BA 221: Management Control Systems

FINAL EXAM

I. Management Control Systems

a. Robert Anthony
i. Process of ensuring the actual operations conform to planned standards of effectiveness
and efficiency
b. Govintarajan
i. Process by which managers influence other members of the organization to implement
the organization’s strategies
c. Microeconomics
i. Process of addressing agency problems (gaps)
1. Gaps  internal control system
II. The Nature of Management Control and Organizational Behavior Goals and Strategies Information
a. Elements of Management Control Systems
i. Strategic Planning
ii. Budgeting
iii. Resource Allocation
iv. Transfer Pricing
b. Control
i. Devices must be in place to ensure that its strategic intentions are achieved
ii. Elements of a Control System
1. Detector/ Sensor
a. Device that measures what is actually happening in the process being
controlled
2. Assessor
a. Device that determines the significance of what is actually happening by
comparing it with some standard or expectation of what should happen
3. Effector
a. Device (feedback) that alters behavior if the assessor indicates the need
to do so
4. Communication Network
a. Devices that transmit information between the detector and the assessor
and between the assessor and the effector

c. Management

1 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 i. An organization consists of a group of people who work together to achieve certain
common goals
ii. Led by a hierarchy of managers – with the CEO at the top. Complexity of the organization
determines the number of layers in the hierarchy
iii. Management Control Process
1. Process by which managers at all levels ensure that the people they supervise
implement their intended strategies
iv. Types of Management Control
1. Strategy Formulation
a. Least systematic
b. Focuses on the long run
c. Rough approximations of the future
d. Focus on the planning process
2. Task Control
a. Most systematic
b. Short-run activities
c. Uses current accurate data
d. Focus on the control process
3. Management Control
a. In between the 2
b. Process by which managers influence other members of the organization
to implement the organization’s strategies

v. Management Control Activities

1. Planning
2. Coordinating
3. Communicating
4. Evaluating
5. Deciding
6. Influencing
vi. Goal Congruence
1. In so far as feasible, the goals of an organization’s individual members should be
consistent with the goals of the organization itself
2. MCS should be designed and operated with the principle of GC in mind
vii. Organizational Structure

2 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 1. Specifies the roles, reporting relationships, and division of responsibilities that
shape decision-making within an organization
viii. Human Resource Management
1. Selection, training, evaluation, promotion, and termination of employees so as to
develop the knowledge and skills required to execute organizational strategy.
2. Culture
a. Common beliefs, attitudes, and norms that explicitly or implicitly guide
managerial actions

ix. Interactive Control

1. Calls management’s attention to developments – both negative and positive, that
indicate the need for new strategic initiatives
2. Today’s Controls  Tomorrow’s Strategy
x. Strategy Formulation
1. Process of deciding on the goals of the organization and strategies for attaining
these goals.
a. Goals
i. Overall aims of an organization
ii. TIMELESS – exist until changed; changed rarely
b. Objectives
i. Specific steps to accomplish goals within a given time frame
2. Big, important plans. States the direction in which senior management wants the
organization to move
3. Complete responsibility for strategy formulation should never be assigned to a
particular person organizational unit
4. SF vs MC
a. SF – process of deciding on new strategies
i. Involves relatively few people
b. MC – process of implementing those strategies
i. Involves managers and their staff at all levels
xi. Task Control
1. Process of ensuring that specified tasks are carried out effectively and efficiently
2. Transaction-oriented
a. Involves the performance of individual tasks according to rules
established in the management control process
3. Devices
a. Numerically-controlled machine tools

3 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 b. Process control computers
c. Robots
xii. TC vs MC
1. TC
a. Most are scientific
b. Focuses on specific tasks performed by the units
2. MC
a. Involves the behavior of managers
b. Focuses on organizational units

d. Systems
i. A prescribed and usually repetitious way of carrying out an activity or a set of activities
ii. More or less rhythmic, coordinated, and recurring series of steps intended to accomplish
a specified purpose
iii. “If all systems ensured the correct action for all situations, there would be no need for
human managers”
III. Understanding Goals and Strategies
a. Profitability
i. Usually the most important goal

b. Investment (debt + equity)

i. “shareholders’ investment”/ equity
1. Amount of financing that wasn’t obtained by debt/ borrowing
ii. Consists of proceeds from the issuance of stock + retained earnings
c. Risk
i. Stake in the company
d. Multiple Stakeholder Approach

4 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 i. Participation in 3 markets
1. Capital Market
a. Where they raise funds
2. Product Market
a. Where they sell its goods and services
3. Factor Market
a. Where it competes for resources such as human capital and raw materials

