Management Control System

Role of management control in capital budgeting decisions

Submitted by
Parth Garg (091202006)
Ankit Sharma (091202034)
Naushad Ali
Trupti Fernandez
Akshatha Amin
Section A
2nd year

Submitted to

Mr.Ajay Shah
Faculty MIM
PROJECT OUTLINE
Management Control system

Management control process is the process by which the managers influence other members
of the organization to implement the organizational strategies. This management control
process is carried out through a system called as a management control system.every control
system has at least 4 alternatives. They are:

1. Detector: is a device that measures what is actually happening in the process of being
controlled.
2. Assessor: is a device that determines the significance of what is actually happening by
comparing it with some standard or expectation of what should happen.
3. Effecter: a device that alters behavior if the assessor indicates the need to do so
4. A communication network: a device that transmits information between the detector
and the sensor and between the assessor and the effecter.

Control
device
Assessor

Detector

Effector

Entity being
controlled

Figure 1
Nature of Investment Decisions
Investment decisions are of based on many factors having different nature. They are:
 An efficient allocation of capital is the most important finance function.
 Investment decisions determine the firm’s value size by influencing its growth,
profitability and risk.
 They include not only those that create revenues and profits but also those that save
money.
 They relate to Assets composition (FAs + CAs) of a Firm.
 They also known as Capital Budgeting or Capital Expenditure Decisions
Meaning of Capital Budgeting

It is defined as “the Firm’s decision to invest its current funds most efficiently in the long-
term assets in anticipation of an expected flow of benefits over a series of years”.The
exchange of current funds for future benefits. The funds are invested in Long-term assets.
The future benefits will occur to the firm over a series of years. They include:
– Expansion
– Modernization and Replacement
– Acquisition
– Sale of a Division or Business (Divestment)
– Change in the method of Sales Distribution
– Advertisement Campaigns
– R&D Programs

Features of Capital Budgeting Decisions

Capital budgeting decision has following features:

 The exchange of current funds for future benefits
 The funds are invested in Long-term assets
 The future benefits will occur to the firm over a series of years.
 The expenditures and benefits of an investment should be measure in cash

Objective of Capital Budgeting Decisions

Capital budgeting decision has following objective:

 To identify those assets (investments) which are worth more than their costs.

Importance of Capital Budgeting Decisions

Capital Budgeting Decisions has following importance:

 They influence the Firm’s growth in the long run

 They affect the risk of the firm
 They involve commitment of large amount of funds
 They are irreversible, or reversible at substantial loss
 They are among the most difficult decisions to make.

Types of Capital Budgeting Decisions

Capital Budgeting Decisions are of two types depending on:

1. Firm’s existence point of view

A. New Firm
 Selection of a Plant
  Capacity utilization at initial stages
 Set up on not simultaneously an Ancillary unit
 Selection of location of Plant

B. Existing Firm:
 Replacement and Modernization
 Expansion
 Diversification

2. From Decision situation point of view

A. Mutually Exclusive Decisions: those decisions which are exclusive but are mutual.
B. Independent Decisions: those decisions that are completely independent of one
another’s effects
C. Contingent Decisions: those decisions which are likely to be effected by other
decisions and also might affect few decisions

Process of Capital Budgeting Decisions

Any Capital Budgeting Decisions process follows the underwritten 9 steps

1. Project/Idea generation
2. Developing Alternatives
3. Evaluation of Alternatives
4. Estimation of Cash Flows
5. Estimation of the required rate of return (the Opportunity cost of capital)
6. Application of a Decision rule for making the choice
7. Selection of the Project/Alternative
8. Implementation
9. Performance Review

Investment rules

Capital Budgeting Decisions involve application of decision rule to evaluate and selective a
alternative. Various investment rules that can act as decision criteria are as follows:

 It should maximise the shareholders’ wealth.

 It should consider all cash flows to determine the true profitability of the project.
 It should provide for an objective and unambiguous way of separating good projects
from bad projects.
 It should help ranking of projects according to their true profitability.
 It should recognise the fact that bigger cash flows are preferable to smaller ones and
early cash flows are preferable to later ones.
 It should help to choose among mutually exclusive projects that project which
maximises the shareholders’ wealth.
It should be a criterion which is applicable to any conceivable investment project independent
of others
Implementation of Capital budgeting decision through management control process

Estimation
Developing Evaluation of cash flow
alternatives of and
Project/plan alternatives required
rate of

Control Device
return

Detector Assessor

Decision rule:
maximization of
shareholders
wealth

Performance Implementation Selection of

review project

Effecter
Figure 2

In figure 2 an attempt has been made to apply the logic of management control system which
we see in figure 1 to the process involved in capital budgeting decisions. We have broken the
process of capital budgeting decision into 4 parts and classified them into 4 parts of
management control system, each describing by way of example of how management control
is playing a role in capital budgeting decision. They are explained as follows:

1. Detector: here detector consists of 1st step of process of capital budgeting decision i.e.
project/ plan. Suppose a company wants to improve its scale of operations and
increase its output. In order to achieve that it plans to expand its existing plant
capacity to increase output. This decision is acknowledged by detector as plan or
project selected.

2. Assessor: assessor consists of step 2 to 3 of process of capital budgeting decision i.e.

from developing of alternatives to their evaluation. Assessor now develops various
alternatives to the existing plan and evaluates these alternatives like acquiring a new
facility or setting up a new plant. The evaluation can be done on any decision
criteria/criteria’s that will be set by management like ranking projects on basis of ROI
 or deciding on projects which gives maximization of shareholders wealth. If the
selected plan by detector does not match the decision criteria, it’s abandoned and the
process of decision making again goes back to the developing alternatives.

3. Effector: it consists of step 7 of process of capital budgeting decision i.e. selection of

alternative. Once the alternative, plan or project is passed by the assessor it is selected
by the assessor. Example the assessor might not allow expansion of existing facility
and recommends opening of a new facility. This project is now selected and
implemented.

4. Communication network: is the two way flow of information between various

departments of the company that are involved in the decision making process like
accounts department, finance department, market research team, strategy formulation
team, various financial calculations and analysis exchanged between them