why do businesses need them?
2. Explain Internal Audit and its role in business.
3. Do all businesses carry out cost audit? What is the role of cost audit?
4. What is Efficiency Audit and how is it useful for business?
5. Why is Energy Audit done?
6. Briefly explain the types of Energy Audit.
7. How is Social Audit useful for business and community?
8. What is the role of Ethics in Control and Business?
K. B. Srivastava, Chandan Datta, 2003; in The Panchayati Raj model in

India by S.P. Jain & Wim Polman ,Food and Agricultural Organisation, RAP
publication 2003/07
“How to Conduct an Energy Audit: A Short Guide for Local Governments

and Communities”-Prepared by: New Jersey Department of Environmental
Protection Office of Planning and Sustainable Communities
: 296

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Introduction to

Unit 1: Introduction to Management Control Systems

Unit 3: Designing Management Controls

Unit 4: Key Success Variables and Performance Measurement

Unit 5: Behaviour in Organisations

Unit 6: Responsibility Centres

Unit 7: Performance Evaluation of Responsibility Centres

Unit 8: Profit Centre

Unit 9: Transfer Pricing

Unit 10: Issues in Transfer Pricing

Unit 11: Measuring and Controlling Assets Employed

Unit 12: Budgets, Responsibility Accounting and Budgetary Control

Unit 13: Multinational Organisations

Unit 14: Management control process in service organizations

Unit 15: MCS in Project Management

Unit 16: Role of Audit in Control Systems

Yashwantrao Chavan Maharashtra Open University

Vice-Chancellor : Prof. Dr. E. Vayunandan

Director,School of Commerce & Management : Dr.Pandit Palande

NATIONAL ADVISORY BOARD

Dr. Pandit Palande Prof.Devanath Tirupati, Dr. Surendra Patole Assistant

Dr. K.S.Ranjani FCA,CWA,M.Phil(Comm)PhD Dr.Varadraj Bapat, M.com,FCA,CWA,PhD

Instructional Technology Editing & Programme Co-ordinator

Dr. Latika Ajitkumar Ajbani

Shri. Anand Yadav

Unit 3: Designing Management Controls 37 NOTES

Unit 4: Key Success Variables and Performance Measurement 50

Management Control Environment

The organization structure depends upon the management control environment.

Management Control Process

Variations in Management Control

Role of Audit in management control

1.1 Unit objectives

So what exactly is this control? Control can be viewed as a process by which

1.3 Evolution of Management Control Theories

· Each part of an organisation is driven by a goal or purpose- for example, a sales

· Different parts of the organisation functions for different purposes-some parts

· Autonomy is granted to various parts of the organisation to fulfil their respective

1.5 Elements of Control Systems

An assessor is a device that determines the significance of what is happening by

1.5.4 Communication network

Check Your Progress

Figure 1.1: Elements of Control System :9

· It is expensive to design controls and implement them in organizations. For

· It is cumbersome to make investment in systems and processes. Several

· There are possibilities of failure of controls considering the complexities

· Controls facilitate “management by exception”. Regular feedback, which is a

· Systems and processes are facilitators of efficiency. Whenever systems are

· Controls provide for a self-correcting mechanism. For example if sales return

1.7 Complexities in designing management control

NOTES · Management control is not automatic. It involves lot of discretionary

· Unlike simple control systems, management control involves coordination

· Most of Management Control is self-control. Unlike devices that have clear

· Coordination- For the plans to be implemented successfully, a great degree of

· Communicating plans and the process controls using suitable information

· Management control process not only involves communication of information

· Control process is incomplete without initiation of corrective actions, financial

1.10 Strategic Planning

1.11 Operational Control

Check Your Progress

Figure 1.2: Scope of Management Control

: 16 inputs can be controlled, management control involves a combination of organisation,

1.15 Key Terms