Kenneth R. Andrews: “Strategy Formulation is a process that senior executives use to evaluate a company’s
strengths and weaknesses in light of the opportunities and threats present in the environment and then to
decide on strategies that fit the company’s core competencies with environmental opportunities.”

e. Corporate-Level Strategy
i. Concerned with the question of WHERE to compete
1. Business Units Strategy: HOW
ii. Issues
1. Definition of businesses in which the firm will participate in
2. Deployment of resources among those businesses
iii. Classification of Companies

5 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 1. Single Industry Firm
a. Operates in one line of business
b. Example: Mobil - petroleum
2. Related Diversified Firm
a. Operates in several industries and their business are connected to each
other through operating synergies
i. Types of linkages
1. Ability to share common resources
2. Ability to share common core competencies
ii. Example: common salesforce and common logistics
b. Example: P&G – diapers, detergent, soap, toothpaste, etc.
3. Unrelated Business Firm
a. Operates in businesses not related to one another
b. Example: Textron – writing instruments, helicopters, chain saws, forklifts,
etc.

f. Core Competence
i. What a firm excels at and what adds significant value for customers

6 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 g. Business Unit Mission
i. Resource Deployment
1. Make decisions regarding the use of the cash generated from some business units
to finance growth in other business units

ii. Boston Consulting Group (BCG) Model

1. Every business unit is placed in one of four categories (Question Mark, Star, Cash
Cow, and Dog) that represent the four cells of a 2x2 matrix
a. Measures industry growth rate on one axis and relative market share on
the other
2. Views industry growth rate as an indicator or relative industry attractiveness and
relative market share as an indicator of the relative competitive position of a
business unit within a given industry

7 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 iii. Industry Analysis
1. The Five Forces
a. Starting point for developing a competitive advantage since it helps to
identify the opportunities and threats in the external environment
2. According to Porter, the structure of an industry should be analyzed in terms of
the collective strength of five competitive forces:
a. Intensity of Rivalry among existing Competitors
i. Industry growth, product differentiability, number and diversity of
competitors, level of fixed costs, intermittent overcapacity, and
exit barriers
b. The bargaining power of customers
i. Number of buyers, buyers’ switching costs, buyers’ ability to
integrate backward, impact of the business unit’s product on
buyer’s total costs, impact of the business unit’s product on
buyer’s product quality/ performance, and significance of the
business unit’s volume to buyers.
c. The bargaining power of suppliers
i. Number of suppliers, supplier’s ability to integrate forward,
presence of substitute inputs, and importance of the business
unit’s volume to suppliers
d. Threat from substitutes
i. Relative price/ performance of substitutes, buyer’s switching
costs, and buyer’s propensity to substitute
e. Threat of new entry
i. Capital requirements, access to distribution channels, economies
of scale, product differentiation, technological complexity of

8 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 product or process, expected retaliation from existing firms,
government policy

iv. Competitive Advantage

1. Low Cost
a. Cost leadership can be achieved through such approaches as economies
of scale in production, experience curve effects, tight cost control, and
cost minimization
2. Differentiation
a. “Providing better customer value for an equivalent cost/ customer value
for a lower cost”
b. Differentiate the product offering of the business unit, creating something
that is perceived by customers as being unique
c. Approaches: brand loyalty, superior customer service, dealer network,
product design and features, and technology

v. Value Chain
1. Disaggregates the firm into its distinct strategic activities
2. Complete set of activities involved in a product, beginning with extraction of raw
material and ending with postdelivery support to customers

3. Value Chain Analysis

9 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 a. Seeks to determine where in the company’s operations (from design to
distribution) customer value can be enhanced or costs lowered
b. Helps
c. Key questions:
i. Can we reduce costs in this activity, holding value (revenues)
constant?
ii. Can we increase value (revenue) in this activity, holding costs
constant?
iii. Can we reduce assets in this activity, holding costs and revenue
constant?
iv. Can we do all 3 simultaneously?
d. Value Chain Framework
i. Method for breaking down the chain – from basic raw materials
to end-use customers – into specific activities in order to
understand the behavior of costs and the sources of
differentiation
IV. Behavior in Organizations
a. Goal Congruence
i. The actions people are led to take in accordance with their perceived self-interest are also
in the best interest of the organization
b. Important Questions
i. What actions does it motivate people to take their own self-interest?
ii. Are these actions in the best interest of the organization?
c. Informal factors that Influence GC
i. External
1. Work Ethic
ii. Internal
1. Culture
a. The common beliefs, shared values, norms of behavior, and assumptions
implicitly accepted and explicitly manifested throughout the organization
2. Management Style
3. The Informal Organization
4. Perception and Communication
d. Formal Control System
i. Management Control System
ii. Rules
1. Physical Controls
2. Manuals
3. System Safeguards
4. Task Control Systems
iii. Formal Control Process

10 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 e. Types of Organizations
i. Functional Structure
1. Each manager is responsible for a specified function such as production or
marketing
2. Involves the notion of a manager who brings specialized knowledge to bear on
decisions related to a specific function
ii. Business Unit Structure
1. Business unit managers are responsible for most of the activities of their
particular unit, and the business unit functions as a semi-independent part of the
company
2. Designed to solve problems inherent in the functional structure
3. BU – responsible for all the functions involved in producing and marketing a
specified product line
iii. Matrix Structure
1. Functional units have dual responsibilities

11 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 f. Functions of the Controller (CFO)
i. Person responsible for designing and operating the management control system
1. Designing and Operating information and control systems
2. Preparing financial statements and financial reports (including tax returns) for
shareholders and other external parties
3. Preparing and analyzing performance reports
4. Supervising internal audit and accounting control procedures
5. Developing personnel in the controller organization
V. Responsibility Centers
a. An organization unit that is headed by a manger who is responsible for its activities
b. Exists to accomplish one or more purposes – objectives

c. Common Terms:
i. Revenue – amounts earned from providing outputs

12 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 ii. Cost – monetary measure of the amount of resources used by a responsibility center
iii. Inputs – resources used by a responsibility center
iv. Efficiency – ratio of outputs to inputs, or the amount of output per unit of input
1. Comparative usage
a. Output with least resources used
b. Most output with same level of resources
v. Effectiveness – relationship between a responsibility center’s output and its objectives;
achievement of goals

“A responsibility center is efficient if it does things right, and its effective if it does the right things.”

vi. Profit
1. Difference between revenue (measure of output) and expense (measure of input)
2. Measure of efficiency and effectiveness

d. Types of Responsibility Centers

i. Revenue
1. Output is measured in monetary terms, but no formal attempt to relate input
(expense or cost) to output

13 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 2. Usually marketing/sales units that don’t have authority to set selling prices and
are not charged for the cost of the goods they market
ii. Expense
1. Inputs are measured in monetary terms, but whose outputs are not
2. Types
a. Engineered (quantifiable)
i. “right” or “proper” amount can be estimated with reasonable
reliability
ii. Characteristics:
1. Input can be measure in monetary terms
2. Output can be measured in physical terms
3. Optimum dollar amount of input required to produce one
unit of output can be determined
iii. Usually in manufacturing operations
iv. The supervisors are responsible for the quality of the products
and the volume of production, efficiency
1. Ensures that manufacturing costs are not minimized at
the expense of quality
b. Discretionary
i. “Managed Costs”
ii. No such engineered estimate is feasible
iii. Depend on Management’s judgment as to the appropriate
amount under the circumstances
iv. Difference between budget and actual expense is not a measure
of efficiency
v. “Management by Objectives” – formal process in which a
budgeter proposes to accomplish specific jobs and suggests the
measurement to be used in performance evaluation
vi. Planning function:
1. Incremental Budgeting
a. Current level of expenditure is taken as starting
point
b. Cons: increased level of services = Parkinson’s
Second Law: overhead costs tend to increase
2. Zero-Base Review
a. “Downsizing”, “Rightsizing” or “restructuring”, or
“process reengineering”
b. Analysis of each DE on a rolling schedule – TIME-
CONSUMING
c. Attempts to analyze from scratch
d. Financial Control
i. Done at the planning stage BEFORE the
costs are incurred
e. TOTAL CONTROL over discretionary expense
centers is achieved primarily through
nonfinancial performance measures
iii. Profit
1. Responsibility center’s financial performance is measure in terms of profit

14 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 2. Conditions for Delegation:
a. Manager should have access to the relevant information needed for
making such a decision
b. There should be some way to measure the effectiveness of the trade-offs
the manager has made
3. Advantages
a. Quality of decisions – managers are close to the point of decision
b. Speed of operating decisions
i. Increased since they do not have to be referred to corporate
headquarters
c. HQ management can concentrate on broader issues
d. Managers are freer to use their imagination and initiative
e. Similar to independent companies – provide excellent training ground for
general management
f. Profit consciousness is enhanced
i. Managers will constantly seek ways to increase profit
g. Provides management with ready-made information on the profitability
of the company’s individual components
h. Output is readily measured – responsive to pressures to improve their
competitive performance
4. Challenges
a. Decentralized decision-making forces top management to rely on reports
over personal knowledge – loss of control
b. Quality of decisions – reduced if PC manager is less competent than the
HQ manager
c. Friction because of appropriate transfer price to be used, assignment of
common costs, and credit for revenues
d. Increased competition amongst organization units
e. Divisionalization – more org units = additional costs
f. Lack of competent general managers
g. Too much emphasis on short-run profitability
h. NOT EQUAL: individual PC and the company profitability
5. Types of Decisions
a. Product – what to goods or services to make and sell
b. Marketing – how, where, and for how much are these goods or services
to be sold
c. Procurement or Sourcing – how to obtain or manufacture the goods or
services
6. Other PCs
a. Marketing
i. If charged with the cost of the products sold
1. Transfer price provides the marketing manager with the
relevant information to make the optimum revenue/cost
trade-offs and checks how well these trade-offs have
been made
2. Transfer price should be based on STANDARD COST of the
products being sold

15 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 a. This separates the marketing cost performance
from that of the manufacturing cost performance
b. Manufacturing
i. To give credit for the selling price of the products minus
estimated marketing expenses
c. Service and Support Units
i. Charge customers for services rendered, with the financial
objective of generating enough business so that their revenues
equal expenses
7. Measuring Profitability
a. Types
i. Management Performance
1. How well the manager is doing
2. Used for planning, coordinating, and controlling the profit
center’s day-to-day activities and as a device for providing
the proper motivation for its manager
ii. Economic Performance
1. How well the PC is doing as an economic entity

8. Profitability Measures
a. Contribution Margin
i. Spread between Revenue and Variable Expenses
ii. Maximization of contribution
b. Direct Profit
i. Reflects the PC’s contribution to the general overhead and profit
of the organization
ii. Does not include HQ expenses
1. Weakness: Does not recognize the motivational benefit of
charging HQ costs
c. Controllable Profit
i. What remains after the deduction of all expenses that may be
influenced by the profit center manager
ii. Disadvantage: excludes noncontrollable HQ expenses it can’t be
directly compared with either published data or trade association
data reporting the profits of other companies in the industry

16 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 d. Income Before Income Taxes
i. All corporate overhead is allocated to PC on relative amount of
expense each profit center incurs
ii. Arguments: corporate staff costs are not controllable and
allocation may be difficult
1. But this keeps HQ office in check
e. Net Income
i. Measures the performance of domestic PC according to the
bottom line (amount of net income after income tax)
ii. Arguments:
1. After-tax income is often a constant percentage of the
pre-tax income
a. No advantage in incorporating income taxes
2. It’s not appropriate to judge PC managers on the
consequences of HQ decisions
9. Revenue Recognition Considerations
a. When order is made
b. When an order is shipped
c. When cash is received
10. Management Considerations
iv. Investment
1. Relationship of profit and investment
a. To motivate business unit managers to accomplish objectives
v. Administrative
1. Include senior corporate management and business unit management, along with
the managers of supporting staff units
2. Challenges:
a. Problems inherent in measuring output
i. Outputs are advice and service
b. Frequent lack of congruence between the goals of departmental staff and
of the company as a whole
vi. Support
1. Units that provide services to other responsibility centers
vii. Research and Development
1. Usually has at least a semi tangible output in the form of patents, new products,
or new processes
2. The relationship of output to input is difficult to appraise on an annual basis
because the completed “product” of an R&D group may involve several years of
effort
3. Characteristics:
a. Unplanned – with management at best specifying the general area to be
explored
b. There is often a significant time lapse between the initiation of research
and the introduction of a successful new product
viii. Marketing
1. Activities/ Order-Getting Activities
a. Filing of Orders
i. Order filing or logistics activities

17 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 ii. Take place AFTER and order has been received
iii. Moving from company to customers
iv. Mostly an engineered expense
b. Obtaining Orders
i. Marketing activities; generation of revenue
ii. Take place BEFORE an order has been received
iii. Evaluated by comparing actual revenue and physical quantities
sold with budgeted revenue and budgeted units
c. Order-Getting Costs
i. Discretionary – no one knows what the optimum amounts should
be
2. Expense = Percentage of budgeted sales
a. Higher the sales volume, the more the company can afford to spend on
advertising
VI. Transfer Pricing
a. Method of accounting for the transfer of goods and services from one profit center to another in
companies that have a significant number of these transactions
b. Mechanism for distributing revenue
c. TRANSFER PRICE
i. Amount used in accounting for any transfer of goods and services between responsibility
centers
ii. Value placed on a transfer of goods and services in transactions in which at least one of
the two parties involved is a profit center (should involve a profit)
d. Fundamental Principle
i. Transfer prices should be similar to the price that would be charged if the product were
sold to outside customers or purchased from outside vendors
ii. Decisions
1. Sourcing Decision
a. Should the company produce the product inside the company or
purchase it from an outside vendor?
2. Transfer Price Decision
a. If produced inside, at what price should the product be transferred
between profit centers?
e. Example Scenarios
i. Ideal Situation  Market Price-based transfer price
1. Induces goal congruence if all of the following conditions exist:
a. Competent People
b. Good Atmosphere
c. A Market Price
d. Freedom to Source
e. Full Information
f. Negotiation
ii. Constraints on Sourcing
1. Limited Markets
a. Price within is based on:
i. Published market prices are available
ii. Market Prices may be set by bids

18 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 iii. Production profit center sells similar products in outside markets,
it is often possible to replicate a competitive price on the basis of
the outside price
iv. If the buying profit center purchases similar products from the
outside, it may be possible to replicate competitive prices for its
proprietary products
2. Excess or Shortage of Industry Capacity

“If the market price exists or can be approximates, use it. However, if there is no way approximating valid
competitive prices, the other option is to develop cost-based transfer prices.”

f. Cost-Based Transfer Prices

i. Decisions to be made:
1. How to define cost
2. How to calculate the profit markup
ii. Cost Basis
1. Standard Costs
a. If used, an incentive is needed to set tight standards and improve
standards
iii. Profit Markup
1. Decisions
a. What the profit markup is based on
b. Level of profit allowed
2. Usually based on percentage of costs
a. BUT no account is taken of capital required
3. Conceptually better if Percentage of Investment is used
a. Problem: if historical cost of the fixed assets is used, new facilities
designed to reduce prices could actually increase costs because old assets
are undervalued
g. Objectives
i. Should provide each business unit with the relevant information it needs to determine
the optimum trade-off between company costs and revenues
ii. Should induce GOAL CONGRUENCE decisions
1. System should be designed so that decisions that improve business unit profits
will also improve company profits
iii. Should help measure the economic performance of the individual business units
iv. Should be simple to understand and easy to administer
h. Upstream Fixed Costs and Profits
i. Methods of mitigating the increase in internal purchase price:
1. Agreement among Business Units
a. Works only if the review process is limited to decisions involving a
significant amount of business to at least one of the profit centers;
otherwise, the value of these negotiations may not be worth the effort.
2. Two-Step Pricing
a. Establish a transfer price that includes two charges (one or both of these
components should include a profit margin):
i. For each unit sold, a charge is made that is equal to the standard
variable cost of production

19 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 ii. A periodic (usually monthly) charge is made that is equal to the
fixed costs associated with the facilities reserved for the buying
unit.
b. TSP corrects misinformation of VC to make decisions: by transferring VC
on a per-unit basis and transferring fixed cost and profit on a lump sum
basis.
i. VC is the same
ii. FC is based on the capacity reserved for the production of
product A that is sold to Unit Y
c. Points to Consider:
i. Monthly charge for FC and Profit should be negotiated
periodically and will depend on the capacity reserved for the
buying unit
ii. Questions may be raised about the accuracy of the cost and
investment allocation
1. Decision of how much capacity to reserve for the various
products
2. If capacity is reserved for a group of products sold to a
business unit, there is no need to allocate FC and
investment to individual products in the group
iii. Manufacturing unit’s profit performance is not affected by the
sales volume of the final unit
1. Solves: marketing efforts by other business units affect
the profit performance of a purely manufacturing unit
iv. Conflict between the interests of the manufacturing unit and
those of the company
v. Similar to “take or pay” of public utilities, pipelines, and coal
mining companies (long term contracts)
3. Profit Sharing
a. Used to ensure congruence between business unit and company interests
b. Operation:
i. Product is transferred to the marketing unit at standard variable
cost
ii. After product is sold, the business units share the contribution
earned, which is the selling price minus the variable
manufacturing and marketing costs
c. Appropriate if:
i. Demand for the manufactured product is not steady enough to
warrant the permanent assignment of facilities
d. This method makes the marketing unit’s interest congruent with the
company’s
e. Challenges:
i. Division of contribution between profit centers
ii. Arbitrarily dividing contribution isn’t a valid basis for info on each
BU’s profitability
iii. Manufacturing unit’s contribution depends on the marketing
unit’s ability to sell as well as the actual selling price

20 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 4. Two sets of Prices
a. Manufacturing unit’s revenue is credited at the outside sales price and
the buying unit is charged the total standard costs
i. Difference is charged to HQ account and eliminated when the BU
statements are consolidated
b. Used when there are frequent conflicts between the buying and selling
units that cannot be resolved by one of the other methods
c. Disadvantages
i. Sum of BU profits is greater than company profits
ii. Creates an illusive feeling that BUs are making money
iii. Motivates BUs to concentrate more on internal transfers where
they are assured of a good markup at the expense of outside
sales
iv. There is additional bookkeeping involved in first debiting the HQ
account every time a transfer is made every time a transfer is
made and then eliminating this account when BU statements are
consolidated
v. Weakness if less conflicts: No alerts. Conflicts signal problems in
either the org structure or other management systems
i. Administration of Transfer Prices
i. Negotiation
1. Result of compromises made by both buyer and seller
2. BUs negotiate because they usually have the best information on markets and
costs to arrive at reasonable prices
ii. Arbitration and Conflict Resolution
1. Senior Executive to decide
2. Committee (high level HQ execs)
a. Settling transfer price disputes
b. Reviews sourcing changes
c. Changing the transfer price rules when appropriate
iii. Product Classification
1. Management can concentrate on the sourcing and pricing of a relatively small
number of high-volume products
VII. Measuring and Controlling Assets Employed
a. HQ evaluation of investment centers is based on:
i. What practices will induce BU managers to use their assets most efficiently and to acquire
the proper amount and kind of assets?
ii. What practices best measure the performance of the unit as an economic entity?
b. Return on investment (ROI)
i. The numerator is income as reported in the income statement.
ii. The denominator is assets employed.
iii. Assets employed = noncurrent liabilities + stockholders’ equity
iv. Assets employed = Total assets – current liabilities
v. Advantages
1. Comprehensive measure because it includes everything that affects the financial
statements.
2. Simple to calculate and easy to understand.

21 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 3. A common denominator that can be applied to any organizational unit
responsible for profits regardless of size and nature of business.
vi. Disadvantages
1. Creates a bias toward little or no expansion in high-profit businesses.
2. Decisions that increase ROI may decrease over-all profits.
a. Example - A business generating 25% ROI may be disposed to keep the
company’s ROI at 30%.
vii. May encourage short-term perspective.
c. Economic Value Added (EVA)
i. EVA is a peso amount, not a ratio.
ii. EVA = net operating profit – capital charge
iii. Advantages
1. All business units have the same profit objective for comparable investments.
2. All investments which are expected to generate profits over and above the cost of
capital can be considered.
3. Different rates may be used for different types of assets. Rate on PPE may be
different for working capital accounts.
4. May have positive correlation with company’s market value.
iv. Disadvantages
1. Income and asset base can be manipulated.
2. May also develop short-term perspective to managers.
d. Measuring Assets Employed
i. Two questions to be asked.
1. What practices will induce business unit managers to use their assets most
efficiently and to acquire the proper amount and kind of new assets?
2. What practices best measure the performance of the unit as an economic entity?
e. Cash
i. Actual cash may not be used for determining the investment base in a business unit.
ii. Some companies use a % of sales to estimate cash that will be used for determining the
investment base.
iii. Some companies omit cash in determining the investment base.
f. Receivable
i. What is the basis of receivables?
ii. At cost or at selling price?
iii. Ending balance or average?
iv. Ending balance less ADA?
g. Inventories
i. What inventory balance should be used?
ii. Ending balance or average balance?
iii. Ending balance less accounts payable?
iv. Possible impact on credit rating
h. Working Capital
i. What is the basis of working capital?
1. Current assets?
2. Current assets – current liabilities?
i. Property, Plant and Equipment
i. Gross value
ii. Book value
iii. Replacement cost

22 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 j. Leased Assets
i. Rent expense vs depreciation expense
ii. Capital charge if the equipment or asset is bought
iii. Compare capital charge for buying and leasing equipment
k. Idle Assets
i. Can they be used by other units?
ii. If cannot be used by other units, how should they be treated?
l. Intangible Assets – R&D
i. Expense?
ii. Capitalize?
m. The Capital Charge for Business Unit
i. Set by corporate headquarters.
ii. Should be higher than the corporation’s rate on debt financing.
iii. Some companies may use a different rate for long-term assets and working capital
accounts because working capital may be partially financed by suppliers which normally
do not charge any interest.
n. Illustrative Example
i. A business unit buys a machine for PHP100,000.
ii. The machine is expected to provide cost savings of PHP27,000/year for the next 5 years.
iii. Annual depreciation using straight-line method: PHP20,000
iv. Company’s required rate of return: 10%
o. EVA vs ROI
i. ROI > EVA
1. ROI is a comprehensive measure in that anything that affects financial statements
is reflected in this ratio
2. ROI is simple to calculate, easy to understand, and meaningful in an absolute
scale (25% is considered high)
3. ROI is a common denominator that can be applied to any organizational unit
responsible for profitability
ii. EVA > ROI
1. EVA of all BUs have the same profit objective for comparable investments (ROI
provides different incentives)
2. Decisions that increase a center’s ROI may decrease its overall profits
a. EVA measurement: investment that produce a profit in excess of the cost
of capital will increase EVA and therefore be economically attractive to
the manager
3. Different interest rates may be used for different types of assets
a. Different rates may be used for different types of fixed assets to take into
account different degrees of risk
4. In contrast to ROI, EVA has a stronger correlation with changes in a company’s
market value
a. Reduces risk of takeover
b. Creates currency for aggressiveness in mergers and acquisitions
c. Reduces cost of capital  allows faster investment for future growth
i. The best proxy for shareholder value at the BU level is to ask
business unit managers to create and grow EVA
ii. EVA motivates managers to increase EVA by taking actions
consistent with increasing stockholder value

23 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 VIII. Variance Analysis

a. Key ideas based on the framework:

i. Identify the key causal factors that affect profits
ii. Break down the overall profit variances by these key causal factors
iii. Focus on the profit impact of variation in each causal factor
iv. Try to calculate the specific, separable impact of each causal factor by varying only that
factor while holding all other factors constant (“spinning only one dial at a time”)
v. Add complexity sequentially, one layer at a time, beginning at a very basic
“commonsense” level (“peel the onion”)
vi. Stop the process when the added complexity at a newly created level is not justified by
added useful insights into the causal factors underlying the overall profit variance
b. Sales
i. Volume
1. Market share
2. Industry volume
ii. Selling Price
c. Manufacturing costs
i. Variable costs

24 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 1. Material
2. Direct labor
3. Overhead
ii. Fixed Costs
d. Non-Manufacturing Costs Variances
i. Administrative
ii. Marketing
iii. R&D
e. Selling Price Variance
i. Price Variance = (Actual Price – Standard Price) x Actual Volume
f. Sales Volume Variance
i. (Actual Sales – Budgeted Sales) x Budgeted Price
g. Mix and Volume Variance (MV Variance): Based on Contribution Margin
i. MV Variance = (Actual Volume – Budgeted Volume) x Budgeted Unit Contribution
h. Mix Variance (Based on Contribution Margin)
i. Mix Variance = (Actual sales volume – Total sales vol. x Budgeted proportion) x Budgeted
unit contribution
i. Volume Variance (Based on Contribution Margin)
i. Volume Variance = ((Total actual sales volume x Budgeted %) – Budgeted sales)) x
Budgeted unit contribution
j. Market Share Variance (Based on Contribution Margin)
i. Market Share Variance = (Actual sales – (industry volume x budgeted market penetration))
x budgeted unit contribution
k. Industry Volume Variance (Based on Contribution Margin)
i. Industry Vol. Var. = (actual industry volume – budgeted industry volume) x Budgeted
market penetration x budgeted unit contribution
l. Expense Variances
i. Fixed costs
ii. Variable costs
m. Limitations of Variance Analysis
i. While it identifies where a variance occurs, it does not tell why the variance occurred or
what is being done about it.
ii. When is variance considered significant?
iii. As performance reports become more highly aggregated, offsetting variances might
mislead the reader.
IX. Performance Measurement
a. A mechanism that improves the likelihood the organization will implement its strategy
successfully

25 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 b. Financial Measures
i. Traditional Accounting Measures
ii. Economic Value Measures
iii. Stock Price
iv. Operating Budgets
v. Limitations of Financial Measures
c. Traditional Accounting Measures

d. Economic Value Measures

i. EVA = (Net Operating Profit After Tax) – (Invested Capital x Weighted Average Cost of
Capital)
e. Operating Budgets
i. Revenue or sales Budget
ii. Production Budget
iii. Cost of sales Budget
iv. Marketing Expense Budget
v. General and Administrative Budget
vi. Budget Profit
f. Limitations of Financial Measures
i. They open doors for window-dressing and financial report manipulation.
ii. They induce managers to make myopic and short-term decisions which can have adverse
long-term effects on the company.
iii. There is attribution problem.
g. Non-Financial Measures
i. Total Quality Management (TQM)
ii. Balanced Scorecard Measurement Systems
h. TQM

26 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 i. TQM is a management philosophy that seeks to integrate the different functional areas in
the organization to improve quality, productivity, customer satisfaction and profitability.
ii. It has to be embraced by everyone in the organization from top management to lower
ranks.
i. Origins of TQM
i. 1930s – Walter Shewhart developed the methods for statistical analysis and control of
quality.
ii. 1950s -Dr. W. Edwards Deming introduced Statistical Quality Control (SQC) to Japanese
engineers and executives.
iii. Joseph M. Juran taught the concepts of controlling quality and managerial breakthrough.
iv. Other Popular Names in TQM
v. Armand V. Feigenbaum whose book Total Quality Control, a forerunner for the present
understanding of TQM, was published.
vi. Philip B. Crosby whose promotion of zero defects paved the way for quality improvement
in many companies.
vii. Kaoru Ishikawa whose synthesis of the TQM philosophy contributed to Japan’s
ascendancy as a quality leader.
j. Eight Principles of TQM
i. Customer-focused
ii. Total employee involvement
iii. Process-centered
iv. Integrated system
v. Strategic and systematic approach
vi. Continual improvement
vii. Fact-based decision making
viii. Communications
k. TQM Performance Measurement by TQM Adopters

Performance Measures Selected Methods of Measurement Used (Top 5)

Number of accidents, employee satisfaction, morale, turnover,

1. Employee Relations
number of lost work days.
Conformance with quality, defect rate, inventory turnover, work-
2. Production
in-process inventory, set-up time cycle time.
Capacity Utilization Rate, Overtime Hours, Rework Hours, Quota
3. Production
on Monthly Shipments.
Return on Investment, Return on Sales, Volume of Business,
4. Finance
Gross Revenue, Gross Profits before tax.
Future market share, relative market share to largest
5. Market competitors, absolute market share, % of sales from new
products.
 Overall customer satisfaction
 Number of complaints
6. Customer
 % of on-time delivery
 Average time of complaint resolution

27 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
  Market research/customer survey
 Inspections
7. Quality of Products/Services  Quality Reports
 External Quality Audits
 ISO 9000 Certification
 Supplier certification
 Suppliers audit/appraisals
8. Quality of Suppliers’
 Random sampling
Products/Services
 IS0 certification
 International sampling plans

l. Balanced Scorecard (BSC)

i. BSC is a set of financial and non-financial measures from four perspectives that are critical
to the success of the company. These are:
1. Financial (e.g. profit margins, ROA, cash flow)
2. Customer (e.g. market share, customer satisfaction index)
3. Internal business process (e.g. employee retention, cycle time reduction)
4. Innovation, Learning and growth (e.g. percentage of sales from new production)
ii. History of BSC
1. BSC was developed by Dr. Robert Kaplan, a professor from Harvard University, and
Dr. David Norton, a lifelong consultant.
2. The two started working together through a project sponsored by KPMG to
examine why organizations struggled with reporting on just reporting financial
measures. In the 1990s, most of the parameters used to measure performance
lagging indicators, instead of leading indicators.
3. Together, the two published five books and 13 articles on this subject, and many
more separately.
m. Balanced Scorecard Performance Measures

i. Financial Perspective
1. Operating profit margin
2. Net profit margin
3. Operating cash flows
4. EPS
5. ROE

28 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER
 6. ROA
7. EVA
8. Stock price
n. Customer Perspective
i. Market share
ii. Customer loyalty
iii. Level of returns
iv. Feedback from customers, e.g surveys
o. Internal Business Perspective
i. Processing time
ii. Production cost
p. Innovation and Learning Perspective
i. Training of employees
ii. Retention of employees
iii. Number of new products launched
iv. Flow of new business ideas
q. Implementation
i. Define strategy
ii. Define measures of strategy
iii. Integrate measures into the management system
iv. Review measures and results frequently
r. Limitations
i. May end up having too many key performance indicators (KPIs)
ii. Can be expensive
iii. May focus too much on the non-financial measures

29 BA 221: MANAGEMENT CONTROL SYSTEMS

FINALS REVIEWER